Management 3460
Institutions and Practices in
International Finance
Fall 2003
Greg Flanagan
International Portfolio
Investment

Chapter Objectives
The student will be able to:
 explain how investors can gain from international diversification.
 explain the effects of fluctuating exchange rates on international portfolio investments.
 explain optimal international portfolio selection.
 describe different approaches to optimal international portfolio selection.
 discuss the reasons for “home bias” in portfolio holdings.
November 13, 2003 2

International Correlation Structure and Risk Diversification
 Security returns are much less correlated across countries than within a country.
 economic, political, institutional, and even psychological factors affecting equity returns tend to vary across countries, resulting in low correlations among international securities.
 business cycles are often high counter cyclical across countries.
November 13, 2003 3

Increased Investment in Foreign Equities (US)
4 November 13, 2003

Stock Market
International Correlation
Structure
AU FR GM JP NL SW UK
.586
Australia
(AU)
France (FR)
Germany
(GM)
Japan (JP)
.286
.183
.152
.576
.312
.238
.344
US
Relatively low international correlations imply that investors should be able to
.653
.300
.509
reduce portfolio risk more if they diversify internationally
.416
rather than domestically.
.282
.624
Netherlands
(NP)
Switzerland
(SW)
United
Kingdom
(UK)
United States
(US)
5
.241
.358
.315
.304
.368
.378
.225
.475
.299
.170
.281
.209
.137
.517
.393
.271
.664
.431
.272
.698
.279
.439
November 13, 2003

0.44
Domestic vs. International
Diversification
When fully diversified, an international portfolio can be less than half as risky as a purely U.S. portfolio.
A fully diversified international portfolio is only 12 percent as risky as holding a single security.
Swiss stocks
0.27
0.12
6
1
U.S. stocks
International stocks
10 20 30 40 50
Number of Stocks November 13, 2003

Optimal International
Portfolio Selection
 The correlation of the one stock market with the returns on the stock markets in other nations varies.
 The correlation of the Canadian stock market with U.S. the stock market is 74%.
 The correlation of the U.S. stock market with the Japanese stock market is 24%.
 A U.S. investor would get more diversification from investments in Japan than Canada.
November 13, 2003 7

Optimal International
Portfolio Selection
 Mean return on investment
 Standard deviation (measure of risk)
 World beta b measures the sensitivity to world markets.
 covariance between the national market and the world market index divided by the variance
 of the world market b i
= s iw
/ s w
2
November 13, 2003 8

Stock Market
Canada (CN)
France (FR)
Germany
(GM)
Japan (JP)
United
Kingdom
United States
9
Summary Statistics for Monthly
Returns 1980-2001 ($U.S.) b
CN
0.46
0.42
0.33
0.57
0.74
Correlation Coefficient
Mean
(%)
FR GM JP UK
.88
0.69
.88% monthly return =
10.56% per year
1.19
1.09
0.41
0.57
0.33
0.50
0.42
0.91
1.23
0.50
0.45
0.31
0.58
1.26
SD
(%)
5.78
6.29
6.26
6.99
5.55
0.99
1.00
0.91
1.20
0.98
4.43
0.86
November 13, 2003

Summary Statistics for Monthly
Returns 1980-2001 ($U.S.)
Stock Market
Canada (CN)
France (FR)
Germany
(GM)
Japan (JP)
United
Kingdom
United States
10
0.57
0.74
Correlation Coefficient
Mean
(%)
SD
(%) b
CN
0.46
0.42
FR GM JP UK b measures the sensitivity of the market to the world market.
.88
5.78
0.99
1.19
6.29
1.00
The Japanese market is more
0.69
sensitive to the world
1.09
market than is the U.S.
6.26
0.91
0.33
0.41
0.33
0.91
6.99
1.20
0.57
0.50
0.50
0.45
0.42
0.31
0.58
1.23
1.26
5.55
0.98
4.43
0.86
November 13, 2003

Optimal International
Portfolio Selection
 Sharpe performance measure provides a risk adjusted performance
 R f the risk free return (T-bill rate)
 R i the mean return for country i
 Standard deviation s i
—the measure of variance (risk)
 SHP = ( R i
– R f
)/ s i
 a the excess return per std. dev. risk.
November 13, 2003 11

Summary Statistics for Monthly
Returns 1980-2001 ($U.S.)
Correlation Coefficient
Stock Market SHP Rank
CN
Canada (CN)
France (FR) 0.46
0.42
Germany
(GM)
Japan (JP) 0.33
United
Kingdom
United States
12
0.57
0.74
FR GM
0.69
0.41
0.57
0.50
0.33
0.50
0.45
JP UK
0.42
0.31
0.58
.057
0.102
0.086
0.052
0.123
0.160
11
6 Low return
9
12
4
2
November 13, 2003 Low risk

