1. Chp 15 International Portfolio Theory and Diversification
Session 8
Chp 15 International Portfolio Theory and Diversification

2. PCL Questions
Besides obtaining financing sources, financial management is also about investments in the form financial assets. What aspects of investments need to be considered by MNE?
How MNE can balance risk and return of assets?
What are the various alternatives or paths for making investments?
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3. International Diversification and Risk
The case for international diversification of portfolios can be decomposed into two components:
the potential risk reduction benefits of holding international securities.
the potential added forex risks
The first components, i.e. 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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4. Exhibit 15.1 Portfolio Risk Reduction Through Diversification
Variance of portfolio return
Variance of market return
Percent risk =
100 80
Total Risk = Diversifiable Risk Market Risk
(unsystematic) (systematic) 60 40
Portfolio of
U.S. stocks
27% 20
Total
risk
Systematic
risk 1 10 20 30 40 50
Number of stocks in portfolio
By diversifying the portfolio, the variance of the portfolio’s return relative to the variance of the market’s return (beta) is reduced to the level of systematic risk -- the risk of the market itself.
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5. 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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6. 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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7. 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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8. 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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9. 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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10. Exhibit 15.3 Optimal Domestic Portfolio Construction
Expected Return
of Portfolio, Rp
Expected Risk
of Portfolio,  p
Domestic portfolio
opportunity set Rf • DP
 DP
R DP
Capital Market
Line (Domestic)
Minimum risk (MRDP )
domestic portfolio
MRDP
Optimal domestic
portfolio (DP)
An investor may choose a portfolio of assets enclosed by the Domestic portfolio opportunity set. The optimal domestic portfolio is found at DP, where the Security Market Line is tangent to the domestic portfolio opportunity set. The domestic portfolio with the minimum risk is designated MRDP.
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11. 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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12. 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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13. Exhibit 15.4 The Internationally Diversified Portfolio Opportunity Set
Expected Return
of Portfolio, Rp • DP
R DP
Internationally diversified
portfolio opportunity set
Domestic portfolio
opportunity set Rf
Expected Risk
of Portfolio,p
 DP
The addition of internationally-diversified portfolios to the total opportunity set available to the investor shifts the total portfolio opportunity set left, providing lower expected risk portfolios for each level of expected portfolio return.
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14. 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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15. 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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16. Exhibit 15.5 The Gains from International Portfolio Diversification
Expected Return
of Portfolio, Rp
Expected Risk
of Portfolio,p
Domestic portfolio
opportunity set
Internationally diversified
portfolio opportunity set Rf • DP IP
 IP
 DP
R IP
R DP
Risk reduction of
optimal portfolio
Increased
return of
optimal
portfolio
Capital Market
Line (Domestic)
Line (International)
Optimal
international
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17. 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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18. Exhibit 15.6 Alternative Portfolio Profiles Under Varying Asset Weights
Expected Portfolio Return (%) • 18 17 •
Maximum
return &
maximum risk
(100% GER)
Initial portfolio
(40% US & 60% GER) 16 •
Minimum risk combination
(70% US & 30% GER) 15 •
Domestic only portfolio
(100% US) 14 13 12
Expected
Portfolio
Risk ( )
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19. 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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20. National Markets and Asset Performance
Interestingly, markets that are contiguous or near-contiguous (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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21. 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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22. 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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23. Foreign Direct Investment Theory and Strategy
Chapter 16
Foreign Direct Investment Theory and Strategy

24. What do you know about FDI and what are the alternatives towards FDI?
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25. The Theory of Comparative Advantage
The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy:
free trade;
perfect competition;
no uncertainty;
costless information, and
no government interference.
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26. The Theory of Comparative Advantage
The theory contains the following features:
Exporters in Country A sell goods or services to unrelated importers in Country B
Firms in Country A specialize in making products that can be produced relatively efficiently, given Country A’s endowment of factors of production, that is, land, labor, capital, and technology
Firms in Country B do likewise, given the factors of production found in Country B
In this way the total combined output of A and B is maximized
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27. The Theory of Comparative Advantage
Because the factors of production cannot be moved freely from Country A to Country B, the benefits of specialization are realized through international trade
The way the benefits of the extra production are shared depends on the terms of trade, the ratio at which quantities of the physical goods are traded
Each country’s share is determined by supply and demand in perfectly competitive markets in the two countries
Neither Country A nor Country B is worse off than before trade, and typically both are better off, albeit perhaps unequally
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28. The Theory of Comparative Advantage
Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today, for the following reasons:
Countries do not appear to specialize only in those products that could be most efficiently produced by that country’s particular factors of production (as a result of government interference and ulterior motivations)
At least two factors of production – capital and technology – now flow directly and easily between countries
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29. The Theory of Comparative Advantage
Modern factors of production are more numerous than in this simple model
Although the terms of trade are ultimately determined by supply and demand, the process by which the terms are set is different from that visualized in traditional trade theory
Comparative advantage shifts over time, as less developed countries become developed and realize their latent opportunities
The classical model of comparative advantage did not really address certain other issues, such as the effect of uncertainty and information costs, the role of differentiated products in imperfectly competitive markets, and economies of scale
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30. The Theory of Comparative Advantage
Comparative advantage is however still a relevant theory to explain why particular countries are most suitable for exports of goods and services that support the global supply chain of both MNEs and domestic firms.
