INTERNATIONAL PORTFOLIO INVESTMENT

What are the advantages of international investment? Why Invest Internationally?

I.THE BENEFITS OF INTERNATIONAL EQUITY INVESTING A.Advantages 1.Offers more opportunities than a purely domestic portfolio 2.Attractive investments overseas 3.Impact on efficient portfolio with diversification benefits THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

II. Basic Portfolio Theory A. What is the efficient frontier? It represents the most efficient combinations of all possible risky assets. II. Basic Portfolio Theory

E(r) The Efficient Frontier A B

The broader the diversification, the more stable the returns and the more diffuse the risk. Basic Portfolio Theory

B.International Diversification 1. Risk-return tradeoff: may be greater Basic Portfolio Theory

Total Risk 1. A Security’s Returns may be segmented into Systematic Risk can not be eliminated Non-systematic Risk can be eliminated by diversification Basic Portfolio Theory

The Benefits of Int’l Diversification

2. International diversification and systematic risk a.Diversify across nations with different economic cycles b.While there is systematic risk within a nation, outside the country it may be nonsystematic and diversifiable INTERNATIONAL DIVERSIFICATION

3.Recent History a.National stock markets have wide differences in returns and risk. b.Emerging markets have higher risk and return than developed markets. c.Cross-market correlations have been relatively low. INTERNATIONAL PORTFOLIO INVESTMENT

4.Theoretical Conclusion International diversification pushes out the efficient frontier. INTERNATIONAL PORTFOLIO INVESTMENT

E(r) The New Efficient Frontier A B C

5.Cross-market correlations a. Recent markets seem to be most correlated when volatility is greatest b. Result: Efficient frontier retreats CROSS-MARKET CORRELATIONS

E(r) The Frontier During Global Crises A B C

D.Investing in Emerging Markets a.Offers highest risk and returns b.Low correlations with returns elsewhere c.As impediments to capital market mobility fall, correlations are likely to increase in the future. Investing in Emerging Markets

E. Barriers to International Diversification 1.Segmented markets 2.Lack of liquidity 3.Exchange rate controls 4.Underdeveloped capital markets 5.Exchange rate risk 6.Lack of information a.not readily accessible b.data is not comparable Barriers to International Diversification

F.Diversify by a 1.Trade in American Depository Receipts (ADRs) 2.Trade in American shares 3.Trade internationally diversified mutual funds: a.Global (all types) b.International (no home country securities) c.Single-country Other Methods to Diversify

4.Calculation of Expected Portfolio Return: r p = a r US + ( 1 - a) r rw where r p = portfolio expected return r US = expected U.S. market return r rw = expected global return INTERNATIONAL PORTFOLIO INVESTMENT

Sample Problem What is the expected return of a portfolio with 35% invested in Japan returning 10% and 65% in the U.S. returning 5%? r p = a r US + ( 1 - a) r rw =.65(.05) +.35(.10) = =6.75% Expected Portfolio Return

Calculation of Expected Portfolio Risk where =the cross-market correlation  US 2 =U.S. returns variance  r w 2 =World returns variance Expected Portfolio Return

What is the risk of a portfolio with 35% invested in Japan with a standard deviation of 6% and a standard deviation of 8% in the U.S. and a correlation coefficient of.7? = [(.65) 2 (.08) 2 + (.35) 2 (.06) 2 +2(.65)(.35)(.08)(.06)(.7)] 1/2 =6.8% Portfolio Risk Example

IV.MEASURING TOTAL RETURNS FROM FOREIGN PORTFOLIOS A.To compute dollar return of a foreign security: or INTERNATIONAL PORTFOLIO INVESTMENT

Bond (calculating return) formula: whereR $ = dollar return B(1) = foreign currency bond price at time 1 (present) C = coupon income during period g = currency depreciation or appreciation INTERNATIONAL PORTFOLIO INVESTMENT

B. (Calculating U.S. $ Return) Stocks Formula: whereR $ = dollar return P(1)= foreign currency stock price at time 1 D= foreign currency annual dividend INTERNATIONAL PORTFOLIO INVESTMENT

Suppose the beginning stock price if FF50 and the ending price is FF48. Dividend income was FF1. The franc depreciates from FF 20 /$ to FF21.05 /$ during the year against the dollar. What is the stock’s US$ return for the year? U.S. $ Stock Returns: Sample Problem

U.S. $ Stock Returns: Sample Solution

Cost of Capital

A firm’s cost of capital depends on which investors, domestic or foreign, supply capital. The implication is that a firm can reduce its cost of capital by internationalizing its ownership structure. Asset Pricing under Foreign Ownership

Nestlé used to issue two different classes of common stock: bearer shares and registered shares. –Foreigners were only allowed to buy bearer shares. –Swiss citizens could buy registered shares. –The bearer stock was more expensive. On November 18, 1988, Nestlé lifted restrictions imposed on foreigners, allowing them to hold registered shares as well as bearer shares. An Example of Foreign Ownership Restrictions: Nestlé

Nestlé’s Foreign Ownership Restrictions 12,000 10,000 8,000 6,000 4,000 2, Source: Financial Times, November 26, 1988 p.1. Adapted with permission. SF Bearer share Registered share 17-31

Following this, the price spread between the two types of shares narrowed dramatically. –This implies that there was a major transfer of wealth from foreign shareholders to Swiss shareholders. –The price of bearer shares declined about 25 percent. –The price of registered shares rose by about 35 percent. Because registered shares represented about two- thirds of the market capitalization, the total value of Nestlé increased substantially when it internationalized its ownership structure. Nestlé’s cost of capital therefore declined. An Example of Foreign Ownership Restrictions: Nestlé

Foreigners holding Nestlé bearer shares were exposed to political risk in a country that is widely viewed as a haven from such risk. The Nestlé episode illustrates –The importance of considering market imperfections. –The peril of political risk. –The benefits to the firm of internationalizing its ownership structure. An Example of Foreign Ownership Restrictions: Nestlé