International Portfolio

Investment

Reading: Chapter 15
 Lecture Outline

 Basics of diversification
 Benefits of international diversification
 Measuring foreign investment performance
 The home bias puzzle

2
 Why Go Global?

 In a nutshell: Diversification!!!
 Potential for higher expected returns for same risk.
 Potential for lower portfolio risk for same return.

Expected return

International investing
Domestic investing

Standard deviation of return

3
 International Correlations &
Diversification
 Security returns are much less correlated across
countries than within a country.
 This is because economic, political, institutional and even
psychological factors affecting security returns tend to vary
across countries, resulting in low correlations among
international securities.
 Types of companies in each country can also vary
significantly.

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 International Stock Returns (’70 – ’04)
Mean Std. Dev. Std. Dev. βW
(%) (%) (%, LC) (1970-2004)

Australia 12.33 24.03 10.98 1.005

France 12.62 21.02 21.04 1.042
Germany 8.91 23.39 28.36 0.950
Japan 5.14 24.40 16.78 1.017
Netherlands 13.45 17.97 22.33 0.974
Switzerland 12.96 17.90 15.78 0.879
UK 11.94 17.73 15.54 1.065
USA 12.22 15.86 16.44 0.920
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International Correlation Structure (’70 – ’04)

Stock Market AU FR GM JP NL SW UK US

Australia (AU) 1              

France (FR) .407 1            

Germany (GM) .349 .667 1          

Japan (JP) .315 .392 .362 1        

Netherlands (NL) .444 .668 .738 .429 1      

Switzerland (SW) .421 .638 .687 .426 734 1    

United Kingdom .489 .574 .475 .373 .653 .579 1  

(UK)

United States (US) .508 .502 .473 .311 .620 .523 .542 1

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Domestic vs. International Diversification

100
Portfolio Risk (%)

U.S. stocks
27
12 International stocks
1 10 20 30 40 50
Number of Stocks

7
 International Investing

 The tools are Mean/Variance Analysis – same as in previous

finance units.

 However, there are many important cross-country differences

that matter when we invest internationally
 Country Risk
 Currency Risk

 We start out with the mathematics of portfolio optimization

8
 Portfolio Theory

Assumptions:
 Nominal returns are normally distributed.
 Investors want more return and less risk as denominated in
their home currency.
 Let wi = proportion of wealth devoted to asset i such
that i wi = 1
Expected return on a portfolio: E  RP    wi E  Ri 
i

Portfolio Variance: Var  RP    P2   wi w j  ij

i j
where ij = ij i j
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 Expected Return on a Portfolio

E[Ri] σi
A American 14.3% 16.4%
B British 17.6% 29.9%
J Japanese 17.7% 35.7%

Example: Equal weights (50%) of A and J:

E[Rp] = wA E[RA] + wJ E[RJ]
= (0.5x0.143)+(0.5x0.177)
= 0.16 or 16%
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 Portfolio Variance

Correlation
E[Ri] i A B J
A American 14.3% 16.4% 1 0.557 0.325
B British 17.6% 29.9% 0.557 1 0.317
J Japanese 17.7% 35.7% 0.325 0.317 1

Example: Equal weights of A and J

P2= wA2 A2 + wJ2 J2 + 2 wA wJ AJ A J
= (0.5)2(0.164)2 + (0.5)2(0.357)2 + 2(0.5)(0.5)(0.325)
(0.164)(0.357) = 0.0481
P= (0.0481)1/2 = 0.2190 or 21.9 percent
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 Diversification & Risk

The risk of a portfolio is measured by the

ratio of the variance of a portfolio’s return
relative to the variance of the market return
(portfolio beta).
As an investor increases the number of
securities in a portfolio, the portfolio’s risk
declines rapidly at first, then asymptotically
approaches the level of systematic risk of
the market.

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 Diversification & Risk

The total risk of any portfolio is therefore

composed of systematic risk (the market)
and unsystematic risk (the individual
securities).
Increasing the number of securities in the
portfolio reduces the unsystematic risk
component leaving the systematic risk
component unchanged.

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 Diversification & Risk
Percent Variance of portfolio return
risk = Variance of market return
100

80

60 Total Risk = Diversifiable Risk + Market Risk

(unsystematic) (systematic)

40 Portfolio of
US stocks

20 Total Systematic
risk risk
1 10 20 30 40 50
Number of stocks in portfolio

By diversifying the portfolio, the variance of the portfolio’s return relative to the variance of the
market’s return (beta) is reduced to the level of systematic risk -- the risk of the market itself.

