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Portfolio Theory and International Securities Markets. Short Review of Portfolio Theory Diversification and Globalization. The World Equity Market. World equity markets grew rapidly from 1992 to 2006

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portfolio theory and international securities markets

Portfolio Theory and International Securities Markets

Short Review of Portfolio Theory Diversification and Globalization

the world equity market
The World Equity Market
  • World equity markets grew rapidly from 1992 to 2006
  • Market capitalization (value) of developed countries stock markets was $33 trillion at year end 1999. By year end 2002 it was $20.9 trillion
  • By 2005 the developed markets had recovered and their market capitalization reached $36.5 trillion
the world equity market1
The World Equity Market
  • Markets fluctuate with economic activity
  • Over time markets recover with the economy
  • World markets had a strong recovery in 2003 and continued into 2007.
  • Developed world securities markets continue to expand
  • Major growth also in the “emerging” markets
    • Argentina - Brazil - China – Taiwan -- Mexico
emerging markets share 2002 and 2005
Emerging Markets Share2002 and 2005
  • 2002 2005
  • Mideast and Africa 18% > 31%
  • South Asia 12% > 14%
  • East Asia 48% < 29%
  • Eastern/Central Europe 7% > 11%
  • Latin America 15% = 15%
diversification benefits
Diversification Benefits
  • Invest in foreign markets fordiversification
  • Foreign markets do NOT move in harmony with each other
  • Diversified portfolio from many countries is less volatile than domestic portfolio - could even have a higher rate of return

As the world markets become more global, returns between countries may become more harmonized.

diversification benefits cont
Diversification Benefits cont.
  • Correlation between the historical returns of different countries is less than 1.0
  • Richard Roll: Most significant factor relating to the size of the market decline in each country was the beta, β, of that market to the world market index
  • No country continually outperforms the others on an annual basis
developing an efficient portfolio
Developing an Efficient Portfolio

Consider large number of portfolios based on

  • Expected value
  • Standard deviation
  • Correlations between the individual securities
  • A portfolio of 14 to 16 stocks is fully diversified
  • Portfolio theory was developed by Professor Harry Markowitz (1950s). Won the Nobel prize in 1990 for this work
efficient frontier line
Efficient Frontier Line
  • 4 points out of 8 possibilities lie on the frontier
  • ACFH delineates the efficient set of portfolios
  • It is efficient because portfolios on this line dominate all other attainable portfolios

ACFH line: efficient frontier

because portfolios on it provide

best risk-return trade-off

capital asset pricing model capm
Capital Asset Pricing Model (CAPM)
  • Professor Sharpe advanced

efficient portfoliosto

capital asset pricing model

  • Assets value based on risk characteristics
  • CAPM takes off where efficient frontier stops
  • Introduce
    • New investment outlet
    • Risk-free asset (RF)
risk free rf asset
Risk-free (RF) Asset
  • Has no risk of default
  • Standard deviation of zero (-0-)
  • Lowest/safest return
    • U.S. Treasury bill
    • U.S. Treasury bond

Zero risk

CAPM combines risk-free

asset & efficient frontier

capital market line cml
Capital Market Line (CML)
  • RFMZ line capital market line (CML)
  • Formula for the capital market line

See next slide

Kp = Expected value of the portfolio

σM = Market standard deviation

RF = Risk-free rate

KM = Market rate of return

σP= Portfolio standard deviation

return on an individual security
Return on an Individual Security

Ki = Stock return, dependent variable, Y-axis

ai (alpha) = Line intersects vertical axis

bi (beta) = Slope of the line

KM = Market return, independent variable, X-axis

ei = Random error term

ai + biKM : Straight line

ei = Deviations, nonrecurring movements


Beta is a measure of Risk relative to a market index. In the U.S. it is usually measured over 60 months against the broad Standard and Poor’s 500 Index.

correlation coefficients between foreign markets and u s markets in rates of return
Correlation Coefficients Between Foreign Markets and U.S. Markets in $ Rates of Return
correlations of total return between u s markets and emerging markets in u s dollars 2000 2005
Correlations of Total Return between U.S. Markets and Emerging Markets in U.S. Dollars 2000-2005
return potential in international markets
Return Potential in International Markets


Less risk exposure

Possible higher returns



Several countries had long-term growth

rates superior to U.S. in terms of real GDP:

  • Norway
  • Singapore
  • China
return potential in international markets1
Return Potential in International Markets
  • Many countries are highly competitive in
  • automobiles, steel, & consumer electronics
  • Germany
  • Japan
  • France
  • Canada

Enjoy higher individual

savings rates than U.S.


