M17_MOFF8079_04_SE_C17.

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PART
6
Topics in
International
Finance
CHAPTER 17
International Portfolio Theory and Diversification

CHAPTER 18
Working Capital Management

CHAPTER 19
International Trade Finance
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C
H International Portfolio
17
A
P
T Theory and
E
R Diversification
It is not a case of choosing those which, to the best of ones judgement, are really the prettiest,
nor even those which average opinion genuinely thinks the prettiest. We have reached the third
degree where we devote our intelligences to anticipating what average opinion expects the average
opinion to be. John Maynard Keynes, The General Theory of Employment, Interest, and Money, 1936.

LEARNING OBJECTIVES
Separate total risk of a portfolio into two components, diversifiable and non-diversifiable.
Demonstrate how the diversifiable and non-diversifiable risks of an investors portfolio
may be reduced through international diversification.
Explore how foreign exchange risk is introduced to the individual investor investing
internationally.
Define the optimal domestic portfolio and the optimal international portfolio.
Review the recent history of equity market performance globally, including the degree
to which the markets are more or less correlated in their movements.
Examine the question of whether markets appear to be more or less integrated over
time.

This chapter explores how application of portfolio theory can reduce risks of asset portfolios
held by MNEs, and risks incurred by MNEs in general from internationally diversified activ-
ities. In the first part of the chapter, we extend portfolio theory from the domestic to the
international business environment. Then, we show how the risk of a portfolio, whether it be
a securities portfolio or the general portfolio of activities of the MNE, is reduced through
international diversification. The second part of the chapter details the theory and applica-
tion of international portfolio theory and presents recent empirical results of the risk-return
trade-offs of internationally diversified portfolios. The third and final section explores inter-
national diversifications impact on the cost of capital for the MNE. The chapter concludes
with the Mini-Case, Strategic Currency Hedging.

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CHAPTER 17 International Portfolio Theory and Diversification W-3

International Diversification and Risk

The case for international diversification of portfolios can be decomposed into two
components: 1) the potential risk reduction benefits of holding international securities and
2) the potential added foreign exchange risk.

Portfolio Risk Reduction

We focus first on risk. The risk of a portfolio is measured by the ratio of the variance of the
portfolios return relative to the variance of the market return. This is the beta of the port-
folio. As an investor increases the number of securities in a portfolio, the portfolios risk
declines rapidly at first, then asymptotically approaches the level of systematic risk of the
market. A fully diversified domestic portfolio would have a beta of 1.0, as shown in
Exhibit 17.1.
Exhibit 17.1 illustrates portfolio risk reduction for the U.S. economy. It shows that a fully
diversified U.S. portfolio is only about 27% as risky as a typical individual stock. This rela-
tionship implies that about 73% of the risk associated with investing in a single stock is diver-
sifiable in a fully diversified U.S. portfolio. Although we can reduce risk substantially through
portfolio diversification, it is not possible to eliminate it totally because security returns are
affected by a common set of factorsa set we characterize as the market.
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 port-
folio reduces the unsystematic risk component leaving the systematic risk component
unchanged.

EXHIBIT 17.1 Portfolio Risk Reduction through Diversification

Percent Risk

100

80
Total Risk = Diversifiable Risk + Market Risk
(unsystematic) (systematic)
60

40 Portfolio of
U.S. Stocks
27%
20 Total
Risk Systematic
Risk

1 10 20 30 40 50
Number of Stocks in Portfolio

When the portfolio is diversified, 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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W-4 PA R T 6 Topics in International Finance

Exhibit 17.2 illustrates the incremental gains of diversifying both domestically and
internationally. The lowest line in Exhibit 17.2 (portfolio of international stocks) represents
a portfolio in which foreign securities have been added. It has the same overall risk shape
as the U.S. stock portfolio, but it has a lower portfolio beta. This means that the inter-
national portfolios market risk is lower than that of a domestic portfolio. This situation
arises because the returns on the foreign stocks are closely correlated not with returns on
U.S. stocks, but rather with a global beta. We will return to this concept in the section
National Markets and Asset Performance later in this chapter.

Foreign Exchange Risk

The foreign exchange risks of a portfolio, whether it be a securities portfolio or the general
portfolio of activities of the MNE, are reduced through international diversification. The
construction of internationally diversified portfolios is both the same as and different from
creating a traditional domestic portfolio. Internationally diversified portfolios are the same
in principle because the investor is attempting to combine assets that are less than perfectly
correlated, reducing the total risk of the portfolio. In addition, by adding assets outside the
home market, assets that previously were not available to be averaged into the portfolios
expected returns and risks, the investor has now tapped into a larger pool of potential
investments.
But international portfolio construction is also different in that when the investor
acquires assets or securities outside the investors host-country market, the investor may also
be acquiring a foreign currency denominated asset. This is not always the case. For example,

EXHIBIT 17.2 Portfolio Risk Reduction through International Diversification

Percent Risk

100

80

60

40 Portfolio of
U.S. Stocks
27%
20 Portfolio of International Stocks
12%

1 10 20 30 40 50
Number of Stocks in Portfolio

When the portfolio is diversified internationally, the portfolios betathe level of

systematic risk which cannot be diversified awayis lowered.
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CHAPTER 17 International Portfolio Theory and Diversification W-5

many U.S.-based investors routinely purchase and hold Eurodollar bonds (on the secondary
market only; it is illegal during primary issuance), which would not pose currency risk to the
U.S.-based investor for they are denominated in the investors home currency. Thus,
the investor has actually acquired two additional assetsthe currency of denomination and
the asset subsequently purchased with the currencyone asset in principle, but two in
expected returns and risks.

