Description
its a power point presentationn on INTERNATIONAL DIVERSIFICATION
INTERNATIONAL
DIVERSIFICATION
Presented by: Kamlesh Mehra
INTERNATIONAL DIVERSIFICATION
World Portfolio represents the total market value of all stocks(or bonds) that an investor would own if he/she bought the total of all marketable stocks on all the major stock exchanges in the world.
Why Go Global?
In a nutshell: Diversification!!!
Potential for higher expected returns for same risk. Potential for lower portfolio risk for same return.
Expected return
International investing
Domestic investing
Standard deviation of return
International Correlations & Diversification
Security returns are much less correlated across countries than within a country.
This is because economic, political, institutional and even psychological factors affecting security returns tend to vary across countries, resulting in low correlations among international securities.
Types of companies in each country can also vary significantly.
Domestic vs. International Diversification
100 Portfolio Risk (%)
U.S. stocks 27 12 1 10 20 30 International stocks 40 50
Number of Stocks
5
International Investing
The tools are Mean/Variance Analysis. However, there are many important cross-country differences that matter when we invest internationally Country Risk Currency Risk We start out with the mathematics of portfolio optimization
Portfolio Theory
Assumptions:
Nominal returns are normally distributed. Investors want more return and less risk as denominated in their home currency. Let wi = proportion of wealth devoted to asset i such that 7i wi = 1
Expected return on a portfolio: E RP
! § wi E Ri
i 2 Portfolio Variance: Var RP
! W P ! §§ wi w j W ij i j
where Wij = Vij Wi Wj
7
Expected Return on a Portfolio
E[Ri] A American B British J Japanese 14.3% 17.6% 17.7%
i
16.4% 29.9% 35.7%
Example: Equal weights (50%) of A and J: E[Rp] = wA E[RA] + wJ E[RJ] = (0.5x0.143)+(0.5x0.177) = 0.16 or 16%
8
Portfolio Variance
Correlation A American 14.3% B British 17.6% J Japanese 17.7%
E[Ri]
16.4% 29.9% 35.7%
Wi
A
B
J
1 0.557 0.325 0.557 1 0.317 0.325 0.317 1
Example: Equal weights of A and J WP2= wA2 WA2 + wJ2 WJ2 + 2 wA wJ VAJ WA WJ = (0.5)2(0.164)2 + (0.5)2(0.357)2 + 2(0.5)(0.5)(0.325)(0.164)(0.357) = 0.0481 WP= (0.0481)1/2 = 0.2190 or 21.9 percent
Diversification & Risk
The
risk of a portfolio is measured by the ratio of the variance of a portfolio¶s return relative to the variance of the market return (portfolio beta). As an investor increases the number of securities in a portfolio, the portfolio¶s risk declines rapidly at first, then asymptotically approaches the level of systematic risk of the market.
Diversification & Risk
The
total risk of any portfolio is therefore composed of systematic risk (the market) and unsystematic risk (the individual securities). the number of securities in the portfolio reduces the unsystematic risk component leaving the systematic risk component unchanged.
Increasing
Diversification & Risk
100
Percent = risk
Variance of portfolio return Variance of market return
80
60
Total Risk
=
Diversifiable Risk (unsystematic)
+
Market Risk (systematic)
Portfolio of US stocks
40 Total 20 risk 1 10 20 Systematic risk 30
40
50
Number of stocks in portfolio
By diversifying the portfolio, the variance of the portfolio¶s return relative to the variance of the market¶s return (beta) is reduced to the level of systematic risk -the risk of the market itself.
12
Limitations of Domestic Investment
If we only invest in domestic shares, then we are limited by the types of companies on offer in our home market. For example, the Australian market is overweight in mining companies and underweight in technology companies compared to the US and other markets.
If we want to invest in IT or electronics companies, how do we do that in Australia? By investing internationally, we have a more diverse range of investment opportunities.
Internationalizing a Domestic Portfolio
Expected Return of Portfolio, Rp
Capital Market Line (Domestic) Optimal domestic portfolio (DP)
DP
R DP
?
MRDP
?
W DP
Minimum risk (MRDP ) domestic portfolio Domestic portfolio opportunity set
Rf
Expected Risk of Portfolio, p
An investor may choose a portfolio of assets enclosed by the Domestic portfolio opportunity set. The optimal domestic portfolio is found at DP, where the Capital Market Line is tangent to the domestic portfolio opportunity set. The domestic portfolio with the minimum risk is MRDP.
