Lecture 18

FM423
Asset Markets
Lecture 18: International Asset Allocation
0. Overview Page 1
Overview
(1) Returns on Foreign Investment
(2) Foreign Exchange Risk
(3) International CAPM
(4) Benefits of International Diversification
(5) International Investment Choices
(6) The Home Bias
Lecture 18: International Asset Allocation Copyright c Zachariadis

1. Returns on Foreign Investment Page 2
1. Returns on Foreign Investment
Why A Global Perspective?
• A larger range of risk-return choices

– Higher returns on equities can be explained by higher growth rates in some countries
• Diversification with foreign securities can help reduce portfolio risk

– Since foreign investments can be influenced by different factors than domestic investments, risks
can be reduced
• Barriers to global investing, both for companies and for individual investors, are getting smaller

Important Issues
• Emphasis of our analysis

– Risk assessment
– Diversification benefits
• What are the risks involved in investment in foreign securities?
• Are there benefits to diversification in foreign securities?

Returns on Foreign Assets
• To calculate the return on foreign securities, we need to consider the variation in returns related to
changes in the relative value of the domestic and foreign currency
• Total return determined by both the investment return and movement in exchange rates
• It is often not possible to completely hedge a foreign investment against the exchange rate risk

Return of a foreign security in the US is a function of two factors:
(1) Return in the foreign market
(2) Return on the foreign exchange rate (currency return)
Example: U.S. Investor invests $20,000 in the British Market

Initial Investment: $20,000
Initial Exchange: 2USD/1GBP
Initial Investment in GBP: £10,000
Risk-free Rate in U.K.: 10%
Future Value in Pound Sterling: £11,000

GBP depreciates to $1.80

£11,000 * 1.8 = $19,800; return in $ (−200 / 20,000) = -1%
GBP remains at $2.00

£11,000 * 2.0 = $22,000; return in $ (2,000 / 20,000) = 10%
GBP appreciates to $2.20

£11,000 * 2.2 = $24,200; return in $ ( 4,200 / 20,000) = 21%
• Movements in foreign exchange can have a major influence
• Both factors must be considered in international investing

2. Foreign Exchange Risk Page 7
2. Foreign Exchange Risk
f
Let Pt be the price of a foreign asset in the foreign currency.
d d/f
The dollar (domestic) price of a foreign asset is Pt = Ptf St
d
Thus, the dollar return on a foreign asset, rt , is given by

d/f d/f
rtd = d
Ptd /Pt−1 −1= Ptf St f
/ Pt−1 St−1 − 1

d/f d/f
= f
Ptf /Pt−1 St /St−1 −1

d/f
= 1+ rtf 1+ st −1
d/f d/f
= rtf + st + rtf st
d/f d/f d/f
where st = St /St−1 − 1 is the percentage change in the exchange rate

Risk and Return in International Investment
d/f d/f
rtd = rtf + st + rtf st
That is, the dollar return on a foreign asset has three components:
• Asset return in the foreign currency, rtf

d/f
• Spot-rate return, st
d/f
• An interaction term, rtf st

• From the above, the expected dollar return on a foreign asset is

h i h i
d f d/f f d/f
E rt = E rt + E st + E rt st
• The dollar variance is

d f d/f f d/f
Var rt = Var rt + st + rt st

f d/f f d/f
= Var rt + Var st + Var rt st

f d/f f f d/f d/f f d/f
+ 2 Cov rt , st + 2 Cov rt , rt st + 2 Cov st , rt st

f d/f
= Var rt + Var st + Interaction terms
• What fraction of the return variance of a foreign investment comes from

– asset return variability? exchange rate variability?

Variance of dollar return on foreign stocks
f
The dominant risk in foreign stock markets comes from the local asset return (r )
Exchange rate variability is less important
The interaction terms are close to zero for most of the international equity investments

Variance of dollar return on foreign bonds
The dominant risk in foreign bond markets is exchange rate variability

Bond return variability is less important
The interaction terms are close to zero

Country-Specific Risk
• Country-specific risk can include for example

– political risk, financial risk and economic risk
– can affect asset returns or exchange rates, or both
• Political risk
– Government stability, corruption, etc.
• Financial risk
– Foreign debt (%GDP), Exchange rate stability, etc.
• Economic risk
– GDP growth, annual inflation, etc.

