LECTURE SIX.

THE INTERNATIONAL

PORTFOLIO THEORY AND THE CAPITAL ASSET

PRICING MODEL

2.6.0 Introduction

This study describes the rationale for international diversification and the role of market segmentation and
market integration in the realisation of benefits associated with international diversifications. The chapter
further, intends to acquaint the learners with skills on how to measure the returns and risks of internationally
diversified assets, and how to design efficient combination of international assets. The assessment and the
determination of returns of foreign securities, bonds and shares will also be discussed, explored and evaluated.
More importantly, the International Assets Pricing Model (ICAPM) will be assessed in light of the standard
Capital Assets Pricing Model (CAPM) and the factors which make international investments or investments in
foreign countries unique unveiled.

2.6.1 Measure of risks and returns associated with internationally diversified portfolio

International diversification is referred as to holding investments of securities or assets in more than one
country with a view of minimising risks for targeted return level or maximising return for a given level of risk.
This is an attempt to reduce risk by investing assets – locating projects in various nations of the world and
especially those whose economic cycles are not perfectly correlated. The international diversification can be
considered a viable strategy for risk reduction because correlation coefficients across markets (countries) are
reasonably low. As such it naturally accepted that the economic, political, institutional and even psychological
factors affecting securities’ (assets’) returns tend to vary a great deal across countries which in turn results in
relatively low correlations among international assets. More importantly the broader the diversification the
more stable the returns and the more diffuse the risks are expected to be.

The efficiency and effectiveness of international diversification as risk reduction strategy is influenced and
depends on the three main factors. These factors are

(i) intercountry correlations – whereby a reasonably low correlationacross markets is expected to be

better off in realising benefits of international diversification
(ii) The variance (risk) of returns for each country’s assets (securities), and
(iii) The expected return in each individual country. Highly asynchronous countries could contribute to
low international correlations and hence benefits of international diversification. It follows that,
closely related countries in terms of economic, legal and political settings cannot bring about
benefits from assets diversified in those countries. This is because the factors would influence the
returns of such assets in the similar way – due to positive relationships coefficients.

Expected return and risk of internationally diversified portfolio

International portfolio is comprised of assets allocated in different countries. The returns and risks from
internationally diversified assets are generally measured in similar manner as those of domestic portfolio
except that the consideration is on the securities invested in different nations. To arrive at an expected return
of international portfolio one should consider the risks and returns in each market and the weights of
investment in each of those markets. In a simplified manner, consider a world portfolio consisting two assets a
fraction of which –Wd is invested in domestic country’s stocks and the remaining fraction - Wf) invested in
foreign stocks. Further, E(Rd) and E (Rf) is defined as returns on the domestic country and foreign country’s
stock respectively.
The expected return of international portfolio E (RPE (RP) = WdE (Rd) + WfE (Rf) ) can be calculated as:

Example

Kilimanjaro Inc. Limited is a multinational company that has investments in five different developing countries.
One of the objectives of the Company is to reduce risk through international diversifications. The Company
however believes that the return on any investment from investment in five countries is not correlated with
the return on any other investment. The details of investment such as the estimated risk and return and the
value in of each of the five investments are shown below.

Estimation of the portfolio risk (σp)

Given the weights of investment in each of the five countries, and the fact that the correlation coefficient of the
portfolio equals to 0 (The returns from the five countries is not correlated). The risk of international portfolio
can be estimated as follows:

Significance of the results: With a portfolio of only five investments the benefit or diversification have reduced
portfolio risk, measured by the standard deviation of expected returns, to approximately that of the lowest risk
individual investment. This portfolio risk reduction is quite large because of the lack of correlation between the
investments. The further away the correlation coefficient is from +1, the greater the risk reduction through
diversification.

Measure of return associated with investing in securities issued in different markets and denominated in
various

The foreign investment is affected by the return on asset within its own market and the changes in exchange
rate between the currency of the asset (security) and that of the buyer. So therefore, the return from foreign
investment will be comprised of return from the security’s home market and return (gain) from the changes in
exchange rate. For simplicity purposes, in measuring the return associated with investing in securities issued in
different markets and denominated in a variety of currencies we assume that the US $ is our domestic currency
(any currency could, of course serve the purpose). It follows that the total dollar returns on an investment can
be decomposed into three elements; Dividend/Interest Income; Capital Gains (Losses) and Currency Gains
(Losses).