The comparative advantage of the 21st century, however, is one based more on services, and their cross-border facilitation by telecommunications and the Internet.
The source of a nations comparative advantage is still created from the mixture of its own labor skills, access to capital, and technology.
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31. The Theory of Comparative Advantage
Many locations for supply chain outsourcing exist today (see the following exhibit).
It takes a relative advantage in costs, not just an absolute advantage, to create comparative advantage.
Clearly, the extent of global outsourcing is reaching out to every corner of the globe.
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32. Exhibit 16.5 Global Outsourcing of Comparative Advantage
CHINA
BUDAPEST
LONDON
BERLIN
EAST. EUROPE
PARIS
SHANGHAI
RUSSIA
PHILIPPINES
UNITED STATES
MANILA
MOSCOW
MEXICO
MONTERREY
SAN JOSE
JOHANNESBURG
GUADALAJARA
BOMBAY
HYDERABAD
BANGALORE
INDIA
COSTA RICA
S. AFRICA
MNEs based in many of the major industrial countries are outsourcing many of their
intellectual functions to providers based in many of the traditional emerging market countries.
Data: Gartner, McKinsey, BW
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33. Market Imperfections: A Rationale for the Existence of the Multinational Firm
MNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets.
Imperfections in the market for products translate into market opportunities for MNEs.
Large international firms are better able to exploit such competitive factors as economies of scale, managerial and technological expertise, product differentiation, and financial strength than are their local competitors.
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34. Market Imperfections: A Rationale for the Existence of the Multinational Firm
Strategic motives drive the decision to invest abroad and become a MNE and can be summarized under the following categories:
Market seekers
Raw material seekers
Production efficiency seekers
Knowledge seekers
Political safety seekers
These categories are not mutually exclusive.
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35. Sustaining and Transferring Competitive Advantage
In deciding whether to invest abroad, management must first determine whether the firm has a sustainable competitive advantage that enables it to compete effectively in the home market.
The competitive advantage must be firm-specific, transferable, and powerful enough to compensate the firm for the potential disadvantages of operating abroad (foreign exchange risks, political risks, and increased agency costs).
There are several competitive advantages enjoyed by MNEs.
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36. Sustaining and Transferring Competitive Advantage
Economies of scale and scope:
Can be developed in production, marketing, finance, research and development, transportation, and purchasing
Large size is a major contributing factor (due to international and/or domestic operations)
Managerial and marketing expertise:
Includes skill in managing large industrial organizations (human capital and technology)
Also encompasses knowledge of modern analytical techniques and their application in functional areas of business
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37. Sustaining and Transferring Competitive Advantage
Advanced technology:
Includes both scientific and engineering skills
Financial strength:
Demonstrated financial strength by achieving and maintaining a global cost and availability of capital
This is a critical competitive cost variable that enables them to fund FDI and other foreign activities
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38. Sustaining and Transferring Competitive Advantage
Differentiated products:
Firms create their own firm-specific advantages by producing and marketing differentiated products
Such products originate from research-based innovations or heavy marketing expenditures to gain brand identification
Competitiveness of the home market:
A strongly competitive home market can sharpen a firm’s competitive advantage relative to firms located in less competitive ones
This phenomenon is known as the diamond of national advantage and has four components
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39. supporting Industries
Exhibit Determinants of National Competitive Advantage: Porter’s Diamond
(1)
Factor conditions
(4)
Firm strategy,
structure, & rivalry
(2)
Demand
conditions
(3)
Related and
supporting Industries
Source: Michael Porter, “The Competitive Advantage of Nations,” Harvard Business Review, March-April 1990.

40. The OLI Paradigm and Internalization
The OLI Paradigm is an attempt to create an overall framework to explain why MNEs choose FDI rather than serve foreign markets through alternative models such as licensing, joint ventures, strategic alliances, management contracts, and exporting.
