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50

EXCHANGE-RATE CHANGES

ARTHUR J. RAYMOND AND GORDON WEIL*

INTRODUCTION

One of the most widely accepted implications of economic theory is that nations

can increase their welfare through participation in international trade in goods

and services. It has also been demonstrated that the movement of factors of

production between nations can generate benefits for the participating countries. A third way in which the residents of different nations can raise their

welfare by participating in international transactions is through the purchase

and sale of foreign assets, viz. portfolio investment. In fact, movements of

capital across borders have increased dramatically as barriers to international

communication and cooperation have been relaxed.' This paper investigates

the potential benefits that arise from international portfolio investment.

In an early and well known article Grubel (1968) demonstrated theoretically

and empirically that benefits could be realized from international portfolio diversification. Since Grubel's paper there have been a number of empirical studies

supporting his initial findings. Levy and Sarnat (1970), like Grubel, generate

the efficient portfolio set and find that it contains foreign assets. Agmon (1972),

Lessard (1975a and 1975b), and Solnik (1974), use simple and multiple regression models to demonstrate that a large proportion of the variation of international stock returns is unsystematic and therefore capable of being eliminated

through international diversification.^ Solnik (1975) further found that randomly chosen portfolios of even modest size, containing as few as five stocks,

outperform randomly chosen portfolios of only US stocks, and that maximum

risk reduction occurs with a portfolio with around twenty stocks. That diversification benefits occur with such small portfolios is valuable information to

potential investors.

The simplest and most straightforward method for showing that international

diversification benefits exist is to correlate national asset indices. If the correlations are less than one international diversification is beneficial. If one country's returns are low then the overall portfolio's return will probably be protected by off-setting returns in other countries. Thus, the overall variation in

returns risk will be reduced by a portfolio containing foreign assets. Adler

and Dumas (1983), Allan (1982), Errunza (1983), Finnerty and Schneeweis

(1979), Grubel and Fadner (1971), Ibbotson et al. (1982), and Joy et al. (1976)

* The authors are respectively, a Lecturer at Tufts University, and Associate Professor at Wheaton

College. (Paper received January 1987, revised October 1987)

455

456

assets and found these correlations generally to be low. This consistency in

empirical findings is undoubtedly partially responsible for the increased use

of internationally diversified portfolios (see Erlich, 1981; and Revey. 1981).

Most of the studies referred to above have used rates of return unadjusted for

exchange-rate changes, or relied on data drawn from the fixed exchange-rate

period. Those few studies that do adjust for exchange-rate changes during the

floating period do not emphasize the effect of exchange-rate changes on diversification benefits. In fact a new edition of one well known finance text by

Rodriguez and Carter (1984) notes that the effect of exchange-rate changes

on diversification benefits remains unclear.

As part of their investigation of diversification benefits Grubel and Fadner

(1971) point out that exchange-rate changes could increase or decrease the diversification benefits that would exist in the absence of these changes. In an

expanding economy, for example, it is typical for both rates of return and

imports to increase. The resulting exchange rate movement is indeterminant.

Hence, exchange rates may move with or against domestic rates of return.

Furthermore, in the short run according to the asset market view of exchange

rate determination, when higher nominal rates of return are due to domestic

inflationary pressures there could be a capital outflow (rather than inflow) if

investors expect a weakening of the external value of currency (see Frenkel,

1981). In this case too the relation between exchange-rate changes and rates

of return remains unclear. Grubel and Fadner did try to determine empirically

the effect of exchange-rate changes on their correlations but their data was

restricted to the fixed-rate period when exchange rates moved by only small

percentages around par. As might be expected they found no effect on

diversification benefits after adjusting for exchange-rate changes.

In this paper we attempt to update the work of Grubel and Fadner by drawing on data from the more recent floating exchange rate era, rather than from

the pegged rate period. Since our data are drawn entirely from that period

it is necessary to create the relevant data that would have existed had exchange

rates not moved as they in fact did. That set of data, a counter-factual, provides the benchmark to which we compare the actual experience during the

fioating period. We have constructed the counter-factual situation under the

assumption that nations pursued sterilized intervention so that during the period

under consideration the exchange rate changes actually observed have been

eliminated without affecting asset returns since the monetary base is

unchanged.^ Our tests are based on ex-post share price indices of industries in

Australia, Ganada, Spain, the UK, and the US.* The resuhs indicate that for

a US investor international diversification is superior to purely domestic diversification. However, in this sample the observed exchange-rate movements have

tended to reduce the diversification benefits from what would have arisen had

a pegged regime existed (viz. had the central banks followed our counter-factual

of sterilized intervention.)

