International portfolio diversification benefits: Cross-country evidence from a local perspective By J. Driessen and L. Laeven Presented by Michal Kolář, Tomáš Matuška, Tomáš Šembera & Tomáš Václavíček

Presentation overview I. Introduction and motivation of the topic II. Data and research method III. Empirical results – International diversification benefits IV. Empirical results – Cross-country variation V. Empirical results – Time- varying diversification benefits VI. Conclusions and key points to remember

I.Introduction and motivation of the topic

How it relates to you personally Do you invest? And do you invest abroad? If not, you might be missing the benefits of diversification.

Research question Are there benefits to investing internationally for non-US investors? What is the economic size of diversification benefits? How do they differ by country – and based on what factors?

Why this hypothesis Many institutions required to invest domestically Home bias Regulations are being lifted Boom in international investing Essentially all literature focuses on US investors only Results not representative! How about investors in Czech Republic or elsewhere? Investing abroad can become more important if domestic market is small, restricted,…

II. Data and research method

What data were used 52 countries (29 developing, 23 rich) Monthly data on returns Time period: 1985 – 2002 Some countries do not have that old data But provided consistently

How to measure it? Utility gain, when restriction is lifted Adding a set of assets to benchmark set (K = 1) I. Improvement in Expected returns II. Increase in Sharpe ratio Sharpe ratio = measure of risk-adjusted return

Benefits of investing regionally Comparison Investing in domestic stock market Investing domestically + into regional stock market Benefits of investing globally Comparison Investing in domestic stock market Investing domestically + into global stock market MSCI indices for the US, Europe, and Far East

A) No market frictions B) Frictions in developing countries C) Frictions in all countries 3 possible assumptions Short sales constraints

III. Empirical results - International diversification benefits

Regional diversification Largest benefits from diversification in Eastern Europe No benefits from diversification when short selling constraint are present (except for Eastern Europe)

Global diversification No friction: Increase of Shape Ration from 1,3 % to 46,3 % expressed in local currency, from 1,5 % to 27,1 % expressed in US $ ( -> 11 % increase on average in US$) Short-selling constraints in developing countries -> don’t affect results Short-selling constraints in all countries -> unrealistic; substantial decrease of benefits of diversification

IV. Empirical results - Cross-country variation

What causes the variation in benefits? Dependent variable  Increase in Sharpe ratio SR of the Global portfolio – SR of the local portfolio Independent variables  ICRG country risk rating Proxy for the country risk (The higher rating the less country risk) Proxy for the investment restrictions, political risk, investor protection and foreign exchange regulations

What does cause variation in benefits? Independent variables  Market capitalization of stock market Proxy size of the stock market  Trade openess Proxy integration in world goods markets  Private credit to GDP Proxy financial sector development in country

Cross-country regression results Only ICRG rating significant Doubts about causality  Using IV -> Instrument Legal Origin Quality of the institutional framework Qualitatively same results

Cross-country regression results Country risk is major determinant of GD Benefits Benefits much larger for countries with higher risk

V. Empirical results - Time-varying diversification benefits

Why analysing time variation Further confirmation of country risk – diversification benefits relationship in time -> If country risk decreases, the diversification benefits should decrease too

Measuring determinants of diversification benefits 1) Moments of returns of local indices estimated using ICRG composite risk index Expected return Volatility Correlation with regional or global index

Expected returns

Volatility of returns

Correlation with indices

Results For 42 out of 52 countries (period 1985 – 2002) the increase in ICRG caused: Increase in correlation with regional or global indices Decrease in expected returns Decrease in volatility of returns The effect of country risk measure on diversification benefits is not clear

Finding the effect on diversification benefits Equations of returns, volatility and correlation used to compute the Sharpe ratios Decrease in diversification benefits over time (decrease in volatility and increase in correlation outweighed the decrease in expected returns) The decrease significant for region with developing countries No clear pattern in change of diversification benefits for developed countries

Conclusions and key points to remember There are substantial regional and global benefits from diversification More significant effect for developing countries Diversification benefits decreased in the period 1985 – 2002 The decrease corresponds to decrease of country risk:  CR   benefits Contribution of paper is focusing on investors outside USA

Thank you for your attention