international portfolio investment chapter 15. lecture objectives international correlation...
TRANSCRIPT
![Page 1: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/1.jpg)
International Portfolio Investment
Chapter 15
![Page 2: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/2.jpg)
Lecture Objectives
International Correlation Structure and Risk DiversificationOptimal International Portfolio SelectionEffects of Changes in the Exchange RateInternational Bond InvestmentInternational Mutual Funds: A Performance EvaluationInternational Diversification through Country FundsInternational Diversification with ADRsInternational Diversification with WEBSWhy Home Bias in Portfolio Holdings?
![Page 3: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/3.jpg)
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.
![Page 4: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/4.jpg)
International Correlation Structure
Source: MSCI 1980-2007
Stock Market AU CA FR GE HK IT JA UK US
Australia 0.62 0.40 0.37 0.46 0.28 0.34 0.55 0.48
Canada 0.49 0.45 0.47 0.39 0.35 0.58 0.73
France 0.73 0.32 0.53 0.41 0.61 0.54
Germany 0.36 0.48 0.32 0.55 0.52
Hong Kong 0.30 0.27 0.49 0.42
Italy 0.37 0.42 0.33
Japan 0.42 0.31
UK 0.61
US
![Page 5: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/5.jpg)
Domestic vs. International Diversification
0.44
0.27
0.12Por
tfol
io R
isk
(%)
Number of Stocks1 10 20 30 40 50
Swiss stocks
U.S. stocks
International stocks
When fully diversified, an international portfolio can be less than half as risky as a purely U.S. portfolio.
![Page 6: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/6.jpg)
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 73%.
The correlation of the 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.
![Page 7: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/7.jpg)
Optimal International PortfolioEfficient frontier
OIP
2.0%
1.5%
1.0%
0.5%
0.0%
US
JP
HKSD
ITGM
CNSWUK
NL
Monthly Standard Deviation0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10%
Rf
Mon
thly
Ret
urn
![Page 8: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/8.jpg)
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%
U.S. 20.70%
Total 100.00%
![Page 9: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/9.jpg)
1.40%
1.11%
Gains from International Diversification
For a U.S. investor, OIP has more return and more risk. The Sharpe measure is 30% for OIP, suggesting that an equivalent-risk OIP would have more return per unit of risk than a domestic portfolio. risk-return tradeoff for the optimal international portfolio and optimal domestic portfolio are shown below and at right.
OIP ODP
Mean Return
1.40% 1.11%
Standard Deviation
4.74% 4.25%
risk
retu
rn
4.25% 4.74%
OIP
ODP
![Page 10: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/10.jpg)
Effects of Changes in the Exchange Rate
The realized dollar return for a U.S. resident investing in a foreign market will depend on• the return in the foreign market• the change in the exchange rate between the
U.S. dollar and the foreign currency
![Page 11: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/11.jpg)
Effects of Changes in the Exchange Rate
The realized dollar return for a U.S. resident investing in a foreign market is given by
1)1)(1($ iii eRR
iiii eReR 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
![Page 12: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/12.jpg)
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%:
$ (1 .15)[1 ( .05)] 1 .0925iR
$ .15 ( .05) (.15)( .05) .0925iR
![Page 13: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/13.jpg)
Effects of Changes in the Exchange Rate
The risk for a U.S. resident investing in a foreign market will depend on • the risk in the foreign market (i.e., the volatility of
foreign market returns)
• the risk in the exchange rate between the U.S. dollar and the foreign currency (i.e., the covariation between the U.S. dollar and the foreign currency)
![Page 14: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/14.jpg)
International Bond Investment
There is substantial exchange rate risk in foreign bond investment. This suggests that investors may be able to increase their gains if they can control this risk, for example with currency forward contracts or swaps.
The existence of euro alters the risk-return characteristics of the euro-zone bond markets enhancing the importance of non-euro currency bonds.
![Page 15: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/15.jpg)
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:
Savings on transaction and information costs.
Circumvention of legal and institutional barriers to direct portfolio investments abroad.
Professional management and record keeping.
![Page 16: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/16.jpg)
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:
Speculate in a single foreign market with minimum cost.
Construct their own personal international portfolios.
Diversify into emerging markets that are otherwise practically inaccessible.
![Page 17: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/17.jpg)
International Diversification with ADRs
Adding ADRs to domestic portfolios has a substantial risk reduction benefit.
![Page 18: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/18.jpg)
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.
![Page 19: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/19.jpg)
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
![Page 20: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/20.jpg)
Home Bias in Portfolio Holdings
Home bias refers to the extent to which portfolio investments are concentrated in domestic equities.
![Page 21: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/21.jpg)
Country World Market Capitalization Weight
Asset Allocation at Home
U.S. 46.85% 85.66%
Japan 11.29% 71.82%
U.K. 8.13% 43.06%
France 4.32% 55.27%
Germany 3.99% 33.49%
Greece 0.46% 93.46%
Spain 1.39% 35.96%
Poland 0.19% 45.61%
Evidence of Home Bias Across Countries
![Page 22: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/22.jpg)
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.
![Page 23: International Portfolio Investment Chapter 15. Lecture Objectives International Correlation Structure and Risk Diversification Optimal International Portfolio](https://reader036.vdocuments.us/reader036/viewer/2022081417/56649e6f5503460f94b6cbd8/html5/thumbnails/23.jpg)
Learning Outcomes
What is an optimal international portfolioHow exchange rate changes affect
international investmentWhat are the different means of gaining
international diversificationWhy there is home bias in portfolio holdings http://video.nytimes.com/video/2006/11/17/world/1194817103057/china-s-yellow-river-part-1.html?scp=1&sq=China's
%20Yellow%20River,%20Part%201&st=cse http://video.nytimes.com/video/2006/11/17/world/1194817096701/china-s-yellow-river-part-2.html?scp=1&sq=China%20
and%20Pollution&st=cse