457

THEORY

If risk is priced in international markets then the gain to be realized from an

internationally diversified portfolio is a more efficient risk-return tradeoff.^ If

portfolio risk is measured by the variance of the portfolio's return then the potential for diversification benefits is indicated by the weighted covariances of every

pairwise combination of assets' returns. Total diversification benefits, excluding

purely domestic diversification, include those realized from diversifying within

foreign countries and across foreign countries as well as those that would be

realized from holding just one foreign asset. The rate of return on an asset

for an investor in county 1 of an n country world is r^.^ and can be written as

( l + r , J = ( 1 + U * (l+-t)

(1)

k'5 currency, and e^. is the appreciation of currency k relative to country I.*"

Of course for X: = 1, t = 0. If J^m * * ~ 0 , the exchange-rate adjusted rate

of return can be approximated by

nm = hm + *

(2)

Tp = W

* R

(3)

where Wisa. vector whose elements are the proportions of wealth held in each

asset and i? is a vector of assets' rates of returns as approximated by r^n,. T h e

risk associated with the world portfolio, measured by its variance, is

V A R {Tp) = W

* C * W

(4)

where C is the variance-covariance matrix of all assets' returns. For large portfolios each element of W approaches 1/^ where s is the number of assets in the

world. T h e benefits of total (not just international) diversification depend upon

the size of the covariance terms the off-diagonal elements of C. Note that

since a correlation coefficient is essentially a standardized covariance it is

legitimate to measure potential diversification benefits in terms of covariances

as well as correlation coefficients.

The covariance terms of C are of the form G O V (r^^ r,^), and are of four

types: (I) between domestic assets {k = j = 1, and m ^ h); (II) between assets

in the same foreign country {k = j ^ 1, and m r^h); (III) between foreign

assets in different countries {k ^j ^ 1); and (IV) between domestic and foreign

assets {k = 1 ^ j). Expanding the covariance between domestic and foreign

assets from equation (2), which measures the extent to which international diversification is beneficial, gives

e])

(5)

458

nominal domestic rates of return with exchange rates. This is the argument

given by Grubel and Fadner and explained in the previous section. Expanding the other types of covariances reveals that exchange-rate changes affect other

diversification benefits through the covariance of exchange-rate changes with

each other as well as with rates of return. Because there are no strong

theoretical arguments about the co-movement of rates of return and exchange

rates with each other, the effect of exchange-rate changes on diversification

is an empirical question.

Our data are indices of monthly share prices for 49 US industries and 67 foreign

industries for the period January 1976 to January 1979. Nominal rates of return

were calculated as simple monthly rates. Letting 4^, be the value of the share

price index for industry m in country k at the time t, the nominal rate of return

was calculated as

'kml = {hml-\lhmt)-'^

(6)

The rates of return, measured in dollars, were calculated by adjusting the index

levels by the exchange rate and then calculating simple monthly rates of return

of the adjusted index. Define Ei^t as the dollar price of foreign currency; of

course, for the US Ei^, = 1.

Then

I',^, = 4^, *

(7)

rkmi = {IU-x'Hm)-'^

(8)

In order to determine the effect of exchange-rate changes experienced during the period of fioating rates on diversification benefits the co-movement of

rates of return, as measured by the correlation coefficient, was estimated both

in dollar terms (from (8)), and then in local currency units (from (6)) according to our country-factual scenario.

