• Market

capitalization and GDP – contemporary view of economic development states that a major
requirement for economic advancement is a developed code of business laws, institutions, and
Lecture 9: International Diversification regulation that allows citizens to legally own, capitalize, and trade capital assets. Thus, we expect
that development on equity markets will serve as catalysts for enrichment of the population, that is,
counties with larger relative capitalization of equities will tend to be richer.
• Home-country bias – whilst we would expect most investors to be aware of the opportunities
Lecture Notes offered by international investing, in practice, investor portfolios notoriously overweight home-
• Measuring relationship between stock market CAPM and economic growth (GDP): country stocks compared to a neutral indexing strategy and underweight, or even ignore, foreign
!"# %&' ()%*+) = - + /(1)'2&+ 3)%*+)4*5)+*67 )5 ) %&'3&7+ 68 !"#) + : equities. Despite a continuous increase in cross-border investing, home-country bias still dominates
• Country-specific reasons might explain why countries are above/below the per capita GDP/Market investor portfolios.
capitalization as a percent of GDP line. Country risk can be ranked on the basis of a risk score. When
an investor is choosing among investment opportunities in foreign countries, the investor can use 25.2 Risk Factors in International Investing
country risk score to:
• Exchange rate risk – the risk borne by investments in foreign safe assets. The magnitude of
§ Compare the countries
exchange rate risk is assessed by examining historical rates of change in various exchange rates and
§ Investigate changes in the risk score of a country over time
their correlations.
§ Investigate future forecasts of risk scores for a country under worst- and best-case scenarios
In the context of international portfolios, exchange rate risk may be partly diversifiable. This is
• Home country bias leads to investors overweighing home-country stocks compared to a neutral evident from the relatively low correlation coefficients between pairs of currencies. Thus, passive
indexing strategy for portfolios. investors with well-diversified international portfolios may not need to hedge 100% of their
• Exchange rate risk represents a risky investment in the performance of one currency relative to exposure to foreign currencies.
another. The currency market also provides a source of great profit for investors with superior information or
• Units of currency, will always be number of units we need per ONE unit in the denominator. analytical ability on forecasting exchange rate movements.
• Investors can hedge currency risk via forward or futures contracts. Hedging exchange rate risk – A dollar-denominated return on a foreign investment when unhedged
• A British investor can lock in a riskless return in two different ways: is: 1 + ' JK = 1 + ' 86'&*L7 @A /@B
1. Invest in riskless UK government securities: (1 + <=> ) Futures or forward markets are used to eliminate the risk of holding another asset. For example, a
2. Invest in riskless US government securities and hedge the currency risk: (1 + US investor can lock in a riskless dollar-denominated return either by investing in United Kingdom
<=? )(@A @B ) where @A and @B are the forward and the current exchange rates respectively. bills and hedging exchange rate risk or by investing in riskless US assets. Because investments in two
@A and @B are quoted as $/£. riskless strategies must provide equal returns, [1 + 'O JP ]RB /@B = 1 + 'O JK , which can be
• The forward rate is priced according to the interest rate parity to: rearranged to the interest rate parity relationship/covered interest arbitrage relationship:
?C AEFGH
= , this is “covered”, future prices and exchange rates are known. It is uncovered when RB 1 + 'O (JK)
?D AEFGI =
future prices and exchange rates are unknown. @B 1 + 'O (JP)
Where ' 86'&*L7 is the possibly risky return earned in the currency of the foreign investment. You
25.1 Global Markets for Equities can set up a perfect hedge only if ' 86'&*L7 is itself a known number. In that case, you must sell in
the forward or futures market an amount of foreign currency equal to [1 + ' 86'&*L7 ] for each
• Developed countries – market capitalization as a
unit of that currency you purchase today.
percentage of GDP is quite variable, suggesting

