International International Portfolio InvestmentPortfolio Investment

Chapter 13Chapter 13

22

Why Invest Why Invest Internationally?Internationally?

What are the advantages?What are the advantages?

33

THE BENEFITS OF INTERNATIONALTHE BENEFITS OF INTERNATIONALEQUITY INVESTINGEQUITY INVESTING

I. Why invest internationally?I. Why invest internationally?A.A. AdvantagesAdvantages

1.1. Offers more opportunities thanOffers more opportunities thana purely domestic portfolioa purely domestic portfolio

2.2. Attractive investments overseasAttractive investments overseas3.3. Diversification benefits positivelyDiversification benefits positively

impact the impact the efficient frontierefficient frontier

CautionCaution: IT MAY BE MORE RISK THAN : IT MAY BE MORE RISK THAN DOMESTIC DOMESTIC INVESTMENTSINVESTMENTS

44

Modern Portfolio Modern Portfolio TheoryTheory

Harry Markowitz, Nobel Prize Harry Markowitz, Nobel Prize WinnerWinner

Central concept:Central concept:

Invest using the risk (Invest using the risk (σσ) and) and return E(r) trade off.return E(r) trade off.

55

Basic Portfolio Basic Portfolio Theory:Theory:

What is the efficient frontier?What is the efficient frontier?

It represents the most efficient It represents the most efficient combinations (portfolios) of all combinations (portfolios) of all possible risky assets.possible risky assets.

66

The Efficient FrontierThe Efficient Frontier

E(r)E(r)

A

B

Why is Portfolio B inefficient?

C Impossible!!

77

Basic Portfolio Theory:Basic Portfolio Theory:DIVERSIFICATIONDIVERSIFICATION

What are diversification benefits:What are diversification benefits:

The broader the diversification,The broader the diversification,

a. the more a. the more stablestable the the returns and returns and

b. the more b. the more diffuse the diffuse the riskrisk..

BASED ON THE INSURANCE PRINCIPLE!BASED ON THE INSURANCE PRINCIPLE!

88

Diversification and The Diversification and The Insurance PrincipleInsurance 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 INTERNATIONAL DIVERSIFICATIONDIVERSIFICATION

B. Another Benefit from International B. Another Benefit from International DiversificationDiversification Risk-return tradeoff:Risk-return tradeoff:

May be greaterMay be greater w when hen investing internationally investing internationally

WHY?WHY?

1010

Basic Portfolio Basic Portfolio Theory:Theory:

1. 1. Total RiskTotal Risk of a Security’s Return may of a Security’s Return may be segmented into two parts:be segmented into two parts:

== Systematic RiskSystematic Risk

such as inflation and unemploymentsuch as inflation and unemployment

which which can not be eliminatedcan not be eliminated

++ Non-systematic RiskNon-systematic Risk

such as industry business cycles such as industry business cycles which which can be eliminatedcan be eliminated by by diversificationdiversification

1111

The Benefits of Int’l The Benefits of Int’l Diversification: The Diversification: The EvidenceEvidence

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INTERNATIONAL INTERNATIONAL DIVERSIFICATIONDIVERSIFICATION

2. Using International diversification 2. Using International diversification to reduce systematic risk:to reduce systematic risk:a.a. Guideline:Guideline: Diversify across Diversify across

nations in different stages nations in different stages of the of the business cyclebusiness cycle

b.b. Benefit: Benefit: While there is systematic While there is systematic risk risk within a domestic portfolio, it within a domestic portfolio, it may bemay be nonsystematic nonsystematic and and diversifiable diversifiable in a in a global portfolioglobal portfolio

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INTERNATIONAL PORTFOLIOINTERNATIONAL PORTFOLIO INVESTMENTINVESTMENT

3.3. Recent HistoryRecent History

a.a. National stock markets have National stock markets have widewide

differences in returns and risk.differences in returns and risk.

b.b. Emerging markets often have Emerging markets often have higher risk and return than higher risk and return than

developed markets.developed markets.

c.c. Cross-market correlations haveCross-market correlations have

been relatively low.been relatively low.

