May 9, 2011
If US Treasury bonds are not risk-free due to inflation risk, does it make sense to diversify a portfolio of government bonds with obligations of other countries?

EFF/KRF: Inflation does not have much volatility over short-term periods, for example, two years or less, so for short-term bonds there is little benefit from international diversification to lower inflation risks. For intermediate and long-term portfolios, international diversification to lower inflation risk makes sense if the portfolio is hedged against short-term changes in exchange rates. The hedge is helpful because purchasing power parity does not hold; that is, exchange rates vary more than can be explained by changes in the price levels in countries. With purchasing power parity, hedging the exchange rate would be unnecessary.

Eugene F. Fama
The Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Booth School of Business
Kenneth R. French
The Roth Family Distinguished Professor of Finance at the Tuck School of Business at Dartmouth College
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Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to Dimensional Fund Advisors LP.