1. INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Fifth Edition Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2. EUN / RESNICK Fifth Edition Chapter Objective: Why investors diversify their portfolios internationally. How much investors can gain from international diversification. The effects of fluctuating exchange rates on international portfolio investments. Whether and how much investors can benefit from investing in U.S. based international mutual funds. The reasons for “home bias” in portfolio holdings. 15 Chapter Fifteen International Portfolio Investment 15-1

3. International Correlation Structure and Risk Diversification Security returns are much less correlated across countries than within a country. This is so because economic, political, institutional, and even psychological factors affecting security returns tend to vary across countries, resulting in low correlations among international securities. Business cycles are often high asynchronous across countries. 15-2

4. Domestic vs. International Diversification 0.44 0.27 0.12 Portfolio Risk (%) Number of Stocks 11020304050 Swiss stocks U.S. stocks International stocks When fully diversified, an international portfolio can be less than half as risky as a purely U.S. portfolio. A fully diversified international portfolio is only 12 percent as risky as holding a single security. 15-3

5. Optimal International Portfolio Selection The correlation of the U.S. stock market with the returns on the stock markets in other nations varies. The correlation of the U.S. stock market with the Canadian stock market is 72%. The correlation of the U.S. stock market with the Japanese stock market is 31%. A U.S. investor would get more diversification from investments in Japan than Canada. 15-4

6. Summary Statistics for Monthly Returns 1980-2007 ($U.S.) Stock Market Correlation Coefficient Mean (%) SD (%)  CNFRGMJPUK Canada (CN) 1.075.551.00 France (FR)0.49 1.206.001.04 Germany (GM) 0.460.73 1.196.291.03 Japan (JP)0.340.400.32 0.926.531.10 United Kingdom 0.590.610.560.42 1.195.200.97 United States0.720.550.520.310.611.114.250.88 1.07% monthly return = 12.84% per year Country stock market vs. world 15-5

7. Stock Market Correlation Coefficient Mean (%) SD (%)  CNFRGMJPUK Canada (CN) 1.075.551.00 France (FR)0.49 1.206.001.04 Germany (GM) 0.460.73 1.196.291.03 Japan (JP)0.340.400.32 0.926.531.10 United Kingdom 0.590.610.560.42 1.195.200.97 United States0.720.550.520.310.611.114.250.88  measures the sensitivity of the market to the world market. Clearly the Japanese market is more sensitive to the world market than is the U.S. Summary Statistics for Monthly Returns 1980-2007 ($U.S.) Country stock market vs. world 15-6

8. Selection of the Optimal International Portfolio Efficient frontier OIP 2.0% 1.5% 1.0% 0.5% 0.0% US JP HK SD IT GM CN SW UK NL Monthly Standard Deviation 0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%8.0%9.0%10% RfRf Monthly Return 15-7

9. Composition of the OIP for a U.S. Investor (Holding Period: 1980—2007 Australia Hong Kong 4.82% 8.76% Italy6.60% Netherlands31.11% Sweden28.01% U.S.20.70% Total100.00% 15-8

10. 1.40% 1.11% Gains from International Diversification For a U.S. investor, OIP has more return and more risk. The Sharpe measure is 30% higher, suggesting that an equivalent-risk OIP would have more return per unit of risk than a domestic portfolio. OIPODP Mean Return 1.40%1.11% Standard Deviation 4.74%4.25% risk return OIP ODP 4.25% 4.74% 15-9

11. Effects of Changes in the Exchange Rate The realized dollar return for a U.S. resident investing in a foreign market will depend not only on the return in the foreign market but also on the change in the exchange rate between the U.S. dollar and the foreign currency. 15-10

12. Effects of Changes in the Exchange Rate The realized dollar return for a U.S. resident investing in a foreign market is given by R i$ = (1 + R i )(1 + e i ) – 1 = R i + e i + R i e i Where R i is the local currency return in the i th market e i is the rate of change in the exchange rate between the local currency and the dollar 15-11

13. Effects of Changes in the Exchange Rate For example, if a U.S. resident just sold shares in a British firm that had a 15% return (in pounds) during a period when the pound depreciated 5%, his dollar return is 9.25%: R i$ = (1 +.15)(1 – 0.05) – 1 = 0.925 =.15 + –.05 +.15×(–.05) = 0.925 15-12

14. Effects of Changes in the Exchange Rate The risk for a U.S. resident investing in a foreign market will depend not only on the risk in the foreign market but also on the risk in the exchange rate between the U.S. dollar and the foreign currency. Var(R i$ ) = Var(R i ) + Var(e i ) + 2Cov(R i,e i ) +  Var The  Var term represents the contribution of the cross-product term, R i e i, to the risk of foreign investment. 15-13

