Presentation on theme: "International Portfolio Investments"— Presentation transcript:
0 International Portfolio Investments FINANCIALMANAGEMENTEUN / RESNICKThird EditionChapter Objectives:Why investors diversify their portfolios internationally.How much investors can gain from international diversification.The effects of fluctuating exchange rates on international portfolio investments.Whether and how much investors can benefit from investing in U.S. based international mutual funds.The reasons for “home bias” in portfolio holdings.11Chapter ElevenInternational Portfolio Investments
1 International Portfolio Investments Chapter 11International Portfolio Investments
2 Chapter OutlineInternational Correlation Structure and Risk DiversificationOptimal International Portfolio SelectionEffects of Changes in the Exchange RateInternational Bond InvestmentInternational Mutual Funds: A Performance Evaluation
3 Chapter Outline (continued) International Diversification through Country FundsInternational Diversification with ADRsInternational Diversification with WEBSWhy Home Bias in Portfolio Holdings?
4 International Correlation Structure and Risk Diversification Security returns are much less correlated across countries than within a country.This is so because economic, political, institutional, and even psychological factors affecting security returns tend to vary across countries, resulting in low correlations among international securities.Business cycles are often high asynchronous across countries.
5 International Correlation Structure Stock MarketAUFRGMJPNLSWUKUSAustralia (AU).586France (FR).286.576Germany (GM).183.312.653Japan (JP).152.238.300.416Netherlands (NP).241.344.509.282.624Switzerland (SW).358.368.475.281.517.664United Kingdom (UK).315.378.299.209.393.431.698United States (US).304.225.170.137.271.272.279.439Relatively low international correlations imply that investors should be able to reduce portfolio risk more if they diversify internationally rather than domestically.
6 Domestic vs. International Diversification When fully diversified, an international portfolio can be less than half as risky as a purely U.S. portfolio.A fully diversified international portfolio is only 12 percent as risky as holding a single security.Portfolio Risk (%)0.44Swiss stocks0.27U.S. stocks0.12International stocksNumber of Stocks
7 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 70%.The correlation of the U.S. stock market with the Japanese stock market is 24%.A U.S. investor would get more diversification from investments in Japan than Canada.
8 Summary Statistics for Monthly Returns 1980-2001 ($U.S.) Stock MarketCorrelation CoefficientMean(%)SDCNFRGMJPUKCanada (CN).885.780.99France (FR)0.461.196.291.00Germany (GM)0.420.691.096.260.91Japan (JP)0.330.416.991.20United Kingdom0.570.501.235.550.98United States0.740.450.310.581.264.430.86.88% monthly return = 10.56% per year
9 Summary Statistics for Monthly Returns 1980-2001 ($U.S.) Stock MarketCorrelation CoefficientMean(%)SDCNFRGMJPUKCanada (CN).885.780.99France (FR)0.461.196.291.00Germany (GM)0.420.691.096.260.91Japan (JP)0.330.416.991.20United Kingdom0.570.501.235.550.98United States0.740.450.310.581.264.430.86measures the sensitivity of the market to the world market.Clearly the Japanese market is more sensitive to the world market than is the U.S.
10 The Optimal International Portfolio OIPEfficient set1.53JPUKUSFRGMRfCN4.2%
11 Composition of the OIP for a U.S. Investor (Holding Period: 1980—2000 Hong Kong market1.61%Italian market1.14%Netherlands market29.96%Swedish market26.45%U.S. market40.84%Total100.00%
12 Gains from International Diversification For a U.S. investor, OIP has more return and more risk. The Sharpe measure is 20% higher, suggesting that an equivalent-risk OIP would have 1.68% more return than a domestic portfolio.returnOIP1.42%1.26%4.51%ODPOIPODPMean Return1.42%1.26%Standard Deviation4.51%4.43%risk4.43%
13 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.