Optimal International
Portfolio Selection
 Maximize the SHP for the portfolio
 Based expected return!
 SHP
P
= [E( R p
) – R f
]/ s p
(p = portfolio)
 E( R p
) =
S i x i
R i
 where x is the weight of the asset
 and
S i x i
= 1
 s p =
[
S i
S j x i x j s ij
] 1/2
13 November 13, 2003

Composition of the OIP for a U.S.
Investor (Holding Period: 1980 —2000)
Hong Kong market
Italian market
1.61%
1.14%
Netherlands market 29.96%
Swedish market 26.45%
U.S. market
Total
40.84%
100.00%
November 13, 2003 14

Gains from
International Diversification
 For a U.S. investor, OIP has more return and more risk. The Sharpe measure is 20% higher, suggesting that an equivalent-risk OIP
1.42%
1.26% would have 1.68% more return than a domestic portfolio.
ODP
OIP
4.51%
4.43% risk
November 13, 2003 15

16 November 13, 2003

17 November 13, 2003

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.
November 13, 2003 18

Effects of Changes in the Exchange Rate
 The realized dollar return for a U.S. resident investing in a foreign market is given by
R i $
= (1 + R i
)(1 + e i
) – 1
= R i
+ e i
+ R i e i
Where
R i is the local currency return in the i th market e i is the rate of change in the exchange rate between the local currency and the dollar
November 13, 2003 19

Effects of Changes in the Exchange Rate
 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%:
R i $
= (1 + .15)(1 –0.05) – 1
= .
15 + -.05 + .15
× (-.05) =0.925
November 13, 2003 20

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( R i $
) = Var( R i
) + Var( e i

Var
) + 2Cov( R i
, e i
) +
The

Var term represents the contribution of the cross-product term, R i e i
, to the risk of foreign
November 13, 2003

Effects of Changes in the Exchange Rate
Var( R i $
) = Var( R i
) + Var( e i
) + 2Cov( R i
, e i
) +

Var
This equation demonstrates that exchange rate fluctuations contribute to the risk of foreign investment through three channels:
1.
Its own volatility, Var( e i
).
2.
Its covariance with the local market returns
Cov( R i
, e i
).
3.
The contribution of the cross-product term,

Var.
November 13, 2003 22

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-return characteristics of the euro-zone bond markets enhancing the importance of non-euro currency bonds.
23 November 13, 2003

International Mutual Funds:
A Performance Evaluation
 A U.S. investor can easily achieve international diversification by investing in a
U.S.-based international mutual fund.
 The advantages include
1.
Savings on transaction and information costs.
2.
Circumvention of legal and institutional barriers to direct portfolio investments abroad.
3.
Professional management and record keeping.
November 13, 2003 24

International Mutual Funds:
A Performance Evaluation
As can be seen below, a sample of U.S. based international mutual funds has outperformed the S&P 500 during the period 1977-1986, with a higher standard deviation. b
US
Mean
Annual
Return
18.96%
Standard
Deviation b
US
R 2
U.S. Based
International
Mutual Funds
S&P 500
5.78% 0.69
0.39
14.04% 4.25% 1.00
1.00
U.S. MNC
Index
25
16.08% 4.38
.98
.90
November 13, 2003

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 b
US
R 2
U.S. Based
International
Mutual Funds
S&P 500
U.S. MNC Index
26
18.96%
14.04%
16.08%
5.78%
4.25%
4.38
0.69
1.00
.98
0.39
1.00
.90
November 13, 2003

International Diversification through 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 county. 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 are
November 13, 2003

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
November 13, 2003 28

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.
November 13, 2003 29

World Equity Benchmark iShares
 iShares (formally WEBS)
 Country-specific baskets of stocks designed to replicate the country indexes of many countries.
 iShares are subject to U.S. SEC and IRS diversification requirements.
 Low cost, convenient way for investors to hold diversified investments in several different countries.
November 13, 2003 30

International Diversification with iShares
 Recent research suggests that iShares are an excellent tool for international risk diversification.
 For investors who desire international exposure, iShares may well serve as a major alternative to such traditional tools as international mutual funds, ADRs, and closed-end country funds
November 13, 2003 31

Why Home Bias in
Portfolio Holdings?
 Home bias refers to the extent to which portfolio investments are concentrated in domestic equities.
November 13, 2003 32

The Home Bias in Equity
Portfolios
Country
France
Germany
Italy
Japan
Spain
Sweden
United Kingdom
United States
Total
Share in World Market
Value
2.6%
3.2%
1.9%
43.7%
1.1%
0.8%
10.3%
36.4%
100.0%
33
Proportion of Domestic
Equities in Portfolio
64.4%
75.4%
91.0%
86.7%
94.2%
100.0%
78.5%
98.0%
November 13, 2003

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.
November 13, 2003 34