1

Multinational Financial Management Alan Shapiro

7th Edition J.Wiley & SonsPower Points byJoseph F. Greco, Ph.D.California State University, Fullerton

2

CHAPTER 15

INTERNATIONAL PORTFOLIO INVESTMENT

3

CHAPTER OVERVIEW:

I. THE BENEFITS OF INTERNATIONAL EQUITY INVESTINGII. INTERNATIONAL BOND INVESTINGIII.OPTIMAL ASSET ALLOCATIONIV. MEASURING THE TOTAL RETURNV. MEASURING EXCHANGE RISK ON FOREIGN SECURITIES

4

I. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

I. THE BENEFITS OF INTERNATIONALEQUITY INVESTINGA. Advantages

1. Offers more opportunities than

a domestic portfolio only2. Larger firms often are

overseas

5

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

B. International Diversification1. Risk-return tradeoff: may be greater basic rule-the broader the diversification,more stable the returns and the more diffuse the risk.

6

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

2. International diversification and systematic risk

a. Diversifying across nations with

different economic cycles

7

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

b. While there is systematic riskwithin a nation, it may benonsystematic and diversifiableoutside the country.

8

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

3. Recent Historya. National stock markets have

widedifferences in returns and risk.

b. Emerging markets have higherrisk and return than developed markets.

c. Cross-market correlations havebeen relatively low.

9

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

C. Correlations and the Gains From Diversification

1. Correlation of foreign market betas

Foreign Correlation Std dev market = with U.S. x for. mkt.

beta market std dev U.S. mkt.

10

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

2. Past empirical evidence suggests inter-

national diversification reduces portfolio risk.

11

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

3. Theoretical ConclusionInternational diversification pushes

outthe efficient frontier.

12

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

4. Calculation of Expected Return:

rp = a rUS + ( 1 - a) rrw

where rp = portfolio expected return

rUS = expected U.S. market return

rrw = expected global return

13

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

5. Calculation of Expected Portfolio Risk = (P )

P = [a 2US2 + (1-a)2 r w

2 + 2a(1-a)

USrw US,rw]1/2

where US,rw = the cross-market correlation

US2 = U.S. returns variance

r w2 = World returns variance

14

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

6. Cross-market correlationsa. Recent markets seem to

be most correlated when volatility is greatest

b. Result: Efficient frontier retreats

15

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

D. Investing in Emerging Marketsa. Offers highest risk and returnsb. Low correlations with returns

elsewherec. As impediments to capital

marketmobility fall, correlations are

likely to increase in the future.

16

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

E.Barriers to International Diversification1. Segmented markets2. Lack of liquidity3. Exchange rate controls4. Less developed capital markets5. Exchange rate risk6. Lack of information

a. readily accessibleb. comparable

17

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

F. Methods to Diversify1. Trade in American Depository

Receipts (ADRs)2. Trade in American shares3. Trade internationally diversified

mutual funds:a. Globalb. Internationalc. Single-country

18

II. INTERNATIONAL BOND INVESTINGII. INTERNATIONAL BOND INVESTING

-internationally diversified bond portfolios offer superior

performance

19

INTERNATIONAL BOND INVESTING

A. Empirical Evidence

1. Foreign bonds provide higher

returns

2. Foreign portfolios outperform

purely domestic

20

III. OPTIMAL INTERNATIONAL ASSET ALLOCATION

III. OPTIMAL INTERNATIONAL ASSETALLOCATION-a diversified combination of stocks and

bonds

A. Offered better risk-return tradeoff

B. Weighting options flexible

21

IV. MEASURING TOTAL RETURNSFROM PORTFOLIO INVESTING

IV. MEASURING TOTAL RETURNSA. Bonds

Dollar = Foreign x Currency return currency gain (loss)

return

22

MEASURING TOTAL RETURNSFROM PORTFOLIO INVESTINGBond return formula:

1 + R$ =[1 +B(1) - B(0) + C ](1+g)

B(0)where R$ = dollar return

B(1) = foreign currency bond price at time 1C = coupon incomeg = depreciation/appreciation

of foreign currency

23

MEASURING TOTAL RETURNSFROM PORTFOLIO INVESTING

B. Stocks (Calculating return)Formula:

1 + R$ =[ 1+ P(1) - P(0) + D ](1+g) P(0)

where R$ = dollar returnP(1) = foreign currency stock

price at time 1D = foreign currency annual

dividend