Hedging FX Risk
d/f
• Remember that, for returns: rtd ≈ rtf + st
• What happens to the risk-return characteristics of international investment when we hedge the FX risk?
• Consider a simple FX hedging strategy in which the investor sells the expected foreign currency payoff
f d/f
from the stock E[Pt ] forward, at F
f
f f
f
• Pt = E Pt + Pt − E Pt
• The amount in parentheses represents the unexpected foreign currency payoff, and this must be sold
d/f
at the future spot rate, St . Thus, the hedged dollar proceeds are (using superscript H for hedged)
dH
f d/f f
f d/f
• Pt = E Pt F + Pt − E Pt St

Hedging FX Risk
n f d/f o f d/f
rtdH = PtdH /Pt−1
dH f d/f f

• − 1 = E Pt F + Pt − E Pt St /Pt−1 St−1 − 1
f f d/f d/f f f f
d/f d/f

= E Pt /Pt−1 F /St−1 + Pt − E Pt /Pt−1 St /St−1 − 1
f d/f

f
f d/f

= 1 + E rt 1 + FP + rt − E rt 1 + st −1
f d/f f d/f
f d/f d/f

=rt + F P + rt st + E rt F P − st
d/f
where F P is the forward premium.
• Since the third and fourth terms are likely to be small, we may write rtdH ≈ rtf + F P d/f
• The implication is that it is possible to hedge the exchange rate component by a forward contract

Hedging FX Risk
• Expected return:
h i
d/f
rtd
f

Unhedged: E = E rt + E st
dH
= E rt + F P d/f
f
Hedged: E rt
• Variance: since F P d/f is constant, then

dH
Hedged Var(rt ) < Unhedged Var(rtd )
• The difference is the variance of the spot rate. This is why FX risk hedging can enhance the risk-return
efficiency of international stock market investment.
• Contracts that hedge the whole currency (FX) risk are called quanto contracts.

3. International CAPM Page 16
3. International CAPM
• Integrated financial markets

– There are no barriers to financial flows; assets in different countries are determined jointly
• Segmented financial markets

– Prices are set independently in each national market
Implications for International Asset Pricing:
• Completely integrated markets

– Systematic risk should be measured against the world market
• Completely segmented markets

– Systematic risk should be measured against the local (e.g., national) market portfolio

International CAPM
• Explicitly recognizes investor heterogeneity arising from imperfection in goods markets

– US investors care about returns in USD
– German investors in Euro
– Japanese investors in Yen
– consumption goods are sold in the local market with prices denominated in the local currency
• This implies that the U.S. T-bond is riskless for U.S. investors, but not for German or Japanese investors
• This violates the key assumption of homogeneous expectations in the CAPM: investors agree on the
distribution of asset returns

International CAPM
• How do we proceed, then?

– Take some numeraire, say USD (this can be any currency)
– Convert returns on all assets including foreign ones into USD

1 + ri$ = (1 + ri¤ )(1 + s$/¤ )
– For a German investor, convert everything to Euros
1 + ri¤ = (1 + ri$ )(1 + s¤/$ )
• The world aggregate investor, comprising of the U.S., German and other nationals, care about both the
asset returns in the chosen numeraire (e.g., $) and foreign exchange rate movements

International CAPM
Implications of the international CAPM:
• Like the CAPM, the market portfolio in the International CAPM includes all risky assets in the world
weighted according to their market values (under the same numeraire)
• Investors also hold a portfolio of domestic and foreign bonds

– domestic bonds offer risk-free investment
– remember foreign bonds are risky!
• Expected return on any asset includes a market premium AND a set of currency premia

