1 Multinational Financial Management Alan Shapiro 7 th Edition J.Wiley & Sons Power Points by Joseph F. Greco, Ph.D. California State University, Fullerton

2 CHAPTER 15 INTERNATIONAL PORTFOLIO INVESTMENT

3 CHAPTER OVERVIEW: I.THE BENEFITS OF INTERNATIONAL EQUITY INVESTING II.INTERNATIONAL BOND INVESTING III.OPTIMAL ASSET ALLOCATION IV.MEASURING THE TOTAL RETURN V.MEASURING EXCHANGE RISK ON FOREIGN SECURITIES

4 I. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING I.THE BENEFITS OF INTERNATIONAL EQUITY INVESTING A.Advantages 1.Offers more opportunities than a domestic portfolio only 2.Larger firms often are overseas

5 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING B.International Diversification 1. Risk-return tradeoff: may be greater basic rule- the broader the diversification, more stable the returns and the more diffuse the risk.

6 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING 2. International diversification and systematic risk a.Diversifying across nations with different economic cycles

7 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING b.While there is systematic risk within a nation, it may be nonsystematic and diversifiable outside the country.

8 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING 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.

9 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING C.Correlations and the Gains From Diversification 1. Correlation of foreign market betas Foreign Correlation Std dev market = with U.S. x for. mkt. beta market std dev U.S. mkt.

10 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING 2. Past empirical evidence suggests inter- national diversification reduces portfolio risk.

11 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING 3.Theoretical Conclusion International diversification pushes out the efficient frontier.

12 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING 4.Calculation of Expected Return: r p = a r US + ( 1 - a) r rw where r p = portfolio expected return r US = expected U.S. market return r rw = expected global return

13 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING 5. Calculation of Expected Portfolio Risk = (  P )  P = [a 2  US 2 + (1-a) 2  r w 2 + 2a(1-a)  US  rw  US,rw ] 1/2 where  US,rw =the cross-market correlation  US 2 =U.S. returns variance  r w 2 =World returns variance

14 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING 6.Cross-market correlations a. Recent markets seem to be most correlated when volatility is greatest b. Result: Efficient frontier retreats

15 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING 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.

16 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING E.Barriers to International Diversification 1.Segmented markets 2.Lack of liquidity 3.Exchange rate controls 4.Less developed capital markets 5.Exchange rate risk 6.Lack of information a.readily accessible b.comparable

17 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING F.Methods to Diversify 1.Trade in American Depository Receipts (ADRs) 2.Trade in American shares 3.Trade internationally diversified mutual funds: a.Global b.International c.Single-country

18 II. INTERNATIONAL BOND INVESTING -internationally diversified bond portfolios offer superior performance

19 INTERNATIONAL BOND INVESTING A.Empirical Evidence 1.Foreign bonds provide higher returns 2.Foreign portfolios outperform purely domestic

20 III.OPTIMAL INTERNATIONAL ASSET ALLOCATION III.OPTIMAL INTERNATIONAL ASSET ALLOCATION - a diversified combination of stocks and bonds A.Offered better risk-return tradeoff B.Weighting options flexible

21 IV.MEASURING TOTAL RETURNS FROM PORTFOLIO INVESTING IV.MEASURING TOTAL RETURNS A.Bonds Dollar = Foreignx Currency return currency gain (loss) return

22 MEASURING TOTAL RETURNS FROM PORTFOLIO INVESTING Bond return formula: 1 + R $ = [ 1 + B(1) - B(0) + C ] (1+g) B(0) whereR $ = dollar return B(1) = foreign currency bond price at time 1 C = coupon income g = depreciation/appreciation of foreign currency

23 MEASURING TOTAL RETURNS FROM PORTFOLIO INVESTING B.Stocks (Calculating return) Formula: 1 + R $ = [ 1+ P(1) - P(0) + D ] (1+g) P(0) whereR $ = dollar return P(1)= foreign currency stock price at time 1 D= foreign currency annual dividend