1 international portfolio investment chapter objective: this chapter discusses the gains from...

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International Portfolio Investment

Chapter Objective:This chapter discusses the gains from international portfolio diversification, which emerged as a major form of cross-border investment in the 1980s, rivaling foreign direct investment by firms.

Chapter Outline:Portfolio Arithmetic – International Perspectives Optimal International Portfolio SelectionInternational Mutual Funds: A Performance EvaluationInternational Diversification through Country FundsInternational Diversification with ADRsInternational Diversification with WEBSInternational Diversification with Hedge FundsWhy Home Bias in Portfolio Holdings

11Chapter Ten

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Portfolio Arithmetic International Perspectives

Investment in international securities offer opportunities for diversification but increases foreign exchange risk;

For example, A Canadian portfolio manager buys 10 UK shares at £10 per

share, at $2.30/£; At the end of the period, the shares have risen in value to £110,

but the pound falls to $2.10/£: The transactions are summarized:

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Three rates of return:

Portfolio Arithmetic – International Perspectives

10.0

110.11100/110

:poundsin return Security

£

£

r

r 087.0

1913.0130.2/10.2

:return rate Exchange

x

x

r

r

0.0043

)087.0)(10.0()087.0(10.0

111

:returndollar Total

x£x£C$

£C$

rrrrr

rrr x

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Portfolio Arithmetic – International Perspectives

C$ gain or loss on British Investment: End of Period

Con

diti

onal

Sha

re v

alue

s, £

Conditional Exchange rates $/£

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International Portfolio Diversification

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Optimal International Portfolio Selection

Security returns are much less correlated across countries than within a country. 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. The correlation of Canadian stock markets with the returns on

the stock markets in other nations varies. The correlation of the U.S. market with the Canadian market is in the

0.60 to 0.75 range. The correlation of the U.S. market with the Japanese market is 0.24%.

A U.S. investor would get more diversification from investments in Japan than Canada.

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Canadian Dollar-Based Equity Market Returns

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Summary Statistics of Returns of 11 Major Stock Market Indices

Relatively low international correlations imply that investors should be able to reduce portfolio risk more if they diversify internationally rather than

domestically.

(1996-2007, weekly data, annualized)

measures the sensitivity of the market to the world

market.

Clearly the Japanese market is more sensitive to the world

market than is the U.S.

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Domestic versus International Diversification

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International Portfolio DesignThe simple case of 2

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International Portfolio DesignThe simple case of 2

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The Optimal International Portfolio

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The Optimal International Portfolio

The optimal proportion of investment in foreign assets in any particular country is greater:1. The greater is the expected return on foreign assets (recorded in terms of foreign currency) relative to expected returns on domestic assets.2. The greater is the expected (real) appreciation of foreign currency against the investor’s home currency.3. The lower is the risk (standard deviation) of returns on foreign assets (converted to the domestic investor’s currency) compared to the risk of domestic investment.4. The smaller is the correlation coefficient between returns on foreign assets (converted to the domestic investor’s currency) and returns on domestic assets.5. The lower is the domestic risk-free rate.

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11.3 International Mutual Funds: Access to the World

A Canadian investor can easily achieve international diversification by investing in a Canadian-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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International Mutual Funds: A Performance Evaluation

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11.4 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. Speculate in a single foreign market with minimum cost.

2. Construct their own personal international portfolios.3. Diversify into emerging markets that are otherwise

practically inaccessible.

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US and Home Market Betas of Country Funds and their Net Asset Values (1985-91)

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11.5 International Diversification with American Depository Receipts (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

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. Adding ADRs to domestic portfolios has a substantial risk

reduction benefit.

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11.6 International Diversification with World Equity Benchmark Shares

World Equity Benchmark Shares (WEBS) Country-specific baskets of stocks designed to replicate the country

indexes of 20 countries. WEBS are subject to U.S. SEC and IRS diversification

requirements. Low cost, convenient way for investors to hold diversified

investments in several different countries. Recent research suggests that WEBs are an excellent tool

for international risk diversification. For investors who desire international exposure, WEBs 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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11.7 International Diversification with Hedge Funds

Unlike traditional mutual funds that depend on ‘buy and hold’ strategies, hedge funds may adopt flexible, dynamic strategies, often aggressively using leverage, short positions and derivative contracts.

Usually not subject to reporting and disclosure requirements. They allow investors to increase international diversification

because: They tend to have low correlation with stock market indices; Allow investors access to foreign markets that are

sometimes not easily accessible.

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The Home Bias in Equity Portfolios

Country Share in World Market Value

Proportion of Domestic Equities in PortfolioFrance 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 100.0%  

Home bias refers to the extent to which portfolio investments are concentrated in domestic equities.

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Why Home Bias in Portfolio Holdings?

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.

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Summary

International portfolio investment has be growing recently because of deregulation and new investment instruments;

Diversification reduces risk: Lower covariance across countries (than within countries) means international diversification reduces risk more;

More effective diversification means higher returns for a fixed level of risk; Foreign exchange uncertainty adds to the risk of foreign investments;

hedging of forex risks allows investors to enhance overall gains from international diversification;

Domestically-based mutual funds and closed-end country funds allow investors to achieve international diversification at home. The majority outperform the domestic stock market in terms of the Sharpe performance measure;

Despite potential gains from international diversification investors allocate a disproportionate share of their assets to domestic securities. Home bias likely reflects imperfections in international markets.