International Diversification

Background
Global market US Market is 40% - 49% of all markets Improved access & technology New instruments Emphasis for our investigation
Risk assessment Diversification

Issues
What are the risks involved in investment in

foreign securities? How do you measure benchmark returns on foreign investments? Are there benefits to diversification in foreign securities?

Foreign Exchange Risk
Foreign Exchange Risk Variation in return related to changes in the

relative value of the domestic and foreign currency. Total return = investment return & return on foreign exchange It’s not possible to completely hedge a foreign investment.

Returns with Foreign Exchange
Return in US is a function of two factors:

1. Return in the foreign market 2. Return on the foreign exchange

Returns with Foreign Exchange: Example
Condition: U.S. Investor invests $10,000 in the British Market Initial Conditions: Initial Investment : $20,000 Initial Exchange: $2.00/ Pound Sterling Initial Investment in Pound Sterling: 10,000 Risk Free Rate in U.K.: 10% Future Value in Pound Sterling: 11,000

Returns with Foreign Pound Depreciates to $1.80 Exchange $19,800 11,000 * 1.8 =

Return in US$ (-200 / 20,000) = -1%

Pound Remains at $2.00 11,000 * 2.0 = $22,000 Return in US$ (2,000 / 20,000) = 10% Pound Appreciates to $2.20 11,000 * 2.20 = $24,200 Return in US$ ( 4,200 / 20,000) = 21%

Returns with Foreign Movements in foreign exchange can Exchangeinfluence have a major
From Figure 25.2
New Zealand nearly 50% of return is from

foreign exchange Australia virtually all of the return in from foreign exchange Returns from U.K. and Switzerland are mostly from returns in local currency

Both factors must be considered in

international investing

Country Specific Risk
Political Risk Services Group Ratings
 Rank countries with respect to political risk,

financial risk and economic risk
 Assign composite rating from very high risk

to very low risk based on the above elements of risk

PSR Risk Variables
Political Risk Variables (country specific risk) Government stability, corruption, changes in policies, etc Financial Risk Variables
Foreign debt (%GDP), Exchange rate stability

etc

Economic Risk Variables GDP per capita, annual inflation etc

Diversification Benefits
Evidence shows international diversification is

beneficial.
It’s possible to expand the efficient frontier

above domestic only frontier.
It’s possible to reduce the systematic risk

level below the domestic only level.

Return

Int’l

** * * * * * *

Dom

Risk

Risk

Dom Int’l

Securities

International Investment Choices
Direct stock purchases American depository receipts Mutual Funds
Open-end funds Closed-end funds WEBS (World Equity Benchmarks)

Measuring Benchmark Returns
Indexes EAFE Index (Europe, Australia, Far East

index)
Issues in measuring performance
Weighting Cross-Holdings

Other possibilities
Country and Region Funds

Performance Attribution with International
Extension to consider additional factors Currency selection Country selection Stock selection Cash and bond selection

Efficient Market Hypothesis (EMH)
Do security prices reflect information ? Why look at market efficiency?
Implications for business and corporate

finance
Implications for investment

01/09/10

17

Random Walk and the EMH
Random Walk - stock prices are random
Actually submartingale
 

Expected price is positive over time Positive trend and random about the trend

01/09/10

18

Security Prices

Time
01/09/10 19

Random Price Changes
Why are price changes random?
Prices react to information Flow of information is random Therefore, price changes are random

01/09/10

20

EMH and Competition
Stock prices fully and accurately reflect

publicly available information.
Once information becomes available,

market participants analyze it.
Competition assures prices reflect

information.

01/09/10

21

Forms of the EMH
 Weak  Semi-strong  Strong

01/09/10

22

Types of Stock Analysis
Technical Analysis - using prices and volume

information to predict future prices.
Weak form efficiency & technical analysis

Fundamental Analysis - using economic and

accounting information to predict stock prices.
Semi strong form efficiency & fundamental

analysis

01/09/10

23

Active or Passive Management
Active Management
Security analysis Timing

Passive Management
Buy and Hold Index Funds

01/09/10

24

Market Efficiency & Portfolio Management
Even if the market is efficient a role exists for

portfolio management:
Appropriate risk level Tax considerations Other considerations

01/09/10

25

Empirical Tests of Market Efficiency
Event studies Assessing performance of professional

managers
Testing some trading rule

01/09/10

26

How Tests Are Structured
1. Examine prices and returns over time

01/09/10

27

-t

0 Announcement Date

+t

01/09/10

28

How Tests Are Structured (cont’d)
Market Model approach a. Rt = at + btRmt + et (Expected Return) b. Excess Return = (Actual - Expected) et = Actual - (at + btRmt)
01/09/10

2. Returns are adjusted to determine if they are abnormal.

29

How Tests Are Structured (cont’d)
2. Returns are adjusted to determine if they are abnormal. Market Model approach c. Cumulate the excess returns over time:

-t
01/09/10

0

+t
30

Issues in Examining the Results Issue Magnitude
Selection Bias Issue Lucky Event Issue Possible Model Misspecification

01/09/10

31

What Does the Evidence Show?
Technical Analysis Short horizon Long horizon Fundamental Analysis Anomalies Exist

01/09/10

32

Anomalies

Small Firm Effect (January Effect) Neglected Firm Market to Book Ratios Reversals Post-Earnings Announcement Drift

01/09/10

33

Explanations of Anomalies
May be risk premiums Behavioral Explanations
Information Processing Errors Behavioral Biases Limits to Arbitrage

01/09/10

34

Information Processing 
Forecasting Errors
Overconfidence Conservatism Sample Neglect and Representativeness

01/09/10

35

Behavioral Biases
Anchoring Mental Accounting Confirmation & Hindsight bias Gambler’s fallacy Herd behaviour Over confidence Overreaction and availability bias Prospect theory

01/09/10

36

Limits to Arbitrage
Fundamental Risk Implementation Costs Model Risk

01/09/10

37

Mutual Fund Performance
Some evidence of persistent positive and

negative performance.
Potential measurement error for

benchmark returns.
Style changes May be risk premiums

01/09/10

38

Sign up to vote on this title
UsefulNot useful