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CONSTRUCTING AND TESTING THE WORLD MARKET PORTFOLIO FOR DOLLAR BASED INVESTORS

SUMMARY 1. The market portfolio is prominent in theoretical and practical asset pricingThe true market portfolio cannot be observed directlyWE ARGUE: It can be constructed from macro-economic cash flow dataINTUITION: ?market portfolio is the value of the economy . SUMMARY 2. We construct this pr

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CONSTRUCTING AND TESTING THE WORLD MARKET PORTFOLIO FOR DOLLAR BASED INVESTORS

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    1. CONSTRUCTING AND TESTING THE “WORLD MARKET PORTFOLIO” FOR DOLLAR BASED INVESTORS Ephraim Clark Kostas Kassimatis 1) International business risk is a wide ranging concept. Examples: - for the exporter it can mean currency risk on export transactions, or the imposition of tariffs, and quotas; - for the direct investment, merger or an acquisition it can mean losses or reduced profits due to macroeconomic mismanagement, exchange controls, expropriation or other types of government intervention; - for the lender it can mean payment delays and default; - for the portfolio investor it can mean market volatility, currency fluctuations, transaction costs such as brokerage fees, stamp duties, taxation and other regulations. The possibilities are limitless. 2) The international economic and financial consultant should be aware of what the risks are and how they can be assessed and managed. Examples: - in a foreign acquisition, the cost of possible losses due to government intervention or the volatility of cash flows caused by currency fluctuations should be factored into the evaluation process; - legal counseling is most effective when it anticipates potential conflicts and and advises on how they can be avoided or their effects minimized.1) International business risk is a wide ranging concept. Examples: - for the exporter it can mean currency risk on export transactions, or the imposition of tariffs, and quotas; - for the direct investment, merger or an acquisition it can mean losses or reduced profits due to macroeconomic mismanagement, exchange controls, expropriation or other types of government intervention; - for the lender it can mean payment delays and default; - for the portfolio investor it can mean market volatility, currency fluctuations, transaction costs such as brokerage fees, stamp duties, taxation and other regulations. The possibilities are limitless. 2) The international economic and financial consultant should be aware of what the risks are and how they can be assessed and managed. Examples: - in a foreign acquisition, the cost of possible losses due to government intervention or the volatility of cash flows caused by currency fluctuations should be factored into the evaluation process; - legal counseling is most effective when it anticipates potential conflicts and and advises on how they can be avoided or their effects minimized.

    2. SUMMARY 1 The market portfolio is prominent in theoretical and practical asset pricing The true market portfolio cannot be observed directly WE ARGUE: It can be constructed from macro-economic cash flow data INTUITION: “market portfolio is the value of the economy

    3. SUMMARY 2 We construct this proxy that we call the “world market portfolio” We test it over the period 1974-2003 IMPORTANT: this portfolio includes all assets including human capital IMPORTANT: this portfolio differs from other proxy portfolios in that it is not a simple summation of prices of individual assets and thus the tests do not suffer from the tautology problem.

    4. SUMMARY 4 The portfolio is efficient with respect to a broad asset universe that includes international money markets, medium and long term government bonds, stock market indices, commodities and real estate. It has a statistically significant correlation across all the asset classes. It is a powerful forecasting tool for constructing portfolios that outperform other popular portfolio proxies and benchmarks.

    10. The Model

    11. DATA Relevant quarterly macroeconomic and exchange rate data for 90 countries from Datastream over the period 1974-2003 and applied the procedures outlined above.

    12. WORLD MARKET PORTFOLIO Table 1 Summary statistics for quarterly returns of the World market portfolio Mean return 1.75% St. Devn. 3.36% Kurtosis 0.008 Skewness 0.20

    13. TESTING THE PORTFOLIO Quarterly data for four types of assets: stocks, government bonds, money markets and commodities. 1974 quarter 1 for most stocks, foreign exchange and some commodities, and 1985 quarter 2 for the remaining series. ending 2003, quarter 4 for all series. all data are available on Datastream. returns for all assets are in U.S. dollars and excess returns are computed using the 3 month U.S. T-bill rate.

