chapter 19 international portfolio investment. chapter overview: i.the benefits of international...

CHAPTER 19CHAPTER 19

INTERNATIONAL INTERNATIONAL PORTFOLIO PORTFOLIO

INVESTMENTINVESTMENT

CHAPTER OVERVIEW:CHAPTER OVERVIEW:

I.I. THE BENEFITS OF THE BENEFITS OF INTERNATIONAL INTERNATIONAL EQUITY INVESTINGEQUITY INVESTING

II.II. INTERNATIONAL BOND INTERNATIONAL BOND INVESTINGINVESTING

III.III. OPTIMAL ASSET ALLOCATIONOPTIMAL ASSET ALLOCATION

IV.IV. MEASURING THE TOTAL RETURNMEASURING THE TOTAL RETURN

V.V. MEASURING EXCHANGE RISK ON MEASURING EXCHANGE RISK ON FOREIGN SECURITIESFOREIGN SECURITIES

I. THE BENEFITS OF INTERNATIONAL I. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING EQUITY INVESTING

I.I. THE BENEFITS OF INTERNATIONALTHE BENEFITS OF INTERNATIONAL

EQUITY INVESTINGEQUITY INVESTING

A.A. AdvantagesAdvantages

1.1. Offers more opportunities thanOffers more opportunities than

a domestic portfolio onlya domestic portfolio only

2.2. Larger firms often are Larger firms often are overseasoverseas

THE BENEFITS OF INTERNATIONAL THE BENEFITS OF INTERNATIONAL EQUITY INVESTINGEQUITY INVESTING

B.B. International DiversificationInternational Diversification

1. Risk-return tradeoff: may be 1. Risk-return tradeoff: may be greater greater

basic rule-basic rule-

the broader the the broader the diversification,diversification,

more stable the returns and more stable the returns and the more diffuse the risk.the more diffuse the risk.


2. International diversification and 2. International diversification and systematic risksystematic risk

a.a. Diversifying across nations Diversifying across nations withwith

different economic cyclesdifferent economic cycles


b.b. While there is systematic riskWhile there is systematic risk

within a nation, it may bewithin a nation, it may be

nonsystematic and nonsystematic and diversifiablediversifiable

outside the country.outside the country.


3.3. Recent HistoryRecent History

a.a. National stock markets have wideNational stock markets have wide

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

b.b. Emerging markets have higherEmerging markets have higher

risk and return than developed risk and return than developed

markets.markets.

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

been relatively low.been relatively low.


C.C. Correlations and the Gains From Correlations and the Gains From DiversificationDiversification

1. Correlation of foreign market betas1. Correlation of foreign market betas

ForeignForeign Correlation Correlation Std dev Std dev market =market = with U.S. x with U.S. x for. mkt.for. mkt.

betabeta market market std dev std dev U.S. mkt.U.S. mkt.


Past empirical evidence suggests inter-Past empirical evidence suggests inter-

national diversification reduces national diversification reduces portfolioportfolio

risk. risk.


3.3. Theoretical ConclusionTheoretical Conclusion

International diversification pushes outInternational diversification pushes out

the efficient frontier.the efficient frontier.


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

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

where where r rp p = portfolio expected return= portfolio expected return

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

rrrw rw = expected global return = expected global return


5.5.Calculation of Expected Portfolio Risk Calculation of Expected Portfolio Risk ((PP ) )

PP = [a = [a 22USUS22 + (1-a) + (1-a)2 2 r wr w

22 + 2a(1-a) + 2a(1-a) USUSrwrw US,rwUS,rw]]1/21/2

wherewhere US,rw US,rw == the cross-market the cross-market correlationcorrelation

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

r wr w22 = = World returns varianceWorld returns variance


6.6. Cross-market correlationsCross-market correlations

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

greatest greatest

b. Result:b. Result:

Efficient frontier retreatsEfficient frontier retreats


D.D. Investing in Emerging MarketsInvesting in Emerging Markets

a.a. Offers highest risk and returnsOffers highest risk and returns

b.b. Low correlations with returnsLow correlations with returns

elsewhereelsewhere

c.c. As impediments to capital As impediments to capital marketmarket

mobility fall, correlations are mobility fall, correlations are likely to increase in the future.likely to increase in the future.


E.E. Barriers to International Barriers to International DiversificationDiversification

1.1. Segmented marketsSegmented markets

2.2. Lack of liquidityLack of liquidity

3.3. Exchange rate controlsExchange rate controls

4.4. Less developed capital marketsLess developed capital markets

5.5. Exchange rate riskExchange rate risk

6.6. Lack of informationLack of informationa.a. readily accessiblereadily accessibleb.b. comparablecomparable


F.F. Methods to DiversifyMethods to Diversify

1.1. Trade in American DepositoryTrade in American Depository

Receipts (ADRs)Receipts (ADRs)

2.2. Trade in American sharesTrade in American shares

3.3. Trade internationally diversifiedTrade internationally diversified

mutual funds:mutual funds:a.a. GlobalGlobalb.b. InternationalInternationalc.c. Single-countrySingle-country

II. INTERNATIONAL BOND II. INTERNATIONAL BOND INVESTINGINVESTING

II. INTERNATIONAL BOND INVESTINGII. INTERNATIONAL BOND INVESTING

-internationally diversified bond -internationally diversified bond

portfolios offer superior portfolios offer superior performance performance

INTERNATIONAL BOND INTERNATIONAL BOND INVESTINGINVESTING

A.A. Empirical EvidenceEmpirical Evidence

1.1. Foreign bonds provide higherForeign bonds provide higher

returnsreturns

2.2. Foreign portfolios outperformForeign portfolios outperform

purely domesticpurely domestic

III.III. OPTIMAL INTERNATIONAL OPTIMAL INTERNATIONAL ASSET ALLOCATION ASSET ALLOCATION

III.III. OPTIMAL INTERNATIONAL ASSETOPTIMAL INTERNATIONAL ASSET

ALLOCATIONALLOCATION

-a diversified combination of stocks -a diversified combination of stocks andand

bondsbonds

A.A. Offered better risk-return tradeoffOffered better risk-return tradeoff

B.B. Weighting options flexibleWeighting options flexible

IV.IV. MEASURING TOTAL RETURNSMEASURING TOTAL RETURNSFROM FOREIGN PORTFOLIOSFROM FOREIGN PORTFOLIOS

IV.IV. MEASURING TOTAL RETURNSMEASURING TOTAL RETURNS

FROM FOREIGN PORTFOLIOSFROM FOREIGN PORTFOLIOS

A.A. BondsBonds

Dollar = ForeignDollar = Foreign x Currencyx Currencyreturn currencyreturn currency gain (loss) gain (loss)

returnreturn


Bond return formula:Bond return formula:

1 + R1 + R$$ ==[[1 +1 +B(1) - B(0) + CB(1) - B(0) + C ]](1+g)(1+g)

B(0)B(0)wherewhere RR$$ = dollar return = dollar return

B(1) = foreign currency bond priceB(1) = foreign currency bond price at time 1 at time 1C = coupon incomeC = coupon incomeg = depreciation/appreciationg = depreciation/appreciation

of foreign currencyof foreign currency


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

Formula:Formula:

1 + R1 + R$$ ==[[ 1+1+ P(1) - P(0) + D P(1) - P(0) + D ]](1+g)(1+g) P(0)P(0)

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 annual= foreign currency annual

dividenddividend

chapter 19 international portfolio investment. chapter overview: i.the benefits of international...

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