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International Investment and Diversification

International Diversification
The World Portfolio
Calculating the Return on Foreign Investments
The Risk of Foreign Securities
Returns from International Diversification
The Effect of Exchange Risk
Return Expectations and Portfolio Performance
Other Evidence on Internationally Diversified
Portfolios
Models for Managing International Portfolios
The World Portfolio
Portfolio Managers are investing a large
percentage of their portfolio funds in other
countries. The global stock market hovers
around \$40 -50 trillion. The global bond market is
Empirical data indicate that over the long term,
equities outperform other investment vehicles, and
that internationally diversified portfolios outperform
portfolios consisting of domestic stocks alone.
Calculating the Return on Foreign Investments
Calculating the return on a foreign investment is very similar
to domestic investments, except that we must take the
change in the currency into account. So, we actually have
two sources of return.

For example, suppose that you purchased shares of Pohang
Iron & Steel (POSCO) on the Korean Stock Exchange (KSE)
on Jan 3, 1997 and sold them on Dec 27, 1997. Here are
the details:

Date Price (Won)
Exch. Rate (Won
per Dollar)
1/3/97 37,300 842.60
12/27/97 45,900 1,500.00
Calculating the Return on Foreign Investments
Now, if you were a Korean investor your return for the year
would have been 23.06%

However, as a U.S. investor your return was a negative
30.88%! Quite a difference, and it was entirely due to the
loss in value of the won relative to the dollar during the
Asian Contagion currency crisis that began in Thailand in
June 1997
% 06 . 23 1
37300
45900
=
Calculating the Return on Foreign Investments
To calculate this return, we first need to calculate your
investment in dollar terms:

Where P
0
is the cost in foreign currency, and FC
0
is the
exchange rate (foreign currency unit/dollar). Your
proceeds from the sale are calculated the same way:

Combining the equations into a rate of return, and
rearranging we get the return in local currency (R
LC
):

0
0
FC
1
P Cost Dollar =
1
1
FC
1
P oceeds Pr Dollar =
1
FC P
FC P
R
1 0
0 1
LC

=
Calculating the Return on Foreign Investments
Now, we can see that your return in dollar terms was
-30.88%

So, you made money on the stock, lost on the
currency, and overall you lost a lot of money on
this investment

% 88 . 30 3088 . 0 1
1500 37300
60 . 842 45900
= =

Returns on Foreign Investments

Heres another example. On Jan 27, 1999 Diageo PLC
(LSE: DGE) was selling for 6.30p. One year earlier it
was selling for 5.42p, so a British investor would
have earned a return of 16.24%.

However, an American investor would have made 17.78%
The American made more because the British pound ()
appreciated (from 1.637 to 1.659 ) against the dollar over that
year. Note that the American originally paid \$8.87 (5.42x 1.637),
but received \$10.45 (6.3x 1.659) and the return is 17.78%.
% 78 . 17 1
6028 . 42 . 5
6108 . 30 . 6
=

% 24 . 16 1
42 . 5
30 . 6
=
Returns on Foreign Investments
H X US
R R R + =
0134 . 0 1
637 . 1
69 . 1
= =
X
R 1624 . 0 1
42 . 5
3 . 6
= =
H
R
1754 . 0 0134 . 0 162 . 0 = + =
US
R
Purchasing power parity (PPP) refers to the
situation in which the exchange rate equals the ratio
of domestic and foreign price levels
A relative change in the prevailing inflation rate in one
country will be reflected as an equal but opposite change
in the value of its currency
Parity (contd)
Absolute purchasing power parity follows from
the law of one price:
A basket of goods in one country should cost the same in
another country after conversion to a common currency
Not very accurate due to:
Transportation costs
Cultural differences
Parity (contd)
Relative purchasing power parity states that
differences in countries inflation rates determine
exchange rates:

12
1
1
1
where change in the spot exchange rate
foreign country inflation rate
domestic country inflation rate
F
D
F
D
I
S
I
S
I
I
+
A =
+
A =
=
=
Parity (contd)
A country with an increase in inflation will experience
a depreciation of its currency because:
Exports decline
Imports increase
There is less demand for goods from that country
International Risk Exposure
Exposure is a measure of the extent to which a
person faces foreign exchange risk

In general, there are two types of exposure:
accounting and economic
Economic exposure is more important
Accounting Exposure
Accounting exposure is:
Of concern to MNCs that have subsidiaries in a number of
foreign countries
Important to people who hold foreign securities and must
prepare dollar-based financial reports

U.S. firms must prepare consolidated financial
statements in U.S. dollars
Economic Exposure
Economic exposure measures the risk that the
value of a security will decline due to an unexpected
change in relative foreign exchange rates

Security analysts should include expected changes
in exchange rates in forecasted cash flows
The Risk of Foreign Securities
2 / 1 2 2
) 2 (
HX H X US
o o o o + + =
2 / 1 2 2
) (
H X US
o o o + =
Total investment risk is decomposed into
the volatility of the local market return, the
volatility of the exchange rate change and
the volatility due to the interaction
between the local market return and the
exchange rate change.

