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## Chapter 15

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**Chapter 15**INTERNATIONAL PORTFOLIO INVESTMENT**Why Invest Internationally?**• What are the advantages of international investment?**THE BENEFITS OF INTERNATIONAL EQUITY INVESTING**• I. THE BENEFITS OF INTERNATIONAL • EQUITY INVESTING • A. Advantages • 1. Offers more opportunities than • a purely domestic portfolio • 2. Attractive investments overseas • 3. Impact on efficient portfolio with diversification benefits**II. Basic Portfolio Theory**• II. Basic Portfolio Theory • A. What is the efficient frontier? • It represents the most efficient combinations of all possible risky assets.**The Efficient Frontier**• E(r) A B**Basic Portfolio Theory**• The broader the diversification, the more stable the returns and the more diffuse the risk.**Basic Portfolio Theory**• B. International Diversification • 1. Risk-return tradeoff: • may be greater**Basic Portfolio Theory**• Total Risk • 1. A Security’s Returns may be segmented into • Systematic Risk • can not be eliminated • Non-systematic Risk • can be eliminated by diversification**INTERNATIONAL DIVERSIFICATION**• 2. International diversification and systematic risk • a. Diversify across nations with • different economic cycles • b. While there is systematic risk • within a nation, outside the country it may be nonsystematic and diversifiable**INTERNATIONAL PORTFOLIO INVESTMENT**• 3. 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.**INTERNATIONAL PORTFOLIO INVESTMENT**• 4. Theoretical Conclusion • International diversification pushes out the efficient frontier.**The New Efficient Frontier**• E(r) C A B**CROSS-MARKET CORRELATIONS**• 5. Cross-market correlations • a. Recent markets seem to be most correlated when volatility is greatest • b. Result: • Efficient frontier retreats**The Frontier During Global Crises**• E(r) C A B**Investing in Emerging Markets**• 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.**Barriers to International Diversification**• E. Barriers to International Diversification • 1. Segmented markets • 2. Lack of liquidity • 3. Exchange rate controls • 4. Underdeveloped capital markets • 5. Exchange rate risk • 6. Lack of information • a. not readily accessible • b. data is not comparable**Other Methods to Diversify**• F. Diversify by a • 1. Trade in American Depository • Receipts (ADRs) • 2. Trade in American shares • 3. Trade internationally diversified • mutual funds: • a. Global (all types) • b. International (no home country securities) • c. Single-country**INTERNATIONAL PORTFOLIO INVESTMENT**• 4. Calculation of Expected Portfolio Return: • rp = a rUS + ( 1 - a) rrw • where • rp = portfolio expected return • rUS = expected U.S. market return • rrw = expected global return**Expected Portfolio Return**• Sample Problem • What is the expected return of a portfolio with 35% invested in Japan returning 10% and 65% in the U.S. returning 5%? • rp = a rUS + ( 1 - a) rrw • = .65(.05) + .35(.10) • = .0325 + .0350 • = 6.75%**Expected Portfolio Return**Calculation of Expected Portfolio Risk • where = the cross-market • correlation • US2 = U.S. returns variance • r w2 = World returns variance**Portfolio Risk Example**• What is the risk of a portfolio with 35% invested in Japan with a standard deviation of 6% and a standard deviation of 8% in the U.S. and a correlation coefficient of .7? • = [(.65)2 (.08) 2 + (.35) 2(.06) 2 +2(.65)(.35)(.08)(.06)(.7)] 1/2 • = 6.8%**INTERNATIONAL PORTFOLIO INVESTMENT**• IV. MEASURING TOTAL RETURNS • FROM FOREIGN PORTFOLIOS • A. To compute dollar return of a foreign security: • or**INTERNATIONAL PORTFOLIOINVESTMENT**• Bond (calculating return) formula: • where R$ = dollar return • B(1) = foreign currency bond price at time 1 (present) • C = coupon income during period • g = currency depreciation or appreciation**INTERNATIONAL PORTFOLIOINVESTMENT**• B. (Calculating U.S. $ Return) • Stocks Formula: • where R$ = dollar return • P(1) = foreign currency stock price at time 1 • D = foreign currency annual • dividend**U.S. $ Stock Returns:Sample Problem**• Suppose the beginning stock price if FF50 and the ending price is FF48. Dividend income was FF1. The franc depreciates from FF 20 /$ to FF21.05 /$ during the year against the dollar. • What is the stock’s US$ return for the year?