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Journal of Business Finance & Accounting, 16(4) Autumn 1989, 0306 686X $2.





One of the most widely accepted implications of economic theory is that nations
can increase their welfare through participation in international trade in goods
and services. It has also been demonstrated that the movement of factors of
production between nations can generate benefits for the participating countries. A third way in which the residents of different nations can raise their
welfare by participating in international transactions is through the purchase
and sale of foreign assets, viz. portfolio investment. In fact, movements of
capital across borders have increased dramatically as barriers to international
communication and cooperation have been relaxed.' This paper investigates
the potential benefits that arise from international portfolio investment.
In an early and well known article Grubel (1968) demonstrated theoretically
and empirically that benefits could be realized from international portfolio diversification. Since Grubel's paper there have been a number of empirical studies
supporting his initial findings. Levy and Sarnat (1970), like Grubel, generate
the efficient portfolio set and find that it contains foreign assets. Agmon (1972),
Lessard (1975a and 1975b), and Solnik (1974), use simple and multiple regression models to demonstrate that a large proportion of the variation of international stock returns is unsystematic and therefore capable of being eliminated
through international diversification.^ Solnik (1975) further found that randomly chosen portfolios of even modest size, containing as few as five stocks,
outperform randomly chosen portfolios of only US stocks, and that maximum
risk reduction occurs with a portfolio with around twenty stocks. That diversification benefits occur with such small portfolios is valuable information to
potential investors.
The simplest and most straightforward method for showing that international
diversification benefits exist is to correlate national asset indices. If the correlations are less than one international diversification is beneficial. If one country's returns are low then the overall portfolio's return will probably be protected by off-setting returns in other countries. Thus, the overall variation in
returns risk will be reduced by a portfolio containing foreign assets. Adler
and Dumas (1983), Allan (1982), Errunza (1983), Finnerty and Schneeweis
(1979), Grubel and Fadner (1971), Ibbotson et al. (1982), and Joy et al. (1976)
* The authors are respectively, a Lecturer at Tufts University, and Associate Professor at Wheaton
College. (Paper received January 1987, revised October 1987)




have calculated correlations between various countries for various indices of

assets and found these correlations generally to be low. This consistency in
empirical findings is undoubtedly partially responsible for the increased use
of internationally diversified portfolios (see Erlich, 1981; and Revey. 1981).
Most of the studies referred to above have used rates of return unadjusted for
exchange-rate changes, or relied on data drawn from the fixed exchange-rate
period. Those few studies that do adjust for exchange-rate changes during the
floating period do not emphasize the effect of exchange-rate changes on diversification benefits. In fact a new edition of one well known finance text by
Rodriguez and Carter (1984) notes that the effect of exchange-rate changes
on diversification benefits remains unclear.
As part of their investigation of diversification benefits Grubel and Fadner
(1971) point out that exchange-rate changes could increase or decrease the diversification benefits that would exist in the absence of these changes. In an
expanding economy, for example, it is typical for both rates of return and
imports to increase. The resulting exchange rate movement is indeterminant.
Hence, exchange rates may move with or against domestic rates of return.
Furthermore, in the short run according to the asset market view of exchange
rate determination, when higher nominal rates of return are due to domestic
inflationary pressures there could be a capital outflow (rather than inflow) if
investors expect a weakening of the external value of currency (see Frenkel,
1981). In this case too the relation between exchange-rate changes and rates
of return remains unclear. Grubel and Fadner did try to determine empirically
the effect of exchange-rate changes on their correlations but their data was
restricted to the fixed-rate period when exchange rates moved by only small
percentages around par. As might be expected they found no effect on
diversification benefits after adjusting for exchange-rate changes.
In this paper we attempt to update the work of Grubel and Fadner by drawing on data from the more recent floating exchange rate era, rather than from
the pegged rate period. Since our data are drawn entirely from that period
it is necessary to create the relevant data that would have existed had exchange
rates not moved as they in fact did. That set of data, a counter-factual, provides the benchmark to which we compare the actual experience during the
fioating period. We have constructed the counter-factual situation under the
assumption that nations pursued sterilized intervention so that during the period
under consideration the exchange rate changes actually observed have been
eliminated without affecting asset returns since the monetary base is
unchanged.^ Our tests are based on ex-post share price indices of industries in
Australia, Ganada, Spain, the UK, and the US.* The resuhs indicate that for
a US investor international diversification is superior to purely domestic diversification. However, in this sample the observed exchange-rate movements have
tended to reduce the diversification benefits from what would have arisen had
a pegged regime existed (viz. had the central banks followed our counter-factual
of sterilized intervention.)



