InternationalPortfolioInvestmentChapter Twelve
Chapter Outline International Correlation Structure and RiskDiversificationOptimal International Portfolio SelectionEffects of Changes in the Exchange RateInternational Bond Investment International Mutual Funds: A Performance Evaluation International Diversification through Country FundsInternational Diversification with ADRsInternational Diversification with ETFsInternational Diversification with Hedge Funds Why Home Bias in Portfolio Holdings?International Diversification with Small-Cap Stocks
Chapter Outline ❖International Correlation Structure and Risk Diversification ❖Optimal International Portfolio Selection ❖Effects of Changes in the Exchange Rate ❖International Bond Investment ❖International Mutual Funds: A Performance Evaluation ❖International Diversification through Country Funds ❖International Diversification with ADRs ❖International Diversification with ETFs ❖International Diversification with Hedge Funds ❖Why Home Bias in Portfolio Holdings? ❖International Diversification with Small-Cap Stocks
International Correlation Structureand Risk DiversificationSecurity returns are much less correlatedacross countries than within a countryThis is true because economic, political,institutional, and even psychological factorsaffecting security returns tend to vary acrosscountries, resulting in low correlations amonginternational securities.Business cycles are often high asynchronousacross countries
International Correlation Structure and Risk Diversification ❖Security returns are much less correlated across countries than within a country. ▪ This is true 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
International Correlation StructureAUFRJPNLUSGMSWUKStock Market.59Australia.29.58France.18.31.65Germany.15.24.30.42Japan.51.24.34.28.62Netherlands.52.36.37.28Switzerland.48.66United.32.38.30.21.39.70.43KingdomUnited States.30.23.17.14.27.27.28.44Relatively low international correlations imply that investors should be able to reduceportfoliorisk moreif they diversify internationallyratherthandomestically
International Correlation Structure Relatively low international correlations imply that investors should be able to reduce portfolio risk more if they diversify internationally rather than domestically. Stock Market AU FR GM JP NL SW UK US Australia .59 France .29 .58 Germany .18 .31 .65 Japan .15 .24 .30 .42 Netherlands .24 .34 .51 .28 .62 Switzerland .36 .37 .48 .28 .52 .66 United Kingdom .32 .38 .30 .21 .39 .43 .70 United States .30 .23 .17 .14 .27 .27 .28 .44 Relatively low international correlations imply that investors should be able to reduce portfolio risk more if they diversify internationally rather than domestically
Domestic vs.InternationalDiversificationWhen fully diversified, an international portfolio can beless than half as risky as a purely U.S. portfolio(%)A fully diversified international portfolio is only 12percent as risky as holding a single security0.44Swiss stocks0.27U.S. stocks0.12International stocksNumber20110304050ofStocks
Domestic vs. International Diversification 0.44 0.27 0.12 Portfolio Risk (%) Number 1 10 20 30 40 50 of Stocks Swiss stocks U.S. stocks International stocks When fully diversified, an international portfolio can be less than half as risky as a purely U.S. portfolio. A fully diversified international portfolio is only 12 percent as risky as holding a single security
Optimal International PortfolioSelection The correlation of the U.S. stock market withthe returns on the stock markets in othernations varies The correlation of the U.S. stock market withthe Canadian stock market is 72% The correlation of the U.S. stock market withthe Japanese stock market is 31%.*A U.S. investor would get morediversification from investments in Japanthan Canada
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 72%. ❖The correlation of the U.S. stock market with the Japanese stock market is 31%. ❖A U.S. investor would get more diversification from investments in Japan than Canada
Summary Statistics for MonthlyReturns 1980-2007 ($U.S.)Correlation CoefficientSDβMeanStockMarket(%)(%)CountrystockmarketJPCNFRGMUKvs..world1.07)5.551.00Canada (CN)0.491.206.001.04France (FR)1.07% monthly return =12.84%peryear0.460.731.196.291.03Germany(GM)0.340.400.320.926.531.10Japan (JP)0.590.610.560.421.195.20United0.97Kingdom0.720.550.520.310.611.114.250.88UnitedStates
Summary Statistics for Monthly Returns 1980-2007 ($U.S.) Stock Market Correlation Coefficient Mean (%) SD (%) CN FR GM JP UK Canada (CN) 1.07 5.55 1.00 France (FR) 0.49 1.20 6.00 1.04 Germany (GM) 0.46 0.73 1.19 6.29 1.03 Japan (JP) 0.34 0.40 0.32 0.92 6.53 1.10 United Kingdom 0.59 0.61 0.56 0.42 1.19 5.20 0.97 United States 0.72 0.55 0.52 0.31 0.61 1.11 4.25 0.88 1.07% monthly return = 12.84% per year Country stock market vs. world
Summary Statistics for MonthlyReturns 1980-2007 ($U.S.)Correlation CoefficientSDβMeanStockMarket(%)(%)CountrystockmarketJPCNFRGMUKvs..world1.075.551.00Canada (CN)Bmeasures the sensitivity ofthemarket to the world market0.491.206.001.04France (FR)Clearly the Japanese market is0.7more sensitive to the world0.461.196.291.03Germanymarket than is the U.S.(GM)1.100.340.400.320.926.53Japan (JP)0.590.610.560.421.195.20United0.97Kingdom0.720.550.520.310.611.114.250.88United States
Stock Market Correlation Coefficient Mean (%) SD (%) CN FR GM JP UK Canada (CN) 1.07 5.55 1.00 France (FR) 0.49 1.20 6.00 1.04 Germany (GM) 0.46 0.73 1.19 6.29 1.03 Japan (JP) 0.34 0.40 0.32 0.92 6.53 1.10 United Kingdom 0.59 0.61 0.56 0.42 1.19 5.20 0.97 United States 0.72 0.55 0.52 0.31 0.61 1.11 4.25 0.88 measures the sensitivity of the market to the world market. Clearly the Japanese market is more sensitive to the world market than is the U.S. Summary Statistics for Monthly Returns 1980-2007 ($U.S.) Country stock market vs. world
Selection of the Optimal International Portfolio2.0%EfficientfrontierSDHK1.5%OIPNLITSUKGMUSCN1.0%JP0.5%RrMonthlyStandardDeviation0.0%0.0%1.0%2.0%4.0%5.0%6.0%7.0%8.0%3.0%9.0%10%
Selection of the Optimal International Portfolio Efficient frontier OIP 2.0% 1.5% 1.0% 0.5% 0.0% US JP HK SD IT GM CN SW UK NL Monthly Standard Deviation 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10% Rf Monthly Return
Composition of the OIP for a U.S.InvestorHolding Period: 1980-20074.82%Australia8.76%Hong KongItaly6.60%31.11%NetherlandsSweden28.01%U.S.20.70%100.00%Total
Composition of the OIP for a U.S. Investor Holding Period: 1980-2007 Australia Hong Kong 4.82% 8.76% Italy 6.60% Netherlands 31.11% Sweden 28.01% U.S. Total 20.70% 100.00%