11/30/2010
International Portfolio
Investment
Chapter Objective:
15
Chapter Fifteen
Background: An overview of portfolio theory and asset
pricing models
Why investors diversify their portfolios internationally.
How much investors can gain from international
diversification.
The effects of fluctuating exchange rates on international
Fifth Edition
portfolio investments.
/ RESNICK
Whether and how much investors can benefitEUN
from
investing in U.S. based international mutual funds.
The reasons for “home bias” in portfolio holdings.
15-0
Chapter Outline










An overview of portfolio theory and asset pricing models
International Correlation Structure and Risk
Diversification
Optimal International Portfolio Selection
Effects of Changes in the Exchange Rate
International Bond Investment
International Mutual Funds: A Performance Evaluation
International Diversification through Country Funds
International Diversification with ADRs
International Diversification with ETFs
Why Home Bias in Portfolio Holdings?
15-1
1
11/30/2010
Overview of portfolio theory and
asset pricing models (1)


Measuring risk and returns
R l for
Rules
f comparing
i risk
i k andd returns
t




Given returns minimize risk
Given risk maximize returns
Coefficient of variation
Return = risk free rate + risk premium

Measuring risk and returns of a portfolio

Role of correlation Coefficients (+, -, 0)
Adding a risk free asset to a risky portfolio


Graphing portfolio characteristic in a risk and returns space
15-2
Overview of portfolio theory and
asset pricing models (2)







Many risky portfolios and risk-free asset
S
Separation
ti Theorem
Th
Capital Market Line (CML): Pricing a diversified risky
portfolio
Total Risk = Unsystematic Risk (UR) + Systematic Risk
(SR)
What determines SR
Why is SR important
Beta = SR
15-3
2
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Overview of portfolio theory and
asset pricing models (3)



Capital Asset Pricing Model (CAPM)
Whyy is CAPM a ppricingg model?
Sharp measure of portfolio performance:
 [E(Rp) – Rf] / σp
E(Rp) = Expected return on portfolio p
Rf = Risk free rate
σp = standard deviation of the portfolio p’s return
15-4
International Correlation Structure
and Risk Diversification

Security returns are much less correlated across
countries than within a country.


This is so because economic, political, institutional, and
even psychological factors affecting security returns
tend to vary across countries, resulting in low
correlations among international securities.
Business cycles are often high asynchronous across
countries.
15-5
3
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International Correlation Structure
Stock Market
Australia
A
U
.59
France
.29
29
Germany
.18
Japan (JP)
.15
FR
GM
JP
NL
SW
UK
US
Relatively low international correlations
.58
58
imply that
should
be able to
Relatively
low investors
international
correlations
reduce
portfolio
risk
more
if they
imply that investors should be able
to
.31
.65
diversify
reduce portfolio
riskinternationally
more if they
rather than
domestically.
.24
.30
.42
diversify
internationally
Netherlands .24
.34
.51
.28
rather
.62 than domestically.
Switzerland .36
.37
.48
.28
.52
.66
United
Kingdom
United
States
15-6
.32
.38
.30
.21
.39
.43
.70
.30
.23
.17
.14
.27
.27
.28
.44
Portfolio Risk (%
P
%)
Domestic vs. International
Diversification
When fully diversified, an international portfolio can be
less than half as risky as a purely U.S.
U S portfolio.
portfolio
A fully diversified international portfolio is only 12
percent as risky as holding a single security.
0.44
Swiss stocks
0 27
0.27
U.S. stocks
International stocks
0.12
1
10
20
30
40
50 Number of
Stocks
15-7
4
11/30/2010
Optimal International Portfolio
Selection




