InternationalPortfolioInvestmentChapter15Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.ChapterOutlineInternationalCorrelationStructureandRiskDiversificationOptimalInternationalPortfolioSelectionEffectsofChangesintheExchangeRateInternationalBondInvestmentInternationalDiversificationatHomeWhyHomeBiasinPortfolioHoldings?15-2Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.IntroductionRapidgrowthininternationalportfolioinvestmentsinrecentyearsreflectstheglobalizationoffinancialmarketsInthischapter,wefocusonthefollowingissues:WhyinvestorsdiversifytheirportfoliosinternationallyHowmuchinvestorscangainfrominternationaldiversificationEffectsoffluctuatingexchangeratesoninternationalportfolioinvestmentsHowinvestorscandiversifyinternationallyathomePossiblereasonsfor“homebias”inactualportfolioholdings

Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.15-3EXHIBIT15.1

U.S.InvestmentinForeignEquities

15-4Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.InternationalCorrelationStructureandRiskDiversificationInvestorscanreduceportfolioriskbyholdingsecuritiesthatarelessthanperfectlycorrelatedInternationaldiversificationhasaspecialdimensionregardingportfolioriskdiversificationSecurityreturnsaresubstantiallylesscorrelatedacrosscountriesthanwithinacountryThisistruebecauseeconomic,political,institutional,andevenpsychologicalfactorsaffectingsecurityreturnstendtovaryagreatdealacrosscountriesBusinesscyclesareoftenhighasynchronousacrosscountries15-5Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.EXHIBIT15.2

CorrelationsamongInternationalStockReturns

15-6Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.InternationalCorrelationStructureandRiskDiversification(Continued)Solnik(1974)studyshowsthatasaportfolioholdsmoreandmorestocks,theriskoftheportfoliosteadilydeclines,andeventuallyconvergestothesystematic(ornondiversifiable)riskSystematicriskreferstotheriskthatremainsevenafterinvestorsfullydiversifytheirportfolioholdingsResultsofthisstudy(shownongraphsinthenextslide)providestrikingevidencesupportinginternational,asopposedtopurelydomestic,diversification15-7Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.EXHIBIT15.3

RiskReduction:DomesticversusInternationalDiversification

15-8Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.CautionaryNotesaboutInternationalCorrelationAnumberofstudiesfoundthatcorrelationsbetweeninternationalstockmarkets,especiallydevelopedmarkets,haveincreasedThesecorrelationsarecomputedattheaggregatestockmarketlevel,nottheindividualstocklevel;securitiesarestilllesscorrelatedacrosscountriesthanwithinacountryEmpiricalstudiesfoundthatinternationalstockmarketstendtomovemorecloselytogetherwhenthemarketvolatilityishigherUnlessinvestorsliquidatetheirportfolioholdingsduringtheturbulentperiod,theycanstillbenefitfrominternationalriskdiversification15-9Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.EXHIBIT15.5

AverageReturnCorrelation,1980-2018

15-10Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.OptimalInternationalPortfolioSelection

15-11Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.OptimalInternationalPortfolioSelection(Continued)Theoptimalinternationalportfolio(OIP)hasthehighestpossibleSharperatioTheOIPcanbesolvedbymaximizingtheSharperatiowithrespecttotheportfolioweightsSHP=[E(Rp)?Rf]/σpAfterobtainingOIPs,wecanmeasuregainsfromholdingtheseportfoliosoverpurelydomesticonesintwoways:IncreaseintheSharpeperformancemeasureIncreaseintheportfolioreturnatthedomestic-equivalentrisklevel15-12Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.EXHIBIT15.6

CompositionoftheOptimalInternationalPortfoliobyInvestor’sDomicile,1980.1–2018.1215-13Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.EXHIBIT15.7-SelectionoftheOptimalInternationalPortfolioforU.S.Investors

15-14Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.TherealizeddollarreturnforaU.S.residentinvestinginaforeignmarketwilldependnotonlyonthereturnintheforeignmarketbutalsoonthechangeintheexchangeratebetweentheU.S.dollarandtheforeigncurrencyRateofreturnindollartermsfrominvestingintheithforeignmarket,Ri$,isgivenby:whereRiisthelocalcurrencyrateofreturnfromtheithforeignmarketandei

