Structural versus Temporary Drivers of Country and Industry Risk

This paper analyzes the dynamics and determinants of the relative benefits of geographical and industry diversification over the last 30 years. First, we develop a new structural regime-switching volatility spillover model to decompose total risk into a systematic and a country (industry) specific component. Contrary to most other studies, we explicitly allow market betas and asset-specific risks to vary with both structural and temporary changes in the economic and financial environment. In a second step, we investigate the relative benefits of geographical and industry diversification by comparing average asset- specific volatilities and model-implied correlations across countries and industries. We find a large positive (negative) effect of the structural factors on country betas (country-specific volatility), especially in Europe, while industry betas are mainly determined by temporary factors. Not taking into account the time variation in betas leads to biases in measures of industry and country-specific risk of up to 33 percent. After correcting for this bias, we find that under the influence of globalization and regionial integration, the traditional dominance geographical over industry diversification has been eroded, and that over the last years geographical and industry diversification roughly yield the same diversification benefits. Finally, our results indicate that the surge in industry risk at the end of the 1990s was partly (but not fully) related to the TMT bubble.