    14. STOCKS 19 countries: Australia, Austria, Belgium, Canada, Denmark, France, Germany, Hong Kong, Ireland, Italy, Japan, Netherlands, Norway, Singapore, South Africa, Sweden, Switzerland, U.K. and U.S.

    15. BONDS 20 total return series: 10 year benchmark government bonds for Germany, Canada, France, Ireland, Japan, Austria, Switzerland, U.K. and U.S. 5 year benchmark government bond for Germany, Belgium, Canada, Denmark, France, Ireland, Japan, Austria, Sweden, Switzerland and U.K., a total of 20 series.

    16. MONEY MARKET 11 series: Australia, Belgium, Canada, Denmark, France, Germany, Italy, Japan, Netherlands, Switzerland and U.K.

    17. COMMODITIES total returns for five indices: Livestock, Precious Metals, Energy, Industrial Metals and Real Estate Goldman Sachs total return for first 4 The real estate index (NAREIT) is compiled by the National Association of Real Estate Investment Trusts (only US available)

    18. EFFICIENCY TESTS Regress excess return = a +br Gibbons et al (1989) multivariate test for the joint significance of the intercepts in the equation 1974Q1-2003: 28 series 1985Q2-2003: all 55 series

    19. Results on efficiency tests 1974 Q1 – 2003 Q4 Stocks: 0.734 (0.77) Stocks & Comm: 0.677 (0.85) Stocks & MM & Comm: 0.809 (0.73)

    20. Results on efficiency tests 1985 Q2 – 2003 Q4 Stocks 1.155 (0.33) Bonds 0.750 (0.76) MM 1.504 (0.15) Stocks & MM & Comm. 1.076 (0.41) Stocks & Bonds & Comm. 0.683 (0.88) Bonds & MM & Comm. 1.273 (0.23) MM & Comm. 1.510 (0.12) All assets 1.369 (0.21)

    21. Testing for Relevance in Returns and Risk Reduction Betas for assets estimated with the world market portfolio Stocks: significant for 13 out of 19 markets, 8 at the 1% level, 4 at the 5% level and 1 at the 10% level. Money markets: 10 betas are significant at the 1% level, while the beta for Canada is significant at the 10% level. Bonds: all betas are statistically significant, three at the 5% level and 17 at the 1% level. Commodities: two of the 5 betas are significant. Importantly, very few alphas are significant at conventional levels: eleven for stocks, one for the money market, four for bonds and one for commodities.

    22. OUT OF SAMPLE TESTING Ex ante portfolio construction Two portfolios: one for which we have prices from 1974Q1 to 2003 Q4 one for which we consider all assets in our sample from 1985Q2 to 2003Q4. the optimization is based on betas which are estimated using the previous 10 years of quarterly observations.

    25. Cumulative Return 1995-2003 Optimizing with the world market portfolio gives a cumulative excess return of 37% for the whole period, about 3.56% per annum. Optimizing with the MSCI gives a cumulative excess return of 6.7%, about 0.72% per annum.

    32. Summary We construct and test a portfolio more compatible with the “market portfolio” of financial theory Motivation: a superior portfolio will be more effective for empirical testing of financial data and for international investing. Intuition: the “market portfolio” of financial theory represents the total value of a national economy Rather than adding up values of individual assets to determine a proxy for the national “market portfolio”, we use the Hicks (1987) model of discounted macro-economic cash flows to calculate the value of the economy directly Avoid shortcomings of the popular proxy indices currently in use that generally exclude many asset classes and are vulnerable to the tautology weakness All assets are represented in the country “market portfolios” but no individual assets enter the portfolio directly, we also avoid the tautology weakness. Our international market portfolio proxy, which we call the world market portfolio, is calculated as the sum of the ninety national market portfolios in our sample.

    33. Conclusions Tests of this portfolio for its potential empirical relevance for model testing and portfolio building The portfolio is efficient with respect to a broad asset universe that includes international money markets, medium and long term government bonds, stock market indices, commodities and real estate It has a statistically significant correlation across all the asset classes It is a powerful forecasting tool for constructing portfolios that outperform other popular portfolio proxies and benchmarks.

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