Japanese Equity Example. A numerical example can illustrate the difficulties associated with
international portfolio diversification and currency risk. A U.S.-based investor takes
US$1,000,000 on January 1, and invests in shares traded on the Tokyo Stock Exchange (TSE).
The spot exchange rate on January 1 is 130.00/$. The $1 million therefore yields
130,000,000. The investor uses 130,000,000 to acquire shares on the Tokyo Stock Exchange
at 20,000 per share, acquiring 6,500 shares, and holds the shares for one year.
At the end of one year the investor sells the 6,500 shares at the market price, which is
now 25,000 per share; the shares have risen 5,000 per share in price. The 6,500 shares at
25,000 per share yield proceeds of 162,500,000.
The Japanese yen are then changed back into the investors home currency, the U.S. dol-
lar, at the spot rate of 125.00/$ now in effect. This results in total U.S. dollar proceeds of
$1,300,000.00. The total return on the investment is then
US$1,300,000 - US$1,000,000
= 30.00%
US$1,000,000
The total U.S. dollar return is actually a combination of the return on the Japanese yen
(which in this case was positive) and the return on the shares listed on the Tokyo Stock
Exchange (which was also positive). This value is expressed by isolating the percentage
change in the share price (r shares) in combination with the percentage change in the currency
value (r /$):
R$ = [(1 + r /$)(1 + r shares, )] - 1
In this case, the value of the Japanese yen, in the eyes of a U.S.-based investor, rose 4.00%
(from 130/$ to 125/$), while the shares traded on the Tokyo Stock Exchange rose 25.00%.
The total investment return in U.S. dollars is therefore
R $ = [(1 + .0400)(1 + .2500)] - 1 = .3000 or 30.00%
Obviously, the risk associated with international diversification, when it includes cur-
rency risk, is inherently more complex than that of domestic investments. You should also
see, however, that the presence of currency risk may alter the correlations associated with
securities in different countries and currencies, providing portfolio composition and diver-
sification possibilities that domestic investment and portfolio construction may not. In
conclusion:
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. Given the limits of the potential
supply of securities, increased demand will bid up the price of the security, resulting in a
lower cost of capital for the firm. The firm issuing the security, the sell-side, is therefore
able to raise capital at a lower cost.
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W-6 PA R T 6 Topics in International Finance

Internationalizing the Domestic Portfolio

First, we review the basic principles of traditional domestic portfolio theory to aid in our
identification of the incremental changes introduced through international diversification.
We then illustrate how diversifying the portfolio internationally alters the potential set of
portfolios available to the investor.

The Optimal Domestic Portfolio

Classic portfolio theory assumes a typical investor is risk-averse. This means that 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 shown in Exhibit 17.3. The set of portfolios formed along
the extreme left edge of the domestic portfolio opportunity set is termed the efficient frontier.
It 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 among all those
possible is the minimum risk domestic portfolio (MRDP).
The individual investor will search out the optimal domestic portfolio (DP) which com-
bines the risk-free asset and a portfolio of domestic securities found on the efficient frontier.
He or she begins with the risk-free asset with return of Rf (and zero expected risk), and
moves out along the security market line until reaching portfolio DP. This portfolio is

EXHIBIT 17.3 Optimal Domestic Portfolio Construction

Expected Return of Optimal domestic Capital market

Portfolio, Rp portfolio (DP) line (domestic)

DP
RDP

Minimum risk (MRDP )

domestic portfolio
MRDP
Rf

Domestic portfolio
opportunity set

Expected Risk
sDP of Portfolio, sp

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
designated MRDP .
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CHAPTER 17 International Portfolio Theory and Diversification W-7

defined as the optimal domestic portfolio because it moves out into risky space at the steep-
est slopemaximizing the slope of expected portfolio return over expected riskwhile still
touching the opportunity set of domestic portfolios. This line is called the capital market line,
and portfolio theory assumes an investor who can borrow and invest at the risk-free rate can
move to any point along this line.
Note that the optimal domestic portfolio is not the portfolio of minimum risk (MRDP).
A line stretching from the risk-free asset to the minimum risk domestic portfolio would have
a lower slope than the capital market line, and the investor would not be receiving as great an
expected return (vertical distance) per unit of expected risk (horizontal distance) as that
found at DP.

International Diversification
Exhibit 17.4 illustrates the impact of allowing the investor to choose among an inter-
nationally diversified set of potential portfolios. The internationally diversified portfolio
opportunity set shifts leftward of the purely domestic opportunity set. At any point on the
efficient frontier of the internationally diversified portfolio opportunity set, the investor can
find a portfolio of lower expected risk for each level of expected return.
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 which are of
less than perfect correlation with the securities and portfolios within the domestic oppor-
tunity set.
For example, Sony Corporation is listed on the Tokyo Stock Exchange. Sonys share price
derives its value from both the individual business results of the firm and the market in which

EXHIBIT 17.4 The Internationally Diversified Portfolio Opportunity Set

Expected Return
of Portfolio, Rp

DP
RDP

Internationally diversified
portfolio opportunity set
Rf
Domestic portfolio
opportunity set

Expected Risk
sDP of Portfolio, sp

The addition of internationally diversified portfolios to the total opportunity set available to
the investor shifts the total portfolio opportunity set left, providing lower expected risk portfolios
for each level of expected portfolio return.
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W-8 PA R T 6 Topics in International Finance

it trades. If either or both are not perfectly positively correlated to the securities and markets
available to a U.S.-based investor, then that investor would observe the opportunity set shift
shown in Exhibit 17.4.

The Optimal International Portfolio

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. We
illustrate this in Exhibit 17.5.
The benefits of international diversification are now obvious. The investors optimal
international portfolio, IP, possesses both higher expected portfolio return (RIP 7 RDP), and
lower expected portfolio risk (sIP 6 sDP), than the purely domestic optimal portfolio. The
optimal international portfolio is superior to the optimal domestic portfolio.

The Calculation of Portfolio Risk and Return

An investor may 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.

