AJAFIN 6605 -10

International Portfolio Diversification.

 A portfolio is a collection of securities held by
individual or institutional investors.
 Diversification is the allocation of investable funds to
a variety of instruments.
The rationale for diversification is that investors
can greatly reduce risk without adversely affecting return.
 Simplifying Assumptions:
Certain simplifying assumptions are made about market
operations and the psychology of investors.
 A Perfect Market: is a market free of any impediments
to trading such as transaction costs, costly information,
regulatory constraints, etc. 1
 The Assumptions are:
– Securities markets operate without transaction costs.
– All investors have access to complete and costless
information relevant to the pricing of securities.
– Investors appraise information in a similar way
(i.e., they have homogeneous expectations).
– Investors are interested only in the risk and expected
return characteristics of securities.
– Investors have the same one-period time horizon.
 While these assumptions are not necessarily true, they
serve as close approximations to the truth and they
simplify the analyses.
Strict assumptions allow mathematical precision and
relaxing them makes the mathematics more complicated.
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 Two-Asset International Portfolios
 The expected return on a two-asset international portfolio
depends on the expected returns of the individual
(national) assets and the proportion of investable funds in
each. Hence,

R IP = w1 R1 + w2 R 2
 The risk of a two-asset international portfolio is measured
by the standard deviation of its returns.
The riskiness of a portfolio depends on the degree of co-
movement of the component assets.
The co-movement can be measured by the covariance or
correlation coefficient.
The risk for a two-asset portfolio can be expressed as: 3
 σ 2
IP= w1 σ 1 w2 σ 2 + 2 w1 w2 σ 1,2
2 2
+ 2 2

= w12 σ 12 + w22 σ 22 + 2 w1 w2 σ 1 σ 2 ρ1,2

where:
or
σIP = var
2
ρ1,2 = σ1,2 / σ1 σ2
σ 1,2 = σ 1 σ 2 ρ1,2
4
 A Perfectly Positive Correlation (ρ =1):
If the two assets comprising the international portfolio are
positively perfectly correlated, then the portfolio variance,

σ IP = w1 σ 1 + w2 σ 2 + 2 w1 w2 σ 1 σ 2 ρ 1,2
2 2 2 2 2

becomes

σ 2
IP = w12 σ 12 + w22 σ 22 + 2 w1 w2 σ 1 σ 2
= ( w1 σ 1 + w2 σ 2 )2
so that:

σ = w1 σ 1 + w2 σ 2
IP

In this special case, the risk of the international portfolio

depends only on the weighted average of the component assets'
risk. 5
 A Perfectly Negative Correlation (ρ = -1)
When the two assets comprising the international portfolio are
perfectly negatively correlated, then the portfolio variance,

σ
2
IP = w12 σ 12 + w22 σ 22 + 2 w1 w2 σ 1 σ 2 ρ 1,2
becomes
σ 2
IP = w12 σ 12 + w22 σ 22 − 2 w1 w2 σ 1 σ 2
= ( w1 σ 1 − w2 σ 2 )2
so that:
σ IP = w1 σ 1 − w2 σ 2
In this case, the risk of the international portfolio is a weighted
difference of the two component assets' risk.
It is therefore possible to form an international “risk free” portfolio
by selecting the appropriate weights so that their weighted
difference is zero. 6
 Multiple-Asset International Portfolios
• For purposes of analyzing risk and return
characteristics, we treat a portfolio as a single asset.
• Expected return is given by:
n
RIP = ∑wiRi
i=
1

• Variance of Expected return is given by:

n 2 n
σ ∑ ∑ wiwjσij , i ≠
n
2
∑ w iσ
2
IP = i+2 j
i =1 i =1 j =1

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• Example: A portfolio has three assets held in proportions
ω 1 = 0.2, ω 2 = 0.5, and ω 3 = 0.3. The asset’s one year
standard deviations are σ 1 = 0.3, σ 2 = 0.2, and σ 3 = 0.4.
Their correlations are ρ 12 = 0.1, ρ 13 = 0.6, ρ 23 =
-0.1. The portfolio’s one year return variance is given
n n
by:
σ =∑
2
∑ ω
i ω
j iσ σ
j ijρ
i =1 j =1

