International portfolio diversification benefits: Cross-country evidence from a local perspective Authors of the Paper: Joost Driessen Luc Laeven Presented by: Osaid Hashmi Tianqi Wang Lucie Wdowyczynová JEM044 - International Finance December 15, 2015

Contents  Introduction  Measuring international diversification benefits  Empirical results on international diversification benefits  Explaining the cross-country variation in diversification benefits  Time-varying diversification benefits  Conclusions

 Introduction Osaid Hashmi

Research Questions  Does international portfolio diversification benefit a local investor?  How does it differ across country and how has it changed over time?  Investors from which area benefit the most from investing abroad?

Market observations  Investors from the developing countries benefit the most from investing abroad  The larger the country risk, the greater the gain  Diversification varies over time as country risk changes

Analysis  Institutional investors in small countries can make large profits if freed of the restrictions  Benefits for markets such as the United States are smaller compared to others  The Paper: i.Measures potential international diversification benefits for a large number of countries ii.Analyzes cross-country differences in these benefits

Analysis approach used  The economic size of the diversification is used  Cross-country and time series variation in benefits is explained using financial and macro-economic variables  Paper is an extension to the research of i.Huberman and Kandel (1987) ii.Bekaert and Urias (1996) iii.DNW (2001) iv.Li et al. (2003) All these are about an investor from the US

Analysis approach used (cont.)  Two types of diversifications have been examined i.Regional Diversification Benefits (Investment in the regional equity index) ii.Global Diversification Benefits (Investment in markets of Europe, US and Far East)  Market Data: 52 countries, 1985 – 2002 (monthly)  Regression Framework: Developed by Huberman and Kandel (1987) and DNW (2001)

Empirical Analysis  Calculation of economic size of the diversification benefits:  Improvement in Sharpe ratios  Increase in expected returns  Cases used:  Frictionless markets  Markets with short-sales constraints

Empirical Results  In case of no short-sales constraints  Economically large and statistically significant benefits for investors in almost all countries  Sharpe ratios increase from 10% to 21%  Global diversification shows greater benefits compared to regional diversification

Empirical Results (cont.)  In case of short-sales constraints  No significant difference as compared to that of without short-sales constraints  Sharpe ratio increases from 10% to 18% when allowing for global diversification  No significant benefits observed for US investors  Developing countries display high gains

 Measuring international diversification benefits Osaid Hashmi

Measuring the benefits  Standard mean-variance framework of Markowitz (1952)  Regional Diversification – A  Global Diversification – B  Does the risk-return tradeoff improve by adding asset set A or B?  We analyze Statistical Significance and Economic Significance

Statistical Signifance  Regression Framework: Developed by Huberman and Kandel (1987), DNW (2001), De Roon and Nijman (2001)  Adding N new assets to a given K benchmark of assets  K benchmark assets: Domestic index K = 1  N assets: Asset sets A (Regional) or B (Global) N = 1 (for A), N = 3 (for B) r t+1 =  +  R t+1 +  t+1

Statistical Significance (cont.)  Frictionless markets: r t+1 =  +  R t+1 +  t+1  r t+1 = N-dimensional column vector with the N returns on the additional assets  R t+1 = K-dimensional return vector for the K benchmark assets   = N-dimensional constant term   = N by K matrix with slope coefficients   t+1 = N-dimensional vector with zero-expectation error terms

Statistical Significance (cont.) r t+1 =  +  R t+1 +  t+1  Null hypothesis: K benchmark assets span the entire market of all K + N assets  lK = lN  Spanning test tests whether local stock market index spans a portfolio that includes asset set A or asset set B  No information on a risk-free rate needed

Statistical Significance (cont.)  Markets with short-selling constraints  17-years monthly data used to minimize small sample problems  Short-sales constraints on only one asset (country’s local index)  Small sample properties of the spanning test depend on number of short-sale restrictions

Economic Significance  Measured in two ways:  Increase in Sharpe ratio when adding new N assets to the K benchmark assets  Increase in expected return when adding new N assets to K benchmark assets

 Empirical results on international diversification benefits Tianqi Wang

Data  52 countries sample…..23 developed countries, 29 developing countries  Time… , monthly  Developed countries…..MSCI  Developing countries…..S&P/IFC Global Index  Risk-free rate…..3-month US Treasury bills rate  GDP per capita, stock market capitalization, private credit to GDP, trade to GDP from World Development Indicators of the World Bank  Country risk…..Country risk ratings reported by ICRG

Estimation of diversification benefits  Three conditions: (i) No short selling constraints. (ii) Short selling constraints in developing countries only. (iii) Short selling constraint in all countries.  Two estimations methods: (i) Increase in Sharpe ratio(SR) (ii) Increase in expected return(ER)  Return expressed by two currencies: (i) Local currency (ii) US dollars

Estimation results

Estimation results (cont.)

