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					333II1 – International Risk Diversification   1




MOTIVES FOR INTERNATIONAL
PORTFOLIO INVESTMENT



The main motives for international
investing are:


   Higher expected returns



   International risk diversification




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UK securities tend to move up and
down together because they are
similarly  affected    by    domestic
conditions such as money supply
announcement,       interest    rates
movements, budget deficit and GDP
growth.



International investment helps to
diversify away the national market risk
without sacrificing expected return.



Alternatively, for the same level of
domestic risk, international investing
can provide superior returns.




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 A. Higher expected returns

 Wider selection of securities. Emerging
 markets provide opportunities for
 superior stock returns.

 Example:

                   Annualised (%) total return to
                           UK investor

   UK                                17.1

   US                                13.5

 Japan                               20.0

Greece                               23.3

 Chile                               52.4

Thailand                             38.1



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 Investing in UK only: 17.1%



 Investing         in     UK        and      Japan:
  18.55%



 Investing in UK and one emerging
  market: 34.75%




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B. International risk diversification


Although stocks in a given market tend
to move up and down together, stocks
in different world markets as a rule do
not.


Investing internationally allows us to
get rid of the downside risks
associated with the domestic market
movement.


In practice, investors in the financial
markets rarely hold a single asset,
instead they always try to diversify.

This is essentially because:


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   Returns on individual assets are
    inherently uncertain (except for
    holdings of cash, where the
    expected nominal return is zero; it
    is assumed that there is no risk -
    but even then the real return, after
    inflation, remains uncertain)

   If returns on different assets are
    imperfectly correlated, then a
    diversified portfolio can offer
    higher expected returns for a given
    risk, or a given expected return at
    lower risk

   Given opportunities to hold assets
    from many countries, it makes
    sense to diversify internationally,
    especially if asset returns are not
    highly correlated across countries.



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Data show that indeed stock market
movements, though correlated around
the world, are imperfectly so.

Performance of major stock markets in
US dollars in 1985 – 1999 (logarithmic
scale):




Source: Solnik, “International Investments”




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International risk diversification stems
from two sources:

   Reduced market correlation


   Reduced portfolio volatility




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1.
  Reduced market correlation



Correlation     coefficients                  between
markets are less than unity.



Several emerging markets have
correlation coefficients with World
index close to zero or even negative.



The UK market exhibits low correlation
with a number of industrial and
emerging markets.




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  Example:



               Correlation           Average (%) of
                  with              common variance
                                      between the 2
                    UK                   markets

  UK                1.00                          -

  US                0.51                        26.01

 Japan              0.35                        12.25

Greece              0.16                        2.56

 Chile              0.11                        1.21

Thailand            0.30                        9.00




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Common world factors affect expected
cash flows of all firms and therefore
their stock and bond prices.

 26.01% of stock and bond price
  movements is common to the UK and
  US markets.

 Only 2.56% of stock and bond price
  movements is common to the UK and
  Greek markets.

 Less than 2.00% of stock and bond
  price movements is common to the
  UK and Chilean markets.




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However, the low correlations with the
UK market, indicate UK economy and
other countries’ government policies are
mostly independent from world-wide
factors.




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2.
  Reduced portfolio volatility

With international market returns not
perfectly       correlated,        a     diversified
portfolio’s risk can be further reduced.


Consider a portfolio, P, containing two
assets (or “asset classes”): domestic (d)
and foreign (f) held in proportions of the
portfolio wd and wf.


Let Rd and Rf be the returns to the two
assets (both are random variables),
 d ,  f be the standard deviations of
the returns on d and f respectively


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and     d, f    the correlation coefficient
between the returns on the two assets
(must lie in the interval [-1, 1]).



The expected return on the portfolio is:

E ( P)  wd  E ( Rd )  w f  E ( R f )

where E(.) denotes the expectation value
of a random variable.


The corresponding portfolio variance
is:




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 p  wd   d  w 2   2 
  2    2     2
                   f     f

        2  wd  w f   d , f   d   f




The total risk associated with the

combined portfolio,  p , will be less
than the weighted average risk arising
from the two separate assets, namely:


wd   d  w f   f


except in the case where:
d , f  1
(i.e. asset returns perfectly correlated).