= ω12 σ 12 + ω22 σ22 + ω32 σ32 +2 ω

1 ω
2 1σ 2σ 12ρ

+ 2ω1 ω3 σ1 σ3 ρ13 +2 ω2 ω3 σ2 σ3 23ρ

= .22 ( .32 ) +.52( .22) +.32( .4)2 (+2 ).2( ) .5( ) .3( ) .2
( ) .1
+ 2( .2) ( .3) ( .3) ( .4) ( .6
) +(2 ).5( ).3( ).2( ) .4 ( ) .1−
= 0.03544 8
• Therefore, the portfolio return’s standard deviation is

σ = 0.03544
= 0.188

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10
 Efficiency Gains from International Diversification:
we measure efficiency gains by comparing the Sharpe
Index (SI) and Treynor Index (TI) for purely domestic
portfolios with the same measures for internationally
diversified portfolios.
RDP − Rf
SI DP =
σDP
RIP −Rf
SI IP =
σIP
TI DP =
RDP −Rf
βDP
RIP − Rf
TI IP =
βIP
11
Where,
β = σ i,m / σ 2
m= ρ i,m* σ i σ m/ σ 2
m

=ρ i,m* σ i

σ
σ =σ σ ρ
m

Since, 1,2 1 2 1,2

Rf = risk-free rate of return

β f = beta with respect to national/international market
σ m = standard deviation of “market” return
ρ = correlation coefficient
σ i ,m = Covariance between m and i

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Characteristics of a Risk-Free Asset:
– It is default free
– Its expected return is certain
– The variance of its return is zero

Jensen’s Alpha:
Alternatively, efficiency gains for an internationally
diversified portfolio can be assessed by computing the
Jensen’s Alpha.
Rj = Rf+ β j (Rm- Rf)
Rj - Rf = α j + β j (Rm- Rf)
We expect α = 0. If α = 0, j’s performance = market
if α > 0, j outperforms market
if α < 0, j underperforms market 13
 Computing Returns on Foreign Investments:
Dollar return = local currency return*currency gain/loss
For Bonds:

B(1) − B(0) + C
1 + Kb = [1 + ](1 + ∆e)
B(0)
where,
B(t) = bond price at time t
C = coupon payment
Δe = percentage change in exchange rates (domestic
currency per unit of foreign) = (et-e0)/e0
Kb= return on bonds (in domestic currency)
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 For Stocks:

P (1) − P (0) + D
1 + Ks = [1 + ](1 + ∆e)
P ( 0)
Where:
Ks = return on stocks
D = dividends
P(t) = stock price at t
Δe = percentage change in exchange rates (et-e0)/e0

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 The return from portfolios containing (assets) of a
number of diverse types of companies is less risky
than the return from portfolios with the same number
of similar types companies.
 Optimum risk-reduction is achieved by creating a
mix of securities whose returns do not move up or
down together in response to the same set of factors
 A further risk reduction can be achieved by
introducing stocks from countries experiencing
economic conditions that are different from those in
the investor’s home country (international diversification)
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 Total risk of a portfolio depends on:

• The number of securities in the portfolio

• The riskiness of each component security
• The degree to which the component securities are
correlated

The basic rule of portfolio diversification is that the

broader the diversification the more stable the return
and the more diffuse the risks.

