International Portfolio Theory and Diversification Multinational Business Finance (2nd Edition) Chapter 16 David Eiteman | Kevin Daly Subhrendu Rath | Arthur Stonehill | Michael Moffett International Portfolio Theory and Diversification

International Diversification and Risk Portfolio Risk reduction The case for international diversification of portfolios can be decomposed into two components, the potential risk reduction benefits of holding international securities. The potential added foreign exchange risk. Portfolio beta A measure of portfolio risk The ratio of the variance of a portfolio’s return relative to the variance of the market return A fully diversified domestic portfolio have a beta of 1.0

International Diversification and Risk Portfolio Risk reduction (Page 459)

International Diversification and Risk The total risk of a portfolio is composed of systematic risk (the market) and unsystematic risk (the individual securities). Increasing the number of securities in the portfolio reduces the unsystematic risk component

International Diversification and Risk (Page 460)

International Diversification and Risk Foreign exchange risk. Purchasing assets in foreign markets in foreign currencies may alter the correlations associated with securities in different countries (and currencies). This provides portfolio composition and diversification possibilities that domestic investment and portfolio construction may not provide. International diversification helps to reduce the foreign exchange risks of a portfolio.

Internationalising the Domestic Portfolio The optimal domestic portfolio Risk-averse typical investor is in search of a portfolio that maximises expected portfolio return per unit of expected portfolio risk. The domestic investor may choose among a set of individual securities in the domestic market. The near-infinite set of portfolio combinations of domestic securities form the domestic portfolio opportunity set The set of portfolios along the extreme left edge of the set is termed the efficient frontier which represents the optimal portfolios of securities that possess the minimum expected risk for each level of expected portfolio return.

Internationalising the Domestic Portfolio The optimal domestic portfolio (Page 463)

Internationalising the Domestic Portfolio The optimal domestic portfolio [Figure 16.3] The minimum risk domestic portfolio (MRDP) is the portfolio with the minimum risk The individual investor will search out the optimal domestic portfolio (DP), which combines the risk-free asset and a portfolio of domestic securities found on the efficient frontier. He or she begins with the risk-free asset (Rf) and moves out along the security market line until reaching portfolio DP. This portfolio (DP) is defined as the optimal domestic portfolio

International Diversification and Risk The internationally diversified portfolio opportunity set shifts leftward of the purely domestic opportunity set.

International Diversification and Risk (Page 464)

International Diversification and Risk The internationally diversified portfolio opportunity set is of lower expected risk than comparable domestic portfolios. The gains arise from the introduction of additional securities and/or portfolios that are of less than perfect correlation with the securities and portfolios within the domestic opportunity set.

International Diversification and Risk (Page 465)

International Diversification and Risk The optimal international portfolio (IP) [Figure 16.5] The investor can choose an optimal portfolio that combines the same risk-free asset with a portfolio from the efficient frontier of the internationally diversified portfolio opportunity set. The IP is found by locating that point on the capital market line which extends from the risk-free asset return of Rf to a point of tangency along the internationally diversified efficient frontier. IP offers higher expected portfolio return with a lower portfolio risk compared to the domestic portfolio alone.

International Diversification and Risk Calculation of portfolio risk and return An investor can reduce investment risk by holding risky assets in a portfolio. as long as the asset returns are not perfectly positively correlated, the investor can reduce risk, because some of the fluctuations of the asset returns will offset each other.

International Diversification and Risk Calculation of portfolio risk and return An example Ausdrill’s Chief Financial Officer, Caitlin, is considering investing Ausdrill’s marketable securities in two different risky assets: an index of the Australian equity markets and an index of the German equity markets. The two equities are characterised by the following expected returns and expected risks.

International Diversification and Risk Calculation of portfolio risk and return An example The expected return of the portfolio

International Diversification and Risk Calculation of portfolio risk and return An example The standard deviation of the portfolio’s expected return

International Diversification and Risk Calculation of portfolio risk and return An example (Page 467)

International Diversification and Risk Calculation of portfolio risk and return Multiple-asset model

National Markets and Asset Performance The true benefits of global diversification arise from the fact that the returns of different stock markets around the world are not perfectly positively correlated. Fact is Different industrial structures in different countries, and Different economies do not exactly follow the same business cycle.

National Markets and Asset Performance (Page 468)

National Markets and Asset Performance (Page 469)

Market Performance Adjusted for Risk: The Sharpe and Treynor Performance Measures Two measures for evaluating risk and return in portfolio performance The Sharpe measure: the average return over and above the risk-free rate of return per unit of portfolio risk The Treynor measure: the portfolio’s total return as the measure of risk it utilises the portfolio’s beta ( βi, the systematic)

Market Performance Adjusted for Risk: The Sharpe and Treynor Performance Measures If a portfolio is perfectly diversified , the two measures give similar rankings If a portfolio is poorly diversified, it is possible for it to show a high ranking on the basis of the Treynor measure, but a lower ranking on the basis of the Sharpe measure. As the difference is attributable to the low level of portfolio diversification, the two measures therefore provide complimentary but different information.

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Is modern portfolio theory outdated? Mini-Case: Is modern portfolio theory outdated?

Additional Exhibit (Page 469)

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