15. Effects of Changes in the Exchange Rate Var(R i$ ) = Var(R i ) + Var(e i ) + 2Cov(R i,e i ) +  Var This equation demonstrates that exchange rate fluctuations contribute to the risk of foreign investment through three channels: 1. Its own volatility, Var(e i ). 2. Its covariance with the local market returns Cov(R i,e i ). 3. The contribution of the cross-product term,  Var. 15-14

16. International Mutual Funds: A Performance Evaluation A U.S. investor can easily achieve international diversification by investing in a U.S.-based international mutual fund. The advantages include 1. Savings on transaction and information costs. 2. Circumvention of legal and institutional barriers to direct portfolio investments abroad. 3. Professional management and record keeping. 15-15

17. International Mutual Funds: A Performance Evaluation As can be seen below, a sample of U.S. based international mutual funds has outperformed the S&P 500 during the period 1977-1986, with a higher standard deviation.  US Mean Annual Return Standard Deviation  US R2R2 U.S. Based International Mutual Funds 18.96%5.78%0.690.39 S&P 50014.04%4.25%1.00 U.S. MNC Index 16.08%4.38.98.90 15-16

18. International Mutual Funds: A Performance Evaluation U.S. stock market movements account for less than 40% of the fluctuations of international mutual funds, but over 90% of the movements in U.S. MNC shares. This means that the shares of U.S. MNCs behave like those of domestic firms, without providing effective international diversification. Mean Annual Return Standard Deviation  US R2R2 U.S. Based International Mutual Funds 18.96%5.78%0.690.39 S&P 50014.04%4.25%1.00 U.S. MNC Index16.08%4.38.98.90 15-17

19. International Diversification through Country Funds Recently, country funds have emerged as one of the most popular means of international investment. A country fund invests exclusively in the stocks of a single county. This allows investors to: 1. Speculate in a single foreign market with minimum cost. 2. Construct their own personal international portfolios. 3. Diversify into emerging markets that are otherwise practically inaccessible. 15-18

20. International Diversification through American Depository Receipts Foreign stocks often trade on U.S. exchanges as ADRs. It is a receipt that represents the number of foreign shares that are deposited at a U.S. bank. The bank serves as a transfer agent for the ADRs 15-19

21. American Depository Receipts There are many advantages to trading ADRs as opposed to direct investment in the company’s shares: ADRs are denominated in U.S. dollars, trade on U.S. exchanges and can be bought through any broker. Dividends are paid in U.S. dollars. Most underlying stocks are bearer securities, the ADRs are registered. 15-20

22. International Diversification with ADRs Adding ADRs to domestic portfolios has a substantial risk reduction benefit. 15-21

23. International Diversification with Exchange Traded Funds Using exchange traded funds (ETFs) like WEBS and spiders, investors can trade a whole stock market index as if it were a single stock. Being open-end funds, WEBS trade at prices that are very close to their net asset values. In addition to single country index funds, investors can achieve global diversification instantaneously just by holding shares of the S&P Global 100 Index Fund that is also trading on the AMEX with other WEBS. 15-22

24. International Diversification with Hedge Funds Hedge funds which represent privately pooled investment funds have experienced phenomenal growth in recent years. This growth has been mainly driven by the desire of institutional investors, such as pension plans, endowments, and private foundations, to achieve positive or absolute returns, regardless of whether markets are rising or falling. 15-23

25. International Diversification with Hedge Funds Unlike traditional mutual funds that generally depend on “buy and hold” investment strategies, hedge funds may adopt flexible, dynamic trading strategies, often aggressively using leverages, short positions, and derivative contracts, in order to achieve their investment objectives. These funds may invest in a wide spectrum of securities, such as currencies, domestic and foreign bonds and stocks, commodities, real estate, and so forth. Many hedge funds aim to realize positive returns, regardless of market conditions. 15-24

26. Home Bias in Portfolio Holdings As previously documented, investors can potentially benefit a great deal from international diversification. The actual portfolios that investors hold, however, are quite different from those predicted by the theory of international portfolio investment. Home bias refers to the extent to which portfolio investments are concentrated in domestic equities. 15-25

27. Why Home Bias in Portfolio Holdings? Three explanations come to mind: 1. Domestic equities may provide a superior inflation hedge. 2. Home bias may reflect institutional and legal restrictions on foreign investment. 3. Extra taxes and transactions/information costs for foreign securities may give rise to home bias. 15-26

28. Why Home Bias in Portfolio Holdings? A recent study of the brokerage records of tens of thousands of U.S. individual investors shows that wealthier, more experienced, and sophisticated investors are more likely to invest in foreign securities. Another study shows that when a country is remote and has an uncommon language, foreign investors tend to stay away. 15-27