Rates of Return Measured in Home Currency Units

Table 1 gives the average correlation coefficient between all industries in the

country listed vertically and the country listed horizontally with returns

measured in home currency units.' The diagonal gives the average correlation coefficients for returns within countries and so is a measure of diversification within each country. From a US portfolio holder's point of view the US/US

entry in the table is a type I correlation coefficient. The other diagonal entries

459

Table 1

Average Gorrelation Goefficients of Rates of Return Within and Across

Gountries Measured in Local Gurrency Units

US

UK

CAN

SP

US

UK

0.4974

(1176)

0.0677

(1568)

0.256

(1225)

0.6814

(496)

0.022

(800)

CAN

0.4533

(300)

SP

0.0848

(245)

-0.349

(160)

AUS

0.2564

(245)

0.1752

(160)

0.0233

(125)

0.1285

(125)

0.4882

(10)

0.0710

(25)

AUS

0.4346

(10)

The numbers in parentheses are the number of correlation coefficients in the average.

country. The top row (other than the US/US entry) is made up of type IV

correlation coefficients, giving correlations between the US and each foreign

country, and the remaining entries are type III correlations. By inspection,

it is apparent that internal correlation coefficients (type I and II) are larger

than cross-country correlations (types III and IV). This suggests by the usual

method of analysis that international diversification benefits would have existed

under our country-factual scenario for investors in all five countries. Namely,

if an investor in any of the countries indicated reduced the relative importance

of domestic assets by adding assets of other countries, overall portfolio risk would

decline.'" Table 1 also provides some information on other types of diversification benefits. Taking a US perspective, the fact that type II (foreign internal)

correlation coefficients are less than one indicates that it would have been wise

for a US investor to diversify within each foreign country. Type III correlation coefficients (between foreign assets in different countries) are also less than

one suggesting diversification into more than one foreign country would have

been beneficial." Also if we take average correlation coefficients (type I for

the US and type II for the others) as a measure of the internal integration of

different asset markets then our results indicate that, except for the UK, a very

similar degree of integration exists in all countries.'^

Table 2 lends statistical force to our casual observations concerning international diversification benefits. The table contains t-statistics for the difference

between the average US internal correlation coefficient and the average

460

Table 2

and Type IV Gorrelation Goefficients with Returns Measured in Home

Gurrency Units

US

UK

CAN

70.23

(2742)

31.29

(2399)

SP

32.08

(1419)

AUS

18.1

(1419)

All differences are significant at the 99 per cent level.

US/foreign correlation coefficients. In all cases the average US/foreign correlation coefficient is less than the average US domestic correlation coefficient

indicating the presence of international diversification benefits.

We should be clear on our methodology. The results just presented did not

make any adjustment for the actual exchange rate changes that took place over

the time period. This should not be taken to imply that we believe that US

investors do not consider exchange rate changes when they consider the benefits

and costs of purchasing a foreign asset. Rather, to find the effect that exchange

rate changes have had on diversification benefits we have constructed a counterfactual scenario in which the central bank of each nation is presumed to have

pursued sterilized intervention thereby holding their exchange rates constant.

With sterilized intervention the monetary base is unaffected so asset returns

would be the same as was produced without intervention. In such a situation

there is no need to convert rates of return out of domestic currency values.

Thus the results present a benchmark to which we compare the actual correlation coefficients observed during our sample period. In the next section the

results of tests are reported when rates of return have been adjusted for exchange

rates, and a comparison is then possible. Furthermore, much of the literature

on this subject rests on calculations similar to those presented above. A comparison of the present results with those found in the studies noted in the first

section will reveal that other studies also found that diversification benefits do

exist for the international investor, when rates of return are measured in local

currency units.

Rates of Return Measured in Dollars

Tables 3 and 4 contain the same information as Tables 1 and 2 respectively,

except that rates of return are measured in dollars as defined by equation (8).

When measured in dollars there are still benefits to international diversification. All of the average correlation coefficients between US assets and foreign

assets are lower than the average correlation coefficient among US assets only.

461

Table 3

Average Correlation Coefficients of Rates of Return Within and Across

Countries Measured in Dollars

US

US

UK

CAN

0.4974

(1176)

0.0843

(1568)

0.2763

(1225)

0.0465

(245)

0.2510

(245)

0.7657

(496)

0.0393

(800)

0.0426

(160)

0.1992

(160)

0.5617

(300)

-0.0809

(125)

0.2814

(125)

0.6541

(10)

0.1124

(25)

UK

CAN

SP

SP

AUS

AUS

0.5939

(10)

Table 4

^-Statistics for the Difference Between the Average Type I Correlation

Coefficient and Type IV Correlation Coefficients with Returns Measured

in Dollars

US

UK

CAN

68.2

(2742)

30.5

(2399)

SP

35.3

(1419)

AUS

18.9

(1419)

All differences are significant at the 99 per cent level.

