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You are on page 1of 24

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

1

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)

2

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.

3

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

4

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.

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.

investors, bidding up the price of that security,

resulting in a lower cost of capital for the issuing firm.

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 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.

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.

9

Optimal domestic

portfolio (DP)

E(Rp)

Capital Market

Line (Domestic)

DP

R DP

MRD

domestic portfolio

Rf

Domestic portfolio

opportunity set

DP

Expected Risk

10

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.

11

combines the same risk-free asset as before with a

portfolio from the efficient frontier of the

internationally diversified portfolio opportunity set.

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.

12

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

13

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.

14

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

(100% US)

13

12

P

0

11

12

13

14

15

16

17

18

19

20

15

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).

16

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

17

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

18

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%?

19

rp

= a rUS + ( 1 - a) rrw

= 0.65(0.05) + 0.35(0.10)

= 6.75%

where

US2

rw2

= U.S. returns variance

= World returns variance

20

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

+2(.65)(.35)(.08)(.06)(.7)] 1/2

= 6.8%

21

PORTFOLIO

To compute dollar return of a foreign security:

B(1) B(0) C

1 R$ 1

(1 g )

B(0)

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

22

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

23

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%

24

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