widespread differences in economic structure across
• Country-specific risk – to achieve the same quality of information about assets in a foreign country
developed countries.
is by nature much more difficult and hence more expensive. Plus, the risk of coming by false or
• Emerging markets – market capitalization as a
misleading information is greater. Country-specific risk depends on the transparency of the
percent of GDP, suggests emerging markets are
investment environment, for example it is easier to analyse the US investment environment than
expected to show significant growth over the coming
that of Indonesia.
years. The growth of capitalization in emerging
In the past, country-specific risk has been known as political risk. As cross-border investment has
markets between 2000 and 2005 was substantial
increased and more resources have been utilised, the quality of related analysis has improved. The
(197%) and much more volatile than growth in This is now 13%
Political Risk Services Group Inc. have two methodologies; Political risk services and International
developed countries, suggesting that both risk and
country risk guide. The latter involves conducting a risk analysis in order to get a composite risk
rewards in this segment of the globe may be
rating from most to least risky, 0-100. Countries are then ranked and divided into risk categories.
substantial.

1 MCQs: 2
 Confirming Pages

The composite risk ranking is a weighted average of three measures: political risk 100-0, financial to a US investor. Since returns may be volatile, managers of international portfolios commonly
CHAPTER 25 International Diversification 885
risk 50-0 and economic risk 50-0. These three measures are added and divided by two. hedge a significant fraction of their foreign investments.

Political Risk Variables Financial Risk Variables Economic Risk Variables • Benefits from international diversification – conventional wisdom is that international
Sample Period (monthly excess return in $U.S.) TA B L E 25.11
diversification can reduce the standard deviation of a domestic portfolio. This improvement
2001–2005* 1996–2000* 1991–1995* 1970–1989** Correlation of U.S. equity
returns with country
Government Military in politics Foreign debt (% of GDP) GDP per capita however may be exaggerated, as data in recent years suggest correlation across markets has
World .95 .92 .64 .86 equity returns
Sweden .89 .60 .42 .38
stability Religious tensions Foreign debt service (% of Real annual GDP growth increased. Germany .85 .66 .33 .33
France .83 .63 .43 .42
Socioeconomic Law and order GDP) Annual inflation rate • Misleading representation of diversification benefits – the benefit from efficient diversification is
United Kingdom .82 .77 .56 .49
Netherlands .82 .63 .50 .56
conditions Ethnic tensions Current account (% of Budget balance (% of reflected in the curvature of the efficient frontier. Other things equal, the lower the covariance
Australia .81 .64 .36 .47
Canada .80 .79 .49 .72
Investment profile Democratic exports) GDP) across stocks, the greater the curvature of the efficient frontier and the greater the risk reduction
Spain .78 .59 .51 .25
Hong Kong .75 .63 .33 .29
Internal conflicts accountability Net liquidity in months of Current account balance for any desired expected return. However, using realized returns can be a highly misleading
Italy .75 .44 .12 .22
Switzerland .73 .56 .43 .49
External conflicts Bureaucracy quality imports (% of GDP) estimate of expected future returns since it is unlikely an investor could accurately predict averages
Denmark .74 .56 .36 .33
Norway .70 .58 .50 .44
Corruption Exchange rate stability of realized returns and covariances. Thus, this only has value as means for performance evaluation.
Belgium .56 .49 .54 .41
Japan .43 .54 .23 .27

Country risk is captured in greater depth by scenario analysis for the composite measure and each of Due to volatility, some stocks are bound to realize large, unexpected average return, reflect in
Austria .40 .53 .19 .12

its components, with worst case and base case scenarios for the composite rating and for the efficient frontiers of enormous apparent potential, suggesting exaggerated diversification benefits.
*Source: Datastream.
**Source: Campbell R. Harvey, “The World Price of Covariance Risk,” Journal of Finance, March 1991.

political risk measure. Risk stability is based on the difference in the best-case and worst-case It has no meaning as a tool to discuss the potential for future investments for real-life investors.
ratings. • Realistic benefits from international diversification – realized
allocation line, the set of efficient complete
portfolios, as elaborated in Chapter 7. The 100

returns are more useful for measuring prospective risk. First,
benefit from this efficient diversification
is reflected in the curvature of the efficient
25.3 International Investing: Risk, Return and Benefits from Diversification market efficiency implies that stock prices will be difficult to
frontier. Other things equal, the lower the 80
covariance across stocks, the greater the cur-
Investors can invest internationally by: predict with any accuracy, but no such implication applies to risk
vature of the efficient frontier and the greater