14 Effects of Changes in the Exchange Rate The realized dollar return for a U.S. resident investing in a foreign market is given byRi$ = (1 + Ri)(1 + ei) – 1= Ri + ei + RieiWhereRi is the local currency return in the ith marketei is the rate of change in the exchange rate between the local currency and the dollar
15 Effects of Changes in the Exchange Rate For example, if a U.S. resident just sold shares in a British firm that had a 15% return (in pounds) during a period when the pound depreciated 5%, his dollar return is 9.25%:Ri$ = ( )(1 –0.05) – 1 = 0.925= ×(-.05) =0.925
16 Effects of Changes in the Exchange Rate The risk for a U.S. resident investing in a foreign market will depend not only on the risk in the foreign market but also on the risk in the exchange rate between the U.S. dollar and the foreign currency.Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + VarThe Var term represents the contribution of the cross-product term, Riei, to the risk of foreign investment.
17 Effects of Changes in the Exchange Rate Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + VarThis equation demonstrates that exchange rate fluctuations contribute to the risk of foreign investment through three channels:Its own volatility, Var(ei).Its covariance with the local market returns Cov(Ri,ei).The contribution of the cross-product term, Var.
18 International Bond Investment There is substantial exchange rate risk in foreign bond investment. This suggests that investors may be able to increase their gains is they can control this risk, for example with currency forward contracts or swaps.The advent of the euro is likely to alter the risk-return characteristics of the euro-zone bond markets enhancing the importance of non-euro currency bonds.
19 International Mutual Funds: A Performance Evaluation A U.S. investor can easily achieve international diversification by investing in a U.S.-based international mutual fund.The advantages includeSavings on transaction and information costs.Circumvention of legal and institutional barriers to direct portfolio investments abroad.Professional management and record keeping.
20 International Mutual Funds: A Performance Evaluation As can be seen below, a sample of U.S. based international mutual funds has outperformed the S&P 500 during the period , with a higher standard deviation. USMean Annual ReturnStandard DeviationUSR2U.S. Based International Mutual Funds18.96%5.78%0.690.39S&P 50014.04%4.25%1.00U.S. MNC Index16.08%126.96.36.199
21 International Mutual Funds: A Performance Evaluation U.S. stock market movements account for less than 40% of the fluctuations of international mutual funds, but over 90% of the movements in U.S. MNC shares. This means that the shares of U.S. MNCs behave like those of domestic firms, without providing effective international diversification.Mean Annual ReturnStandard DeviationUSR2U.S. Based International Mutual Funds18.96%5.78%0.690.39S&P 50014.04%4.25%1.00U.S. MNC Index16.08%188.8.131.52
22 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:Speculate in a single foreign market with minimum cost.Construct their own personal international portfolios.Diversify into emerging markets that are otherwise practically inaccessible.
23 American Depository Receipts Foreign stocks often trade on U.S. exchanges as ADRs.It is a receipt that represents the number of foreign shares that are deposited at a U.S. bank.The bank serves as a transfer agent for the ADRs
24 American Depository Receipts 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.
25 International Diversification with ADRs Adding ADRs to domestic portfolios has a substantial risk reduction benefit.
26 World Equity Benchmark Shares World Equity Benchmark Shares (WEBS)Country-specific baskets of stocks designed to replicate the country indexes of 14 countries.WEBS are subject to U.S. SEC and IRS diversification requirements.Low cost, convenient way for investors to hold diversified investments in several different countries.
27 International Diversification with WEBS Recent research suggests that WEBs are an excellent tool for international risk diversification.For investors who desire international exposure, WEBs may well serve as a major alternative to such traditional tools as international mutual funds, ADRs, and closed-end country funds
28 Why Home Bias in Portfolio Holdings? Home bias refers to the extent to which portfolio investments are concentrated in domestic equities.
29 The Home Bias in Equity Portfolios CountryShare in World Market ValueProportion of Domestic Equities in PortfolioFrance2.6%64.4%Germany3.2%75.4%Italy1.9%91.0%Japan43.7%86.7%Spain1.1%94.2%Sweden0.8%100.0%United Kingdom10.3%78.5%United States36.4%98.0%Total
30 Why Home Bias in Portfolio Holdings? Three explanations come to mind:Domestic equities may provide a superior inflation hedge.Home bias may reflect institutional and legal restrictions on foreign investment.Extra taxes and transactions/information costs for foreign securities may give rise to home bias.