International CAPM
• Risk-pricing expression for the ICAPM: the expected return on an asset is the sum of the risk-free rate
plus the market risk premium plus various currency risk premia:
E(Ri ) = R0 + βiw RPw + γil SRP1 + · · · + γiK SRPk
• β is the world market exposure of the asset and γ s are the currency exposures, or sensitivities, of the
asset returns to the various exchange rates (1 to K). RPW is the world market risk premium and
SRPK are the currency risk premia
• To use the model, one needs to estimate two types of variables: (i) the market and currency exposures
for each asset; (ii) the risk premia on the (global) market and on currencies

Tests of the ICAPM
• Empirical researchers have explored several questions:

– Is the global market risk priced?
– Is domestic market risk priced (segmentation)?
– Is currency risk priced?
– Are other firm attributes priced beyond global market risk?
• Current research supports the conclusion that assets are priced in an integrated global market
• Evidence is sufficiently strong to justify using the ICAPM in structuring global portfolios
• However, the evidence can be somewhat different for emerging smaller markets

4. Benefits of International Diversification Page 22
4. Benefits of International
Diversification
• Can we reduce risk through international diversification?

– The lower the correlation coefficient between investments, the greater the benefit of diversification
– Foreign markets are imperfectly correlated, possible gains from international diversification
– It is possible to expand the efficient frontier above the domestic only frontier
– It is possible to reduce the systematic risk level below the domestic only level

Benefits of International Diversification
• Correlations vary greatly between pairs of countries

– The degree of independence of a stock market is directly linked to the independence of a nations
economy and governmental policies
– E.g., correlation between U.S. and Canadian returns > that between U.S. and European returns
– In general, long-term bond or equity returns are not very highly correlated across countries
• Correlations are increasing over time, as global competition and various regulatory barriers have fallen
• International correlations increase in periods of high market volatility

OP UK
Efficient set
U.S. investing
JP
FR
US
GM
R CN
f

Portfolio Risk (%) 1 stock (30-40% risk)
U.S. stocks (15-20%)
U.S. systematic risk

International stocks (10-15%)
1 10 20 30 40 50
Number of Stocks in portfolio

• Caveat: Correlations increase dramatically in periods of crises. So the benefits of international risk
diversification disappear when they are most needed. A phenomenon referred to as correlation
breakdown.

5. International Investment Choices Page 27
5. International Investment Choices
• Direct stock/bond purchases

– The most difficult approach: purchasing stock in the foreign country (in the foreign currency) and
transferring back to the investors home country
• Mutual Funds (issued in the US)

– Global funds: invest in both U.S. and foreign stocks and bonds
– International funds: invest mostly outside the U.S.
– Funds can specialize
∗ Diversification across many countries

∗ Concentrate in a segment of the world (Global Energy)
∗ Concentrate in a specific country (Brazil)
∗ Concentrate in types of markets (Emerging Markets)

5. International Investment Choices Page 28
International Investment Choices
• Fixed-income investments
– Eurobond: an international bond that pays cash flows in a currency not native to the country of issue
– Yankee bond: a bond denominated in U.S. dollars, sold in the U.S., but issued by a foreign
corporation or government
• American depository receipts (ADRs)

– Certificates issued by a U.S. bank (represent indirect ownership of shares of a foreign firm on
deposit in the bank)
– Traded in the US market and quoted in U.S. dollars
– Very popular, over 1500 ADR programs available in 2002

6. Home Bias Page 29
6. Home Bias
• Despite the potential benefits of international portfolio diversification, most investors tilt their portfolios
towards domestic securities.
• National equity as % of total equity holdings:

– Japanese investors: 95%
– U.S. investors: 90%
– Canadians: 89%
– Germans: 82%
– British: 78%
(Tesar & Werner, 1998)

Home Bias
• Portfolio holdings have been changing rapidly

– U.S. investors held only 4% foreign stocks in 1987
– U.S. investors held only 10% foreign stocks in 1996
– Reflected in balance of payments statistics:
∗ Large gross purchases of foreign stocks & bonds by U.S. investors, firms and banks in 1990s
∗ Even larger gross purchases of U.S. stocks & bonds by foreigners in 1990s (net capital inflow)
• Nevertheless, investors still mostly hold their own countrys assets