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 Potential benefits of international diversification can
be demonstrated by:
• Estimating correlation coefficient of returns across
countries
• Demonstrating that national factors have a dominant
influence on security returns relative to any common
world factor.
For example in the model:

RM N C = a 0 + a1 RL + b1 Rf 1 + b 2 Rf 2 + ...+ bnRfn
 The returns for a MNC are explained by a local factor
(L) and a number of international factors (f).
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frequently, a1 is found to be more significant for each local market.
RMNC = return on a MNC
RL = local market factor(s)
Rf = foreign market factor

Some Practical Considerations:

The international money manager faces an array of problems in
his global investment approach.
✦ Large variety of stocks
✦ Large number of national markets and currencies
✦ Many sectors to choose from, i.e., industry (service) sectors
✦ Wide range of investors’ objectives to be met
✦ Questions of weather securities are primarily influenced by
domestic factors or by international (industrial) factors? 19
 Technical Problems:
✦ Traditional Analysis (valuation) takes 2 steps - (a)
specific analysis of a company and its product market
(EPS) and (b) relative valuation of the company within
the stock market (P/E ratio).
Dividend discount model provides a more
quantitative approach.
✦ Information: Difficult to obtain on foreign firms,
difficult to interpret and analyze using “domestic”
methods or standards.
✦ Language and Presentation of financial reports.
Wide variation from country to country in format, degree
of detail, and reliability.
However, data services, such as Moody’s are becoming
international in coverage of companies.
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✦ Comparative Analysis: Made difficult by existence of
differences in - accounting methods, cultural environment,
institutional characteristics, political environment, and tax
regimes.
✦ Stock Market Valuation: Stock markets in different countries
value different attributes.
Thus, the same earnings forecast may lead to a different stock
price valuation depending on the nationality or location of the
corporation.
✦ Country Analysis: (for use in asset allocation in international
portfolio management).
Large number of indicators are monitored in each
country, for example:
– real growth rate of GNP/GDP
– monetary and fiscal policies
– wage and employment conditions
– competitiveness
– social and political situations
– potential crisis in key sectors; e.g.. energy, banking, etc. 21
✦ Real economic growth, a major influence on national
stock market, varies markedly among countries.
Countries with excellent economic growth, e.g., Japan in
the 1980s and Singapore, Hong Kong, Taiwan in the 90s
and currently, China and India tend to record excellent
long-term performances.
✦ Countries with volatile economic growth, experience
volatile stock market performances.
✦ Empirical Evidence on International Factors in
Security Returns:
Lessard (1976) and Solnik (1976) report the existence
of international factors in stock returns, but observe that
domestic factors are much stronger.
International industry effects appear weak compared to
national effects.
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✦ Studies by Solnik (1984) and Adler and Simon (1986)
report a weak correlation between stock market indexes
and currency movements, but this does not rule out the
existence of a selective exchange rate influence on
some firms.
✦Solnik and Defreitas (1986) examine relative importance
of world stock index, industrial sector index, currency
movements, and domestic factors (national market index)
on stock returns report that:
(i) Industrial factors show a generally positive and
significant effect on stock returns,
(ii) Currency movements show a generally weak but
positive effect on stock returns. 23
✦ On International Capital Asset Pricing Model:
Problems with CAPM and the APT:
Problems exist with formulating an international capital
asset pricing model, including:
– Definition of a world market portfolio is difficult.
– There are restrictions on foreign investments in many markets
– Limited negotiability of assets in many markets.
– Differential taxes.
– Transaction costs.

✦ Arbitrage Pricing Theory:

Is a multi-factor model in which the return on a
security is determined by a number of common
factors plus a term specific to the security in question.
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✦ Recall the CAPM:
Kx= Krf +βx(Km- Krf )
is a
single factor model, where risk is a function of only the
relationship between a security’s return and the market return
(or the security’s beta coefficient)
Unfortunately, APT does not specify which factors are relevant
to the model.

The APT can be expressed as follows:

R = a0 + α1F1 + α2F2 +....+ αkFk + ε

where F1,..., Fk are k factors common to all securities and ε is a

random term specific to a particular security and therefore
independent of all F’s. 25
✦ Arbitrage ensures that only the α’s are priced
so that expected return is given by:

E(R) = Rf + α 1RP1 + α 2RP2 +...+ α kRPk

Rf = risk-free rate
RPi = the risk premium associated with factor i.