14
Internationalizing a Domestic Portfolio
Expected Return of Portfolio, Rp
Optimal international portfolio CML (Domestic)
R IP R DP
IP
?
DP
?
Internationally diversified portfolio opportunity set Domestic portfolio opportunity set
Rf W IP W DP
Expected Risk of Portfolio, p
An investor may choose a portfolio of assets enclosed by the international portfolio opportunity set. The optimal international portfolio is found at IP, where the Capital Market Line is tangent to the international portfolio opportunity set.
15
Domestic vs. International Diversification
100 Portfolio Risk (%)
U.S. stocks 27 12 1 10 20 30 International stocks 40 50
Number of Stocks
16
Key Results of Portfolio Theory
The extent to which risk is reduced by portfolio diversification depends on the correlation of assets in the portfolio. As the number of assets increases, portfolio variance becomes more dependent on the covariances (or correlations) and less dependent on variances. The risk of an asset when held in a large portfolio depends on its return covariance (or correlation) with other assets in the portfolio. Example ± MSCI World Index & MSCI Emerging Markets Index
Amount of risk reduction
Combinations of the two portfolios if correlation = 1
18
Exchange Rate Risk
The realized dollar return for an Australian 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 Australian dollar and the foreign currency, i.e.
Uncertainty about what will happen to the foreign stock market (rforeign market). Uncertainty about what will happen to the exchange rate (g$/FC).
Exchange Rate Risk
The realized dollar return for an Australian resident investing in a foreign market is given by:
Ri $ ! (1 Ri )(1 ri ) 1
Where, Ri is the local currency return in the ith market. ri is the rate of change in the exchange rate between the local currency and the dollar.
20
Where to Invest?
Country China India Brazil Hong Kong South Korea Germany Singapore Mexico U.S. Canada U.S. U.K. U.S. France Italy Japan Index SSEC BSE Bovespa HSI Seoul Comp. DAX 30 ST Index IPC Nasdaq TSE DJIA FTSE 100 S&P 500 CAC 40 MIBTEL Nikkei '09 Return 96.66% 47.15% 43.65% 39.31% 32.25% 22.29% 16.63% 11.68% 9.81% 7.16% 6.43% 3.80% 3.53% 1.31% -7.81% -11.13%
21
How to Invest?
Direct share investment ± purchase shares in foreign markets using foreign currencies. Can be hard to do! ADRs/GDRs ± purchase shares in foreign companies that are traded on your home exchange in local currency. Limited number! MNCs ± why can¶t we just buy shares in multinational companies to diversify internationally? Diversification benefits not as good as investing internationally!
So what are the easy ways?
22
International Mutual Funds
An Australian investor can easily achieve international diversification by investing in an Australian-based international mutual fund. The advantages include:
1. Savings on transaction and information costs. 2. Circumvention of legal and institutional barriers to direct portfolio investments abroad. 3. Professional management and record keeping.
23
Country Funds
Recently, country funds have emerged as one of the most popular means of international investment. A country fund invests exclusively in the stocks of a single country.This allows investors to: 1. Speculate in a single foreign market with minimum cost. 2. Construct their own personal international portfolios. 3. Diversify into emerging markets that might be inaccessible to individual investors.
24
Other Avenues
Exchange Traded Funds ± ETFs are investment
companies, registered with the SEC with assets consisting of baskets of securities included in an index fund. One share in an ETF provides an investor diversification to all the constituents of the relevant index and its price and yield track the indices performance.
World Equity Benchmark Shares (WEBS)/iShares ± Country specific baskets of stocks designed to replicate indices of 14 countries.
Low cost, convenient way for investors to hold diversified investments in several different countries.
25
Home Bias Puzzle ± Possible Explanations
Barriers to international investment (e.g. foreign investment not allowed in a lot of countries).
restrictions on capital flows have fallen over time can use country funds
International trading frictions: turnover taxes, other taxes, limited liquidity
Not a huge problem for larger markets, yet home bias remains
Domestic equities may provide a superior inflation hedge. Sovereign risk - repatriation of funds Exchange rate risk Information asymmetries Psychological impediments
26
Conclusions
1 2 3
Low correlations across international markets may increase the risk-return trade off risk-
Important time variations may exist that can challenge these benefits. Time horizon matters. matters.
Investors might not be taking full advantage of the benefits of international diversification. This is known as the µhome bias¶ puzzle.
