Lec 11 - Chapter 16

Chapter 16
International
Portfolio
Theory
Outline
• International diversification and risks

• Internationalizing domestic portfolios
• National Markets and Asset Performance
• Market Performance Adjusted for Risk: The
Sharpe and Treynor Performance Measures
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1-2 © 2013 Pearson Education
I. International Diversification
and Risk
• The case for international diversification of portfolios
can be decomposed into two components:
1. The potential risk reduction benefits of holding
international securities.
2. The potential added foreign exchange risk
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Exhibit 16.1 Portfolio Risk
Reduction Through Diversification
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and Risk
1. Portfolio risk reduction:
• Total risk of a portfolio = systematic risk (the market) +
unsystematic risk (the individual securities).
• As an investor increases the number of securities in a
portfolio, the portfolio’s risk declines rapidly at first, then
asymptotically approaches the level of systematic risk of the
market.
• Increasing the number of securities in the portfolio reduces
the unsystematic risk component leaving the systematic risk
component unchanged.
• A domestic portfolio that is fully diversified would have a beta
of 1.0.
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Exhibit 16.2 Portfolio Risk Reduction
Through International Diversification
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and Risk
2. Foreign exchange risk:
• The foreign exchange risks of a portfolio are reduced
through international diversification whether it be a
securities portfolio or the general portfolio of activities of the
MNE.
• Purchasing assets in foreign markets, in foreign currencies
may alter the correlations associated with securities in
different countries (and currencies).
• The risk associated with international diversification, when it
includes currency risk, is very complicated when compared to
domestic investments.
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and Risk
• The investor has acquired two additional assets—the

currency of denomination and the asset subsequently
purchased with the currency—one asset in principle, but
two in expected returns and risks
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and Risk
• Example. U.S.-based investor takes US$ 1 million on January
1 and invests in shares traded on the Tokyo Stock Exchange
(TSE). The spot exchange rate on January 1 is ¥130.00/$. The
$1 million therefore yields ¥130,000,000. The investor uses
¥130,000,000 to acquire shares on the Tokyo Stock Exchange
at ¥20,000 per share, acquiring 6,500 shares, and holds the
shares for one year. At the end of one year, the investor sells
the 6,500 shares at the market price, which is now ¥25,000
per share. The new spot rate is now ¥125.00/$. Calculate the
Yen investment return.
R$ = [(1 + r¥/$)(1 + rshares,¥)] - 1
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and Risk
In conclusion:
• International diversification benefits induce investors to
demand foreign securities (the so-called buy-side).
• If the addition of a foreign security to the portfolio of the
investor aids in the reduction of risk for a given level of
return, or if it increases the expected return for a given
level of risk, then the security adds value to the portfolio.
• A security that adds value will be demanded by investors,
bidding up the price of that security, resulting in a lower
cost of capital for the issuing firm.
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II. Internationalizing the
Domestic Portfolio
• Internationally diversified portfolios are the same in
principle because the investor is attempting to
combine assets that are less than perfectly
correlated, reducing the total risk of the portfolio.
• Classic portfolio theory assumes a typical investor
is risk-averse.
• The typical investor is therefore in search of a
portfolio that maximizes expected portfolio
return per unit of expected portfolio risk.
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Exhibit 16.3 Optimal Domestic
Portfolio Construction
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Internationalizing the Domestic
Portfolio
• The near-infinite set of portfolio combinations of
domestic securities form the domestic portfolio
opportunity set (Exhibit 16.3).
• The set of portfolios along the extreme left edge of
the set is termed the efficient frontier.
• This efficient frontier represents the optimal
portfolios of securities that possess the minimum
expected risk for each level of expected
portfolio return.
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Portfolio
• The portfolio with the minimum risk along all those
possible is the minimum risk domestic portfolio (MRDP).
• The individual investor will search out the optimal
domestic portfolio (DP), which combines the risk-free
asset and a portfolio of domestic securities found on the
efficient frontier.
• He or she begins with the risk-free asset (Rf) and
moves out along the security market line until reaching
portfolio DP.
• This portfolio is defined as the optimal domestic
portfolio because it moves out into risky space at the
steepest slope. (See Exhibit 16.3)
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Exhibit 16.4 The Internationally
Diversified Portfolio Opportunity Set
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Portfolio
• The internationally diversified portfolio opportunity
set shifts leftward of the purely domestic
opportunity set.
• The internationally diversified portfolio opportunity
set is of lower expected risk than comparable
domestic portfolios. This is due to additional
securities and/or portfolios, which are of less than
perfect correlation with the securities/portfolios
within the domestic opportunity set.
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Exhibit 16.5 The Gains from International
Portfolio Diversification
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Portfolio
• Optimal international portfolio (IP) combines the

same risk-free asset as before with a portfolio from
the efficient frontier of the internationally
diversified portfolio opportunity set.
• By allowing investors to hold foreign assets, we
substantially enlarge the feasible set of
investments → higher return can be obtained at a
given level of risk, or lower risk can be attained at
the same level of return compared to the domestic
portfolio alone.
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Calculation of portfolio risk &
return: 2-asset model
Construct a portfolio with 2 risky assets with w1, w2 -
the respective weights for the two assets (w1 + w2 = 1);
E(R1), E(R2) are the respective expected returns.
• Portfolio expected return:
E(Rp) = w1E(R1) + w2E(R2)
• Portfolio risk:
Var(Rp) = w21Var(R1) + w22Var(R2) + 2w1w2Cov(R1, R2)
σ2p = w21σ21 + w22σ22 + 2ρ(R1, R2) w1w2σ1σ2
(with ρ(R1, R2): the correlation of R1 and R2).
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return: 2-asset model
Trident’s CFO Maria Gonzalez is considering investing

