International Portfolio Diversification
International Portfolio Diversification
R IP = w1 R1 + w2 R 2
The risk of a two-asset international portfolio is measured
by the standard deviation of its returns.
The riskiness of a portfolio depends on the degree of co-
movement of the component assets.
The co-movement can be measured by the covariance or
correlation coefficient.
The risk for a two-asset portfolio can be expressed as: 3
σ 2
IP= w1 σ 1 w2 σ 2 + 2 w1 w2 σ 1,2
2 2
+ 2 2
where:
or
σIP = var
2
ρ1,2 = σ1,2 / σ1 σ2
σ 1,2 = σ 1 σ 2 ρ1,2
4
A Perfectly Positive Correlation (ρ =1):
If the two assets comprising the international portfolio are
positively perfectly correlated, then the portfolio variance,
σ IP = w1 σ 1 + w2 σ 2 + 2 w1 w2 σ 1 σ 2 ρ 1,2
2 2 2 2 2
becomes
σ 2
IP = w12 σ 12 + w22 σ 22 + 2 w1 w2 σ 1 σ 2
= ( w1 σ 1 + w2 σ 2 )2
so that:
σ = w1 σ 1 + w2 σ 2
IP
σ
2
IP = w12 σ 12 + w22 σ 22 + 2 w1 w2 σ 1 σ 2 ρ 1,2
becomes
σ 2
IP = w12 σ 12 + w22 σ 22 − 2 w1 w2 σ 1 σ 2
= ( w1 σ 1 − w2 σ 2 )2
so that:
σ IP = w1 σ 1 − w2 σ 2
In this case, the risk of the international portfolio is a weighted
difference of the two component assets' risk.
It is therefore possible to form an international “risk free” portfolio
by selecting the appropriate weights so that their weighted
difference is zero. 6
Multiple-Asset International Portfolios
• For purposes of analyzing risk and return
characteristics, we treat a portfolio as a single asset.
• Expected return is given by:
n
RIP = ∑wiRi
i=
1
7
• Example: A portfolio has three assets held in proportions
ω 1 = 0.2, ω 2 = 0.5, and ω 3 = 0.3. The asset’s one year
standard deviations are σ 1 = 0.3, σ 2 = 0.2, and σ 3 = 0.4.
Their correlations are ρ 12 = 0.1, ρ 13 = 0.6, ρ 23 =
-0.1. The portfolio’s one year return variance is given
n n
by:
σ =∑
2
∑ ω
i ω
j iσ σ
j ijρ
i =1 j =1
σ = 0.03544
= 0.188
9
10
Efficiency Gains from International Diversification:
we measure efficiency gains by comparing the Sharpe
Index (SI) and Treynor Index (TI) for purely domestic
portfolios with the same measures for internationally
diversified portfolios.
RDP − Rf
SI DP =
σDP
RIP −Rf
SI IP =
σIP
TI DP =
RDP −Rf
βDP
RIP − Rf
TI IP =
βIP
11
Where,
β = σ i,m / σ 2
m= ρ i,m* σ i σ m/ σ 2
m
=ρ i,m* σ i
σ
σ =σ σ ρ
m
12
Characteristics of a Risk-Free Asset:
– It is default free
– Its expected return is certain
– The variance of its return is zero
Jensen’s Alpha:
Alternatively, efficiency gains for an internationally
diversified portfolio can be assessed by computing the
Jensen’s Alpha.
Rj = Rf+ β j (Rm- Rf)
Rj - Rf = α j + β j (Rm- Rf)
We expect α = 0. If α = 0, j’s performance = market
if α > 0, j outperforms market
if α < 0, j underperforms market 13
Computing Returns on Foreign Investments:
Dollar return = local currency return*currency gain/loss
For Bonds:
B(1) − B(0) + C
1 + Kb = [1 + ](1 + ∆e)
B(0)
where,
B(t) = bond price at time t
C = coupon payment
Δe = percentage change in exchange rates (domestic
currency per unit of foreign) = (et-e0)/e0
Kb= return on bonds (in domestic currency)
14
For Stocks:
P (1) − P (0) + D
1 + Ks = [1 + ](1 + ∆e)
P ( 0)
Where:
Ks = return on stocks
D = dividends
P(t) = stock price at t
Δe = percentage change in exchange rates (et-e0)/e0
15
The return from portfolios containing (assets) of a
number of diverse types of companies is less risky
than the return from portfolios with the same number
of similar types companies.