✦ The APT focuses on the relative pricing of the

security under study, while the factor are exogenous.

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 Factors must be estimated from the data.
Generally three sets of factors are selected:
– international factors
– purely domestic factors
– industry-wide factors

 Actual Vs Potential Gains:

[Cheol Eun and Bruce Resnick (1987)]
Most of previous studies constructed optimal international
portfolios using historical return data and show that
internationally diversified portfolios dominate purely
domestic portfolios in terms of mean-variance efficiency.
The assumption here is that investors know the true
probability distribution of stock market returns. 27
 To construct and optimal portfolio using modern
portfolio theory requires estimating the parameters Ri,
αi, εim which are expected values.
Such estimation is subject to errors.
 Estimation is also compounded by government
controls, different accounting standards, language
barriers, exchange rate changes, etc.
 In general, therefore, the existence of potential gains
is one matter, capturing such gains is another matter.

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Some “Ex-Ante” Strategies for International
Diversification:
 Naive Strategy: equal investment in each national market
 Historical Diversification Strategy: is based on the
assumption that the best estimate of a stock’s expected
return is the grand mean of the historical mean returns on
all the stock being considered for investment.
Jobson and Korkie (1980, 1981) report that the grand
mean approach resulted in the most efficient portfolio in
the domestic setting.
 The grand mean uses historical covariance matrix.29
Some Practical Diversification Alternatives:
There are several ways for investors to diversify:
 American Depository Receipts (ADRs): is a
negotiable certificate issued by a U.S. bank evidencing
the ownership of a foreign stock (dollar denominated).
(An ADR represents some multiple of underlying foreign share)
 American Depository Shares (ADS): are dollar-
denominated securities representing shares of stock in
a foreign company held on deposit on behalf of their
owners by a custodian bank in the issuing company’s
home country. (ADR and ADS often used interchangeably)
 European Depository Receipts.
 Buying Foreign Stocks Listed on U.S. Exchanges.
 Buying Foreign Stocks in Their Home Markets.30
 Mutual Funds (Internationally Diversified)
• Global funds
• International funds
• Regional funds
• Single country funds etc.
 Global Depository Receipts (GDR): Bank certificates
issued in more than one country for shares in a foreign
company.
Similar to ADRs but they are generally traded on two or
more markets outside the foreign issuer’s home market.
 Global Registered Share (GRS): is similar to an
ordinary share with the added benefit that investors can
trade shares on any stock exchange in the world where
registered and in the local currency. 31
Home Bias?
 A noticeable “home bias” observed on the part of U.S.
investors is a further indication of the fact that there
exist significant barriers to international investment,
for example:
– Greater information and transaction costs.
– Foreign exchange regulations.
– Legal restriction.
– Double/multiple taxation of foreign investment.
– Persistent “parochial" (narrow, limited, provincial)
attitude of many investors.
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 Empirical evidence on existence of superior risk-
return tradeoff by investing internationally:
 EAFE Index (Europe, Australia, Far East): Represents
major stock markets outside North America and has had
lower risk than most if its individual country components.
 World Index: Combines the EAFE with North America
and displays lower risks than any of its component country
except the US.
 Emerging Markets Index: Encompasses all of South and
Central America, all of Far East (except Japan), Hong
Kong, Singapore, Australia, New Zealand, Africa, parts of
Southern Europe, and nations of the former Soviet Union.
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 Effective Dollar Return (on foreign securities)
1+ R$ = (1+Rf)(1+Δe)
R$ ≈ Rf +Δe, where e = d/f.
The standard deviation of dollar return on foreign
security can be expressed as:

σ$ = [σ f+ σ Δe + 2 σ f σ ρ ]
2 2 1/2
Δe f, Δe

 Other factors for diversification by US investors:

Weak dollar; Many global markets outperforming US S&P 500;
Best companies in a given industry may not be in US; About
60% of world’s investment opportunity outside US; Most of
expected L-T growth from EMs.
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