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25 2 ALTHOUGH WE IN the United States cus- tomarily use a broad index of U.S. equities as the market-index portfolio, the practice is increasingly inappropriate. U.S. equities rep- resent less than 40% of world equities and a far smaller fraction of total world wealth. In this chapter, we look beyond domestic markets to survey issues of international and extended diversification. In one sense, international investing may be viewed as no more than a straightforward generaliza- tion of our earlier treatment of portfolio selection with a larger menu of assets from which to construct a portfolio. Similar issues of diversification, security analysis, security selection, and asset allocation face the inves- tor. On the other hand, international invest- ments pose some problems not encountered in domestic markets. Among these are the presence of exchange rate risk, restrictions on capital flows across national boundar- ies, an added dimension of political risk and
country-specific regulations, and differing accounting practices in different countries. Therefore, in this chapter we review the major topics covered in the rest of the book, emphasizing their international aspects. We start with the central concept of portfo- lio theory—diversification. We will see that global diversification offers opportunities for improving portfolio risk–return trade- offs. We also will see how exchange rate fluctuations and political risk affect the risk of international investments. We next turn to passive and active investment styles in the international context. We will consider some of the special problems involved in the inter- pretation of passive index portfolios, and we will show how active asset allocation can be generalized to incorporate country and currency choices in addition to traditional domestic asset class choices. Finally, we dem- onstrate performance attribution for inter- national investments.
CHAPTER TWENTY-FIVE
International
Diversification
PA R
T V
II
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C H A P T E R 2 5 International Diversification 883
25.1 Global Markets for Equities
1 FTSE Index Co. [the sponsor of the British FTSE (Financial Times Share Exchange) stock market index] uses
14 specific criteria to divide countries into “developed” and “emerging” lists. Our list of developed countries
includes all 25 countries that appear on FTSE’s list.
You can easily invest today in capital markets of nearly 100 countries and obtain
up-to-date data about your investments in each of them. By 2011, 52 countries had stock
markets with aggregate market capitalization above $1 billion. The data and discussion in
this chapter are based on these countries.
The investments industry commonly distinguishes between “developed” and “emerg-
ing” markets. A typical emerging economy still is undergoing industrialization, is growing
faster than developed economies, and has capital markets that usually entail greater risk.
We use the FTSE 1 criteria, which emphasize capital market conditions, to classify markets
as emerging or developed.
Developed Countries To appreciate the myopia of an exclusive investment focus on U.S. stocks and bonds, consider
the data in Table 25.1 . The U.S. accounts for less than 40% of world stock market capitaliza-
tion. Clearly, active investors can attain better risk–return trade-offs by extending their search
for attractive securities to both developed and emerging markets. Developed countries made
up 68% of world gross domestic product in 2010, and 85% of the world market capitalization.
The first two columns of Table 25.1 show market capitalization in 2000 and 2011. The first
line shows capitalization for all world exchanges, showing total capitalization of corporate equity
in 2011 as $38.2 trillion, of which U.S. stock exchanges made up $13.9 trillion, or 36.4%. The
year-to-year changes in the figures in these columns demonstrate the volatility of these markets.
The next three columns of Table 25.1 compare country equity capitalization as a per-
centage of the world’s in 2000 and 2011, as well as the growth in capitalization over those
12 years. The two crises of the first dozen years of the 21st century, the bursting of the
tech bubble in 2000–2001 and the financial crisis of 2008–2009, hit the developed coun-
tries hardest. Average growth of developed-country equity markets over these years was an
anemic 1.7%, compared with a world average of 2.8% and 16.3% for emerging markets.
The last three columns of Table 25.1 show GDP, per capita GDP, and the equity capi-
talization as a percentage of GDP in 2010. Although per capita GDP in developed coun-
tries is not as variable across countries as total GDP, which is determined in part by total
population, market capitalization as a percentage of GDP is quite variable. This suggests
widespread differences in economic structure even across developed countries.
Emerging Markets For a passive strategy, one could argue that a portfolio of equities of just the six countries
with the largest capitalization would make up 64% (in 2011) of the world portfolio and
may be sufficiently diversified. However, this argument will not hold for active portfo-
lios that seek to tilt investments toward promising assets. Active portfolios will naturally
include many stocks or indexes of emerging markets.
