Download Chapter 25 International Diversification

Chapter Twenty Five
International Diversification
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Background
• Total mkt. cap of corporate
• By 2011, 52
equity in 2011 was $38.2
countries have stock
trillion (U.S. = 36.4%).
markets with a mkt.
cap over $1 billion. • Top six countries make up
64% of the world portfolio.
• U.S. accounts for
• But is this diversified enough?
<40%
• Developed countries
account for 85%
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Table 25.1, Market Capitalization of Stock
Exchanges in Developed Countries
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Table 25.2, Market Capitalization of Stock
Exchanges in Emerging Markets
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Background
• Clearly, U.S. stocks do not comprise a fully
diversified equity portfolio.
• International investing provides greater
diversification opportunities.
• It also carries some special risks.
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Issues
• A developed stock market enriches the
population (Figure 25.1). However, certain issues
still remain.
• Home-country bias:
– Investors frequently overweight home-country
stocks.
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Figure 25.1 Per Capita GDP and Market
Capitalization as Percentage of GDP
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Risk Factors in International Investing
Foreign Exchange Risk
• Variation in return due to changes in the
exchange rate.
• Foreign investments may yield more or less
home currency than expected.
• A foreign investment is simultaneously an
investment in an overseas asset and in a
foreign currency.
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Risk Factors in International Investing
Two sources of variation
or risk:
1. Return expressed in local currency
2. Return obtained when local currency is
exchanged for home currency.
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Example 25.1 Exchange Rate Risk
• Suppose the risk-free rate in U.K. is 10% and the
current exchange rate is $2/£1.
• A U.S. investor with $20,000 can buy £10,000 and
invest them to obtain £11,000 in one year.
• If the £ depreciates to $1.80, the investment will
yield only $19, 800, a $200 loss.
• The investment was not risk free to a U.S.
investor!
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Example 25.1 Exchange Rate Risk
• The equation shows that the return to the U.S.
investor is:
– The pound-denominated return
– Multiplied by
– The exchange rate “return”
E1
1  r (US )  1  r f (UK ) 
E0
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Figure 25.2 Stock Market Returns in U.S.
Dollars and Local Currencies for 2010
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Hedging Exchange Rate Risk
• Futures or forward markets are used to hedge the risk.
• The U.S. investor can make a riskless dollar return
either by investing in UK bills and hedging exchange
rate risk or by investing in riskless U.S. assets.
F0
1  rf (UK ) 
 1  rf (US )
E0
rearranged:
F0 1  rf (US )

E0 1  rf (UK )
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Political Risk
• In principle, security analysis at the
macroeconomic, industry, and firm-specific
level is similar in all countries.
• In practice, getting good information about
foreign investments can be more difficult.
• PRS Group (Political Risk Services) assesses
political risk by country.
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Table 25.5 Variables used in PRS’s Political
Risk Score
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Table 25.6 Current Risk Ratings and
Composite Risk Forecasts
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Table 25.7 Composite and Political Risk
Forecasts
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Table 25.7 Interpretation
• The table captures country risk through
scenario analysis.
• Risk stability is based on the difference in the
rating between the best- and worst-case
scenarios.
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Table 25.8 Political Risk Points by Component
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Foreign Investment Avenues
• Purchase securities directly in the capital
markets of other countries.
• American depository receipts (ADR)
• International mutual funds
• International ETFs
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Risk and Return: Summary Statistics
• Analysis focuses on excess returns over the
risk-free rate, but differs across countries.
• Aggregated country-index portfolios, via
value-weighted portfolios of developed and
emerging markets based on mkt. cap.
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Risk and Return: Summary Statistics
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Are Investments in Emerging Markets
Riskier?
• For the overall portfolio, standard deviation of
excess returns is the appropriate measure of
risk.
• For an asset to be added to the current
portfolio, beta (covariance with U.S. portfolio)
is the appropriate measure of risk.
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Figure 25.3 Monthly Std Deviation of Excess
Returns in Developed, Emerging Markets
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Figure 25.4 Index Dollar Return Beta on U.S.
Stocks, 2002–2011
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Figure 25.5 Average Dollar-Denominated
Excess Returns
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Average Country-Index Returns and Capital
Asset Pricing Theory
• Figure 25.5 shows a clear advantage to
investing in emerging markets.
• Results are consistent with risk ranking by
standard deviation, but not with ranking by
beta.
• Beta rankings may fail because of homecountry bias, which dominates international
investing.
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Benefits from International Diversification
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Figure 25.11 International Diversification
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Figure 25.13 Efficient Frontier of Country
Portfolios
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Are Benefits Preserved in Bear Markets?
• Correlations between
countries may increase
in a crisis.
• Roll’s model suggests a
common factor
underlying the
movement of stocks
around the world.
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• Prediction:
Diversification only
protects against
country-specific events.
• What happened in
1987? In 2008?
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Figure 25.14 Regional Indexes around the
Crash, October 14–October 26, 1987
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Figure 25.15 Beta and SD of Portfolios
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Three Rules of Thumb
To passively diversify your portfolio, include
country indexes in order of:
1.Market capitalization (from high to low)
2.Beta against the U.S. (from low to high)
3.Country index standard deviation (from high
to low)
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Figure 25.16 Risks and rewards of
international portfolios, 2000–2009
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Performance Attribution
• The EAFE index is a commonly used benchmark
for portfolio performance.
• Measure the contribution of:
1. Currency selection
2. Country selection
3. Stock selection
4. Cash/bond selection
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Table 25.12 Example of Performance
Attribution: International
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