The ^ratios reported in Table 4 further indicate that each of these differences

is indeed statistically significant. A US investor who holds an internationally

diversified portfolio, subject to exchange risk, will still have lower risk than

if the portfolio contained only US assets. As would be expected, type II and

type III correlation coefficients are less than one as in the previous sub-section.

An internationally diversified portfolio should contain more than one asset in

each foreign country and more than one foreign country's assets. Thus the

four types of correlations labelled type IIV can alternatively be viewed as

four sources of diversification benefits. However, it is the correlation between

US and foreign assets that determine if international diversification ultimately

pays.

462

for the difference in the average type II, III, and IV correlation coefficients

that result from including exchange-rate changes in the analysis. Each <-ratio

was constructed for the average correlation coefficient without exchange-rate

changes minus the average correlation coefficient with exchange-rate changes.

Of those differences that are significandy different from zero, and most of them

are, all are negative except for the US/SP and CAN/SP comparisons, which

have small weights in our world portfolio anyway. These results imply that

in general, correlation coefficients have increased as a result of including

exchange-rate changes in the rate of return on foreign assets. We can conclude,

therefore, that the effect of exchange-rate changes has been to reduce the benefits

from international diversification, but they have certainly not eliminated them.

As is the case with all analysis that rests on a comparison of observed data

with a hypothetical counter-factual alternative, the strength of these conclusions depends on the meaningfulness of that counter-factual. Our counterfactual scenario, sterilized intervention, implies that we are comparing the

current float to the alternative of absolutely fixed exchange rates. One may

well ask how well our conclusions stand-up in a world with some, though

limited, flexibility of exchange rates. We address that question below.

Our counter-factual is created by measuring the covariances (or correlation

coefficients) between rates of return on domestic and foreign assets in each country's own currency. Operationally this is most easily seen in equation (5) and

the second and third equations of note 7 in which the covariance and variance

Table 5

^-Statistics for Changes in the Average Correlation Coefficients

as a Result of Including Exchange Rate Changes (Without With)

UK

CAN

SP

US

-3.6*

(3134)

-2.9'

(2448)

UK

-8.5*

(494)

-3.2*

(1584)

4.0*

(488)

-10.8*

(318)

33.9*

(248)

CAN

-12.2*

(598)

SP

AUS

The numbers in parentheses are degrees of freedom.

A * indicates significance at the 99 per cent level.

-2.6'

(18)

AUS

0.46

(488)

-3.8*

(318)

-15.2*

(248)

-2.1

(48)

-2.4

(18)

463

terms that include the exchange rate are forced to become zero. The results

reported in Table 5 are essentially generated by subtracting from those equations noted above (with exchange rate terms held to zero) the same equation

this time with the observed variation in exchange rates. The results of those

subtractions are almost invariably negative. We could describe a limited amount

of exchange rate flexibility by setting free those terms forced to zero. Since

those terms are positive, for the time period studied, the exercise must reduce

the negative values from our subtractions that are reported in Table 5. Hence

we might conclude that by permitting limited fiexibility in the exchange rate

we find that fioating exchange rates reduce diversification benefits a bit less

than when the alternative is absolutely fixed rates, but never that it increases

diversification benefits.

There is, however, a problem with the above approach. Implicitly we have

assumed that permitting the exchange rate to vary would have no effect on

rates of return. From a larger, general equilibrium, perspective, we would

expect rates of return as well as other economic variables to follow a different

path when exchange rates vary than when they are held constant through

sterilized intervention. Thus we should recognize that when sterilized intervention is not practiced and exchange rates do vary to some limited extent, the

movement in rates of return will also be affected. Hence the conclusions of

the preceeding paragraph (which do not account for any difference in the paths

of rates of return) cannot bear too much weight. If we try to pin down more

closely the diversification benefits when exchange rates vary a limited amount

we encounter the insurmountable problem of having to postulate, and test,

any number of different potential scenarios. The different scenarios being

motivated in large part by the actions of the Central Bank, the Treasury, and

the expectations of investors. Since the actions of each of these agents is nearly

impossible to predict we are unable to argue convincingly that one scenario

is necessarily a more likely outcome than another. Thus we feel it is best to

use as our basis for comparison the unambiguous and limiting case of absolutely

fixed exchange rates.

