Chapter 17
International
Portfolio
Theory and
Diversification
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International Diversification
and Risk
• The case for international diversification of portfolios can be
decomposed into two components, the first of which is the
potential risk reduction benefits of holding international securities.
• This initial focus is on risk.
• The risk of a portfolio is measured by the ratio of the variance of a
portfolio’s return relative to the variance of the market return
(portfolio beta).
• As an investor increases the number of securities in a portfolio,
the portfolio’s risk declines rapidly at first, then asymptotically
approaches the level of systematic risk of the market.
• A domestic portfolio that is fully diversified would have a beta of
1.0.
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Exhibit 17.1 Portfolio Risk
Reduction Through Diversification
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International Diversification
and Risk
• The total risk of any portfolio is therefore
composed of systematic risk (the market)
and unsystematic risk (the individual
securities).
• Increasing the number of securities in the
portfolio reduces the unsystematic risk
component leaving the systematic risk
component unchanged.
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International Diversification
and Risk
• The second component of the case for international diversification
addresses foreign exchange risk.
• The foreign exchange risks of a portfolio, whether it be a securities
portfolio or the general portfolio of activities of the MNE, are
reduced through international diversification.
• Purchasing assets in foreign markets, in foreign currencies may
alter the correlations associated with securities in different
countries (and currencies).
• This provides portfolio composition and diversification possibilities
that domestic investment and portfolio construction may not
provide.
• The risk associated with international diversification, when it
includes currency risk, is very complicated when compared to
domestic investments.
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International Diversification
and Risk
• International diversification benefits induce investors to
demand foreign securities (the so called buy-side).
• If the addition of a foreign security to the portfolio of the
investor aids in the reduction of risk for a given level of
return, or if it increases the expected return for a given
level of risk, then the security adds value to the portfolio.
• A security that adds value will be demanded by investors,
bidding up the price of that security, resulting in a lower
cost of capital for the issuing firm.
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Exhibit 17.2 Portfolio Risk Reduction
Through International Diversification
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Internationalizing the Domestic
Portfolio
• Classic portfolio theory assumes a typical investor is
risk-averse.
• This means an investor is willing to accept some risk
but is not willing to bear unnecessary risk.
• The typical investor is therefore in search of a portfolio
that maximizes expected portfolio return per unit of
expected portfolio risk.
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Internationalizing the Domestic
Portfolio
• The domestic investor may choose among a set of
individual securities in the domestic market.
• The near-infinite set of portfolio combinations of domestic
securities form the domestic portfolio opportunity set
(next exhibit).
• The set of portfolios along the extreme left edge of the
set is termed the efficient frontier.
• This efficient frontier represents the optimal portfolios of
securities that possess the minimum expected risk for
each level of expected portfolio return.
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Internationalizing the Domestic
Portfolio
• The portfolio with the minimum risk along all those possible
is the minimum risk domestic portfolio (MRDP).
• The individual investor will search out the optimal domestic
portfolio (DP), which combines the risk-free asset and a
portfolio of domestic securities found on the efficient frontier.
• He or she begins with the risk-free asset (Rf) and moves out
along the security market line until reaching portfolio DP.
• This portfolio is defined as the optimal domestic portfolio
because it moves out into risky space at the steepest slope.
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Exhibit 17.3 Optimal Domestic
Portfolio Construction
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International Diversification
and Risk
• The next exhibit illustrates the impact of allowing
the investor to choose among an internationally
diversified set of potential portfolios.
• The internationally diversified portfolio opportunity
set shifts leftward of the purely domestic
opportunity set.
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Exhibit 17.4 The Internationally Diversified
Portfolio Opportunity Set
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International Diversification
and Risk
• It is critical to be clear as to exactly why the
internationally diversified portfolio opportunity set
is of lower expected risk than comparable
domestic portfolios.
• The gains arise directly from the introduction of
additional securities and/or portfolios that are of
less than perfect correlation with the securities
and portfolios within the domestic opportunity set.
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International Diversification
and Risk
• The investor can now choose an optimal portfolio that combines the
same risk-free asset as before with a portfolio from the efficient
frontier of the internationally diversified portfolio opportunity set.
• The optimal international portfolio, IP, is again found by locating
that point on the capital market line (internationally diversified)
which extends from the risk-free asset return of Rf to a point of
tangency along the internationally diversified efficient frontier.
• The benefits are obvious in that a higher expected portfolio return
with a lower portfolio risk can be obtained when compared to the
domestic portfolio alone.
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Exhibit 17.5 The Gains from
International Portfolio Diversification
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International Diversification
and Risk
• An investor can reduce investment risk by
holding risky assets in a portfolio.
• As long as the asset returns are not
perfectly positively correlated, the investor
can reduce risk, because some of the
fluctuations of the asset returns will offset
each other.
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Exhibit 17.6 Alternative Portfolio Profiles
Under Varying Asset Weights
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National Markets
and Asset Performance
• Asset portfolios are traditionally constructed using both
interest bearing risk-free assets and risky assets.
• For the 100 year period ending in 2000, the risk of investing
in equity assets has been rewarded with substantial returns.
• The true benefits of global diversification, however, arise
from the fact that the returns of different stock markets
around the world are not perfectly positively correlated.
• This is because the are different industrial structures in
different countries, and because different economies do not
exactly follow the same business cycle.
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National Markets
and Asset Performance
• Interestingly, markets that are contiguous or nearcontiguous (geographically) seemingly demonstrate the
higher correlation coefficients for the past century.
• It is often said that as capital markets around the world
become more and more integrated over time, the benefits of
diversification will be reduced.
• Analysis of market data supports this idea (although the
correlation coefficients between markets are still far from
1.0).
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Market Performance Adjusted for Risk:
The Sharpe and Treynor Performance
Measures
• To consider both risk and return in evaluating
portfolio performance, we introduce two measures:
The Sharpe Measure (SHP)
= SHPi = Ri – Rf
σi
The Treynor Measure (TRN)
= TRNi = Ri – Rf
βi
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Market Performance Adjusted for Risk:
The Sharpe and Treynor Performance
Measures
• Though the equations of the Sharpe and Treynor
measures look similar, the difference between them is
important.
• If a portfolio is perfectly diversified (without any
unsystematic risk), the two measures give similar
rankings, because the total portfolio risk is equivalent to
the systematic risk.
• If a portfolio is poorly diversified, it is possible for it to
show a high ranking on the basis of the Treynor measure,
but a lower ranking on the basis of the Sharpe measure.
• As the difference is attributable to the low level of
portfolio diversification, the two measures therefore
provide complimentary but different information.
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Mini-Case Questions: Is Modern
Portfolio Theory Outdated?
• Why might the bell curve not be helpful
when trying to construct and manage
modern financial portfolios?
• What risks are created if most of the major
market agents are using the same models
at the same times?
• Since the time of the article, the world
economy has suffered a significant crisis.
What elements of the article may have
proved correct?
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Chapter 17
Additional
Chapter
Exhibits
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Exhibit 17.7 Real Returns and Risks on the
Three Major Asset Classes, Globally, 1900–2000
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Exhibit 17.8 Correlation Coefficients
between World Equity Markets, 1900–
2000
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Exhibit 17.9 Summary Statistics of the Monthly Returns for 18
Major Stock Markets, 1977–1996 (all returns converted into U.S.
dollars and include all dividends paid)
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Exhibit 17.10 Comparison of Selected
Correlation Coefficients between Stock Markets
for Two Time Periods (dollar returns)
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