Week 7

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INVESTMENTS | BODIE, KANE, MARCUS

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Chapter Twenty Five

International Diversification

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Background

  • By 2011, 52 countries have stock markets with a mkt. cap over $1 billion.
  • U.S. accounts for <40%
  • Developed countries account for 85%

  • Total mkt. cap of corporate equity in 2011 was $38.2 trillion (U.S. = 36.4%).
  • Top six countries make up 64% of the world portfolio.
  • But is this diversified enough?

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Table 25.1, Market Capitalization of Stock Exchanges in Developed Countries

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Table 25.2, Market Capitalization of Stock Exchanges in Emerging Markets

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Background

  • Clearly, U.S. stocks do not comprise a fully diversified equity portfolio.
  • International investing provides greater diversification opportunities.
  • It also carries some special risks.

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Issues

  • A developed stock market enriches the population (Figure 25.1). However, certain issues still remain.
  • Home-country bias:
  • Investors frequently overweight home-country stocks.

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Figure 25.1 Per Capita GDP and Market Capitalization as Percentage of GDP

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Risk Factors in International Investing

Foreign Exchange Risk

  • Variation in return due to changes in the exchange rate.
  • Foreign investments may yield more or less home currency than expected.
  • A foreign investment is simultaneously an investment in an overseas asset and in a foreign currency.

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Risk Factors in International Investing

Return expressed in local currency

Return obtained when local currency is exchanged for home currency.

Two sources of variation or risk:

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Example 25.1 Exchange Rate Risk

  • Suppose the risk-free rate in U.K. is 10% and the current exchange rate is $2/£1.
  • A U.S. investor with $20,000 can buy £10,000 and invest them to obtain £11,000 in one year.
  • If the £ depreciates to $1.80, the investment will yield only $19, 800, a $200 loss.
  • The investment was not risk free to a U.S. investor!

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Example 25.1 Exchange Rate Risk

  • The equation shows that the return to the U.S. investor is:
  • The pound-denominated return
  • Multiplied by
  • The exchange rate “return”

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Figure 25.2 Stock Market Returns in U.S. Dollars and Local Currencies for 2010

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Hedging Exchange Rate Risk

  • Futures or forward markets are used to hedge the risk.
  • The U.S. investor can make a riskless dollar return either by investing in UK bills and hedging exchange rate risk or by investing in riskless U.S. assets.

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Political Risk

  • In principle, security analysis at the macroeconomic, industry, and firm-specific level is similar in all countries.
  • In practice, getting good information about foreign investments can be more difficult.
  • PRS Group (Political Risk Services) assesses political risk by country.

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Table 25.5 Variables used in PRS’s Political Risk Score

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Table 25.6 Current Risk Ratings and Composite Risk Forecasts

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Table 25.7 Composite and Political Risk Forecasts

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Table 25.7 Interpretation

  • The table captures country risk through scenario analysis.

  • Risk stability is based on the difference in the rating between the best- and worst-case scenarios.

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Table 25.8 Political Risk Points by Component

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Foreign Investment Avenues

  • Purchase securities directly in the capital markets of other countries.
  • American depository receipts (ADR)
  • International mutual funds
  • International ETFs

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Risk and Return: Summary Statistics

  • Analysis focuses on excess returns over the risk-free rate, but differs across countries.
  • Aggregated country-index portfolios, via value-weighted portfolios of developed and emerging markets based on mkt. cap.

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Risk and Return: Summary Statistics

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Are Investments in Emerging Markets Riskier?

  • For the overall portfolio, standard deviation of excess returns is the appropriate measure of risk.

  • For an asset to be added to the current portfolio, beta (covariance with U.S. portfolio) is the appropriate measure of risk.

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Figure 25.3 Monthly Std Deviation of Excess Returns in Developed, Emerging Markets

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Figure 25.4 Index Dollar Return Beta on U.S. Stocks, 2002–2011

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Figure 25.5 Average Dollar-Denominated Excess Returns

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Average Country-Index Returns and Capital Asset Pricing Theory

  • Figure 25.5 shows a clear advantage to investing in emerging markets.
  • Results are consistent with risk ranking by standard deviation, but not with ranking by beta.
  • Beta rankings may fail because of home-country bias, which dominates international investing.

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Benefits from International Diversification

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Figure 25.11 International Diversification

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Figure 25.13 Efficient Frontier of Country Portfolios

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Are Benefits Preserved in Bear Markets?

  • Correlations between countries may increase in a crisis.
  • Roll’s model suggests a common factor underlying the movement of stocks around the world.
  • Prediction: Diversification only protects against country-specific events.
  • What happened in 1987? In 2008?

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Figure 25.14 Regional Indexes around the Crash, October 14–October 26, 1987

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Figure 25.15 Beta and SD of Portfolios

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Three Rules of Thumb

To passively diversify your portfolio, include country indexes in order of:

Market capitalization (from high to low)

Beta against the U.S. (from low to high)

Country index standard deviation (from high to low)

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Figure 25.16 Risks and rewards of international portfolios, 2000–2009

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Performance Attribution

  • The EAFE index is a commonly used benchmark for portfolio performance.
  • Measure the contribution of:

Currency selection

Country selection

Stock selection

Cash/bond selection

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Table 25.12 Example of Performance Attribution: International

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