(i) Measuring total returns from foreign bond investment

The return on investment in foreign corporate bonds is made up of the interest income (coupon income),
capital gain or loss and gain or loss of the currency denominating the bond. The domestic (home) currency
return on foreign bonds investment can be determined by the following formula.

Domestic currency return = foreign currency return x Currency gain or loss on a foreign bond.

This also can be presented as follow:

Example

Suppose you are given the following data regarding one - period foreign bond investment. The initial bond price
of the bond is 95, and the coupon income is 8. It is also certain that the end- of period bond price will be 97,
and the foreign currency appreciates by 3% against the dollar during the period.

Required:

Calculate the one- period dollar return of the foreign bond investment.

Solution

The domestic currency ($) return = foreign currency return x currency gain or loss on a foreign bond.

ii) Measuring total returns from foreign stock investment

The domestic currency return on investment on foreign corporate securities is made up of dividend income,
capital gain or loss and currency gain or loss. This is given by the following formula
Given the initial price of foreign currency stock X is $50, the dividend income is 1, the end of period stock price
is $48, and the foreign currency depreciates by 5% against the dollar during the period.

Required:

Calculate the total dollar return for stock X.

Solution:

The total domestic currency (dollar) return is -6.9%. This implies that the investor suffered both a capital loss on
the foreign currency principal and a currency loss on the investment’s dollar value.

2.6.2 International capital assets pricing Model (ICAPM) in evaluating internationally allocated investments

International capital pricing model (ICAPM) is an extension and is built on traditional and standard capital
assets pricing model (CAPM) developed by Sharpe (1978). The CAPM model was regarded an important tool for
evaluating domestic efficient portfolio management only. Consequent to globalisation, shrinkage of economic
and investment spaces, improved communication and transportation, the expansion of investment activities
internationally, and holding of assets (securities and shares) in different markets and denominated in different
currencies became possible. Through international diversification the multinational firms and companies could
hold assets in different jurisdictions and in assorted currencies. This called for development of the International
Capita Assets Pricing Model (ICAPM). This model is used for evaluating the performance of various elements of
investment portfolio denominated in different currencies across selected countries of the world. The ICAPM is
as a result applied to measure returns and risks of the internationally diversified assets and based on different
currencies. The model is relevant and applied in evaluating the performance of international stocks and shares,
which could not be possible under the standard CAPM.

The two models share two main assumptions. The shared assumptions include but not limited to (i) investors
have homogeneous preference, and (ii) They have access to similar assets and opportunities. In addition to
assuming that the investors have similar preference and opportunities, the ICAPM contrary to the standard
CAPM assume that the investors will not have similar expectations because they would pay different prices
around the world depending on the country where the investment is located. This is because the ICAPM
considers state of economy where the purchasing power parity (PPP) theory does not hold, such that the prices
of assets will be different across the nations. It should be recalled that the purchasing power parity works on
assumption that the prices of goods and services are similar across the world under law of one price.

It shown elsewhere in this section that International Capital Assets Pricing Model (ICAPM) is applicable and
suitable in assessing, evaluating the returns and risks of internationally allocated investment portfolios and
which are denominated in different currencies. The model considers unique factors and characteristics which
are presumably influential on investments and returns of globally allocated assets and denominated in different
currencies as well. This is because the extension and expansion of investment to foreign markets exposes
multinational Corporations (MNCs) and international firms to risks peculiar to global business environment.
These risks are inflation rate differentials between countries, exchange rate risk due to multiplicity use of
foreign currencies, and political risks. Both of the risks could affect the price of international assets and its
forward premium. The ICAPM considers these risks when determining the cost of capital in international
context.

The main difference between the standard CAPM and ICAPM lies on these variables which are unique for
investments allocated in foreign markets.