Two-Asset Model. Let us assume Tridents CFO Maria Gonzalez is considering investing
Tridents marketable securities in two different risky assets, an index of the U.S. equity
markets and an index of the German equity markets. The two equities are characterized by

EXHIBIT 17.5 The Gains from International Portfolio Diversification

Capital market
Optimal
line (international)
Expected Return of international
Portfolio, Rp portfolio Capital market
line (domestic)
Increased IP
return of RIP
optimal DP
RDP
portfolio

Internationally diversified
portfolio opportunity set
Rf
Domestic portfolio
opportunity set

Expected Risk
sIP sDP of Portfolio, sp

Risk reduction of optimal portfolio

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CHAPTER 17 International Portfolio Theory and Diversification W-9

the following expected returns (the mean of recent returns) and expected risks (the standard
deviation of recent returns):

Expected Return Expected Risk (S)

United States equity index (US) 14% 15%
German equity index (GER) 18% 20%
Correlation coefficient (rUS@GER) 0.34

If the weights of investment in the two assets are wUS and wGER respectively, and
wUS + wGER = 1, the risk of the portfolio (sp), usually expressed in terms of the standard
deviation of the portfolios expected return, is given by the following equation:

sp = 2w2US s2US + w2GER s2GER + 2wUS wGER rUS - GER sUS sGER

where s2US and sGER2 are the squared standard deviations of the expected returns of risky
assets in the United States and Germany (the variances), respectively. The Greek letter rho,
rUS@GER, is the correlation coefficient between the two market returns over time.
We now plug in the values for the standard deviations of the United States (15%) and
Germany (20%), and the correlation coefficient of 0.34. Assuming that Maria initially wishes
to invest 40% of her funds in the United States (0.40), and 60% of her funds in German equi-
ties (0.60), the expected risk of the portfolio will be

sp = 2(0.40)2(0.15)2 + (0.60)2(0.20)2 + 2(0.40)(0.60)(0.34)(0.15)(0.20)

which, when reduced, is

= 20.0036 + 0.0144 + 0.0049 = 0.151 15.1%

Note that the portfolio risk is not the weighted average of the risks of the individual
assets. As long as the correlation coefficient (r) is smaller than 1.0, some of the fluctuations of
the asset returns will offset each other, resulting in risk reduction. The lower the correlation
coefficient, the greater the opportunity for risk diversification.
We obtain the expected return of the portfolio with the following equation:
E(Rp) = wUSE(RUS) + wGERE(RGER)
where E(Rp), E(RUS), and E(RGER) are the expected returns of the portfolio, the United
States equity index, and the German equity index, respectively. Using the expected returns
for the United States (14%) and German (18%) equity indexes above, we find the expected
return of the portfolio to be
E(Rp) = (0.4)(0.14) + (0.6)(0.18) = 0.164 16.4%

Altering the Weights. Before Maria finalizes the desired portfolio, she wishes to evaluate the
impact of changing the weights between the two equity indexes on the expected risk and
expected returns of the portfolio. Using weight increments of 0.5, she graphs the alternative
portfolios in the customary portfolio risk-return graphic. Exhibit 17.6 illustrates the result.
The different portfolios possible using different weights with the two equity assets pro-
vides Maria some interesting choices. The two extremes, the greatest expected return and the
minimum expected risks, call for very different weight structures. The greatest expected
return is, as we would expect from the original asset expectations, 100% German in composi-
tion. The minimum expected risk portfolio, with approximately 15.2% expected risk, is made
up of approximately 70% U.S. and 30% German securities.
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W-10 PA R T 6 Topics in International Finance

EXHIBIT 17.6 Alternative Portfolio Profiles under Varying Asset Weights

Expected Portfolio
Return (%)

18
Initial portfolio
17 (40% U.S. and 60% GER) Maximum
return and
maximum risk
16 (100% GER)

Minimum risk combination

15
(70% U.S. and 30% GER)

14 Domestic only portfolio

(100% U.S.)
13

12
Expected
Portfolio
0 11 12 13 14 15 16 17 18 19 20 Risk (s )

Multiple Asset Model. We can generalize the above equations to a portfolio consisting of
multiple assets. The portfolio risk is
N N-1 N
w 2s 2 + a a wiwjrijsisj
Ca i j
sp =
i=1 i=1 j=i+1

and the portfolio expected return is

N
E(Rp) = a wiE(Ri)
i=1

where N stands for the total number of assets included in the portfolio. By allowing investors
to hold foreign assets, we substantially enlarge the feasible set of investments; higher return
can be obtained at a given level of risk, or lower risk can be attained at the same level of
return.

National Markets and Asset Performance

As demonstrated in the previous section, international portfolio construction allows the
investor to gather in different expected returnssometimes higher, sometimes lowerwith
the real gains arising from reduction in the expected risk of the portfolio.
A multitude of studies have analyzed historical returns from the worlds various equity
markets. One of the longest historical time period coverage is that of Dimson, Marsh, and
Staunton (2002), who analyzed a century of equity returns over 16 different markets. They
found that U.S. equities delivered an inflation-adjusted mean return of 8.7% versus mean
returns of 2.1% on Treasury bonds. But they also concluded that the U.S. market was not
exceptional, with equity markets in Australia, Germany, Japan, South Africa, and Sweden all
exhibiting higher mean returns for the century. Importantly, they also found that equity
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CHAPTER 17 International Portfolio Theory and Diversification W-11

returns for all 16 countries exhibited positive mean returns, the lowest being 4.8% in Bel-
gium, and the highest being 9.9% in Sweden.
The true benefits of global diversification do indeed arise from the fact that the
returns of different stock markets around the world are not perfectly positively corre-
lated. (Exhibit 17.7 describes U.S. equity market correlations with select global equity
markets in recent years.) Because there are different industrial structures in different
countries and because different economies follow very different business cycles, we expect
smaller return correlations between investments in different countries than between
investments within a given country. And in fact, that is what most of the empirical studies
indicate.
As demonstrated by Global Finance in Practice 17.1, however, average performances
over extended periods of time may be misleading when it comes to assessing market move-
ments and correlations as a result of singular events. A low average correlation over a series
of years may prove to be little comfort for those suffering a highly correlated market decline
from a singular global disaster.
Exhibit 17.8 presents a comparison of correlation coefficients between major global
equity markets over a variety of different periods. The comparison yields a number of conclu-
sions and questions:
The correlation between equity markets for the full twentieth century shows quite low lev-
els of correlation between some of the largest markets (for example .55 between the U.S.
and U.K.).