Capital formation and

potential investment opportunity

current quotations on foreign market performance
Current Quotations on Foreign Market Performance
  • Track performance of selected world markets
  • 1st index EAFE =Europe, Australia, FarEast
  • Quotes are in local currencies & in U.S. $
  • U.S. investors compare returns in U.S. against an investment in U.S. stock market


Instructions to navigate msci website: on Power Point tool bar click View, choose Notes Page

other market differences
Other Market Differences
  • Culture
  • Willingness to take risk
  • Desire for dividend income versus growth in share value
  • Number & type of companies available to stockholders
  • Bureaucratic differences
other market differences cont
Other Market Differences cont.
  • Accounting conventions
  • Government regulation of markets
  • Problem with comparing P/E ratios:

Earnings calculated differently according to local or regional accounting

currency fluctuations and rates of return
Currency Fluctuations and Rates of Return
  • Tracking foreign markets requires adjustments
  • Reported returns adjusted for

foreign currency effects

  • How important is the foreign currency effect in relation to overall return performance in foreign currency?
  • Do foreign exchanges overpower actual return on investments in foreign countries?
currency fluctuations and rates of return1
Currency Fluctuations and Rates of Return
  • Foreign currency effect is about 10 to 20% as significant as the actual return performance in the foreign currency
  • If dollar is rising/falling rapidly over a short period the impact can be much greater
currency fluctuations and rates of return2
Currency Fluctuations and Rates of Return
  • Investment in Switzerland: 10% return
  • CHF declines by 5% against U.S. $
  • CHF profits are worth less in $

Gain on investment:

  • 110% (Investment with 10% profit)
  • Adjusted value of CHF relative to U.S. $
  • = 0.95 =1.00 - 0.05 decline in currency
  • 104.5% (= 110 x 0.95) of original investment
  • Actual return in U.S. $ 4.5% insteadof 10%

Swiss franc = CHF

currency fluctuations and rates of return3
Currency Fluctuations and Rates of Return
  • Examine currency effects in Sweden YTD
  • Return in local currency 4.58% (3rd column)
  • Return in U.S. $............. 6.31% (7th column)
  • Change in $/SEK made a positive return in kronor become a negative return in U.S. $

See Table 19-8 next 2 slide

Swedish currency Krona (pl. Kronor) symbol SEK

currency fluctuations and rates of return4
Currency Fluctuations and Rates of Return

Computed returns:

  • 104.58% (Investment with 4.58% profit)
  • (Adjusted value of the SEK to U.S. $)

0.896 (1.000 - 0.104 decline in currency)

  • 93.7% (= 104.58 x 0.896) of original investment

See Table 19-8 next slide

other obstacles to international investments
Other Obstacles to International Investments
  • Political Risks
  • Tax Problems
  • Lack of Market Efficiency
  • Administrative Problems
  • Information Problems
  • Corruption
political risks
Political Risks
  • Danger of nationalization of foreign firms
  • Restriction of capital flows to investors
  • Violent overthrow of political party in power
  • Not meeting their foreign debt obligations
  • Check the political/economic climate
tax problems
Tax Problems
  • Foreign countries may impose 15 to 30% withholding tax against dividends or interest paid to nonresidents
  • Tax-exempt U.S. investors can secure exemption or rebate
  • Taxable U.S. investors can claim a U.S. tax credit for taxes paid in foreign countries
  • Inconvenience rather than loss of funds
lack of market efficiency
Lack of Market Efficiency
  • U.S. capital markets the most liquid & efficient in the world
  • Investors accustomed to trading on NYSE will find it difficult to adjust to foreign markets
  • Larger spread between bid (sell) & ask (buy) price
  • Difficulty executing large transaction
  • Higher commission rates
Elkins/McSherry Global Universe of Transaction Costs Developed Markets 4 factors: price, commission, fees, mkt impact
administrative problems
Administrative Problems
  • Adjusting to various local systems

