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International Portfolio Diversification

International Portfolio Diversification

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Published by Gaurav Kumar

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Categories:Business/Law
Published by: Gaurav Kumar on Jan 28, 2010
Copyright:Attribution Non-commercial

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10/20/2010

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AJAFIN 6605 -10International Portfolio Diversification.
A portfolio is a collection of securities held byindividual or institutional investors.
Diversification is the allocation of investable funds toa variety of instruments
.The rationale for diversification is that investorscan greatly reduce risk without adversely affecting return.
Simplifying Assumptions
:
Certain simplifying assumptions are made about marketoperations and the psychology of investors.
A Perfect Market
: is a market free of any impedimentsto trading such as transaction costs, costly information,regulatory constraints, etc.
1
 
The Assumptions are
:
 – Securities markets operate without transaction costs. – All investors have access to complete and costlessinformation relevant to the pricing of securities. – Investors appraise information in a similar way(i.e., they have homogeneous expectations). – Investors are interested only in the risk and expectedreturn characteristics of securities. – Investors have the same one-period time horizon
.
 
While these assumptions are not necessarily true, theyserve as close approximations to the truth and theysimplify the analyses
.
Strict assumptions allow mathematical precision and
relaxing them makes the mathematics more complicated.
2
 
 
Two-Asset International Portfolios
The expected return on a two-asset international portfoliodepends on the expected returns of the individual(national) assets and the proportion of investable funds ineach. Hence,
The risk of a two-asset international portfolio is measured by the standard deviation of its returns.The riskiness of a portfolio depends on the degree of co-movement of the component assets.The co-movement can be measured by the covariance or correlation coefficient.The risk for a two-asset portfolio can be expressed as:
 Rw+ Rw =  R
2211 IP 
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