2.6.3 Market integration and segmentation concepts and barriers to international diversification

Multinational corporations do not operate in a free business world. Investments across countries are subject to
various restrictions and impediments which could be legal, policy or social. These barriers and restrictions can
substantially influence the international diversification decisions and negatively affect the benefits of
international portfolio. The barriers could be in terms of legal, informational and economic restrictions; specific
taxes regulations, exchange control and lack of liquidity.

i. Barriers to international diversifications

The benefits of international diversification are considered to be real especially where capital markets are
segmented. It follows that the investment of assets and securities across countries will enable investor to
reduce risks with a given level of return. However, the benefits of international diversification are not
automatic and free. The benefits are normally affected (reduced) by the extent by which the host countries
around the world will impose restrictions. This is because investing in foreign countries will always encounter
some barriers. The barriers which reduce the benefits of global portfolios are as follows:
  Legal
 economic and policy restrictions to investing overseas
 lack of liquidity
 currency controls and remittance restrictions
 specific tax regulations
 political and exchange risk
 Lack of adequate and readily accessible and comparable information on potential foreign security
acquisitions.

The barriers perceivably increase riskiness of assets allocated in foreign markets and give the investors
justifications for investing their money locally (domestic market).

ii. Capital market segmentation and integration and benefits of international diversifications

It is generally accepted that the ability of investors’ risk reduction through international diversification is partly
a function of the degree of the independence of a country’s capital market from the rest of the world. This is
because the objective of risk reduction through global diversification can reasonably be achieved if the returns
and risks in different countries do no move together, that is, they should move in opposite direction. This is
only possible when each country’s capital market is independent from each other, in terms of national
economic and monetary policies which influence nations’ macro-economic conditions, such as interest rates,
inflation rates, and currency control decisions. This condition depends on whether the global market is
integrated, market integration or the market is segmented, market segmentation.

iii. Capital market integration

This concept denotes homogeneity of capital market around the world. It implies that the capital markets
around the world are interrelated and dependent to each other such that the factors influencing the returns
and risks of assets are similar. The capital market integration has negative effect on ability of risk reduction
through international diversification.

It follows that with highly integrated capital market globally, the risk reduction benefit of internationally
diversified assets is minimized. The assets invested in an integrated financial market have identical risks and
similar expected returns and risk is reduction is less achieved. The correlation coefficients of returns and risks in
this kind of market is high and therefore (defeats) negatively affects the possibility of risk reduction through
global portfolio. The integrated global capital markets imply that respective county’s market share similar
characteristics and therefore locating assets in these different countries do not represent significant potential
for reduction of risk. An integrated market would only offer the opportunity to reduce unsystematic risk

iv. Capital market segmentation

This is in contrast to capital market integration. If capital markets are segmented it implies that the
consumption and investment opportunity sets in domestic country differ from that of foreign countries. In a
segmented capital market, the conditions and factors that influence returns and risks of assets and securities
differ across countries because financial markets do not share similar characteristics. The returns and variation
of returns for assets allocated in different countries are therefore different and do conform to each other. The
returns for an investment in each specific capital market is determined and influenced by that country’s specific
conditions. The capital market segmentation is therefore associated with high potential for risk reduction
through international diversification because the correlation coefficients for internationally diversified assets
are low. If markets are segmented, international diversification may offer the opportunity to reduce both
systematic and unsystematic risk.
Example:

Shalom Inc. is a Tanzanian based company which intends to expand its operations trough international
diversifications in order to reduce both systematic and unsystematic risk.

Required:

Discuss the validity to investors of Shalom Inc’s objective for risk reduction through international diversification.

Solution

In theory a well-diversified investor will not place any extra value on companies that diversify. This is because
an investor can diversify himself, by investing in shares and in securities of different companies operating
across countries. If the diversification is international, the benefits will depend on whether the countries where
the investments take place are part of any integrated market or are largely segmented by government
restrictions taxes and exchange controls. If markets are segmented, international diversification may offer the
opportunity to reduce both systematic and unsystematic risk. An integrated market would only offer the
opportunity to reduce unsystematic risk. However, most markets are neither fully integrated nor segmented,
meaning that international diversification will lead to some reduction in systematic risk, which would be valued
by investors. It is to be hoped that risk reduction is not the only objective of Shalom Inc. Limited - returns and
shareholder utility are important.