For example,

  • Hong Kong, Swiss, & Mexican stock markets settle accounts one day after the transaction
  • London: two-week settlement
  • Different administrative procedures add extra difficulty in executing trades
  • Avoid these difficulties by going through mutual funds and other investment outlets
information problems
Information Problems
  • U.S. securities markets are the best at providing investment information
  • S.E.C. has rigorous requirements for full disclosure information
  • FASB continually providing pronouncements on GAAP for financial reporting
  • Publicly traded companies required to provide stockholders with fully audited annual reports
  • Evaluative reports/ratings by Moody’s, Standard & Poor’s, Value Line, & other firms
information problems1
Information Problems
  • Extensive economic data provided by governmental sources e.g.
    • Department of Commerce
    • Federal Reserve System
  • International firms in less sophisticated foreign markets do not provide sufficient data
  • Language problems for the analyst
methods of participating in foreign investments
Methods of Participating in Foreign Investments

International investment

  • Investing in firms in foreign markets
  • Purchasing foreign shares trading in U.S.
  • Open-end mutual funds investing overseas
  • Closed-end mutual funds with foreign portfolio
  • Buying shares of multinational corporations
  • Exchange Traded Funds (ETFs)
methods of participating in foreign investments1
Methods of Participating in Foreign Investments
  • Direct Investments
  • Indirect Investments
direct investments
Direct Investments
  • Directly purchase shares of firm in foreign market
  • Use foreign broker/overseas branch of U.S. broker

Difficulties and administrative problems:

  • Information-gathering problems
  • Tax problems
  • Stock-delivery problems
  • Capital-transfer problems
  • Communication difficulties in executing orders
  • Sophisticated money manager follow this approach
direct investments1
Direct Investments
  • Purchase shares of foreign firms that trade in U.S. stock markets (NYSE)
  • Purchase ADRs

ADRs represent ownership interest

in a foreign company’s common stock


Go to:

1. International

2. Non-U.S. Listed Company Directory

direct investments hyperlinks to some companies that have adrs
Direct Investments - Hyperlinks to some companies that have ADRs






indirect investments
Indirect Investments

Investments in international securities include:

  • Purchasing shares of multinational corporations
  • Mutual funds and/or closed-end investment funds specializing in worldwide investments
  • Investing in exchange traded funds (ETF)
  • Use a private firm specializing in foreign investment portfolio management
a purchasing shares of multinational corporations
(a)- Purchasing Shares of Multinational Corporations
  • Firms with operations in several countries
  • Opportunity for international diversification
    • Major oil companies e.g. Exxon, BP, Shell
    • Large banking firms e.g. Barclays, HSBC
    • Pharmaceuticals e.g. Glaxo, Novartis
    • Consumer Products e.g. Sony, Coca Cola
b mutual funds and closed end investment companies
(b)- Mutual Funds and Closed-End Investment Companies
  • Mutual funds offer
    • Diversification Efficiency
    • Professional management
      • Does not mean out performing the market
    • Time Savings
  • Invest in closed-end investment companies specializing in international equity investments

May trade at premium/discount from NAV

c exchange traded funds etfs
(c)- Exchange Traded Funds (ETFs)
  • Use ETFs to invest in international markets
  • Biggest market the American Stock Exchange
  • Lists over 40 international funds
  • ETF: basket of securities that track an index
  • Trades like an individual stock with all day
    • Trading
    • Price tracking


exchange traded funds etfs
Exchange Traded Funds (ETFs)
  • An ETF mimics a major index, e.g.
    • Financial Times 100 for United Kingdom
    • DAX for Germany, Heng Seng for Hong Kong
  • ETF can track
    • A broad stock index
    • Bond index
    • Broad Industry index or Sector index
  • Lower costs
  • Better tax efficiency than mutual funds
  • Ability to diversify using these funds


d specialists in international securities
(d)-Specialists in International Securities

Large investors may engage services of firms with specialized expertise in foreign equities

  • Banks
  • Investment counselors
    • Morgan Guaranty Trust Company
    • State Street Bank and Trust Company
    • Batterymarch Financial Management
    • Fidelity Trust Company of New York
  • Minimum investment well in excess of $100,000
  • Cater to large institutional investors
  • Diversify by investing in international securities
  • Different foreign markets influenced by varying & contradictory factors
  • Effective risk reduction


Sharp & unexpected increase in energy prices

negative impact on oil importers may be

offset by positive impact on oil exporters


Investments in selected foreign equity markets may provide

  • Excellent return opportunities
  • Many countries’ GDP growth is = or > U.S.
  • Greater savings rates
  • Higher capital formation
  • Don’t forget demographics
  • Risks – business, financial, exchange rate, market, accounting, economic, and political risks.