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International Finance

International Portfolio Investments

Security X & Y with the following attributes Security X Y Return 20% 30% Risk 10% 16%

Correlation coefficient (X,Y) = 0.5

40% of funds invested on X Calculate the portfolio return & risk Ep = Wi Ei = (.40)(.20) + (.60)(.30) = 0.26 = 26% 2p = w21 21 + w22 22 + 2w1w2 1,2 1*2 = (40%)2(10%)2+(60%)2(16%)2+2(40%)(60%)(0.5)(10%)(16%) = 12.1%

International Correlation Structure and Risk Diversification


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.

U.S based investor takes US$1000000 on January 1, 2002, and invests in a share traded on the Tokyo Stock Exchange (TSE). On January 1,

2002, the spot exchange rate is 130.00/$. The investor uses his funds
to acquire shares on the TSE at 20000 per share, and holds the shares for one year. At the end of one year, the investor sells the shares at the market price, which is 25000. On January 1, 2003, the spot rate is 125.00/$. Calculate the total return on the investment (US$1300000 US$1000000)/ US$1000000 = 30% The total return is a combination of the return on the Japanese Yen and the return on the shares listed on the TSE

R$ = [(1 + r/$)(1 + rshares,)] 1 rshares, = Percentage change in the share price r/$ = Percentage change in the currency value R$ = [(1 + 0.2500)(1 + 0.0400)] 1 =30%

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

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.

International Correlation Structure


Stock Market Australia (AU) France (FR) Germany (GM) Japan (JP) Netherlands (NP) Switzerland (SW) United Kingdom (UK) United States (US) AU .586 .286 .183 .152 .241 .358 .315 .576 .312 .238 .344 .368 .378 FR GM JP NL SW UK US

Relatively low international correlations imply that investors should be able to reduce portfolio risk more if they .653 diversify internationally .300 .416 rather than domestically.
.509 .475 .299 .282 .281 .209 .624 .517 .393 .664 .431 .698

.304

.225

.170

.137

.271

.272

.279

.439

Domestic vs. International Diversification


Portfolio Risk (%) A fully When diversified fully diversified, international an international portfolio is only portfolio 12 percent can beas less risky than ashalf holding as risky a single as a purely U.S. portfolio. security. Swiss stocks U.S. stocks International stocks 1 10 20 30 40 50 Number of Stocks

0.44 0.27

0.12

Optimal International Portfolio Selection


The correlation of the U.S. stock market 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 70%. The correlation of the U.S. stock market with the Japanese stock market is 24%. A U.S. investor would get more diversification from investments in Japan than Canada.

Summary Statistics for Monthly Returns ($U.S.)


Stock Market

Correlation Coefficient

Mean (%)

SD (%)

CN
Canada (CN) France (FR) Germany (GM) Japan (JP) United Kingdom United States 0.38

FR

GM

JP

UK
.79 1.42 1.23 1.47 5.83 7.01 6.74 7.31 5.41 4.56 0.90 1.02 0.87 1.22 0.90 0.80

.79% monthly return = 9.48% per year 0.33 0.66


0.26 0.58 0.70 0.42 0.54 0.45 0.36 0.49 0.37 0.42 0.24 0.57

1.52 1.33

Summary Statistics for Monthly Returns ($U.S.)


Stock Market

Correlation Coefficient

Mean (%)

SD (%)

CN
Canada (CN) France (FR) Germany (GM) Japan (JP) United Kingdom United States 0.38 0.33 0.26 0.58 0.70

FR

GM

JP

UK
.79 1.42 1.23 1.47 5.83 7.01 6.74 7.31 5.41 4.56 0.90 1.02 0.87 1.22 0.90 0.80

measures the sensitivity of the market to the world market. Clearly the Japanese market is more sensitive to the world 0.66 market than is the U.S.
0.42 0.54 0.45 0.36 0.49 0.37 0.42 0.24 0.57

1.52 1.33

The Optimal International Portfolio


Mean Return (monthly)
3 2.5 2

1.53 1.5
1

OIP
US UK

Efficient set
JP GM CN FR

R 0.5
f

0 0 2

Standard Deviation (monthly)