If risk is priced in international markets then the gain to be realized from an
internationally diversified portfolio is a more efficient risk-return tradeoff.^ If
portfolio risk is measured by the variance of the portfolio's return then the potential for diversification benefits is indicated by the weighted covariances of every
pairwise combination of assets' returns. Total diversification benefits, excluding
purely domestic diversification, include those realized from diversifying within
foreign countries and across foreign countries as well as those that would be
realized from holding just one foreign asset. The rate of return on an asset
for an investor in county 1 of an n country world is r^.^ and can be written as
( l + r , J = ( 1 + U * (l+-t)


where 4m is the nominal rate of return on asset m in country k measured in

k'5 currency, and e^. is the appreciation of currency k relative to country I.*"
Of course for X: = 1, t = 0. If J^m * * ~ 0 , the exchange-rate adjusted rate
of return can be approximated by
nm = hm + *


The return on a world portfolio is

Tp = W

* R


where Wisa. vector whose elements are the proportions of wealth held in each
asset and i? is a vector of assets' rates of returns as approximated by r^n,. T h e
risk associated with the world portfolio, measured by its variance, is
V A R {Tp) = W

* C * W


where C is the variance-covariance matrix of all assets' returns. For large portfolios each element of W approaches 1/^ where s is the number of assets in the
world. T h e benefits of total (not just international) diversification depend upon
the size of the covariance terms the off-diagonal elements of C. Note that
since a correlation coefficient is essentially a standardized covariance it is
legitimate to measure potential diversification benefits in terms of covariances
as well as correlation coefficients.
The covariance terms of C are of the form G O V (r^^ r,^), and are of four
types: (I) between domestic assets {k = j = 1, and m ^ h); (II) between assets
in the same foreign country {k = j ^ 1, and m r^h); (III) between foreign
assets in different countries {k ^j ^ 1); and (IV) between domestic and foreign
assets {k = 1 ^ j). Expanding the covariance between domestic and foreign
assets from equation (2), which measures the extent to which international diversification is beneficial, gives


where k = 1 5^ 7- How exchange-rate changes affect the covariance of nominal



rates of return alone, depends upon GOV(i,[,n, ,) the co-movement of

nominal domestic rates of return with exchange rates. This is the argument
given by Grubel and Fadner and explained in the previous section. Expanding the other types of covariances reveals that exchange-rate changes affect other
diversification benefits through the covariance of exchange-rate changes with
each other as well as with rates of return. Because there are no strong
theoretical arguments about the co-movement of rates of return and exchange
rates with each other, the effect of exchange-rate changes on diversification
is an empirical question.


Our data are indices of monthly share prices for 49 US industries and 67 foreign
industries for the period January 1976 to January 1979. Nominal rates of return
were calculated as simple monthly rates. Letting 4^, be the value of the share
price index for industry m in country k at the time t, the nominal rate of return
was calculated as
'kml = {hml-\lhmt)-'^


The rates of return, measured in dollars, were calculated by adjusting the index
levels by the exchange rate and then calculating simple monthly rates of return
of the adjusted index. Define Ei^t as the dollar price of foreign currency; of
course, for the US Ei^, = 1.

