Chapter 17
International
Portfolio
Theory and
Diversification
Copyright © 2010
Pearson
Hall. AllHall.
rights
reserved.
Copyright
© 2010Prentice
Pearson Prentice
All rights
reserved.
17.1 International Diversification
and Risk
• international diversification of portfolios,
====risk reduction of holding international
securities.
• As an investor increases the number of securities
in a portfolio, the portfolio’s risk declines rapidly
at first, then asymptotically approaches the level
of systematic risk of the market.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-2
Exhibit 17.1 Portfolio Risk
Reduction Through Diversification
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-3
Portfolio Risk Reduction (P.432)
• The total risk of any portfolio is therefore
composed of systematic risk (the market)
and unsystematic risk (the individual
securities).
• Increasing the number of securities in the
portfolio reduces the unsystematic risk
component leaving the systematic risk
component unchanged.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-4
Foreign Exchange Risk (P.433)
• The second component of the case for
international diversification addresses foreign
exchange risk.
• Purchasing assets in foreign markets, in foreign
currencies may alter the correlations associated
with securities in different countries (and
currencies).
• The risk associated with international
diversification, when it includes currency risk, is
very complicated when compared to domestic
investments.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-5
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.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-6
Exhibit 17.2 Portfolio Risk Reduction
Through International Diversification
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-7
17.2 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.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-8
The Optimal Domestic
Portfolio(P.435)
• 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.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-9
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.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-10
Exhibit 17.3 Optimal Domestic
Portfolio Construction
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-11
International Diversification (P.436)
• The internationally diversified portfolio opportunity
set shifts leftward of the purely domestic
opportunity set.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-12
Exhibit 17.4 The Internationally Diversified
Portfolio Opportunity Set
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-13
International Diversification
• It is critical to be clear as to exactly why the
internationally diversified portfolio opportunity set
is of lower expected risk than comparable
domestic portfolios.
• The gains arise directly from the introduction of
additional securities and/or portfolios that are of
less than perfect correlation with the securities
and portfolios within the domestic opportunity set.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-14
The Optimal International
Portfolio(P.438)
• The investor can now choose an optimal portfolio that combines the
same risk-free asset as before with a portfolio from the efficient
frontier of the internationally diversified portfolio opportunity set.
• The optimal international portfolio, IP, is again found by locating
that point on the capital market line (internationally diversified)
which extends from the risk-free asset return of Rf to a point of
tangency along the internationally diversified efficient frontier.
• The benefits are obvious in that a higher expected portfolio return
with a lower portfolio risk can be obtained when compared to the
domestic portfolio alone.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-15
Exhibit 17.5 The Gains from
International Portfolio Diversification
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-16
Altering the Weights(P.440)
• An investor can reduce investment risk by
holding risky assets in a portfolio.
• As long as the asset returns are not
perfectly positively correlated, the investor
can reduce risk, because some of the
fluctuations of the asset returns will offset
each other.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-17
Exhibit 17.6 Alternative Portfolio Profiles
Under Varying Asset Weights
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-18
17.3 National Markets
and Asset Performance
• For the 100 year period ending in 2000, the risk of investing
in equity assets has been rewarded with substantial returns.
• The true benefits of global diversification=== the returns of
different stock markets around the world are not perfectly
positively correlated.
• This is because the are different industrial structures in
different countries, and because different economies do not
exactly follow the same business cycle.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-19
National Markets
and Asset Performance
• Interestingly, markets that are contiguous or nearcontiguous (geographically) seemingly demonstrate the
higher correlation coefficients for the past century.
• It is often said that as capital markets around the world
become more and more integrated over time, the benefits of
diversification will be reduced.
• Analysis of market data supports this
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-20
Market Performance Adjusted for Risk:
The Sharpe and Treynor Performance
Measures (P.443)
• To consider both risk and return in evaluating
portfolio performance, we introduce two measures:
The Sharpe Measure (SHP)
= SHPi = Ri – Rf
σi
The Treynor Measure (TRN)
= TRNi = Ri – Rf
βi
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-21
the Sharpe and Treynor measures
• Though the equations of look similar, the difference
between them is important.
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-22
Exhibit 17.7 Real Returns and Risks on the
Three Major Asset Classes, Globally, 1900–2000
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-23
Exhibit 17.8 Correlation Coefficients
between World Equity Markets, 1900–
2000
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-24
Exhibit 17.9 Summary Statistics of the Monthly Returns for 18
Major Stock Markets, 1977–1996 (all returns converted into U.S.
dollars and include all dividends paid)
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-25
Exhibit 17.10 Comparison of Selected
Correlation Coefficients between Stock Markets
for Two Time Periods (dollar returns)
Copyright © 2010 Pearson Prentice Hall. All rights reserved.
17-26