The correlation of the U.S. stock market with the
returns on the stock markets in other nations
varies.
The correlation of the U.S. stock market with the
Canadian stock market is 72%.
The correlation of the U.S.
U S stock market with the
Japanese stock market is 31%.
A U.S. investor would get more diversification
from investments in Japan than Canada.
15-8
Summary Statistics for Monthly
Returns 1980-2007 ($U.S.)
Correlation Coefficient
Stock Market
CN
FR
GM
JP
SD
((%))
1.07
5.55
Countryy
stock
market
vs. world
1.00
1.20
6.00
1.04
1.19
6.29
1.03
0.92
6.53
1.10
1.19
5.20
0.97
1.11
4.25
0.88
UK
Canada (CN)
France (FR)
0.49
Germany
(GM)
0.46
1.07% monthly return =
12.84% per year
0.73
Japan (JP)
0.34
0.40
0.32
United
Kingdom
0.59
0.61
0.56
0.42
United States
0.72
0.55
0.52
0.31
0.61

Mean
((%))
15-9
5
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Summary Statistics for Monthly
Returns 1980-2007 ($U.S.)
Correlation Coefficient
Stock Market
CN
Canada (CN)
FR
GM
JP
SD
((%))
1.07
5.55
Countryy
stock
market
vs. world
1.00
1.20
6.00
1.04
1.19
6.29
1.03
0.92
6.53
1.10
1.19
5.20
0.97
1.11
4.25
0.88
UK
 measures the sensitivity of the
market to the world market.
France (FR)
0.49
Germany
(GM)
0.46
Japan (JP)
0.34
0.40
0.32
United
Kingdom
0.59
0.61
0.56
0.42
United States
0.72
0.55
0.52
0.31
Clearly the Japanese market is
0.73more sensitive to the world
market than is the U.S.
US
0.61

Mean
((%))
15-10
Selection of the Optimal International Portfolio
2.0%
Efficient frontier
SD
1.5%
OIP
Monthly Return
NL
US
1.0%
0.5%
0.0%
0.0%
UK
SW
CN
HK
IT
GM
JP
Rf
Monthly Standard Deviation
1.0% 2.0% 3.0% 4.0%
5.0% 6.0% 7.0% 8.0% 9.0%
10%
15-11
6
11/30/2010
Composition of the OIP for a U.S. Investor
(Holding Period: 1980—2007
Australia
Hong Kong
4.82%
8.76%
Italy
6.60%
Netherlands
31.11%
Sweden
28 01%
28.01%
U.S.
20.70%
Total
100.00%
15-12
Composition of the OIP, by Countries:
1980—2007
15-13
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11/30/2010

For a U.S. investor, OIP has
more return and more risk.
risk
The Sharpe measure is 30%
higher, suggesting that an
equivalent-risk OIP would
have more return per unit of
risk than a domestic portfolio.
OIP
ODP
Mean
Return
1.40%
1.11%
Standard
Deviation
4.74%
4.25%
return
Gains from
International Diversification
OIP
1.40%
1.11%
ODP
4.74%
4.25%
risk
15-14
Effects of Changes
in the Exchange Rate

The realized dollar return for a U.S. resident
investing in a foreign market will depend not only
on the return in the foreign market but also on the
change in the exchange rate between the U.S.
dollar and the foreign currency.
15-15
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Effects of Changes
in the Exchange Rate

The realized dollar return for a U.S. resident
i
investing
i in
i a foreign
f i market
k is
i given
i
by
b
Ri$ = (1 + Ri)(1 + ei) – 1
= Ri + ei + Riei
Where
Ri is the local currency return in the ith market
ei is the rate of change in the exchange rate between
the local currency and the dollar
15-16
Effects of Changes
in the Exchange Rate

For example, if a U.S. resident just sold shares in
a British firm that had a 15% return (in pounds)
during a period when the pound depreciated 5%,
his dollar return is 9.25%:
Ri$ = (1 + .15)(1 – 0.05) – 1 = 0.925
= .15 + –.05 + .15×(–.05) = 0.925
15-17
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Effects of Changes
in the Exchange Rate

The risk for a U.S. resident investing in a foreign
market will depend not only on the risk in the
foreign market but also on the risk in the
exchange rate between the U.S. dollar and the
foreign currency.
Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,eei) + Var
The Var term represents the contribution of the
cross-product term, Riei, to the risk of foreign
investment.
15-18
Effects of Changes
in the Exchange Rate
Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + Var
This equation demonstrates that exchange rate
fluctuations contribute to the risk of foreign
investment through three channels:
1. Its own volatility, Var(ei).
2. Its covariance
i
with
i h the
h local
l l market
k returns
Cov(Ri,ei).
3. The contribution of the cross-product term, Var.
15-19
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International Portfolio:
Risk Decomposition
15-20
International Bond Investment


