Multinational Financial Management Alan Shapiro 7th Edition Power Points by J.Wiley & Sons 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 SECURITIES FOREIGN I THE BENEFITS OF INTERNATIONAL EQUITY INVESTING I THE BENEFITS OF INTERNATIONAL EQUITY INVESTING A Advantages Offers more opportunities than a domestic portfolio only Larger firms often are overseas THE BENEFITS OF INTERNATIONAL EQUITY INVESTING B International Diversification greater Risk-return tradeoff: may be basic rulethe broader the diversification, more stable the returns and the more diffuse the risk THE BENEFITS OF INTERNATIONAL EQUITY INVESTING International diversification and a systematic risk 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 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 Correlation of foreign market betas Foreign market = beta Correlation Std dev with U.S x for mkt market std dev U.S mkt THE BENEFITS OF INTERNATIONAL EQUITY INVESTING Past empirical evidence suggests international diversification reduces portfolio risk 10 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING Theoretical Conclusion International diversification pushes out the efficient frontier 11 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING Calculation of Expected Return: r where p = ar US + ( - a) r rw r = portfolio expected return p r r US rw = expected U.S market return = expected global return 12 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING Calculation of Expected Portfolio Risk = (σ ) P σ = [a 2σ + (1-a)2 σ + 2a(1-a) P US rw σ σ σ ]1/2 US rw US,rw where σ US,rw = σ US σ rw the cross-market correlation = U.S returns variance = World returns variance 13 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING Cross-market correlations a Recent markets seem to be most correlated when volatility is greatest b Result: Efficient frontier retreats 14 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 15 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING E Barriers to International Diversification Segmented markets Lack of liquidity Exchange rate controls Less developed capital markets Exchange rate risk Lack of information a readily accessible b comparable 16 THE BENEFITS OF INTERNATIONAL EQUITY INVESTING F Methods to Diversify Trade in American Depository Receipts (ADRs) Trade in American shares Trade internationally diversified mutual a b c funds: Global International Single-country 17 II INTERNATIONAL BOND INVESTING II INTERNATIONAL BOND INVESTING -internationally diversified bond portfolios offer superior performance 18 INTERNATIONAL BOND INVESTING A Empirical Evidence Foreign bonds provide higher returns Foreign portfolios outperform purely domestic 19 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 20 IV MEASURING TOTAL RETURNS FROM PORTFOLIO INVESTING IV MEASURING TOTAL RETURNS A Bonds Dollar = Foreign x Currency gain (loss) return return currency 21 MEASURING TOTAL RETURNS FROM PORTFOLIO INVESTING Bond return formula: + R $ [1 + = B(1) - B(0) + C ] (1+g) B(0) where R = dollar return $ B(1) = foreign currency bond price at time C = coupon income g = depreciation/appreciation of foreign currency 22 MEASURING TOTAL RETURNS FROM PORTFOLIO INVESTING B Stocks (Calculating return) Formula: + R where $ [ 1+ = P(1) - P(0) + D ] (1+g) P(0) = dollar return R $ P(1) = foreign currency stock price at time D = foreign currency annual dividend 23