Portfolio Risk

Total Risk of a Securitys Returns may be segmented
into
Systematic Risk can not be eliminated

Non-systematic Risk can be eliminated by diversification
The Benefits of International Diversification
INTERNATIONAL DIVERSIFICATION
International diversification and systematic risk
a. Diversify across nations with different
economic cycles
b. While there is systematic risk within a nation,
outside the country it may be nonsystematic
and diversifiable risk

INTERNATIONAL PORTFOLIO INVESTMENT
Recent History
a. National stock markets have wide
differences in returns and risk.
b. Emerging markets have higher risk and
return than developed markets.
c. Cross-market correlations have been
relatively low.
22
INTERNATIONAL PORTFOLIO INVESTMENT
Theoretical Conclusion
International diversification pushes out the
efficient frontier.
The New Efficient Frontier
E(r)
A
B
C
CROSS-MARKET CORRELATIONS

Cross-market correlations
a. Recent markets seem to be most correlated
when volatility is greatest
b. Result: Efficient frontier retreats
The Frontier During Global Crises
E(r)
A
B
C
Investing in Emerging Markets
Investing in Emerging Markets
a. Offers highest risk and returns
b. Low correlations with returns elsewhere
c. As impediments to capital market
mobility fall, correlations are likely to
increase in the future.
Barriers to International Diversification
1. Segmented markets
2. Lack of liquidity
3. Exchange rate controls
4. Underdeveloped capital markets
5. Exchange rate risk
6. Lack of information
b. data is not comparable
Other Methods to Diversify
Diversify by a
a. Global (all types)
b. International (no home country
securities)
c. Single-country
INTERNATIONAL PORTFOLIO INVESTMENT
Calculation of Expected Portfolio Return:
r
p
= a r
US
+ ( 1 - a) r
w
where

r
p
= portfolio expected return
r
US
= expected U.S. market return
r
w
= expected global return

Portfolio Return
Problem
What is the expected return of a portfolio with
35% invested in Japan returning 10% and 65%
in the U.S. returning 5%?
r
p
= a r
US
+ ( 1 - a) r
w

= .65(.05) + .35(.10)
= .0325 + .0350
= 6.75%
INTERNATIONAL PORTFOLIO INVESTMENT
Calculation of Expected Portfolio Risk

Where =the cross-market correlation

o
US
2
=U.S. returns variance
o
w
2
=World returns variance
2 / 1 2 2 2 2
) ) )( 1 ( 2 ) 1 ( (
W US W US P
a a a a o o o o o + + =

Portfolio Risk
What is the risk of a portfolio with 35% invested in
Japan with a standard deviation of 6% and a standard
deviation of 8% in the U.S. and a correlation coefficient
of .7?

= [(.65)
2
(.08)
2
+ (.35)
2
(.06)
2

+2(.65)(.35)(.08)(.06)(.7)]
1/2

=6.8%

2 / 1 2 2 2 2
) ) )( 1 ( 2 ) 1 ( (
W US W US P
a a a a o o o o o + + =
INTERNATIONAL PORTFOLIO INVESTMENT
MEASURING TOTAL RETURNS FROM FOREIGN PORTFOLIOS
A. To compute dollar return of a foreign security:
1 0
\$
0
( )( )
US ForeignCurrency
e e
R R
e

=
0 1
\$
1
( )( )
US ForeignCurrency
e e
R R
e

=
For currency appreciation:
For currency depreciation:
INTERNATIONAL PORTFOLIO INVESTMENT
Bond (calculating return) formula:

where R
US
= dollar return
B
1
= foreign currency bond price at time 1
B
0
=bond price at 0
C = coupon income during period
g = currency depreciation or appreciation

) 1 ]( 1 [ 1
0
0 1
g
B
C B B
R
US
+
+
+ = +
INTERNATIONAL PORTFOLIO INVESTMENT
Stocks (Calculating return)
Formula:

Where R
US
= dollar return
P(1) = foreign currency stock price at time 1
D = foreign currency annual dividend

\$
(1) (0)
1 1 (1 )
(0)
P P D
R g
P
( +
+ = + +
(

\$
(1) (0)
1 1 (1 )
(0)
P P D
R g
P
( +
+ = + +
(

U.S. Stock Returns: Sample Problem
Suppose the beginning stock price is FF50 and
the ending price is FF48. Dividend income
was FF1. The franc depreciates from FF 20
/\$ to FF21.05 /\$ during the year against the
dollar.
What is the stocks US\$ return for the year?

U.S. Stock Returns: Sample Solution
48 50 1 .20 .2105
1 1 1
50 .2105
+
( (
= + +
( (

\$
6.9% R =
) 1 ]( 1 [ 1
0
0 1
g
P
D P P
R
US
+
+
+ = +
% 9 . 6 1 ) 95 . 0 )( 98 . 0 ( 1 = = +
US
R
Evidence on Internationally Diversified
Portfolios
With the globalization of financial markets, the trend
toward international diversification can already be seen
in the activities of mutual funds, pension funds and other
institutional investors.