There is substantial exchange rate risk in foreign
bond investment. This suggests that investors may
be able to increase their gains is they can control
this risk, for example with currency forward
contracts or swaps.
The advent of the euro is likely to alter the risk
riskreturn characteristics of the euro-zone bond
markets enhancing the importance of non-euro
currency bonds.
15-21
11
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International Mutual Funds: A
Performance Evaluation


1.
2.
3.
A U.S. investor can easily achieve international
diversification by investing in a U.S.-based
international mutual fund.
The advantages include
Savings on transaction and information costs.
Ci
Circumvention
i off legal
l l andd institutional
i i i l barriers
b i
to direct portfolio investments abroad.
Professional management and record keeping.
15-22
International Mutual Funds: A
Performance Evaluation
As can be seen below, a sample of U.S. based international
mutual
t l funds
f d has
h outperformed
t f
d the
th S&P 500 during
d i the
th
period 1977-1986, with a higher standard deviation. US
Mean
Annual
Return
18.96%
Standard
Deviation
US
R2
5.78%
0.69
0.39
S&P 500
14.04%
4.25%
1.00
1.00
U.S. MNC
Index
16.08%
4.38
.98
.90
U.S. Based
International
Mutual Funds
15-23
12
11/30/2010
International Mutual Funds: A
Performance Evaluation
U.S. stock market movements account for less than 40% of the
fluctuations of international mutual funds,, but over 90% of the
movements in U.S. MNC shares. This means that the shares of U.S.
MNCs behave like those of domestic firms, without providing effective
international diversification.
Mean Annual
Return
Standard
Deviation
US
R2
U S Based
U.S.
International
Mutual Funds
18.96%
5.78%
0.69
0.39
S&P 500
14.04%
4.25%
1.00
1.00
U.S. MNC Index
16.08%
4.38
.98
.90
15-24
International Diversification through
Country Funds


Recently, country funds have emerged as one of
the
h most popular
l means off international
i
i l
investment.
A country fund invests exclusively in the stocks
of a single county. This allows investors to:
1.
2.
3.
Speculate in a single foreign market with minimum
cost.
t
Construct their own personal international portfolios.
Diversify into emerging markets that are otherwise
practically inaccessible.
15-25
13
11/30/2010
International Diversification through
Country Funds : Some Evidence
RF = α + βUS RUS + βHM RHM + е
15-26
International Diversification through
Country Funds : More Evidence
15-27
14
11/30/2010
International Diversification through
Country Funds: Is it worth it?
15-28
International Diversification through
American Depository Receipts



Foreign stocks often trade on U.S. exchanges as
ADRs.
It is a receipt that represents the number of
foreign shares that are deposited at a U.S. bank.
The bank serves as a transfer agent for the ADRs
15-29
15
11/30/2010
American Depository Receipts

There are many advantages to trading ADRs as
opposed to direct investment in the company’s
shares:




ADRs are denominated in U.S. dollars, trade on U.S.
exchanges and can be bought through any broker.
Dividends are paid in U.S. dollars.
Most underlying stocks are bearer securities, the ADRs
are registered.
Adding ADRs to domestic portfolios has a substantial
risk reduction benefit.
15-30
World Equity Benchmark Shares



In April 1996, the American Stock Exchange (AMEX)
introduced a class of securities called World Equity
Benchmark Shares (WEBS), designed and managed by
Barclays Global Investors.
In essence, WEBS are exchange-traded funds (ETFs) that
are designed to closely track foreign stock market indexes.
Currently, there are 23 WEBS tracking the Morgan Stanley
Capital International (MSCI) indexes for the following
i di id l countries:
individual
t i Australia,
A t li Austria,
A t i Belgium,
B l i
Brazil,
B il
Canada, Chile, China, France, Germany, Hong Kong,
Italy, Japan, Korea, Malaysia, Mexico, the Netherlands,
Singapore, South Africa, Spain, Sweden, Switzerland,
Taiwan, and the United Kingdom.
15-31
16
11/30/2010
International Diversification with
Exchange Traded Funds


