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International Investment and Diversification
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International Diversification
The World Portfolio Calculating the Return on Foreign Investments
The Risk of Foreign Securities
Returns from International Diversification
The Effect of Exchange Risk
Return Expectations and Portfolio Performance
Other Evidence on Internationally Diversified
Portfolios Models for Managing International Portfolios
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The World Portfolio
Portfolio Managers are investing a largepercentage of their portfolio funds in othercountries. The global stock market hovers
around $40 -50 trillion. The global bond market isabout $82 trillion.Empirical data indicate that over the long term,equities outperform other investment vehicles, and
that internationally diversified portfolios outperformportfolios consisting of domestic stocks alone.
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Calculating the Return on Foreign Investments
Calculating the return on a foreign investment is very similarto domestic investments, except that we must take thechange in the currency into account. So, we actually havetwo sources of return.
For example, suppose that you purchased shares of PohangIron & Steel (POSCO) on the Korean Stock Exchange (KSE)on Jan 3, 1997 and sold them on Dec 27, 1997. Here arethe details:
Date Price (Won)
Exch. Rate (Won
per Dollar)
1/3/97 37,300 842.60
12/27/97 45,900 1,500.00
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Calculating the Return on Foreign Investments
Now, if you were a Korean investor your return for the year
would have been 23.06%
However, as a U.S. investor your return was a negative30.88%! Quite a difference, and it was entirely due to theloss in value of the won relative to the dollar during theAsian Contagion currency crisis that began in Thailand inJune 1997
%06.23137300
45900
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Calculating the Return on Foreign Investments
To calculate this return, we first need to calculate yourinvestment in dollar terms:
Where P0 is the cost in foreign currency, and FC0 is theexchange rate (foreign currency unit/dollar). Yourproceeds from the sale are calculated the same way:
Combining the equations into a rate of return, andrearranging we get the return in local currency (RLC):
0
0FC
1PCostDollar
1
1FC
1PoceedsPrDollar
1FCP
FCPR
10
01LC
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Calculating the Return on Foreign Investments
Now, we can see that your return in dollar terms was-30.88%
So, you made money on the stock, lost on thecurrency, and overall you lost a lot of money onthis investment
%88.303088.01150037300
60.84245900
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Returns on Foreign Investments
Heres another example. On Jan 27, 1999 Diageo PLC(LSE: DGE) was selling for 6.30p. One year earlier itwas selling for 5.42p, so a British investor wouldhave earned a return of 16.24%.
However, an American investor would have made 17.78%
The American made more because the British pound ()
appreciated (from 1.637 to 1.659 ) against the dollar over that
year. Note that the American originally paid $8.87 (5.42x 1.637),
but received $10.45 (6.3x 1.659) and the return is 17.78%.
%78.171
6028.42.5
6108.30.6
%24.16142.530.6
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Returns on Foreign Investments
HXUSRRR
0134.01637.1
69.1
XR 1624.0142.53.6
HR
1754.00134.0162.0 USR
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Purchasing Power Parity
Purchasing power parity (PPP) refers to thesituation in which the exchange rate equals the ratioof domestic and foreign price levels
A relative change in the prevailing inflation rate in onecountry will be reflected as an equal but opposite changein the value of its currency
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Purchasing Power
Parity (contd)
Absolute purchasing power parity follows fromthe law of one price: A basket of goods in one country should cost the same in
another country after conversion to a common currency
Not very accurate due to:
Transportation costs Trade barriers
Cultural differences
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Purchasing Power
Parity (contd)
Relative purchasing power parity states thatdifferences in countries inflation rates determineexchange rates:
12
11
1
where change in the spot exchange rateforeign country inflation rate
domestic country inflation rate
F
D
F
D
IS
I
S
I
I
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Purchasing Power
Parity (contd)
A country with an increase in inflation will experiencea depreciation of its currency because:
Exports decline
Imports increase
There is less demand for goods from that country
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International Risk Exposure
Exposure is a measure of the extent to which aperson faces foreign exchange risk
In general, there are two types of exposure:
accounting and economic Economic exposure is more important
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Accounting Exposure
Accounting exposure is: Of concern to MNCs that have subsidiaries in a number of
foreign countries
Important to people who hold foreign securities and mustprepare dollar-based financial reports
U.S. firms must prepare consolidated financialstatements in U.S. dollars
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Economic Exposure
Economic exposure measures the risk that thevalue of a security will decline due to an unexpectedchange in relative foreign exchange rates
Security analysts should include expected changesin exchange rates in forecasted cash flows
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The Risk of Foreign Securities
2/122)2(
HXHXUS
2/122 )( HXUS
Total investment risk is decomposed intothe volatility of the local market return, thevolatility of the exchange rate change and
the volatility due to the interactionbetween the local market return and theexchange rate change.