27
Thankyou
Any Question
doc_701643980.pptx
its a power point presentationn on INTERNATIONAL DIVERSIFICATION
INTERNATIONAL
DIVERSIFICATION
Presented by: Kamlesh Mehra
INTERNATIONAL DIVERSIFICATION
World Portfolio represents the total market value of all stocks(or bonds) that an investor would own if he/she bought the total of all marketable stocks on all the major stock exchanges in the world.
Why Go Global?
In a nutshell: Diversification!!!
Potential for higher expected returns for same risk. Potential for lower portfolio risk for same return.
Expected return
International investing
Domestic investing
Standard deviation of return
International Correlations & Diversification
Security returns are much less correlated across countries than within a country.
This is because economic, political, institutional and even psychological factors affecting security returns tend to vary across countries, resulting in low correlations among international securities.
Types of companies in each country can also vary significantly.
Domestic vs. International Diversification
100 Portfolio Risk (%)
U.S. stocks 27 12 1 10 20 30 International stocks 40 50
Number of Stocks
5
International Investing
The tools are Mean/Variance Analysis. However, there are many important cross-country differences that matter when we invest internationally Country Risk Currency Risk We start out with the mathematics of portfolio optimization
Portfolio Theory
Assumptions:
Nominal returns are normally distributed. Investors want more return and less risk as denominated in their home currency. Let wi = proportion of wealth devoted to asset i such that 7i wi = 1
Expected return on a portfolio: E RP
! § wi E Ri
i 2 Portfolio Variance: Var RP
! W P ! §§ wi w j W ij i j
where Wij = Vij Wi Wj
7
Expected Return on a Portfolio
E[Ri] A American B British J Japanese 14.3% 17.6% 17.7%
i
16.4% 29.9% 35.7%
Example: Equal weights (50%) of A and J: E[Rp] = wA E[RA] + wJ E[RJ] = (0.5x0.143)+(0.5x0.177) = 0.16 or 16%
8
Portfolio Variance
Correlation A American 14.3% B British 17.6% J Japanese 17.7%
E[Ri]
16.4% 29.9% 35.7%
Wi
A
B
J
1 0.557 0.325 0.557 1 0.317 0.325 0.317 1
Example: Equal weights of A and J WP2= wA2 WA2 + wJ2 WJ2 + 2 wA wJ VAJ WA WJ = (0.5)2(0.164)2 + (0.5)2(0.357)2 + 2(0.5)(0.5)(0.325)(0.164)(0.357) = 0.0481 WP= (0.0481)1/2 = 0.2190 or 21.9 percent
Diversification & Risk
The
risk of a portfolio is measured by the ratio of the variance of a portfolio¶s return relative to the variance of the market return (portfolio beta). As an investor increases the number of securities in a portfolio, the portfolio¶s risk declines rapidly at first, then asymptotically approaches the level of systematic risk of the market.
Diversification & Risk
The
total risk of any portfolio is therefore composed of systematic risk (the market) and unsystematic risk (the individual securities). the number of securities in the portfolio reduces the unsystematic risk component leaving the systematic risk component unchanged.
Increasing
Diversification & Risk
100
Percent = risk
Variance of portfolio return Variance of market return
80
60
Total Risk
=
Diversifiable Risk (unsystematic)
+
Market Risk (systematic)
Portfolio of US stocks
40 Total 20 risk 1 10 20 Systematic risk 30
40
50
Number of stocks in portfolio
By diversifying the portfolio, the variance of the portfolio¶s return relative to the variance of the market¶s return (beta) is reduced to the level of systematic risk -the risk of the market itself.
12
Limitations of Domestic Investment
If we only invest in domestic shares, then we are limited by the types of companies on offer in our home market. For example, the Australian market is overweight in mining companies and underweight in technology companies compared to the US and other markets.
If we want to invest in IT or electronics companies, how do we do that in Australia? By investing internationally, we have a more diverse range of investment opportunities.
Internationalizing a Domestic Portfolio
Expected Return of Portfolio, Rp
Capital Market Line (Domestic) Optimal domestic portfolio (DP)
DP
R DP
?
MRDP
?
W DP
Minimum risk (MRDP ) domestic portfolio Domestic portfolio opportunity set
Rf
Expected Risk of Portfolio, p
An investor may choose a portfolio of assets enclosed by the Domestic portfolio opportunity set. The optimal domestic portfolio is found at DP, where the Capital Market Line is tangent to the domestic portfolio opportunity set. The domestic portfolio with the minimum risk is MRDP.
