CH 15: International Portfolio Investment

International Correlation Structure and Risk Diversification

Security returns are much less correlated across countries than within a country.

  • Due to economic, political, and psychological factors varying across countries.

  • Business cycles are often high asynchronous across countries.

Domestic vs. International Diversification

When fully diversified, an international portfolio can be less than half as risky as a purely U.S portfolio.

A fully diversified international portfolio is only 12% as risky as holding a single security.

Effects of Changes in the Exchange Rate

** The realized dollar return for a U.S resident investing in a foreign market will depend not only on the return in the foreign market but also on the change in the exchange rate between the US dollar and the foreign currency.

International Bond Investment

There is substantial exchange rate risk in foreign bond investment. This suggest that investors may be able to increase their gains if they can control this risk, for example with currency forward contracts or swaps.

International Mutual Funds

A U.S investor can easily achieve international diversification by investing in a U.S based international mutual fund.

A Performance Evaluation

Advantages include:

  • Savings on transaction and information costs

  • Circumvention of legal and institutional barriers to direct portfolio investments abroad

  • Professional management and record keeping

Country funds

Country funds have emerged as one of the most popular means of international investment. Invests exclusively in the stocks of a single county. This allows investors to:

  • Speculate in a single foreign market with minimum cost

  • Construct individual international portfolios

  • Diversify into emerging markets that are otherwise practically inaccessible.

American Depository Receipt

An American Depository Receipts is a receipt that represents the number of foreign shares that are deposited at a U.S. Bank.

Foreign stocks often trade on U.S exchanges as ADRs.

The bank serves as a transfer agent for the ADRs.

Advantages to trading ADRs as opposed to direct investment in the company’s shares:

  • ADRs are denominated in U.S dollars, trade on U.S exchanges, and can be bought through any broker

  • Dividends are paid in U.S dollars

  • Most underlying stocks are bearer securities and the ADRs are registered

**Adding ADRs to domestic portfolios has a substantial risk reduction benefit.

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World Equity Benchmark Shares

American Stock Exchange (AMEX) introduced a class of securities called World Equity Benchmark Shares (WEBS) (1996). Designed and managed by Barclays Global Investors.

In essence, WEBS are ETFs that are designed to closely track foreign stock market indexes.

Using ETFs like WEBS and spiders, investors can trade a whole stock market index as if it were a single stock.

Being open-end funds, WEBS trade at prices that are very close to their net asset values. In addition to single country index funds, investors can achieve global diversification instantaneously just by holding shares of the S&P Global 100 index Fund.

International Diversification with Hedge

Hedge funds which represent privately pooled investment funds have experienced phenomenal growth in recent years. A private investment partnership, generally do not register as an investment company and there forth are not subject to any reporting or disclosure requirements.

  • This growth has been mainly driven by the desire of institutional investors (Pension plans, endowments, and private foundations) to achieve positive or absolute returns, regardless of whether markets are rising or falling.

  • Hedge funds may adopt flexible, dynamic trading strategies, often aggressive, in order to achieve investment objectives.

  • These funds may invest in a wide spectrum of securities, such as currencies, domestic and foreign bonds, and stocks.

  • Many Hedge funds aim to realize positive returns, regardless of market conditions.

  • Tend to have low correlations with various stock market benchmarks and thus offer diversification.

  • Hedge funds allow investors to access foreign markets that are not easily accessible.

  • Allow investors to benefit from certain global macroeconomic events.

Associated risks:

  • Hedge funds may make wrong bets based on the incorrect prediction of future events and wrong models.

  • The failure of long term capital management provides an example of the risk associated with hedge fund investing.

Investors may not be allowed to liquidate their investments during a certain lock-up period.

In the U.S, only institutional investors and wealthy individuals are allowed to invest in hedge funds.

Home Bias in Portfolio Holdings

Actual portfolios that investors hold, however, are quite different from those predicted by the theory of international portfolio investment.

Home bias refers to the extent to which portfolio investments are concentrated in domestic equities.

  • 3 Explanations: 1) Domestic equities may provide a superior inflation hedge. 2) Home bias may reflect institutional and legal restrictions on foreign investment. 3) Extra taxes and transactions/information costs for foreign securities may give rise to home bias.

Investors can clearly enhance the gains from international investment by augmenting their portfolios with foreign, small-cap stocks.

Summary

International portfolio investment (IPI) has been growing rapidly in recent years due to a) the deregulation of financial markets b) the introduction of such investment vehicles as international mutual funds, country funds, and internationally cross-listed stocks.

Investors diversify to reduce risk; the extent of the risk reduction depends on the covariances among individual securities making up the portfolio. Since security returns tend to covary much less across countries than within a country, investors can reduce portfolio risk more by diversifying internationally than purely domestically.

Exchange rates are substantially more volatile than bond market returns but less so than stock market returns. Investors can enhance their gains from international diversification, when they hedge exchange risk using, for example forward contracts.