Table 25.2 makes the point. Surely, active portfolio managers must prudently scour
stocks in markets such as China and Russia with annual growth rates so far in the 21st cen-
tury in excess of 33% (1⁄3 per year!). Table 25.2 shows data from the 20 largest emerging
markets. But managers also would not want to have missed other markets that exhibited
marked, if not quite so dramatic, growth over the same years.
These 20 emerging markets make up 24% of the world GDP and, together with the 32
developed markets in Table 25.1 , make up 92% of the world GDP. Per capita GDP in these
emerging markets was quite variable, ranging from $1,019 (Pakistan) to $41,122 (Singapore).
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886 P A R T V I I Applied Portfolio Management
Market capitalization as a percent of GDP of the BRICS countries (Brazil, Russia, India,
China, and South Africa) is still below 70% (only 11% in China!), suggesting that these
emerging markets are expected to show significant growth over the coming years, even with-
out spectacular growth in GDP.
The growth of capitalization in emerging markets over this period was much more vola-
tile than growth in developed countries, implying that both risk and rewards in this seg-
ment of the globe may be substantial.
Market Capitalization and GDP A contemporary view of economic development (rigorously stated in de Soto, 2000) holds
that an important requirement for economic advancement is a developed code of business
laws, institutions, and regulations that allows citizens to legally own, capitalize, and trade
capital assets. As a corollary, we expect that development of equity markets will serve as
a catalyst for enrichment of the population, that is, that countries with larger relative capi-
talization of equities will tend to be richer. For rich countries, with already-large equity
markets, this relationship will be weaker.
Figure 25.1 depicts the relationship 2 between per capita GDP and market capitalization
(where both variables have been transformed to log 10 scale). Figure 25.1 , panel A shows a scat-
ter diagram and regression line for 2000, while the situation in 2011 is shown in Figure 25.1 ,
panel B. While developed markets are mostly above the line and emerging markets mostly
below it, the latter dramatically moved up in relative market capitalization over these years.
This move was sufficient to greatly moderate the slope of the line. One can also easily see the
upward shift of the whole world on the vertical axis that measures per capita GDP.
The regression slope coefficient measures the average percent change in per capita
income when market capitalization increases by 1%. In 2000, this value was .64, but it fell
to .35 in 2011. The scatter around the regression line has also visibly grown, as reflected in
an R-square of .52 in 2000 but only .10 in 2011.
Home-Country Bias Home-country bias refers to the common tendency for investors to underweight foreign
equities in their portfolio of risky assets. If investors allocated their stock investments
across countries in proportion to outstanding equity, U.S. investors in 2011 would have
placed only 36.4% of their equity in U.S. firms ( Table 25.1 ) with the remaining 63.6% held
in foreign markets. Non-U.S. investors would have held a greater share of U.S. equities
than domestic investors. But in fact, most investors show a pronounced bias toward hold-
ing stock in their home countries.
U.S. investors’ holdings of foreign stocks and long-term bonds and foreigners’ holdings
of U.S stocks and long-term bonds in 2001 and 2011 were:
Year U.S. Investor
Holdings Abroad a Foreign Investor Holdings in U.S. b
2001 2,170 3,932 2011 6,481 11,870
a Billions of dollars. b About 2/3 of these holding are in equities. Source: Report on U.S. portfolio holdings of foreign securities as of 12/31/2011. Department of the Treasury, October 2012.
Home-country bias remains in force but is far less pronounced today than it was 10 years ago.
2 This simple single-variable regression is put forward not as a causal model but simply as a way to describe the
relation between per capita GDP and the size of markets.
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C H A P T E R 2 5 International Diversification 887
Figure 25.1 Per capita GDP and market capitalization as percent of GDP. Panel A: Log scale, 2000 data; Panel B: Log scale, 2010 data.
U.S.Japan
U.K.
Canada
France
Germany
Brazil
India
Russia
China
100
1,000
10,000
100,000
A
1 10 100 1000
P e r
C a p
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Market Capitalization as % of GDP
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Developed Countries Emerging Markets Regression Line
B
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Brazil
India
Russia
Taiwan
China
100
1,000
10,000
100,000
1 10 100 1000
P e r
C a p
it a G
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Market Capitalization as % of GDP
25.2 Risk Factors in International Investing
Opportunities in international investments do not come free of risk or of the cost of special-
ized analysis. Two risk factors that are unique to international investments are exchange
rate risk and political risk, discussed in the next two sections.
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Exchange Rate Risk It is best to begin with a simple example.
