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International Portfolio Investment Chapter 15

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Page 1: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

International Portfolio Investment

Chapter 15

Page 2: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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Why Invest Internationally?

What are the advantages of international investment?

Page 3: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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THE BENEFITS OF INTERNATIONALEQUITY INVESTING

I. THE BENEFITS OF INTERNATIONAL

EQUITY INVESTING

A. Advantages

1. Offers more opportunities than

a purely domestic portfolio

2. Attractive investments overseas

3. Impact on efficient portfolio with diversification benefits

Page 4: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

4

Basic Portfolio Theory:

What is the efficient frontier?

It represents the most efficient combinations of all possible risky assets.

Page 5: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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The Efficient Frontier

E(r)

A

B

Page 6: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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Basic Portfolio Theory:

The broader the diversification, the more stable the returns and the more diffuse the risk.

Page 7: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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INTERNATIONAL DIVERSIFICATION

B.International Diversification

1. Risk-return tradeoff:

may be greater

Page 8: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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Basic Portfolio Theory:

Total Risk of a Security’s Returns may be segmented into

Systematic Risk

can not be eliminated

Non-systematic Risk

can be eliminated by diversification

Page 9: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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The Benefits of Int’l Diversification

Page 10: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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INTERNATIONAL DIVERSIFICATION

2. International diversification and systematic risk

a. Diversify across nations withdifferent economic cycles

b. While there is systematic riskwithin a nation, outside the

country it may be nonsystematic and diversifiable

Page 11: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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INTERNATIONAL PORTFOLIO INVESTMENT

3. Recent History

a. National stock markets have wide

differences in returns and risk.

b. Emerging markets have higher

risk and return than developed

markets.

c. Cross-market correlations have

been relatively low.

Page 12: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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INTERNATIONAL PORTFOLIO INVESTMENT

3. Theoretical Conclusion

International diversification pushes out the efficient frontier.

Page 13: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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The New Efficient FrontierE(r)

A

B

C

Page 14: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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CROSS-MARKET CORRELATIONS

6. Cross-market correlations

a. Recent markets seem to be most correlated when volatility is

greatest

b. Result:

Efficient frontier retreats

Page 15: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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The Frontier During Global Crises

E(r)

A

B

C

Page 16: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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Investing in Emerging Markets

D. Investing in Emerging Markets

a. Offers highest risk and returns

b. Low correlations with returns

elsewhere

c. As impediments to capital market mobility fall, correlations are

likely to increase in the future.

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Barriers to International DiversificationE.Barriers to International Diversification

1. Segmented markets2. Lack of liquidity3. Exchange rate controls4. Underdeveloped capital markets5. Exchange rate risk6. Lack of information

a. not readily accessibleb. data is not comparable

Page 18: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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Other Methods to Diversify

F. Diversify by a 1. Trade in American Depository

Receipts (ADRs)2. Trade in American shares3. Trade internationally diversified

mutual funds:a. Global (all types)b. International (no home

country securities)c. Single-country

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INTERNATIONAL PORTFOLIO INVESTMENT

4. Calculation of Expected Portfolio Return:

rp = a rUS + ( 1 - a) rrw

where

rp = portfolio expected return

rUS = expected U.S. market return

rrw = expected global return

Page 20: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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Portfolio Return

Sample ProblemWhat is the expected return of a portfolio with 35% invested in Japan returning 10% and 65% in the U.S. returning 5%?

rp = a rUS + ( 1 - a) rrw

= .65(.05) + .35(.10) = .0325 + .0350= 6.75%

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INTERNATIONAL PORTFOLIO INVESTMENT

5. Calculation of Expected Portfolio Risk

where = the cross-market correlation

US2 = U.S. returns variance

r w2 = World returns variance

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Portfolio Risk

What is the risk of a portfolio with 35% invested in Japan with a standard deviation of 6% and a standard deviation of 8% in the U.S. and a correlation coefficient of .7?

= [(.65)2 (.08) 2 + (.35) 2(.06) 2 +2(.65)(.35)(.08)(.06)(.7)] 1/2

= 6.8%

1/ 22 2 2 2(1 ) 2 (1 )P US rw US rwa a a a

1/ 22 2 2 2(1 ) 2 (1 )P US rw US rwa a a a

Page 23: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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INTERNATIONAL PORTFOLIO INVESTMENT

IV. MEASURING TOTAL RETURNS

FROM FOREIGN PORTFOLIOS

A. To compute dollar return of a foreign security:

or

1 0$

0

( )( )US ForeignCurrency

e eR R

e

0 1$

1

( )( )US ForeignCurrency

e eR R

e

Page 24: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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Flash Back!

For currency appreciation:

For currency depreciation:

1 0$

0

( )( )US ForeignCurrency

e eR R

e

0 1$

1

( )( )US ForeignCurrency

e eR R

e

Page 25: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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INTERNATIONAL PORTFOLIO INVESTMENT

Bond (calculating return) formula:

where R$ = dollar return B(1) = foreign currency bond price at time 1 (present)

C = coupon income during periodg = currency depreciation or appreciation

$

(1) (0)1 1 (1 )

(0)

B B CR g

B

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INTERNATIONAL PORTFOLIO INVESTMENT

B. Stocks (Calculating return)

Formula:

where R$ = dollar returnP(1) = foreign currency stock price at time 1D = foreign currency annual

dividend

$

(1) (0)1 1 (1 )

(0)

P P DR g

P

$

(1) (0)1 1 (1 )

(0)

P P DR g

P

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U.S. $ Stock Returns:Sample Problem

Suppose the beginning stock price if FF50 and the ending price is FF48. Dividend income was FF1. The franc depreciates from FF 20 /$ to FF21.05 /$ during the year against the dollar.

What is the stock’s US$ return for the year?

Page 28: International Portfolio Investment Chapter 15. 2 Why Invest Internationally? What are the advantages of international investment?

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U.S. $ Stock Returns:Sample Solution

$

(1) (0)1 1 (1 )

(0)

P P DR g

P

48 50 1 .20 .21051 1 1

50 .2105

.98 .95 1

$ 6.9%R $ 6.9%R