International Portfolio Diversification

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International Portfolio Diversification
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Todays Topic International Investing
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Combining Securities into Portfolios
Probability hi
Security A
rA,i
0
E(rA)
Probability hi
Security B
rB,i
0
E(rB)
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Portfolio of Stocks A B
Probability hi
?
rP,i
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Diversification
C
A
Portfolio distribution for portfolio C
0 13
E
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The Minimum Variance Set
Expected return
Standard deviation of return
B
A
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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.
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International Monthly Returns 1980-2001 (U.S.)
Country stock market vs world
.88 monthly return 10.56 per year
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International Monthly Returns 1980-2001 (U.S.)
Country stock market vs world

• 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.

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The Optimal International Portfolio
OIP
Efficient set
JP
1.53
UK
US
FR
GM
Rf
CN
4.2
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Composition of the OIP for a U.S.
Investor(Holding Period 19802000
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The Gains from International Diversification

• For a U.S. investor, OIP has more return and more
  risk. The Sharpe measure is 20 higher,
  suggesting that an equivalent-risk OIP would have
  1.68 more return than a domestic portfolio.

return
OIP
1.42 1.26
ODP
risk
4.43
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60-month rolling correlations with the U.S. stock
market
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Are Cross-Country Correlations Constant?

• Correlation with U.S. market
• Calm Volatile Unconditional
• Country periods periods correlation
• Canada 0.729 0.753 0.723
• France 0.331 0.525 0.407
• Germany 0.327 0.461 0.353
• Japan 0.265 0.366 0.297
• Switzerland 0.458 0.650 0.508
• U.K. 0.468 0.525 0.469

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National markets during the international stock
market crash of October 1987
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Volatility Contagion (S.D. of Monthly Dollar
Returns)
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The Tequila Effect Mexican Financial Crises
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The Asian Flu Financial Crises