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Cross-Market Cross-Market Correlations Correlations

With a U.S. portfolio:With a U.S. portfolio:

1. High positive correlations:1. High positive correlations:

2.2. Low or Negative correlations:Low or Negative correlations:

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INTERNATIONAL PORTFOLIOINTERNATIONAL PORTFOLIO INVESTMENTINVESTMENT

4.4. Theoretical ConclusionTheoretical Conclusion

International diversification International diversification pushes out the efficient pushes out the efficient

frontier.frontier.

1616

The New Efficient The New Efficient FrontierFrontier

E(r)E(r)

A

B

C

1717

CROSS-MARKET CROSS-MARKET CORRELAITONSCORRELAITONS

5.5. Cross-market correlationsCross-market correlations

a. Recent markets seem to a. Recent markets seem to be be most correlated when most correlated when volatility volatility is greatestis greatest

b. Result:b. Result:

Efficient frontier retreatsEfficient frontier retreats

1818

The Frontier During The Frontier During Global CrisesGlobal Crises

E(r)E(r)

A

B

C

1919

Investing in Emerging Investing in Emerging MarketsMarkets

C.C. Investing in Emerging MarketsInvesting in Emerging Markets

a.a. Offers highest risk and Offers highest risk and returnsreturns

b.b. Low correlations with returnsLow correlations with returns

elsewhereelsewhere

Caution:Caution:As impediments to capital As impediments to capital market mobility fall, market mobility fall, correlations are correlations are

likely to likely to increase in the future.increase in the future.

2020

Barriers to Barriers to International International DiversificationDiversificationD.D. Barriers to International Barriers to International

DiversificationDiversification1.1. Segmented marketsSegmented markets2.2. Lack of liquidityLack of liquidity3.3. Exchange rate controlsExchange rate controls4.4. Underdeveloped capital marketsUnderdeveloped capital markets5.5. Exchange rate riskExchange rate risk6.6. Lack of informationLack of information

a.a. not readily accessiblenot readily accessibleb.b. data is not comparabledata is not comparable

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Other Methods to Other Methods to DiversifyDiversify

F.F. Diversify by a Diversify by a 1.1. Trade in American DepositoryTrade in American Depository

Receipts (ADRs)Receipts (ADRs)2.2. Trade in American sharesTrade in American shares3.3. Trade internationally diversifiedTrade internationally diversified

mutual funds:mutual funds:a.a. Global (all types)Global (all types)b.b. International (no home International (no home

country securities)country securities)c.c. Single-countrySingle-country

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INTERNATIONAL PORTFOLIOINTERNATIONAL PORTFOLIO INVESTMENTINVESTMENT

4.4.Calculation of Expected Portfolio Return:Calculation of Expected Portfolio Return:

rrp p = a r = a rUSUS + ( 1 - a) r + ( 1 - a) rrwrw

where where

rrp p = portfolio expected return= portfolio expected return

rrUSUS = expected U.S. market = expected U.S. market

return return

rrrwrw = expected global return= expected global return

2323

Portfolio ReturnPortfolio Return

Sample ProblemSample ProblemWhat is the expected return of a What is the expected return of a

portfolio with 35% invested in Japan portfolio with 35% invested in Japan returning 10% and 65% in the U.S. returning 10% and 65% in the U.S. returning 5%?returning 5%?

rrp p = a r= a rUSUS + ( 1 - a) r + ( 1 - a) rrwrw

= .65(.05) + .35(.10) = .65(.05) + .35(.10) == .0325 + .0350.0325 + .0350== 6.75%6.75%

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INTERNATIONAL PORTFOLIOINTERNATIONAL PORTFOLIO INVESTMENTINVESTMENT

Calculation of Expected Portfolio Risk Calculation of Expected Portfolio Risk

wherewhere == the cross-market the cross-market correlationcorrelation

USUS22 == U.S. returns varianceU.S. returns variance

r wr w22 == World returns varianceWorld returns variance

1/ 22 2 2 2(1 ) 2 (1 )P US rw US rwa a a a

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Portfolio RiskPortfolio Risk

What is the risk of a portfolio with 35% What is the risk of a portfolio with 35% invested in Japan with a standard deviation invested in Japan with a standard deviation of 6% and a standard deviation of 8% in the of 6% and a standard deviation of 8% in the U.S. and a correlation coefficient of .7?U.S. and a correlation coefficient of .7?

