7 International Portfolio

International Finance
Lecture notes
D/ Hanaa Abdelaziz
7- International Portfolio
Investment
International Portfolio
Investment
Chapter Objective:
Why investors diversify their portfolios internationally.
How much investors can gain from international
diversification.
The effects of fluctuating exchange rates on international
portfolio investments. Fifth Edition
Whether and how much investors can benefit from
investing in U.S. based international mutualEUN / RESNICK
funds.
The reasons for “home bias” in portfolio holdings.
International Correlation Structure
and Risk Diversification
⚫ Security returns are much less correlated across
countries than within a country.
⚫ This is so 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.
Domestic vs. International
Diversification
When fully diversified, an international portfolio can be
Portfolio Risk (%)
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.
0.44
Swiss stocks
0.27
U.S. stocks
0.12 International stocks
1 10 20 30 40 50 Number of
Stocks
Optimal International Portfolio
Selection
⚫ The correlation of the U.S. stock market with the
returns on the stock markets in other nations
varies.
Canadian stock market is 72%.
Japanese stock market is 31%.
⚫ A U.S. investor would get more diversification
from investments in Japan than Canada.
Selection of the Optimal International Portfolio
2.0%
Efficient frontier
SD
1.5% HK
OIP
NL
IT
Monthly Return
UK GM
US SW
CN
1.0%
JP
0.5%
Rf
Monthly Standard Deviation

0.0%
0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10%
Effects of Changes
in the Exchange Rate
⚫ The realized dollar return for a U.S. resident
investing in a foreign market will depend not only
on the return in the foreign market but also on the
change in the exchange rate between the U.S.
dollar and the foreign currency.
Effects of Changes
⚫ The realized dollar return for a U.S. resident
investing in a foreign market is given by
Ri$ = (1 + Ri)(1 + ei) – 1
= Ri + ei + Riei
Where
Ri is the local currency return in the ith market
ei is the rate of change in the exchange rate between
the local currency and the dollar
Effects of Changes
⚫ For example, if a U.S. resident just sold shares in
a British firm that had a 15% return (in pounds)
during a period when the pound depreciated 5%,
his dollar return is 9.25%:
⚫ Ri$ = (1 + Ri)(1 + ei) – 1
= (1 + .15)(1 – 0.05) – 1 = 0.925
⚫ Ri$ = Ri + ei + Riei
= .15 + –.05 + .15×(–.05) = 0.925
Effects of Changes
⚫ The risk for a U.S. resident investing in a foreign
market will depend not only on the risk in the
foreign market but also on the risk in the
exchange rate between the U.S. dollar and the
foreign currency.
Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + Var
The Var term represents the contribution of the

cross-product term, Riei, to the risk of foreign
investment.
Effects of Changes
Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + Var
This equation demonstrates that exchange rate
fluctuations contribute to the risk of foreign
investment through three channels:
1. Its own volatility, Var(ei).
2. Its covariance with the local market returns

