Size of the Gains from International Risk Sharing(By Carlos Gonzalez, Xufei Zhang and Kankan Wu)

The roadmap

2. Risk Sharing and the Benefits of Portfolio Diversification

3. How much risk-sharing is there across countries?

4. Cross Border Portfolio Diversification

5. Home Equity Bias

6. Are there unexploited gains form international risk-sharing?

1. Introduction

7. Emerging Countries

8. References

Size of the Gains from International Risk Sharing1. Introduction.

Financial capital moves freely across country borders.

Returns and similar-denominated assets in different countries are very close to each other – differences in returns have essentially been eliminated because some investors by and sell assets internationally.

Assumptions

Residents of most industrialized countries hold most of their wealth in domestic assets, forgoing the benefits of diversifying their portfolios by including foreign assets.

We will examine some of the data on the extent of international risk sharing in developed and developing countries. Those data suggest that the amount of international risk-sharing is rather small.

So, are there significant unexploited gains from risk-sharing?

Main Purpose

Results

Size of the Gains from International Risk Sharing2. Risk Sharing and the Benefits of Portfolio Diversification

How do households share risk in the real world? Through financial markets. Can purchase stocks and bonds.

Why is a diversified portfolio so important? Different businesses face different risks.

The risk of a portfolio of stocks declines as the number of stocks in the portfolio increases

Portfolio Theory

The figure shows that the risk associated with the portfolio declines fairly smoothly as the number of stocks in the portfolio increases. BUT, once the portfolio has 10-15 stocks adding more doesn’t seem to decrease the risk of the portfolio much further. This remaining risk is the MARKET RISK. (See Fama and Sill)

Portfolio Diversification and Risk 1995-1999

Size of the Gains from International Risk Sharing2. Risk Sharing and the Benefits of Portfolio Diversification

Is there a way to lower portfolio risk even further? One way to lower market risk is to hold stocks not traded on our domestic market, in particular, stocks that trade on foreign markets.

Trading financial assets with residents of other countries, investors can share some of their domestic risk.

Foreign markets

How much risk-sharing is there across countries?

If the financial markets are “open”, investors would hold portfolios that are diversified internationally.

BUT, the data show there is less than perfect international risk sharing.

Main Reasons

At least in developing countries, might be that the benefits of undertaking further measures to reduce risk may not outweigh the costs.

Size of the Gains from International Risk Sharing2. Risk Sharing and the Benefits of Portfolio Diversification

“The best way to reduce the risk in any investment portfolio is by diversification”

“The less the patterns of returns form different investments coincide with one another, the greater the benefits of holding these investments in the same portfolio” – i.e. Correlation coefficient of -1

Portfolio Theory

“…many investors have held too much of their money in highly correlated equity markets like UK, Europe and the US.”

Result: until march last year all of their investments performed poorly at the same time.

Returns for the FTSE All-Share fell by 5.3%, while the FTSE World Europe (excl. UK) fell by 7.73%, and the S&P 500 fell by 10.96%

Over the past five years, the correlation coefficient of returns between the FTSE All-Share and S&P has been 0.86.

Portfolio EVIDENCE – The Illusions of Diversification

Size of the Gains from International Risk Sharing2. Risk Sharing and the Benefits of Portfolio Diversification

“The motive for international diversification for many investors has been to take advantage of the low correlation between stocks in different national markets. But as some markets gradually move in the same direction, someone could have a portfolio that appears to be very diversified but that, in fact, is not at all.” (See FT 21/Feb/04)

Size of the Gains from International Risk Sharing3. How much risk-sharing is there across countries?

How freely financial capital flows across borders are? No direct data, but indirect evidence on cross border flows.

If financial markets are open, dollar-denominated returns on nearly identical assets in different countries should be nearly the same.

International Capital Flows

Onshore-Offshore Interest Differential

The figure plots the difference between the interest rate on a Eurodollar* deposit with a 3 month maturity and the interest rate on a three month US certificate of deposit. Eurodollars are US dollars deposited in foreign banks outside the US or in foreign branches of US banks.

This demonstrates that financial capital now flows quite freely between the US and the London financial market. Similarly, small differentials are found when economists analyse many of the world’s developed financial markets. (See Sill)

Size of the Gains from International Risk Sharing4. Cross Border Portfolio Diversification

Investor portfolios are

NOT highly diversified

internationally, especially those

investors in USA and Japan.

Lack of portfolio diversification

internationally.

Evidence

Home Equity Bias (HEB)

1989 - The share of foreign equities in total equity holdings was 4% for residents in USA, 2% for Japan, 18% for UK. (See French and Poterba)

1991 - More than 96% of US wealth was invested in US equity. The fraction of the total US stock market held by Germany, Canada, Japan, and the UK was below 12%. (See Tesar and Werner, 1994)

The fact that equity holdings are disproportionately invested in domestic equity.

Size of the Gains from International Risk Sharing5. Home Equity Bias

Home Equity Bias 1987 - 1996

Note, that in each of the countries, the HEB has been getting smaller over time (that is, the percent of wealth invested in foreign assets is increasing) However, there are some problems with these measures of home equity bias, e.g. domestic firms have overseas operations.

The figure shows that HEB is

smaller for the UK and

Germany than it is for Canada

and the US. HEB is greatest for

Japan.

(See Tesar and Werner 1998)

Size of the Gains from International Risk Sharing6. Are there unexploited gains form international risk-sharing?

There is something missing!!!! – REAL WORLD

In the case of developed countries, many economists think not. The gains from further international risk-sharing may be very small.

For developing countries, which often do not have open financial markets, the gains may be substantial.

• Financial markets are not complete.

• Transaction costs may prevent portfolios from being as internationally diversified. (Also exist taxes, tariff payments and types of capital controls)

• There are other channels through which investors can share risk without using international financial markets: international trade in goods and services and domestic saving and investment.

Size of the Gains from International Risk Sharing7. Emerging Markets

Source: FTSE

Size of the Gains from International Risk Sharing7. Emerging Markets

Country Classification

15

FTSE’s Current Country Classification

Source: FTSE

Size of the Gains from International Risk Sharing7. Emerging Markets

Stock markets - % increase in $ terms

Source: The Economist

Size of the Gains from International Risk Sharing7. Emerging Markets (See FT 7/Feb/04)

Size of the Gains from International Risk Sharing7. Emerging Markets

Stock-exchange listings and Return on Capital

More money will be invested abroad as firms seek higher returns!!!

Size of the Gains from International Risk Sharing8. References

• Broadbent Ben, Schumacher Dirk, Schels Sabine, “No gain without pain – Germany’s adjustment to a higher cost of capital”. Global Economics Paper No. 103.

•Fama, Eugene. “Foundations of Finance”. New York Basic Books, 1976.

• French, Kenneth and James Poterba. “Investor Diversification and International Equity Markets”, American Economic Review, 81 (1991), pp. 222-26

• Sill Keith. “The Gains from International Risk-Sharing”Business Review Q3 2001, pp. 23-32

• Tesar, Linda and Ingrid Werner. “International Equity Transactions and US Portfolio Choice,” NBER Working Paper 4611, 1994

• Tesar, Linda and Ingrid Werner. “The Internationalization of Securities Markets Since the 1987 Crash,” Brookings-Wharton papers on Financial Services, Washington: Brookings Institution, 1998

• Tesar, Linda. “Evaluating the Gains from International Risk sharing”, Carnegie-Rochester conference Series on Public Policy, 42 (1995), pp. 95-143

• The Economist (several numbers)

• Financial Times (printed version)