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Lecture 12 International Portfolio Theory and Diversification.

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1 Lecture 12 International Portfolio Theory and Diversification

2 Important Information Next Week’s Reading Assignment –Monday: Chapter 23: International Trade Finance Quiz 4, Wednesday, Nov 19 –Chapters 15, 18, 19, and 23 –Lectures 10, 11, 12, and 13

3 Objectives of Lecture 12 Discuss the total risk of a portfolio in terms of its two components: –diversifiable and non-diversifiable Demonstrate how both the diversifiable and non- diversifiable risks of an investor’s portfolio may be reduced through international diversification Discuss how foreign exchange risk impacts investing internationally Review the recent history of equity market performance globally, including the degree to which the markets are more or less correlated in their movements Examine the question of whether markets appear to be more or less integrated over time

4 Total Risk of a Portfolio We can think of a portfolio as consisting of either: –Financial assets Portfolio investment –Real assets Foreign direct investment Portfolio theory suggests that the risk associated with either can be reduced through international diversification. In an international context, diversification needs to be discussed through two components: –Potential risk reduction benefits of diversification –Potential additional risk associated with foreign exchange exposure.

5 Diversifiable and Non-diversifiable Risk The total risk of a portfolio consists of: –The unique risk associated with the individual security (or real asset). Unsystematic risk; can be diversified away through the selection of assets which are not perfectly correlated. –The market risk that tends to affect the entire market in a similar fashion. Systematic risk; Regardless of the number of assets we add, this risk cannot be reduced for a particular market (country). It is non-diversifiable!

6 Measuring Risk Risk can be measured for an individual asset, or a portfolio of assets, by the variance, or standard deviation, of its returns –Variance measures the “width” of a probability distribution of returns. –The larger the measure of returns dispersion, the greater the total risk, and thus, the greater the probability of changes in asset value

7 Portfolio Risk Reduction –As an investor increases the number of securities, the portfolio’s risk declines rapidly at first and then asymptotically approaches the level of systematic risk of the market –A fully diversified portfolio would have a beta of 1.0 (equal to the market risk).

8 Total Risk Portfolio of U.S. stocks 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. Systematic risk Total risk Total Risk = Diversifiable Risk + Market Risk (unsystematic) (systematic) Percent risk = Variance of portfolio return Variance of market return 20 40 60 80 Number of stocks in portfolio 10203040501 100

9 Internationalizing the Portfolio Including foreign assets in the portfolio can result in lowering the portfolio’s market, or systematic, risk. –This situation arises if the returns on foreign assets are not closely correlated with the returns on home (or U.S.) assets.

10 International Diversification Portfolio of international stocks By diversifying the portfolio internationally, the level of systematic risk which could not be diversified away under domestic constraints, is lowered. Percent risk = Variance of portfolio return Variance of market return 20 40 60 80 Number of stocks in portfolio 10203040501 100 Portfolio of U.S. stocks

11 International Diversification Risk reduction is possible through international diversification if the returns of different stock market around the world are not perfectly positively correlated Question: Are these returns correlated or not, and are they changing over time?

12 National Equity Market Performance

13 Are Markets Increasingly Integrated?

14 Conclusions The relatively low correlation coefficients among returns of 18 major stock markets in the 20-year period (1977- 1996) indicates great potential for international diversification The overall picture is that the correlations have increased over time However, although capital market integration has decreased some benefits of international portfolio diversification, the correlations between markets are still far from 1.0

15 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 diversification Internationally diversified portfolios are the same in principle because the investor is attempting to combine assets which are less than perfectly correlated, reducing the risk of the portfolio

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