Trident’s marketable securities in two different risky assets,
an index of the U.S. equity markets and an index of the
German equity markets. Assuming that Maria initially
wishes to invest 40% of her funds in the United States and
60% of her funds in German Equities, calculate expected
return and risk of the portfolio: E(Rp) = ?; σp = ?
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Exhibit 16.6 Alternative Portfolio Profiles
Under Varying Asset Weights
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return: Multiple-asset model
• Portfolio expected return:
• Portfolio risk:
(N: total number of assets included in the portfolio)
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National Markets
and Asset Performance
• For the 100-year period ending in 2000, the risk of investing
in equity assets has been rewarded with substantial returns.
• The true benefits of global diversification, however, arise
from the fact that the returns of different stock markets
around the world are not perfectly positively
correlated.
• This is because there are different industrial structures in
different countries, and because different economies do not
exactly follow the same business cycle.
• Exhibit 16.7 describes U.S. equity market correlations with
select global equity markets in recent years.
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Exhibit 16.7 Major Equity Market
Correlations with the United States Equity
Market
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III. National Markets and Asset
Performance
• Exhibit 16.8 presents a comparison of
correlation coefficients between major
global equity markets over a variety of
different periods.
– Correlation levels between the U.S. and most
countries is well below 1.0 on average for the
20th century. The U.S. and Canada correlation,
however, is much higher than the average.
– Correlations differ across sub-periods, but seem
to be rising over time.
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Equation 16.8 Equity Market
Correlations Over Time
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IV. Market Performance Adjusted for
Risk: The Sharpe and Treynor
Performance Measures
• Investors should examine returns by the amount of return

per unit of risk accepted, rather than in isolation (as in
simply mean risks and returns)
• To consider both risk and return in evaluating portfolio
performance, we introduce two measures:
The Sharpe Measure (SHP) Ri : the average return for portfolio i
Rf :is the average risk-free rate return
𝑅𝑖 − 𝑅𝑓 σi: is the total risk of portfolio i.
SHPi =
σi Βi: the systematic risk of the portfolio
against world market portfolio
The Treynor Measure (TRN)
𝑅𝑖 − 𝑅𝑓
TRNi =
βi
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IV. Market Performance Adjusted for Risk:
The Sharpe and Treynor Performance
Measures
• The Sharpe measure indicates on average how much excess
return (above risk-free rate) an investor is rewarded per unit
of portfolio risk the investor bears.
• The Treynor measure is very similar, but using the portfolio’s
beta, the systematic risk of the portfolio as the measure of
risk,
• Exhibit 16.9 now looks at return AND risk data across
countries over time.
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Exhibit 16.9 Summary Statistics of the Monthly Returns for
18 Major Stock Markets, 1977-1996 (all returns converted into
U.S. dollars and include all dividends paid)
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Measures
• Though the equations of the Sharpe and Treynor measures
look similar, the difference between them is important.
• If a portfolio is perfectly diversified (without any unsystematic
risk), the two measures give similar rankings, because the
total portfolio risk is equivalent to the systematic risk.
• If a portfolio is poorly diversified, it is possible for it to show a
high ranking on the basis of the Treynor measure, but a lower
ranking on the basis of the Sharpe measure.
• As the difference is attributable to the low level of portfolio
diversification, the two measures therefore provide
complimentary but different information.
• Exhibit 16.9 now looks at return AND risk data across
countries over time.
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Measures
Example: Calculate the Sharpe ratio and Treynor ratio for Hong
Kong market portfolio. Given the monthly mean return for Hong
Kong in Exhibit 16.9 was 1.5%, σi= 9.61%, βi = 1.09. Assuming
the average risk-free rate was 5% per year during this period.
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Exhibit 16.10 Comparison of Selected Correlation
Coefficients Between Stock Markets for Two
Different Time Periods (dollar returns)
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Are Markets Increasingly
Integrated?
• Are Markets Increasingly Integrated? – Most

likely yes
• Correlations still well-below 1.0 so benefits
to diversification are still very real
• Exhibit 16.10 illustrates these points with
selected data
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Lec 11 - Chapter 16

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Chapter 16

• International diversification and risks

• The investor has acquired two additional assets—the

R$ = [(1 + r¥/$)(1 + rshares,¥)] - 1

• Optimal international portfolio (IP) combines the

Trident’s CFO Maria Gonzalez is considering investing

(N: total number of assets included in the portfolio)

• Investors should examine returns by the amount of return

• Are Markets Increasingly Integrated? – Most

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