frl 433 international investment and diversification

7/28/2019 FRL 433 International Investment and Diversification

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International Investment and Diversification


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International Diversification

The World Portfolio Calculating the Return on Foreign Investments

The Risk of Foreign Securities

Returns from International Diversification

The Effect of Exchange Risk

Return Expectations and Portfolio Performance

Other Evidence on Internationally Diversified

Portfolios Models for Managing International Portfolios


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The World Portfolio

Portfolio Managers are investing a largepercentage of their portfolio funds in othercountries. The global stock market hovers

around $40 -50 trillion. The global bond market isabout $82 trillion.Empirical data indicate that over the long term,equities outperform other investment vehicles, and

that internationally diversified portfolios outperformportfolios consisting of domestic stocks alone.


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Calculating the Return on Foreign Investments

Calculating the return on a foreign investment is very similarto domestic investments, except that we must take thechange in the currency into account. So, we actually havetwo sources of return.

For example, suppose that you purchased shares of PohangIron & Steel (POSCO) on the Korean Stock Exchange (KSE)on Jan 3, 1997 and sold them on Dec 27, 1997. Here arethe details:

Date Price (Won)

Exch. Rate (Won

per Dollar)

1/3/97 37,300 842.60

12/27/97 45,900 1,500.00


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Now, if you were a Korean investor your return for the year

would have been 23.06%

However, as a U.S. investor your return was a negative30.88%! Quite a difference, and it was entirely due to theloss in value of the won relative to the dollar during theAsian Contagion currency crisis that began in Thailand inJune 1997

%06.23137300

45900


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To calculate this return, we first need to calculate yourinvestment in dollar terms:

Where P0 is the cost in foreign currency, and FC0 is theexchange rate (foreign currency unit/dollar). Yourproceeds from the sale are calculated the same way:

Combining the equations into a rate of return, andrearranging we get the return in local currency (RLC):

0

0FC

1PCostDollar

1

1FC

1PoceedsPrDollar

1FCP

FCPR

10

01LC


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Now, we can see that your return in dollar terms was-30.88%

So, you made money on the stock, lost on thecurrency, and overall you lost a lot of money onthis investment

%88.303088.01150037300

60.84245900


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Returns on Foreign Investments

Heres another example. On Jan 27, 1999 Diageo PLC(LSE: DGE) was selling for 6.30p. One year earlier itwas selling for 5.42p, so a British investor wouldhave earned a return of 16.24%.

However, an American investor would have made 17.78%

The American made more because the British pound ()

appreciated (from 1.637 to 1.659 ) against the dollar over that

year. Note that the American originally paid $8.87 (5.42x 1.637),

but received $10.45 (6.3x 1.659) and the return is 17.78%.

%78.171

6028.42.5

6108.30.6

%24.16142.530.6


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Returns on Foreign Investments

HXUSRRR

0134.01637.1

69.1

XR 1624.0142.53.6

HR

1754.00134.0162.0 USR


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Purchasing Power Parity

Purchasing power parity (PPP) refers to thesituation in which the exchange rate equals the ratioof domestic and foreign price levels

A relative change in the prevailing inflation rate in onecountry will be reflected as an equal but opposite changein the value of its currency


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Purchasing Power

Parity (contd)

Absolute purchasing power parity follows fromthe law of one price: A basket of goods in one country should cost the same in

another country after conversion to a common currency

Not very accurate due to:

Transportation costs Trade barriers

Cultural differences


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Purchasing Power

Parity (contd)

Relative purchasing power parity states thatdifferences in countries inflation rates determineexchange rates:

12

11

1

where change in the spot exchange rateforeign country inflation rate

domestic country inflation rate

F

D

F

D

IS

I

S

I

I


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Purchasing Power

Parity (contd)

A country with an increase in inflation will experiencea depreciation of its currency because:

Exports decline

Imports increase

There is less demand for goods from that country


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International Risk Exposure

Exposure is a measure of the extent to which aperson faces foreign exchange risk

In general, there are two types of exposure:

accounting and economic Economic exposure is more important


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Accounting Exposure

Accounting exposure is: Of concern to MNCs that have subsidiaries in a number of

foreign countries

Important to people who hold foreign securities and mustprepare dollar-based financial reports

U.S. firms must prepare consolidated financialstatements in U.S. dollars


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Economic Exposure

Economic exposure measures the risk that thevalue of a security will decline due to an unexpectedchange in relative foreign exchange rates

Security analysts should include expected changesin exchange rates in forecasted cash flows


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The Risk of Foreign Securities

2/122)2(

HXHXUS

2/122 )( HXUS

Total investment risk is decomposed intothe volatility of the local market return, thevolatility of the exchange rate change and

the volatility due to the interactionbetween the local market return and theexchange rate change.


