International Finance

Part 1 Introduction
Global Asset Classes and their Characteristics

Dr. Peter Oertmann

peter.oertmann@vescore.com

Agenda

Prologue: The asset allocation process

Brush up: Risk and return

Market parameters of global asset classes

Some facts on stock market volatilities and correlations

2012 Peter Oertmann

Agenda

Prologue: The asset allocation process

Brush up: Risk and return

Market parameters of global asset classes

Some facts on stock market volatilities and correlations

2012 Peter Oertmann

Building blocks of an asset allocation process

Selection of
asset classes

Regulatory
restrictions
Risks
Covariance
Matrix

10%

10%

5%
15%

Global
investment
universe

Portfolio
construction
Expected
returns

Investors preferences

2012 Peter Oertmann

40%

20%

Investors portfolio

Aspects along the process

Investors preferences
Return target
Liability structure
Investment philosophy (benchmark-oriented, absolute return, )
Risk budget / capability (reserves, )

Regulatory restrictions (for pension plans, insurance companies, )

Restrictions on asset classes
Restrictions on investment products
Restrictions on risk management

Selection of asset classes

Availability of investment opportunities (asset manager, funds, derivatives, )
Investment philosophy

2012 Peter Oertmann

Aspects along the process (cont.)

Asset risks
How to calculate the covariance matrix (data period, frequency, )

Expected asset returns

Choice of an asset pricing approach

Portfolio construction
General structure (traditional, core-satellite, )
Choice of an optimization method (Markowitz, Black-Litterman, ...)

2012 Peter Oertmann

Overview Part 1
Asset returns, volatilities, and correlations

Regulatory
restrictions
Risks
Covariance
Matrix

Content

Brush-up: Return calculation

Data for international markets

Empirical facts

Portfolio
construction
Expected
returns
Selection of
asset classes

2012 Peter Oertmann

Investors
preferences

Overview Part 2-4

IAPM, Multifactor Models, Return Forecasting, and Asset Pricing

Regulatory
restrictions
Risks
Covariance
Matrix
Portfolio
construction
Expected
returns
Selection of
asset classes

2012 Peter Oertmann

Investors
preferences

Content
International parity relations
Theoretical backgrounds
Structures of IAPM
Specification of multifactor models
Application of multifactor models
Forecasting returns
Modeling of risk premiums
Sentiment and asset returns
Conditional asset pricing
Market integration

Overview Part 5
Global Asset Allocation

Regulatory
restrictions
Risks
Covariance
Matrix

Content
Strategic asset allocation
Global tactical asset allocation
Managing capital market risks
Overlay management

Portfolio
construction
Expected
returns
Selection of
asset classes

2012 Peter Oertmann

Investors
preferences

Overview Part 6
Institutional Investing in the 2nd Decade

Regulatory
restrictions
Risks
Covariance
Matrix
Portfolio
construction

Content
Investing in a changing world
BCG report: Trends in institutional
investing
Structuring the risk-return space
1/N for asset allocation
Commodities as an alternative
asset class

Expected
returns
Selection of
asset classes

2012 Peter Oertmann

Investors
preferences

10

Literature

2012 Peter Oertmann

Zimmermann/Drobetz/Oertmann:
Global Asset Allocation, Wiley Finance,
2002, ISBN: 978-0-471-26426-2
Selected references to books and
journals are given in the lecture