Percent Risk
60
measures. Second, errors in estimates of standard deviation and
the risk reduction for any desired expected
1. Purchasing securities directly in the capital markets of other countries return. So far, so good. But suppose we

2. Purchasing shares of foreign firms traded in home markets either directly or in the form correlation from realized data are of a lower order of magnitude
replace expected returns with realized aver-
age returns from a sample period to construct
40
U.S. Stocks
27
of American depository receipts (ADRs), whereby financial institutions purchase shares than estimates of expected return. Thus, using risk estimates from
an efficient frontier; what is the possible use
of this graph? 20
Global Stocks

of a foreign firm in that firm’s country, then issue claims to those shares in the home realized returns does not exaggerate as much the potential
The ex post efficient frontier (derived
realized returns) describes the portfolio of
from 11.7

country. Each ADR is then a claim on a given number of shares of stock held by the benefits from diversification. only one investor—the clairvoyant who actu- 1 10 20 30 40 50
ally predicted the precise averages of realized Number of Stocks

financial institute. Expected returns are best based on appropriate risk measures of
returns on all assets and estimated a covari-
ance matrix that materialized, precisely, in the
3. Invest indirectly in mutual funds with an international focus. the assets. The CAPM suggests using the beta of the stock against the world portfolio. To generate
actual realizations of the sample period returns F I G U R E 25.7 International diversification. Portfolio
standard deviation as a percent of the average standard
on all assets. Obviously, we are talking about
4. Invest in exchange-traded funds known as iShares or World Equity Benchmark Shares expected excess returns for all assets, we specify the expected excess return on the world portfolio.
a slim to empty set of investors. For all other,
deviation of a one-stock portfolio
Source: B. Solnik, “Why Not Diversify Internationally Rather Than
less-than-clairvoyant investors, such a frontier
that are country-specific index products. We obtain the expected excess return on each asset by multiplying the beta of the asset by the
may have value only for purposes of perfor-
Domestically.” Financial Analysts Journal, July/August 1974, pp. 48–54.
Copyright 1976, CFA Institute. Reproduced and republished from Financial
Analysts Journal with permission from the CFA Institute. All rights reserved.

5. Trade derivative securities based on prices in foreign security markets. world portfolio expected return. This means the world portfolio will lie on the efficient frontier, at
mance evaluation.

• Risk and return: summary statistics – we can use annualized average returns, standard deviations in the point of tangency with the world capital market line. The curvature of the efficient frontier will
home and foreign currency computed from monthly returns, as well as beta against the home not be affected by the estimate of the world portfolio excess return. A higher estimate will simply
country and correlation with home returns. Such statistics help in the development of insights into shift the curve upward. This shows realistic benefits from international diversification.
the risk and reward in international investing. • Benefits from international diversification during bear (pessimistic) markets – some studies
bod8237x_ch25_867-901.indd 885 4/30/08 12:06:35 AM

• Risk associated with investing in emerging markets – evidence clearly shows that investment in suggest that correlation in country portfolio returns increases during periods of turbulence in capital
emerging markets is largely riskier than in developed countries, at least as measured by total markets. If so, benefits from diversification would be lost exactly when they are needed most. This
volatility of returns. However, in terms of systematic risk as measured by beta against the US suggests a common factor underlying the movement of stocks around the world, meaning a
market, emerging markets are not necessarily riskier. macroeconomic shock would affect all countries and that diversification can only mitigate country-
• Average returns when investing in emerging markets – investment in emerging markets can specific events. Hence, this supports that the diversification benefits shown by the world CAPM
provide higher average returns than investing in developing countries. However, such data is subject model are realistic.
to considerable imprecision and standard deviation of emerging market equities is not an adequate
measure of risk. These returns also show evidence that is inconsistent with CAPM. In the context of
a diversified international portfolio, the risk of any single market is measured by its covariance with
the overall portfolio. The beta of many countries against the US is practically the same for dollar and
local currency returns – however, currency fluctuations in some countries would add significant risk

3 4