EXHIBIT 17.7 Major Equity Market Correlations with the United States
Equity Market

0.80

0.70

0.60

0.50

0.40

0.30

0.20

0.10

0.00
en
lia

ce

om
m

ng

s
k

nd
ad

pa

nd
ar

an
iu
ra

ed
an

Ko

d
la
m
lg

an

Ja
m

rla
st

ng
Fr

er
Sw
en
Be

er
Au

g
C

he

itz

Ki
on
D

et

Sw

d
H

te
ni
U

Source: Author estimates for the 19702010 period.

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W-12 PA R T 6 Topics in International Finance

GLOBAL FINANCE IN PRACTICE 17.1 Mussa often recites a television news story in which the gov-
ernor of Ohio claimed that a major prison riot was the work of
Market Correlations and Extraordinary outside agitators.)
Events In some cases in history, however, the correlation in
equity market movements displays an interesting twist. On
Market correlation studies focus on market movements over January 17, 1991, the U.S. initiated its counterattack on Iraqi
segments of time, such as monthly average returns over forces which had occupied Kuwait. The date had been
years or blocks of years. But correlation coefficients between watched with intense interest for months as then President
markets on singular events, such as major global crises, dis- George Bush had warned Iraq that it had until that date to
asters, or events of global profile, often show near-perfect withdraw. When no withdrawal occurred, the U.S. attack
correlations, with all markets moving identically. began on January 17. Nineteen global equity markets all
In most cases, the identification of the event (for exam- closed up that day, with percentage increases ranging from
ple the terrorist attacks of September 11, 2001) is relatively 1.17% in Toronto to 7.56% in Frankfurt (the DAX). But there
easy. In other instances, however, such as the stock market was one market that closed down that daythe Johannes-
crash of October 19, 1987; the crash of October 13, 1989; or burg exchange index. The reason? That is the one equity
the collapse of the Thai baht on July 2, 1997, instigating the market in the world, at least at that time, that was dominated
Asian Crisis of 1997; finding a smoking gun is difficult. by the value of goldthat substance to which many investors
Whether it be the madness of crowds or unknown forces, the run when the world is at risk (as in the spring of 2011), or flee
causal event is difficult to find even after the fact. (Michael when all seems to be returning to calm.

That same century of data, however, yields a high correlation between the U.S. and
Canada (.80) which is relatively high compared to other pairs, but not as high as one might
suspect for such highly integrated economies.
The correlation coefficients between those same equity markets for selected subperiods
over the last quarter of the twentieth century, however, show significantly different corre-
lation coefficients. For example, the 19771986 period finds five of the seven market pairs
with lower correlations than the century averages.

EXHIBIT 17.8 Equity Market Correlations Over Time

Correlation Estimates for Selected Subperiods

Correlation Dimson et al* Authors MSCI** Authors MSCI** Dimson et al*

Between 19002000 19771986 19871996 19962000
U.S. and Canada 0.80 0.66 0.77 0.78
U.S. and Denmark 0.38 0.26 0.18 0.46
U.S. and France 0.36 0.37 0.55 0.56
U.S. and Germany 0.12 0.24 0.42 0.56
U.S. and Japan 0.21 0.16 0.26 0.49
U.S. and Switzerland 0.50 0.38 0.47 0.44
U.S. and U.K. 0.55 0.40 0.67 0.67
Average 0.42 0.35 0.47 0.57
Sources: * Coefficients drawn from Triumph of the Optimists, 101 Years of Global Investment Returns, by Dimson, March, and
Staunton, Princeton University Press, 2002, p. 15; ** Authors calculations using data extracted over multiple issues of Morgan Stan-
ley Capital International.
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CHAPTER 17 International Portfolio Theory and Diversification W-13

When moving from the 19771986 period to the 19871996 period, six of the seven pairs
show higher correlations. This tendency continues when moving from the 19871996
period to the 19962000 period, when six of the seven pair correlations once again
increase.
So what does the future hold for market correlations? Many equity market futurists
believe that the digitally integrated global marketplace, combined with the spread of equity
cross-listings will probably cause a significant increase in market correlations. Only time
and datawill tell.

Market Performance Adjusted for Risk: The Sharpe and Treynor

Performance Measures
Although Exhibits 17.8 and 17.9 provided some insights into the long-term historical per-
formance of individual national markets and key assets, they do not provide a complete pic-
ture of how returns and risks must be considered in combination. Exhibit 17.9 presents
summary statistics for the monthly returns across 18 major equity markets for the 19771996
period. In addition to the traditional measures of individual market performance of mean

EXHIBIT 17.9 Summary Statistics of the Monthly Returns for 18 Major Stock Markets,
19771996 (all returns converted into U.S. dollars and include all dividends
paid)

Mean Standard Sharpe Treynor

Return (%) Deviation (%) Beta (Bi ) M. (SHPi ) M. (TRNi )
Australia 1.00 7.44 1.02 0.078 0.0057
Austria 0.77 6.52 0.54 0.055 0.0066
Belgium 1.19 5.53 0.86 0.141 0.0091
Canada 0.82 5.34 0.93 0.076 0.0044
Denmark 0.99 6.25 0.68 0.092 0.0085
France 1.18 6.76 1.08 0.113 0.0071
Germany 0.97 6.17 0.84 0.089 0.0065
Hong Kong 1.50 9.61 1.09 0.113 0.0100
Italy 0.96 7.57 0.89 0.071 0.0061
Japan 1.08 6.66 1.21 0.099 0.0055
Netherlands 1.39 4.93 0.89 0.197 0.0109
Norway 1.00 7.94 1.02 0.073 0.0057
Singapore 1.09 7.50 1.01 0.090 0.0057
Spain 0.83 6.81 0.94 0.060 0.0044
Sweden 1.37 6.67 0.97 0.143 0.0099
Switzerland 1.10 5.39 0.86 0.127 0.0080
United Kingdom 1.35 5.79 1.06 0.162 0.0089
United States 1.01 4.16 0.82 0.143 0.0072
Average 1.09 6.51 0.93 0.107 0.0073
The results are computed with stock market data from Morgan Stanleys Capital International Perspectives, monthly.
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W-14 PA R T 6 Topics in International Finance

