International Diversification

1
Chapter 25

• InternationalDiversification

2
Background

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

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?

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

5
Efficient Frontier with International
Diversification
6
Systematic Risk Level with International
Diversification
7
International Investment Choices

• Direct stock purchases
• American depository receipts
• Mutual Funds
• Open-end funds
• Closed-end funds
• WEBS

8
Risks in International Investing

• Political Risks
• Expropriation of assets
• Restrictions on foreign exchange
• Political instability

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

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

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

12
Return Example Dollar Appreciates

• Initial Investment 100,000
• Initial Exchange 2.00/ Pound Sterling
• Final Exchange2.10/ Pound Sterling
• Return in British Security 10
• Return in US Dollars
• (1 rUS) (1.10) (1.05) (1.155)
• rUS 15.5

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

14
Measuring Benchmark Returns

• Indexes
• EAFE Index
• Issues in measuring performance
• Weighting
• Cross-Holdings
• Other possibilities
• Country and Region Funds

15
Performance Attribution with International
Investment

• Extension to consider additional factors
• Currency selection
• Country selection
• Stock selection
• Cash and bond selection

16
Security Analysis with International Investments

• Accounting rules and conventions complicate
  security analysis
• Depreciation
• Reserves
• Consolidation
• Taxes
• P/E ratios