1. Copyright © 2003 Pearson Education, Inc.Slide 19-1 Prepared by Shafiq Jadallah To Accompany Fundamentals of Multinational Finance Michael H. Moffett, Arthur I. Stonehill, David K. Eiteman Chapter 19 International Portfolio Theory & Diversification

2. Copyright © 2003 Pearson Education, Inc.Slide 19-2 Chapter 19 International Portfolio Theory & Diversification  Learning Objectives Separate total risk of a portfolio into 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 Explore how foreign exchange risk impacts the individual investor investing internationally Define the optimal domestic portfolio and the optimal international portfolio

3. Copyright © 2003 Pearson Education, Inc.Slide 19-3 Chapter 19 International Portfolio Theory & Diversification  Learning Objectives 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 Explore whether international portfolio theory may be extended to the estimation of a company’s cost of equity using the international CAPM

4. Copyright © 2003 Pearson Education, Inc.Slide 19-4 International Diversification & Risk  Portfolio Risk Reduction The risk of a portfolio is measured by the ratio of the variance of the portfolio’s return relative to the variance of the market return This is defined as the beta of the portfolio 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

5. Copyright © 2003 Pearson Education, Inc.Slide 19-5 International Diversification & 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

6. Copyright © 2003 Pearson Education, Inc.Slide 19-6 International Diversification & Risk Portfolio of international 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. 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

7. Copyright © 2003 Pearson Education, Inc.Slide 19-7 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

8. Copyright © 2003 Pearson Education, Inc.Slide 19-8 Foreign Exchange Risk  An illustration with Japanese equity US investor takes $1,000,000 on 1/1/2002 and invests in stock traded on the Tokyo Stock Exchange (TSE) –On 1/1/2002, the spot rate was ¥130/$ The investor purchases 6,500 shares valued at ¥20,000 for a total investment of ¥130,000,000 At the end of the year, the investor sells the shares at a price of ¥25,000 per share yielding ¥162,500,000 –On 1/1/2003, the spot rate was ¥125/$ The investor receives a 30% return on investment ($300,000/$1,00,000 = 30%)

9. Copyright © 2003 Pearson Education, Inc.Slide 19-9 Foreign Exchange Risk  An illustration with Japanese equity The total return reflects not only the appreciation in stock price but also the appreciation of the yen The formula for the total return is Where: ¥130/¥125 =.04¥25,000/¥20,000 =.25

10. Copyright © 2003 Pearson Education, Inc.Slide 19-10 Internationalizing the Domestic Portfolio  Classic portfolio theory assumes that a typical investor is risk- averse The typical investor wishes to maximize expected return per unit of expected risk  An investor may choose from an almost infinite choice of securities  This forms the domestic portfolio opportunity set  The extreme left edge of this set is termed the efficient frontier This represents the optimal portfolios of securities that possess the minimum expected risk per unit of return The portfolio with the minimum risk among all those possible is the minimum risk domestic portfolio

11. Copyright © 2003 Pearson Education, Inc.Slide 19-11 Internationalizing the Domestic Portfolio Expected Return of Portfolio, R p Expected Risk of Portfolio,  p Domestic portfolio opportunity set 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 MR DP. RfRf Capital Market Line (Domestic)  DP R DP Minimum risk (MR DP ) domestic portfolio MR D P DP Optimal domestic portfolio (DP)

12. Copyright © 2003 Pearson Education, Inc.Slide 19-12 Internationalizing the Domestic Portfolio  If the investor is allowed to choose among an internationally diversified set of securities, the portfolio set of securities shifts to upward and to the left  This is called the internationally diversified portfolio opportunity set

13. Copyright © 2003 Pearson Education, Inc.Slide 19-13 Internationalizing the Domestic Portfolio Expected Return of Portfolio, R p Expected Risk of Portfolio,  p 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 Capital Market Line is tangent to the domestic opportunity set. The domestic portfolio with the minimum risk is designated MR DP. RfRf Capital Market Line (Domestic)  DP R DP Domestic portfolio opportunity set DP Internationally diversified portfolio opportunity set

