Portfolio allocation under sovereign risk Evidence from Brazil
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Abstract
This paper examines a portfolio allocation strategy in which investment decisions depend on whether sovereign risk is high or low. We gauge sovereign risk by means of the spread on the 5-year credit default swap (CDS). The central premise is that the CDS spread provides a timely, market-based proxy for institutional risk, enabling portfolio weights to adjust dynamically across low- and high-risk environments. We show that the mean-variance portfolio conditional on the CDS spread regime entails a better risk-adjusted performance in the Brazilian market than the unconditional mean-variance portfolio and equal-weighted portfolio. This is particularly true for periods of high sovereign risk.
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References
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