Week 7

International diversification

Chapter Overview

This chapter notes that domestic (U.S.A) securities comprise less than half of the entire assets available for investment purposes. The benefits of increased diversification as a result of international investing are presented. International indexes are available for passive investing purposes.

Changes in foreign exchange rates are an important component of the total return on international investing. Although exchange rate risk is present in international investing, exchange rate futures may allow a portion of that risk to be hedged.

Learning Objectives

After studying this chapter, the student should understand the advantages of international diversification, and be able to devise hedge strategies to offset currency risk involved in international investing. The student should also be able to attribute investment returns into contributing factors such as country, currency, and stock selections.

Presentation of Material

25.1 Global Market for Equities

This section presents initial background for the chapter. The growth of international investment has been dramatic. Domestic opportunities account for less than 40 percent of investment opportunities. Emerging markets provide opportunities to both potentially increase rates of return, but also to diversify portfolios. Technological advances have improved access to foreign markets and new instruments are constantly developing. The concept of home-country bias is introduced, along with why it stunts emerging market investment.

25.2. Risks Factors in International Investing

The major elements of foreign exchange risk are presented. It is not possible to completely hedge for foreign exchange risk since the returns that an investor gets in foreign markets are not completely predictable. Equation 25.2, called the interest rate parity relationship, describes the process of hedging currencies. Return figures for 2010, Figure 25.2, show the importance of foreign exchange on equity returns and highlight the potential advantage of international diversification.

Hedging exchange rate risk and the major elements of country specific risk as measured by the Political Risk Services Group (in the International Country Risk Guide, ICRG) are presented. The ICRG system considers three categories of risk variables and sample measures are presented under each category. In addition, Table 25.7 presents the ICRG’s predictions.

25.3 International Investing: Risk, Return, and Benefits from Diversification

The evidence shows that there are positive benefits to international diversification. It is possible to expand the efficient frontier when adding international investments to the portfolio. Diversification into foreign markets also affords opportunities to lower the level of systematic risk when compared to a portfolio that is made up of only domestic stocks.

Table 25.10 displays returns for developed and emerging markets for 2002 through 2011. The tables display correlations in both U.S. Dollars and local currencies for the various markets.

25.4 Assessing the Potential of International Diversification

Some of the contribution to diversification results from short-selling. Markets have become more closely related in recent years limiting the risk reduction benefits to diversification, though overall results indicate that there are still significant benefits to international investing. The three rules of thumb are included as a diversification strategy.

25.5 International Investing and Performance Attribution

Benchmark returns on international investing are measured by a variety of indexes. One widely used index is the European, Australian, and Far East (EAFE) Index. It is important to be aware of the weighting scheme when using the EAFE Index to gauge returns from foreign investment. The weighting that is used for the index is based on market capitalization. Many argue that it may be more appropriate to base the weighting on Gross Domestic Product rather than capitalization.

Performance attribution, presented in Chapter 24, will consider additional elements with international investing. Performance can be attributed to currency and country selection in addition to asset allocation and security selection.

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