International Portfolio Investment

1. International Portfolio Investment Chapter 11

2. Chapter Outline • Portfolio Arithmetic – International Perspectives • Optimal International Portfolio Selection • International Mutual Funds: A Performance Evaluation • International Diversification through Country Funds • International Diversification with ADRs • International Diversification with WEBS • Why Home Bias in Portfolio Holdings?

3. 11.1 Portfolio Arithmetic – International Perspectives • Investment in international securities offer opportunities for diversification but increases foreign exchange risk; • For example, • A Canadian portfolio manager buys 10 UK shares at £10 per share, at $2.30/£; • At the end of the period, the shares have risen in value to £110, but the pound falls to $2.10/£: The transactions are summarized:

4. Portfolio Arithmetic – International Perspectives • Three rates of return:

5. Portfolio Arithmetic – International Perspectives

6. International Portfolio Diversification

7. Canadian Dollar-Based Equity Market Returns

8. 11.2 Optimal International Portfolio Selection • 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.

9. Optimal International Portfolio Selection • The correlation of Canadian stock markets 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 58%. • The correlation of the U.S. stock market with the Japanese stock market is 26%. • A U.S. investor would get more diversification from investments in Japan than Canada.

10. Canadian Dollar-Based Equity Correlations Relatively low international correlations imply that investors should be able to reduce portfolio risk more if they diversify internationally rather than domestically.

11. Summary Statistics for Monthly Returns for 12 Major Stock Markets • measures 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. 1/1980-12/2001

12. Domestic versus International Diversification

13. The Optimal International Portfolio OIP Efficient set 1.53 JP UK US FR GM Rf CN 4.2%

14. Composition of the OIP for a U.S. Investor (Holding Period: 1980—2000

15. OIP ODP Mean Return 1.42% 1.26% Standard Deviation 4.51% 4.43% 4.51% 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. return OIP 1.42% 1.26% ODP risk 4.43%

16. OIP by Investors’ Domicile (1980-2001)

17. 11.3 International Mutual Funds: Access to the World • A U.S. investor can easily achieve international diversification by investing in a U.S.-based international mutual fund. • The advantages include • Savings on transaction and information costs. • Circumvention of legal and institutional barriers to direct portfolio investments abroad. • Professional management and record keeping.

18. International Mutual Funds: A Performance Evaluation

19. 11.4 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.

20. 11.5 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

21. 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.

22. International Diversification with ADRs • Adding ADRs to domestic portfolios has a substantial risk reduction benefit.

23. 11.6 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.

24. 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

25. 11.7 Why Home Bias in Portfolio Holdings? • Home bias refers to the extent to which portfolio investments are concentrated in domestic equities.

26. Country Share in World Market Value Proportion of Domestic Equities in Portfolio France 2.6% 64.4% Germany 3.2% 75.4% Italy 1.9% 91.0% Japan 43.7% 86.7% Spain 1.1% 94.2% Sweden 0.8% 100.0% United Kingdom 10.3% 78.5% United States 36.4% 98.0% Total 100.0% The Home Bias in Equity Portfolios

27. 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.

28. Summary • International portfolio investment has be growing recently because of deregulation and new investment instruments; • Diversification reduces risk: Lower covariance across countries (than within countries) means international diversification reduces risk more; • More effective diversification means higher returns for a fixed level of risk; • Foreign exchange uncertainty adds to the risk of foreign investments; hedging of forex risks allows investors to enhance overall gains from international diversification;

29. Summary • Domestically-based mutual funds and closed-end country funds allow investors to achieve international diversification at home; • Despite potential gains from international diversification investors allocate a disproportionate share of their assets to domestic securities – a home bias. Home bias likely reflects imperfections in international markets.

30. 11A 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.

31. Effects of Changes in the Exchange Rate • The realized dollar return for a U.S. resident investing in a foreign market is given by • Ri$ = (1 + Ri)(1 + ei) – 1 • = Ri + ei+ Riei • Where • Riis the local currency return in the ith market • eiis the rate of change in the exchange rate between the local currency and the dollar

32. 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 + .15)(1 –0.05) – 1 = 0.925 • = .15 + -.05 + .15×(-.05) = 0.925

33. 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) + Var • The Var term represents the contribution of the cross-product term, Riei, to the risk of foreign investment.

34. Effects of Changes in the Exchange Rate • Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + Var • This 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.