return and standard deviation (for risk), the individual national markets beta to the global
portfolio is reported as well as two measures of risk-adjusted returns, the Sharpe and Treynor
measures.
Investors should examine returns by the amount of return per unit of risk accepted,
rather than in isolation (as in simply mean risks and returns). For example, in Exhibit
17.9, the Hong Kong market had the highest average monthly return at 1.50%, but also
the highest risk, a standard deviation of 9.61%. (A major contributing factor to its high
volatility was, perhaps, the political uncertainty about the future of the British colony
after 1997.)
To consider both risk and return in evaluating portfolio performance, we introduce two
measures in Exhibit 17.9, the Sharpe measure (SHP) and the Treynor measure (TRN). The
Sharpe measure calculates the average return over and above the risk-free rate of return per
unit of portfolio risk:
Ri - Rf
Sharpe Measure = SHPi =
si

where Ri is the average return for portfolio i during a specified time period, Rf is the average
risk-free rate of return, and si is the risk of portfolio i. The Treynor measure is very similar,
but instead of using the standard deviation of the portfolios total return as the measure of
risk, it utilizes the portfolios beta, bi , the systematic risk of the portfolio, as measured against
the world market portfolio:
Ri - Rf
Treynor Measure = TRNi =
bi

The Sharpe measure indicates on average how much excess return (above risk-free rate)
an investor is rewarded per unit of portfolio risk the investor bears.
Though the equations of the Sharpe and Treynor measures look similar, the difference
between them is important. If a portfolio is perfectly diversified (without any
unsystematic risk), the two measures give similar rankings because the total portfolio risk
is equivalent to the systematic risk. If a portfolio is poorly diversified, it is possible for it to
show a high ranking on the basis of the Treynor measure, but a lower ranking on the basis
of the Sharpe measure. The difference is attributable to the low level of portfolio diversi-
fication. The two measures, therefore, provide complementary but different information.
Hong Kong Example. The mean return for Hong Kong in Exhibit 17.9 was 1.5%. If we
assume the average risk-free rate was 5% per year during this period (or 0.42% per month),
the Sharpe measure would be calculated as follows:
Ri - Rf 0.015 - 0.0042
SHPHKG = = = 0.113
si 0.0961
For each unit (%) of portfolio total risk an investor bore, the Hong Kong market rewarded
the investor with a monthly excess return of 0.113% in 19771996.
Alternatively, the Treynor measure was
Ri - Rf 0.015 - 0.0042
TRNHKG = = = 0.0100
bi 1.09

Although the Hong Kong market had the second highest Treynor measure, its Sharpe
measure was ranked eighth, indicating that the Hong Kong market portfolio was not very
M17_MOFF8079_04_SE_C17.QXD 7/1/11 2:31 PM Page W-15

CHAPTER 17 International Portfolio Theory and Diversification W-15

well diversified from the world market perspective. Instead, the highest ranking belonged
to the Netherlands market, which had the highest Sharpe (0.197) and Treynor (0.0109)
measures.
Does this mean that a U.S. investor would have been best rewarded by investing in the
Netherlands market over this period? The answer is yes if the investor were allowed to invest
in only one of these markets. It would definitely have been better than staying home in the
U.S. market, which had a Sharpe measure of 0.143 for the period. However, if the investor
were willing to combine these markets in a portfolio, the performance would have been even
better. Since these market returns were not perfectly positively correlated, further risk reduc-
tion was possible through diversification across markets.

Are Markets Increasingly Integrated?

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. To examine this question, we
break the 20-year sample period of 19771996 into halves: 19771986 and 19871996.
Dividing the periods at 1986, the date coincides with the official movement toward a sin-
gle Europe. At this time, most European Union countries deregulated their securities
marketsor at least began the process of removing remaining restrictions on the free
flow of capital across the borders.
Exhibit 17.10 reports selected stock markets correlation coefficients with the United
States for each subperiod. Only the Danish-U.S. market correlation actually fell from the first
to the second period. The Canadian-U.S. correlation rose from an already high 0.66 to 0.77 in
the latter period. Similarly, the correlations between the United States and both Singapore
and the United Kingdom rose to 0.66 and 0.67, respectively.
The overall picture is that the correlations have increased over time. The answer to
the question, Are markets increasingly integrated? is most likely yes. However,
although capital market integration has decreased some benefits of international
portfolio diversification, the correlation coefficients between markets are still far from
1.0. There are still plenty of risk-reducing opportunities for international portfolio
diversification.

EXHIBIT 17.10 Comparison of Selected Correlation Coefficients between Stock Markets

for Two Different Time Periods (dollar returns)

Correlation to United States 197786 198796 Change

Canada 0.66 0.77 +0.11
Denmark 0.26 0.18 -0.08
France 0.37 0.55 +0.18
Germany 0.24 0.42 +0.18
Hong Kong 0.13 0.61 +0.48
Japan 0.16 0.26 +0.10
Singapore 0.31 0.66 +0.35
Switzerland 0.38 0.47 +0.09
United Kingdom 0.40 0.67 +0.27

Correlation coefficients are computed from data from Morgan Stanleys Capital International Perspectives.
M17_MOFF8079_04_SE_C17.QXD 7/1/11 2:31 PM Page W-16