I',^, = 4^, *


becomes the index of industries prices measured in dollars and

rkmi = {IU-x'Hm)-'^


becomes the simple monthly return measured in dollars.*

In order to determine the effect of exchange-rate changes experienced during the period of fioating rates on diversification benefits the co-movement of
rates of return, as measured by the correlation coefficient, was estimated both
in dollar terms (from (8)), and then in local currency units (from (6)) according to our country-factual scenario.
Rates of Return Measured in Home Currency Units

Table 1 gives the average correlation coefficient between all industries in the
country listed vertically and the country listed horizontally with returns
measured in home currency units.' The diagonal gives the average correlation coefficients for returns within countries and so is a measure of diversification within each country. From a US portfolio holder's point of view the US/US
entry in the table is a type I correlation coefficient. The other diagonal entries



Table 1
Average Gorrelation Goefficients of Rates of Return Within and Across
Gountries Measured in Local Gurrency Units























The numbers in parentheses are the number of correlation coefficients in the average.

are type II correlation coefficients, correlations among industries within each

country. The top row (other than the US/US entry) is made up of type IV
correlation coefficients, giving correlations between the US and each foreign
country, and the remaining entries are type III correlations. By inspection,
it is apparent that internal correlation coefficients (type I and II) are larger
than cross-country correlations (types III and IV). This suggests by the usual
method of analysis that international diversification benefits would have existed
under our country-factual scenario for investors in all five countries. Namely,
if an investor in any of the countries indicated reduced the relative importance
of domestic assets by adding assets of other countries, overall portfolio risk would
decline.'" Table 1 also provides some information on other types of diversification benefits. Taking a US perspective, the fact that type II (foreign internal)
correlation coefficients are less than one indicates that it would have been wise
for a US investor to diversify within each foreign country. Type III correlation coefficients (between foreign assets in different countries) are also less than
one suggesting diversification into more than one foreign country would have
been beneficial." Also if we take average correlation coefficients (type I for
the US and type II for the others) as a measure of the internal integration of
different asset markets then our results indicate that, except for the UK, a very
similar degree of integration exists in all countries.'^
Table 2 lends statistical force to our casual observations concerning international diversification benefits. The table contains t-statistics for the difference
between the average US internal correlation coefficient and the average



Table 2

^-Statistics for Difference Between the Average Type I Gorrelation Goefficient

and Type IV Gorrelation Goefficients with Returns Measured in Home
Gurrency Units








Numbers in parentheses are degrees of freedom.

All differences are significant at the 99 per cent level.

US/foreign correlation coefficients. In all cases the average US/foreign correlation coefficient is less than the average US domestic correlation coefficient
indicating the presence of international diversification benefits.
We should be clear on our methodology. The results just presented did not
make any adjustment for the actual exchange rate changes that took place over
the time period. This should not be taken to imply that we believe that US
investors do not consider exchange rate changes when they consider the benefits
and costs of purchasing a foreign asset. Rather, to find the effect that exchange
rate changes have had on diversification benefits we have constructed a counterfactual scenario in which the central bank of each nation is presumed to have
pursued sterilized intervention thereby holding their exchange rates constant.
With sterilized intervention the monetary base is unaffected so asset returns
would be the same as was produced without intervention. In such a situation
there is no need to convert rates of return out of domestic currency values.
Thus the results present a benchmark to which we compare the actual correlation coefficients observed during our sample period. In the next section the
results of tests are reported when rates of return have been adjusted for exchange
rates, and a comparison is then possible. Furthermore, much of the literature
on this subject rests on calculations similar to those presented above. A comparison of the present results with those found in the studies noted in the first
section will reveal that other studies also found that diversification benefits do
exist for the international investor, when rates of return are measured in local
currency units.
Rates of Return Measured in Dollars
Tables 3 and 4 contain the same information as Tables 1 and 2 respectively,
except that rates of return are measured in dollars as defined by equation (8).
When measured in dollars there are still benefits to international diversification. All of the average correlation coefficients between US assets and foreign
assets are lower than the average correlation coefficient among US assets only.



Table 3
Average Correlation Coefficients of Rates of Return Within and Across
Countries Measured in Dollars
























The numbers in parentheses are sample sizes.

