International Portfolio Investment Chapter 15

Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio Selection Effects of Changes in the Exchange Rate International Bond Investment International Mutual Funds: A Performance Evaluation International Diversification through Country Funds International Diversification with ADRs International Diversification with WEBS Why Home Bias in Portfolio Holdings?

International Correlation Structure and Risk Diversification Security returns are much less correlated across countries than within a country. This is so because economic, political, institutional, and even psychological factors affecting security returns tend to vary across countries, resulting in low correlations among international securities. Business cycles are often high asynchronous across countries.

International Correlation Structure Stock Market AU CA FR GE HK IT JA UK US Australia 0.62 0.40 0.37 0.46 0.28 0.34 0.55 0.48 Canada 0.49 0.45 0.47 0.39 0.35 0.58 0.73 France 0.32 0.53 0.41 0.61 0.54 Germany 0.36 0.52 Hong Kong 0.30 0.27 0.42 Italy 0.33 Japan 0.31 Source: MSCI 1980-2007

Domestic vs. International Diversification When fully diversified, an international portfolio can be less than half as risky as a purely U.S. portfolio. Swiss stocks 0.44 Portfolio Risk (%) U.S. stocks 0.27 0.12 International stocks 1 10 20 30 40 50 Number of Stocks

Optimal International Portfolio Selection The correlation of the U.S. stock market with the returns on the stock markets in other nations varies. The correlation of the U.S. stock market with the Canadian stock market is 73%. The correlation of the U.S. stock market with the Japanese stock market is 31%. A U.S. investor would get more diversification from investments in Japan than Canada.

Optimal International Portfolio 2.0% Optimal International Portfolio Efficient frontier SD HK 1.5% OIP NL IT UK GM SW US CN 1.0% JP Monthly Return 0.5% Rf Monthly Standard Deviation 0.0% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10%

Composition of the OIP for a U.S. Investor (Holding Period: 1980—2007) Australia Hong Kong 4.82% 8.76% Italy 6.60% Netherlands 31.11% Sweden 28.01% U.S. 20.70% Total 100.00%

Gains from International Diversification For a U.S. investor, OIP has more return and more risk. The Sharpe measure is 30% for OIP, suggesting that an equivalent-risk OIP would have more return per unit of risk than a domestic portfolio. risk-return tradeoff for the optimal international portfolio and optimal domestic portfolio are shown below and at right. return OIP 1.40% 1.11% ODP   OIP ODP Mean Return 1.40% 1.11% Standard Deviation 4.74% 4.25% 4.25% 4.74% risk

Effects of Changes in the Exchange Rate The realized dollar return for a U.S. resident investing in a foreign market will depend on the return in the foreign market the change in the exchange rate between the U.S. dollar and the foreign currency

Effects of Changes in the Exchange Rate The realized dollar return for a U.S. resident investing in a foreign market is given by Where Ri is the local currency return in the ith market ei is the rate of change in the exchange rate between the local currency and the dollar

Effects of Changes in the Exchange Rate For example, if a U.S. resident just sold shares in a British firm that had a 15% return (in pounds) during a period when the pound depreciated 5%, his dollar return is 9.25%:

Effects of Changes in the Exchange Rate The risk for a U.S. resident investing in a foreign market will depend on the risk in the foreign market (i.e., the volatility of foreign market returns) the risk in the exchange rate between the U.S. dollar and the foreign currency (i.e., the covariation between the U.S. dollar and the foreign currency)

International Bond Investment There is substantial exchange rate risk in foreign bond investment. This suggests that investors may be able to increase their gains if they can control this risk, for example with currency forward contracts or swaps. The existence of euro alters the risk-return characteristics of the euro-zone bond markets enhancing the importance of non-euro currency bonds.

International Mutual Funds: A Performance Evaluation A U.S. investor can easily achieve international diversification by investing in a U.S.-based international mutual fund. The advantages include: Savings on transaction and information costs. Circumvention of legal and institutional barriers to direct portfolio investments abroad. Professional management and record keeping.

International Diversification through Country Funds Recently, country funds have emerged as one of the most popular means of international investment. A country fund invests exclusively in the stocks of a single county. This allows investors to: Speculate in a single foreign market with minimum cost. Construct their own personal international portfolios. Diversify into emerging markets that are otherwise practically inaccessible.

International Diversification with ADRs Adding ADRs to domestic portfolios has a substantial risk reduction benefit.

World Equity Benchmark Shares World Equity Benchmark Shares (WEBS) Country-specific baskets of stocks designed to replicate the country indexes of 14 countries. WEBS are subject to U.S. SEC and IRS diversification requirements. Low cost, convenient way for investors to hold diversified investments in several different countries.

International Diversification with WEBS Recent research suggests that WEBs are an excellent tool for international risk diversification. For investors who desire international exposure, WEBs may well serve as a major alternative to such traditional tools as international mutual funds, ADRs, and closed-end country funds

Home Bias in Portfolio Holdings Home bias refers to the extent to which portfolio investments are concentrated in domestic equities.

World Market Capitalization Weight Evidence of Home Bias Across Countries Country World Market Capitalization Weight Asset Allocation at Home U.S. 46.85% 85.66% Japan 11.29% 71.82% U.K. 8.13% 43.06% France 4.32% 55.27% Germany 3.99% 33.49% Greece 0.46% 93.46% Spain 1.39% 35.96% Poland 0.19% 45.61%

Why Home Bias in Portfolio Holdings? Three explanations come to mind: Domestic equities may provide a superior inflation hedge. Home bias may reflect institutional and legal restrictions on foreign investment. Extra taxes and transactions/information costs for foreign securities may give rise to home bias.

Learning Outcomes What is an optimal international portfolio How exchange rate changes affect international investment What are the different means of gaining international diversification Why there is home bias in portfolio holdings http://video.nytimes.com/video/2006/11/17/world/1194817103057/china-s-yellow-river-part-1.html?scp=1&sq=China's%20Yellow%20River,%20Part%201&st=cse http://video.nytimes.com/video/2006/11/17/world/1194817096701/china-s-yellow-river-part-2.html?scp=1&sq=China%20and%20Pollution&st=cse