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 Limitations of Domestic Investment

 If we only invest in domestic shares, then we are limited

by the types of companies on offer in our home market.
 For example, the Australian market is overweight in
mining companies and underweight in technology
companies compared to the US and other markets.
 If we want to invest in IT or electronics companies, how
do we do that in Australia?
 By investing internationally, we have a more diverse
range of investment opportunities.

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Internationalizing a Domestic Portfolio
Expected Return Capital Market
Line (Domestic)
of Portfolio, Rp
Optimal domestic
portfolio (DP)

DP
R DP
•
Minimum risk (MRDP )

•
domestic portfolio
MRDP
Domestic portfolio
Rf opportunity set

Expected Risk
 DP of Portfolio,p

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 Capital Market Line is tangent to the domestic portfolio opportunity set. The domestic portfolio with the minimum risk is
MRDP.

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 Internationalizing a Domestic Portfolio
Optimal
Expected Return
international
of Portfolio, Rp CML (Domestic)
portfolio

•
IP
R IP

R DP DP
•
Internationally diversified
portfolio opportunity set

Domestic portfolio
opportunity set
Rf
Expected Risk
 IP  DP of Portfolio,p

An investor may choose a portfolio of assets enclosed by the international portfolio opportunity set. The optimal international portfolio
is found at IP, where the Capital Market Line is tangent to the international portfolio opportunity set.

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Domestic vs. International Diversification

100
Portfolio Risk (%)

U.S. stocks
27
12 International stocks
1 10 20 30 40 50
Number of Stocks

18
 Key Results of Portfolio Theory

 The extent to which risk is reduced by portfolio

diversification depends on the correlation of assets in
the portfolio.
 As the number of assets increases, portfolio variance
becomes more dependent on the covariances (or
correlations) and less dependent on variances.
 The risk of an asset when held in a large portfolio
depends on its return covariance (or correlation) with
other assets in the portfolio.
 Example – MSCI World Index & MSCI Emerging
Markets Index

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Two Asset Case

20
Combinations of
the two portfolios
if correlation = 1

21
 Combinations of
the two portfolios
Amount of if correlation = 1
risk
reduction

22
23
 Are Correlations Constant?
 Longin & Solnik estimated national stock market
correlations during periods of high and low market
volatility assuming constant correlations (i,us) between
index i and the U.S. market.
 While, movements in volatility of various market
indices are not synchronized, they nevertheless
conclude that volatility is “contagious”.
 This means that stock markets tend to move together
during BAD times. Which is not good, as it is during
bad times that we really want differences across
markets.

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De Santis and Gerard (1997) The Bad News On Correlations

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 Exchange Rate Risk

 The realized dollar return for an Australian resident

investing in a foreign market will depend not only on
the return in the foreign market but also on the change
in the exchange rate between the Australian dollar and
the foreign currency, i.e.
 Uncertainty about what will happen to the foreign stock
market (rforeign market).
 Uncertainty about what will happen to the exchange rate
(g$/FC).

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 Exchange Rate Risk

 The realized dollar return for an Australian

resident investing in a foreign market is given by:
Ri $  (1  Ri )(1  ri )  1

Where,
Ri is the local currency return in the ith market.
ri is the rate of change in the exchange rate
between the local currency and the dollar.

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 Exchange Rate Risk
 An example with Japanese shares:
 US investor takes $1,000,000 on 1/1/2002 and invests in
shares traded on the Tokyo Stock Exchange (TSE)
• On 1/1/2002, the spot exchange rate was ¥130/$

 The investor purchases 6,500 shares valued at ¥20,000 for a

total investment of ¥130,000,000
 At the end of the year, the investor sells the shares at a price
of ¥25,000 per share yielding ¥162,500,000
• On 1/1/2003, the spot exchange rate was ¥125/$

 The investor receives a 30% return on investment

($1,300,000/$1,000,000) - 1 = 30%

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 Exchange Rate Risk

 An example with Japanese shares:

 The total return reflects not only the rise in the yen stock
price but also the appreciation of the yen.
 The formula for the total return is:


