International portfolio investment1

International Portfolio Investment

Chapter 15

2

Why Invest Internationally?

What are the advantages of international investment?

3

THE BENEFITS OF INTERNATIONALEQUITY 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

4

Basic Portfolio Theory:

What is the efficient frontier?

It represents the most efficient combinations of all possible risky assets.

5

The Efficient Frontier

E(r)

A

B

6

Basic Portfolio Theory:

The broader the diversification, the more stable the returns and the more diffuse the risk.

7

Diversification

The Insurance Principle:

U U UU U UU U U

US US US

US US US

US US US

S S S

Not diversified Diversified

8

INTERNATIONAL DIVERSIFICATION

B.International Diversification

1. Risk-return tradeoff:

may be greater

9

Basic Portfolio Theory:

Total Risk of a Security’s Returns may be segmented into

Systematic Risk

can not be eliminated

Non-systematic Risk

can be eliminated by diversification

10

The Benefits of Int’l Diversification

11

INTERNATIONAL DIVERSIFICATION

2. International diversification and systematic risk

a. Diversify across nations withdifferent economic cycles

b. While there is systematic riskwithin a nation, outside the

country it may be nonsystematic and diversifiable

12

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.

13

INTERNATIONAL PORTFOLIO INVESTMENT

3. Theoretical Conclusion

International diversification pushes out the efficient frontier.

14

The New Efficient FrontierE(r)

A

B

C

15

CROSS-MARKET CORRELATIONS

6. Cross-market correlations

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

greatest

b. Result:

Efficient frontier retreats

16

The Frontier During Global Crises

E(r)

A

B

C

17

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.

18

Barriers to International DiversificationE.Barriers to International Diversification

1. Segmented markets2. Lack of liquidity3. Exchange rate controls4. Underdeveloped capital markets5. Exchange rate risk6. Lack of information

a. not readily accessibleb. data is not comparable

19

Other Methods to Diversify

F. Diversify by a 1. Trade in American Depository

Receipts (ADRs)2. Trade in American shares3. Trade internationally diversified

mutual funds:a. Global (all types)b. International (no home

country securities)c. Single-country

20

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

21

Portfolio Return

Sample 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) rrw

= .65(.05) + .35(.10) = .0325 + .0350= 6.75%

22

INTERNATIONAL PORTFOLIO INVESTMENT

5. Calculation of Expected Portfolio Risk

where = the cross-market correlation

US2 = U.S. returns variance

r w2 = World returns variance

23

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%

1/ 22 2 2 2(1 ) 2 (1 )P US rw US rwa a a a

1/ 22 2 2 2(1 ) 2 (1 )P US rw US rwa a a a

24

INTERNATIONAL PORTFOLIO INVESTMENT

IV. MEASURING TOTAL RETURNS

FROM FOREIGN PORTFOLIOS

A. To compute dollar return of a foreign security:

or

1 0$

0

( )( )US ForeignCurrency

e eR R

e

0 1$

1

( )( )US ForeignCurrency

e eR R

e

25

Flash Back!

For currency appreciation:

For currency depreciation:

1 0$

0

( )( )US ForeignCurrency

e eR R

e

0 1$

1

( )( )US ForeignCurrency

e eR R

e

26

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 periodg = currency depreciation or appreciation

$

(1) (0)1 1 (1 )

(0)

B B CR g

B

27

INTERNATIONAL PORTFOLIO INVESTMENT

B. Stocks (Calculating return)

Formula:

where R$ = 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 g

P

28

U.S. $ Stock Returns:Sample 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 stock’s US$ return for the year?

29

U.S. $ Stock Returns:Sample Solution

$

(1) (0)1 1 (1 )

(0)

P P DR g

P

48 50 1 .20 .21051 1 1

50 .2105

.98 .95 1

$ 6.9%R $ 6.9%R