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International Diversification Chapter 25 McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Background DCs are defined as developed (high income) countries with per capital exceeding $9,300 (in year 2000). EMs; Active portfolios will include many stocks and indexes of EMs. 20 EMs made up of 16% of the world GDP, together with 25 DCs make 95% of GDP.China, Brazil and Korea are the largest EMs in the world. 25-2 Largest markets in the world are; U.S, Japan, UK, France, Germany and Switzerland. Global market US Market is 40% - 49% of all markets Improved access & technology New instruments 25-3 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? 25-4 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. 25-5 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 25-6 Returns with Foreign Exchange: Example Condition: U.S. Investor invests in the British Market Initial Conditions: Initial Investment : $20,000 Initial Exchange: $2.00/ Pound Initial Investment in Pound: 10,000 Risk Free Rate in U.K.: 10% Future Value in Pound : 11,000 25-7 Returns with Foreign Exchange Pound Depreciates to $1.80 11,000 * 1.8 = $19,800 Return in US$ (-200 / 20,000) = -1% Pound Remains at $2.00 11,000 * 2.0 = $22,000 Return in US$ (2,000 / 20,000) = 10% Pound Appreciates to $2.20 11,000 * 2.20 = $24,200 Return in US$ ( 4,200 / 20,000) = 21% 25-8 Returns with Foreign Exchange Movements in foreign exchange can have a major influence From Figure 25.2 New Zealand nearly 50% of return is from foreign exchange Australia virtually all of the return is from foreign exchange Returns from U.K. and Switzerland are mostly from returns in local currency Both factors must be considered in international investing 25-9 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 25-10 PRS Risk Variables Political Risk Variables Government stability, corruption etc Financial Risk Variables Foreign debt (%GDP), Exchange rate stability etc Economic Risk Variables GDP per capita, annual inflation etc 25-11 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. 25-12 Gains From International Diversification Int’l Return ** * * * * * Dom * Risk 25-13 Systematic Risk Level with International Risk Dom Int’l Securities 25-14 International Investment Choices Direct stock purchases Depository receipts Investment companies Open-end funds Closed-end funds 25-15 Is Exchange Rate Risk is Important in Inter Portfolios Changes in Exchange rates are not highly correlated across countires. When int port are well diversified, the exchange rate risk can be diminished. Hedging currency is not a significant issue in diversification. 25-16 Benefits from Int Diversification Correlations of retuns in US dollars (when currency risk is not hedged) and correlations of returns in local currency (when the exchange risk is hedged) are very similar, then hedging is not a significant issue in diversifying internationally. (Table 25.11) 25-17 Measuring Benchmark Returns EAFE Index Other possibilities Country and Region Funds 25-18 Performance Attribution with International Currency selection: contribution of the exchange rate fluctuations relative to a benchmark currency. Country selection: cont. of investing better stock markets of the world. Stock selection: measured as the weighed ave. Of the stock returns in excess of the equity index. Cash and bond selection 25-19