1. International Diversification
Investments
Cover image
CHAPTER 25
International Diversification
Slides by
Richard D. Johnson
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

2. Emphasis for our investigation
Background
Global market
US market is 39.2% of all markets in 2005
US market share is down from 47% in 2000
Improved access & technology
New instruments
Emphasis for our investigation
Risk assessment
Diversification

3. Table 25.1 Market Capitalization of Stock Exchanges in Developed Countries

4. Table 25.2 Market Capitalization of Stock Exchanges in Emerging Markets

5. Figure 25.1 Per Capita GDP and Market Capitalization as Percentage of GDP (log scale)

6. Issues
What are the risks involved in investment in foreign securities?
How do you measure benchmark returns on foreign investments?
Are there benefits to diversification in foreign securities?

7. Foreign Exchange Risk
Foreign Exchange Risk
Variation in return related to changes in the relative value of the domestic and foreign currency.
Total return = investment return & return on foreign exchange
It’s not possible to completely hedge a foreign investment.

8. Returns with Foreign Exchange
Return in US is a function of two factors:
1. Return in the foreign market
2. Return on the foreign exchange

9. Figure 25. 2 Stock Market Returns in U. S
Figure 25.2 Stock Market Returns in U.S. Dollars and Local Currencies for 2005

10. Table 25. 3 Rates of Change in the U. S
Table 25.3 Rates of Change in the U.S. Dollar against Major World Currencies, 2001 – 2005 (monthly data)

11. Political Risk Services Group Ratings
Country Specific Risk
Political Risk Services Group Ratings
Rank countries with respect to political risk, financial risk and economic risk
Assign composite rating from very high risk to very low risk based on the above elements of risk

12. Table 25.4 Composite Risk Ratings for October 2004 and November 2003

13. Table 25.5 Variables Used in PRS’s Political Risk Score

14. Table 25.6 Current Risk Ratings and Composite Risk Forecasts

15. Table 25.7 Composite and Political Risk Forecasts

16. Table 25.8 Political Risk Points by Component, October 2004

17. Diversification Benefits
Evidence shows international diversification is beneficial.
It’s possible to expand the efficient frontier above domestic only frontier.
It’s possible to reduce the systematic risk level below the domestic only level.

18. Table 25.9 Risk and Return across the Globe, 2001 – 2005 (Developed Countries)

19. Table 25.9 Risk and Return across the Globe, 2001 – 2005 (Emerging Markets)

20. Figure 25.3 Annualized Standard Deviation of Investments across the Globe ($ returns 2001 – 2005)

21. Figure 25.4 Beta on U.S. Stocks across the Globe, 2001 – 2005

22. Figure 25.3 Annualized Average $ Return of Investments across the Glove 2001 – 2005

23. Figure 25.6 Standard Deviation of Investments across the Globe in U.S. Dollars versus Local Currency, 2001 – 2005

24. Table 25.10 Correlation for Asset Returns: Unhedged Currencies
Insert Table Unhedged Currencies

25. Table 25.10 Correlation for Asset Returns: Hedged Currencies
Insert Table Hedged Currencies

26. Table 25. 11 Correlation of U. S
Table Correlation of U.S. Equity Returns with Country Equity Returns

27. Figure 25.7 International Diversification

28. Figure 25.8 Ex Post Efficient Frontier of Country Portfolios, 2001 – 2005

29. Figure 25.9 Efficient Frontier of Country Portfolios (world expected excess return = .6% per month)

30. Figure 25.10 Regional Indexes around the Crash, October 14 – October 26, 1987

31. Figure 25.11 Efficient Diversification by Various Methods

32. Figure 25.12 Diversification by Market Capitalization: National Markets versus Regional Funds

33. Figure 25.13 Diversification Benefits over Time

34. Table 25.12 Weighting Schemes for EAFE Countries

35. Performance Attribution with International
Extension to consider additional factors
Currency selection
Country selection
Stock selection
Cash and bond selection

36. Table 25.13 Example of Performance Attribution: International