1. Chapter 11 International Portfolio Investment
Management 3460 Institutions and Practices in International Finance
Fall 2003
Greg Flanagan
Chapter 11 International Portfolio Investment

2. Chapter Objectives The student will be able to:
explain how investors can gain from international diversification.
explain the effects of fluctuating exchange rates on international portfolio investments.
explain optimal international portfolio selection.
describe different approaches to optimal international portfolio selection.
discuss the reasons for “home bias” in portfolio holdings.
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3. International Correlation Structure and Risk Diversification
Security returns are much less correlated across countries than within a country.
economic, political, institutional, and even psychological factors affecting equity returns tend to vary across countries, resulting in low correlations among international securities.
business cycles are often high counter cyclical across countries.
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4. Increased Investment in Foreign Equities (US)
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5. International Correlation Structure
Stock Market AU FR GM JP NL SW UK US
Australia (AU)
.586
France (FR)
.286
.576
Germany (GM)
.183
.312
.653
Japan (JP)
.152
.238
.300
.416
Netherlands (NP)
.241
.344
.509
.282
.624
Switzerland (SW)
.358
.368
.475
.281
.517
.664
United Kingdom (UK)
.315
.378
.299
.209
.393
.431
.698
United States (US)
.304
.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.
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6. Domestic vs. International Diversification
When fully diversified, an international portfolio can be less than half as risky as a purely U.S. portfolio.
A fully diversified international portfolio is only 12 percent as risky as holding a single security.
0.44
Portfolio Risk (%)
Swiss stocks
0.27
U.S. stocks
0.12
International stocks
Number of Stocks
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7. Optimal International Portfolio Selection
The correlation of the one stock market with the returns on the stock markets in other nations varies.
The correlation of the Canadian stock market with U.S. the stock market is 74%.
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.
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8. Optimal International Portfolio Selection
Mean return on investment
Standard deviation (measure of risk)
World beta b measures the sensitivity to world markets.
covariance between the national market and the world market index divided by the variance of the world market
bi = siw/sw2
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9. Summary Statistics for Monthly Returns 1980-2001 ($U.S.)
Stock Market
Correlation Coefficient
Mean
(%) SD  CN FR GM JP UK
Canada (CN)
.88
5.78
0.99
France (FR)
0.46
1.19
6.29
1.00
Germany (GM)
0.42
0.69
1.09
6.26
0.91
Japan (JP)
0.33
0.41
6.99
1.20
United Kingdom
0.57
0.50
1.23
5.55
0.98
United States
0.74
0.45
0.31
0.58
1.26
4.43
0.86
.88% monthly return = 10.56% per year
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10. Summary Statistics for Monthly Returns 1980-2001 ($U.S.)
Stock Market
Correlation Coefficient
Mean
(%) SD  CN FR GM JP UK
Canada (CN)
.88
5.78
0.99
France (FR)
0.46
1.19
6.29
1.00
Germany (GM)
0.42
0.69
1.09
6.26
0.91
Japan (JP)
0.33
0.41
6.99
1.20
United Kingdom
0.57
0.50
1.23
5.55
0.98
United States
0.74
0.45
0.31
0.58
1.26
4.43
0.86
measures the sensitivity of the market to the world market.
The Japanese market is more sensitive to the world market than is the U.S.
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11. Optimal International Portfolio Selection
Sharpe performance measure provides a risk adjusted performance
Rf the risk free return (T-bill rate)
Ri the mean return for country i
Standard deviation si —the measure of variance (risk)
SHP = (Ri –Rf)/si
a the excess return per std. dev. risk.
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12. Summary Statistics for Monthly Returns 1980-2001 ($U.S.)
Stock Market
Correlation Coefficient
SHP
Rank CN FR GM JP UK
Canada (CN)
.057 11
Low return
France (FR)
0.46
0.102 6
Germany (GM)
0.42
0.69
0.086 9
Japan (JP)
0.33
0.41
0.33
0.052 12
United Kingdom
0.57
0.57
0.50
0.42
0.123 4
United States
0.74
0.50
0.45
0.31
0.58
0.160 2
Low risk
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13. Optimal International Portfolio Selection
Maximize the SHP for the portfolio
Based expected return!
