1. Chapter Fifteen International Portfolio Investments Chapter Objectives: Why investors diversify their portfolios ( 证券组合 ) internationally. How much investors can gain from international diversification. The effects of fluctuating exchange rates on international portfolio investments. Whether and how much investors can benefit from investing in U.S. based international mutual funds. The reasons for “home bias” in portfolio holdings.

2. The rapid growth in international portfolio investment International portfolio diversification becomes a major form of cross-border investment in the 1980s (FPI ＞ FDI) Exhibit 15.1 Why investors diversify their portfolios internationally? (background) Deregulation of financial markets The introduction of international investment tools.

3. 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.

4. International Correlation Structure Stock MarketAUFRGMJPNLSWUKUS Australia (AU).58 6 France (FR).28 6.576 Germany (GM).18 3.312.653 Japan (JP).15 2.238.300.416 Netherlands (NP).24 1.344.509.282.624 Switzerland (SW).35 8.368.475.281.517.664 United Kingdom (UK).31 5.378.299.209.393.431.698 United States (US).30 4.225.170.137.271.272.279.439 Relatively low international correlations imply that investors should be able to reduce portfolio risk more if they diversify internationally rather than domestically.

5. Domestic vs. International Diversification 0.44 0.27 0.12 Portfolio Risk (%) Number of Stocks 11020304050 Swiss stocks U.S. stocks International stocks When fully diversified, an international portfolio can be less than half as risky as a purely U.S. portfolio.

6. 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 70%. The correlation of the U.S. stock market with the Japanese stock market is 24%. A U.S. investor would get more diversification from investments in Japan than Canada.

7. Summary Statistics for Monthly Returns 1980-1992 ($U.S.) Stock Market Correlation Coefficient Mean (%) SD (%)  CNFRGMJPUK Canada (CN).795.830.90 France (FR)0.38 1.427.011.02 Germany (GM) 0.330.66 1.236.740.87 Japan (JP)0.260.420.36 1.477.311.22 United Kingdom 0.580.540.490.42 1.525.410.90 United States0.700.450.370.240.571.334.560.80.79% monthly return = 9.48% per year P360 ， exhibit 15.4

8. Summary Statistics for Monthly Returns 1980-1992 ($U.S.) Exhibit 15.4 Stock Market Correlation Coefficient Mean (%) SD (%)  CNFRGMJPUK Canada (CN).795.830.90 France (FR)0.38 1.427.011.02 Germany (GM) 0.330.66 1.236.740.87 Japan (JP)0.260.420.36 1.477.311.22 United Kingdom 0.580.540.490.42 1.525.410.90 United States0.700.450.370.240.571.334.560.80  measures the sensitivity of the market to the world market. Clearly the Japanese market is more sensitive to the world market than is the U.S.

9. Composition of the OIP for a U.S. Investor Exhibit 15.6 Refer to appendix 15B

10. 1.42% 1.26% Gains from International Diversification For a U.S. investor, the risk-return tradeoff for the optimal international portfolio and optimal domestic portfolio are shown below and at right. Exhibit 15.7 OIPODP Mean Return 1.42%1.26% Standard Deviation 4.51%4.43% risk return 4.43% 4.51% OIP ODP

11. Effects of Changes in the Exchange Rate The realized dollar return for a U.S. resident investing in a foreign market will depend not only on the return in the foreign market but also on the change in the exchange rate between the U.S. dollar and the foreign currency.

12. 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 R i is the local currency return in the i th market e i is the rate of change in the exchange rate between the local currency and the dollar

13. 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%:

14. Effects of Changes in the Exchange Rate The risk for a U.S. resident investing in a foreign market will depend not only on the risk in the foreign market but also on the risk in the exchange rate between the U.S. dollar and the foreign currency. The  Var term represents the contribution of the cross-product term, Ri ei, to the risk of foreign investment （交叉积项）.

15. Effects of Changes in the Exchange Rate This equation demonstrates that exchange rate fluctuations contribute to the risk of foreign investment through three channels: 1. Its own volatility, Var(e i ). 2. Its covariance with the local market returns Cov(R i,e i ). 3. The contribution of the cross-product term,  Var. Exhibit 15.8 (decomposition of the variance of international security return in USD)

16. 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 advent of the euro is likely to alter the risk- return characteristics of the euro-zone bond markets enhancing the importance of non-euro currency bonds.

17. The way to achieve international diversification international mutual fund Country fund American deposit receipts World equity benchmark shares Hedge funds

18. 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: 1. Savings on transaction and information costs. 2. Circumvention of legal and institutional barriers to direct portfolio investments abroad. 3. Professional management and record keeping.

19. International Mutual Funds: A Performance Evaluation As can be seen below, a sample of U.S. based international mutual funds has outperformed the S&P 500 during the period 1977-1986, with a higher standard deviation.  See exhibit 15.10

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

21. The Home Bias in Equity Portfolios CountryShare in World Market Value Proportion of Domestic Equities in Portfolio France2.6%64.4% Germany3.2%75.4% Italy1.9%91.0% Japan43.7%86.7% Spain1.1%94.2% Sweden0.8%100.0% United Kingdom10.3%78.5% United States36.4%98.0% Total 100.0%

22. Why Home Bias in Portfolio Holdings? Some explanations come to mind: 1. Domestic equities may provide a superior inflation hedge. 2. Home bias may reflect institutional and legal restrictions on foreign investment. 3. Extra taxes and transactions/information costs for foreign securities may give rise to home bias. 4. Foreign exchange risk (empirical reserch)

23. End Chapter Fifteen