CONCLUSION

Our ex-post test using industry data from five countries reinforces the conclusion of many other researchers that benefits from international diversification

do exist. Theoretically, industry returns may be positively or negatively correlated with exchange-rate changes so that diversification benefits may increase

or decrease as a result of including exchange-rate changes. Our results indicate

that under floating exchange rates international diversification still pays, but

not as much as would have been the case had exchange rates been pegged.'^

This result is further reinforced by a comparison of Crubel and Fadner's correlation coefficients (from the fixed period) and ours from the fioating period.

464

While the two data sets are drawn from two very different time periods, cover

different industries, and include different countries, on average our correlations are slightly higher than those found in their study.

APPENDIX

Data Sources

The sources of the industry data are:

(1)

(2)

(3)

(4)

(5)

US: Standard and Poor's Statistical Service, Security Price Index Record 1980.

UK: F.T.-Actuaries Share Indices, Financial Times, last day of each month for fmancial

transactions, Jan. 2, 1975-Jan. 31, 1979.

CAN: Industry Price Indexes, Statistics Canada, Minister oflndustry. Trade and Commerce, March 1979.

SP: Moody's International Manual, Moody's Investor Service, Inc., New York, 1982,

Madrid Stock Exchange, p a 51.

AUS: Moody's International Manual, Moody's Investor Service, Inc., New York, 1982,

Australia, p a 46.

All exchange rate data were taken from 'Supplement on Exchange Rates'. International Financial

Statistics, Supplement Series No. 1, International Monetary Fund, 1981.

NOTES

1 At the time of writingjapan and the United States have announced the relaxation of Japanese

capital restrictions in the interest of promoting efficient world capital markets.

2 Lessard (1975) reports less diversification benefits for the US since the US is such a large part

of the world market.

3 It is, of course possible to critique almost any counter-factual scenario. In this case one could

argue that nations may not have had sufficient reserves to undertake the sterilized intervention

we assume.

4 The sample consists of 5 industries in Spain and Australia, 25 industries in Canada, 32 industries

in the UK, and 49 industries in the US.

5 In poorly integrated markets where risk may not be appropriately priced, there may be assets

with returns higher than can be explained by risk. Ehrlich (1981) suggests that this is the view

of many pension fund executives.

6 An exact definition of the rate of return could also include the rate of inflation.

7 Type I, II, and III covariances are respectively:

iji,), i = > = I and

j

, iji,)^COV(ij^, ,)

for k = j ^ I and m ^ h;

for i = j = 1.

8 There is a bias in both ij^, and r/^, due to the omission of dividends which was not available

from our sources. However, the use of simple arithmetic rates of return reduces that bias by

overstating rates of return.

9 Our approach is to examine potential diversification benefits on the basis of correlation coefficients of rates of return among all industries (foreign and domestic) in our sample. Thus, the

type of model we employ is what Eun and Resnick (1984) term the 'Full Historical Model'.

Their study showed this model to be one of the most accurate approaches to forecasting correlation coefficients. Indeed, it is their benchmark for comparing alternative approaches.

10 It is possible to analyze diversification benefits from any country's point of view because the

465

data is in each country's own units. When exchange rate adjustments are made in the second

part of this section, so that all returns are measured in dollars, all analysis will have to be from

the US perspective.

11 If type II and type III correlation coefficients were both equal to one then international diversification could be accomplished by holding any one foreign asset, all others would be perfect

substitutes and so redundant in the portfolio.

12 By taking unweighted averages we are assuming that the relevant portfolio is one made up

of equal amounts of equities. Adler and Dumas (1979) point out that any market segmentation

(e.g. deviations from purchasing power parity) obscures the concept of an equilibrium or market

portfolio because such a portfolio will differ by nationality. Consequendy, it should be

emphasized that our measure of diversification benefits only applies to the equal weight portfolio we have constructed. For very large portfolios, weights approach equality so our analysis

can be construed to be applicable to very large portfolios.

