chapter 19 international portfolio investment. chapter overview: i.the benefits of international...
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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.
THE BENEFITS OF INTERNATIONAL THE BENEFITS OF INTERNATIONAL EQUITY INVESTINGEQUITY INVESTING
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
THE BENEFITS OF INTERNATIONAL THE BENEFITS OF INTERNATIONAL EQUITY INVESTINGEQUITY INVESTING
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.
THE BENEFITS OF INTERNATIONAL THE BENEFITS OF INTERNATIONAL EQUITY INVESTINGEQUITY INVESTING
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.
THE BENEFITS OF INTERNATIONAL THE BENEFITS OF INTERNATIONAL EQUITY INVESTINGEQUITY INVESTING
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.
THE BENEFITS OF INTERNATIONAL THE BENEFITS OF INTERNATIONAL EQUITY INVESTINGEQUITY INVESTING
Past empirical evidence suggests inter-Past empirical evidence suggests inter-
national diversification reduces national diversification reduces portfolioportfolio
risk. risk.
THE BENEFITS OF INTERNATIONAL THE BENEFITS OF INTERNATIONAL EQUITY INVESTINGEQUITY INVESTING
3.3. Theoretical ConclusionTheoretical Conclusion
International diversification pushes outInternational diversification pushes out
the efficient frontier.the efficient frontier.
THE BENEFITS OF INTERNATIONAL THE BENEFITS OF INTERNATIONAL EQUITY INVESTINGEQUITY INVESTING
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
THE BENEFITS OF INTERNATIONAL THE BENEFITS OF INTERNATIONAL EQUITY INVESTINGEQUITY INVESTING
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
THE BENEFITS OF INTERNATIONAL THE BENEFITS OF INTERNATIONAL EQUITY INVESTINGEQUITY INVESTING
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
THE BENEFITS OF INTERNATIONAL THE BENEFITS OF INTERNATIONAL EQUITY INVESTINGEQUITY INVESTING
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.
THE BENEFITS OF INTERNATIONAL THE BENEFITS OF INTERNATIONAL EQUITY INVESTINGEQUITY INVESTING
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
THE BENEFITS OF INTERNATIONAL THE BENEFITS OF INTERNATIONAL EQUITY INVESTINGEQUITY INVESTING
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
IV.IV. MEASURING TOTAL RETURNSMEASURING TOTAL RETURNSFROM FOREIGN PORTFOLIOSFROM FOREIGN PORTFOLIOS
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
IV.IV. MEASURING TOTAL RETURNSMEASURING TOTAL RETURNSFROM FOREIGN PORTFOLIOSFROM FOREIGN PORTFOLIOS
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