International Portfolio Investment

Chapter 15

Lecture Objectives

International Correlation Structure and Risk DiversificationOptimal International Portfolio SelectionEffects of Changes in the Exchange RateInternational Bond InvestmentInternational Mutual Funds: A Performance EvaluationInternational Diversification through Country FundsInternational Diversification with ADRsInternational Diversification with WEBSWhy Home Bias in Portfolio Holdings?

International Correlation Structure and Risk Diversification

Security returns are much less correlated across countries than within a country.This is so because economic, political,

institutional, and even psychological factors affecting security returns tend to vary across countries, resulting in low correlations among international securities.

Business cycles are often high asynchronous across countries.

International Correlation Structure

Source: MSCI 1980-2007

Stock Market AU CA FR GE HK IT JA UK US

Australia 0.62 0.40 0.37 0.46 0.28 0.34 0.55 0.48

Canada 0.49 0.45 0.47 0.39 0.35 0.58 0.73

France 0.73 0.32 0.53 0.41 0.61 0.54

Germany 0.36 0.48 0.32 0.55 0.52

Hong Kong 0.30 0.27 0.49 0.42

Italy 0.37 0.42 0.33

Japan 0.42 0.31

UK 0.61

US

Domestic vs. International Diversification

0.44

0.27

0.12Por

tfol

io R

isk

(%)

Number of Stocks1 10 20 30 40 50

Swiss stocks

U.S. stocks

International stocks

When fully diversified, an international portfolio can be less than half as risky as a purely U.S. portfolio.

Optimal International Portfolio Selection

The correlation of the U.S. stock market with the returns on the stock markets in other nations varies.

The correlation of the U.S. stock market with the Canadian stock market is 73%.

The correlation of the U.S. stock market with the Japanese stock market is 31%.

A U.S. investor would get more diversification from investments in Japan than Canada.

Optimal International PortfolioEfficient frontier

OIP

2.0%

1.5%

1.0%

0.5%

0.0%

US

JP

HKSD

ITGM

CNSWUK

NL

Monthly Standard Deviation0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10%

Rf

Mon

thly

Ret

urn

Composition of the OIP for a U.S. Investor

(Holding Period: 1980—2007)

Australia

Hong Kong

4.82%

8.76%

Italy 6.60%

Netherlands 31.11%

Sweden 28.01%

U.S. 20.70%

Total 100.00%

1.40%

1.11%

Gains from International Diversification

For a U.S. investor, OIP has more return and more risk. The Sharpe measure is 30% for OIP, suggesting that an equivalent-risk OIP would have more return per unit of risk than a domestic portfolio. risk-return tradeoff for the optimal international portfolio and optimal domestic portfolio are shown below and at right.

  OIP ODP

Mean Return

1.40% 1.11%

Standard Deviation

4.74% 4.25%

risk

retu

rn

4.25% 4.74%

OIP

ODP

Effects of Changes in the Exchange Rate

The realized dollar return for a U.S. resident investing in a foreign market will depend on• the return in the foreign market• the change in the exchange rate between the

U.S. dollar and the foreign currency

Effects of Changes in the Exchange Rate

The realized dollar return for a U.S. resident investing in a foreign market is given by

1)1)(1($ iii eRR

iiii eReR Where

Ri is the local currency return in the ith market

ei is the rate of change in the exchange rate between the local currency and the dollar

Effects of Changes in the Exchange Rate

For example, if a U.S. resident just sold shares in a British firm that had a 15% return (in pounds) during a period when the pound depreciated 5%, his dollar return is 9.25%:

$ (1 .15)[1 ( .05)] 1 .0925iR

$ .15 ( .05) (.15)( .05) .0925iR

Effects of Changes in the Exchange Rate

The risk for a U.S. resident investing in a foreign market will depend on • the risk in the foreign market (i.e., the volatility of

foreign market returns)

• the risk in the exchange rate between the U.S. dollar and the foreign currency (i.e., the covariation between the U.S. dollar and the foreign currency)

International Bond Investment

There is substantial exchange rate risk in foreign bond investment. This suggests that investors may be able to increase their gains if they can control this risk, for example with currency forward contracts or swaps.

The existence of euro alters the risk-return characteristics of the euro-zone bond markets enhancing the importance of non-euro currency bonds.

International Mutual Funds: A Performance Evaluation

A U.S. investor can easily achieve international diversification by investing in a U.S.-based international mutual fund.

The advantages include:

Savings on transaction and information costs.

Circumvention of legal and institutional barriers to direct portfolio investments abroad.

Professional management and record keeping.

International Diversification through Country Funds

Recently, country funds have emerged as one of the most popular means of international investment.

A country fund invests exclusively in the stocks of a single county. This allows investors to:

Speculate in a single foreign market with minimum cost.

Construct their own personal international portfolios.

Diversify into emerging markets that are otherwise practically inaccessible.

International Diversification with ADRs

Adding ADRs to domestic portfolios has a substantial risk reduction benefit.

World Equity Benchmark Shares

World Equity Benchmark Shares (WEBS)Country-specific baskets of stocks designed to

replicate the country indexes of 14 countries.

WEBS are subject to U.S. SEC and IRS diversification requirements.

Low cost, convenient way for investors to hold diversified investments in several different countries.

International Diversification with WEBS

Recent research suggests that WEBs are an excellent tool for international risk diversification.

For investors who desire international exposure, WEBs may well serve as a major alternative to such traditional tools as international mutual funds, ADRs, and closed-end country funds

Home Bias in Portfolio Holdings

Home bias refers to the extent to which portfolio investments are concentrated in domestic equities.

Country World Market Capitalization Weight

Asset Allocation at Home

U.S. 46.85% 85.66%

Japan 11.29% 71.82%

U.K. 8.13% 43.06%

France 4.32% 55.27%

Germany 3.99% 33.49%

Greece 0.46% 93.46%

Spain 1.39% 35.96%

Poland 0.19% 45.61%

Evidence of Home Bias Across Countries

Why Home Bias in Portfolio Holdings?

Three explanations come to mind:

1. Domestic equities may provide a superior inflation hedge.

2. Home bias may reflect institutional and legal restrictions on foreign investment.

3. Extra taxes and transactions/information costs for foreign securities may give rise to home bias.

Learning Outcomes

What is an optimal international portfolioHow exchange rate changes affect

international investmentWhat are the different means of gaining

international diversificationWhy there is home bias in portfolio holdings http://video.nytimes.com/video/2006/11/17/world/1194817103057/china-s-yellow-river-part-1.html?scp=1&sq=China's

%20Yellow%20River,%20Part%201&st=cse http://video.nytimes.com/video/2006/11/17/world/1194817096701/china-s-yellow-river-part-2.html?scp=1&sq=China%20

and%20Pollution&st=cse