W-16 PA R T 6 Topics in International Finance

Summary of Learning Objectives

Separate total risk of a portfolio can be separated into two This portfolio is defined as the optimal domestic port-
components, diversifiable and non-diversifiable. folio because it moves out into risky space at the
The total risk of any portfolio is composed of steepest slopemaximizing the slope of expected
systematic (the market) and unsystematic (the individ- portfolio return over expected riskwhile still touch-
ual securities) risk. Increasing the number of securities ing the opportunity set of domestic portfolios.
in the portfolio reduces the unsystematic risk compo- The optimal international portfolio, IP, is found by
nent but cannot change the systematic risk component. finding that point on the capital market line (interna-
tionally diversified) which extends from the risk free
Demonstrate how the diversifiable and non-diversifiable asset return of Rf to a point of tangency along the
risks of an investors portfolio may be reduced through internationally diversified efficient frontier.
international diversification. The investors optimal international portfolio, IP, pos-
An internationally diversified portfolio has a lower sesses both higher expected portfolio return
portfolio beta. This means that the portfolios market (RIP 7 RDP), and lower expected portfolio risk
risk is lower than that of a domestic portfolio. This sit- (sIP 6 sDP), than the purely domestic optimal port-
uation arises because the returns on the foreign stocks folio. The optimal international portfolio is superior to
are not closely correlated with returns on U.S. stocks, the optimal domestic portfolio.
but rather with a global beta.
Investors construct internationally diversified portfo- Review the recent history of equity market performance
lios in an attempt to combine assets which are less globally, including the degree to which the markets are
than perfectly correlated, reducing the total risk of the more or less correlated in their movements.
portfolio. In addition, by adding assets outside the
home market, the investor has now tapped into a
Risk reduction is possible through international diver-
sification because the returns of different stock mar-
larger pool of potential investments.
kets around the world are not perfectly positively
correlated.
Explore how foreign exchange risk is introduced to the
individual investor investing internationally. Because of different industrial structures in different
countries and because different economies do not
The international investor has actually acquired two
exactly follow the same business cycle, smaller return
additional assetsthe currency of denomination and
correlations are expected between investments in dif-
the asset subsequently purchased with the currency
ferent countries than investments within a given
two assets in one in principle, but two in expected
country.
returns and risks.
The foreign exchange risks of a portfolio, whether it
be a securities portfolio or the general portfolio of Examine the question of whether markets appear to be
activities of the MNE, are reduced through interna- more or less integrated over time.
tional diversification. The overall picture is that the correlations have
increased over time. Nevertheless, 91 of the 153 corre-
Define the optimal domestic portfolio and the optimal lations (59%) and the overall mean (0.46) were still
international portfolio. below 0.5 in 19871996. The answer to the question of
The individual investor will search out the optimal are markets increasingly integrated? is Yes.
domestic portfolio (DP) which combines the risk-free However, although capital market integration has
asset and a portfolio of domestic securities found on decreased some benefits of international portfolio
the efficient frontier. The investor begins with the risk- diversification, the correlation coefficients between
free asset with return of Rf (and zero expected risk), markets are still far from 1.0. There are still plenty of
and moves out along the security market line until risk-reducing opportunities for international portfolio
reaching portfolio DP. diversification.
M17_MOFF8079_04_SE_C17.QXD 7/1/11 2:31 PM Page W-17

CHAPTER 17 International Portfolio Theory and Diversification W-17

MINI-CASE markets that meet modern financial efficiency criteria,

Strategic Currency Hedging1 there is no real consensus of the proper valuation
model(s) for currencies. This means that there is a much
Strategic currency hedging policy can be an important higher possibility that currency values could deviate for
risk control measure for funds with international assets. long periods of time from their correct value.
Passive currency exposure can be seen as a source of risk Finally, and quite promisingly, a number of recent stud-
with no compensating risk premium. Hedging currency ies had indicated that active currency managers do indeed
exposure removes return component that is a source of add value to their portfolio performance. Exhibit 1 reports
expected risk but not expected return. Leaving assets the result of one recent study following 19 active currency
unhedged could be the correct policy decision, but it managers over a seven-year period. As shown, even at the
should not be the default position. The decision should be 75th percentile, active currency managers have had on
based on a systematic analysis of the costs and benefits of average positive performance in four of the seven years.
currency hedging. Given that currency adds risk, has zero Seans review of the studies also reconfirmed a simple
expected excess return over long periods of time, and is but extremely important element of active currency man-
relatively inexpensive to hedge, it is puzzling that the agement: the currency strategy must be considered sepa-
international investors default position is not 100% rate from the bond or equity strategy of any portfolio.
hedged rather than the industry norm of 0% hedged. These markets move on the basis of very different drivers
Currency Management: Strategies at different points in time, by country. Exhibit 2 on the
to Add Alpha and Reduce Risk, next page was also quite convincing on this point, as the
by Andrew Dales and Richard Meese, separable returns and risks on equities and currency pairs
Investment Insights, for a select set of equity markets were distinct. And, just as
Barclays Global Investment, importantly, the Sharpe ratios for the hedged versus
October 2003, Volume 6, Issue 7, p. 2. unhedged portfolios were largely the same. So, in the end,
a blanket policy of hedging all currency risk seemingly
Sean OConnor was in his second analytical rotation in the
does not change the risk-return trade-off appreciably.
management training program at Zenex Securities. He had
been assigned to the international equities division for the
past three months, and had now been given the task of CASE QUESTION S
reviewing both the theory and evidence related to active cur-
1. According to Exhibit 1, were there a significant number
rency management of internationally diversified portfolios.
of portfolio managers able to add value to international
Sean was now reviewing an article which argued that
portfolios through active (selective) currency manage-
there were at least three basic arguments supporting
ment consistently over the time period studied?
active currency management. First, unlike equity markets
like the New York Stock Exchange, many of the partici- 2. According to Exhibit 2, would the international
pants who trade daily in the global currency markets are investor in an Australia portfolio be better off, on aver-
not trading for a profit. Corporate hedgers are trading for age, with a completely hedged or unhedged portfolio?
hedging purposes; central banks trade in pursuit of a vari- 3. If you were Sean, what would you conclude from this
ety of macroeconomic goals. Unlike many other financial specific study?

EXHIBIT 1 Russell/Mellon Survey of 19 Active Managers

Percentile 1 year 2 years 3 years 4 years 5 years 6 years 7 years

25th 3.14 3.13 1.64 1.14 0.94 0.95 1.25
Median 1.01 0.77 1.04 0.40 0.44 0.63 0.83
75th -0.07 0.22 0.36 -0.01 -0.04 0.31 0.36
Mean 1.05 0.98 0.80 0.46 0.35 0.63 1.07
Source: Russell/Mellon Analytical Services, LLC, as quoted by Barclays, June 30, 2003.

