International Finance - 3 DAYS DUE

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Multinational Financial Management
Alan Shapiro
7th Edition
J.Wiley & Sons

Power Points by

Joseph F. Greco, Ph.D.

California State University, Fullerton

CHAPTER 15

INTERNATIONAL PORTFOLIO INVESTMENT

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

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

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.

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

2. International diversification and systematic risk

a. Diversifying across nations with

different economic cycles

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

b. While there is systematic risk

within a nation, it may be

nonsystematic and diversifiable

outside the country.

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.

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.

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

2. Past empirical evidence suggests inter-

national diversification reduces portfolio risk.

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

3. Theoretical Conclusion

International diversification pushes out

the efficient frontier.

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

4. Calculation of Expected Return:

rp = a rUS + ( 1 - a) rrw

where rp = portfolio expected return

rUS = expected U.S. market return

rrw = expected global return

THE BENEFITS OF INTERNATIONAL EQUITY INVESTING

5. Calculation of Expected Portfolio Risk = (P )

P = [a 2US2 + (1-a)2 r w2 + 2a(1-a) USrw US,rw]1/2

where US,rw = the cross-market

correlation

US2 = U.S. returns variance

r w2 = World returns variance

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

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.

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

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

II. INTERNATIONAL BOND INVESTING

II. INTERNATIONAL BOND INVESTING

-internationally diversified bond

portfolios offer superior performance

INTERNATIONAL BOND INVESTING

A. Empirical Evidence

1. Foreign bonds provide higher

returns

2. Foreign portfolios outperform

purely domestic

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

IV. MEASURING TOTAL RETURNS
FROM PORTFOLIO INVESTING

IV. MEASURING TOTAL RETURNS

A. Bonds

Dollar = Foreign x Currency return currency gain (loss)

return

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

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