The Case for International Diversification Flashcards
"a discuss the implications of international diversification for domestic equity and fixed-income portfolios, based on the traditional assumptions of low correlations across international markets; b distinguish between the asset return and currency return for an international security; c evaluate the contribution of currency risk to the volatility of an international security position; d discuss the impact of international diversification on the efficient frontier; e evaluate the potential p
Case for International Diversification
- Attractive correlation
- Superior expected returns
- Trends in barrier
Attractive Correlation
It is reduces the total risk if the foreign assets correlation with the domestic market is not too large.
- Degree of correlation is dependent on independence of nation’s economy and govet. policies.
- With equities - hedged and unhedged not much difference in correlation
- With bonds - hedged and unhedged are different
Currency exchanges have to be considered
Currency contribution
- Difference between the st. dev of foreign asset measured in dollars and st dev of foreign asset measured in its local currency
Portfolio Return Performance
Global investing should increase the sharpe ratio
- higher expected returns from faster growing economies and firms located around the world.
“Adding foreign bonds in a global asset allocation can be attractive from a risk–return viewpoint because of their low correlation with domestic bond and stock investments”
- Return is exactly equal to avg return of its components
Forward looking optimization
- It should be forward looking and not based on past performance
- Performance can be explained by economic factors
- Economic Flexibility also explains the investment performance
Currency risk not a barrier in international investment
- Currency is smaller than risk of corresponding stock market but larger than the corresponding risk of bond market.
- Market and currency are not additive
- Correlation of currency risk with asset price is important element. Smaller the correlation, better diversification
- Currency risk should be measured for the portfolio and not for individual securities
- Contribution of currency risk decreases with the length of investment horizon.
Case against international investment
- Increased correlation
- Historical results affects future
- Barriers
Correlation
- Increases over time due to following reasons:
a. Capital markets deregulated
b. Capital Mobility increased
c. National economies opening free trade
d. Corporations are becoming increasingly global - Correlation increases when markets are volatile
a. Distribution returns have fat tails
b. Market volatility varies over time but is contagious
c. Correlation increases dramatically in periods of high volatility
Past performance is a good indicator for future performance
Unlikely that one country will outperform all the time
Barriers to international investment
- Familiarity with foreign markets: Perceived more risky because are not familiar
- Political risk - unstable political, social, economic enviorment esp in emerging markets
- Market efficiency:i Liquidity - a. Volume related b. Imposition of capital controls on foreign investments ii. Reliable and timely information iii. price manipulation and insider trading
- Regulations: Limiting the foreign invesstments by local investors, limiting foreign investment in national companies
- Transaction Costs - a. brokerage commission b. price impact of trade c. custody costs d. management fees by international money managers
- Taxes: Withholding tax - results in opportunity costs
- Currency risk - though it can be hedged drawback of admin and trading costs
Case for international diversification revisited
- Correlation breakdown is spurious. Because the sample of volatile returns is not a true estimate of the return. Correlation increases during volatile times is biased.
- Emergence of new markets along with increased correlation. The asset classes have increased and there re more than just equity.
- Global investing rather than international diversification as companies have become global.
Global Investing than International Diversification
- Global Industry Factors: Industry factor has more influence on a company than country specific factor
- Regional and Country factors: The more global a company (eg toyota’s presence in US and Japan) the less sensitive to country headquarters factors
- Global Investing: Investors should be more global from their research to portfolio.
Case for emerging markets
Higher risk but higher return over longer term
Positive and moderate correlation with developed markets
Factors to be considered while investing in emerging markets
- Volatility, Correlations and Currency Risk
- Portfolio Return Performance
- Investability
- Segmentation versus Integration
Volatility, Correlations and Currency Risk - EM
Volatility: - Larger - Distribution of returns not symmetric - Probability of risk is much higher - Political and social crisis - Infrastruture can limit growth - Quality of goods - Corruption Correlation: - Periodic large crisis which are prolonged - Spread of crisis depends on the factors whetehr local or global Currency Risk: - Double whammy - becuase currency and stocks both are related to the economic factors
