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Chapter 15. INTERNATIONAL PORTFOLIO INVESTMENT. Why Invest Internationally?. What are the advantages of international investment?. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING. I. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING A. Advantages 1. Offers more opportunities than

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Chapter 15 l.jpg

Chapter 15

INTERNATIONAL PORTFOLIO INVESTMENT


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Why Invest Internationally?

  • What are the advantages of international investment?


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THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

  • 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


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II. Basic Portfolio Theory

  • II. Basic Portfolio Theory

  • A. What is the efficient frontier?

  • It represents the most efficient combinations of all possible risky assets.



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Basic Portfolio Theory

  • The broader the diversification, the more stable the returns and the more diffuse the risk.


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Basic Portfolio Theory

  • B. International Diversification

  • 1. Risk-return tradeoff:

  • may be greater


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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



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INTERNATIONAL 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


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INTERNATIONAL PORTFOLIO INVESTMENT

  • 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.


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INTERNATIONAL PORTFOLIO INVESTMENT

  • 4. Theoretical Conclusion

  • International diversification pushes out the efficient frontier.



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CROSS-MARKET CORRELATIONS

  • 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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Investing in Emerging Markets

  • 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.


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Barriers to International Diversification

  • 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


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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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Expected 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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Expected Portfolio Return

Calculation of Expected Portfolio Risk

  • where = the cross-market

  • correlation

  • US2 = U.S. returns variance

  • r w2 = World returns variance


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Portfolio Risk Example

  • 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%


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INTERNATIONAL PORTFOLIO INVESTMENT

  • IV. MEASURING TOTAL RETURNS

  • FROM FOREIGN PORTFOLIOS

  • A. To compute dollar return of a foreign security:

  • or


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INTERNATIONAL PORTFOLIOINVESTMENT

  • Bond (calculating return) formula:

  • 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 PORTFOLIOINVESTMENT

  • B. (Calculating U.S. $ Return)

  • Stocks Formula:

  • 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 FF 20 /$ to FF21.05 /$ 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