14. Copyright © 2003 Pearson Education, Inc.Slide 19-14 Internationalizing the Domestic Portfolio  This new opportunity set allows the investor a new choice for portfolio optimization  The optimal international portfolio (IP) allows the investor to maximize return per unit of risk more so than would be received with just a domestic portfolio

15. Copyright © 2003 Pearson Education, Inc.Slide 19-15 Internationalizing the Domestic Portfolio Expected Return of Portfolio, R p Expected Risk of Portfolio,  p 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 MR DP. RfRf CML (Domestic)  DP R DP Domestic portfolio opportunity set DP Internationally diversified portfolio opportunity set R IP  IP IP Optimal international portfolio CML (International)

16. Copyright © 2003 Pearson Education, Inc.Slide 19-16 Calculating Portfolio Risk and Return  The two-asset model consists of two components The expected return of the portfolio The expected risk of the portfolio  The expected return is calculated as Where:A = one asset B = second asset w = weights (respectively) E(r) = expected return of assets

17. Copyright © 2003 Pearson Education, Inc.Slide 19-17 Calculating Portfolio Risk and Return  The expected risk is calculated as Where:A = first asset B = second asset w = weights (respectively) σ = standard deviation of assets  = correlation coefficient of the two assets

18. Copyright © 2003 Pearson Education, Inc.Slide 19-18 Calculating Portfolio Risk and Return  Example of two-asset model Where:US = US security GER = German security w US = weight of US security – 40% w GER = weight of German security – 60% σ US = standard deviation of US security – 15% ρ = correlation coefficient of the two assets – 0.34

19. Copyright © 2003 Pearson Education, Inc.Slide 19-19 Calculating Portfolio Risk and Return  Example of two-asset model Where:E US = expected return on US security – 14% E GER = expected return on German security – 18% w US = weight of US security w US = weight of German security E(r) = expected return of portfolio

20. Copyright © 2003 Pearson Education, Inc.Slide 19-20 Calculating Portfolio Risk and Return 111213014151617181920 Expected Portfolio Risk (  ) Expected Portfolio Return (%) 12 13 14 15 16 17 18 Maximum return & maximum risk (100% GER) Minimum risk combination (70% US & 30% GER) Domestic only portfolio (100% US) Initial portfolio (40% US & 60% GER)

21. Copyright © 2003 Pearson Education, Inc.Slide 19-21 Calculating Portfolio Risk and Return  The multiple asset model for portfolio return

22. Copyright © 2003 Pearson Education, Inc.Slide 19-22 Calculating Portfolio Risk and Return  The multiple asset model for portfolio risk

23. Copyright © 2003 Pearson Education, Inc.Slide 19-23 National Equity Market Performance

24. Copyright © 2003 Pearson Education, Inc.Slide 19-24 National Equity Market Performance

25. Copyright © 2003 Pearson Education, Inc.Slide 19-25 Sharp and Treynor Performance Measures  Investors should not examine returns in isolation but rather the amount of return per unit risk  To consider both risk and return for portfolio performance there are two main measures applied The Sharpe measure The Treynor measure

26. Copyright © 2003 Pearson Education, Inc.Slide 19-26 Sharp and Treynor Performance Measures  The Sharpe measure calculates the average return over and above the risk-free rate per unit of portfolio risk Where:R i = average portfolio return R f = market return σ = risk of the portfolio

27. Copyright © 2003 Pearson Education, Inc.Slide 19-27 Sharp and Treynor Performance Measures  The Treynor measure is similar to Sharpe’s measure except that it measures return over the portfolio’s beta  The measures are similar dependant upon the diversification of the portfolio If the portfolio is poorly diversified, the Treynor will show a high ranking and vice versa for the Sharpe measure Where:R i = average portfolio return R f = market return β = beta of the portfolio