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Portfolio Risk
Total Riskof a Securitys Returns may be segmented
intoSystematic Risk can not be eliminated
Non-systematic Risk can be eliminated by diversification
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The Benefits of International Diversification
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INTERNATIONAL DIVERSIFICATION
International diversification and systematic riska. Diversify across nations with differenteconomic cycles
b. While there is systematic risk within a nation,
outside the country it may be nonsystematicand diversifiable risk
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INTERNATIONAL PORTFOLIO INVESTMENT
Recent Historya. National stock markets have wide
differences in returns and risk.
b. Emerging markets have higher risk andreturn than developed markets.
c. Cross-market correlations have beenrelatively low.
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INTERNATIONAL PORTFOLIO INVESTMENT
Theoretical Conclusion
International diversification pushes out the
efficient frontier.
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The New Efficient Frontier
E(r)
A
B
C
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CROSS-MARKET CORRELATIONS
Cross-market correlations
a. Recent markets seem to be most correlatedwhen volatility is greatest
b. Result: Efficient frontier retreats
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The Frontier During Global Crises
E(r)
A
B
C
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Investing in Emerging Markets
Investing in Emerging Marketsa. Offers highest risk and returns
b. Low correlations with returns elsewhere
c. As impediments to capital marketmobility fall, correlations are likely toincrease in the future.
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Barriers to International Diversification
1. Segmented markets2. Lack of liquidity
3. Exchange rate controls
4. Underdeveloped capital markets
5. Exchange rate risk6. Lack of information
a. not readily accessibleb. data is not comparable
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Other Methods to Diversify
Diversify by a1.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
Calculation of Expected Portfolio Return:rp = a rUS + ( 1 - a) rwwhere
rp = portfolio expected returnrUS = expected U.S. market return
rw = expected global return
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Portfolio Return
ProblemWhat 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) rw= .65(.05) + .35(.10)
= .0325 + .0350
= 6.75%
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INTERNATIONAL PORTFOLIO INVESTMENT
Calculation of Expected Portfolio Risk
Where =the cross-market correlationUS
2 =U.S. returns variance
w2 =World returns variance
2/12222 )))(1(2)1(( WUSWUSP aaaa
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Portfolio Risk
What is the risk of a portfolio with 35% invested inJapan with a standard deviation of 6% and a standarddeviation of 8% in the U.S. and a correlation coefficientof .7?
= [(.65)2 (.08) 2 + (.35) 2(.06) 2
+2(.65)(.35)(.08)(.06)(.7)] 1/2
=6.8%
2/12222 )))(1(2)1((WUSWUSP
aaaa
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INTERNATIONAL PORTFOLIO INVESTMENT
MEASURING TOTAL RETURNS FROM FOREIGN PORTFOLIOS
A. To compute dollar return of a foreign security:
1 0$
0
( )( )US ForeignCurrencye e
R Re
0 1$
1
( )( )US ForeignCurrency e eR Re
For currency appreciation:
For currency depreciation:
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INTERNATIONAL PORTFOLIO INVESTMENT
Bond (calculating return) formula:
where RUS = dollar returnB1 = foreign currency bond price at time 1B
0=bond price at 0
C = coupon income during periodg = currency depreciation or appreciation
)1](1[10
01 gB
CBBRUS
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INTERNATIONAL PORTFOLIO INVESTMENT
Stocks (Calculating return)
Formula:
Where RUS = dollar returnP(1) = foreign currency stock price at time 1D = foreign currency annual dividend
$(1) (0)1 1 (1 )
(0)P P DR g
P
$
(1) (0)1 1 (1 )(0)
P P DR gP
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U.S. Stock Returns: Sample Problem
Suppose the beginning stock price is FF50 andthe ending price is FF48. Dividend incomewas 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 Returns: Sample Solution
48 50 1 .20 .21051 1 1
50 .2105
$ 6.9%R
)1](1[10
01 gP
DPPRUS
%9.61)95.0)(98.0(1 US
R
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Evidence on Internationally DiversifiedPortfolios
With the globalization of financial markets, the trendtoward international diversification can already be seenin the activities of mutual funds, pension funds and other
institutional investors.