istherateofchangeintheexchangeratebetweenthelocalcurrencyandthedollarEffectsofChangesintheExchangeRate15-15Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.Exchangeratechangesaffecttheriskofforeigninvestmentasfollows,wheretheΔVartermrepresentsthecontributionofthecross-productterm,Riei,totheriskofforeigninvestmentExchangeratefluctuationscontributetotheriskofforeigninvestmentthroughthreepossiblechannels:Itsownvolatility,Var(ei)Itscovariancewiththelocalmarketreturns,Cov(Ri,ei)Contributionofthecross-productterm,ΔVarEffectsofChangesintheExchangeRate(Continued)15-16Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.InternationalBondInvestmentWorldbondmarketiscomparableintermsofcapitalizationvaluetotheworldstockmarket,butithasnotreceivedasmuchattentionininternationalinvestmentliteratureExistingstudiesshowthatwheninvestorscontrolexchangeriskbyusingcurrencyforwardcontracts,theycansubstantiallyenhancetheefficiencyofinternationalbondportfoliosTheadventoftheeuroalteredtherisk-returncharacteristicsoftheeuro-zonebondmarkets,enhancingtheimportanceofnon-eurocurrencybonds15-17Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.EXHIBIT15.10-SummaryStatisticsoftheMonthlyReturnstoBondsandtheCompositionoftheOptimalInternationalBondPortfolio15-18Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.InternationalDiversification:MutualFundsPurchasingforeignstocksdirectlyfromforeignexchangescanentailsignificanttransactioncostsOthermodesofinternationaldiversificationarelesscumbersome:U.S.-basedinternationalmutualfundsinvestinsecuritiesfromcountriesotherthantheU.S.Advantagesofinternationalmutualfunds:Investorscansaveanyextratransactionand/orinformationcoststheymayhavetoincurwhentheyattempttoinvestdirectlyinforeignmarketsCircumventmanylegal/institutionalbarrierstodirectportfolioinvestmentsinforeignmarketsBenefitfromtheexpertiseofprofessionalfundmanagers15-19Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.InternationalDiversification:CountryFundsAcountryfundinvestsexclusivelyinstocksofasinglecountryPopularmeansofinternationalinvestmentintheU.S.,aswellasinotherdevelopedcountriesUsingcountryfunds,investorscanSpeculateinasingleforeignmarketwithminimumcostsConstructtheirownpersonalinternationalportfoliosusingcountryfundsasbuildingblocksDiversifyintoemergingmarketsthatareotherwisepracticallyinaccessible15-20Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.EXHIBIT15.11–U.S.andHomeMarketBetasofClosed-EndCountryFundsandtheirNAVs15-21Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.InternationalDiversification:ETFsInthelastseveralyears,therehasbeenabroadshiftfromactivelymanagedmutualfundstopassiveinvestmentvehiclesAnexchange-tradedfund(ETF)isaninvestmentvehiclethatseekstotracktheperformanceofaspecificindex,typicallyanequityindexETFsarehighlyliquid,anditiseasytobuyandsellthemMostETFsarepassive,thoughsomeactiveETFsexistAfamilyofETFscallediShares(managedbyBlackRock)hasthebroadestrangeofcountryETFswith65fundsacross42countries15-22Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.InternationalDiversification:ADRsAmericandepositoryreceipts(ADRs)representreceiptsforforeignsharesheldintheU.S.(depository)banks’foreignbranchesorcustodiansADRsaretradedonU.S.exchangeslikedomesticAmericansecuritiesBecausethemajorityofADRsarefromsuchdevelopedcountriesasAustralia,Japan,andtheU.K.,U.S.investorshavealimitedopportunitytodiversifyintoemergingmarketsusingADRsHowever,inafewemergingmarketslikeMexico,investorscanchoosefromseveralADRs.15-23Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.InternationalDiversification:HedgeFundsHedgefundsthatrepresentprivatelypooledinvestmentfundshaveexperiencedatremendousgrowthinrecentyearsMayinvestinawidespectrumofsecurities,suchascurrencies,domesticandforeignbondsandstocks,commodities,realestate,etc.Manyaimtorealizepositivereturns,regardlessofmarketconditionsLegally,hedgefundsareprivateinvestmentpartnershipsTendtohaverelativelylowcorrelationswithvariousstockmarketbenchmarksandthusallowinvestorstodiversifytheirportfoliorisk15-24Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.InternationalDiversificationwithIndustry,Style,andFactorPortfoliosInvestorscanenhancethegainsfrominternationalinvestmentbyaugmentingtheirportfolioswithindustry,small-cap,orfactorfundsStudiesdocumentgreaterdiversificationbenefitsfrominvestingacrossnotjustcountries,butalsoindustries

InternationaldiversificationcanbefurtherenhancedbyemployingfactorandstyleinvestingStyleinvestingreferstocategorizingassetsintodifferentstylesbasedoncommoncharacteristics(e.g.,large-capandvaluestocks)Threefactors—size,book-to-market,andmomentum—havebeenwidelyusedinassetpricingmodelstoexplainstockreturns15-25Copyright?2021bytheMcGraw-HillCompanies,Inc.Allrightsreserved.HomeBiasinPortfolioHoldingsInportfolioholdings,thetendencyofaninvestortoholdalargerportionofthehomecountrysecuritiesthanisoptimumfordiversificationofr