International Diversification Investments Cover image CHAPTER 25 International Diversification Slides by Richard D. Johnson McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

Emphasis for our investigation Background Global market US market is 39.2% of all markets in 2005 US market share is down from 47% in 2000 Improved access & technology New instruments Emphasis for our investigation Risk assessment Diversification

Table 25.1 Market Capitalization of Stock Exchanges in Developed Countries

Table 25.2 Market Capitalization of Stock Exchanges in Emerging Markets

Figure 25.1 Per Capita GDP and Market Capitalization as Percentage of GDP (log scale)

Issues What are the risks involved in investment in foreign securities? How do you measure benchmark returns on foreign investments? Are there benefits to diversification in foreign securities?

Foreign Exchange Risk Foreign Exchange Risk Variation in return related to changes in the relative value of the domestic and foreign currency. Total return = investment return & return on foreign exchange It’s not possible to completely hedge a foreign investment.

Returns with Foreign Exchange Return in US is a function of two factors: 1. Return in the foreign market 2. Return on the foreign exchange

Figure 25. 2 Stock Market Returns in U. S Figure 25.2 Stock Market Returns in U.S. Dollars and Local Currencies for 2005

Table 25. 3 Rates of Change in the U. S Table 25.3 Rates of Change in the U.S. Dollar against Major World Currencies, 2001 – 2005 (monthly data)

Political Risk Services Group Ratings Country Specific Risk Political Risk Services Group Ratings Rank countries with respect to political risk, financial risk and economic risk Assign composite rating from very high risk to very low risk based on the above elements of risk

Table 25.4 Composite Risk Ratings for October 2004 and November 2003

Table 25.5 Variables Used in PRS’s Political Risk Score

Table 25.6 Current Risk Ratings and Composite Risk Forecasts

Table 25.7 Composite and Political Risk Forecasts

Table 25.8 Political Risk Points by Component, October 2004

Diversification Benefits Evidence shows international diversification is beneficial. It’s possible to expand the efficient frontier above domestic only frontier. It’s possible to reduce the systematic risk level below the domestic only level.

Table 25.9 Risk and Return across the Globe, 2001 – 2005 (Developed Countries)

Table 25.9 Risk and Return across the Globe, 2001 – 2005 (Emerging Markets)

Figure 25.3 Annualized Standard Deviation of Investments across the Globe ($ returns 2001 – 2005)

Figure 25.4 Beta on U.S. Stocks across the Globe, 2001 – 2005

Figure 25.3 Annualized Average $ Return of Investments across the Glove 2001 – 2005

Figure 25.6 Standard Deviation of Investments across the Globe in U.S. Dollars versus Local Currency, 2001 – 2005

Table 25.10 Correlation for Asset Returns: Unhedged Currencies Insert Table 25.10 Unhedged Currencies

Table 25.10 Correlation for Asset Returns: Hedged Currencies Insert Table 25.10 Hedged Currencies

Table 25. 11 Correlation of U. S Table 25.11 Correlation of U.S. Equity Returns with Country Equity Returns

Figure 25.7 International Diversification

Figure 25.8 Ex Post Efficient Frontier of Country Portfolios, 2001 – 2005

Figure 25.9 Efficient Frontier of Country Portfolios (world expected excess return = .6% per month)

Figure 25.10 Regional Indexes around the Crash, October 14 – October 26, 1987

Figure 25.11 Efficient Diversification by Various Methods

Figure 25.12 Diversification by Market Capitalization: National Markets versus Regional Funds

Figure 25.13 Diversification Benefits over Time

Table 25.12 Weighting Schemes for EAFE Countries

Performance Attribution with International Extension to consider additional factors Currency selection Country selection Stock selection Cash and bond selection

Table 25.13 Example of Performance Attribution: International