International Diversification

Background
Global market
US Market is 40% - 49% of all markets
Improved access & technology
New instruments
Emphasis for our investigation
Risk assessment
Diversification
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?
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.
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

Returns with Foreign Exchange:
Example
Condition: U.S. Investor invests $10,000 in the
British Market
Initial Conditions:
Initial Investment : $20,000
Initial Exchange: $2.00/ Pound Sterling
Initial Investment in Pound Sterling: 10,000
Risk Free Rate in U.K.: 10%

Future Value in Pound Sterling: 11,000

Returns with Foreign
Pound Depreciates to $1.80
Exchange
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%
Returns with Foreign
Movements in foreign exchange can
Exchange
have a major influence
From Figure 25.2
New Zealand nearly 50% of return is from
foreign exchange
Australia virtually all of the return in from
foreign exchange
Returns from U.K. and Switzerland are
mostly from returns in local currency
Both factors must be considered in
international investing
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
PSR Risk Variables
Political Risk Variables (country specific risk)
Government stability, corruption, changes in
policies, etc
Financial Risk Variables
Foreign debt (%GDP), Exchange rate stability
etc
Economic Risk Variables
GDP per capita, annual inflation etc
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.
 Int’l
Return
Dom
** *
* * *
*
*

Risk
Risk

Dom
Int’l

Securities
International Investment
Choices
Direct stock purchases

American depository receipts

Mutual Funds
Open-end funds

Closed-end funds

WEBS (World Equity Benchmarks)

Measuring Benchmark
Returns
Indexes
EAFE Index (Europe, Australia, Far East
index)
Issues in measuring performance
Weighting

Cross-Holdings

Other possibilities
Country and Region Funds
Performance Attribution with
International
Extension to consider additional factors

Currency selection

Country selection

Stock selection

Cash and bond selection

Efficient Market Hypothesis
(EMH)
Do security prices reflect information ?

Why look at market efficiency?

Implications for business and corporate

finance
Implications for investment

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Random Walk and the
EMH
Random Walk - stock prices are random

Actually submartingale

 Expected price is positive over time

 Positive trend and random about the trend

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 Security
Prices

Time

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Random Price Changes
Why are price changes random?
Prices react to information

Flow of information is random

Therefore, price changes are random

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EMH and Competition
Stock prices fully and accurately reflect
publicly available information.
Once information becomes available,
market participants analyze it.
Competition assures prices reflect
information.

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Forms of the EMH
 Weak

 Semi-strong

 Strong

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Types of Stock Analysis
Technical Analysis - using prices and volume
information to predict future prices.
Weak form efficiency & technical analysis

Fundamental Analysis - using economic and

accounting information to predict stock prices.
Semi strong form efficiency & fundamental
analysis

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Active or Passive
Management
Active Management
Security analysis
Timing

Passive Management
Buy and Hold
Index Funds

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Market Efficiency & Portfolio
Management
Even if the market is efficient a role exists for
portfolio management:
Appropriate risk level

Tax considerations

Other considerations

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Empirical Tests of Market
Efficiency
Event studies

Assessing performance of professional

managers
Testing some trading rule

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How Tests Are Structured
1. Examine prices and returns over time

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-t 0 +t

Announcement Date
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How Tests Are Structured
(cont’d)
2. Returns are adjusted to determine if they are
abnormal.
Market Model approach
a. Rt = at + btRmt + et
(Expected Return)
b. Excess Return =
(Actual - Expected)
et = Actual - (at + btRmt)

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How Tests Are Structured
(cont’d)
2. Returns are adjusted to determine if they are
abnormal.
Market Model approach
c. Cumulate the excess returns over
time:

-t 0 +t
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Issues in Examining the
Results
Magnitude Issue

Selection Bias Issue

Lucky Event Issue

Possible Model Misspecification

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What Does the Evidence
Show?
Technical Analysis
Short horizon
Long horizon

Fundamental Analysis

Anomalies Exist

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Anomalies
Small Firm Effect (January Effect)

Neglected Firm

Market to Book Ratios

Reversals

Post-Earnings Announcement Drift

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Explanations of
Anomalies
May be risk premiums

Behavioral Explanations
Information Processing Errors
Behavioral Biases
Limits to Arbitrage

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Information Processing
 Forecasting Errors

Overconfidence

Conservatism

Sample Neglect and Representativeness

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Behavioral Biases
Anchoring
Mental Accounting
Confirmation & Hindsight bias
Gambler’s fallacy
Herd behaviour
Over confidence
Overreaction and availability bias
Prospect theory

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Limits to Arbitrage
Fundamental Risk

Implementation Costs

Model Risk

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Mutual Fund Performance
Some evidence of persistent positive and
negative performance.

Potential measurement error for

benchmark returns.
Style changes
May be risk premiums

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