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Topic 8: International Portfolio

Investment (Shapiro, Chapter 15)


What are the advantages of international
investment?
A. Advantages
1. Offers more opportunities than a purely
domestic portfolio
2. Attractive investments overseas
3. Impact on efficient portfolio with
diversification benefits
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The case for international diversification of


portfolios can be decomposed into two
components, the first of which is the potential
risk reduction benefits of holding international
securities.
The risk of a portfolio (P ) is measured by the
ratio of the covariance of a portfolios return
relative to the variance of the market return
(portfolio beta).

P = (CovPM /VarM)
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As investor increases the number of securities in a


portfolio, the portfolios unsystematic risk declines
rapidly at first, then asymptotically approaches the
level of systematic risk of the market. A domestic
portfolio that is fully diversified would have a beta of
1, equal to that of market portfolio.
The total risk of any portfolio is therefore composed of
systematic risk (the market) and unsystematic risk
(the individual securities).
By diversifying the portfolio, the variance of the
portfolios return relative to the variance of the
markets return (beta) is reduced to the level of
systematic risk - the risk of the market itself.
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Portfolio Risk Reduction Through Diversification


Percent risk =Variance of portfolio return
Variance of market return
100

Total Risk

80

Diversifiable Risk
(unsystematic)

Market Risk
(systematic)

60

Portfolio of
U.S. stocks

40

27%

Total
risk

20

Systematic
risk
10

20

30

40

50

Number of stocks in portfolio


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The second component of the case for international


diversification addresses foreign exchange risk.
The foreign exchange risks of a portfolio, whether it be
a securities portfolio or the general portfolio of
activities of the MNEs, are reduced through
international diversification.
Purchasing assets in foreign markets, in foreign
currencies may alter the correlations associated with
securities in different countries (and currencies).
This provides portfolio composition and diversification
possibilities that domestic investment and portfolio
construction may not provide.

International diversification benefits induce investors to


demand foreign securities (the so called buy-side).
If the addition of a foreign security to the portfolio of
the investor aids in the reduction of risk for a given
level of return, or if it increases the expected return
for a given level of risk, then the security adds value
to the portfolio.

A security that adds value will be demanded by


investors, bidding up the price of that security,
resulting in a lower cost of capital for the issuing firm.

Classic portfolio theory assumes a typical investor is


risk-averse. This means an investor is willing to
accept some risk but is not willing to bear
unnecessary risk.
The typical investor is therefore in search of a portfolio
that maximizes expected portfolio return per unit of
expected portfolio risk.
The domestic investor may choose among a set of
individual securities in the domestic market.
The near-infinite set of portfolio combinations of
domestic securities form the domestic portfolio
opportunity set (see graphs in class).

The set of portfolios along the extreme left edge of


the set is termed the efficient frontier.
This efficient frontier represents the optimal portfolios
of securities that possess the minimum expected
risk for each level of expected portfolio return.
The portfolio with the minimum risk along all those
possible is the minimum risk domestic portfolio
(MRDP).
The broader the diversification, the more stable the
returns and the more diffuse the risk.

The investor will search out the optimal domestic


portfolio (DP), which combines the risk-free asset
and a portfolio of domestic securities found on the
efficient frontier.
He or she begins with the risk-free asset (Rf) and
moves out along the security market line until
reaching portfolio DP. This portfolio is defined as the
optimal domestic portfolio because it moves out into
risky space at the steepest slope.
An investor may choose a portfolio of assets enclosed
by the Domestic portfolio opportunity set. The
optimal domestic portfolio is found at DP, where the
Security Market Line is tangent to the domestic
portfolio opportunity set. The domestic portfolio with
the minimum risk is designated MRDP.
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Optimal Domestic Portfolio Construction


Optimal domestic
portfolio (DP)

E(Rp)

Capital Market
Line (Domestic)

DP

R DP

MRD

Minimum risk (MRDP )


domestic portfolio

Rf

Domestic portfolio
opportunity set

DP

Expected Risk

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The next exhibit illustrates the impact of allowing the


investor to choose among an internationally
diversified set of potential portfolios.
The internationally diversified portfolio opportunity set
shifts leftward of the purely domestic opportunity set.
It is critical to be clear as to exactly why the
internationally diversified portfolio opportunity set is
of lower expected risk than comparable domestic
portfolios.
The gains arise directly from the introduction of
additional securities and/or portfolios that are of less
than perfect correlation with the securities and
portfolios within the domestic opportunity set.
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The investor can now choose an optimal portfolio that


combines the same risk-free asset as before with a
portfolio from the efficient frontier of the
internationally diversified portfolio opportunity set.

