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CHAPTER 15
INTERNATIONAL
PORTFOLIO
INVESTMENT
I nternational Diversification:

The benefits of diversification are well perceived by
portfolio managers, that many in developed countries
started investing in foreign bonds, stocks and other
instruments. They found that can extend
diversification principle to foreign stocks, bonds etc,
to improve returns for a given risk by adopting
proper techniques of diversification.

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Need of I nternational
Diversification:

The size and character of international Equity and bond markets
are widely varying that it will increase the scope for larger
investment and larger diversification.
The returns in local currencies of some foreign countries are
higher than in domestic markets. Thus, for example in
Singapore, Malaysia, Taiwan and India the returns in local
currencies are higher than in U S economy.
The economic trends, business conditions and local profitability
and earnings ratio differ widely among countries that the EPS in
some developing countries is higher and give opportunity for
better diversification and higher returns, through international
investments.

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International investment is
advantageous due to larger investment avenues now open in
the first place and secondly due to the imperfect correlation
among the international investment markets. The total risk of a
portfolio including the international investment will be lower
than with only domestic investment. The degree of volatility,
and all risk measures, indicates that these risks vary among the
countries and in different degrees and the possibility of
covariance, or high correlation will be low.
The frontier of efficiency portfolio can be widened, by inclusion
of foreign investment in a portfolio. Thus many international
portfolio managers prefer to invest in India and so will be the
case of India n portfolio managers, if they can diversify into
international investment. There are some directions however,
which will increase risk in such investment.


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CHAPTER OVERVIEW:
I. THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
II. INTERNATIONAL BOND INVESTING
III.OPTIMAL ASSET ALLOCATION
IV. MEASURING THE TOTAL RETURN
V. MEASURING EXCHANGE RISK ON
FOREIGN SECURITIES
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I. THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING

I. THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
A. Advantages
1. Offers more opportunities than
a domestic portfolio only
2. Larger firms often are overseas
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THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
B. International Diversification
1. Risk-return tradeoff: may be
greater
basic rule-
the broader the diversification,
more stable the returns and
the more diffuse the risk.

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THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
2. International diversification and
systematic risk
a. Diversifying across nations with
different economic cycles

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THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
b. While there is systematic risk
within a nation, it may be
nonsystematic and diversifiable
outside the country.

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THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
3. Recent History
a. National stock markets have wide
differences in returns and risk.
b. Emerging markets have higher
risk and return than developed
markets.
c. Cross-market correlations have
been relatively low.
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THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
C. Correlations and the Gains From
Diversification
1. Correlation of foreign market betas

Foreign Correlation Std dev
market = with U.S. x for. mkt.
beta market std dev
U.S. mkt.


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THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
2. Past empirical evidence suggests inter-
national diversification reduces
portfolio risk.

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THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
3. Theoretical Conclusion
International diversification pushes out
the efficient frontier.


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THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
4. Calculation of Expected Return:
r
p
= a r
US
+ ( 1 - a) r
rw

where r
p
= portfolio expected return
r
US
= expected U.S. market return
r
rw
= expected global return



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THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
5. Calculation of Expected Portfolio Risk = (
P
)

P
= [a
2

US
2
+ (1-a)
2

r w
2
+ 2a(1-a)

US

rw

US,rw
]
1/2


where
US,rw
= the cross-market

correlation

US
2
= U.S. returns variance

r w
2
= World returns variance
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THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
6. Cross-market correlations
a. Recent markets seem to be
most correlated when volatility
is greatest
b. Result:
Efficient frontier retreats
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THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
D. Investing in Emerging Markets
a. Offers highest risk and returns
b. Low correlations with returns
elsewhere
c. As impediments to capital market
mobility fall, correlations are
likely to increase in the future.
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THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
E. Barriers to International Diversification
1. Segmented markets
2. Lack of liquidity
3. Exchange rate controls
4. Less developed capital markets
5. Exchange rate risk
6. Lack of information
a. readily accessible
b. comparable
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THE BENEFITS OF INTERNATIONAL
EQUITY INVESTING
F. Methods to Diversify
1. Trade in American Depository
Receipts (ADRs)
2. Trade in American shares
3. Trade internationally diversified
mutual funds:
a. Global
b. International
c. Single-country
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II. INTERNATIONAL BOND
INVESTING
II. INTERNATIONAL BOND INVESTING
-internationally diversified bond
portfolios offer superior performance

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INTERNATIONAL BOND
INVESTING
A. Empirical Evidence
1. Foreign bonds provide higher
returns
2. Foreign portfolios outperform
purely domestic
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III. OPTIMAL INTERNATIONAL ASSET
ALLOCATION

III. OPTIMAL INTERNATIONAL ASSET
ALLOCATION
-a diversified combination of stocks and
bonds
A. Offered better risk-return tradeoff
B. Weighting options flexible
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IV. MEASURING TOTAL RETURNS
FROM PORTFOLIO INVESTING
IV. MEASURING TOTAL RETURNS
A. Bonds

Dollar = Foreign x Currency
return currency gain (loss)
return
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MEASURING TOTAL RETURNS
FROM PORTFOLIO INVESTING
Bond return formula:
1 + R
$
=[1 +B(1) - B(0) + C ](1+g)
B(0)
where R
$
= dollar return


B(1) = foreign currency bond price at time 1
C = coupon income
g = depreciation/appreciation
of foreign currency



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MEASURING TOTAL RETURNS
FROM PORTFOLIO INVESTING
B. Stocks (Calculating return)
Formula:
1 + R
$
=[ 1+ P(1) - P(0) + D ](1+g)
P(0)
where R
$
= dollar return
P(1) = foreign currency stock
price at time 1
D = foreign currency annual
dividend

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