Correlations between international equity market returns tend to increase in highly volatile bear markets, which has led some to doubt the benefits of international diversification. This article solves the dynamic portfolio choice problem of a U.S. investor faced with a time-varying investment opportunity set modeled using a regime-switching process which may be characterized by correlations and volatilities that increase in bad times. International diversification is still valuable with regime changes and currency hedging imparts further benefit. The costs of ignoring the regimes are small for all-equity portfolios but increase when a conditionally risk-free asset can be held.

Correlations between U.S. stocks and the aggregate U.S. market are much greater for downside moves, especially for extreme downside moves, than for upside moves. We develop a new statistic for measuring, comparing, and testing asymmetries in conditional correlations. Conditional on the downside, correlations in the data differ from the conditional correlations implied by a normal distribution by 11.6%. We find that conditional asymmetric correlations are fundamentally different from other measures of asymmetries, such as skewness and co-skewness. We find that small stocks, value stocks, and past loser stocks have more asymmetric movements. Controlling for size, we find that stocks with lower betas exhibit greater correlation asymmetries, and we find no relationship between leverage and correlation asymmetries. Correlation asymmetries in the data reject the null hypothesis of multivariate normal distributions at daily, weekly, and monthly frequencies. However, several empirical models with greater flexibility, particularly regime-switching models, perform better at capturing correlation asymmetries.

Correlations between international equity market returns tend to increase in highly volatile bear markets, which has led some to doubt the benefits of international diversification. This article solves the dynamic portfolio choice problem of a U.S. investor faced with a time-varying investment opportunity set modeled using a regime-switching process which may be characterized by correlations and volatilities that increase in bad times. International diversification is still valuable with regime changes and currency hedging imparts further benefit. The costs of ignoring the regimes are small for all-equity portfolios but increase when a conditionally risk-free asset can be held.