Cov(Ri,ei).
3. The contribution of the cross-product term, Var.
International Mutual Funds: A
Performance Evaluation
⚫ A U.S. investor can easily achieve international
diversification by investing in a U.S.-based
international mutual fund.
⚫ The advantages include
1. Savings on transaction and information costs.
2. Avoidance of legal and institutional barriers to
direct portfolio investments abroad.
3. Professional management and record keeping.
International Diversification through
Country Funds
⚫ Recently, country funds have emerged as one of
the most popular means of international
investment.
⚫ A country fund invests exclusively in the stocks
of a single county. This allows investors to:
1. Speculate in a single foreign market with minimum
cost.
2. Construct their own personal international portfolios.
3. Diversify into emerging markets that are otherwise
practically inaccessible.
International Diversification through
American Depository Receipts
⚫ Foreign stocks often trade on U.S. exchanges as
ADRs.
⚫ It is a receipt that represents the number of
foreign shares that are deposited at a U.S. bank.
⚫ The bank serves as a transfer agent for the ADRs
American Depository Receipts
⚫ There are many advantages to trading ADRs as
opposed to direct investment in the company’s
shares:
⚫ ADRs are denominated in U.S. dollars, trade on U.S.
exchanges and can be bought through any broker.
⚫ Dividends are paid in U.S. dollars.
⚫ Most underlying stocks are bearer securities, the ADRs
are registered.
International Diversification
with ADRs
⚫ Adding ADRs to domestic portfolios
has a substantial risk reduction
benefit.
International Diversification with
Exchange Traded Funds
⚫ Using exchange traded funds (ETFs) like WEBS and
spiders, investors can trade a whole stock market index as
if it were a single stock.
⚫ Being open-end funds, WEBS trade at prices that are very
close to their net asset values. In addition to single country
index funds, investors can achieve global diversification
instantaneously just by holding shares of the S&P Global
100 Index Fund that is also trading on the AMEX with
other WEBS.
International Diversification with Hedge
Funds
⚫ Hedge funds which represent privately pooled
investment funds have experienced phenomenal
growth in recent years.
⚫ This growth has been mainly driven by the desire
of institutional investors, such as pension plans,
endowments, and private foundations, to achieve
positive or absolute returns, regardless of whether
markets are rising or falling.
International Diversification with Hedge
Funds
⚫ Unlike traditional mutual funds that generally depend on
“buy and hold” investment strategies, hedge funds may
adopt flexible, dynamic trading strategies, often
aggressively using leverages, short positions, and
derivative contracts, in order to achieve their investment
objectives.
⚫ These funds may invest in a wide spectrum of securities,
such as currencies, domestic and foreign bonds and stocks,
commodities, real estate, and so forth.
⚫ Many hedge funds aim to realize positive returns,
regardless of market conditions.
Home Bias in Portfolio Holdings
⚫ As previously documented, investors can
potentially benefit a great deal from international
diversification.
⚫ The actual portfolios that investors hold, however,
are quite different from those predicted by the
theory of international portfolio investment.
⚫ Home bias refers to the extent to which portfolio
investments are concentrated in domestic equities.
Why Home Bias in Portfolio Holdings?
⚫ Three explanations come to mind:
1. Domestic equities may provide a superior
inflation hedge.
2. Home bias may reflect institutional and
legal restrictions on foreign investment.
3. Extra taxes and transactions/information
costs for foreign securities may give rise to
home bias.
Why Home Bias in Portfolio Holdings?
⚫ A recent study of the brokerage records of tens
of thousands of U.S. individual investors shows
that wealthier, more experienced, and
sophisticated investors are more likely to invest
in foreign securities.
⚫ Another study shows that when a country is
remote and has an uncommon language, foreign
investors tend to stay away.
Problems
⚫ - We obtain the following data in dollar terms:
Stock market Return (mean) Risk (SD)
United States 1.26% per month 4.43%
United Kingdom 1.23% per month 5.55%
⚫ The correlation coefficient between the two

markets is 0.58. Suppose that you invest equally,
i.e., 50% each, in the two markets. Determine the
expected return and standard deviation risk of the
resulting international portfolio.
⚫
Solution:
The expected return of the equally weighted
portfolio is:
E(Rp) = (.5)(1.26%) + (.5)(1.23%) = 1.25%
The variance of the portfolio is:
Var (Rp) =
(.5)2(4.43)2 + (.5)2(5.55)2 +2(.5)2(4.43)(5.55)(.58)
= 4.91 +7.70 + 7.13 = 19.74
The standard deviation of the portfolio is thus 4.44%.

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International Finance

less than half as risky as a purely U.S. portfolio.

Monthly Standard Deviation

The Var term represents the contribution of the

2. Its covariance with the local market returns

United States 1.26% per month 4.43%

United Kingdom 1.23% per month 5.55%

⚫ The correlation coefficient between the two

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