11

Agenda

Prologue: The asset allocation process

Brush up: Risk and return

Market parameters of global asset classes

Some facts on stock market volatilities and correlations

2012 Peter Oertmann

12

Brush-up:
Calculating returns
Time period
Example
t-1

Monthly returns
S&P 500 (USD) 2008-2010
20,0%

Simple return

15,0%

Rit =

Pit Pi, t 1
Pi, t 1

Continuously compounded return

10,0%

5,0%

0,0%

-5,0%

Pit

Rit = ln

Pi, t 1

-10,0%

-15,0%

-20,0%
Jan
08

2012 Peter Oertmann

Mrz
08

Mai
08

Jul
08

Sep
08

Nov
08

Jan
09

Mrz
09

Mai
09

Jul
09

Sep
09

Nov
09

Jan
10

Mrz
10

Mai
10

Jul
10

Sep
10

Nov
10

13

Brush-up:
Measuring investment risk
Variance of return

Measure of dispersion

Example

Mean squared deviation of

Monthly returns
S&P 500 (USD) 2008-2010

returns form the mean return

20,0%

2i

1 T
= Var(Ri ) = (Rit Ri )2
T t =1

15,0%

10,0%

5,0%

Volatility

0,0%

Square root of variance

-5,0%

-10,0%

i = Std(Ri ) =

1 T
(Rit Ri )2
T t =1

-15,0%

-20,0%
Jan
08

Mrz
08

Mai
08

Jul
08

Sep
08

Nov
08

Jan
09

Mrz
09

Mai
09

Jul
09

Sep
09

Nov
09

Jan
10

Mrz
10

Mai
10

Jul
10

Sep
10

Nov
10

Monthly volatility 6.6%

2012 Peter Oertmann

14

Brush-up:
Measuring investment risk (cont.)
Volatility from different perspectives
Transformation rules

(daily volatility) (22 days)

= (monthly volatility)

Volatility calculations
Yearly Monthly

Daily

100.0%

28.9%

6.2%

(monthly volatility) (12 months)

80.0%

23.1%

4.9%

= (yearly volatility)

60.0%

17.3%

3.7%

50.0%

14.4%

3.1%

40.0%

11.5%

2.5%

30.0%

8.7%

1.8%

20.0%

5.8%

1.2%

15.0%

4.3%

0.9%

10.0%

2.9%

0.6%

2012 Peter Oertmann

15

Brush-up:
Calculating portfolio returns
Approach

Weighting the returns of portfolio components (single assets)

Using simple (!) returns, not continuous returns

Two asset case

Rpt = w 1 R1t + w 2 R2 t

Mean:

Rp = w 1 R1 + w 2 R2

N (many) asset case

N

Rpt = w i Rit
i =1

2012 Peter Oertmann

Mean:

Rp = w i Ri
i =1

16

Brush-up:
Measuring the risk of a portfolio
Starting point

Simple weighting of the variances / volatilities of the portfolio components is not

adequate

Return covariances have to be taken into account

Portfolio variance
2 asset case

p2 = w12 12 + w 22 22 + 2 w1 w 2 12

3 asset case

p2 = w12 12 + w 22 22 + w 32 32
+ 2 w1 w 2 12 + 2 w1 w 3 13 + 2 w 2 w 3 23

2012 Peter Oertmann

17

Brush-up:
Measuring the risk of a portfolio (cont.)
General formula of portfolio variance
Matrix notation

11 12 13 L w 1

w
2p = w ' V w = [w 1 w 2 w 3 L] 21 22 33 2
31 32 33 w 3

M
where

Double-sum notation

2p

2012 Peter Oertmann

portfolio weight of an asset

ii

asset variance

ij

covariance between two assets

N N

= w i w j ij
i =1j =1

18

Brush-up:
Measuring the risk of a portfolio (cont.)
Crucial insights

Portfolio risk is based on the

variances of its components as well
as on the covariance between its
components
Covariances between the portfolio
components contribute the largest
part to portfolio risk

2012 Peter Oertmann

Covariances dominate
Number of ...
Assets
VARs

COVs

2
3
4
5
10
100
1000
2500

2
6
12
20
90
9900
999000
6247500

2
3
4
5
10
100
1000
2500

19

Agenda

Prologue: The asset allocation process

Brush up: Risk and return

Market parameters of global asset classes

Some facts on stock market volatilities and correlations

2012 Peter Oertmann

20

Relative sizes of world stock markets

end-1899

end-2010

UK

30,5%

8,1%

USA

19,3%

41,4%

France

14,3%

3,9%

Germany

6,9%

3,2%

Japan

4,0%

8,2%

Canada

1,8%

4,1%

Russia

3,9%

Belgium

3,8%

Austria-Hungary

3,5%

Netherlands

1,6%

Italy

1,6%

Switzerland
Spain

5,1%

Others

3,7%

end-1899
end-2010

35%
30%

20%
5,2%
15%

3,0%

10%
5%

1,4%
1,3%

Sweden

40%

25%

3,4%

Australia

45%

16,8%

0%
UK

USA

France

Germany

Japan

Canada

Data source: Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the Optimists, 2002; Credit Suisse AG, 2011; own calculations