“O” owner-specific (competitive advantage in the home market that can be transferred abroad)
“L” location-specific (specific characteristics of the foreign market allow the firm to exploit its competitive advantage)
“I” internalization (maintenance of its competitive position by attempting to control the entire value chain in its industry)
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41. Where to Invest?
The decision about where to invest abroad is influenced by behavioral factors.
The decision about where to invest abroad for the first time is not the same as the decision about where to reinvest abroad.
In theory, a firm should identify its competitive advantages, and then search worldwide for market imperfections and comparative advantage until it finds a country where it expects to enjoy a competitive advantage large enough to generate a risk-adjusted return above the firm’s hurdle rate.
In practice, firms have been observed to follow a sequential search pattern as described in the behavioral theory of the firm.
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42. Where to Invest?
The decision to invest abroad is often a stage in the firm’s development process.
Eventually the firm experiences a stimulus from the external environment, which leads it to consider production abroad.
Some important external stimuli are:
An outside proposal, from a quality source
Fear of losing a market
The “bandwagon” effect
Strong competition from abroad in the home market
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43. How to Invest Abroad: Modes of Foreign Involvement
The globalization process includes a sequence of decisions regarding where production is to occur, who is to own or control intellectual property, and who is to own the actual production facilities.
The following exhibit provides a roadmap to explain this FDI sequence.
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44. Exhibit 16.8 The FDI Sequence: Foreign Presence & Foreign Investment
The Firm and its
Competitive Advantage
Greater Foreign Presence
Change
Competitive Advantage
Exploit Existing Competitive
Advantage Abroad
Greater
Foreign
Investment
Production at Home:
Exporting
Production Abroad
Licensing
Management Contract
Control Assets
Abroad
Joint Venture
Wholly-Owned
Affiliate
Greenfield
Investment
Acquisition of a
Foreign Enterprise

45. How to Invest Abroad: Modes of Foreign Investment
Exporting versus production abroad:
There are several advantages to limiting a firm’s activities to exports as it has none of the unique risks facing FDI, Joint Ventures, strategic alliances and licensing with minimal political risks
The amount of front-end investment is typically lower than other modes of foreign involvement
Some disadvantages include the risks of losing markets to imitators and global competitors
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46. How to Invest Abroad: Modes of Foreign Investment
Licensing and management contracts versus control of assets abroad:
Licensing is a popular method for domestic firms to profit from foreign markets without the need to commit sizeable funds
However, there are disadvantages which include:
License fees are lower than FDI profits
Possible loss of quality control
Establishment of a potential competitor in third-country markets
Risk that technology will be stolen
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47. How to Invest Abroad: Modes of Foreign Investment
Management contracts are similar to licensing, insofar as they provide for some cash flow from a foreign source without significant foreign investment or exposure
Management contracts probably lessen political risk because the repatriation of managers is easy
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48. How to Invest Abroad: Modes of Foreign Investment
Joint venture versus wholly owned subsidiary:
A joint venture is here defined as shared ownership in a foreign business
Some advantages of a MNE working with a local joint venture partner are:
Better understanding of local customs, mores and institutions of government
Providing for capable mid-level management
Some countries do not allow 100% foreign ownership
Local partners have their own contacts and reputation which aids in business
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49. How to Invest Abroad: Modes of Foreign Investment
However, joint ventures are not as common as 100%-owned foreign subsidiaries as a result of potential conflicts or difficulties including:
Increased political risk if the wrong partner is chosen
Divergent views about the need for cash dividends, or the best source of funds for growth (new financing versus internally generated funds)
Transfer pricing issues
Difficulties in the ability to rationalize production on a worldwide basis
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50. How to Invest Abroad: Modes of Foreign Investment
Greenfield investment versus acquisition:
A greenfield investment is defined as establishing a production or service facility starting from the ground up
Compared to a greenfield investment, a cross-border acquisition is clearly much quicker and can also be a cost effective way to obtain technology and/or brand names
Cross-border acquisitions are however, not without pitfalls, as firms often pay too high a price or utilize expensive financing to complete a transaction
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51. How to Invest Abroad: Modes of Foreign Investment
The term strategic alliance conveys different meanings to different observers.
In one form of cross-border strategic alliance, two firms exchange a share of ownership with one another.
A more comprehensive strategic alliance, partners exchange a share of ownership in addition to creating a separate joint venture to develop and manufacture a product or service
Another level of cooperation might include joint marketing and servicing agreements in which each partner represents the other in certain markets.
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52. THE END