International Corporate Finance Chp 16:International portfolio theory and diversification Xin Chen Visiting Associate Professor Aarhus School of Business
1 International Corporate Finance Chp 16: International portfolio theory and diversification Xin Chen Visiting Associate Professor Aarhus School of Business
Classical portfolio theory Maximize expected portfolio return per unit of expected portfolio risk. Separate total risk of a portfolio into two components systematic risk and unsystematic risk. --Systematic risk is the risk of the market itself(non- diversifiable). --Unsystematic risk is the risk of individual securities within the market and the portfolio (diversifiable). Increasing the number of securities in the portfolio reduces and ultimately eliminates the unsystematic risk the risk of the individual securities leaving only the risk of the market,the systematic risk
Classical portfolio theory Maximize expected portfolio return per unit of expected portfolio risk. Separate total risk of a portfolio into two components ： systematic risk and unsystematic risk. --Systematic risk is the risk of the market itself (non- diversifiable). --Unsystematic risk is the risk of individual securities within the market and the portfolio (diversifiable). Increasing the number of securities in the portfolio reduces and ultimately eliminates the unsystematic risk - the risk of the individual securities - leaving only the risk of the market, the systematic risk
Exhibit 16.1 Portfolio Risk Reduction Through Diversification Percent Variance of portfolio return risk Variance of market return 100 80 Total risk =Diversifiable risk+Market risk (unsystematic) (systematic) 60 40 Portfolio of U.S.stocks 27%… 20 Total risk Systematic risk 1 10 20 30 40 50 Number of stocks in portfolio When the portfolio is diversified,the variance of the portfolio's return relative to the variance of the market's return(beta)is reduced to the level of systematic risk-the risk of the market itself
Exhibit 16.1 Portfolio Risk Reduction Through Diversification
International Diversification and 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). 分 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
International Diversification and 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
EXHIBIT 15.2 Portfolio Risk Reduction Through International Diversification Percent_Variance of portfolio return risk Variance of market return 100 80 60 40 Portfolio of U.S.stocks 27%心… 20 Portfolio of international stocks 12% 1 10 20 30 40 50 Number of stocks in portfolio When the portfolio is diversified internationally,the portfolio's beta-the level of systematic risk that cannot be diversified away-is lowered
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
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
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
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
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
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
Internationalizing the Domestic Portfolio The portfolio with the minimum risk along all those possible is the minimum risk domestic portfolio(MRpp) 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 (R)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
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
Exhibit 16.3 Optimal Domestic Portfolio Construction Expected return of Optimal domestic Capital market portfolio,Rp portfolio(DP) line (domestic) DP RpP Minimum risk domestic portfolio(MRpp) MRDP Rf Domestic portfolio opportunity set Expected risk ODP of portfolio,Op An investor may choose a portfolio of assets enclosed by the domestic portfolio opportunity set. The optimal domestic portfolio is found at DP,where the capital market line is tangent to the domestic portfolio opportunity set.The domestic portfolio with the minimum risk is designated MRDP
Exhibit 16.3 Optimal Domestic Portfolio Construction