2012 Peter Oertmann

21

Sector weightings within US stock market

Weight

70%

5,2%

0,3%

Breweries and Distillers

0,3%

0,4%

Utilities

4,8%

3,8%

Telegraph and Telephone

3,9%

5,6%

Insurance

0,0%

4,9%

Other Transport

3,7%

0,5%

Chemicals

0,5%

1,2%

Food Manufacturing

2,5%

1,2%

Retailers

0,1%

5,6%

Tobacco

4,0%

0,8%

Sectors that were small in 1900

4,8%

62,4%

40%

30%

20%

10%

0%
Sectors that were
small in 1900

Iron, Coal, Steel

end-2000

50%

Tobacco

0,2%

Retailers

0,7%

Food Manufacturing

Textiles

Chemicals

0,0%

Other Transport

0,0%

end-1899

Insurance

Mining

60%

Telegraph and
Telephone

12,9%

Utilities

6,7%

Breweries and
Distillers

Banks and Finance

Iron, Coal, Steel

0,2%

Textiles

62,8%

Railroads

Mining

end-2000

Banks and Finance

end-1899

Railroads

US Sectors

Data source: Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the Optimists, 2002

2012 Peter Oertmann

22

Returns and risk

of international stock and fixed income markets from 1900 to 2010
Real return

Nominal return

Equities

Bonds

Bills

Standard deviation

Equities

Bonds

Bills

Equities

Bonds

Bills

North America
USA

New York Stock Exchange, est. 1792

6,3%

1,8%

1,0%

9,4%

4,8%

3,9%

20,3%

10,2%

4,7%

Canada

Toronto Stock Exchange, est. 1861

5,9%

2,1%

1,6%

9,1%

5,2%

4,7%

17,2%

10,4%

4,9%

Brussels stock exchange, est. 1801

2,5%

-0,1%

-0,3%

8,0%

5,2%

5,0%

23,6%

12,0%

8,0%

Europe (Eurozone)
Belgium
Finland

Helsinki Stock Exchange, est. 1912

5,4%

-0,2%

-0,5%

13,1%

7,1%

6,8%

30,3%

13,7%

11,9%

France

Paris stock exchange dates back to 1724

3,1%

-0,1%

-2,8%

10,5%

7,1%

4,2%

23,5%

13.0%

9,6%

Germany

German stock exchange dates back to 1685

3,1%

-1,9%

-2,4%

8,3%

2,8%

2,3%

32,2%

15,5%

13,2%

Ireland

Stock exchanges in Dublin and Cork date back to 1793

3,8%

0,9%

0,7%

8,2%

5,2%

5,0%

23,2%

14,9%

6,7%

Italy

Stock exchange in Milan dates back to 1808

2,0%

-1,7%

-3,6%

10,6%

6,7%

4,5%

29,0%

14,1%

11,5%

Netherlands

Amsterdam stock exchange dates back to 1611

5,0%

1,4%

0,7%

8,0%

4,4%

3,6%

21,8%

9,4%

5,0%

Spain

Madrid Stock Exchange, est. 1831

3,6%

1,3%

0,3%

9,6%

7,2%

6,2%

22,3%

11,8%

5,9%

Denmark

Copenhagen Stock Exchange, est. 1808

5,1%

3,0%

2,3%

9,2%

7,1%

6,2%

20,9%

11,7%

6,0%

Norway

Oslo Stock Exchange, est. 1819

4,2%

1,7%

1,2%

8,1%

5,5%

4,9%

27,4%

12,2%

7,2%

Sweden

Stockholm Stock Exchange, est. 1863

6,3%

2,4%

1,9%

10,1%

6,1%

5,5%

22,9%

12,4%

6,8%

Switzerland

Swiss stock markets date back to 1850

4,2%

2,1%

0,8%

6,6%

4,5%

3,1%

19,8%

9,3%

5,0%

UK

Stock trading dates back to 1698

5,3%

1,4%

1,0%

9,5%

5,4%

5,0%

20,0%

13,7%

6,4%

Australia

Australian Securities Exchange (ASX), est. 1861

7,4%

1,5%

0,7%

11,6%

5,4%

4,6%

18,2%

13,2%

5,4%

Japan

Tokyo stock exchange, est. 1878

3,8%

-1,1%

-1,9%

11,1%

5,8%

5,0%

29,8%

20,1%

13,9%

New Zealand

New Zealand Exchange dates back to 1870

5,8%

2,0%

1,7%

9,8%

5,8%

5,5%

19,7%

9,0%

4,7%

South Africa

Johannesburg stock exchange (JSE), est. 1887

7,3%

1,8%

1,0%

12,6%

6,8%

6,0%

22,6%

10,4%

6,2%

World

GDP-weighted indices, denominated in USD

5,5%

1,6%

1,0%

8,6%

4,7%

3,9%

17,7%

10,4%

4,7%

Europa (Others)