Table 4
^-Statistics for the Difference Between the Average Type I Correlation
Coefficient and Type IV Correlation Coefficients with Returns Measured
in Dollars








The numbers in parentheses are degrees of freedom.

All differences are significant at the 99 per cent level.

The ^ratios reported in Table 4 further indicate that each of these differences
is indeed statistically significant. A US investor who holds an internationally
diversified portfolio, subject to exchange risk, will still have lower risk than
if the portfolio contained only US assets. As would be expected, type II and
type III correlation coefficients are less than one as in the previous sub-section.
An internationally diversified portfolio should contain more than one asset in
each foreign country and more than one foreign country's assets. Thus the
four types of correlations labelled type IIV can alternatively be viewed as
four sources of diversification benefits. However, it is the correlation between
US and foreign assets that determine if international diversification ultimately



Table 5 addresses the central question of this paper. It presents ^-statistics

for the difference in the average type II, III, and IV correlation coefficients
that result from including exchange-rate changes in the analysis. Each <-ratio
was constructed for the average correlation coefficient without exchange-rate
changes minus the average correlation coefficient with exchange-rate changes.
Of those differences that are significandy different from zero, and most of them
are, all are negative except for the US/SP and CAN/SP comparisons, which
have small weights in our world portfolio anyway. These results imply that
in general, correlation coefficients have increased as a result of including
exchange-rate changes in the rate of return on foreign assets. We can conclude,
therefore, that the effect of exchange-rate changes has been to reduce the benefits
from international diversification, but they have certainly not eliminated them.
As is the case with all analysis that rests on a comparison of observed data
with a hypothetical counter-factual alternative, the strength of these conclusions depends on the meaningfulness of that counter-factual. Our counterfactual scenario, sterilized intervention, implies that we are comparing the
current float to the alternative of absolutely fixed exchange rates. One may
well ask how well our conclusions stand-up in a world with some, though
limited, flexibility of exchange rates. We address that question below.
Our counter-factual is created by measuring the covariances (or correlation
coefficients) between rates of return on domestic and foreign assets in each country's own currency. Operationally this is most easily seen in equation (5) and
the second and third equations of note 7 in which the covariance and variance
Table 5
^-Statistics for Changes in the Average Correlation Coefficients
as a Result of Including Exchange Rate Changes (Without With)












The numbers in parentheses are degrees of freedom.
A * indicates significance at the 99 per cent level.





terms that include the exchange rate are forced to become zero. The results
reported in Table 5 are essentially generated by subtracting from those equations noted above (with exchange rate terms held to zero) the same equation
this time with the observed variation in exchange rates. The results of those
subtractions are almost invariably negative. We could describe a limited amount
of exchange rate flexibility by setting free those terms forced to zero. Since
those terms are positive, for the time period studied, the exercise must reduce
the negative values from our subtractions that are reported in Table 5. Hence
we might conclude that by permitting limited fiexibility in the exchange rate
we find that fioating exchange rates reduce diversification benefits a bit less
than when the alternative is absolutely fixed rates, but never that it increases
diversification benefits.
There is, however, a problem with the above approach. Implicitly we have
assumed that permitting the exchange rate to vary would have no effect on
rates of return. From a larger, general equilibrium, perspective, we would
expect rates of return as well as other economic variables to follow a different
path when exchange rates vary than when they are held constant through
sterilized intervention. Thus we should recognize that when sterilized intervention is not practiced and exchange rates do vary to some limited extent, the
movement in rates of return will also be affected. Hence the conclusions of
the preceeding paragraph (which do not account for any difference in the paths
of rates of return) cannot bear too much weight. If we try to pin down more
closely the diversification benefits when exchange rates vary a limited amount
we encounter the insurmountable problem of having to postulate, and test,
any number of different potential scenarios. The different scenarios being
motivated in large part by the actions of the Central Bank, the Treasury, and
the expectations of investors. Since the actions of each of these agents is nearly
impossible to predict we are unable to argue convincingly that one scenario
is necessarily a more likely outcome than another. Thus we feel it is best to
use as our basis for comparison the unambiguous and limiting case of absolutely
fixed exchange rates.


