International Portfolio Investment Chapter 15

Why Invest Internationally? What are the advantages of international investment?

THE BENEFITS OF INTERNATIONAL EQUITY 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

Basic Portfolio Theory: What is the efficient frontier? It represents the most efficient combinations of all possible risky assets.

The Efficient Frontier A B

Basic Portfolio Theory: The broader the diversification, the more stable the returns and the more diffuse the risk.

INTERNATIONAL DIVERSIFICATION B. International Diversification 1. Risk-return tradeoff: may be greater

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

The Benefits of Int’l Diversification

INTERNATIONAL DIVERSIFICATION 2. International diversification and systematic risk a. Diversify across nations with different economic cycles b. While there is systematic risk within a nation, outside the country it may be nonsystematic and diversifiable

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.

INTERNATIONAL PORTFOLIO INVESTMENT 3. Theoretical Conclusion International diversification pushes out the efficient frontier.

The New Efficient Frontier A B

CROSS-MARKET CORRELATIONS a. Recent markets seem to be most correlated when volatility is greatest b. Result: Efficient frontier retreats

The Frontier During Global Crises

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.

Barriers to International Diversification E. Barriers to International Diversification 1. Segmented markets 2. Lack of liquidity 3. Exchange rate controls 4. Underdeveloped capital markets 5. Exchange rate risk 6. Lack of information a. not readily accessible b. data is not comparable

Other Methods to Diversify F. Diversify by a 1. 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

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

Portfolio Return Sample Problem What 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%

INTERNATIONAL PORTFOLIO INVESTMENT Calculation of Expected Portfolio Risk where = the cross-market correlation US2 = U.S. returns variance r w2 = World returns variance

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%

INTERNATIONAL PORTFOLIO INVESTMENT IV. MEASURING TOTAL RETURNS FROM FOREIGN PORTFOLIOS A. To compute dollar return of a foreign security: or

Flash Back! For currency appreciation: For currency depreciation:

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 period g = currency depreciation or appreciation

INTERNATIONAL PORTFOLIO INVESTMENT B. Stocks (Calculating return) Formula: where R$ = dollar return P(1) = foreign currency stock price at time 1 D = foreign currency annual dividend

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?

U.S. $ Stock Returns: Sample Solution