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This conclusion can be summed up in
the following inequality:

 p  (wd   d  w f   f ) 2 .
  2




Example:

UK market volatility:                         10%

Italian market volatility:                    15%

Correlation:                                  0.2



What is total portfolio’s volatility?



Assume equal weights (50% / 50%).

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Total portfolio’s volatility:



 p  wd   d  w 2   2 
  2    2     2
                   f     f

        2  wd  w f   d , f   d   f



= (0.52 * 0.12 + 0.52 * 0.152 +

       + 2 * 0.5 * 0.5 * 0.2 * 0.1 * 0.15)


= 1%


 p = 9.81 %




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Absence of perfect correlation between
two stocks means that a portfolio’s risk
is not the sum of its individual
components risk.



Does currency rates volatility matter?

Currency volatility has never been the
major component of total return on a
diversified portfolio over a long period
of time.

In addition, market volatility and
currency volatility (as measured by the
std. dev. of returns) are not additive
and exchange risk may be hedged for
major currencies by selling futures or
forward currency contracts.




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Portfolio returns

Significant  risk-return   trade-offs,
depending on the mix of assets in the
portfolio.

Risk/Return Trade-off in a diversified
Portfolio over the period 1971-1994:




Source: Solnik, “International Investments”




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Solnik (1974): "Why Not Diversify
Internationally   Rather    than
Domestically".

Diversifying within US market can
reduce risk to approx. 27% of risk of
holding individual share.

Diversifying within UK market, can
reduce risk to approx. 34.5%.

Diversifying internationally, can reduce
risk to approx. 11.7%.



Question: How many assets do we need
for a balanced portfolio that gets portfolio
risk down to reasonably low levels?



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For a US portfolio, holding 20 randomly
selected stocks is enough to get risk down
to 30% of the risk of holding a single
stock.

Beyond this point, adding more stocks
makes little difference.




For an international portfolio (US +
European stocks), 20 stocks is already
enough to get the portfolio risk down to
below 15% of the risk of holding a single
US stock.




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International diversification => reduction

of risk without sacrificing return.


However ….


…. note that in an international portfolio,

investors need to think about the

currency in which they wish to enjoy

their returns.


If, as we normally assume, this is their

usual domestic currency (thus USD in the

case of American investors, £ sterling for

those based in the UK etc.).

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Hence in terms of the investor’s domestic
currency, the expected returns to and risk
associated with an investment portfolio
also depend on the foreign exchange risk.




In what follows, we mostly do not take
this into account explicitly, but in
practice it cannot safely be neglected.




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EMPIRICAL   EVIDENCE   ON
INTERNATIONAL       STOCK
MARKETS CORRELATIONS:



Recent research allows for answering the
following questions:



1. Has correlation              across        markets
  increased?



2. Does correlation across markets
  increase at times of crisis or market
  turbulence?




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1. Has correlation across markets
increased?

Yes, there is an evidence for some
tendency for correlation to increase over
long periods, according to a variety of
empirical studies.

One would expect such a tendency as
markets around the world are liberalized,
capital flows more freely, different
economies are more closely integrated
through trade and investment flows.

The surprise, therefore, is probably that
correlations have not increased any more
than they actually have.




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2. Does correlation across markets
increase at times of crisis or market
turbulence?

  Some common shocks, e.g. 1970s oil
    price crisis, when all markets tend to
    move together; and the 1990 Gulf
    War; at such times, market
    correlation does increase.

  Global factors that affect many
   countries lead to higher correlation
   across financial markets in different
   countries.




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  There is some evidence - though the
    picture is quite mixed – that
    significant financial volatility can be
    contagious, i.e. unsettled conditions
    in one major market can spread to
    affect many other markets. How
    much this is due to objective factors,
    how much to investor perceptions
    (“herd” behaviour) is not clear.

  At other times, shocks affecting one
   or a few countries do not affect
   others, so markets do not move
   together and there are profitable
   opportunities for international risk
   diversification.




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SUMMARY:


 Motives for international investment

     A. High expected return

     B. International risk diversification



 International diversification means
  reduction of risk without sacrificing
  return.




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