For regional diversification benefits:  The increase in expected return for Eastern European countries of investing in the region is 0.3% per month on average as expressed in US dollar terms, even when short selling constraints are present.  For other regions no improvements in expected returns can be obtained from investing within the region when short selling constraints are present. For global diversification benefits:  For most countries, the benefits of global diversification significantly outweigh the benefits of regional diversification, and the benefits are also more significant in a statistical sense.  The increase in expected return as a result of global diversification under the assumption of no market frictions and expressed in local currency returns ranges from a low of 0.0% per month for the Netherlands and Switzerland to a high of 3.3% per month for Argentina.

Rejection of spanning tests by region

Results on the statistical tests of mean–variance spanning  For global diversification, the spanning hypothesis is rejected for all countries at the 1% confidence level, both when assuming no short-selling constraint and short selling constraints in developing countries only.  When short-selling constraints are added for all countries, the global spanning hypothesis is not rejected for 18 out of the 52 countries in the sample, suggesting that short-sales constraints on all assets eliminate the diversification benefits for a substantial number of countries.

 Explaining the cross-country variation in diversification benefits Tianqi Wang

What are the factors that explain the cross-country differences?  Previous research has shown that many developing countries are not (well) integrated with world capital markets (Harvey, 1995). This would suggest that there are substantial benefits to international portfolio diversification for investors in less developed countries.  To test for this hypothesis the paper use a regression framework that controls for other country-specific factors.  The paper only use the increase in the Sharpe ratio as a measure for diversification benefits for this cross- country analysis.

Cross-country estimation model Independent variables:  Stock market capitalization-----proxy for size of the stock market  Trade to GDP -----proxy for trade openness  Private sector credit to GDP -----proxy for the level of financial sector development of the country  ICRG risk ratings-----proxy for the country risk, including all factors that could contribute to the degree of stock market integration Dependent variable:  Difference between the Sharpe ratio of the global portfolio (including the local index) and the Sharpe ratio of the local index

Cross-country differences in the benefits of foreign diversification

Cross-country estimation results  Of all the country-specific variables that the paper investigated,only the ICRG country risk rating to be a statistically significant explanatory variable for the increase in the Sharpe ratio variable.  Diversification benefits are much larger for countries with higher country risk.

 Time-varying diversification benefits Lucie Wdowyczynová

Time-varying diversification benefits  The results from the previous section should imply that if country risk decreases, the diversification benefits decrease  in this part it is tested  To measure the time-varying diversification benefits, the model observes:  expected returns  variances  and correlations …for each stock market as a function of the country risk of the country

Time-varying diversification benefits (cont.)  A proxy for country risk – the ICRG composite risk index  Analysis os time-varying diversification benefits performed for both developed and developing countries  The results for developing countries are more important (the largest variation in country risk)  For developed countries other factors besides country risk may be more important

Models

Models (cont.)  For each country, estimations have been done using (nonlinear) regression:

Estimation results

Comments on results  For the median country an increase in the ICRG measure ⇨ an increase in the correlation with global indices, a decrease in variance and expected return of the local index – holds for 42/52 countries  Explanatory power and the statistical significance not very large, but ICRG seems to pick up economically important swings in exp. returns, variances and correlations

Comments on results (cont.)  For most countries the country risk as well as the diversification benefits have decreased over the period  The decrease is significant for regions with many developing countries  Much of the difference with developed countries has disappeared over the period

 Conclusions Lucie Wdowyczynová

Conclusions  There exist substantial regional and global diversification benefits for domestic investors in both developed and developing countris  Benefits of international portfolio diversification are larger for developing countries  Country risk – good determinant of diversification benefits  Diversification benefits have decreased over period (improvements in country risk over time)

Conclusions (cont.)  The article offers a local rather than a US perspective  For investors in many non-American countries the potential benefits from investing abroad are still substantial  Mean-variance investors are substantially worse off in less developer countries when not investing abroead  Restrictions exist – a further liberalization of international financial markets needed  Globally oriented mutual funds in developing countries may foster diversification benefits

References  Driessen, J., Laeven, L., “International Portfolio Diversification Benefits: Cross-Country Evidence from a Local Perspective”. Journal of Banking and Finance, 31, pp