Using the data in Example 25.1, calculate the rate of return in dollars to a U.S. investor hold- ing the British bill if the year-end exchange rate is: ( a ) E 1 5 $2.00/£; ( b ) E 1 5 $2.20/£.
CONCEPT CHECK 25.1
We can generalize from Example 25.1 . The $20,000 is exchanged for $20,000/ E 0 pounds, where E 0 denotes the original exchange rate ($2/£). The U.K. investment grows to (20,000/ E 0 )[1 1 r f (UK)] British pounds, where r f (UK) is the risk-free rate in the United Kingdom. The pound proceeds ultimately are converted back to dollars at the subsequent
exchange rate E 1 , for total dollar proceeds of 20,000( E 1 / E 0 )[1 1 r f (UK)]. The dollar- denominated return on the investment in British bills, therefore, is
1 1 r (US) 5 31 1 rf (UK)4E1/E0 (25.1) We see in Equation 25.1 that the dollar-denominated return for a U.S. investor equals
the pound-denominated return times the exchange rate “return.” For a U.S. investor, the
investment in British bills is a combination of a safe investment in the United Kingdom
and a risky investment in the performance of the pound relative to the dollar. Here, the
pound fared poorly, falling from a value of $2 to only $1.80. The loss on the pound more
than offset the earnings on the British bill.
Figure 25.2 illustrates this point. It presents rates of
returns on stock market indexes in several countries for
2010. The colored bars depict returns in local currencies,
while the dark bars depict returns in dollars, adjusted for
exchange rate movements. It’s clear that exchange rate
fluctuations over this period had large effects on dollar-
denominated returns in several countries. Pure exchange rate risk is the risk borne by invest-
ments in foreign safe assets. The investor in U.K. bills of
Example 25.1 bears the risk of the U.K./U.S. exchange rate only. We can assess the mag-
nitude of exchange rate risk by examining historical rates of change in various exchange
rates and their correlations.
Table 25.3 , panel A shows historical exchange rate risk measured by the standard
deviation of monthly percent changes in the exchange rates of major currencies against
the U.S. dollar over the period 2001–2011. The data show that currency risk is quite
high. The annualized standard deviation of the percent changes in the exchange rate
ranged from 9.13% (Japanese yen) to 13.87% (Australian dollar). The standard deviation
Consider an investment in risk-free British government bills paying 10% annual interest in British pounds. While these U.K. bills would be the risk-free asset to a British inves- tor, this is not the case for a U.S. investor. Suppose, for example, the current exchange rate is $2 per pound, and the U.S. investor starts with $20,000. That amount can be exchanged for £10,000 and invested at a riskless 10% rate in the United Kingdom to provide £11,000 in 1 year.
What happens if the dollar–pound exchange rate varies over the year? Say that dur- ing the year, the pound depreciates relative to the dollar, so that by year-end only $1.80 is required to purchase £1. The £11,000 can be exchanged at the year-end exchange rate for only $19,800 ( 5 £11,000 3 $1.80/£), resulting in a loss of $200 relative to the initial $20,000 investment. Despite the positive 10% pound-denominated return, the dollar-denominated return is negative 1%.
Example 25.1 Exchange Rate Risk
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0 5% 10% 15% 20% 25% 30%
Japan
Australia
Norway
Germany
U.K.
Pakistan
India
Russia
Brazil
China
Return (in Local Currencies)Return (in U.S. $)
15.59 0.71
14.73 0.66
11.82 12.51
9.32 16.91
8.80 12.22
27.06 29.05
20.95 16.22
19.40 20.30
6.81 1.72
4.83 5.10
C H A P T E R 2 5 International Diversification 889
Figure 25.2 Stock market returns in U.S. dollars and local currencies for 2010 Source: Datastream, online.thomsonreuters.com/datastream .
of returns on U.S. large stocks for the same period was 16%. Hence, exchange rate
volatility was roughly 70% that of the volatility on stocks. Clearly, an active investor
who believes that a foreign stock is underpriced but has no information about any mis-
pricing of its currency should consider hedging the currency risk exposure when tilt-
ing the portfolio toward the stock. Exchange rate risk of the major currencies has been
relatively high so far in this century. For example, a study by Solnik (1999) for the
period 1971–1998 finds lower standard deviations, ranging from 4.8% (Canadian dollar)
to 12% (Japanese yen).
