The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
We estimate a latent factor model that decomposes international stock returns into global, country-, and industry-specific shocks and allows for stock-specific exposures to these shocks. We find that across stocks there is substantial dispersion in these exposures, which is partly explained by the extent to which firms operate across countries. We show that portfolios consisting of stocks with low exposures to country shocks achieve substantial variance reduction relative to the global market, both in- and out-of-sample. The shock exposures are thus a stock-selection device for international portfolio diversification.