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IBUS 302: International Finance

IBUS 302: International Finance. Topic 16–Portfolio Analysis Lawrence Schrenk, Instructor. Learning Objectives. Calculate the return, standard deviation and correlation of foreign equity. ▪ Describe international diversification. Explain the International Asset Pricing Model (IAPM)

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IBUS 302: International Finance

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  1. IBUS 302: International Finance Topic 16–Portfolio Analysis Lawrence Schrenk, Instructor

  2. Learning Objectives • Calculate the return, standard deviation and correlation of foreign equity.▪ • Describe international diversification. • Explain the International Asset Pricing Model (IAPM) • Discuss home bias.▪

  3. Returns, Volatility, Correlation

  4. The Algebra of Portfolio Theory Assumptions • Nominal returns are normally distributed • Investors want more return and less risk in their functional currency Expected Return on a Portfolio E[rP] = Si xi E[ri] Portfolio Variance Var(rP) = sP2 = Si Sj xi xj sij where sij = rij si sj The algebra of portfolio diversification

  5. Expected Return on a Portfolio E[ri] σi American (A) 11.1% 16.9% Japanese (J) 15.7% 34.6% Example: Equal weights of A and J E[rP] = xA E[rA] + xJ E[rJ] = (½)(0.111)+(½)(0.157) = 0.134, or 13.4% The algebra of portfolio diversification

  6. Variance of a Portfolio Correlation E[ri] si A J A American 11.1% 16.9% 1.000 0.302 J Japanese 15.7% 34.6% 0.302 1.000 sP2 = xA2sA2 + xJ2sJ2 + 2 xA xJ rAJ sA sJ = (½)2(0.169)2 + (½)2(0.346)2 + 2(½)(½)(0.302)(0.169)(0.346) = 0.0459 sP = (0.0459)1/2 = 0.214, or 21.4% The algebra of portfolio diversification

  7. Diversification J Return r= -1 r = +1 r = +0.302 A s The benefits of international portfolio diversification

  8. 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 covariance (or correlation) with other assets in the portfolio. The benefits of international portfolio diversification

  9. InternationalPortfolio Diversification Return Potential for… • higher returns • lower portfolio risk W M rF s The benefits of international portfolio diversification

  10. Domestic versus International Diversification U.S. diversification only International diversification 1.0 0.5 26% 12% 5 10 15 20 25 Number of stocks in portfolio The benefits of international portfolio diversification

  11. International Stock Returns (1970-2006) Mean Stdev βW SI Value ($bn) Australia 11.5 24.2 0.194 0.976 932 Canada 11.9 19.5 0.262 0.975 994 France 14.4 27.9 0.272 1.109 1,698 Germany 13.8 29.8 0.235 1.117 1,213 Japan 15.7 34.6 0.257 1.355 2,969 Switzerland 14.4 24.2 0.314 0.973 970 U.K. 14.5 27.5 0.280 1.124 3,252 U.S. 11.1 16.9 0.254 0.849 14,968 World 11.3 17.0 0.265 1.000 32,785 U.S. T-bills 6.8 3.2 0.000 -0.015 - βW versus the MSCI world stock market index Sharpe Index (SI) = (rP- rF) / σP

  12. International Equity Correlations (1970-2006) Aus Can Fra Ger Jap Swi UK US Canada 0.603 France 0.405 0.485 Germany 0.342 0.404 0.665 Japan 0.315 0.326 0.392 0.355 Switzerland 0.408 0.465 0.629 0.679 0.418 U.K. 0.479 0.514 0.571 0.465 0.361 0.576 U.S. 0.496 0.719 0.501 0.463 0.302 0.515 0.534 World 0.584 0.732 0.676 0.637 0.666 0.683 0.695 0.854 The benefits of international portfolio diversification

  13. International Asset Pricing Model (IAPM)

  14. Capital Asset Pricing Model (CAPM) Review • All investors will choose to hold the market portfolio, i.e., all assets, in proportion to their market values. • This market portfolio is the optimal risky portfolio. • The part of a stock’s risk that is diversifiable does not matter to investors.

  15. Capital Asset Pricing Model (CAPM) Review • Risk • Diversifiable/Non-Market/Company Risk • Non-Diversifiable/Market/Risk • Only Market Risk Relevant! • Uses variance as a measure of risk • Specifies that only that portion of variance that is not diversifiable is rewarded. • Measures the non-diversifiable risk with beta, which is standardized around one.

  16. Beta • Market Beta = 1.0 = average level of risk • A Beta of .5 is half as risky as average • A Beta of 2.0 is twice as risky as average • A negative beta asset moves in opposite direction to market Exxon 0.65 AT&T 0.90 IBM 0.95 Wal-Mart 1.10 General Motors 1.15 Microsoft 1.30 Harley-Davidson 1.65

  17. Beta Calculation

  18. CAPM Equation r = rF + β(E[rM] - rF) r = Required Return on Asset rF = Risk-Free Rate of Return β = Beta Coefficient for Asset E[rM] = Expected Market Return

  19. Capital Asset Pricing Model (CAPM) Review Efficient Frontier Capital Market Line (CML) E[rj] M Investment opportunity set E[rM] rF σM s▪ Asset pricing models: CAPM

  20. International Asset Pricing Model (IAPM) • Global market portfolio in the IAPM includes all assets in the world weighted according to their market values. • IAPM assumes that investors in each country share the same consumption basket and purchasing power parity holds.

  21. Home Bias • Home bias refers to the extent to which portfolio investments are concentrated in domestic equities. • Possible Explanations • Domestic equities may provide a superior inflation hedge. • Home bias may reflect institutional and legal restrictions on foreign investment. • Extra taxes and transactions/information costs for foreign securities may give rise to home bias.

  22. Country Share in World Market Value Proportion of Domestic Equities in Portfolio France 2.6% 64.4% Germany 3.2% 75.4% Italy 1.9% 91.0% Japan 43.7% 86.7% Spain 1.1% 94.2% Sweden 0.8% 100.0% United Kingdom 10.3% 78.5% United States 36.4% 98.0% Total 100.0% Home Bias Data

  23. Home Bias Explanations • Barriers to International Investment • Regulatory and Tax Reasons • High Share of Non-Tradables in Consumption • Substitution of Investment in Foreign Assets by investment In Multinational Corporations (MNC) • Informational Imperfections

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