Using exchange traded funds (ETFs) like WEBS and
spiders,
id
investors
i
can trade
d a whole
h l stockk market
k index
i d as
if it were a single stock.
Being open-end funds, WEBS trade at prices that are very
close to their net asset values. In addition to single country
index funds, investors can achieve global diversification
instantaneously just by holding shares of the S&P Global
100 Index Fund that is also trading on the AMEX with
other WEBS.
15-32
International Diversification with Hedge Funds


Hedge funds which represent privately pooled
investment funds have experienced phenomenal
growth in recent years.
This growth has been mainly driven by the desire
of institutional investors, such as pension plans,
endowments and private foundations,
endowments,
foundations to achieve
positive or absolute returns, regardless of whether
markets are rising or falling.
15-33
17
11/30/2010
International Diversification with Hedge Funds



Unlike traditional mutual funds that generally depend on
“buy
buy and hold”
hold investment strategies,
strategies hedge funds may
adopt flexible, dynamic trading strategies, often
aggressively using leverages, short positions, and
derivative contracts, in order to achieve their investment
objectives.
These funds may invest in a wide spectrum of securities,
such as currencies
currencies, domestic and foreign bonds and stocks,
stocks
commodities, real estate, and so forth.
Many hedge funds aim to realize positive returns,
regardless of market conditions.
15-34
International Diversification with Hedge Funds


Hedge funds tend to have relatively low correlations with various
stock market benchmarks and thus offer diversification
diversification.
In addition, hedge funds allow investors to access foreign markets
that are not easily accessible.


For example, J.P. Morgan provides access to the Jayhawk China Fund,
a hedge fund investing in Chinese stocks not readily available in U.S.
markets.
Also, hedge funds may allow investors to benefit from certain
global macroeconomic events.
events In fact,
fact many hedge funds are
classified as “global/macro” funds.

Examples of global/macro funds include such well-known names as
George Soros’ Quantum Fund, Julian Robertson’s Jaguar Fund, and
Louis Bacon’s Moore Global Fund.
15-35
18
11/30/2010
International Diversification with Hedge Funds

Legally, hedge funds are private investment partnerships. As
such these funds generally do not register as an investment
such,
company under the Investment Company Act and are not
subject to any reporting or disclosure requirements.


As a result, many hedge funds operate under rather opaque
environments.
While investors may benefit from hedge funds, they need to
be aware of the associated risk as well.


Hedge
H
d ffunds
d may make
k wrong bbets
t bbased
d on th
the incorrect
i
t
prediction of future events and wrong models.
The failure of Long Term Capital Management provides an
example of the risk associated with hedge fund investing.
15-36
Home Bias in Portfolio Holdings



As previously documented, investors can
potentially benefit a great deal from international
diversification.
The actual portfolios that investors hold, however,
are quite different from those predicted by the
theory of international portfolio investment.
investment
Home bias refers to the extent to which portfolio
investments are concentrated in domestic equities.
15-37
19
11/30/2010
Home Bias in Equity Portfolios
Country
Share in World Market
Vl
Value
Proportion of Domestic
E iti in
Equities
i Portfolio
P tf li
France
2.6%
64.4%
Germany
3.2%
75.4%
Italy
1.9%
91.0%
Japan
43.7%
86.7%
Spain
p
1.1%
94.2%
Sweden
0.8%
100.0%
United Kingdom
10.3%
78.5%
36.4%
98.0%
United States
Total
100.0%
15-38
Why Home Bias in Portfolio Holdings?

Three explanations come to mind:
1. Domestic equities may provide a superior
inflation hedge.
2. Home bias may reflect institutional and
legal restrictions on foreign investment.
3. Extra taxes and transactions/information
costs for foreign securities may give rise to
home bias.
15-39
20
11/30/2010
Why Home Bias in Portfolio Holdings?


