International Portfolio
Investments
11
Chapter Eleven
INTERNATIONAL
Chapter Objectives:
FINANCIAL
Why investors diversify their portfolios internationally.
How much investors can gain from MANAGEMENT
international
diversification.
The effects of fluctuating exchange rates on international
Third Edition
portfolio investments.
Whether and how much investors can benefit
from
EUN
/ RESNICK
investing in U.S. based international mutual funds.
The reasons for “home bias” in portfolio holdings.
Chapter 11
International
Portfolio
Investments
Chapter Outline
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
Chapter Outline (continued)
International Diversification through Country
Funds
International Diversification with ADRs
International Diversification with WEBS
Why Home Bias in Portfolio Holdings?
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.
International Correlation Structure
Stock Market
AU
FR
Australia (AU)
.586
France (FR)
.286
.576
Germany (GM)
.183
.312
Japan (JP)
.152
.238
Netherlands
(NP)
.241
.344
Switzerland
(SW)
.358
United Kingdom
(UK)
United States
(US)
GM
JP
NL
SW
UK
US
Relatively low international correlations
imply that investors should be able to
.653
reduce portfolio risk more if they
diversify internationally
.300
.416
rather than domestically.
.509
.282
.624
.368
.475
.281
.517
.664
.315
.378
.299
.209
.393
.431
.698
.304
.225
.170
.137
.271
.272
.279
.439
Portfolio Risk (%)
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.
0.44
Swiss stocks
0.27
U.S. stocks
International stocks
0.12
1
10
20
30
40
50 Number of
Stocks
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 70%.
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.
Summary Statistics for Monthly
Returns 1980-2001 ($U.S.)
Correlation Coefficient
Stock Market
CN
FR
GM
JP

Mean
(%)
SD
(%)
.88
5.78
0.99
1.19
6.29
1.00
1.09
6.26
0.91
0.91
6.99
1.20
1.23
5.55
0.98
1.26
4.43
0.86
UK
Canada (CN)
France (FR)
0.46
Germany
(GM)
0.42
.88% monthly return =
10.56% per year
0.69
Japan (JP)
0.33
0.41
0.33
United
Kingdom
0.57
0.57
0.50
0.42
United States
0.74
0.50
0.45
0.31
0.58
Summary Statistics for Monthly
Returns 1980-2001 ($U.S.)
Correlation Coefficient
Stock Market
CN
FR
GM
JP
France (FR)
0.46
Germany
(GM)
0.42
Japan (JP)
0.33
0.41
0.33
United
Kingdom
0.57
0.57
0.50
0.42
United States
0.74
0.50
0.45
0.31
SD
(%)
.88
5.78
0.99
1.19
6.29
1.00
1.09
6.26
0.91
0.91
6.99
1.20
1.23
5.55
0.98
1.26
4.43
0.86
UK
 measures the sensitivity of the
market to the world market.
Canada (CN)

Mean
(%)
Clearly the Japanese market is
0.69more sensitive to the world
market than is the U.S.
0.58
Mean Return (monthly)
The Optimal International Portfolio
3
2.5
2
OIP
1.53
1.5
Efficient set
JP
US
UK
1
GM
Rf
0.5
FR
CN
0
0
2
4
4.2%
6
Standard Deviation (monthly)
8
Composition of the OIP for a U.S. Investor
(Holding Period: 1980—2000
Hong Kong market
1.61%
Italian market
Netherlands
market
1.14%
29.96%
Swedish market
U.S. market
26.45%
40.84%
Total
100.00%
For a U.S. investor, OIP has
more return and more risk. The
Sharpe measure is 20% higher,
suggesting that an equivalentrisk OIP would have 1.68%
more return than a domestic
portfolio.
OIP
ODP
Mean
Return
1.42%
1.26%
Standard
Deviation
4.51%
4.43%
return
Gains from
International Diversification
OIP
1.42%
1.26%
ODP
4.51%
4.43%
risk
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.
Effects of Changes
in the Exchange Rate
The realized dollar return for a U.S. resident investing in a
foreign market is given by
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
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
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$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + Var
The Var term represents the contribution of the
cross-product term, Riei, to the risk of foreign
investment.
Effects of Changes
in the Exchange Rate
Var(Ri$) = 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 with the local market returns Cov(Ri,ei).
3. The contribution of the cross-product term, Var.
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.
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.
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. 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
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
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
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.
2.
3.
Speculate in a single foreign market with minimum cost.
Construct their own personal international portfolios.
Diversify into emerging markets that are otherwise practically
inaccessible.
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
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.
International Diversification
with ADRs
Adding ADRs to domestic portfolios has a
substantial risk reduction benefit.
World Equity Benchmark Shares
World Equity Benchmark Shares (WEBS)
– Country-specific baskets of stocks designed to
replicate the country indexes of 14 countries.
– WEBS are subject to U.S. SEC and IRS
diversification requirements.
– Low cost, convenient way for investors to hold
diversified investments in several different countries.
International Diversification with
WEBS
Recent research suggests that WEBs are an
excellent tool for international risk diversification.
For investors who desire international exposure,
WEBs may well serve as a major alternative to
such traditional tools as international mutual
funds, ADRs, and closed-end country funds
Why Home Bias in
Portfolio Holdings?
Home bias refers to the extent to which portfolio
investments are concentrated in domestic
equities.
The Home Bias in Equity Portfolios
Country
Share in World Market
Value
Proportion of Domestic
Equities in Portfolio
France
2.6%
64.4%
Germany
3.2%
75.4%
Italy
1.9%
91.0%
Japan
43.7%
86.7%
Spain
1.1%
94.2%
Sweden
0.8%
100.0%
United Kingdom
10.3%
78.5%
United States
36.4%
98.0%
Total
100.0%
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.