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Portfolio Risk

Total Riskof a Securitys Returns may be segmented

intoSystematic Risk can not be eliminated

Non-systematic Risk can be eliminated by diversification


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The Benefits of International Diversification


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INTERNATIONAL DIVERSIFICATION

International diversification and systematic riska. Diversify across nations with differenteconomic cycles

b. While there is systematic risk within a nation,

outside the country it may be nonsystematicand diversifiable risk


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INTERNATIONAL PORTFOLIO INVESTMENT

Recent Historya. National stock markets have wide

differences in returns and risk.

b. Emerging markets have higher risk andreturn than developed markets.

c. Cross-market correlations have beenrelatively low.


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Theoretical Conclusion

International diversification pushes out the

efficient frontier.


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The New Efficient Frontier

E(r)

A

B

C


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CROSS-MARKET CORRELATIONS

Cross-market correlations

a. Recent markets seem to be most correlatedwhen volatility is greatest

b. Result: Efficient frontier retreats


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The Frontier During Global Crises

E(r)

A

B

C


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Investing in Emerging Markets

Investing in Emerging Marketsa. Offers highest risk and returns

b. Low correlations with returns elsewhere

c. As impediments to capital marketmobility fall, correlations are likely toincrease in the future.


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Barriers to International Diversification

1. Segmented markets2. Lack of liquidity

3. Exchange rate controls

4. Underdeveloped capital markets

5. Exchange rate risk6. Lack of information

a. not readily accessibleb. data is not comparable


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Other Methods to Diversify

Diversify by a1.Trade in American Depository Receipts(ADRs)

2.Trade in American shares

3.Trade internationally diversified mutual funds:a. Global (all types)

b. International (no home country

securities)c. Single-country


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Calculation of Expected Portfolio Return:rp = a rUS + ( 1 - a) rwwhere

rp = portfolio expected returnrUS = expected U.S. market return

rw = expected global return


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Portfolio Return

ProblemWhat is the expected return of a portfolio with

35% invested in Japan returning 10% and 65%

in the U.S. returning 5%?

rp = a rUS + ( 1 - a) rw= .65(.05) + .35(.10)

= .0325 + .0350

= 6.75%


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Calculation of Expected Portfolio Risk

Where =the cross-market correlationUS

2 =U.S. returns variance

w2 =World returns variance

2/12222 )))(1(2)1(( WUSWUSP aaaa


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Portfolio Risk

What is the risk of a portfolio with 35% invested inJapan with a standard deviation of 6% and a standarddeviation of 8% in the U.S. and a correlation coefficientof .7?

= [(.65)2 (.08) 2 + (.35) 2(.06) 2

+2(.65)(.35)(.08)(.06)(.7)] 1/2

=6.8%

2/12222 )))(1(2)1((WUSWUSP

aaaa


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MEASURING TOTAL RETURNS FROM FOREIGN PORTFOLIOS

A. To compute dollar return of a foreign security:

1 0$

0

( )( )US ForeignCurrencye e

R Re

0 1$

1

( )( )US ForeignCurrency e eR Re

For currency appreciation:

For currency depreciation:


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Bond (calculating return) formula:

where RUS = dollar returnB1 = foreign currency bond price at time 1B

0=bond price at 0

C = coupon income during periodg = currency depreciation or appreciation

)1](1[10

01 gB

CBBRUS


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Stocks (Calculating return)

Formula:

Where RUS = dollar returnP(1) = foreign currency stock price at time 1D = foreign currency annual dividend

$(1) (0)1 1 (1 )

(0)P P DR g

P

$

(1) (0)1 1 (1 )(0)

P P DR gP


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U.S. Stock Returns: Sample Problem

Suppose the beginning stock price is FF50 andthe ending price is FF48. Dividend incomewas FF1. The franc depreciates from FF 20/$ to FF21.05 /$ during the year against the

dollar.What is the stocks US$ return for the year?


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U.S. Stock Returns: Sample Solution

48 50 1 .20 .21051 1 1

50 .2105

$ 6.9%R

)1](1[10

01 gP

DPPRUS

%9.61)95.0)(98.0(1 US

R


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Evidence on Internationally DiversifiedPortfolios

With the globalization of financial markets, the trendtoward international diversification can already be seenin the activities of mutual funds, pension funds and other

institutional investors.

frl 433 international investment and diversification

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