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INTERNATIONAL PORTFOLIO INVESTMENT

OBJECTIVE 
The very objective of portfolio investment management is to select an optimal portfolio where the risk-return trade-off is optimal.  This denotes a position where return is maximum with a given level of risk or where the risk is minimum with a given level of return.

CONCEPT OF OPTIMAL PORTFOLIO 
There are various concepts being underlined for selection of an optimal portfolio by striking a balance between risk and return.  The concepts are as follows:(a) The concept of probability -for measurement of return (b) The concept & measurement of risk

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Measurement of returns (a)The concept of probability:No finance manager knows in advance what would be the actual returns from an investment.  Probabilities are merely numbers that represent the likelihood of chance of occurrence of various outcomes.

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The probability distribution may be either Discrete or Continuous.  Discrete distribution has only finite no. of outcomes, whereas in case of a continuous distribution the outcome is not finite.

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Expected return from a single investment  The expected return is the mean of probability distribution. It is the probability-weighted average of outcomes. Expected returns from international investment  In case of international investment, the estimation of expected returns takes into a/c also the changes in the exchange rate. And so, the return from a security abroad in terms of a home country currency(HC) is calculated.

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Portfolio return  Portfolio return is the weighted average of the expected return from different securities existing in the portfolio.

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(b) The concept and measurement of risk:Risk for a single investment  Risk represents the variance between the actual returns and the expected returns. After the computation of the expected value or the mean, it is necessary to measure the variance or the deviation of outcomes from the mean. 

The deviation is known as dispersion or the spread of probability distribution.

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Portfolio risk  The investor tries to reduce the risk involved in the existing portfolio through diversification. Diversification means simultaneous investment in other securities may be within the country or may be outside the country.  But diversification will help reduce risk only when the co-variance/correlation between the existing portfolio and the new portfolio is negative.

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After the calculation of covariance/correlation an investor needs to find out the S.D of a portfolio.

Limitation to diversification: Systematic risk vs Unsystematic risk 
Portfolio risk can be reduced through diversification.  Diversification reduces only a particular type of risk.  A particular asset or a portfolio of asset possesses two types of risk: one being the unsystematic risk that can be diversified away, and other being the systematic risk that cannot be diversified away through investment in domestic securities.

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The unsystematic risk is firm-specific and so simultaneous investment in other securities may lower it.  Systematic risk is a macro-economic risk, it is inherent in the performance of the economy as a whole. so it is similar for all the securities in the market. This is why it is also known as the market risk.  It cannot be reduced through diversification in the domestic market although systematic risk too can be reduced through international investment as the macroeconomic fundamentals vary in different countries.

Optimisation of portfolio 
Optimisation of portfolio means selection of a particular portfolio that involves minimum risk with a given return or maximum return with a given risk

Benefits of International Portfolio Investment 
An investor opts for international portfolio investment because international diversification of portfolio of assets helps achieve a higher risk-adjusted return. This means that an investor is able to reduce risk and raise return through international investment

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Reduction in risk: International investment is superior to domestic investment in so far as the former helps diversify risk.  Different sectors in an individual economy are in one way or the other interrelated and as a result, are collectively subject to the same impact of the overall domestic policy.  The returns from investment in different sectors of an individual economy respond jointly to prospects for domestic activity and to uncertainty about these prospects.

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On the other hand, the macroeconomic fundamentals of different countries differ widely and do not witness exactly the same stage of business cycle.  All these means that foreign investment generates diversification benefits that cannot be reaped by investing In the domestic country alone.

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Better risk-return trade-off: The international investment helps raise the return with a given risk or helps lower the risk with a given rate of return. 
This happens because more profitable investment avenues exist in an enlarged universe.

Problems of international investment 
It is an established fact that the international diversification of portfolio is gainful. But there are also some problems that mar an optimal international diversification of portfolio. These problems are broadly: 1.unfavourable exchange rate movement 2.frictions international financial market 3.manipulation of security prices 4.unequal access to information