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Chapter 17

International Portfolio Theory and Diversification

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

International Diversification and Risk
• The case for international diversification of portfolios can be decomposed into two components, the first of which is the potential risk reduction benefits of holding international securities. • This initial focus is on risk. • The risk of a portfolio is measured by the ratio of the variance of a portfolio’s return relative to the variance of the market return (portfolio beta). • 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.

• A domestic portfolio that is fully diversified would have a beta of 1.0.

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17-3 .1 Portfolio Risk Reduction Through Diversification Copyright © 2010 Pearson Prentice Hall.Exhibit 17. All rights reserved.

All rights reserved.International Diversification and Risk • The total risk of any portfolio is therefore composed of systematic risk (the market) and unsystematic risk (the individual securities). 17-4 . • Increasing the number of securities in the portfolio reduces the unsystematic risk component leaving the systematic risk component unchanged. Copyright © 2010 Pearson Prentice Hall.

17-5 . • The foreign exchange risks of a portfolio. • The risk associated with international diversification. is very complicated when compared to domestic investments. when it includes currency risk. • Purchasing assets in foreign markets. in foreign currencies may alter the correlations associated with securities in different countries (and currencies). are reduced through international diversification. All rights reserved. Copyright © 2010 Pearson Prentice Hall. whether it be a securities portfolio or the general portfolio of activities of the MNE. • This provides portfolio composition and diversification possibilities that domestic investment and portfolio construction may not provide.International Diversification and Risk • The second component of the case for international diversification addresses foreign exchange risk.

Copyright © 2010 Pearson Prentice Hall. bidding up the price of that security. • 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. All rights reserved. • A security that adds value will be demanded by investors. resulting in a lower cost of capital for the issuing firm. then the security adds value to the portfolio.International Diversification and Risk • International diversification benefits induce investors to demand foreign securities (the so called buy-side). 17-6 . or if it increases the expected return for a given level of risk.

2 Portfolio Risk Reduction Through International Diversification Copyright © 2010 Pearson Prentice Hall. All rights reserved. 17-7 .Exhibit 17.

17-8 . • The typical investor is therefore in search of a portfolio that maximizes expected portfolio return per unit of expected portfolio risk. • This means an investor is willing to accept some risk but is not willing to bear unnecessary risk.Internationalizing the Domestic Portfolio • Classic portfolio theory assumes a typical investor is risk-averse. All rights reserved. Copyright © 2010 Pearson Prentice Hall.

All rights reserved.Internationalizing the Domestic Portfolio • The domestic investor may choose among a set of individual securities in the domestic market. • The set of portfolios along the extreme left edge of the set is termed the efficient frontier. • The near-infinite set of portfolio combinations of domestic securities form the domestic portfolio opportunity set (next exhibit). Copyright © 2010 Pearson Prentice Hall. • This efficient frontier represents the optimal portfolios of securities that possess the minimum expected risk for each level of expected portfolio return. 17-9 .

All rights reserved. 17-10 .Internationalizing the Domestic 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). • He or she begins with the risk-free asset (Rf) and moves out along the security market line until reaching portfolio DP. which combines the risk-free asset and a portfolio of domestic securities found on the efficient frontier. • This portfolio is defined as the optimal domestic portfolio because it moves out into risky space at the steepest slope. Copyright © 2010 Pearson Prentice Hall.

All rights reserved.3 Optimal Domestic Portfolio Construction Copyright © 2010 Pearson Prentice Hall.Exhibit 17. 17-11 .

Copyright © 2010 Pearson Prentice Hall. All rights reserved.International Diversification and Risk • The next exhibit illustrates the impact of allowing the investor to choose among an internationally diversified set of potential portfolios. • The internationally diversified portfolio opportunity set shifts leftward of the purely domestic opportunity set. 17-12 .

All rights reserved.4 The Internationally Diversified Portfolio Opportunity Set Copyright © 2010 Pearson Prentice Hall.Exhibit 17. 17-13 .

International Diversification and Risk • It is critical to be clear as to exactly why the internationally diversified portfolio opportunity set is of lower expected risk than comparable domestic portfolios. • The gains arise directly from the introduction of additional securities and/or portfolios that are of less than perfect correlation with the securities and portfolios within the domestic opportunity set. All rights reserved. 17-14 . Copyright © 2010 Pearson Prentice Hall.

