What Are the Sources of Country and Industry Diversification?

Abstract

In this paper, we develop a new framework in which one can analyze industry and country effects by examining their underlying return components. We find that the global cash flow factor explains on average 48% of the variation of industry cash flows and the global discount rates explain 43% of the variation of industry discount rates. These are more than double the explanatory power of the two factors over country cash flow and discount rate variations, which are 23% and 13% respectively. This suggests that global factors are much less important for return components at country level than at industry level. The larger benefits of diversification across countries than across industries are thus driven more by better diversification of expected returns, although better diversification of cash flows also drives the result. Moreover, emerging markets tend to have much smaller co-movements of both dividends and equity risk premiums with those of the world, suggesting a lower degree of integration with the world goods and financial markets. This appears to be the basis for emerging market diversification.