13 We are referring only to that part of risk of a portfolio due to the co-movement of returns.

The question of the effect of exchange rate changes on the variance of returns has not been

addressed in this paper.

REFERENCES

Adler, M. and B. Dumas (1983) 'International Portfolio Choice and Corporate Finance: A Synthesis', Journal of Finance, XXXVIII, 3 (June 1983), pp. 925-984.

Agmon, T. (1972), 'The Relations Among Equity Markets: A Study of Share Price Co-movement

in the United States, United Kingdom, Germany andjapan'. Journal of Finance, XXXVII,

4 (September 1972), pp. 839-856.

Allan, I. (1982), 'Return and Risk in International Capital Markets', The Columbia Journal of World

Business, Summer, XVII, 2 (Summer 1982), pp. 3-23.

Ehrlich, E.E. (1981), 'International Diversification by United States Pension Funds'. Federal Reserve

Bank of New York Quarterly Review, VI, 3 (Autumn 1981), pp. 1-14.

Elton, E.J. and M.J. Gruber, eds. (1975), International Capital Markets (Amsterdam, North Holland,

1975).

Errunza, V.R. (1983), 'Emerging Markets: A New Opportunity for Improving Global Portfolio

Performance', Financial Analyst's Journal, September/October, 1983, pp. 5158.

Eun, C S . and B.G. Resnick (1984), 'Estimating the Correlation Structure of International Share

Prices', The Journal of Finance, XXXIX, 5 (December 1984), pp. 1311-1324.

Finnerty, J.E. and T. Schneeweis (1979), 'The Co-movement of International Assets and Returns',

Journal of International Business Studies, X, 3 (Winter 1979), pp. 66-75.

Frenkel, J. A. (1981), 'Flexible Exchange Rates, Prices and the Role of "News": Lessons from the

i970's'. Journal of Political Economy, LXXXIX, 4 (1981), pp. 665-705.

Grubel, H.G. (1968), 'Internationally Diversified Portfolios; Welfare Gains and Capital Flows',

American Economic Review, LVIII, 5 (December 1968), pp. 1299-1314.

and K. Fadner (1971), 'The Interdependence of International Equity Markets', youma/

of Finance (March 1971), pp. 89-94.

Ibbotson, R.G., R.C. Carr and A.W. Robinson (1982), 'International Equity and Bond Returns',

Financial Analysts Journal (Ju\ylAugust 1982), pp. 6183.

Joy, O.M., D.B. Panton, F.R. Reilly and S.A. Martin (1976), 'Co-movement of Major International Equity Markets', The Financial Review, 1976, pp. 121.

Lessard, D. (1975), 'World, Country, and Industry Relationships in Equity Returns', in Elton

and Gruber eds.. International Capital Markets (1975), pp. 279-297.

(1975), 'The Structure and Gains From International Diversification', in Elton Gruber

ed.. International Capital Markets (North Holland, Amsterdam, 1975), pp. 207220.

Levy, H. and M. Sarnat (1970), 'International Diversification of Investment Portfolios', American

Economic Review, LX, 4 (September 1970), pp. 668-675.

Raymond, A.J. (1983), 'Asset Returns Under Fixed and Floating Exchange Rate: A Research

Proposal', Unpublished paper (February 1983).

Revey, P.A. (1981), 'Evolution and Growth of The United States Foreign Exchange Market',

Federal Reserve Bank of New York Quarterly Review, V I , 3 (Augumn 1981), pp. 3244.

466

Rodriquez, R.M. and E.E. Carter (198^) Intemationat Financial Management, 3rd edition (New Jersey,

Prentice-Hall. Inc., 1984), p. 587.

Solnik, B.H. (1974), 'The International Pricing of Risk: An Empirical Investigation of World

Capital Market Structure', Journal of Finance, XXIX, 2 (May 1974), pp. 365-378.

(1975), 'Why Not Diversify Internationally', Financial Analyst's Journal (Juiy/August 1975),

pp. 48-54.

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