2.6.4 END OF THE INTERNATIONAL PORTFOLIO THEORY AND THE CAPITAL ASSET PRICING MODEL
QUESTIONS.

Q1. Discuss the determinants of effectiveness and efficiency of international diversification as a risk reduction
strategy.

Q2.(a) Briefly discuss the factors that determine the riskiness of an international portfolio of assets.

(b) You are a financial consultant working with a Tanzanian based multinational firm. The firm’s Managing
Director has approached you to assist in an urgent investment decision. The firm is planning to invest in the UK,
Kenya and the USA. It has currently no business in these countries. The firm considers establishing an equally
invested two-investment portfolio comprising investments in any two of the three countries. A

Preliminary appraisal of investment in each country was carried out, the results of which are detailed in the
table below.

UK Kenya USA

Expected Return 20% 10% 30%

Standard Deviation 8% 6% 15%

The coefficients of correlation between investments are estimated to be:

UK - Kenya -0.4

UK – USA -0.7

USA - Kenya 0.9

Required:
 (i) Compute the risk and return of the alternative investment portfolios.
(ii) Advise the firm on the appropriate investment portfolio based on portfolio relative risk.

Q3. A Tanzanian based investor, Mr. Samba has just sold his shares held in Tausi Incorporation Limited - a
Kenyan based company that he had purchased six months ago. The investor (Samba) had invested TSHS
10,000,000 to buy the Tausi shares for Kenyan Shillings (KES) 120 per share. The exchange rate six months ago,
at the date of transaction was KES 0.056/TSHS. Samba sold the share for stock for KES 135 per share and
converted the Kenyan Shillings proceeds into Tanzanian shilling at KES 0.05 per TSHS.

Required:

a) Compute the domestic currency (TSHS) total percentage rate of return on Mr. Samba’s investment in
Tausi shares.
b) Show the total profit and clearly state the implication of exchange rate changes on the Samba’ share’s
return.

Q4. Mr. Nyensanza is the Managing Director of Mfanyakweli Plc, a company listed on the local stock exchange.
The company has excess funds amounting to Tshs.35 billion which the Managing Director is pondering investing
between Ugandan and Malawian portfolios. The Managing Director has called a meeting to table the matter to
the members for further discussion. During the discussion one of the members questioned the reliability and
practicability of international diversification which revealed that most of the participants were aware of its
benefits only but not its barriers which in turn might be a limiting factor.

Required:

As a portfolio manager, elaborate to the members the barriers to international diversification

Q5. Nshomire Plc currently operates only in Tanzania but is considering diversifying its activities internationally
into either Uganda or Kenya. Estimates have been obtained of the likely risk and return of investments in these

countries which are expected to vary during different economic states of Tanzania. After either diversification,
an approximately 30% of the market value of the company would be represented by overseas investments.

The standard deviations of expected returns of Uganda, Kenya and Tanzania are 4.86, 12.26 and 4.03
respectively. Also, the covariance of expected returns of Tanzania/Uganda and Tanzania/Kenya are 17.89 and
31.98 respectively.

Members of Nshomire’s board of directors have different views about such diversification. Director A believes
that the company should focus exclusively upon the Tanzania market as it always has, because overseas
investments are too risky. Director B believes that overseas diversification will offer the company the
opportunity to achieve a much better combination of risk and return than purely domestic investments and will
open up new opportunities. Director C considers overseas investments expensive and argues that overseas
diversification will not be valued by shareholders who could easily achieve such diversification themselves.
Director D is also in favour of Kenya but suggests that a much higher proportion of the company’s activities
should be located there, possibly between 50% and 70%.

Required:
 (a) (i) Discuss the views of each of the four directors. Include in your discussion, relevant calculations
regarding portfolio risks and returns.
(ii) Estimate and explain the implications of the correlation coefficients between Tanzania and Uganda
and between Tanzania and Kenya
(b) Nshomire Plc has also purchased CAPM-based risk and return estimates from an investment bank.

Q6. A Tanzanian portfolio manager is contemplating to build up an international portfolio which is 60% invested
in the Dar es Salaam stock exchange (DSE) and 40% invested in either of two foreign markets: Nairobi Stock
Exchange (NSE) and New York Stock Exchange (NYSE). The manager has gathered the following information on
three different stock exchanges.