This paper investigates the potential benefits of international diversification with short selling constraints from the perspective of Chinese investors. Based on a stream of time-rolling realized portfolios, we show that Chinese investors can gain substantially from international investments. In particular, the expected portfolio returns as well as the risk-adjusted returns can be greatly enhanced by diversifying over emerging markets, and the portfolio risk can be largely reduced by investing in developed markets in comparison with purely domestic investments. The results are robust when the out-of-sample tests are employed and when investors start with a more mean-variance efficient domestic portfolio. In addition, our analysis illustrates that optimal portfolio weights vary significantly over time due to fluctuations in the correlations among international markets, suggesting that international portfolios need to be rebalanced frequently in order to generate the greatest possible diversification benefits.

There is growing evidence that economic crises are transmitted across economies and equity markets. This motivates two questions. First, can the direction and magnitude of a country's stock market reaction during an extreme case ("contagion") be explained by economic fundamentals? Second, are there benefits of international diversification during times of widespread contagion among equity markets? We examine the reaction of major world equity markets to the 1997 Asian Crisis. In particular, we investigate the interrelationships among world equity markets, the factors explaining the different directions and magnitudes of countries' reactions to this crisis and the effectiveness of the global diversification of investment portfolios during financial crises. Our analyses provide evidence that is consistent with the correlations among world equity markets increasing dramatically during the period of the Asian Crisis. However, this effect is concentrated on a short period around the crisis. The benefits of international diversification may be obtainable, even when the period contains a worldwide financial crisis. We show that the productivity and interest rate macroeconomic variables, worldwide beta and the existence of derivatives trading are important in explaining the stock market returns during the Asian Crisis. The effect of the worldwide beta variable is particularly strong. Finally, the trade variables are insignificant, their influences being subsumed by interest rate and inflation macroeconomic variables. On balance, we interpret our results as supporting a rational view of the spread of an economic crisis to other markets.