IP. is again found by locating that point on the capital market line (internationally diversified) which extends from the risk-free asset return of Rf to a point of tangency along the internationally diversified efficient frontier. All rights reserved. Copyright © 2010 Pearson Prentice Hall. • The optimal international portfolio.International Diversification and Risk • The investor can now choose an optimal portfolio that combines the same risk-free asset as before with a portfolio from the efficient frontier of the internationally diversified portfolio opportunity set. 17-15 . • The benefits are obvious in that a higher expected portfolio return with a lower portfolio risk can be obtained when compared to the domestic portfolio alone.

All rights reserved. 17-16 .Exhibit 17.5 The Gains from International Portfolio Diversification Copyright © 2010 Pearson Prentice Hall.

International Diversification and Risk • An investor can reduce investment risk by holding risky assets in a portfolio. 17-17 . All rights reserved. Copyright © 2010 Pearson Prentice Hall. because some of the fluctuations of the asset returns will offset each other. the investor can reduce risk. • As long as the asset returns are not perfectly positively correlated.

17-18 .6 Alternative Portfolio Profiles Under Varying Asset Weights Copyright © 2010 Pearson Prentice Hall.Exhibit 17. All rights reserved.

• The true benefits of global diversification. and because different economies do not exactly follow the same business cycle. arise from the fact that the returns of different stock markets around the world are not perfectly positively correlated. 17-19 .National Markets and Asset Performance • Asset portfolios are traditionally constructed using both interest bearing risk-free assets and risky assets. Copyright © 2010 Pearson Prentice Hall. • For the 100 year period ending in 2000. however. • This is because the are different industrial structures in different countries. All rights reserved. the risk of investing in equity assets has been rewarded with substantial returns.

17-20 . Globally. All rights reserved.7 Real Returns and Risks on the Three Major Asset Classes.Exhibit 17. 1900–2000 Copyright © 2010 Pearson Prentice Hall.

17-21 .8 Correlation Coefficients between World Equity Markets. All rights reserved.Exhibit 17. 1900– 2000 Copyright © 2010 Pearson Prentice Hall.

National Markets and Asset Performance • Interestingly. Copyright © 2010 Pearson Prentice Hall. the benefits of diversification will be reduced. • It is often said that as capital markets around the world become more and more integrated over time.0). All rights reserved. 17-22 . markets that are contiguous or nearcontiguous (geographically) seemingly demonstrate the higher correlation coefficients for the past century. • Analysis of market data supports this idea (although the correlation coefficients between markets are still far from 1.

17-23 .Exhibit 17.10 Comparison of Selected Correlation Coefficients between Stock Markets for Two Time Periods (dollar returns) Copyright © 2010 Pearson Prentice Hall. All rights reserved.

we introduce two measures: The Sharpe Measure (SHP) = SHPi = Ri – Rf σi The Treynor Measure (TRN) = TRNi = Ri – Rf βi Copyright © 2010 Pearson Prentice Hall.Market Performance Adjusted for Risk: The Sharpe and Treynor Performance Measures • To consider both risk and return in evaluating portfolio performance. All rights reserved. 17-24 .

it is possible for it to show a high ranking on the basis of the Treynor measure. • As the difference is attributable to the low level of portfolio diversification. Copyright © 2010 Pearson Prentice Hall. but a lower ranking on the basis of the Sharpe measure. • If a portfolio is poorly diversified. the two measures give similar rankings. 17-25 . All rights reserved. • If a portfolio is perfectly diversified (without any unsystematic risk). the two measures therefore provide complimentary but different information. the difference between them is important.Market Performance Adjusted for Risk: The Sharpe and Treynor Performance Measures • Though the equations of the Sharpe and Treynor measures look similar. because the total portfolio risk is equivalent to the systematic risk.

17-26 .Exhibit 17.9 Summary Statistics of the Monthly Returns for 18 Major Stock Markets. dollars and include all dividends paid) Copyright © 2010 Pearson Prentice Hall. All rights reserved.S. 1977–1996 (all returns converted into U.

All rights reserved.Chapter 17 Additional Chapter Exhibits Copyright © 2010 Pearson Prentice Hall. .

. What elements of the article may have proved correct? 17-28 Copyright © 2010 Pearson Prentice Hall. All rights reserved.Mini-Case Questions: Is Modern Portfolio Theory Outdated? • Why might the bell curve not be helpful when trying to construct and manage modern financial portfolios? • What risks are created if most of the major market agents are using the same models at the same times? • Since the time of the article. the world economy has suffered a significant crisis.