1. International Portfolio Investment Chapter 13

2. 2 Why Invest Internationally? What are the advantages?

3. 3 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING I. Why invest internationally? A.Advantages 1.Offers more opportunities than a purely domestic portfolio 2.Attractive investments overseas 3.Diversification benefits positively impact the efficient frontier Caution: IT MAY BE MORE RISK THAN DOMESTIC INVESTMENTS

4. 4 Modern Portfolio Theory Harry Markowitz, Nobel Prize Winner Central concept: Invest using the risk (σ) and return E(r) trade off.

5. 5 Basic Portfolio Theory: What is the efficient frontier? It represents the most efficient combinations (portfolios) of all possible risky assets.

6. 6 The Efficient Frontier E(r) A B Why is Portfolio B inefficient? C Impossible!!

7. 7 Basic Portfolio Theory: DIVERSIFICATION What are diversification benefits: The broader the diversification, a. the more stable the returns and b. the more diffuse the risk. BASED ON THE INSURANCE PRINCIPLE!

8. 8 Diversification and The Insurance Principle UUU UUU UUU USUSUS USUSUS USUSUS SSS Not diversified Diversified

9. 9 INTERNATIONAL DIVERSIFICATION B. Another Benefit from International Diversification Risk-return tradeoff: Risk-return tradeoff: May be greater w hen investing internationally WHY? WHY?

10. 10 Basic Portfolio Theory: 1. Total Risk of a Security’s Return may be segmented into two parts: =Systematic Risk such as inflation and unemployment which can not be eliminated +Non-systematic Risk such as industry business cycles which can be eliminated by diversification

11. 11 The Benefits of Int’l Diversification: The Evidence

12. 12 INTERNATIONAL DIVERSIFICATION 2. Using International diversification to reduce systematic risk: a.Guideline: Diversify across nations in different stages of the business cycle b.Benefit: While there is systematic risk within a domestic portfolio, it may be nonsystematic and diversifiable in a global portfolio

13. 13 INTERNATIONAL PORTFOLIO INVESTMENT 3.Recent History a.National stock markets have wide differences in returns and risk. b.Emerging markets often have higher risk and return than developed markets. c.Cross-market correlations have been relatively low.

14. 14 Cross-Market Correlations With a U.S. portfolio: 1. High positive correlations: 2.Low or Negative correlations:

15. 15 INTERNATIONAL PORTFOLIO INVESTMENT 4.Theoretical Conclusion International diversification pushes out the efficient frontier.

16. 16 The New Efficient Frontier E(r) A B C

17. 17 CROSS-MARKET CORRELAITONS 5.Cross-market correlations a. Recent markets seem to be most correlated when volatility is greatest b. Result: Efficient frontier retreats Efficient frontier retreats

18. 18 The Frontier During Global Crises E(r) A B C

19. 19 Investing in Emerging Markets C.Investing in Emerging Markets a.Offers highest risk and returns b.Low correlations with returns elsewhereCaution: As impediments to capital market mobility fall, correlations are likely to increase in the future.

20. 20 Barriers to International Diversification D.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

21. 21 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

22. 22 INTERNATIONAL PORTFOLIO INVESTMENT 4.Calculation of Expected Portfolio Return: r p = a r US + ( 1 - a) r rw where where r p = portfolio expected return r US = expected U.S. market return r US = expected U.S. market return r rw = expected global return r rw = expected global return

23. 23 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%? r p = a r US + ( 1 - a) r rw r p = a r US + ( 1 - a) r rw =.65(.05) +.35(.10) =.0325 +.0350 =6.75%

24. 24 INTERNATIONAL PORTFOLIO INVESTMENT Calculation of Expected Portfolio Risk where =the cross-market correlation  US 2 =U.S. returns variance  US 2 =U.S. returns variance  r w 2 =World returns variance  r w 2 =World returns variance

25. 25 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%

26. 26 INTERNATIONAL PORTFOLIO INVESTMENT IV.MEASURING TOTAL RETURNS FROM FOREIGN PORTFOLIOS A.To compute dollar return of a foreign security: or

27. 27 INTERNATIONAL PORTFOLIO INVESTMENT Bond (calculating return) formula: whereR $ = dollar return B(1) = foreign currency bond price at time 1 (present) B(1) = foreign currency bond price at time 1 (present) C = coupon income during period g = currency depreciation or appreciation

28. 28 INTERNATIONAL PORTFOLIO INVESTMENT B.Stocks (Calculating return) Formula: whereR $ = dollar return P(1)= foreign currency stock price at time 1 D= foreign currency annual dividend dividend

29. 29 U.S. $ Stock Returns: Sample Problem 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 $.20 /FF to $.2105 /FF during the year against the dollar. What is the stock’s US$ return for the year?

30. 30 U.S. $ Stock Returns: Sample Solution During the year the price of British bonds went from £102 to £106, while paying a coupon of £9. At the same time, the exchange rate went from$1.76/ £ to $1.62/ £. What was the total dollar return, in percent, on British bonds for the year? e 0 =$1.76/£ e 1 =$1.62/£ In direct terms: e 0 = £.5682/$ e 1 = £.6173/$ e 0 = £.5682/$ e 1 = £.6173/$

31. 31 U.S. $ Stock Returns: Sample Solution