A recent study of the brokerage records of tens
of thousands of U.S. individual investors shows
that wealthier, more experienced, and
sophisticated investors are more likely to invest
in foreign securities.
Another study shows that when a country is
remote and has an uncommon language, foreign
investors tend to stay away.
15-40
21
In Class Exercise # 1: Chapter 15
Use the following information on British Air stocks, bonds and the British pound during the 2009-2010
period:
1/1/2009
1/1/2010
Div /Coupon
British Air stock price level (in British pounds)
BP 78.75
BP 95.67
BP 1.50
British Air bond price level (in British pounds)
BP 950
BP 920
BP 95.00
Dollar price of British pounds
$ 1.75
$ 1.60
Standard deviation of the percentage change in the returns (in
BP) on British Air stock during the 2009-2010 period:
22.50%
Standard deviation of the percentage change in the returns (in
BP) on British Air bonds during the 2009-2010 period:
8.25%
Standard deviation of the percentage change in the dollar price
of British pounds during the 2009-2010 period:
17.00%
Correlation coefficient between the returns on the British Air
stocks and the British pound
0.31
Correlation coefficient between the returns on the British Air
bonds and the British pound
0.52
a) Calculate the percentage return over the 2009-2010 period, in US dollar terms, for:
(i) British Air stocks
(ii) British Air bonds
b) Calculate the standard deviation of returns over the 2009-2010 period, in US dollar terms for:
(i) British Air stocks
(ii) British Air bonds
In Class Exercise # 2: Chapter 15
Suppose you wish to invest in a portfolio which has Use the following information on the stocks of
Samsung (a Korean company) and Mexico Air (a Mexican company) during the 2009-2010 period:
Returns (in $) on Samsung stock during the 2009-2010 period:
30 %
Returns (in $) on Mexico Air stocks during the 2009-2010 period:
10 %
Standard deviation of returns (in $) on Samsung stock during the 2009-2010 period:
25 %
Standard deviation returns (in $) on Mexico Air stocks during the 2009-2010 period:
12 %
Correlation coefficient between the returns on the Samsung and Mexico Air stocks
0.25
Calculate the percentage return and the standard deviation of returns over the 2009-2010 period, in US
dollar terms for a portfolio which consisted of 60% Samsung and 40% in Mexico Air stocks:
In Class Exercise # 3: Chapter 15
Use the following information on Ericsson and Mexico Air stocks, the Swedish Krona and the Mexican
Pesos during the 2009-2010 period:
1/1/09
1/1/10
Div/Shr
Ericsson (ER) stock price level (in Swedish Krona)
Kr 55.00
Kr 45.00
Kr 2.5
Mexico Air (MA) stock price level (in Mexican Pesos)
MP 880
MP 1130
MP 18.0
Dollar price of Swedish Krona
$ 0.075
$ 0.1005
Dollar price of Mexican Pesos
$ 0.1055
$ 0.1050
Standard deviation of returns (in Kr) on ER stock
during the 2009-2010 period:
12.50%
Standard deviation of returns (in MP) on MA stocks
during the 2009-2010 period:
18.25%
Standard deviation of the percentage change in the
dollar price of Kr during the 2009-2010 period:
17.00%
Standard deviation of the percentage change in the
dollar price of MP during the 2009-2010 period:
29.00%
Correlation coefficient between the returns on the ER
stocks and the Kr
0.28
Correlation coefficient between the returns on the MA
stocks and the MP
0.35
Correlation coefficient between the returns on the MA
stocks and ER stocks
0.03
R
a) Calculate the percentage return and the standard deviation of returns over the 2009-2010 period, in
US dollar terms, for:
(i) Ericsson (ER) stocks:
RER$ =
σER$2 =
σER$ =
(ii) Mexico Air (MA) stocks:
RMA$ =
σMA$2 =
σMA$ =
b) Calculate the percentage return and the standard deviation of returns over the 2009-2010 period, in
US dollar terms for a portfolio which consisted of 25% ER and 75% in MA stocks:
RP$ =
σP$2 =
σP$ =
In Class Exercise # 4: Chapter 15
