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Chapter 25

Chapter 25. International Diversification. Background. Global market US Market is 40% - 45% of all markets Improved access & technology New instruments Emphasis for our investigation Risk assessment Diversification. Issues.

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Chapter 25

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  1. Chapter 25 InternationalDiversification 25-1

  2. Background • Global market • US Market is 40% - 45% of all markets • Improved access & technology • New instruments • Emphasis for our investigation • Risk assessment • Diversification 25-2

  3. Issues • What are the risks involved in investment in foreign securities? • How do you measure benchmark returns on foreign investments? • Are there benefits to diversification in foreign securities? 25-3

  4. Diversification Benefits Evidence shows international diversification is beneficial • Possible to expand the efficient frontier above domestic only frontier • Possible to reduce the systematic risk level below the domestic only level 25-4

  5. Int’l Return Dom * * * * * * * * Risk Efficient Frontier with International Diversification 25-5

  6. Risk Dom Int’l Securities Systematic Risk Level with International Diversification 25-6

  7. International Investment Choices • Direct stock purchases • American depository receipts • Mutual Funds • Open-end funds • Closed-end funds • WEBS 25-7

  8. Risks in International Investing Political Risks • Expropriation of assets • Restrictions on foreign exchange • Political instability 25-8

  9. Risks in International Investing Foreign Exchange Risk • Variation in return related to changes in the relative value of the domestic and foreign currency • Total return = investment return & return on foreign exchange • Not possible to completely hedge a foreign investment 25-9

  10. Returns with FX • Return in US is a function of two factors 1. Return in the foreign market 2. Return on the foreign exchange 25-10

  11. Returns with FX (1 + rUS) = (1 + rFM) (1 + rFX) rUS = return on the foreign investment in US Dollars rFM = return on the foreign market in local currency rFX = return on the foreign exchange 25-11

  12. Return Example: Dollar Appreciates Initial Investment : $100,000 Initial Exchange: $2.00/ Pound Sterling Final Exchange:$2.10/ Pound Sterling Return in British Security: 10% Return in US Dollars (1 + rUS) = (1.10) (1.05) = (1.155) rUS = 15.5% 25-12

  13. Return Example: Dollar Depreciates Initial Investment : $100,000 Initial Exchange: $2/ Pound Sterling Final Exchange: $1.85/ Pound Sterling Return in British Security: 10% Return in US Dollars (1 + rUS) = (1.10) (.9250) = (1.0175) rUS = 1.75% 25-13

  14. Measuring Benchmark Returns • Indexes • EAFE Index • Issues in measuring performance • Weighting • Cross-Holdings • Other possibilities • Country and Region Funds 25-14

  15. Performance Attribution with International Investment Extension to consider additional factors • Currency selection • Country selection • Stock selection • Cash and bond selection 25-15

  16. Security Analysis with International Investments Accounting rules and conventions complicate security analysis • Depreciation • Reserves • Consolidation • Taxes • P/E ratios 25-16

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