Internationtal Diversification

8/14/2019 Internationtal Diversification

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International Diversification


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Global market

US Market is 40% - 49% of all markets

Improved access & technologyNew instruments

Emphasis for our investigation

Risk assessment

Diversification

Background


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What are the risks involved in investment inforeign securities?

How do you measure benchmark returns onforeign investments?

Are there benefits to diversification in foreignsecurities?

Issues


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Foreign Exchange Risk

Variation in return related to changes in therelative value of the domestic and foreign

currency.Total return = investment return & return on

foreign exchange

Its not possible to completely hedge a foreign

investment.

Foreign Exchange Risk


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Return in US is a function of two factors:

1. Return in the foreign market

2. Return on the foreign exchange

Returns with Foreign

Exchange


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Condition: U.S. Investor invests $10,000 in theBritish Market

Initial Conditions:

Initial Investment : $20,000

Initial Exchange: $2.00/ Pound Sterling

Initial Investment in Pound Sterling: 10,000

Risk Free Rate in U.K.: 10%

Future Value in Pound Sterling: 11,000

Returns with Foreign Exchange:

Example


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Pound Depreciates to $1.80

11,000 * 1.8 = $19,800Return in US$ (-200 / 20,000) = -1%

Pound Remains at $2.00

11,000 * 2.0 = $22,000Return in US$ (2,000 / 20,000) = 10%

Pound Appreciates to $2.2011,000 * 2.20 = $24,200Return in US$ ( 4,200 / 20,000) = 21%


Exchange


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ExchangeMovements in foreign exchange can

have a major influenceFrom Figure 25.2New Zealand nearly 50% of return is from

foreign exchange

Australia virtually all of the return in fromforeign exchange

Returns from U.K. and Switzerland are

mostly from returns in local currencyBoth factors must be considered in

international investing


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Political Risk Services Group Ratings

Rank countries with respect to political risk,

financial risk and economic risk

Assign composite rating from very high risk

to very low risk based on the above

elements of risk

Country Specific Risk


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PSR Risk VariablesPolitical Risk Variables (country specific risk)

Government stability, corruption, changes inpolicies, etc

Financial Risk VariablesForeign debt (%GDP), Exchange rate stability

etc

Economic Risk VariablesGDP per capita, annual inflation etc


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Evidence shows international diversification is

beneficial.

Its possible to expand the efficient frontier

above domestic only frontier.

Its possible to reduce the systematic risk

level below the domestic only level.

Diversification Benefits


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Return

Risk

* *

*

**

* *

*Dom

Intl


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Risk

Securities

Intl

Dom


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Direct stock purchases

American depository receipts

Mutual Funds

Open-end funds

Closed-end funds

WEBS (World Equity Benchmarks)

International Investment

Choices


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Indexes

EAFE Index (Europe, Australia, Far East

index)

Issues in measuring performance

Weighting

Cross-Holdings

Other possibilities

Country and Region Funds

Measuring Benchmark

Returns


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Performance Attribution with

InternationalExtension to consider additional factors

Currency selection

Country selection

Stock selection

Cash and bond selection


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Efficient Market Hypothesis

(EMH)

Do security prices reflect information ?

Why look at market efficiency?

Implications for business and corporate

finance

Implications for investment

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SecurityPrices

Time

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Random Price ChangesWhy are price changes random?

Prices react to information

Flow of information is random

Therefore, price changes are random

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EMH and CompetitionStock prices fully and accurately reflect

publicly available information.Once information becomes available,

market participants analyze it.

Competition assures prices reflect

information.

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Forms of the EMH Weak

Semi-strong

Strong

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Types of Stock AnalysisTechnical Analysis - using prices and volume

information to predict future prices.

Weak form efficiency & technical analysis

Fundamental Analysis - using economic and

accounting information to predict stock prices.

Semi strong form efficiency & fundamentalanalysis

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Active or Passive

ManagementActive Management

Security analysis

Timing

Passive Management

Buy and HoldIndex Funds

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Market Efficiency & Portfolio

ManagementEven if the market is efficient a role exists for

portfolio management:

Appropriate risk level

Tax considerations

Other considerations

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Empirical Tests of Market

EfficiencyEvent studies

Assessing performance of professional

managers

Testing some trading rule

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How Tests Are Structured1. Examine prices and returns over time

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0 +t-t

Announcement Date

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How Tests Are Structured

(contd)2. Returns are adjusted to determine if they areabnormal.

Market Model approach

a. Rt= a

t+ b

tR

mt+ e

t

(Expected Return)

b. Excess Return =

(Actual - Expected)

et= Actual - (a

t+ b

tR

mt)

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How Tests Are Structured

(contd)2. Returns are adjusted to determine if they are

abnormal.

Market Model approach

c. Cumulate the excess returns overtime:

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Issues in Examining the

ResultsMagnitude Issue

Selection Bias Issue

Lucky Event Issue

Possible Model Misspecification

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What Does the Evidence

Show?Technical Analysis

Short horizon

Long horizon

Fundamental Analysis

Anomalies Exist

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AnomaliesSmall Firm Effect (January Effect)

Neglected Firm

Market to Book Ratios

Reversals

Post-Earnings Announcement Drift

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Explanations of

AnomaliesMay be risk premiums

Behavioral Explanations

Information Processing Errors

Behavioral BiasesLimits to Arbitrage

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Information ProcessingForecasting Errors

Overconfidence

Conservatism

Sample Neglect and Representativeness

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Behavioral BiasesAnchoringMental Accounting

Confirmation & Hindsight bias

Gamblers fallacyHerd behaviour

Over confidence

Overreaction and availability bias

Prospect theory

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Limits to ArbitrageFundamental Risk

Implementation Costs

Model Risk

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Mutual Fund PerformanceSome evidence of persistent positive and

negative performance.

Potential measurement error forbenchmark returns.

Style changes

May be risk premiums

Internationtal Diversification

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