Use the following information on the stocks of Matusita (a Japanese company) and Mexico Air (a
Mexican company), the Japanese Yen and the Mexican Pesos during the 2009-2010 period:
1/1/2009
1/1/2010
Div/Shr
Matusita (MT), a Japanese company’s, stock price level (in JY)
JY 1575
JY 1740
JY 180
Mexico Air (MA) stock price level (in MP)
MP 875
MP 1030
MP 25
Dollar price of Japanese Yen (JY)
$ 0.0075
$ 0.0078
Dollar price of Mexican Pesos (MP)
$ 0.1000
$ 0.0900
Standard deviation of returns (in JY) on Matusita stock during
the 2009-2010 period:
15 %
Standard deviation returns (in MP) on Mexico Air stocks during
the 2009-2010 period:
20 %
Standard deviation of the percentage change in the dollar price
of JY during the 2009-2010 period:
5%
Standard deviation of the percentage change in the dollar price
of MP during the 2009-2010 period:
10 %
Correlation coefficient between the returns on the Matusita
(MT) stocks and the JY
0.75
Correlation coefficient between the returns on the Mexico Air
(MA) stocks and the MP
0.25
Correlation coefficient between the returns on the Matusita
(MT) and Mexico Air (MA) stocks
0.10
a) Calculate the percentage return and the standard deviation of returns over the 2009-2010 period, in
US dollar terms, for:
(i) Matusita (MT) stocks
RMT$ =
σMT$2 =
σMT$ =
(ii) Mexico Air stocks
RMA$ =
σMA$2 =
σMA$ =
b) Calculate the percentage return and the standard deviation of returns over the 2009-2010 period, in
US dollar terms for a portfolio which consisted of 60% Matusita and 40% in Mexico Air stocks:
RP$ =
σP$2 =
σP$ =
R
Variable Definition
P0A,P1A ,DA = Beginning price, ending price, and dividends or interests of foreign
security A (stocks or bonds) measured in foreign currency X1
P0B,P1B ,DB = Beginning price, ending price, and dividends or interests of foreign
security B (stocks or bonds) measured in foreign currency X2
SR0, SR1= Beginning and ending spot rates for foreign currency of country A or B
RSA, RSB = Return on foreign securities A and B (stocks or bonds) measured in
foreign currency
RXA ,RXB = Return on foreign currency of countries A and B measured in US dollars
R$A, R$B = Dollar return on foreign securities A and B (stocks or bonds)
SASB = Standard deviation of return on foreign security A and B measured in
foreign currency
XA XB = Standard deviation of return on foreign currency countries A and B
measured in US dollars
$A$B = Standard deviation of dollar return on foreign securities A and B
SA,XA
SA XA = Correlation coefficient of returns on foreign security A measured in foreign
currency and the dollar return on foreign currency of country A
SB,XB = Correlation coefficient of returns on foreign security B measured in foreign
currency and the dollar return on foreign currency of country B
A,B = Correlation coefficient of returns on foreign security A and returns on foreign
security B
R$P = Dollar return on a portfolio containing securities A & B
$P = Standard deviation of dollar return on a portfolio containing securities A & B
WA, WB = Proportion of funds invested in security A and security B
Formulas for Chapter 15
RSA = (P1A - P0A + DA) / P0A : Foreign currency return on security A
RSB = (P1B - P0B + DB) / P0B : Foreign currency return on security B
RXA,RXB = (SR1 - SR0) / SR0 : Dollar return on foreign currency of countries A or B
R$A = (1 + RSA ) * (1 + RXA ) – 1 : Dollar return on security A
R$B = (1 + RSB ) * (1 + RXB ) – 1 : Dollar return on security B
$A = [SA2 + XA2 + 2*SA*XA*SA,XA ]1/2 : Standard deviation of dollar return on
security A
$B = [
[ SB2 + XB2 + 2*
2* SB*
* XB*
* SB,XB ]1/2 : Standard deviation of dollar return on
security B
R$P = WA* R$A + WB * R$B : Dollar return on the portfolio containing securities A & B
$P = [ WA2 * $A2 + WB2 * $B2 + 2 *WA* WB*$A*$B*AB ]1/2:
Standard deviation of dollar return on the portfolio containing securities A & B
1