= [(.65)= [(.65)22 (.08) (.08) 22 + (.35) + (.35) 22(.06) (.06) 2 2 +2(.65)+2(.65)(.35)(.08)(.06)(.7)] (.35)(.08)(.06)(.7)] 1/21/2

== 6.8%6.8%

1/ 22 2 2 2(1 ) 2 (1 )P US rw US rwa a a a

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INTERNATIONAL PORTFOLIOINTERNATIONAL PORTFOLIO INVESTMENTINVESTMENT

IV.IV. MEASURING TOTAL RETURNSMEASURING TOTAL RETURNS

FROM FOREIGN PORTFOLIOSFROM FOREIGN PORTFOLIOS

A.A. To compute dollar return To compute dollar return of a of a foreign security: foreign security:

oror

1 0$

0

( )( )US ForeignCurrency

e eR R

e

0 1$

1

( )( )US ForeignCurrency

e eR R

e

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INTERNATIONAL PORTFOLIOINTERNATIONAL PORTFOLIO INVESTMENTINVESTMENT

Bond (calculating return) formula:Bond (calculating return) formula:

wherewhere RR$$ = dollar return = dollar return B(1) = B(1) = foreign currency bond priceforeign currency bond price at at

time 1 (present)time 1 (present)C = coupon income during periodC = coupon income during periodg = currency depreciation g = currency depreciation or appreciationor appreciation

$

(1) (0)1 1 (1 )

(0)

B B CR g

B

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INTERNATIONAL PORTFOLIOINTERNATIONAL PORTFOLIO INVESTMENTINVESTMENT

B.B. Stocks (Calculating return)Stocks (Calculating return)

Formula:Formula:

wherewhere RR$$ = dollar return= dollar returnP(1)P(1) = foreign currency stock = foreign currency stock

price at time 1 price at time 1DD = foreign currency = foreign currency annualannual

dividenddividend

$

(1) (0)1 1 (1 )

(0)

P P DR g

P

2929

U.S. $ Stock Returns:U.S. $ Stock Returns:Sample ProblemSample Problem

Suppose the beginning stock price if Suppose the beginning stock price if FF50 and the ending price is FF48. FF50 and the ending price is FF48. Dividend income was FF1. The franc Dividend income was FF1. The franc depreciates from $.20 /FF to $.2105 depreciates from $.20 /FF to $.2105 /FF during the year against the dollar. /FF during the year against the dollar. What is the stock’s US$ return for the What is the stock’s US$ return for the year?year?

3030

U.S. $ Stock Returns:U.S. $ Stock Returns:Sample SolutionSample Solution

During the year the price of British bonds During the year the price of British bonds went from went from £102 to £106, while paying a £102 to £106, while paying a coupon of £9. At the same time, the coupon of £9. At the same time, the exchange rate went from$1.76/ £ to exchange rate went from$1.76/ £ to $1.62/ £. What was the total dollar return, $1.62/ £. What was the total dollar return, in percent, on British bonds for the year?in percent, on British bonds for the year?

ee00=$1.76/£ =$1.76/£ ee11=$1.62/£=$1.62/£

In direct terms:In direct terms:

ee00= £.5682/$= £.5682/$ ee11= £.6173/$= £.6173/$

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U.S. $ Stock Returns:U.S. $ Stock Returns:Sample SolutionSample Solution

1 0$

0

0 1

1

1 1 1

( )

106 102 9 .5682 .61731 1

102 .6173

(1.1275)(1 .0795)

(1.1275)(.9205) 1

3.79%

B B Cr g

B

e eg

e