4.2 4 %

Gains from International Diversification


For a U.S. investor, the risk-return tradeoff for the optimal international portfolio and optimal domestic portfolio are shown OIPat right. ODP below and
Mean Return Standard Deviation 1.53% 4.27% 1.33% 4.27% 4.56% 4.56%

return

OIP ODP

1.53% 1.33%

risk

An investor is considering investing in two different risky assets, an index of the U.S equity markets and an index of the German equity markets. Expected return U.S equity index 14% German equity index 18% Correlation coefficient (Us-GER) 0.34 40% of investment on U.S Calculate the return & risk on international portfolio Expected risk 15% 20%

Country E(Ri) i Wi A 0.12 0.20 0.60 B 0.08 0.10 0.30 C 0.04 0.03 0.10 AB = 0.25 AC = -0.08 BC = 0.15 Calculate the international portfolio expected return & risk

E(Rp) = (0.60)(0.12) + (0.30)(0.80) + (0.10)(0.04) = 10%


2p = W2i 2j + WiWjCovij

2p = [W2A2A+W2B2B+W2C2C]+[2WAWBABAB+2WAWCACAC + 2WBWC BCBC]


= 13.6%

Investors should examine returns by the amount of return per unit of risk accepted, rather than in isolation. To consider both risk and return in evaluating portfolio performance, Sharpe measure (SHP) Treynor measure (TRN) SHPi = ( Ri Rf ) / i

Where, Ri = Average return for portfolio i during a specified time period Rf = Average risk free rate of return i = risk of portfolio i
TRNi = (Ri Rf) / i Assume that the risk free is 5% per year for Hong Kong, calculate SHP and TRN

Assume the U.S dollar returns (monthly averages) shown below for three Baltic republics. Calculate the SHP and TRN measures of market performance. Country Estonia Latvia Lithuania M.Ret 1.12% 0.75% 1.6% SD 16% 22.8% 13.5% Rf 0.42% 0.42% 0.42% Beta 1.65 1.53 1.20

International Mutual Funds: A Performance Evaluation


A U.S. investor can easily achieve international diversification by investing in a U.S.-based international mutual fund. The advantages include: 1. Savings on transaction and information costs. 2. Availability of legal and institutional barriers to direct portfolio investments abroad. 3. Professional management and record keeping.

The Capital Asset Pricing Model CAPM The CAPM is an equation that expresses the equilibrium relationship between a securitys expected return and its systematic risk. E(ri) = rf + i(rM - rf)

Nestle, is a Swiss-based multinational firm. A prospective Swiss


investor might assume a risk-free return of 3.3% (index of Swiss government bond issues), an average return on a portfolio of Swiss

equities of 10.2% (Financial Times Swiss Index), and a Nestle of 0.885.


Calculate the expected rate of return on Nestle equity. 9.41%

The International Capital Asset Pricing Model


The international version of the CAPM includes risk premium for multi-country exposure. The general form of international CAPM is given as: E(ri) rf = i[E(rM) rf] + i,k[E(Sn) + rnf rf]

rf = Continuous compounded risk-free rate in the domestic country Sn = Exchange rate of country k rnf = Continuous compounded risk-free rate in country k n = Number of countries considered i and i = regression coefficients

In the case of Nestle, for the same period as before, a global portfolio
index such as the Financial Times index would show a market return of 13.7%. In addition, a beta for Nestle estimated on Nestles returns

versus the global portfolio index would be 0.585. Calculate


expected return of an internationally diversified Swiss investor.

the

Why Home Bias in Portfolio Holdings?


Home bias refers to the extent to which portfolio investments are concentrated in domestic equities.

The Home Bias in Equity Portfolios


Country France Germany Italy Share in World Market Value 2.6% 3.2% 1.9% Proportion of Domestic Equities in Portfolio 64.4% 75.4% 91.0%

Japan
Spain Sweden United Kingdom United States Total

43.7%
1.1% 0.8% 10.3% 36.4%

86.7%
94.2% 100.0% 78.5% 98.0%

100.0%

Why Home Bias in Portfolio Holdings?


Three explanations come to mind: 1. Domestic equities may provide a superior inflation hedge. 2. Home bias may reflect institutional and legal restrictions on foreign investment. 3. Extra taxes and transactions/information costs for foreign securities may give rise to home bias.