Multinational Financial Management Alan Shapiro

9th Edition J.Wiley & Sons

Power Points by

Joseph F. Greco, Ph.D.

California State University, Fullerton

CHAPTER 15

International Portfolio Investment

Why Invest Internationally?

What are the advantages of international investment?

THE BENEFITS OF INTERNATIONALEQUITY INVESTING

I. THE BENEFITS OF INTERNATIONAL

EQUITY INVESTINGA. Advantages

1. Offers more opportunities than

a purely domestic portfolio

2. Attractive investments overseas

3. Impact on efficient portfolio with diversification benefits

Basic Portfolio Theory

II. Basic Portfolio TheoryA. What is the efficient frontier?

It represents the most efficient combinations of all possible risky assets

The Efficient Frontier

E(r)

A

B

Portfolio A is efficient

Portfolio B is inefficient

Basic Portfolio Theory

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

Basic Portfolio Theory

B.International Diversification1. Risk-return tradeoff:

may be greater

Basic Portfolio Theory

C. Total Risk 1. A Security’s Returns may be segmented into

Systematic Risk

can not be eliminated

Non-systematic Risk

can be eliminated by diversification

The Benefits of Int’l Diversification

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

INTERNATIONAL PORTFOLIO INVESTMENT

3. Recent Historya. 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.

INTERNATIONAL PORTFOLIO INVESTMENT

4. Theoretical Conclusion:

International diversification pushes out the efficient frontier.

The New Efficient FrontierE(r)

AB

C

CROSS-MARKET CORRELATIONS

5. Cross-market correlationsa. Recent markets seem to be most correlated when volatility is greatest

b. Result:

Efficient frontier retreats

The Frontier During Global CrisesE(r)

A

B

C

Investing in Emerging Markets

D. Investing in Emerging Markets

1. Offers highest risk and returns

2. Low correlations with returns

elsewhere

3. As impediments to capital market mobility fall, correlations are likely to

increase in the future

Barriers to International Diversification

E. Barriers to International Diversification1. 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

Other Methods to Diversify

F. Diversify by 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

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

Expected 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%

Expected Portfolio Return

Calculation of Expected Portfolio Risk

where = the cross-market correlation

US2 = U.S. returns variance

r w2 = World returns variance

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

Portfolio Risk Example

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

INTERNATIONAL PORTFOLIO INVESTMENT

III. MEASURING TOTAL RETURNS FROM FOREIGN PORTFOLIOSA. To compute dollar return of a foreign security:

or1 0

$0

( )( )US ForeignCurrency

e eR R

e

0 1$

1

( )( )US ForeignCurrency

e eR R

e

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

INTERNATIONAL PORTFOLIO INVESTMENT

B. Calculating U.S. $ Return Equity 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

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?

U.S. $ Stock Returns:Sample Solution

48 50 1 .20 .21051 1 1

50 .2105

$

(1) (0)1 1 (1 )

(0)

P P DR g

P

.98 .95 1

$ 6.9%R