SHPP = [E(Rp) –Rf]/sp (p =portfolio)
E(Rp) = SixiRi
where x is the weight of the asset
and Sixi = 1
sp = [SiSjxixj sij]1/2
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14. Composition of the OIP for a U.S. Investor (Holding Period: 1980—2000)
Hong Kong market
1.61%
Italian market
1.14%
Netherlands market
29.96%
Swedish market
26.45%
U.S. market
40.84%
Total
100.00%
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15. Gains from International Diversification
For a U.S. investor, OIP has more return and more risk. The Sharpe measure is 20% higher, suggesting that an equivalent-risk OIP would have 1.68% more return than a domestic portfolio.
return
OIP
1.42%
1.26%
4.51%
ODP
risk
4.43%
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18. Effects of Changes in the Exchange Rate
The realized dollar return for a U.S. resident investing in a foreign market will depend not only on the return in the foreign market but also on the change in the exchange rate between the U.S. dollar and the foreign currency.
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19. Effects of Changes in the Exchange Rate
The realized dollar return for a U.S. resident investing in a foreign market is given by
Ri$ = (1 + Ri)(1 + ei) – 1
= Ri + ei + Riei
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
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20. Effects of Changes in the Exchange Rate
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%:
Ri$ = ( )(1 –0.05) – 1
= ×(-.05) =0.925
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21. 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.
Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + Var
The Var term represents the contribution of the cross-product term, Riei, to the risk of foreign investment.
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22. Effects of Changes in the Exchange Rate
Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + Var
This equation demonstrates that exchange rate fluctuations contribute to the risk of foreign investment through three channels:
Its own volatility, Var(ei).
Its covariance with the local market returns Cov(Ri,ei).
The contribution of the cross-product term, Var.
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23. International Bond Investment
There is substantial exchange rate risk in foreign bond investment. This suggests that investors may be able to increase their gains is 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.
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24. 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.
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25. 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 , with a higher standard deviation. US
Mean Annual Return
Standard Deviation
US R2
U.S. Based International Mutual Funds
18.96%
5.78%
0.69
0.39
S&P 500
14.04%
4.25%
1.00
U.S. MNC Index
16.08%
4.38
.98
.90
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26. International Mutual Funds: A Performance Evaluation
U.S. stock market movements account for less than 40% of the fluctuations of international mutual funds, but over 90% of the movements in U.S. MNC shares. This means that the shares of U.S. MNCs behave like those of domestic firms, without providing effective international diversification.
Mean Annual Return
Standard Deviation
US R2
U.S. Based International Mutual Funds
18.96%
5.78%
0.69
0.39
S&P 500
14.04%
4.25%
1.00
U.S. MNC Index
16.08%
4.38
.98
.90
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27. 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.
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28. American Depository Receipts
Foreign stocks often trade on U.S. exchanges as ADRs.
It is a receipt that represents the number of foreign shares that are deposited at a U.S. bank.
The bank serves as a transfer agent for the ADRs
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29. American Depository Receipts
There are many advantages to trading ADRs as opposed to direct investment in the company’s shares:
ADRs are denominated in U.S. dollars, trade on U.S. exchanges and can be bought through any broker.
Dividends are paid in U.S. dollars.
Most underlying stocks are bearer securities, the ADRs are registered.
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30. World Equity Benchmark iShares
iShares (formally WEBS)
Country-specific baskets of stocks designed to replicate the country indexes of many countries.
iShares are subject to U.S. SEC and IRS diversification requirements.
Low cost, convenient way for investors to hold diversified investments in several different countries.
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31. International Diversification with iShares
Recent research suggests that iShares are an excellent tool for international risk diversification.
For investors who desire international exposure, iShares may well serve as a major alternative to such traditional tools as international mutual funds, ADRs, and closed-end country funds
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32. Why Home Bias in Portfolio Holdings?
Home bias refers to the extent to which portfolio investments are concentrated in domestic equities.
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33. The Home Bias in Equity Portfolios
Country
Share in World Market Value
Proportion of Domestic Equities in Portfolio
France
2.6%
64.4%
Germany
3.2%
75.4%
Italy
1.9%
91.0%
Japan
43.7%
86.7%
Spain
1.1%
94.2%
Sweden
0.8%
100.0%
United Kingdom
10.3%
78.5%
United States
36.4%
98.0%
Total
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34. 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.
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