In the context of international portfolios, exchange rate risk may be mostly diversifi-
able. This is evident from the low correlation coefficients in Table 25.3 , panel B. (There
are notable exceptions in the table, though, and this observation will be reinforced when
we compare the risk of hedged and unhedged country portfolios in a later section.) Thus,
passive investors with well-diversified international portfolios need not be concerned with
hedging exposure to foreign currencies.
The effect of exchange rate fluctuations also shows up in Table 25.3 , panel C, which
presents the returns on money market investments in different countries. While these invest-
ments are virtually risk-free in local currency, they are risky in dollar terms because of
exchange rate risk. International investment flows by currency speculators should roughly
equalize the expected dollar returns in various currencies, adjusted for risk. Moreover,
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890 P A R T V I I Applied Portfolio Management
A. Standard deviation (annualized %)
Euro (€) U.K. (£) Switzerland
(SF) Japan (¥) Australia
(A$) Canada
(C$)
11.04 9.32 11.94 9.13 13.87 10.04
B. Correlation matrix
Euro (€) U.K. (£) Switzerland
(SF) Japan (¥) Australia
(A$) Canada
(C$)
U.K. (£) 0.63 1 Switzerland (SF) 0.83 0.51 1 Japan (¥) 0.27 0.08 0.42 1 Australia (A$) 0.75 0.6 0.61 0.05 1 Canada (C$) 0.51 0.49 0.37 20.02 0.72 1
C. Average annual returns from rolling over one-month LIBOR rates (%)
Country Currency
Return in Local
Currency
Expected Gain from Currency
Actual Gain from Currency
Actual Return in
U.S. Dollars
Surprise Component of Return
SD of Annual Return
U.S. $ 2.18 2.18 Euro € 2.38 20.20 4.38 6.77 4.58 11.04 U.K. £ 3.51 21.32 1.09 4.60 2.41 9.32 Switzerland SF 0.90 1.28 6.46 7.36 5.17 11.94 Japan ¥ 0.24 1.94 5.75 5.99 3.81 9.13 Australia A$ 5.25 23.07 7.94 13.19 11.01 13.87 Canada C$ 2.50 20.31 5.01 7.51 5.32 10.04
Table 25.3
Rates of change in major currencies against the U.S. dollar, 2002–2011 (annualized monthly rate)
Source: Exchange rates: Datastream, online.thomsonreuters.com/datastream; LIBOR rates: www.economagic.com.
exchange rate risk is largely diversifiable, as Table 25.3 , panel B shows, and hence we
would expect similar dollar returns from cash investments in major currencies.
We can illustrate exchange rate risk using a yen-denominated investment during this
period. The low yen-denominated LIBOR rate, .24%, compared to the U.S.-dollar LIBOR
rate, 2.18%, suggests that investors expected the yen to appreciate against the dollar by
around 1.94%, the interest rate differential across the two countries. But those expectations
were not realized; in fact, the yen actually appreciated against the dollar at an annual rate
of 5.75%, leading to an annual dollar-denominated return on a yen investment of 5.99%
(the .24% yen interest rate together with the realized exchange rate appreciation of 5.75%).
However, such deviations between prior expectations and actual returns of this magnitude
are not shocking. The “surprise” return in a yen LIBOR investment (converted into dollars)
was the difference between the actual return in dollars, 5.99%, and the dollar-denominated
LIBOR rate of 2.18%, amounting to 3.81%. This surprise is actually considerably less than
the yen standard deviation of 9.13%. In fact, none of the six surprises exceeded the stan-
dard deviation, which is actually the surprising event here.
Investors can hedge exchange rate risk using a forward or futures contract in foreign
exchange. Recall that such contracts entail delivery or acceptance of one currency for
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C H A P T E R 2 5 International Diversification 891
How many pounds would the investor in Example 25.2 need to sell forward to hedge exchange rate risk if: ( a ) r (UK) 5 20%; and ( b ) r (UK) 5 30%?
CONCEPT CHECK 25.2
another at a stipulated exchange rate. To illustrate, recall Example 25.1. In this case, to
hedge her exposure to the British pound, the U.S. investor would agree to deliver pounds
for dollars at a fixed exchange rate, thereby eliminating the future risk involved with con-
version of the pound investment back into dollars.
You may recall that the hedge underlying Example 25.2 is the same type of hedging
strategy at the heart of the spot-futures parity relationship first discussed in Chapter 22.