14
Internationalizing a Domestic Portfolio
Expected Return of Portfolio, Rp
Optimal international portfolio CML (Domestic)
R IP R DP
IP
?
DP
?
Internationally diversified portfolio opportunity set Domestic portfolio opportunity set
Rf W IP W DP
Expected Risk of Portfolio, p
An investor may choose a portfolio of assets enclosed by the international portfolio opportunity set. The optimal international portfolio is found at IP, where the Capital Market Line is tangent to the international portfolio opportunity set.
15
Domestic vs. International Diversification
100 Portfolio Risk (%)
U.S. stocks 27 12 1 10 20 30 International stocks 40 50
Number of Stocks
16
Key Results of Portfolio Theory
The extent to which risk is reduced by portfolio diversification depends on the correlation of assets in the portfolio. As the number of assets increases, portfolio variance becomes more dependent on the covariances (or correlations) and less dependent on variances. The risk of an asset when held in a large portfolio depends on its return covariance (or correlation) with other assets in the portfolio. Example ± MSCI World Index & MSCI Emerging Markets Index
Amount of risk reduction
Combinations of the two portfolios if correlation = 1
18
Exchange Rate Risk
The realized dollar return for an Australian 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 Australian dollar and the foreign currency, i.e.
Uncertainty about what will happen to the foreign stock market (rforeign market). Uncertainty about what will happen to the exchange rate (g$/FC).
Exchange Rate Risk
The realized dollar return for an Australian resident investing in a foreign market is given by:
Ri $ ! (1 Ri )(1 ri ) 1
Where, Ri is the local currency return in the ith market. ri is the rate of change in the exchange rate between the local currency and the dollar.
20
Where to Invest?
Country China India Brazil Hong Kong South Korea Germany Singapore Mexico U.S. Canada U.S. U.K. U.S. France Italy Japan Index SSEC BSE Bovespa HSI Seoul Comp. DAX 30 ST Index IPC Nasdaq TSE DJIA FTSE 100 S&P 500 CAC 40 MIBTEL Nikkei '09 Return 96.66% 47.15% 43.65% 39.31% 32.25% 22.29% 16.63% 11.68% 9.81% 7.16% 6.43% 3.80% 3.53% 1.31% -7.81% -11.13%
21
How to Invest?
Direct share investment ± purchase shares in foreign markets using foreign currencies. Can be hard to do! ADRs/GDRs ± purchase shares in foreign companies that are traded on your home exchange in local currency. Limited number! MNCs ± why can¶t we just buy shares in multinational companies to diversify internationally? Diversification benefits not as good as investing internationally!
So what are the easy ways?
22
International Mutual Funds
An Australian investor can easily achieve international diversification by investing in an Australian-based international mutual fund. The advantages include:
1. Savings on transaction and information costs. 2. Circumvention of legal and institutional barriers to direct portfolio investments abroad. 3. Professional management and record keeping.
23
Country Funds
Recently, country funds have emerged as one of the most popular means of international investment. A country fund invests exclusively in the stocks of a single country.This allows investors to: 1. Speculate in a single foreign market with minimum cost. 2. Construct their own personal international portfolios. 3. Diversify into emerging markets that might be inaccessible to individual investors.
24
Other Avenues
Exchange Traded Funds ± ETFs are investment
companies, registered with the SEC with assets consisting of baskets of securities included in an index fund. One share in an ETF provides an investor diversification to all the constituents of the relevant index and its price and yield track the indices performance.
World Equity Benchmark Shares (WEBS)/iShares ± Country specific baskets of stocks designed to replicate indices of 14 countries.
Low cost, convenient way for investors to hold diversified investments in several different countries.
25
Home Bias Puzzle ± Possible Explanations
Barriers to international investment (e.g. foreign investment not allowed in a lot of countries).
restrictions on capital flows have fallen over time can use country funds
International trading frictions: turnover taxes, other taxes, limited liquidity
Not a huge problem for larger markets, yet home bias remains
Domestic equities may provide a superior inflation hedge. Sovereign risk - repatriation of funds Exchange rate risk Information asymmetries Psychological impediments
26
Conclusions
1 2 3
Low correlations across international markets may increase the risk-return trade off risk-
Important time variations may exist that can challenge these benefits. Time horizon matters. matters.
Investors might not be taking full advantage of the benefits of international diversification. This is known as the µhome bias¶ puzzle.
27
Thankyou
Any Question
doc_701643980.pptx