Financial Management in the International Corporation Exchange Rates and International Parity Conditions Monday, January 12, 1998

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International Portfolio Management
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We will talk about...

1. Why investors diversify their portfolios
   internationally.
2. How much the investors can gain from
   international diversification.
3. The effect of fluctuating exchange rates on
   international portfolio investments.
4. Portfolio Theory (unhedged and hedged versions).

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International Investment

• Direct Purchase of Foreign Shares
• This route is usually reserved for large
  institutional investors because of high
  transaction costs.
• American Depositary Receipts (ADRs)
• After a U.S. bank has taken custody of foreign
  shares in its foreign office, ADRs can be issued
  as claims against the foreign shares.
• The issuing bank services the ADRs by collecting
  all dividends, rights offerings, etc., and
  distributing the proceeds in US to the ADR
  owners.

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International Investment

• Mutual Funds
• Mutual funds that invest in foreign stocks can be
  grouped into several categories from a U.S.
  perspective
• Global - Investing in U.S. and non-U.S. shares.
• International - Investing in non-U.S. shares
  only.
• Regional - Investing in a geographic area.
• Country - Investing in a single country.
• Specialty - International investments in an
  industry group such as telecommunications, or
  special themes such as newly privatized firms.

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International Investment

• Exchange Traded Funds (ETFs)
• ETFs represent shares in an index fund that is
  intended to track the performance of a single
  country index.

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Correlation structure and risk

• Average return on emerging market index in
  1990-1998
• 3.5 high volatility.
• Average return on SP500 index in 1990-1998
• 13 low volatility.
• Why would investors buy emerging markets stocks?

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Correlation structure and risk
Dont put all your eggs in one
basket Individually, emerging stock markets are
more risky than developed ones, but because the
ups and downs of rich-country markets are not
strongly matched with the ups and downs of
emerging countries markets , holding
emerging-market share as part of a diversified
portfolio allows investors to reduce the
volatility of their overall portfolio.
If an investor has put money into foreign markets
which are highly correlated with his home market
then all of the investors eggs are still in the
same basket.
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Portfolio Riskin domestic and international
stocks

• A fundamental result in portfolio theory is that
  the idiosyncratic risks of individual securities
  can be reduced by investing in a broadly
  diversified portfolio of many securities.
• Various empirical studies indicate that
• For the same portfolio size, randomly selected
  international stocks offered more diversification
  than randomly selected U.S. stocks.
• Diversification across countries reduced risk
  more than diversification across industries
  within a single country.
• The world portfolio offered a risk/return
  trade-off at least as favorable, and often
  considerably more favorable, than any individual
  country.

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Correlation structure and risk
Security returns are much less correlated across
countries than within country. Investors want as
high return as possible for the amount of risk
they are willing to bear or to get the return
they want by taking as little risk as possible.
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Correlation among international stock returns
Stock Market FR GM JP NL US Australia 0.568 0.286
0.138 0.152 0.304 France 0.312 0.238 0.344 0.225
Germany 0.416 0.344 0.225 Japan 0.208 0.137
Netherlands 0.271
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Risk reduction domestic vs. international
diversification
portfolio risk
U.S. stocks
0.27
number of stocks
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Risk reduction domestic vs. international
diversification
portfolio risk
U.S. stocks
0.27
International stocks
0.12
number of stocks
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Optimal portfolio selection
Investors may be willing to assume additional
risk if they are sufficiently compensated by a
higher expected return. Sharpe Performance
measures (SR) provides a risk-adjusted
performance measure. It represents the excess
return (above and beyond the risk-free rate of
interest) per standard deviation risk. SR (Ri -
Rf)/?i Ri - the mean of return in country i. ?i
- risk in country i.
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Optimal portfolio selection

• When finding optimal portfolio allocation we need
  to consider 3 factors
• Return
• Risk (stock price volatility exchange rate
  volatility)
• Correlation with other countries stock prices.
• Optimal portfolio for U.S. investors can be
  different from optimal portfolio for Japanese
  investor.

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Evaluating the gains
The gains from holding international portfolio is
measured by the increase in Sharpe performance
measure. ?SR SR(OIP) - SR(DP) OIP optimal
international portfolio DP domestic
portfolio ?SR represents the extra return per
standard deviation risk accruing from
international investment. The SRs of the
international portfolios demonstrates potential
benefits of international diversification.
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Evaluating the gains
However, SHP formula does not take into account
transaction costs (commissions and bid-ask
spread) and taxes. It is known that countries
have different transaction costs and tax rates.
If they are high in foreign countries, benefits
of international portfolio diversification will
be reduced. There are barriers to cross-border
capital movements. Countries, especially emerging
economies, set restrictions on capital flows, in
order to reduce the problem of hot money or to
preserve domestic ownership of corporations. To
the extent that restrictions on capital flows are
severe, it will be difficult to capture full
benefits of international diversification.
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Effect of changes in the exchange rate

• Rate of return on Dax 100 is 20.
• Rate of return on Dow Jones is 15.
• Would you buy Dax 100 or Dow Jones?
• What if Euro depreciates against dollar?
• The realized dollar returns for a U.S. resident
  investing in a foreign market will depend not
  only on the return in the foreign market but also
  on the change in the exchange rate between the
  dollar and the foreign currency.

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Effect of changes in the exchange rate
Ri local currency rate of return from the ith
foreign market. ?Si the rate of change in the
exchange rate between the local currency and the
dollar, expressed in per local currency. Ri
the rate of return in dollar terms from investing
in the i's foreign market. Ri (1 Ri)(1
?Si)-1 Ri ?Si Ri ?Si
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Effect of changes in the exchange rate
Pension funds in Argentina, Bolivia, Columbia,
Mexico, and Chile. By investing internationally
they show better performance but money leaves the
country. Those pensions will be paid in home
currency. But exchange rate fluctuations can
cause big swings in the domestic-currency value
of foreign assets.
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Internationalizing domestic portfolio
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 Security Market Line is tangent to
the domestic portfolio opportunity set. The
domestic portfolio with the minimum risk is MRDP.
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Internationalizing domestic portfolio
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 opportunity set. The domestic
portfolio with the minimum risk is MRDP.
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Internationalizing domestic portfolio
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 Security Market Line is tangent to
the domestic portfolio opportunity set. The
domestic portfolio with the minimum risk is MRDP.
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Correlation among international stock returns

• Correlation between shares declines as markets
  become globalized.
• Globalization is good for any economy (more
  trade).
• Globalization may be bad for investors.
• As the worlds financial markets grow more
  integrated their movements may also become more
  correlated.
• Investors with money (U.S.) may not be willing to
  invest abroad which might slow economic growth
  down in developing countries.

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Key points
1. International portfolio investment has been
growing rapidly in recent years due to (a) the
deregulation of financial markets, and (b) the
introduction of mutual funds. 2. Investors
diversify to reduce risk. The extent by which the
risk is reduced depends on the covariance among
individual securities comprising the portfolio.
Since the security returns tend to covary much
less across countries than within a country,
investors can reduce portfolio risk more by
diversifying internationally than purely
domestically. 3. Foreign exchange rate
uncertainty contributes to the risk of foreign
investment through its own volatility as well as
with through its covariance with local market
returns.