28. Copyright © 2003 Pearson Education, Inc.Slide 19-28 Sharp and Treynor Performance Measures  Example: –Hong Kong average return was 1.5% –Assume risk free rate of 5% –Standard deviation is 9.61%

29. Copyright © 2003 Pearson Education, Inc.Slide 19-29 Sharp and Treynor Performance Measures  Example: –Hong Kong average return was 1.5% –Assume risk free rate of 5% –beta is 1.09

30. Copyright © 2003 Pearson Education, Inc.Slide 19-30 Sharp and Treynor Performance Measures  For each unit of risk the Hong Kong market rewarded an investor with a monthly excess return of 0.113%  The Treynor measure for Hong Kong was the second highest among the global markets and the Sharpe measure was eighth  This indicates that the Hong Kong market portfolio was not very well diversified from the world market perspective

31. Copyright © 2003 Pearson Education, Inc.Slide 19-31 Are Markets Increasingly Integrated?

32. Copyright © 2003 Pearson Education, Inc.Slide 19-32 The International CAPM  Recall that CAPM is  The difference for the international CAPM is that the beta calculation would be relevant for the equity market for analysis instead of the domestic market Where:β = beta of the security  = correlation coefficient of the market and the security σ = standard deviation of return

33. Copyright © 2003 Pearson Education, Inc.Slide 19-33 The International CAPM

34. Copyright © 2003 Pearson Education, Inc.Slide 19-34 Summary of Learning Objectives  The total risk of any portfolio is composed of systematic (the market) and unsystematic (individual securities) risk. Increasing the number of securities in a portfolio reduces the unsystematic risk component  An internationally diversified portfolio has a lower beta. This means that the portfolio’s market risk is lower than that of a domestic portfolio; this arises because the returns on the foreign stocks are not closely correlated with returns on US stocks

35. Copyright © 2003 Pearson Education, Inc.Slide 19-35 Summary of Learning Objectives  Investors construct internationally diversified portfolios in an attempt to combine assets which are less than perfectly correlated, reducing the total risk of the portfolio. In addition, by adding assets outside the home market, the investor has now tapped into a larger pool of potential investments  International portfolio construction is also different in that when the investor acquires assets outside their home market, the investor may also be acquiring a foreign-currency denominated asset

36. Copyright © 2003 Pearson Education, Inc.Slide 19-36 Summary of Learning Objectives  The investor has actually acquired two assets – the currency of denomination and the asset subsequently purchased with the currency – two assets in principle but two in expected returns and risks  The foreign exchange risks of a portfolio are reduced through international diversification  The individual investor will search out the optimal domestic portfolio which combines the risk-free asset and a portfolio of domestic securities found on the efficient frontier

37. Copyright © 2003 Pearson Education, Inc.Slide 19-37 Summary of Learning Objectives  This portfolio is defined as the optimal domestic portfolio because it moves out into risky space at the steepest slope – maximizing the slope of expected return over expected risk – while still touching the opportunity set of domestic portfolios  The optimal international portfolio is found by finding that point on the capital market line which extends from the risk-free rate of return to a point of tangency along the internationally diversified efficient frontier

38. Copyright © 2003 Pearson Education, Inc.Slide 19-38 Summary of Learning Objectives  The investor’s optimal portfolio possesses both higher than expected portfolio return and lower expected risk than the purely domestic portfolio  Risk reduction is possible through international diversification because the returns of different stock market around the world are not perfectly positively correlated  The relatively low correlation coefficients among returns of 18 major stock markets in the 20-year period indicates great potential for international diversification

39. Copyright © 2003 Pearson Education, Inc.Slide 19-39 Summary of Learning Objectives  The overall picture is that the correlations have increased over time  Nevertheless, 91 of the 153 correlations had overall means still below 0.5 in 1987-1996, thus markets are increasingly integrated  However, although capital market integration has decreased some benefits of international portfolio diversification, the correlations between markets are still far from 1.0  In theory, the primary distinction in the estimation of the cost of equity for an individual firm using CAPM is the definition of the “market” and a recalculation of the firm’s beta for that market