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International Portfolio Investment
Chapter 15
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2
Why Invest Internationally?
What are the advantages of international investment?
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THE BENEFITS OF INTERNATIONALEQUITY INVESTING
I. THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
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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Basic Portfolio Theory:
What is the efficient frontier?
It represents the most efficient combinations of all possible risky assets.
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The Efficient Frontier
E(r)
A
B
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Basic Portfolio Theory:
The broader the diversification, the more stable the returns and the more diffuse the risk.
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Diversification
The Insurance Principle:
U U UU U UU U U
US US US
US US US
US US US
S S S
Not diversified Diversified
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INTERNATIONAL DIVERSIFICATION
B.International Diversification
1. Risk-return tradeoff:
may be greater
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Basic Portfolio Theory:
Total Risk of a Security’s Returns may be segmented into
Systematic Risk
can not be eliminated
Non-systematic Risk
can be eliminated by diversification
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The Benefits of Int’l Diversification
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INTERNATIONAL DIVERSIFICATION
2. International diversification and systematic risk
a. Diversify across nations withdifferent economic cycles
b. While there is systematic riskwithin a nation, outside the
country it may be nonsystematic and diversifiable
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INTERNATIONAL PORTFOLIO INVESTMENT
3. Recent History
a. National stock markets have wide
differences in returns and risk.
b. Emerging markets have higher
risk and return than developed
markets.
c. Cross-market correlations have
been relatively low.
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INTERNATIONAL PORTFOLIO INVESTMENT
3. Theoretical Conclusion
International diversification pushes out the efficient frontier.
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The New Efficient FrontierE(r)
A
B
C
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CROSS-MARKET CORRELATIONS
6. Cross-market correlations
a. Recent markets seem to be most correlated when volatility is
greatest
b. Result:
Efficient frontier retreats
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The Frontier During Global Crises
E(r)
A
B
C
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Investing in Emerging Markets
D. Investing in Emerging Markets
a. Offers highest risk and returns
b. Low correlations with returns
elsewhere
c. As impediments to capital market mobility fall, correlations are
likely to increase in the future.
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Barriers to International DiversificationE.Barriers to International Diversification
1. Segmented markets2. Lack of liquidity3. Exchange rate controls4. Underdeveloped capital markets5. Exchange rate risk6. Lack of information
a. not readily accessibleb. data is not comparable
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Other Methods to Diversify
F. Diversify by a 1. Trade in American Depository
Receipts (ADRs)2. Trade in American shares3. 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
4. Calculation of Expected Portfolio Return:
rp = a rUS + ( 1 - a) rrw
where
rp = portfolio expected return
rUS = expected U.S. market return
rrw = expected global return
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Portfolio Return
Sample ProblemWhat is the expected return of a portfolio with 35% invested in Japan returning 10% and 65% in the U.S. returning 5%?
rp = a rUS + ( 1 - a) rrw
= .65(.05) + .35(.10) = .0325 + .0350= 6.75%
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INTERNATIONAL PORTFOLIO INVESTMENT
5. Calculation of Expected Portfolio Risk
where = the cross-market correlation
US2 = U.S. returns variance
r w2 = 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 .7?
= [(.65)2 (.08) 2 + (.35) 2(.06) 2 +2(.65)(.35)(.08)(.06)(.7)] 1/2
= 6.8%
1/ 22 2 2 2(1 ) 2 (1 )P US rw US rwa a a a
1/ 22 2 2 2(1 ) 2 (1 )P US rw US rwa a a a
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INTERNATIONAL PORTFOLIO INVESTMENT
IV. MEASURING TOTAL RETURNS
FROM FOREIGN PORTFOLIOS
A. To compute dollar return of a foreign security:
or
1 0$
0
( )( )US ForeignCurrency
e eR R
e
0 1$
1
( )( )US ForeignCurrency
e eR R
e
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Flash Back!
For currency appreciation:
For currency depreciation:
1 0$
0
( )( )US ForeignCurrency
e eR R
e
0 1$
1
( )( )US ForeignCurrency
e eR R
e
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INTERNATIONAL PORTFOLIO INVESTMENT
Bond (calculating return) formula:
where R$ = dollar return B(1) = foreign currency bond price at time 1 (present)
C = coupon income during periodg = currency depreciation or appreciation
$
(1) (0)1 1 (1 )
(0)
B B CR g
B
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INTERNATIONAL PORTFOLIO INVESTMENT
B. Stocks (Calculating return)
Formula:
where R$ = dollar returnP(1) = foreign currency stock
price at time 1D = foreign currency annual
dividend
$
(1) (0)1 1 (1 )
(0)
P P DR g
P
$
(1) (0)1 1 (1 )
(0)
P P DR g
P
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U.S. $ Stock Returns:Sample Problem
Suppose the beginning stock price if FF50 and the ending price is FF48. Dividend income was FF1. The franc depreciates from FF 20 /$ to FF21.05 /$ during the year against the dollar.
What is the stock’s US$ return for the year?
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U.S. $ Stock Returns:Sample Solution
$
(1) (0)1 1 (1 )
(0)
P P DR g
P
48 50 1 .20 .21051 1 1
50 .2105
.98 .95 1
$ 6.9%R $ 6.9%R