International Diversification Investments Cover image CHAPTER 25 International Diversification Slides by Richard D. Johnson McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
Emphasis for our investigation Background Global market US market is 39.2% of all markets in 2005 US market share is down from 47% in 2000 Improved access & technology New instruments Emphasis for our investigation Risk assessment Diversification
Table 25.1 Market Capitalization of Stock Exchanges in Developed Countries
Table 25.2 Market Capitalization of Stock Exchanges in Emerging Markets
Figure 25.1 Per Capita GDP and Market Capitalization as Percentage of GDP (log scale)
Issues What are the risks involved in investment in foreign securities? How do you measure benchmark returns on foreign investments? Are there benefits to diversification in foreign securities?
Foreign Exchange Risk Foreign Exchange Risk Variation in return related to changes in the relative value of the domestic and foreign currency. Total return = investment return & return on foreign exchange It’s not possible to completely hedge a foreign investment.
Returns with Foreign Exchange Return in US is a function of two factors: 1. Return in the foreign market 2. Return on the foreign exchange
Figure 25. 2 Stock Market Returns in U. S Figure 25.2 Stock Market Returns in U.S. Dollars and Local Currencies for 2005
Table 25. 3 Rates of Change in the U. S Table 25.3 Rates of Change in the U.S. Dollar against Major World Currencies, 2001 – 2005 (monthly data)
Political Risk Services Group Ratings Country Specific Risk Political Risk Services Group Ratings Rank countries with respect to political risk, financial risk and economic risk Assign composite rating from very high risk to very low risk based on the above elements of risk
Table 25.4 Composite Risk Ratings for October 2004 and November 2003
Table 25.5 Variables Used in PRS’s Political Risk Score
Table 25.6 Current Risk Ratings and Composite Risk Forecasts
Table 25.7 Composite and Political Risk Forecasts
Table 25.8 Political Risk Points by Component, October 2004
Diversification Benefits Evidence shows international diversification is beneficial. It’s possible to expand the efficient frontier above domestic only frontier. It’s possible to reduce the systematic risk level below the domestic only level.
Table 25.9 Risk and Return across the Globe, 2001 – 2005 (Developed Countries)
Table 25.9 Risk and Return across the Globe, 2001 – 2005 (Emerging Markets)
Figure 25.3 Annualized Standard Deviation of Investments across the Globe ($ returns 2001 – 2005)
Figure 25.4 Beta on U.S. Stocks across the Globe, 2001 – 2005
Figure 25.3 Annualized Average $ Return of Investments across the Glove 2001 – 2005
Figure 25.6 Standard Deviation of Investments across the Globe in U.S. Dollars versus Local Currency, 2001 – 2005
Table 25.10 Correlation for Asset Returns: Unhedged Currencies Insert Table 25.10 Unhedged Currencies
Table 25.10 Correlation for Asset Returns: Hedged Currencies Insert Table 25.10 Hedged Currencies
Table 25. 11 Correlation of U. S Table 25.11 Correlation of U.S. Equity Returns with Country Equity Returns
Figure 25.7 International Diversification
Figure 25.8 Ex Post Efficient Frontier of Country Portfolios, 2001 – 2005
Figure 25.9 Efficient Frontier of Country Portfolios (world expected excess return = .6% per month)
Figure 25.10 Regional Indexes around the Crash, October 14 – October 26, 1987
Figure 25.11 Efficient Diversification by Various Methods
Figure 25.12 Diversification by Market Capitalization: National Markets versus Regional Funds
Figure 25.13 Diversification Benefits over Time
Table 25.12 Weighting Schemes for EAFE Countries
Performance Attribution with International Extension to consider additional factors Currency selection Country selection Stock selection Cash and bond selection
Table 25.13 Example of Performance Attribution: International