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Reading: Chapter 15
Lecture Outline
Basics of diversification Benefits of international diversification Measuring foreign investment performance The home bias puzzle
Why Go Global?
In a nutshell: Diversification!!!
Potential for higher expected returns for same risk. Potential for lower portfolio risk for same return.
Expected return International investing Domestic investing
InternationalCorrelations& Diversification
Security returns are much less correlated across countries than within a country.
This is because economic, political, institutional and even psychological factors affecting security returns tend to vary across countries, resulting in low correlations among international securities.
Types of companies in each country can also vary significantly.
W
(1970-2004)
.508
.502
.473
.311
.620
.523
.542
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International Investing
The tools are Mean/Variance Analysis same as in previous finance units. However, there are many important cross-country differences that matter when we invest internationally Country Risk Currency Risk We start out with the mathematics of portfolio optimization
Portfolio Theory
Assumptions:
Nominal returns are normally distributed. Investors want more return and less risk as denominated in their home currency.
Let wi = proportion of wealth devoted to asset i such that i wi = 1 Expected return on a portfolio: E ( RP ) = wi E ( Ri )
i
2 Var ( RP ) = P = wi w j ij i j j
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= ij i
Example: Equal weights (50%) of A and J: E[Rp] = wA E[RA] + wJ E[RJ] = (0.5x0.143)+(0.5x0.177) = 0.16 or 16%
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Portfolio Variance
E[Ri] Correlation A B J
1 0.557 0.325 0.557 1 0.317 0.325 0.317 1
2 P
= wA2
+ wJ2
+ 2 wA wJ
A J
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Total Risk
40 Total risk 1 10 20
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By diversifying the portfolio, the variance of the portfolios return relative to the variance of the markets return (beta) is reduced to the level of systematic risk -- the risk of the market itself.
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DP
R DP
MRDP
D P
Rf
An investor may choose a portfolio of assets enclosed by the Domestic portfolio opportunity set. The optimal domestic portfolio is found at DP, where the Capital Market Line is tangent to the domestic portfolio opportunity set. The domestic portfolio with the minimum risk is MRDP .
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R IP R DP
IP
DP
Rf
IP
D P
An investor may choose a portfolio of assets enclosed by the international portfolio opportunity set. The optimal international portfolio is found at IP, where the Capital Market Line is tangent to the international portfolio opportunity set.
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The investor purchases 6,500 shares valued at 20,000 for a total investment of 130,000,000 At the end of the year, the investor sells the shares at a price of 25,000 per share yielding 162,500,000
On 1/1/2003, the spot exchange rate was 125/$
R $ = 1 + r $/ 1 + r shares,
Where:
$
[(
)(
)] 1
Where to Invest?
Country China India Brazil Hong Kong South Korea Germany Singapore Mexico U.S. Canada U.S. U.K. U.S. France Italy Japan Index SSEC BSE Bovespa HSI Seoul Comp. DAX 30 ST Index IPC Nasdaq TSE DJIA FTSE 100 S&P 500 CAC 40 MIBTEL Nikkei '07 Return 96.66% 47.15% 43.65% 39.31% 32.25% 22.29% 16.63% 11.68% 9.81% 7.16% 6.43% 3.80% 3.53% 1.31% -7.81% -11.13% 31
Where to Invest?
2006 returns
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How to Invest?
Direct share investment purchase shares in foreign markets using foreign currencies. Can be hard to do! ADRs/GDRs purchase shares in foreign companies that are traded on your home exchange in local currency. Limited number! MNCs why cant we just buy shares in multinational companies to diversify internationally? Diversification benefits not as good as investing internationally! So what are the easy ways?
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Country Funds
Recently, country funds have emerged as one of the most popular means of international investment. A country fund invests exclusively in the stocks of a single country. This allows investors to: 1. Speculate in a single foreign market with minimum cost. 2. Construct their own personal international portfolios. 3. Diversify into emerging markets that might be inaccessible to individual investors.
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Other Avenues
Exchange Traded Funds ETFs are investment companies,
registered with the SEC with assets consisting of baskets of securities included in an index fund.
One share in an ETF provides an investor diversification to all the constituents of the relevant index and its price and yield track the indices performance.
World Equity Benchmark Shares (WEBS)/iShares Country specific baskets of stocks designed to replicate indices of 14 countries.
Low cost, convenient way for investors to hold diversified investments in several different countries.
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Proportion of Domestic Equities in Portfolio 64.4% 75.4% 91.0% 86.7% 94.2% 100.0% 78.5% 98.0%
Domestic equities may provide a superior inflation hedge. Sovereign risk - repatriation of funds Exchange rate risk Information asymmetries Psychological impediments
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Conclusions
1 2 3
Low correlations across international markets may Low correlations across international markets may increase the risk-return trade off increase the risk-return trade off Important time variations may exist that can Important time variations may exist that can challenge these benefits. Time horizon matters. challenge these benefits. Time horizon matters. Investors might not be taking full advantage of the Investors might not be taking full advantage of the benefits of international diversification. This is benefits of international diversification. This is known as the home bias puzzle. known as the home bias puzzle.
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