Optimum risk-reduction is achieved by creating a
mix of securities whose returns do not move up or
down together in response to the same set of factors
A further risk reduction can be achieved by
introducing stocks from countries experiencing
economic conditions that are different from those in
the investor’s home country (international diversification)
16
Total risk of a portfolio depends on:
17
Potential benefits of international diversification can
be demonstrated by:
• Estimating correlation coefficient of returns across
countries
• Demonstrating that national factors have a dominant
influence on security returns relative to any common
world factor.
For example in the model:
RM N C = a 0 + a1 RL + b1 Rf 1 + b 2 Rf 2 + ...+ bnRfn
The returns for a MNC are explained by a local factor
(L) and a number of international factors (f).
18
frequently, a1 is found to be more significant for each local market.
RMNC = return on a MNC
RL = local market factor(s)
Rf = foreign market factor
Rf = risk-free rate
RPi = the risk premium associated with factor i.
26
Factors must be estimated from the data.
Generally three sets of factors are selected:
– international factors
– purely domestic factors
– industry-wide factors
28
Some “Ex-Ante” Strategies for International
Diversification:
Naive Strategy: equal investment in each national market
Historical Diversification Strategy: is based on the
assumption that the best estimate of a stock’s expected
return is the grand mean of the historical mean returns on
all the stock being considered for investment.
Jobson and Korkie (1980, 1981) report that the grand
mean approach resulted in the most efficient portfolio in
the domestic setting.
The grand mean uses historical covariance matrix.29
Some Practical Diversification Alternatives:
There are several ways for investors to diversify:
American Depository Receipts (ADRs): is a
negotiable certificate issued by a U.S. bank evidencing
the ownership of a foreign stock (dollar denominated).
(An ADR represents some multiple of underlying foreign share)
American Depository Shares (ADS): are dollar-
denominated securities representing shares of stock in
a foreign company held on deposit on behalf of their
owners by a custodian bank in the issuing company’s
home country. (ADR and ADS often used interchangeably)
European Depository Receipts.
Buying Foreign Stocks Listed on U.S. Exchanges.
Buying Foreign Stocks in Their Home Markets.30
Mutual Funds (Internationally Diversified)
• Global funds
• International funds
• Regional funds
• Single country funds etc.
Global Depository Receipts (GDR): Bank certificates
issued in more than one country for shares in a foreign
company.
Similar to ADRs but they are generally traded on two or
more markets outside the foreign issuer’s home market.
Global Registered Share (GRS): is similar to an
ordinary share with the added benefit that investors can
trade shares on any stock exchange in the world where
registered and in the local currency. 31
Home Bias?
A noticeable “home bias” observed on the part of U.S.
investors is a further indication of the fact that there
exist significant barriers to international investment,
for example:
– Greater information and transaction costs.
– Foreign exchange regulations.
– Legal restriction.
– Double/multiple taxation of foreign investment.
– Persistent “parochial" (narrow, limited, provincial)
attitude of many investors.
32
Empirical evidence on existence of superior risk-
return tradeoff by investing internationally:
EAFE Index (Europe, Australia, Far East): Represents
major stock markets outside North America and has had
lower risk than most if its individual country components.
World Index: Combines the EAFE with North America
and displays lower risks than any of its component country
except the US.
Emerging Markets Index: Encompasses all of South and
Central America, all of Far East (except Japan), Hong
Kong, Singapore, Australia, New Zealand, Africa, parts of
Southern Europe, and nations of the former Soviet Union.
33
Effective Dollar Return (on foreign securities)
1+ R$ = (1+Rf)(1+Δe)
R$ ≈ Rf +Δe, where e = d/f.
The standard deviation of dollar return on foreign
security can be expressed as:
σ$ = [σ f+ σ Δe + 2 σ f σ ρ ]
2 2 1/2
Δe f, Δe