In both instances, futures or forward markets are used to eliminate the risk of holding
another asset. The U.S. investor can lock in a riskless dollar-denominated return either by
investing in United Kingdom bills and hedging exchange rate risk or by investing in risk-
less U.S. assets. Because investments in two riskless strategies must provide equal returns,
we conclude that [1 1 r f (UK)] F 0 / E 0 5 1 1 r f (US), which can be rearranged to
F0 E0 5
1 1 rf (US)
1 1 rf (UK) (25.2)
This relationship is called the interest rate parity relationship or covered interest arbitrage relationship , which we first encountered in Chapter 23.
Unfortunately, such perfect exchange rate hedging usually is not so easy. In our exam-
ple, we knew exactly how many pounds to sell in the forward or futures market because the
pound-denominated return in the United Kingdom was riskless. If the U.K. investment had
not been in bills, but instead had been in risky U.K. equity, we would have known neither
the ultimate value in pounds of our U.K. investment nor how many pounds to sell forward.
The hedging opportunity offered by foreign exchange forward contracts would thus be
imperfect.
To summarize, the generalization of Equation 25.1 for unhedged investments is that
1 1 r(US) 5 31 1 r(foreign)4E1/E0 (25.3) where r (foreign) is the possibly risky return earned in the currency of the foreign investment. You can set up a per-
fect hedge only in the special case that r (foreign) is itself a known number. In that case, you know you must sell in
the forward or futures market an amount of foreign cur-
rency equal to [1 1 r (foreign)] for each unit of that cur- rency you purchase today.
Political Risk In principle, security analysis at the macroeconomic, industry, and firm-specific level is
similar in all countries. Such analysis aims to provide estimates of expected returns and
risk of individual assets and portfolios. However, to achieve the same quality of informa-
tion about assets in a foreign country is by nature more difficult and hence more expensive.
Moreover, the risk of coming by false or misleading information is greater.
If the forward exchange rate in Example 25.1 had been F 0 5 $1.93/£ when the invest- ment was made, the U.S. investor could have assured a riskless dollar-denominated return by arranging to deliver the £11,000 at the forward exchange rate of $1.93/£. In this case, the riskless U.S. return would then have been 6.15%:
[1 1 rf (UK)]F0/E0 5 (1.10)1.93/2.00 5 1.0615
Example 25.2 Hedging Exchange Rate Risk
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892 P A R T V I I Applied Portfolio Management
Rank in January 2011 Country
Composite Risk Rating
January 2011
Composite Risk Rating
February 2012
January 2011 versus
February 2010 Rank in
February 2010
Very low risk 1 Norway 90.5 90.00 0.50 1
11 Germany 83.5 83.50 0.00 5 13 Canada 82.8 82.75 0.00 6 16 Qatar 82.0 81.25 0.75 11 19 Japan 81.0 80.00 1.00 17
Low risk 31 United Kingdom 77.3 73.75 3.50 39 32 United States 77.0 77.25 2 0.25 26 39 China, People’s Rep. 75.0 76.25 2 1.25 30 44 Brazil 74.5 72.75 1.75 46 68 Spain 70.0 71.00 2 1.00 58
Moderate risk 78 Indonesia 68.5 67.25 1.25 81 86 India 67.3 70.50 2 3.25 62
104 Egypt 64.5 66.50 2 2.00 84 111 Turkey 63.3 63.50 2 0.25 100
High risk 124 Venezuela 59.5 53.75 5.75 133 127 Iraq 58.5 59.25 2 0.75 119 129 Pakistan 57.3 57.00 0.25 125
Very high risk 138 Haiti 48.5 49.75 2 1.25 137 140 Somalia 41.5 36.75 4.75 140
Table 25.4
Composite risk ratings for January 2011 versus February 2010
Source: International Country Risk Guide, January 2011, Table 1, The PRS Group, Inc. Used with permission.
3 You can find more information on the Web site: www.prsgroup.com . We are grateful to the PRS Group for
supplying us data and guidance.
Consider two investors: an American wishing to invest in Indonesian stocks and an
Indonesian wishing to invest in U.S. stocks. While each would have to consider macro-
economic analysis of the foreign country, the task would be much more difficult for the
American investor. The reason is not that investment in Indonesia is necessarily riskier
than investment in the U.S. You can easily find many U.S. stocks that are, in the final
analysis, riskier than a number of Indonesian stocks. The difference lies in the fact that
U.S. financial markets are more transparent than those of Indonesia.
