International Portfolio Investment

1
International Portfolio Investment

• Chapter 13

2
Why Invest Internationally?

• What are the advantages?

3
THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

• I. Why invest internationally?
• A. Advantages
• 1. Offers more opportunities than
• a purely domestic portfolio
• 2. Attractive investments overseas
• 3. Diversification benefits positively
• impact the efficient frontier
• Caution IT MAY BE MORE RISK THAN DOMESTIC
  INVESTMENTS

4
Modern Portfolio Theory

• Harry Markowitz, Nobel Prize Winner
• Central concept
• Invest using the risk (s) and return E(r) trade
  off.

5
Basic Portfolio Theory

• What is the efficient frontier?
• It represents the most efficient combinations
  (portfolios) of all possible risky assets.

6
The Efficient Frontier
Impossible!!
C

• E(r)

A
Why is Portfolio B inefficient?
B
7
Basic Portfolio TheoryDIVERSIFICATION

• What are diversification benefits
• The broader the diversification,
• a. the more stable the returns and
• b. the more diffuse the risk.
• BASED ON THE INSURANCE PRINCIPLE!

8
Diversification and The Insurance Principle
US US US US US US US US US S S S
U U U U U U U U U
Not diversified
Diversified
9
INTERNATIONAL DIVERSIFICATION

• B. Another Benefit from International
  Diversification
• Risk-return tradeoff
• May be greater when investing
  internationally
• WHY?

10
Basic Portfolio Theory

• 1. Total Risk of a Securitys Return may be
  segmented into two parts
• Systematic Risk
• such as inflation and unemployment
• which can not be eliminated
• Non-systematic Risk
• such as industry business cycles which can be
  eliminated by diversification

11
The Benefits of Intl Diversification The
Evidence
12
INTERNATIONAL DIVERSIFICATION

• 2. Using International diversification to
  reduce systematic risk
• a. Guideline Diversify across nations in
  different stages of the business cycle
• b. Benefit While there is systematic risk
  within a domestic portfolio, it may
  be nonsystematic and diversifiable in a
  global portfolio

13
INTERNATIONAL PORTFOLIO INVESTMENT

• 3. Recent History
• a. National stock markets have wide
• differences in returns and risk.
• b. Emerging markets often have higher risk
  and return than developed markets.
• c. Cross-market correlations have
• been relatively low.

14
Cross-Market Correlations

• With a U.S. portfolio
• 1. High positive correlations
• 2. Low or Negative correlations

15
INTERNATIONAL PORTFOLIO INVESTMENT

• 4. Theoretical Conclusion
• International diversification pushes out the
  efficient frontier.

16
The New Efficient Frontier
C

• E(r)

A
B
17
CROSS-MARKET CORRELAITONS

• 5. Cross-market correlations
• a. Recent markets seem to be most
  correlated when volatility is greatest
• b. Result
• Efficient frontier retreats

18
The Frontier During Global Crises
C

• E(r)

A
B
19
Investing in Emerging Markets

• C. Investing in Emerging Markets
• a. Offers highest risk and returns
• b. Low correlations with returns
• elsewhere
• Caution
• As impediments to capital market mobility
  fall, correlations are likely to
  increase in the future.

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Barriers to International Diversification

• D. Barriers to International Diversification
• 1. Segmented markets
• 2. Lack of liquidity
• 3. Exchange rate controls
• 4. Underdeveloped capital markets
• 5. Exchange rate risk
• 6. Lack of information
• a. not readily accessible
• b. 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 shares
• 3. 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

23
Portfolio Return

• Sample Problem
• What 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

• 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

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INTERNATIONAL PORTFOLIO INVESTMENT

• IV. MEASURING TOTAL RETURNS
• FROM FOREIGN PORTFOLIOS
• A. To compute dollar return of a foreign
  security
• or

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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 period
• g currency depreciation or
  appreciation

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INTERNATIONAL PORTFOLIO INVESTMENT

• B. Stocks (Calculating return)
• Formula
• where R dollar return
• P(1) foreign currency stock price
  at time 1
• D foreign currency annual
• dividend

29
U.S. Stock ReturnsSample Problem

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

30
U.S. Stock ReturnsSample Solution

• During the year the price of British bonds went
  from 102 to 106, while paying a coupon of 9.
  At the same time, the exchange rate went
  from1.76/ to 1.62/ . What was the total
  dollar return, in percent, on British bonds for
  the year?
• e01.76/ e11.62/
• In direct terms
• e0 .5682/ e1 .6173/

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U.S. Stock ReturnsSample Solution