Our ex-post test using industry data from five countries reinforces the conclusion of many other researchers that benefits from international diversification
do exist. Theoretically, industry returns may be positively or negatively correlated with exchange-rate changes so that diversification benefits may increase
or decrease as a result of including exchange-rate changes. Our results indicate
that under floating exchange rates international diversification still pays, but
not as much as would have been the case had exchange rates been pegged.'^
This result is further reinforced by a comparison of Crubel and Fadner's correlation coefficients (from the fixed period) and ours from the fioating period.



While the two data sets are drawn from two very different time periods, cover
different industries, and include different countries, on average our correlations are slightly higher than those found in their study.

Data Sources
The sources of the industry data are:

US: Standard and Poor's Statistical Service, Security Price Index Record 1980.
UK: F.T.-Actuaries Share Indices, Financial Times, last day of each month for fmancial
transactions, Jan. 2, 1975-Jan. 31, 1979.
CAN: Industry Price Indexes, Statistics Canada, Minister oflndustry. Trade and Commerce, March 1979.
SP: Moody's International Manual, Moody's Investor Service, Inc., New York, 1982,
Madrid Stock Exchange, p a 51.
AUS: Moody's International Manual, Moody's Investor Service, Inc., New York, 1982,
Australia, p a 46.

All exchange rate data were taken from 'Supplement on Exchange Rates'. International Financial
Statistics, Supplement Series No. 1, International Monetary Fund, 1981.

1 At the time of writingjapan and the United States have announced the relaxation of Japanese
capital restrictions in the interest of promoting efficient world capital markets.
2 Lessard (1975) reports less diversification benefits for the US since the US is such a large part
of the world market.
3 It is, of course possible to critique almost any counter-factual scenario. In this case one could
argue that nations may not have had sufficient reserves to undertake the sterilized intervention
we assume.
4 The sample consists of 5 industries in Spain and Australia, 25 industries in Canada, 32 industries
in the UK, and 49 industries in the US.
5 In poorly integrated markets where risk may not be appropriately priced, there may be assets
with returns higher than can be explained by risk. Ehrlich (1981) suggests that this is the view
of many pension fund executives.
6 An exact definition of the rate of return could also include the rate of inflation.
7 Type I, II, and III covariances are respectively:
iji,), i = > = I and
, iji,)^COV(ij^, ,)
for k = j ^ I and m ^ h;
for i = j = 1.
8 There is a bias in both ij^, and r/^, due to the omission of dividends which was not available
from our sources. However, the use of simple arithmetic rates of return reduces that bias by
overstating rates of return.
9 Our approach is to examine potential diversification benefits on the basis of correlation coefficients of rates of return among all industries (foreign and domestic) in our sample. Thus, the
type of model we employ is what Eun and Resnick (1984) term the 'Full Historical Model'.
Their study showed this model to be one of the most accurate approaches to forecasting correlation coefficients. Indeed, it is their benchmark for comparing alternative approaches.
10 It is possible to analyze diversification benefits from any country's point of view because the



data is in each country's own units. When exchange rate adjustments are made in the second
part of this section, so that all returns are measured in dollars, all analysis will have to be from
the US perspective.
11 If type II and type III correlation coefficients were both equal to one then international diversification could be accomplished by holding any one foreign asset, all others would be perfect
substitutes and so redundant in the portfolio.
12 By taking unweighted averages we are assuming that the relevant portfolio is one made up
of equal amounts of equities. Adler and Dumas (1979) point out that any market segmentation
(e.g. deviations from purchasing power parity) obscures the concept of an equilibrium or market
portfolio because such a portfolio will differ by nationality. Consequendy, it should be
emphasized that our measure of diversification benefits only applies to the equal weight portfolio we have constructed. For very large portfolios, weights approach equality so our analysis
can be construed to be applicable to very large portfolios.
13 We are referring only to that part of risk of a portfolio due to the co-movement of returns.
The question of the effect of exchange rate changes on the variance of returns has not been
addressed in this paper.

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