In the past, when international investing was novel, the added risk was referred to as
political risk and its assessment was an art. As cross-border investment has increased and more resources have been utilized, the quality of related analysis has improved. A lead-
ing organization in the field (which is quite competitive) is the PRS Group (Political Risk
Services) and the presentation here follows the PRS methodology. 3
PRS’s country risk analysis results in a country composite risk rating on a scale of 0
(most risky) to 100 (least risky). Countries are then ranked by the composite risk measure
and divided into five categories: very low risk (100–80), low risk (79.9–70), moderate risk
(69.9–60), high risk (59.9–50), and very high risk (less than 50). To illustrate, Table 25.4
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C H A P T E R 2 5 International Diversification 893
Political Risk Variables Financial Risk Variables Economic Risk Variables
Government stability Foreign debt (% of GDP) GDP per capita Socioeconomic conditions Foreign debt service (% of GDP) Real annual GDP growth Investment profile Current account (% of exports) Annual inflation rate Internal conflicts Net liquidity in months of imports Budget balance (% of GDP) External conflicts Exchange rate stability Current account balance (% GDP) Corruption Military in politics Religious tensions Law and order Ethnic tensions Democratic accountability Bureaucracy quality
Table 25.5
Variables used in PRS’s political risk score
shows the placement of countries in the January 2011 issue of the PRS International Country Risk Guide. It is not surprising to find Norway at the top of the very-low-risk list, and small emerging markets at the bottom, with Somalia (ranked 140) closing the list.
What may be surprising is the fairly mediocre ranking of the U.S. (ranked 32), comparable
to Libya (20) and Bahrain (29), all three in the low-risk category.
The composite risk rating is a weighted average of three measures: political risk, finan-
cial risk, and economic risk. Political risk is measured on a scale of 100–0, while financial
risk and economic risk are measured on a scale of 50–0. The three measures are added and
divided by 2 to obtain the composite rating. The variables used by PRS to determine the
composite risk rating from the three measures are shown in Table 25.5 .
Table 25.6 shows the three risk measures for seven of the countries in Table 25.4 , in
order of the January 2011 ranking of the composite risk ratings. The table shows that
by political risk, the United States ranked third among these seven countries. But in the
financial risk measure, the U.S. ranked sixth among the seven. The surprisingly poor
Composite Ratings Current Ratings
Country Year Ago
February 2010 Current
January 2011 Political Risk January 2011
Financial Risk January 2011
Economic Risk January 2011
Norway 90.00 90.50 88.5 46.5 46.0 Canada 82.75 82.75 86.5 40.0 39.0 Japan 80.00 81.00 78.5 44.0 39.5 United States 77.25 77.00 81.5 37.0 35.5 China, People’s Rep. 76.25 75.00 62.5 48.0 39.5 India 70.50 67.25 58.5 43.5 32.5 Turkey 63.50 63.25 57.0 34.5 35.0
Table 25.6
Current risk ratings and composite risk forecasts
Source: International Country Risk Guide, January 2011, Table 2B, The PRS Group, Inc. Used with permission.
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894 P A R T V I I Applied Portfolio Management
A. Composite risk forecasts
One Year Ahead Five Years Ahead
Country Current Rating January 2011
Worst Case
Best Case
Risk Stability
Worst Case
Best Case
Risk Stability
Norway 90.5 88.3 93.3 5.0 83.3 92.8 9.5 Canada 82.8 78.3 84.3 6.0 75.3 86.5 11.3 Japan 81.0 77.0 84.3 7.3 72.5 87.5 15.0 United States 77.0 73.3 80.3 7.0 69.5 83.0 13.5 China, People’s Rep. 75.0 70.8 79.0 8.3 61.3 82.0 20.8 India 67.3 64.0 72.3 8.3 57.5 77.0 19.5 Turkey 63.3 57.8 67.5 9.8 53.8 71.5 17.8
B. Political risk forecasts
One Year Ahead Five Years Ahead
Country Current Rating January 2011
Worst Case
Best Case
Risk Stability
Worst Case
Best Case
Risk Stability
Norway 88.5 88.0 92.0 4.0 86.0 89.5 3.5 Canada 86.5 83.0 88.5 5.5 81.5 89.5 8.0 Japan 78.5 75.5 84.0 8.5 72.0 88.0 16.0 United States 81.5 77.5 85.5 8.0 76.0 87.0 11.0 China, People’s Rep. 62.5 58.5 68.5 10.0 55.0 73.0 18.0 India 58.5 55.0 64.0 9.0 53.5 71.0 17.5 Turkey 57.0 52.5 63.5 11.0 51.5 69.0 17.5
Table 25.7
Composite and political risk forecasts
Source: A: International Country Risk Guide, January 2011, Table 2C; B: International Country Risk Guide, January 2011, Table 3C. The PRS Group, Inc. Used with permission.