1ThisMini-Case is fictional. Many of the arguments and concepts utilized are based on Currency Management: Strategies to Add
Alpha and Reduce Risk, by Andrew Dales and Richard Meese, Investment Insights, Barclays Global Investment, October 2003, Vol-
ume 6, Issue 7.
M17_MOFF8079_04_SE_C17.QXD 7/1/11 2:31 PM Page W-18

W-18 PA R T 6 Topics in International Finance

EXHIBIT 2 Annual Historical Excess Returns, Annual Risk, and Sharpe Ratios for Selected Equities
and Currencies, January 1978February 2003

Average excess
Asset Country return (%) Annual risk (%) Sharpe ratio
Equities Australia 4.22 19.30 0.22
Canada 3.33 17.70 0.19
Japan 2.34 18.60 0.13
United Kingdom 3.73 17.00 0.22
United States 5.85 15.70 0.37
Forward currency AUD/USD 0.62 9.99 0.06
CAD/USD 0.34 4.81 0.07
JPY/USD 0.74 12.70 0.06
GBP/USD (1.15) 11.10 (0.10)
Unhedged Australia 4.44 15.60 0.28
international Canada 4.07 13.90 0.29
equities Japan 5.62 17.90 0.31
United Kingdom 2.70 16.50 0.16
United States 3.23 17.00 0.19
Hedged Australia 3.30 14.10 0.23
international Canada 3.37 14.00 0.24
equities Japan 4.17 14.40 0.29
United Kingdom 3.62 14.00 0.26
United States 2.98 14.80 0.20

Source: Adapted from Barclays, op cit, p. 7.

Questions 6. Optimal Domestic Portfolio. Define in words

(without graphics) how the optimal domestic
1. Diversification Benefits. How does the diversifica- portfolio is constructed.
tion of a portfolio change its expected returns and
7. Minimum Risk Portfolios. If the primary benefit of
expected risks? Is this in principle any different for
portfolio diversification is risk reduction, is the
internationally diversified portfolios?
investor always better off choosing the portfolio with
2. Risk Reduction. What types of risk are present in a the lowest expected risk?
diversified portfolio? Which type of risk remains
8. International Risk. Many portfolio managers, when
after the portfolio has been diversified?
asked why they do not internationally diversify their
3. Measurement of Risk. How, according to portfolio portfolios, answer that the risks are not worth the
theory, is the risk of the portfolio measured exactly? expected returns. Using the theory of international
diversification, how would you evaluate this statement?
4. Market Risk. If all national markets have market
risk, is all market risk the same? 9. Correlation Coefficients. The benefits of portfolio
construction, domestically or internationally, arise
5. Currency Risk. The currency risk associated with from the lack of correlation among assets and
international diversification is a serious concern for markets. The increasing globalization of business is
portfolio managers. Is it possible for currency risk expected to change these correlations over time. How
ever to benefit the portfolios return? do you believe they will change and why?
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CHAPTER 17 International Portfolio Theory and Diversification W-19

10. Relative Risk and Return. Conceptually, how do the Mean Risk-Free Standard Country
Sharpe and Treynor performance measures define Market Return (R) Rate (Rf) Deviation (S) Beta (B)
risk differently? Which do you believe is a more Estonia 1.12% 0.42% 16.00% 1.65
useful measure in an internationally diversified Latvia 0.75% 0.42% 22.80% 1.53
portfolio?
Lithuania 1.60% 0.42% 13.50% 1.20
11. International Equities and Currencies. As the
newest member of the asset allocation team in your 2. Google and Vodafone. An investor is evaluating a
firm, you constantly find yourself being quizzed by two-asset portfolio of the following securities:
your fellow group members. The topic is international Expected Expected
diversification. One analyst asks you the following Assumptions Return Risk (S) Correlation (R)
question: Google (U.S.) 18.60% 22.80% 0.60
Security prices are driven by a variety of factors, but cor- Vodafone (U.K.) 16.00% 24.00%
porate earnings are clearly one of the primary drivers.
And corporate earningson averagefollow busi- a. If the two securities have a correlation of +.60,
ness cycles. Exchange rates, as they taught you back in what is the expected risk and return for a portfolio
college, reflect the markets assessment of the growth that is equally weighted?
prospects for the economy behind the currency. So if b. If the two securities have a correlation of +.60,
securities go up with the business cycle, and currencies what is the expected risk and return for a portfolio
go up with the business cycle, why do we see currencies that is 70% Google and 30% Vodafone?
and securities prices across the globe not going up and c. If the two securities have a correlation of +.60,
down together? what is the expected risk and return for a portfolio
that has the minimum combined risk.
What is the answer?
3. Tutti-Frutti Equity Fund. An investor is evaluating a
12. Are MNEs Global Investments? Firms with
two-asset portfolio of the following securities:
operations and assets across the globe, true MNEs,
are in many ways as international in composition as Expected Expected
the most internationally diversified portfolio of Security Return Risk (S) Correlation (R)
unrelated securities. Why do investors not simply Tutti Equities 12.50% 26.40%
invest in MNEs traded on their local exchanges and 0.72
Frutti Equities 10.80% 22.50%
forgo the complexity of purchasing securities traded
on foreign exchanges? a. If the two equity funds have a correlation of +.72,
13. ADRs versus Direct Holdings. When you are what is the expected risk and return for the
constructing your portfolio, you know you want to following portfolio weightings?
include Cementos de Mexico (Mexico), but you Portfolio A: 75% Tutti, 25% Frutti
cannot decide whether you wish to hold it in the form Portfolio B: 50% Tutti, 50% Frutti
of ADRs traded on the NYSE or directly through Portfolio C: 25% Tutti, 75% Frutti
purchases on the Mexico City Bolsa. b. Which of the portfolios is preferable? On what
a. Does it make any difference in regard to currency basis?
risk? 4. Spiegel Chemikalie. Oriol Almenara is a European
b. List the pros and cons of ADRs and direct analyst and strategist for Mirror Funds, a New York-
purchases. based mutual fund company. Oriol is currently
c. What would you recommend if you were an evaluating the recent performance of shares in
asset investor for a corporation with no Spiegel Chemikalie, a publicly traded specialty
international operations or internationally chemical company in Germany listed on the
diversified holdings? Frankfurt DAX. The baseline investment amount
used by Mirror is $200,000.