Home Bias
• Many factors can tilt investor holdings toward more domestic assets
• Domestic assets as a hedge against domestic risk

– Domestic stock portfolios can hedge domestic inflation risk
– Banks and insurers with domestic liabilities have an incentive to hedge with domestic assets
• Market frictions
– Government controls: limitations on foreign ownership of domestic assets
– Taxes on cross-border transactions (capital gains, dividend)
– Transactions costs: these reflect the markets operating efficiency and influence informational and
allocational efficiency

Home Bias
• Unequal access to information, due to, for example, time difference language barrier, different
accounting standards
– It is difficult to get and interpret information from distant markets,
– Once invested, it is difficult to monitor the actions of distant managers
• Coval and Moskowitz find that U.S. fund managers prefer local firms, especially small firms that
produce non-traded goods
• Kang and Stulz report that Japanese MNCs (traded in Japan) with greater international presence (e.g.,
large export volume) have larger foreign ownership.

Home Bias
• Investor irrationality
– Individuals prefer investments that are culturally similar and geographically nearby
– Seeking psychological comfort
• Grinblatt and Keloharju find that investors in Finland are more likely to own firms that are
– located nearby, communicate in their native tongue (Swedish vs Finnish), or have CEOs of the
same cultural background
• Cohen reports that employees tend to overweight own company stocks in their personal portfolios

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FM423

(1) Returns on Foreign Investment

(2) Foreign Exchange Risk

(3) International CAPM

(4) Benefits of International Diversification

(5) International Investment Choices

(6) The Home Bias

Lecture 18: International Asset Allocation Copyright c Zachariadis

1. Returns on Foreign Investment

Why A Global Perspective?

• A larger range of risk-return choices

• Diversification with foreign securities can help reduce portfolio risk

Lecture 18: International Asset Allocation Copyright c Zachariadis

• Emphasis of our analysis

• What are the risks involved in investment in foreign securities?

• Are there benefits to diversification in foreign securities?

Lecture 18: International Asset Allocation Copyright c Zachariadis

Returns on Foreign Assets

Lecture 18: International Asset Allocation Copyright c Zachariadis

Returns on Foreign Assets

Return of a foreign security in the US is a function of two factors:

(1) Return in the foreign market

(2) Return on the foreign exchange rate (currency return)

Example: U.S. Investor invests $20,000 in the British Market

Future Value in Pound Sterling: £11,000

Lecture 18: International Asset Allocation Copyright c Zachariadis

Returns on Foreign Assets

GBP depreciates to $1.80

GBP remains at $2.00

GBP appreciates to $2.20

• Movements in foreign exchange can have a major influence

• Both factors must be considered in international investing

Lecture 18: International Asset Allocation Copyright c Zachariadis

2. Foreign Exchange Risk

Lecture 18: International Asset Allocation Copyright c Zachariadis

Risk and Return in International Investment

• Asset return in the foreign currency, rtf

Lecture 18: International Asset Allocation Copyright c Zachariadis

Risk and Return in International Investment

• From the above, the expected dollar return on a foreign asset is

• The dollar variance is

• What fraction of the return variance of a foreign investment comes from

Lecture 18: International Asset Allocation Copyright c Zachariadis

Risk and Return in International Investment

Variance of dollar return on foreign stocks

Lecture 18: International Asset Allocation Copyright c Zachariadis

Risk and Return in International Investment

Variance of dollar return on foreign bonds

The dominant risk in foreign bond markets is exchange rate variability

Lecture 18: International Asset Allocation Copyright c Zachariadis

• Country-specific risk can include for example

– can affect asset returns or exchange rates, or both

Lecture 18: International Asset Allocation Copyright c Zachariadis

Lecture 18: International Asset Allocation Copyright c Zachariadis

Lecture 18: International Asset Allocation Copyright c Zachariadis

• Variance: since F P d/f is constant, then

Lecture 18: International Asset Allocation Copyright c Zachariadis

• Integrated financial markets

• Segmented financial markets

Implications for International Asset Pricing:

• Completely integrated markets

• Completely segmented markets

Lecture 18: International Asset Allocation Copyright c Zachariadis