performance of the U.S. in this dimension was probably due to its exceedingly large gov-
ernment and balance-of-trade deficits, which put considerable pressure on its exchange
rate. Exchange rate stability, foreign trade imbalance, and foreign indebtedness all enter
PRS’s computation of financial risk. The financial crisis that began in August of 2008 was
a striking vindication of PRS’s judgment of assigning relatively low financial scores to the
U.S. and other major markets.
Country risk is captured in greater depth by scenario analysis for the composite mea-
sure and each of its components. Table 25.7 (panels A and B) shows 1- and 5-year worst-
case and best-case scenarios for the composite ratings and for the political risk measure.
Risk stability is based on the difference in the rating between the best- and worst-case
scenarios and is quite large in most cases. The worst-case scenario can move a country to a
higher risk category. For example, Table 25.7 , panel B, shows that in the worst-case 5-year
scenario, China and Turkey were particularly vulnerable to deterioration in the political
environment.
Finally, Table 25.8 shows ratings of political risk by each of its 12 components.
Corruption (variable F) in Japan is rated better than in the U.S. In democratic accountability
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C H A P T E R 2 5 International Diversification 895
(variable K), China ranked worst, and the United States, Canada, and India best, while
China ranked best in government stability (variable A).
Each monthly issue of the International Country Risk Guide of the PRS Group includes great detail and holds some 250 pages. Other organizations compete in supplying such
evaluations. The result is that today’s investor can become well equipped to properly assess
the risk involved in international investing.
This table lists the total points for each of the following political risk components out of the maximum points indi- cated. The final columns in the table show the overall political risk rating (the sum of the points awarded to each component) and the change from 2010.
A Government stability 12 G Military in politics 6 B Socioeconomic conditions 12 H Religious tensions 6 C Investment profile 12 I Law and order 6 D Internal conflict 12 J Ethnic tensions 6 E External conflict 12 K Democratic accountability 6 F Corruption 6 L Bureaucracy quality 4
Country A B C D E F G H I J K L
Risk Rating
January 2011
Change from
December 2010
Canada 8.5 9.0 11.5 11.0 11.0 5.0 6.0 6.0 5.5 3.5 5.5 4.0 86.5 0.5 China, People’s Rep. 9.0 8.0 6.5 9.0 9.0 2.0 3.0 5.0 4.0 3.5 1.5 2.0 62.5 0.0 India 6.0 4.5 8.5 6.0 9.5 2.0 4.0 2.5 4.0 2.5 6.0 3.0 58.5 21.5 Japan 5.0 8.5 11.5 10.0 9.0 4.5 5.0 5.5 5.0 5.5 5.0 4.0 78.5 20.5 Norway 7.5 10.5 11.5 11.0 11.0 5.0 6.0 5.5 6.0 4.5 6.0 4.0 88.5 0.0 Turkey 8.5 5.5 7.5 7.5 7.5 2.5 2.0 4.0 3.5 2.0 4.5 2.0 57.0 0.0 United States 8.0 8.5 12.0 10.0 9.5 4.0 4.0 5.5 5.0 5.0 6.0 4.0 81.5 0.5
Table 25.8
Political risk points by component, January 2011
Source: International Country Risk Guide, January 2011, Table 3B, The PRS Group, Inc. Used with permission.
25.3 International Investing: Risk, Return, and Benefits from Diversification
U.S. investors have several avenues through which they can invest internationally. The
most obvious method, which is available in practice primarily to larger institutional inves-
tors, is to purchase securities directly in the capital markets of other countries. However,
even small investors now can take advantage of several investment vehicles with an inter-
national focus.
Shares of several foreign firms are traded in U.S. markets either directly or in the form
of American depository receipts, or ADRs. A U.S. financial institution such as a bank will
purchase shares of a foreign firm in that firm’s country, then issue claims to those shares in
the United States. Each ADR is then a claim on a given number of the shares of stock held
by the bank. Some stocks trade in the U.S. both directly and as ADRs.
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