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Copyright © 2010 Pearson Prentice Hall. All rights reserved.
Chapter 17
International Portfolio Theory and Diversification
Copyright © 2010 Pearson Prentice Hall. All rights reserved.17-2
International Diversification and Risk
• The case for international diversification of portfolios can be decomposed into two components, the first of which is the potential risk reduction benefits of holding international securities.
• This initial focus is on risk.
• The risk of a portfolio is measured by the ratio of the variance of a portfolio’s return relative to the variance of the market return (portfolio beta).
• As an investor increases the number of securities in a portfolio, the portfolio’s risk declines rapidly at first, then asymptotically approaches the level of systematic risk of the market.
• A domestic portfolio that is fully diversified would have a beta of 1.0.
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Exhibit 17.1 Portfolio Risk Reduction Through Diversification
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International Diversification and Risk
• The total risk of any portfolio is therefore composed of systematic risk (the market) and unsystematic risk (the individual securities).
• Increasing the number of securities in the portfolio reduces the unsystematic risk component leaving the systematic risk component unchanged.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.17-5
International Diversification and Risk
• The second component of the case for international diversification addresses foreign exchange risk.
• The foreign exchange risks of a portfolio, whether it be a securities portfolio or the general portfolio of activities of the MNE, are reduced through international diversification.
• Purchasing assets in foreign markets, in foreign currencies may alter the correlations associated with securities in different countries (and currencies).
• This provides portfolio composition and diversification possibilities that domestic investment and portfolio construction may not provide.
• The risk associated with international diversification, when it includes currency risk, is very complicated when compared to domestic investments.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.17-6
International Diversification and Risk
• International diversification benefits induce investors to demand foreign securities (the so called buy-side).
• If the addition of a foreign security to the portfolio of the investor aids in the reduction of risk for a given level of return, or if it increases the expected return for a given level of risk, then the security adds value to the portfolio.
• A security that adds value will be demanded by investors, bidding up the price of that security, resulting in a lower cost of capital for the issuing firm.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.17-7
Exhibit 17.2 Portfolio Risk Reduction Through International Diversification
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Internationalizing the Domestic Portfolio
• Classic portfolio theory assumes a typical investor is risk-averse.
• This means an investor is willing to accept some risk but is not willing to bear unnecessary risk.
• The typical investor is therefore in search of a portfolio that maximizes expected portfolio return per unit of expected portfolio risk.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.17-9
Internationalizing the Domestic Portfolio
• The domestic investor may choose among a set of individual securities in the domestic market.
• The near-infinite set of portfolio combinations of domestic securities form the domestic portfolio opportunity set (next exhibit).
• The set of portfolios along the extreme left edge of the set is termed the efficient frontier.
• This efficient frontier represents the optimal portfolios of securities that possess the minimum expected risk for each level of expected portfolio return.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.17-10
Internationalizing the Domestic Portfolio
• The portfolio with the minimum risk along all those possible is the minimum risk domestic portfolio (MRDP).
• The individual investor will search out the optimal domestic portfolio (DP), which combines the risk-free asset and a portfolio of domestic securities found on the efficient frontier.
• He or she begins with the risk-free asset (Rf) and moves out along the security market line until reaching portfolio DP.
• This portfolio is defined as the optimal domestic portfolio because it moves out into risky space at the steepest slope.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.17-11
Exhibit 17.3 Optimal Domestic Portfolio Construction
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International Diversification and Risk
• The next exhibit illustrates the impact of allowing the investor to choose among an internationally diversified set of potential portfolios.
• The internationally diversified portfolio opportunity set shifts leftward of the purely domestic opportunity set.
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Exhibit 17.4 The Internationally Diversified Portfolio Opportunity Set
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International Diversification and Risk
• It is critical to be clear as to exactly why the internationally diversified portfolio opportunity set is of lower expected risk than comparable domestic portfolios.
• The gains arise directly from the introduction of additional securities and/or portfolios that are of less than perfect correlation with the securities and portfolios within the domestic opportunity set.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.17-15
International Diversification and Risk
• The investor can now choose an optimal portfolio that combines the same risk-free asset as before with a portfolio from the efficient frontier of the internationally diversified portfolio opportunity set.
• The optimal international portfolio, IP, is again found by locating that point on the capital market line (internationally diversified) which extends from the risk-free asset return of Rf to a point of tangency along the internationally diversified efficient frontier.
• The benefits are obvious in that a higher expected portfolio return with a lower portfolio risk can be obtained when compared to the domestic portfolio alone.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.17-16
Exhibit 17.5 The Gains from International Portfolio Diversification
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International Diversification and Risk
• An investor can reduce investment risk by holding risky assets in a portfolio.
• As long as the asset returns are not perfectly positively correlated, the investor can reduce risk, because some of the fluctuations of the asset returns will offset each other.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.17-18
Exhibit 17.6 Alternative Portfolio Profiles Under Varying Asset Weights
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National Markets and Asset Performance
• Asset portfolios are traditionally constructed using both interest bearing risk-free assets and risky assets.
• For the 100 year period ending in 2000, the risk of investing in equity assets has been rewarded with substantial returns.
• The true benefits of global diversification, however, arise from the fact that the returns of different stock markets around the world are not perfectly positively correlated.
• This is because the are different industrial structures in different countries, and because different economies do not exactly follow the same business cycle.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.17-20
National Markets and Asset Performance
• Interestingly, markets that are contiguous or near-contiguous (geographically) seemingly demonstrate the higher correlation coefficients for the past century.
• It is often said that as capital markets around the world become more and more integrated over time, the benefits of diversification will be reduced.
• Analysis of market data supports this idea (although the correlation coefficients between markets are still far from 1.0).
Copyright © 2010 Pearson Prentice Hall. All rights reserved.17-21
Market Performance Adjusted for Risk: The Sharpe and Treynor Performance Measures
• To consider both risk and return in evaluating portfolio performance, we introduce two measures:
The Sharpe Measure (SHP)
= SHPi = Ri – Rf
σi
The Treynor Measure (TRN)
= TRNi = Ri – Rf
βi
Copyright © 2010 Pearson Prentice Hall. All rights reserved.17-22
Market Performance Adjusted for Risk: The Sharpe and Treynor Performance Measures
• Though the equations of the Sharpe and Treynor measures look similar, the difference between them is important.
• If a portfolio is perfectly diversified (without any unsystematic risk), the two measures give similar rankings, because the total portfolio risk is equivalent to the systematic risk.
• If a portfolio is poorly diversified, it is possible for it to show a high ranking on the basis of the Treynor measure, but a lower ranking on the basis of the Sharpe measure.
• As the difference is attributable to the low level of portfolio diversification, the two measures therefore provide complimentary but different information.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.17-23
Mini-Case Questions: Is Modern Portfolio Theory Outdated?
• Why might the bell curve not be helpful when trying to construct and manage modern financial portfolios?
• What risks are created if most of the major market agents are using the same models at the same times?
• Since the time of the article, the world economy has suffered a significant crisis. What elements of the article may have proved correct?
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Exhibit 17.7 Real Returns and Risks on the Three Major Asset Classes, Globally, 1900–2000
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Exhibit 17.8 Correlation Coefficients between World Equity Markets, 1900–2000
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Exhibit 17.9 Summary Statistics of the Monthly Returns for 18 Major Stock Markets, 1977–1996 (all returns converted into U.S. dollars and include all dividends paid)