Asia-Pacific

Africa

Data source: Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the Optimists, 2002; Credit Suisse AG, 2011; Wikipedia; own calculations

2012 Peter Oertmann

23

Real returns
of international stock and fixed income markets from 1900 to 2010
8%

6%

4%

2%

0%

-2%

-4%
USA

CAN

BEL

FIN

FRA

GER

Equities

IRE

ITA

NET

SPA

DEN NOR SWE

SWI

Bonds

UKI

AUS

JAP

NZE

SAF

WRL

Bills

Data source: Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the Optimists, 2002; Credit Suisse AG, 2011; own calculations

2012 Peter Oertmann

24

Standard deviations
of international stock and fixed income markets from 1900 to 2010
35%

30%

25%

20%

15%

10%

5%

0%
USA

CAN

BEL

FIN

FRA

GER

Equities

IRE

ITA

NET

SPA DEN NOR SWE

SWI

Bonds

UKI

AUS

JAP

NZE

SAF

WRL

Bills

Data source: Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the Optimists, 2002; Credit Suisse AG, 2011; own calculations

2012 Peter Oertmann

25

Equity risk premiums of international stock markets

Equity risk premium vs. bonds
1900-2010

1961-2010

2001-2010

USA

4,4%

2,6%

-3,9%

Canada

3,7%

1,7%

-0,9%

Belgium

2,6%

1,0%

-4,7%

Finland

5,6%

4,6%

-7,3%

France

3,2%

-0,9%

-6,0%

Germany

5,4%

-0,1%

-4,3%

Ireland

2,9%

3,5%

-6,2%

Italy

3,7%

-1,9%

-7,3%

Netherlands

3,5%

3,3%

-7,1%

Spain

2,3%

3,4%

1,3%

Denmark

2,0%

1,2%

0,9%

Norway

2,5%

2,8%

3,1%

Sweden

3,8%

4,8%

0,3%

Switzerland

2,1%

2,1%

-4,2%

UK

3,9%

3,4%

-1,3%

Australia

5,9%

3,5%

2,7%

Japan

5,0%

-1,4%

-5,2%

New Zealand

3,8%

2,2%

1,1%

South Africa

5,5%

6,9%

5,8%

World

3,8%

1,2%

-4,0%

7,0%

North America
6,0%

Europe (Eurozone)
5,0%

4,0%

3,0%

Europa (Others)
2,0%

1,0%

Asia-Pacific

South Africa

New Zealand

Japan

Australia

UK

Switzerland

Sweden

Norway

Denmark

Spain

Netherlands

Italy

Ireland

Germany

France

Finland

Belgium

USA

Canada

Africa

0,0%

1900-2010

Data source: Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the Optimists, 2002; Credit Suisse AG, 2011; own calculations

2012 Peter Oertmann

26

Stock-bond correlations
rolling over a window of 60 months for real returns

Bonds =
save haven

Inflation
accelerating
Bonds =
save haven

Data source: Credit Suisse Global Investment Returns Yearbook 2011, Credit Suisse AG

2012 Peter Oertmann

27

Stock-bond correlations
over various time horizons for real returns

Data source: Credit Suisse Global Investment Returns Yearbook 2011, Credit Suisse AG (and Antti Ilmanen)

2012 Peter Oertmann

28

Correlation heat map

of international asset classes 2001-2011
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21

Asset Class
MSCI World
MSCI EMU
MSCI Switzerland
MSCI UK
MSCI USA
MSCI Japan
MSCI EM East Europe
MSCI EM Latin America
MSCI EM Asia
iboxx Sovereigns
iboxx Corporates
BarCap Inflation Linked Bond Index
JPM EMBI
ML Global High Yield BB-B Index
Global Convertibles
DJ UBS Commodities Index
CYD MarketNeutral+ Index
HFRI Fund of Fund Index
EPRA/NAREIT Global Real Estate Index
Macquarie Global Infrastructure Index
LPX Index

