International Finance FIN456 ♦ Fall 2012 Michael Dimond

Michael Dimond School of Business Administration International Diversification & Risk Portfolio Risk Reduction –Beta of a portfolio is measured by the ratio of the variance of the portfolio’s return relative to the variance of the market return –As an investor increases the number of securities, the portfolio’s risk declines rapidly at first and then asymptotically approaches the level of systematic risk of the market –A fully diversified portfolio would have a beta of 1.0

Michael Dimond School of Business Administration Foreign Exchange Risk The foreign exchange risks of a portfolio, whether it be a securities portfolio or the general portfolio of activities of the MNE, are reduced through diversification Internationally diversified portfolios are the same in principle because the investor is attempting to combine assets which are less than perfectly correlated, reducing the risk of the portfolio

Michael Dimond School of Business Administration Foreign Exchange Risk An illustration with Japanese equity –US investor takes $1,000,000 on 1/1/2002 and invests in stock traded on the Tokyo Stock Exchange (TSE) On 1/1/2002, the spot rate was ¥130/$ –The investor purchases 6,500 shares valued at ¥20,000 for a total investment of ¥130,000,000 –At the end of the year, the investor sells the shares at a price of ¥25,000 per share yielding ¥162,500,000 On 1/1/2003, the spot rate was ¥125/$ –The investor receives a 30% return on investment ($300,000/$1,00,000 = 30%)

Michael Dimond School of Business Administration Internationalizing the Domestic Portfolio Classic portfolio theory assumes that a typical investor is risk- averse –The typical investor wishes to maximize expected return per unit of expected risk An investor may choose from an almost infinite choice of securities This forms the domestic portfolio opportunity set The extreme left edge of this set is termed the efficient frontier –This represents the optimal portfolios of securities that possess the minimum expected risk per unit of return –The portfolio with the minimum risk among all those possible is the minimum risk domestic portfolio

Michael Dimond School of Business Administration Optimal Domestic Portfolio Construction

Michael Dimond School of Business Administration Internationalizing the Domestic Portfolio If the investor is allowed to choose among an internationally diversified set of securities, the portfolio set of securities shifts to upward and to the left This is called the internationally diversified portfolio opportunity set

Michael Dimond School of Business Administration Internationalizing the Domestic Portfolio This new opportunity set allows the investor a new choice for portfolio optimization The optimal international portfolio (IP) allows the investor to maximize return per unit of risk more so than would be received with just a domestic portfolio

Michael Dimond School of Business Administration Exhibit 17.5 The Gains from International Portfolio Diversification

Michael Dimond School of Business Administration Where:A = one asset B = second asset w = weights (respectively) E(r) = expected return of assets Calculating Portfolio Risk and Return The two-asset model consists of two components –The expected return of the portfolio –The expected risk of the portfolio The expected return is calculated as

Michael Dimond School of Business Administration Where:A = first asset B = second asset w = weights (respectively) σ = standard deviation of assets  = correlation coefficient of the two assets Calculating Portfolio Risk and Return The expected risk is calculated as

Michael Dimond School of Business Administration Where:US = US security GER = German security w US = weight of US security – 40% w GER = weight of German security – 60% σ US = standard deviation of US security – 15% ρ = correlation coefficient of the two assets – 0.34 US-GER Calculating Portfolio Risk and Return Example of two-asset model

Michael Dimond School of Business Administration Where:E US = expected return on US security – 14% E GER = expected return on German security – 18% w US = weight of US security w US = weight of German security E(r) = expected return of portfolio Calculating Portfolio Risk and Return Example of two-asset model

Michael Dimond School of Business Administration Alternative Portfolio Profiles Under Varying Asset Weights

Michael Dimond School of Business Administration Calculating Portfolio Risk and Return The multiple asset model for portfolio return

Michael Dimond School of Business Administration Calculating Portfolio Risk and Return The multiple asset model for portfolio risk

Michael Dimond School of Business Administration National Markets & Asset Performance Asset portfolios are traditionally constructed using both interest bearing risk-free assets and risky assets For at least the past 100 years ending in 2000, the risk of investing in equity assets has been rewarded with substantial returns A comprehensive study shows all 16 countries examined show positive average annual equity returns ranging from 4.8% in Belgium to 9.9% in Sweden

Michael Dimond School of Business Administration Real Returns and Risks on the Three Major Asset Classes, Globally, 1900–2000

Michael Dimond School of Business Administration National Markets & Asset Performance The next exhibit reports correlation coefficients between world equity markets for the 1900 – 2000 period –The correlation coefficients in the lower-bottom-left of the exhibit are for the entire period –The correlation coefficients in the upper-top-right of the exhibit are for the period The relatively low correlation coefficients among returns for the 16 countries for either period indicates great potential for international diversification

Michael Dimond School of Business Administration Correlation Coefficients Between World Equity Markets, 1900–2000

Michael Dimond School of Business Administration Are Markets Increasingly Integrated? As correlation increases, benefits of diversification will reduce Correlations have increased over time, however, the correlation coefficients are still far from 1.0, providing plenty of risk-reducing opportunities for international portfolio diversification

Michael Dimond School of Business Administration

Summary Statistics of the Monthly Returns for 18 Major Stock Markets, 1977–1996 (all returns converted into U.S. dollars and include all dividends paid)

Michael Dimond School of Business Administration Sharp and Treynor Performance Measures Investors should not examine returns in isolation but rather the amount of return per unit risk To consider both risk and return for portfolio performance there are two main measures applied –The Sharpe measure –The Treynor measure

Michael Dimond School of Business Administration Where:R i = average portfolio return R f = market return σ = risk of the portfolio Sharp and Treynor Performance Measures The Sharpe measure calculates the average return over and above the risk-free rate per unit of portfolio risk

Michael Dimond School of Business Administration Where:R i = average portfolio return R f = market return β = beta of the portfolio Sharp and Treynor Performance Measures The Treynor measure is similar to Sharpe’s measure except that it measures return over the portfolio’s beta The measures are similar dependant upon the diversification of the portfolio –If the portfolio is poorly diversified, the Treynor will show a high ranking and vice versa for the Sharpe measure

Michael Dimond School of Business Administration Sharp and Treynor Performance Measures Example: –Hong Kong average return was 1.5% –Assume risk free rate of 5% –Standard deviation is 9.61%

Michael Dimond School of Business Administration Sharp and Treynor Performance Measures Example: –Hong Kong average return was 1.5% –Assume risk free rate of 5% –beta is 1.09

Michael Dimond School of Business Administration Sharp and Treynor Performance Measures For each unit of risk the Hong Kong market rewarded an investor with a monthly excess return of 0.113% The Treynor measure for Hong Kong was the second highest among the global markets and the Sharpe measure was eighth This indicates that the Hong Kong market portfolio was not very well diversified from the world market perspective