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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

Portfolio theory and international securities markets

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 Emerging Markets in U.S. Dollars 2000-2005


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

Returns in developed markets in u s
Returns in Developed Markets In U.S. $ Emerging Markets in U.S. Dollars 2000-2005

5 yr returns in emerging markets in u s 2000 2005
5 Yr. Returns in Emerging Markets Emerging Markets in U.S. Dollars 2000-2005in U.S. $ 2000-2005

Return potential in international markets1
Return Potential in International Markets Emerging Markets in U.S. Dollars 2000-2005

  • 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 period 1969-2001

  • 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 period 1969-2001

  • 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. period 1969-2001

  • 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 period 1969-2001

  • 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 period 1969-2001

  • 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 period 1969-2001

  • 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 period 1969-2001Rates 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 period 1969-2001Rates 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 period 1969-2001

  • Political Risks

  • Tax Problems

  • Lack of Market Efficiency

  • Administrative Problems

  • Information Problems

  • Corruption

Political risks
Political Risks period 1969-2001

  • 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 period 1969-2001

  • 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 period 1969-2001

  • 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

Portfolio theory and international securities markets
Elkins/McSherry Global Universe of period 1969-2001Transaction Costs Developed Markets 4 factors: price, commission, fees, mkt impact

Market capitalization of developed world markets year end 2005 in billions of u s
Market Capitalization of Developed World period 1969-2001Markets (Year end 2005) in billions of U.S.

Market capitalization of the largest emerging markets year end 2005 in billions of u s
Market Capitalization of The Largest Emerging period 1969-2001Markets (year end 2005) in billions of U.S.

Market capitalization of the three largest u s companies in billions u s
Market Capitalization of the Three period 1969-2001Largest U.S. Companies in billions U.S.$

Administrative problems
Administrative Problems period 1969-2001

  • 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 period 1969-2001

  • 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 period 1969-2001

  • 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 period 1969-2001

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 period 1969-2001

  • Direct Investments

  • Indirect Investments

Direct investments
Direct Investments period 1969-2001

  • 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 period 1969-2001

  • 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 - period 1969-2001Hyperlinks to some companies that have ADRs






Indirect investments
Indirect Investments period 1969-2001

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 period 1969-2001

  • 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 period 1969-2001

  • 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 period 1969-2001(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) period 1969-2001

  • 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)- period 1969-2001Specialists 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

Summary period 1969-2001

  • 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

Summary period 1969-2001

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.