Addition of more risky foreign assets to a purely domestic portfolio will reduces its total risk correlations is not large.. When a portfolio is partly invested in domestic assets & part
Trang 11 THE TRADITIONAL CASE FOR INTERNATIONAL DIVERSIFICATION
= ௗ ௗ + =ௗ ௗ+ +ௗ ௗ,
=
ௗ,=ௗ, ௗ
$=+ +
$
ଶ= ଶ + ௌ+ 2 ௌ,ௌ
Two motivations for global investment:
Reduction of the volatility
Profitable opportunities
Addition of more risky foreign assets to a purely domestic portfolio will reduces its total risk (correlations is not large)
When a portfolio is partly invested in domestic assets & partly in foreign assets:
The correlation, the risk reduction
Currency considerations:
where
$ = Return of foreign asset in U.S $ term
= Return of foreign asset in local currency
S = % ∆ in the foreign currency
Third term captures the fact that currency appreciation captures original capital as well as capital gains
Global EF is to the left of the domestic EF (return opportunities & risk diversification)
On avg the common variance b/w The U.S & other markets is < 50%
Canadian $ bonds are most strongly correlated with U.S $ bonds
Correlation of U.S bonds with every foreign bond market is <50
Global investing should the Sharpe ratio
Passive global diversification is wise in terms of risk but doesn’t provide a free lunch
in terms of return
Currency Risk Not a Barriers to International Investment
Currency risk is smaller (larger) than the Risk of corresponding stock (bond) market
Currency risk is not a significant barrier to international investment because:
Market & currency risks are no additive
Exchange risk can be hedged through derivatives
Part of currency risk gets diversified away by the mix of currencies represented in the portfolio
Contribution of currency risk with the length of investment horizon
EM = Emerging Markets
EF = Efficient Frontier
Trang 22 THE CASE AGAINST INTERNATIONAL DIVERSIFICATION
Changing correlations among international economies can have very undesirable effects (e.g overstating benefits of international diversification)
Correlations have been over time because:
Free trade among nations has
Integrated capital markets
Foreign operations by corporations
Mobility of capital has with institutional investors
Correlations b/w markets appear to when volatility in international markets
Statistical aberration ⇒ the problem with estimating correlation during periods of rising volatility is that the calculated correlation will be biased upward when in reality it has not changed
Barriers to International Investments
International investment is far less from what it should be because of the following reasons
Lack of familiarity with foreign markets
Political risk
Lack of market efficiency
Lack of liquidity
Timely & reliable information
Price manipulation & insider trading
Regulation
Higher transaction cost
Brokerage commission
Price impact of trade
Custody cost
Management fees
Taxes
Currency risk
3 THE CASE FOR INTERNATIONAL DIVERSIFICATION REVISITED
The conclusion that correlation increases in periods of crises seems to be simply a statistical bias due to faulty econometrics
An enlarged investment opportunities set offers additional international diversification benefits
Traditionally, investors were diversifying across country factors:
First decide on a country allocation
Second, select securities within countries
Today, nationality of a firm has become fuzzy & companies compete in global industries
Although industry factors have become more important & country factors less important, an investor should not assume that diversifying across border is no longer required
This cross- country, cross industry approach, is required to capture the full risk
& benefits of international diversification
Trang 34 THE CASE FOR EMERGING MARKETS
EM offer opportunities of higher return
Although the stand-alone risk of EM is higher but low correlation with developed world markets offer diversification benefits
Crises on EM tend to be larger & prolonged & international correlation tends to
in periods of crises
In EM’s stock return & currency returns are usually +vely correlated (suffer twice in case of a downturn)
Investability of Emerging Markets
Foreign investor may not be able to exploit attractive EM return for several reasons:
Restrictions on the amount of stock that can be held by foreigners
Small free float
Repatriation of invested capital is often restricted
Discriminatory taxes
Foreign currency restrictions
Low liquidly
Only authorized investors allow investment
Segmentation v/s Integration Issue
EMs are segmented markets
EM returns correspond more closely to local risks which results in E(R)
EMs make an attractive addition to a global portfolio ( E(R), but in portfolio risk
is not large due to low correlations)