International Portfolio Investment

Chapter 15
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 Chapter Outline
• International Correlation Structure and Risk
Diversification
• Optimal International Portfolio Selection
• Effects of Changes in the Exchange Rate
• International Bond Investment
• International Diversification at Home
• Why Home Bias in Portfolio Holdings?

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EXHIBIT 15.1
U.S. Investment in Foreign Equities

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 International Correlation Structure
and Risk Diversification
• Investors can reduce portfolio risk by holding
securities that are less than perfectly correlated
• International diversification has a special
dimension regarding portfolio risk diversification
• Security returns are substantially less correlated
across countries than within a country
– This is true because economic, political, institutional,
and even psychological factors affecting security
returns tend to vary a great deal across countries
– Business cycles are often high asynchronous across
countries Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 15-4
Correlation Coefficient
 Example
• Calculate the correlation coefficient
between the following two stocks and
explain what does it mean:

Stock S.D. Covariance

A 0.50 0.25
B 0.75 0.25
EXHIBIT 15.2
Correlations among International Stock Returns

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 International Correlation Structure
and Risk Diversification (Continued)
• Solnik (1974) study shows that as a portfolio holds
more and more stocks, the risk of the portfolio
steadily declines, and eventually converges to the
systematic (or non-diversifiable) risk
– Systematic risk refers to the risk that remains even after
investors fully diversify their portfolio holdings
– Results of this study (shown on graphs in the next slide)
provide striking evidence supporting international, as
opposed to purely domestic, diversification

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EXHIBIT 15.3
Risk Reduction: Domestic versus International
Diversification

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Optimal International Portfolio Selection
• Rational investors would select portfolios by
considering returns as well as risk
– World beta measures the sensitivity of a national market
to world market movements, with a higher number
indicating greater sensitivity to world market movements
• Sharpe performance measure (SHP) provides a
risk-adjusted performance measure
– 𝑅ത i and σi are respectively, the mean and standard
deviation of returns, while Rf is the risk-free interest rate

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Optimal International Portfolio Selection
(Continued)
• The optimal international portfolio (OIP) has the
highest possible Sharpe ratio
– The OIP can be solved by maximizing the Sharpe ratio with
respect to the portfolio weights
– SHP = [E(Rp) − Rf]/σp
• After obtaining OIPs, we can measure gains from
holding these portfolios over purely domestic ones in
two ways:
1. Increase in the Sharpe performance measure
2. Increase in the portfolio return at the domestic-equivalent
risk level Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 15-11
 Example
• Calculate the Sharpe ratio of the following
two portfolios and explain briefly which will
be a better investment:

Portfolio Average Return Risk-free Return S.D

A 10% 2% 0.50
B 12% 3% 0.75
EXHIBIT 15.7 - Selection of the Optimal
International Portfolio for U.S. Investors

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Effects of Changes in the Exchange Rate
• The realized dollar return for a U.S. resident
investing in a foreign market will depend not only on
the return in the foreign market but also on the
change in the exchange rate between the U.S. dollar
and the foreign currency
– Rate of return in dollar terms from investing in the ith
foreign market, Ri $, is given by:

where Ri is the local currency rate of return from the ith

foreign market and ei is the rate of change in the exchange
rate between the local currency and the dollar
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 Example
• Calculate the rate of return in dollar terms
from investing in the following UK
investment:

Investment Rate of Return in the UK GBP/US$

A 10% 1.23
 International Bond Investment
• World bond market is comparable in terms of
capitalization value to the world stock market, but
it has not received as much attention in
international investment literature
– Existing studies show that when investors control
exchange risk by using currency forward contracts,
they can substantially enhance the efficiency of
international bond portfolios
– The advent of the euro altered the risk-return
characteristics of the euro-zone bond markets,
enhancing the importance of non-euro currency bonds

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EXHIBIT 15.10 - Summary Statistics of the
Monthly Returns to Bonds and the Composition
of the Optimal International Bond Portfolio

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International Diversification: Mutual Funds
• Purchasing foreign stocks directly from foreign
exchanges can entail significant transaction costs
• Other modes of international diversification are less
cumbersome:
– U.S.-based international mutual funds invest in securities
from countries other than the U.S.
– Advantages of international mutual funds:
• Investors can save any extra transaction and/or information
costs they may have to incur when they attempt to invest
directly in foreign markets
• Circumvent many legal/institutional barriers to direct
portfolio investments in foreign markets
• Benefit from the expertise of professional fund managers
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International Diversification: Country Funds
• A country fund invests exclusively in stocks of a
single country
• Popular means of international investment in the
U.S., as well as in other developed countries
• Using country funds, investors can
1. Speculate in a single foreign market with minimum
costs
2. Construct their own personal international portfolios
using country funds as building blocks
3. Diversify into emerging markets that are otherwise
practically inaccessible
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 International Diversification: ETFs
• In the last several years, there has been a broad
shift from actively managed mutual funds to
passive investment vehicles
• An exchange-traded fund (ETF) is an investment
vehicle that seeks to track the performance of a
specific index, typically an equity index
– ETFs are highly liquid, and it is easy to buy and sell them
– Most ETFs are passive, though some active ETFs exist
– A family of ETFs called iShares (managed by BlackRock)
has the broadest range of country ETFs with 65 funds
across 42 countries
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 International Diversification: ADRs
• American depository receipts (ADRs) represent
receipts for foreign shares held in the U.S.
(depository) banks’ foreign branches or
custodians
– ADRs are traded on U.S. exchanges like domestic
American securities
– Because the majority of ADRs are from such
developed countries as Australia, Japan, and the U.K.,
U.S. investors have a limited opportunity to diversify
into emerging markets using ADRs
• However, in a few emerging markets like Mexico,
investors can choose from several ADRs.
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International Diversification: Hedge Funds
• Hedge funds that represent privately pooled
investment funds have experienced a tremendous
growth in recent years
– May invest in a wide spectrum of securities, such as
currencies, domestic and foreign bonds and stocks,
commodities, real estate, etc.
– Many aim to realize positive returns, regardless of
market conditions
– Legally, hedge funds are private investment
partnerships
– Tend to have relatively low correlations with various
stock market benchmarks and thus allow investors to
diversify their portfolio risk
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 Home Bias in Portfolio Holdings
• In portfolio holdings, the tendency of an investor to
hold a larger portion of the home country securities
than is optimum for diversification of risk is home bias
– Though investors could benefit a great deal from
international diversification, the actual portfolios that
investors hold are quite different from those predicted
by the theory of international portfolio investment
• U.S. mutual funds, for instance, invested about 87% of their
funds in domestic equities on average during 1998–2007,
when the U.S. stock market only accounted for about 45% of
the world market capitalization value during the period

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EXHIBIT 15.13 – The Home Bias in Equity
Portfolios: Selected Countries, 1998 - 2007

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Why Home Bias in Portfolio Holdings?
• Observed home bias in portfolio holdings leads to
the following possibilities:
1. Domestic securities may provide investors with
certain extra services, such as hedging against
domestic inflation, that foreign securities do not
2. There may be barriers, formal or informal, to
investing in foreign securities that keep investors
from realizing gains from international
diversification

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