International Financial Management Vicentiu Covrig 1 International Portfolio Investment (chapter 11)

International Financial Management Vicentiu Covrig 2 International Correlation Structure and Diversification Main benefit of international investing is diversification The cross-country correlations are less then one, and for some pair of countries less than 0.5 Correlations between countries are not stable through time Security returns are much less correlated across countries than within a country.

International Financial Management Vicentiu Covrig 3 The Optimal International Portfolio OIP % UK US CN FR JP GM

International Financial Management Vicentiu Covrig 4 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 0.7. The correlation of the U.S. stock market with the Japanese stock market is A U.S. investor would get more diversification from investments in Japan than Canada.

International Financial Management Vicentiu Covrig 5 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. 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 ($/FC)

International Financial Management Vicentiu Covrig 6 Effects of Changes in the Exchange Rate For example, if a U.S. resident just sold shares in a Mexican firm that had a 20% return (in pesos) during a period when the peso depreciated 5%, his dollar return is : R i$ = (1 +.2)(1 –0.05) – 1 = 0.14 or 14%

International Financial Management Vicentiu Covrig 7 International Diversification through International Mutual Funds 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.

International Financial Management Vicentiu Covrig 8 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. World Equity Benchmark Shares (WEBS) - Country-specific baskets of stocks designed to replicate the country indexes of 14 countries.

International Financial Management Vicentiu Covrig 9 Trading in International Equities The easiest way is to trade ADRs 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.

International Financial Management Vicentiu Covrig 10 Why Home Bias in Portfolio Holdings? Home bias refers to the extent to which portfolio investments are concentrated in domestic equities. Explanations for home bias:

International Financial Management Vicentiu Covrig 11 Learning outcomes: - what are the benefits of investing internationally (with a focus on diversification) - discuss three ways in which a US investor can diversify internationally - What is home bias and what are the factors that explain it - Recommended end-of-chapter questions: 1, 2, 5, 6, 10, 11 - Recommended end-of-chapter problems: 1, 2, 4