Transcript Document 7560272

International Portfolio
Investment
Chapter 13
Why Invest
Internationally?
What are the advantages?
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THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
I. Why invest internationally?
A. Advantages
1.
Offers more opportunities than
a purely domestic portfolio
2.
Attractive investments overseas
3.
Diversification benefits positively
impact the efficient frontier
Caution: IT MAY BE MORE RISK THAN DOMESTIC
INVESTMENTS
3
Modern Portfolio Theory
Harry Markowitz, Nobel Prize Winner
Central concept:
Invest using the risk (σ) and return
E(r) trade off.
4
Basic Portfolio Theory:
What is the efficient frontier?
It represents the most efficient
combinations (portfolios) of all possible
risky assets.
5
The Efficient Frontier
Impossible!!
C
E(r)
A
Why is Portfolio B inefficient?
B

6
Basic Portfolio Theory:
DIVERSIFICATION
What are diversification benefits:
The broader the diversification,
a. the more stable the returns and
b. the more diffuse the risk.
BASED ON THE INSURANCE PRINCIPLE!
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Diversification and The
Insurance Principle
U
U
U
U
U
U
Not
diversified
U
U
U
US
US
US
US
US
US
US
US
US
S
S
S
Diversified
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INTERNATIONAL
DIVERSIFICATION
B. Another Benefit from International
Diversification
Risk-return tradeoff:
May be greater when
investing internationally
WHY?
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Basic Portfolio Theory:
1. Total Risk of a Security’s Return may
be segmented into two parts:
= Systematic Risk
such as inflation and unemployment
which can not be eliminated
+ Non-systematic Risk
such as industry business cycles which
can be eliminated by diversification
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The Benefits of Int’l
Diversification: The Evidence
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INTERNATIONAL
DIVERSIFICATION
2. Using International diversification to
reduce systematic risk:
a.
Guideline: Diversify across
nations in different stages of the
business cycle
b.
Benefit: While there is systematic risk
within a domestic portfolio, it may be
nonsystematic and diversifiable in a
global portfolio
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INTERNATIONAL PORTFOLIO
INVESTMENT
3. Recent History
a.
National stock markets have wide
differences in returns and risk.
b.
Emerging markets often have
higher risk and return than
developed markets.
c.
Cross-market correlations have
been relatively low.
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Cross-Market Correlations
With a U.S. portfolio:
1. High positive correlations:
2. Low or Negative correlations:
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INTERNATIONAL PORTFOLIO
INVESTMENT
4. Theoretical Conclusion
International diversification
pushes out the efficient frontier.
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The New Efficient Frontier
C
E(r)
A
B

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CROSS-MARKET
CORRELAITONS
5. Cross-market correlations
a. Recent markets seem to be
most correlated when volatility
is greatest
b. Result:
Efficient frontier retreats
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The Frontier During Global
Crises C
E(r)
A
B

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Investing in Emerging
Markets
C. Investing in Emerging Markets
a. Offers highest risk and returns
b. Low correlations with returns
elsewhere
Caution:
As impediments to capital
market mobility fall,
correlations are likely to
increase in the future.
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Barriers to International
Diversification
D.
1.
2.
3.
4.
5.
6.
Barriers to International Diversification
Segmented markets
Lack of liquidity
Exchange rate controls
Underdeveloped capital markets
Exchange rate risk
Lack of information
a.
not readily accessible
b.
data is not comparable
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Other Methods to
Diversify
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
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INTERNATIONAL PORTFOLIO
INVESTMENT
4. Calculation of Expected Portfolio Return:
rp = a rUS + ( 1 - a) rrw
where
rp
= portfolio expected return
rUS
= expected U.S. market
return
rrw
= expected global return
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Portfolio Return
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%?
rp = a rUS + ( 1 - a) rrw
=
=
=
.65(.05) + .35(.10)
.0325 + .0350
6.75%
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INTERNATIONAL PORTFOLIO
INVESTMENT
Calculation of Expected Portfolio Risk
1/ 2
 P  a   (1  a)   2a(1  a) US rw  
2
where
2
US
2

=
US2
 r w2
=
=
2
rw
the cross-market
correlation
U.S. returns variance
World returns variance
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Portfolio Risk
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?
1/ 2
 P  a   (1  a)   2a(1  a) US rw  
2
2
US
2
2
rw
= [(.65)2 (.08) 2 + (.35) 2(.06) 2
+2(.65)(.35)(.08)(.06)(.7)]
= 6.8%
1/2
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INTERNATIONAL PORTFOLIO
INVESTMENT
IV. MEASURING TOTAL RETURNS
FROM FOREIGN PORTFOLIOS
A. To compute dollar return of a
foreign security:
e1  e0
RUS $  ( RForeignCurrency )(
)
e0
or
e0  e1
RUS $  ( RForeignCurrency )(
)
e1
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INTERNATIONAL PORTFOLIO
INVESTMENT
Bond (calculating return) formula:
 B(1)  B(0)  C 
1  R$  1 
(1  g )

B(0)


where
R$ = dollar return
B(1) = foreign currency bond price
at time 1 (present)
C = coupon income during period
g = currency depreciation
or appreciation
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INTERNATIONAL PORTFOLIO
INVESTMENT
B. Stocks (Calculating return)
Formula:
 P(1)  P(0)  D 
1  R$  1 
(1  g )

P(0)


where
R$
= dollar return
P(1) = foreign currency stock
price at time 1
D
= foreign currency annual
dividend
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U.S. $ Stock Returns:
Sample Problem
Suppose the beginning stock price if FF50 and
the ending price is FF48. Dividend income
was FF1. The franc depreciates from $.20
/FF to $.2105 /FF during the year against
the dollar. What is the stock’s US$ return
for the year?
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U.S. $ Stock Returns:
Sample Solution
During the year the price of British bonds
went from £102 to £106, while paying a
coupon of £9. At the same time, the
exchange rate went from$1.76/ £ to $1.62/
£. What was the total dollar return, in
percent, on British bonds for the year?
e0=$1.76/£
e1=$1.62/£
In direct terms:
e0= £.5682/$
e1= £.6173/$
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U.S. $ Stock Returns:
Sample Solution
 B1  B0  C 
1  r$  1 
 1  g 
B0


(e0  e1 )
g
e1
 106  102  9    .5682  .6173 
 1 
 1 

102
.6173




 (1.1275)(1  .0795)
 (1.1275)(.9205)  1
 3.79%
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