R $  1  r $/¥ 1  r shares,¥   1 
Where: [(1/¥125)/(1/ ¥130)]-1 = 0.04; [¥25,000/¥20,000]-1 = 0.25

R   1  0.041  0.25   1  0.30

$

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 Exchange Rate Risk

 The risk for an Australian resident investing in a foreign

market will depend not only on the risk in the foreign
market but also on the risk of the exchange rate between
the Australian dollar and the foreign currency:
Var( Ri $ )  Var( Ri )  Var( g i )  2 Cov(Ri $ , g i )
This equation demonstrates that exchange rate fluctuations contribute to
the risk of foreign investment through two channels:
1. Its own volatility - Var(gi).
2. Its covariance with the local market returns - Cov(Ri,gi).

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 Where to Invest?
Country Index '07 Return
China SSEC 96.66%
India BSE 47.15%
Brazil Bovespa 43.65%
Hong Kong HSI 39.31%
South Korea Seoul Comp. 32.25%
Germany DAX 30 22.29%
Singapore ST Index 16.63%
Mexico IPC 11.68%
U.S. Nasdaq 9.81%
Canada TSE 7.16%
U.S. DJIA 6.43%
U.K. FTSE 100 3.80%
U.S. S&P 500 3.53%
France CAC 40 1.31%
Italy MIBTEL -7.81%
Japan Nikkei -11.13%
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Where to Invest?

2006 returns

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 How to Invest?

 Direct share investment – purchase shares in foreign

markets using foreign currencies. Can be hard to do!
 ADRs/GDRs – purchase shares in foreign companies
that are traded on your home exchange in local
currency. Limited number!
 MNCs – why can’t we just buy shares in multinational
companies to diversify internationally? Diversification
benefits not as good as investing internationally!
So what are the easy ways?
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 International Mutual Funds

 An Australian investor can easily achieve international

diversification by investing in an Australian-based
international mutual fund.
 The advantages include:
1. Savings on transaction and information costs.
2. Circumvention of legal and institutional barriers to direct
portfolio investments abroad.
3. Professional management and record keeping.

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 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
country. This allows investors to:
1. Speculate in a single foreign market with minimum cost.
2. Construct their own personal international portfolios.
3. Diversify into emerging markets that might be inaccessible
to individual investors.

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 Other Avenues

 Exchange Traded Funds – ETFs are investment companies,

registered with the SEC with assets consisting of baskets of
securities included in an index fund.
 One share in an ETF provides an investor diversification to all the
constituents of the relevant index and its price and yield track the
indices performance.
 World Equity Benchmark Shares (WEBS)/iShares –
Country specific baskets of stocks designed to replicate
indices of 14 countries.
 Low cost, convenient way for investors to hold diversified
investments in several different countries.

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 Home Bias Puzzle
 Home bias refers to the extent to which portfolio
investments are concentrated in domestic equities.
Share in World Proportion of Domestic
Country Market Value Equities in Portfolio
France 2.6% 64.4%
Germany 3.2% 75.4%
Italy 1.9% 91.0%
Japan 43.7% 86.7%
Spain 1.1% 94.2%
Sweden 0.8% 100.0%
United Kingdom 10.3% 78.5%
United States 36.4% 98.0%
Total 100.0%  

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 Home Bias Puzzle – Possible Explanations
 Barriers to international investment (e.g. foreign investment not
allowed in a lot of countries).
 restrictions on capital flows have fallen over time
 can use country funds
 International trading frictions: turnover taxes, other taxes, limited
liquidity
 Not a huge problem for larger markets, yet home bias remains
 Domestic equities may provide a superior inflation hedge.
 Sovereign risk - repatriation of funds
 Exchange rate risk
 Information asymmetries
 Psychological impediments
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 Conclusions

1 Low
Low correlations
correlations across
increase
increase the
across international
the risk-return
international markets
risk-return trade
trade off
off
markets may
may

2 Important
Important time
challenge
time variations
challenge these
variations may
these benefits.
may exist
benefits. Time
exist that
that can
Time horizon
can
horizon matters.
matters.

Investors
Investors might
might not
not be
be taking
taking full
full advantage
advantage of
of the
the
3 benefits
benefits of
known
known as
of international
as the
international diversification.
the ‘home
‘home bias’
diversification. This
bias’ puzzle.
puzzle.
This is
is

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