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Source: Vescore

2012 Peter Oertmann

29

Correlation heat map

of international asset classes various time periods
2001-2006
1
2
3
4
5
6
7
8
9
10
11
12
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14
15
16
17
18
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20
21

Asset Class
MSCI World
MSCI EMU
MSCI Switzerland
MSCI UK
MSCI USA
MSCI Japan
MSCI EM East Europe
MSCI EM Latin America
MSCI EM Asia
iboxx Sovereigns
iboxx Corporates
BarCap Inflation Linked Bond Index
JPM EMBI
ML Global High Yield BB-B Index
Global Convertibles
DJ UBS Commodities Index
CYD MarketNeutral+ Index
HFRI Fund of Fund Index
EPRA/NAREIT Global Real Estate Index
Macquarie Global Infrastructure Index
LPX Index

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2006-2011
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Source: Vescore

2012 Peter Oertmann

30

Summary of facts

Stock markets considerably changed since 1900

International stock markets returned 2.5 to 7.4% on a yearly basis in real terms
over the period 1900 to 2010, the return of the world market was 5.5%
The long-term equity risk premium is positive, the world market equity risk
premium is 3.8% over the period 1900 to 2010
Over the first decade of the 21st century (2000-2010) the equity risk premium was
significantly negative for many stock markets
The average long-term correlation between stock and bond markets is positive
with a coefficient of 0.24
Bonds diversify stock portfolios, especially in times of an increased risk aversion;
but inflation shocks lead to a higher co-movement between stocks and bonds

2012 Peter Oertmann

31

Agenda

Prologue: The asset allocation process

Brush up: Risk and return

Market parameters of global asset classes

Some facts on stock market volatilities and correlations

2012 Peter Oertmann

32

A study for 13 stock markets

Research questions
Does stock market risk depend on market conditions?
How do volatility and correlation interact?
Is stock market risk related to economic conditions?

Source: Global Asset Allocation, Chapter 3

2012 Peter Oertmann

33

Descriptive statistics for the stock markets in the study

Source: Global Asset Allocation, Chapter 3

2012 Peter Oertmann

34

Correlations over the sample period

Source: Global Asset Allocation, Chapter 3

2012 Peter Oertmann

35

Up and down volatility

Source: Global Asset Allocation, Chapter 3

2012 Peter Oertmann

36

Correlation and volatility

Approach of Solnik, Boucrelle, and Le Fur (1996)

Regression of 36-month moving correlation between two countries on both

countries 36-month moving volatilities

Using monthly innovations to correct for autocorrelation

ij,t = a + b1 j,t + b 2 i,t + u ij,t

Source: Global Asset Allocation, Chapter 3

2012 Peter Oertmann

37

Correlation and volatility U.S. vs. other markets

Source: Global Asset Allocation, Chapter 3

2012 Peter Oertmann

38

Correlation and volatility Switzerland vs. other markets

Source: Global Asset Allocation, Chapter 3

2012 Peter Oertmann

39

Correlation and average volatility

Source: Global Asset Allocation, Chapter 3

2012 Peter Oertmann

40

Semi-correlations up-up vs. down-down

Source: Global Asset Allocation, Chapter 3

2012 Peter Oertmann

41

Correlations during expansions and recessions

Source: Global Asset Allocation, Chapter 3

2012 Peter Oertmann

42

Empirical evidence

Stock market volatility is higher when markets go down

In periods of high volatility, stock markets become more correlated and in

periods of low volatility, they are less correlated

Higher correlations are detected when equity market go down simultaneously, as

well as when real economic activity is shrinking

Source: Global Asset Allocation, Chapter 3

2012 Peter Oertmann

43

Implications for investors

Optimal portfolios are unstable because market parameters are time-varying

Bad news lead to higher volatility than good news

International diversification benefits seem to vanish in exactly those market

environments when they are most strongly needed

Widely used portfolio risk measures such as VaR, or shortfall, are affected by
asymmetric parameters

Source: Global Asset Allocation, Chapter 3

2012 Peter Oertmann

44

Literature

Global Asset Allocation: Chapter 3

Dimson, E., P. Marsh, and M. Staunton (2002): Triumph of the Optimists, Princeton University Press

Dimson, E. et al. (2011): Credit Suisse Global Investment Returns, Credit Suisse AG

2012 Peter Oertmann

45