Download International Portfolio Investment

INTERNATIONAL
FINANCIAL
MANAGEMENT
Fifth Edition
EUN / RESNICK
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
International Portfolio
Investment
15
Chapter Fifteen
Chapter Objective:
Why investors diversify their portfolios internationally.
How much investors can gain from international
diversification.
The effects of fluctuating exchange rates on international
Fifth Edition
portfolio investments.
EUN
/ RESNICK
Whether and how much investors can benefit
from
investing in U.S. based international mutual funds.
The reasons for “home bias” in portfolio holdings.
15-1
International Correlation Structure
and Risk Diversification

Security returns are much less correlated across
countries than within a country.


15-2
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.
Portfolio Risk (%)
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
Swiss stocks
0.27
U.S. stocks
International stocks
0.12
1
10
20
30
40
50 Number of
Stocks
15-3
Optimal International Portfolio
Selection




15-4
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 72%.
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.
Summary Statistics for Monthly
Returns 1980-2007 ($U.S.)
Correlation Coefficient
Stock Market
CN
FR
GM
JP
15-5
SD
(%)
1.07
5.55
Country
stock
market
vs. world
1.00
1.20
6.00
1.04
1.19
6.29
1.03
0.92
6.53
1.10
1.19
5.20
0.97
1.11
4.25
0.88
UK
Canada (CN)
France (FR)
0.49
Germany
(GM)
0.46
1.07% monthly return =
12.84% per year
0.73
Japan (JP)
0.34
0.40
0.32
United
Kingdom
0.59
0.61
0.56
0.42
United States
0.72
0.55
0.52
0.31
0.61

Mean
(%)
Summary Statistics for Monthly
Returns 1980-2007 ($U.S.)
Correlation Coefficient
Stock Market
CN
GM
JP
France (FR)
0.49
Germany
(GM)
0.46
Japan (JP)
0.34
0.40
0.32
United
Kingdom
0.59
0.61
0.56
0.42
United States
0.72
0.55
0.52
0.31
SD
(%)
1.07
5.55
Country
stock
market
vs. world
1.00
1.20
6.00
1.04
1.19
6.29
1.03
0.92
6.53
1.10
1.19
5.20
0.97
1.11
4.25
0.88
UK
 measures the sensitivity of the
market to the world market.
Canada (CN)
15-6
FR
Clearly the Japanese market is
0.73more sensitive to the world
market than is the U.S.
0.61

Mean
(%)
Selection of the Optimal International Portfolio
2.0%
Efficient frontier
SD
1.5%
HK
OIP
Monthly Return
NL
US
1.0%
0.5%
0.0%
0.0%
15-7
UK
SW
CN
IT
GM
JP
Rf
Monthly Standard Deviation
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
15-8
100.00%

For a U.S. investor, OIP has
more return and more risk.
The Sharpe measure is 30%
higher, suggesting that an
equivalent-risk OIP would
have more return per unit of
risk than a domestic portfolio.
OIP
ODP
Mean
Return
1.40%
1.11%
Standard
Deviation
4.74%
15-9
4.25%
return
Gains from
International Diversification
OIP
1.40%
1.11%
ODP
4.74%
4.25%
risk
Effects of Changes
in the Exchange Rate

15-10
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.
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
15-11
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%:
Ri$ = (1 + .15)(1 – 0.05) – 1 = 0.925
= .15 + –.05 + .15×(–.05) = 0.925
15-12
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$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + Var
The Var term represents the contribution of the
cross-product term, Riei, to the risk of foreign
investment.
15-13
Effects of Changes
in the Exchange Rate
Var(Ri$) = 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:
1. Its own volatility, Var(ei).
2. Its covariance with the local market returns
Cov(Ri,ei).
3. The contribution of the cross-product term, Var.
15-14
International Mutual Funds: A
Performance Evaluation


1.
2.
3.
15-15
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 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. US
Mean
Annual
Return
18.96%
Standard
Deviation
US
R2
5.78%
0.69
0.39
S&P 500
14.04%
4.25%
1.00
1.00
U.S. MNC
Index
16.08%
4.38
.98
.90
U.S. Based
International
Mutual Funds
15-16
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.
15-17
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
1.00
U.S. MNC Index
16.08%
4.38
.98
.90
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:
1.
2.
3.
15-18
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 through
American Depository Receipts



15-19
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
American Depository Receipts

There are many advantages to trading ADRs as
opposed to direct investment in the company’s
shares:



15-20
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.
International Diversification
with ADRs

15-21
Adding ADRs to domestic portfolios has a
substantial risk reduction benefit.
International Diversification with
Exchange Traded Funds


15-22
Using exchange traded funds (ETFs) like WEBS and
spiders, investors can trade a whole stock market index as
if it were a single stock.
Being open-end funds, WEBS trade at prices that are very
close to their net asset values. In addition to single country
index funds, investors can achieve global diversification
instantaneously just by holding shares of the S&P Global
100 Index Fund that is also trading on the AMEX with
other WEBS.
International Diversification with Hedge Funds


15-23
Hedge funds which represent privately pooled
investment funds have experienced phenomenal
growth in recent years.
This growth has been mainly driven by the desire
of institutional investors, such as pension plans,
endowments, and private foundations, to achieve
positive or absolute returns, regardless of whether
markets are rising or falling.
International Diversification with Hedge Funds



15-24
Unlike traditional mutual funds that generally depend on
“buy and hold” investment strategies, hedge funds may
adopt flexible, dynamic trading strategies, often
aggressively using leverages, short positions, and
derivative contracts, in order to achieve their investment
objectives.
These funds may invest in a wide spectrum of securities,
such as currencies, domestic and foreign bonds and stocks,
commodities, real estate, and so forth.
Many hedge funds aim to realize positive returns,
regardless of market conditions.
Home Bias in Portfolio Holdings



15-25
As previously documented, investors can
potentially benefit a great deal from international
diversification.
The actual portfolios that investors hold, however,
are quite different from those predicted by the
theory of international portfolio investment.
Home bias refers to the extent to which portfolio
investments are concentrated in domestic equities.
Why Home Bias in Portfolio Holdings?

15-26
Three 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.
Why Home Bias in Portfolio Holdings?


15-27
A recent study of the brokerage records of tens
of thousands of U.S. individual investors shows
that wealthier, more experienced, and
sophisticated investors are more likely to invest
in foreign securities.
Another study shows that when a country is
remote and has an uncommon language, foreign
investors tend to stay away.