The optimal international portfolio (IP) is again found


by locating that point on the capital market line
(internationally diversified) which extends from the
risk-free asset return of Rf to a point of tangency
along the internationally diversified efficient frontier.
The benefits are obvious in that a higher expected
portfolio return with a lower portfolio risk can be
obtained when compared to the domestic portfolio
alone.
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The Gains from International Portfolio Diversification


E(Rp)
Increased
R
return of IP
optimal R DP
portfolio

Optimal
international
portfolio

IP

Capital Market
Line (International)

Capital Market
Line (Domestic)

DP

Internationally diversified
portfolio opportunity set
Rf

Domestic portfolio
opportunity set

IP

DP

Risk reduction of
optimal portfolio

Expected
Risk, P
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An investor can reduce investment risk by holding


risky assets in a portfolio.
As long as the asset returns are not perfectly
positively correlated, the investor can reduce risk,
because some of the fluctuations of the asset
returns will offset each other.
The true benefits of global diversification, however,
arise from the fact that the returns of different stock
markets around the world are not perfectly
positively correlated.
This is because the are different industrial structures
in different countries, and because different
economies do not exactly follow the same business
cycle.
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Alternative Portfolio Profiles Under Varying Asset


Weights
Expected Portfolio
Return (%)

18

17

Minimum risk
combination
(70% US &
30% GER)

16

15

Maximum
return &
Initial portfolio
(40% US & 60% GER) maximum risk
(100% GER)

14

Domestic only portfolio


(100% US)

13

12

P
0

11

12

13

14

15

16

17

18

19

20
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Interestingly, markets that are contiguous or nearcontiguous (geographically) seemingly demonstrate


the higher correlation coefficients for the past
century.
It is often said that as capital markets around the
world become more and more integrated over time,
the benefits of diversification will be reduced.
Analysis of market data supports this idea (although
the correlation coefficients between markets are
still far from 1).

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Barriers to International Diversification


1.
2.
3.
4.
5.
6.

Segmented markets
Lack of liquidity
Exchange rate controls
Underdeveloped capital markets
Exchange rate risk
Lack of information
a) not readily accessible
b) data is not comparable

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Other Methods to Diversify


Diversify by a
1) Trade in American Depository Receipts
(ADRs)
2) Trade in American shares
3) Trade internationally diversified mutual
funds:
a) Global (all types)
b) International (no home country
securities)
c) Single-country
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INTERNATIONAL PORTFOLIO INVESTMENT


Calculation of Expected Portfolio Return:
rp = arUS + ( 1 - a)rrw
where rp
= portfolio expected return
rUS = expected U.S. market return
rrw = expected global return (rest of
the world)
Portfolio Return: Sample Problem
What is the expected return of a portfolio with
35% invested in Japan returning 10% and 65% in
the U.S. returning 5%?
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rp

= a rUS + ( 1 - a) rrw
= 0.65(0.05) + 0.35(0.10)
= 6.75%

Calculation of Expected Portfolio Risk

where

US2
rw2

= the cross-market correlation


= U.S. returns variance
= World returns variance
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Portfolio Risk
What is the risk of a portfolio with 35% invested in
Japan with a standard deviation of 6% and a
standard deviation of 8% in the U.S. and a
correlation coefficient of 0.7?
1/ 2

P a (1 a) 2a(1 a) US rw
2

2
US

2
rw

= [(.65)2 (.08) 2 + (.35) 2(.06) 2


+2(.65)(.35)(.08)(.06)(.7)] 1/2
= 6.8%
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MEASURING TOTAL RETURNS FROM FOREIGN


PORTFOLIO
To compute dollar return of a foreign security:

(a) Bond return formula:

B(1) B(0) C
1 R$ 1
(1 g )

B(0)

Where R$ = dollar return


B(0) = foreign currency bond price at time 0
B(1) = foreign currency bond price at time 1
C = coupon income during period
g = currency depreciation/appreciation
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(b) Stocks return formula:

P(1) P(0) D
1 R$ 1
(1 g )

P(0)

P(1) P(0) D
1 R$ 1
(1 g )
P
(0)

where

R$ = dollar return
P(0) = foreign currency stock
price at time 0
P(1) = foreign currency stock
price at time 1
D
= foreign currency annual
dividend
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U.S. $ Stock Returns: Sample Problem


Suppose the beginning stock price is EUR50 and
the ending price is EUR48. Dividend income was
EUR1. The euro depreciates from EUR20/$ to
EUR21.05/$ during the year against the dollar.
What is the stocks US$ return for the year?
P(1) P(0) D
1 R$ 1
(1 g )

P(0)

48 50 1 .20 .2105
1
1
1

50
.2105

R$ 6.9%
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