INTERNATIONAL PORTFOLIO INVESTMENT

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Chapter 15

• INTERNATIONAL PORTFOLIO INVESTMENT

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Why Invest Internationally?

• What are the advantages of international
  investment?

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THE BENEFITS OF INTERNATIONAL EQUITY 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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II. Basic Portfolio Theory

• II. Basic Portfolio Theory
• A. 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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Basic Portfolio Theory

• B. International Diversification
• 1. Risk-return tradeoff
• may be greater

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Basic Portfolio Theory

• Total Risk
• 1. A Securitys 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 Intl Diversification
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INTERNATIONAL DIVERSIFICATION

• 2. International diversification and
  systematic risk
• a. Diversify across nations with
• different economic cycles
• b. While there is systematic risk
• within 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

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

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The New Efficient Frontier

• E(r)

C
A
B
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CROSS-MARKET CORRELATIONS

• 5. 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)

C
A
B
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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 Diversification

• E. 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

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Expected 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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Expected Portfolio Return

• 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 Example

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

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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 FF 20 / to
  FF21.05 / during the year against the dollar.
• What is the stocks US return for the year?

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U.S. Stock ReturnsSample Solution