Problems Jan 1 Dec 31

Element Purchase Sale Distributions
1. The Baltic Sea. Assume the U.S. dollar returns Share price, euros :135.00 :157.60 :15.00
(monthly averages) shown in the following table for
Exchange rate, $1.3460 $1.4250
the three Baltic republics. Calculate the Sharpe and
US$/euro
Treynor measures of market performance.
M17_MOFF8079_04_SE_C17.QXD 7/1/11 2:31 PM Page W-20

W-20 PA R T 6 Topics in International Finance

a. What was the return on the security in local 9. Bastion Technology: U.S. Dollar-Based Investors (B).
currency terms? Use the same data, but assume an exchange rate
b. What was the return on the security in U.S. dollar which began at $1.8160/ in June 2008, and then
terms? consistently appreciated versus the U.S. dollar 3.0%
c. Does this mean it was a good investment for a per year for the entire period. Calculate the annual
local investor, a U.S.-based investor, or both? average total return (including dividends) to a U.S.
Bastion Technology is an information technology services dollar-based investor holding the shares for the entire
provider. It currently operates primarily within the Euro- period shown. What is the average return, including
dividend distributions, to a U.S. dollar-based investor
pean marketplace, and therefore is not active or traded on
for the period shown?
any North American Stock Exchange. The companys
share price and dividend distributions have been as fol- 10. Kamchatka-Common Equity Portfolio (A). An
lows in recent years: investor is evaluating a two-asset portfolio which
combines a U.S. equity fund with a Russian equity fund.
Assumptions 6/30/2008 6/30/2009 6/30/2010 6/30/2011 The expected returns, risks, and correlation coefficients
Share price () 37.40 42.88 40.15 44.60 for the coming one-year period are as follows:
Dividend () 1.50 1.60 1.70 1.80 Expected Expected Correlation
Spot rate (:/) 1.8160 1.7855 1.8482 2.0164 Assumptions Return Risk (S) (R)
Common equity fund 10.50% 18.60% 0.52
(United States)
5. Bastion Technology: British Pound-Based Investors. Kamchatka equity fund 16.80% 36.00%
Using the data above, calculate the annual average (Russia)
capital appreciation rate on Bastion shares, as well as
the average total return (including dividends) to a Assuming the expected correlation coefficient is 0.52
British pound-based investor holding the shares for for the coming year, which weights (use increments of
the entire period shown. 5% such as 95/5, 90/10) result in the best trade-off
6. Bastion Technology: Euro-Based investors (A). Using between expected risk and expected return?
the same data, calculate the annual average total 11. Kamchatka-Common Equity Portfolio (B). Rework
return (including dividends) to a euro-based investor problem 10, but assume that you have reduced the
holding the shares for the entire period shown. expected correlation coefficient from 0.52 to
Assume an investment of :100,000. What is the 0.38.Which weights (use increments of 5% such as
average return, including dividend distributions, to a 95/5, 90/10) result in the best trade-off between
euro-based investor for the period shown? expected risk and expected return?
7. Bastion Technology: Euro-Based Investors (B). 12. Brazilian Investors Diversify. The Brazilian economy
Using the same databut assuming an exchange rate in 2001 and 2002 had gone up and down. The
which began at :1.4844/ in June 2008, and then Brazilian reais (R$) had also been declining since
consistently appreciated versus the euro 1.50% per 1999 (when it was floated). Investors wished to
year for the entire period. Calculate the annual diversify internationallyinto U.S. dollars for the
average total return (including dividends) to a euro- most partto protect themselves against the
based investor holding the shares for the entire domestic economy and currency. A large private
period shown. What is the average return, including investor had, in April 2002, invested R$500,000 in
dividend distributions, to a euro-based investor for Standard and Poors 500 Indexes which are traded on
the period shown? the American Stock Exchange (AMSE: SPY). The
8. Bastion Technology: U.S. Dollar-Based Investors (A). beginning and ending index prices and exchange rates
Using the same data, calculate the annual average between the reais and the dollar were as follows:
total return (including dividends) to a U.S. dollar- April 10, 2002 April 10, 2003
based investor holding the shares for the entire Element Purchase Sale
period shown. Assume an investment of $100,000. Share price of SPYDERS $112.60 $87.50
What is the average return, including dividend (U.S. dollars)
distributions, to a U.S. dollar-based investor for the Exchange rate (Reais/$) 2.27 3.22
period shown?
M17_MOFF8079_04_SE_C17.QXD 7/1/11 2:31 PM Page W-21

CHAPTER 17 International Portfolio Theory and Diversification W-21

a. What was the return on the index fund for the year major mutual fund providers (Fidelity, Scudder,
to a U.S.-based investor? Merrill Lynch, Kemper, and so on) and any others of
b. What was the return to the Brazilian investor for interest, to do the following:
the one-year holding period? If the Brazilian a. Distinguish between international funds, global
investor could have invested locally in Brazil in an funds, worldwide funds, and overseas funds
interest bearing account guaranteeing 12%, would b. Determine how international funds have been
that have been better than the American diver- performing, in U.S. dollar terms, relative to mutual
sification strategy? funds offering purely domestic portfolios
c. Use the Security and Exchange Commissions
Internet Exercises Web site, www.sec.gov/pdf/ininvest.pdf, to review
the risk-return issues related to international
1. Modern Portfolio Theory. Use the MoneyOnLine site investing
to review the fundamental theories, assumptions, and
3. Yahoo! Finance Investment Learning Center.
statistical tools that make up modern portfolio theory.
Yahoo! Finance provides detailed current basic and
MoneyOnLine Limited www.moneyonline.co.nz/ advanced research and reading materials related to
modern-portfolio-theory all aspects of investing, including portfolio
2. International Diversification via Mutual Funds. All management. Use its Web site to refresh your
major mutual fund companies now offer a variety of memory on the benefitsand risksof portfolio
internationally diversified mutual funds. The degree diversification.
of international composition across funds, however, Yahoo! Finance Learning biz.yahoo.com/edu/ed_begin
differs significantly. Use the Web sites of any of the .html