Understanding Foreign Investment Risk: Portfolio Theory & International Diversification, Study Guides, Projects, Research of Finance

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M.Sc. Finance , MSc International Banking and Finance, and M.Sc. International Accounting and Financial Studies

PORTFOLIO THEORY

International Diversification

Rate of Return on Foreign Investment The return on foreign investments depends on

• (^) The rate of return on the foreign assets denominated in the foreign currency
• (^) The change in the exchange rate
  • (^) An appreciation of the foreign currency being advantageous
  • (^) An depreciation of the foreign currency reducing the return in terms of the investor’s domestic currency 2

Calculating the Rate of Return on Foreign Investment (2) UK US X UK UK UK US X R R R R x R

(1 R ) (1 R )(1 R )

x x x x   

R

UK 4

Calculating the Rate of Return on

Foreign Investment: discrete and

continuous (3)

UK US X

R * R R *

(Continuous) R* ln( 1. 15 ) ln( 0. 90 )

(Discrete) R ( 1 0. 15 )( 1 0. 10 ) 1.

UK UK

5

Calculating the Risk of Foreign

Investment

     ( ) ( ) 2 ( , ) ( ( )) ( ( )) 2 ( ( )) ( ( )) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ( )) 2 2 2 2 US X US X US US X X US US X X UK US X US X UK US X UK US X UK UK UK VAR R VAR R COV R R E R E R E R E R E R E R E R E R VAR R E R R E R E R R R R E R E R E R VAR R E R E R                     A standard two asset portfolio equation, but without the weights. 7 Assume that COV(R US , R X ) = 0

1 10 20 30 40 50 50% 27% 11.7% US Stocks Global Stocks International and Domestic (USA)Diversification SD(P) as % of the SD (Typical Single Security) SD(R P ) 8

Correlation of Stock Indices in Different Markets (measured in dollars) Canada France Germany Japan UK Canada France 0. Germany 0.454 0. Japan 0.355 0.415 0. UK 0.460 0.642 0.594 0. USA 0.709 0.534 0.489 0.348 0. Average correlation coefficeint = 0. Source: Elton and Gruber 10

Assessing the Attraction of Foreign

Investment

When the Ratio of the expected international risk premium (expressed in domestic currency) is higher than for the domestic market international investment becomes particularly attractive. There are further advantages associated with a correlation of less than one between international and domestic returns. 11

I D D D F I I F SD R E R R SD R E R R ,    

Analysing the return on a foreign investment

• (^) Assume an investment of £1 is made in the USA the overall monetary return will be given by .
• (^) The sterling payoff from the investment will be given by
• (^) If the pound appreciates, the overall sterling return will be less than the return in the USA, while a depreciation of the pound, implies the overall sterling return will be greater than the return in the USA. ( 1 ) USA  r 1 1 ( 1 ) o USA S S  r

Naïve Diversification on an International Basis Solnik (1974) demonstrated that

• (^) As a portfolio is made up of a larger and larger number of shares the risk of the portfolio falls but at a decreasing rate, levelling out at about 27 per cent of the risk of a typical security
• (^) In a fully diversified portfolio where shares are chosen on an international basis the risk falls to about 12 per cent of the typical stock.
• (^) The advantage of international diversification tend to be greater for smaller countries where fewer shares are traded than for USA – for Switzerland a fully diversified portfolio is about 44 per cent as risky as typical share
• (^) Roll (1988) and Longin and Solnik (1995) report that correlations are higher when market volatility rises

Rationale for Home Bias

• (^) Early 1990s US markets accounted for less than 50 per cent of the world’s capitalisation but 90 per cent of US portfolios were invested in the USA.
• (^) The neglect of international investment opportunities is even more surprising given the domestic commitment of human capital.
• (^) Overseas investment is expensive in terms of transactions costs.
• (^) Less information is generally available in foreign markets than in the USA.
• (^) Domestic investments provide more effective hedges against (domestic) inflation.
• (^) Various legal and institutional restrictions limit the scope for foreign investment.