International%20Portfolio%20Theory%20and%20Diversification

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Lecture 12

• International Portfolio Theory and Diversification

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Important Information

• Next Weeks Reading Assignment
• Monday Chapter 23 International Trade Finance
• Quiz 4, Wednesday, Nov 19
• Chapters 15, 18, 19, and 23
• Lectures 10, 11, 12, and 13

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Objectives of Lecture 12

• Discuss the total risk of a portfolio in terms of
  its two components
• diversifiable and non-diversifiable
• Demonstrate how both the diversifiable and
  non-diversifiable risks of an investors
  portfolio may be reduced through international
  diversification
• Discuss how foreign exchange risk impacts
  investing internationally
• Review the recent history of equity market
  performance globally, including the degree to
  which the markets are more or less correlated in
  their movements
• Examine the question of whether markets appear to
  be more or less integrated over time

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Total Risk of a Portfolio

• We can think of a portfolio as consisting of
  either
• Financial assets
• Portfolio investment
• Real assets
• Foreign direct investment
• Portfolio theory suggests that the risk
  associated with either can be reduced through
  international diversification.
• In an international context, diversification
  needs to be discussed through two components
• Potential risk reduction benefits of
  diversification
• Potential additional risk associated with foreign
  exchange exposure.

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Diversifiable and Non-diversifiable Risk

• The total risk of a portfolio consists of
• The unique risk associated with the individual
  security (or real asset).
• Unsystematic risk can be diversified away
  through the selection of assets which are not
  perfectly correlated.
• The market risk that tends to affect the entire
  market in a similar fashion.
• Systematic risk Regardless of the number of
  assets we add, this risk cannot be reduced for a
  particular market (country). It is
  non-diversifiable!

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Measuring Risk

• Risk can be measured for an individual asset, or
  a portfolio of assets, by the variance, or
  standard deviation, of its returns
• Variance measures the width of a probability
  distribution of returns.
• The larger the measure of returns dispersion, the
  greater the total risk, and thus, the greater the
  probability of changes in asset value

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Portfolio Risk Reduction

• Portfolio Risk Reduction
• As an investor increases the number of
  securities, the portfolios risk declines rapidly
  at first and then asymptotically approaches the
  level of systematic risk of the market
• A fully diversified portfolio would have a beta
  of 1.0 (equal to the market risk).

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Total Risk
Total Risk Diversifiable Risk
Market Risk
(unsystematic) (systematic)
Portfolio of U.S. stocks
By diversifying the portfolio, the variance of
the portfolios return relative to the variance
of the markets return (beta) is reduced to the
level of systematic risk -- the risk of the
market itself.
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Internationalizing the Portfolio

• Including foreign assets in the portfolio can
  result in lowering the portfolios market, or
  systematic, risk.
• This situation arises if the returns on foreign
  assets are not closely correlated with the
  returns on home (or U.S.) assets.

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International Diversification
Portfolio of U.S. stocks
Portfolio of international stocks
By diversifying the portfolio internationally,
the level of systematic risk which could not be
diversified away under domestic constraints, is
lowered.
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International Diversification

• Risk reduction is possible through international
  diversification if the returns of different stock
  market around the world are not perfectly
  positively correlated
• Question Are these returns correlated or not,
  and are they changing over time?

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National Equity Market Performance
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Are Markets Increasingly Integrated?
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Conclusions

• The relatively low correlation coefficients among
  returns of 18 major stock markets in the 20-year
  period (1977-1996) indicates great potential for
  international diversification
• The overall picture is that the correlations have
  increased over time
• However, although capital market integration has
  decreased some benefits of international
  portfolio diversification, the correlations
  between markets are still far from 1.0

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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 diversification
• Internationally diversified portfolios are the
  same in principle because the investor is
  attempting to combine assets which are less than
  perfectly correlated, reducing the risk of the
  portfolio