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CHAPTER 19

CHAPTER 19. INTERNATIONAL PORTFOLIO INVESTMENT. CHAPTER OVERVIEW:. I. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING II. INTERNATIONAL BOND INVESTING III. OPTIMAL ASSET ALLOCATION IV. MEASURING THE TOTAL RETURN V. MEASURING EXCHANGE RISK ON FOREIGN SECURITIES.

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CHAPTER 19

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  1. CHAPTER 19 INTERNATIONAL PORTFOLIO INVESTMENT

  2. CHAPTER OVERVIEW: • I. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING • II. INTERNATIONAL BOND INVESTING • III. OPTIMAL ASSET ALLOCATION • IV. MEASURING THE TOTAL RETURN • V. MEASURING EXCHANGE RISK ON FOREIGN SECURITIES

  3. I. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING • I. THE BENEFITS OF INTERNATIONAL • EQUITY INVESTING • A. Advantages • 1. Offers more opportunities than • a domestic portfolio only • 2. Larger firms often are overseas

  4. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING • B. International Diversification • 1. Risk-return tradeoff: may be greater • basic rule- • the broader the diversification, • more stable the returns and the more diffuse the risk.

  5. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING • 2. International diversification and systematic risk • a. Diversifying across nations with • different economic cycles

  6. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING • b. While there is systematic risk • within a nation, it may be • nonsystematic and diversifiable • outside the country.

  7. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING • 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.

  8. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING • C. Correlations and the Gains From Diversification • 1. Correlation of foreign market betas • Foreign Correlation Std dev • market = with U.S. x for. mkt. • beta market std dev • U.S. mkt.

  9. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING • Past empirical evidence suggests inter- • national diversification reduces portfolio • risk.

  10. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING • 3. Theoretical Conclusion • International diversification pushes out • the efficient frontier.

  11. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING • 4. Calculation of Expected Return: • rp = a rUS + ( 1 - a) rrw • where rp = portfolio expected return • rUS = expected U.S. market return • rrw = expected global return

  12. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING • 5. Calculation of Expected Portfolio Risk (P ) • P = [a 2US2 + (1-a)2 r w2 + 2a(1-a) USrw US,rw]1/2 • where US,rw = the cross-market • correlation • US2 = U.S. returns variance • r w2 = World returns variance

  13. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING • 6. Cross-market correlations • a. Recent markets seem to be most correlated when volatility is greatest • b. Result: • Efficient frontier retreats

  14. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING • 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.

  15. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING • E. Barriers to International Diversification • 1. Segmented markets • 2. Lack of liquidity • 3. Exchange rate controls • 4. Less developed capital markets • 5. Exchange rate risk • 6. Lack of information • a. readily accessible • b. comparable

  16. THE BENEFITS OF INTERNATIONAL EQUITY INVESTING • F. Methods to Diversify • 1. Trade in American Depository • Receipts (ADRs) • 2. Trade in American shares • 3. Trade internationally diversified • mutual funds: • a. Global • b. International • c. Single-country

  17. II. INTERNATIONAL BOND INVESTING • II. INTERNATIONAL BOND INVESTING • -internationally diversified bond • portfolios offer superior performance

  18. INTERNATIONAL BOND INVESTING • A. Empirical Evidence • 1. Foreign bonds provide higher • returns • 2. Foreign portfolios outperform • purely domestic

  19. III. OPTIMAL INTERNATIONAL ASSET ALLOCATION • III. OPTIMAL INTERNATIONAL ASSET • ALLOCATION • -a diversified combination of stocks and • bonds • A. Offered better risk-return tradeoff • B. Weighting options flexible

  20. IV. MEASURING TOTAL RETURNSFROM FOREIGN PORTFOLIOS • IV. MEASURING TOTAL RETURNS • FROM FOREIGN PORTFOLIOS • A. Bonds • Dollar = Foreign x Currency return currency gain (loss) • return

  21. IV. MEASURING TOTAL RETURNSFROM FOREIGN PORTFOLIOS • Bond return formula: • 1 + R$ =[1 +B(1) - B(0) + C](1+g) • B(0) • where R$ = dollar return • B(1) = foreign currency bond price at time 1 • C = coupon income • g = depreciation/appreciation • of foreign currency

  22. IV. MEASURING TOTAL RETURNSFROM FOREIGN PORTFOLIOS • B. Stocks (Calculating return) • Formula: • 1 + R$ =[1+ P(1) - P(0) + D](1+g) • P(0) • where R$ = dollar return • P(1) = foreign currency stock price at time 1 • D = foreign currency annual • dividend

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