chapter 15 Flashcards
Portfolio risk diversification
Security returns are substantially less correlated across countries than within a country. Intuitively, this is so because economic, political, institutional and even psychological factors affecting security returns tend to vary a great deal across countries, resulting in relatively low correlations among international securities.
Relatively low international correlations imply that investors should be able to reduce portfolio risk more
if they diversify internationally rather than domestically. Since the magnitude of g ains from international diversification in terms of risk reduction depend on the international correlation structure, it is useful to examine it empirically.
systematic risk
refers to the risk that remains even after investors fully diversify their portfolio holdings
world beta
measures the sensitivity of a national market to world market movements. National stock markets have rather distinct risk-return characteristics. THe mean return per month ranges from 0.44 percent for japan to 1.01 percent for sweden, whereas the standard deviation ranges from 4.59 percent for the united states to 9.04 percent for hong kong. Sweden has the highest world beta measure 1.23 while the united states has the lowest 0.88. This means that the swedish stock market is the most sensitive to worlk market movements and the US market the least sensitive
Sharpe performance measure
provides a risk adjustment performance measure. it represents the excess return (above and beyond the risk-free interest rate) per standard deviation risk.
sharpe performance measure formula
SHPi = R* - Rf/omegai
R* (R with a bar on top) = mean
omega = standard deviation
Rf = the risk free interest rate
We can measure hte gians from holding international portfolios in two different ways
The increase in the sharpe performance measure
The increase in the porfolio return at the domestic-equivalent risk level.
The increase in the sharpe performance measure, deltaSHP, is given by the difference in the sharpe ratio between the optimal international portfolio (OIP) and the domestic portfolio (DP), that is,
DeltaSHP =SHP(OIP) - SHP(DP)
DeltaSHP represents the extra return per standard deviation risk accruing from internation al investments. ON the other hand the increase in the portfolio return at the “domestic-equivalent” risk level is measured by the difference in return between the domestic portfolio (DP) and the international portfolio (IP) that has the same risk as the domestic portfolio. This extra return DeltaR accruing from international investments at the domestic-equivalent risk level, can be computed by multiplying DeltaSHP by the standard deviation of the domestic portfolio, that is,
DeltaR = (DeltaSHP)*(omegaDP)
The realized dollar returns for a US 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 dollar and the local (foreign) currency. Thus, the success of foreign investment rests on the performances of both the foreign security market and the foreign currency.
Formally the rate of return in dollar terms from investing in the ith foreign market, Ri$ is given by
Ri$ = (1+Ri)(1+ei) -1 = Ri + ei + Riei
Where Ri is the local currency rate of return from the ith foreign market and ei is the rate of change in the exchange rate between the local currency and the dollar; ei will be positive (negative) if the foreign currency appreciates (depreciates) against the dollar.
This expression suggests that exchange rate changes affect the risk of foreign investment as follows:
Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + deltaVar
Where the deltaVar term represents the contribution of the corss-product term, Riei, to the risk of foreign investment. Should the exchange rate be certain, only one term, Var(Ri), would remain in the right hand side of the equation.
Exchange rate fluctuations contribute to the risk of foreign investments through three possible channels
1) its own volatility, Var(ei)
2) Its covariance with the local market returns, Cov(Ri,ei)
3) The contribution of the corss-product term, deltaVar
by investing in international mutual funds, investors can
save any extra transaction and/or inform costs they may have to incur when they attempt to invest directly in foreign markets
circumvent many legal and institutional barriers to direct portfolio investments in foreign markets
Potentially benefit from the expertise of professional fund managers
Using country funds investors can
speculate in a single foreign market with minimum costs
Construct their own personal international portfolios using country funds as building blocks
Diversify into emerging markets that are otherwise practically incaccessible
closed-end country fund (CECF)
issues a given number of shares that trade on the stock exchange of hte host country as if the fund were an individual stock by itself.
Unlike shares of open-end mutual funds, shares of a closed end country fund cannot be redeemed at the underlying net asset value set at the home market of the fund
“two-factor” market model formula
Ri = alphai + betaUSi*Rus + betaHMiRHM + ei
Where
Ri= the return on the ith country fund
Rus = The return on the US market index provided by the standard and poors 500 index
RHM = the return on the home market of the country
betaUSi = the US beta of the ith country fund, measuring the sensitivity of the fund returns to the US market returns
betaHMi = the home market beta of the ith country fund, measuring the sensitivity of the fund returns to the home market returns, and
ei = the residual error term
World equity benchmark shares (WEBS)
originally designed and managed by Barclays global investors. In essence, WEBS are exchange-traded funds (ETFs) that are designed to close track foreign stock market indexes. Currently there are WEBS tracking the morgan stanley capital international indexes and for hella countriesE
