Chapter 17

International Portfolio Theory and Diversification

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International Diversification and Risk

The case for international diversification of portfolios can be decomposed into two components, the first of which is the potential risk reduction benefits of holding international securities. This initial focus is on risk. The risk of a portfolio is measured by the ratio of the variance of a portfolios return relative to the variance of the market return (portfolio beta). As an investor increases the number of securities in a portfolio, the portfolios risk declines rapidly at first, then asymptotically approaches the level of systematic risk of the market.

A domestic portfolio that is fully diversified would have a beta of 1.0.

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Exhibit 17.1 Portfolio Risk Reduction Through Diversification

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International Diversification and Risk

The total risk of any portfolio is therefore composed of systematic risk (the market) and unsystematic risk (the individual securities). Increasing the number of securities in the portfolio reduces the unsystematic risk component leaving the systematic risk component unchanged.

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International Diversification and Risk

The second component of the case for international diversification addresses foreign exchange risk. The foreign exchange risks of a portfolio, whether it be a securities portfolio or the general portfolio of activities of the MNE, are reduced through international diversification. Purchasing assets in foreign markets, in foreign currencies may alter the correlations associated with securities in different countries (and currencies). This provides portfolio composition and diversification possibilities that domestic investment and portfolio construction may not provide. The risk associated with international diversification, when it includes currency risk, is very complicated when compared to domestic investments.

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International Diversification and Risk

International diversification benefits induce investors to demand foreign securities (the so called buy-side). If the addition of a foreign security to the portfolio of the investor aids in the reduction of risk for a given level of return, or if it increases the expected return for a given level of risk, then the security adds value to the portfolio. A security that adds value will be demanded by investors, bidding up the price of that security, resulting in a lower cost of capital for the issuing firm.

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Exhibit 17.2 Portfolio Risk Reduction Through International Diversification

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Internationalizing the Domestic Portfolio

Classic portfolio theory assumes a typical investor is risk-averse. This means an investor is willing to accept some risk but is not willing to bear unnecessary risk. The typical investor is therefore in search of a portfolio that maximizes expected portfolio return per unit of expected portfolio risk.

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Internationalizing the Domestic Portfolio

The domestic investor may choose among a set of individual securities in the domestic market. The near-infinite set of portfolio combinations of domestic securities form the domestic portfolio opportunity set (next exhibit).

The set of portfolios along the extreme left edge of the set is termed the efficient frontier.
This efficient frontier represents the optimal portfolios of securities that possess the minimum expected risk for each level of expected portfolio return.

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Internationalizing the Domestic Portfolio

The portfolio with the minimum risk along all those possible is the minimum risk domestic portfolio (MRDP). The individual investor will search out the optimal domestic portfolio (DP), which combines the risk-free asset and a portfolio of domestic securities found on the efficient frontier. He or she begins with the risk-free asset (Rf) and moves out along the security market line until reaching portfolio DP. This portfolio is defined as the optimal domestic portfolio because it moves out into risky space at the steepest slope.

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Exhibit 17.3 Optimal Domestic Portfolio Construction

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International Diversification and Risk

The next exhibit illustrates the impact of allowing the investor to choose among an internationally diversified set of potential portfolios. The internationally diversified portfolio opportunity set shifts leftward of the purely domestic opportunity set.

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Exhibit 17.4 The Internationally Diversified Portfolio Opportunity Set

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International Diversification and Risk

It is critical to be clear as to exactly why the internationally diversified portfolio opportunity set is of lower expected risk than comparable domestic portfolios. The gains arise directly from the introduction of additional securities and/or portfolios that are of less than perfect correlation with the securities and portfolios within the domestic opportunity set.

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International Diversification and Risk

The investor can now choose an optimal portfolio that combines the same risk-free asset as before with a portfolio from the efficient frontier of the internationally diversified portfolio opportunity set. The optimal international portfolio, IP, is again found by locating that point on the capital market line (internationally diversified) which extends from the risk-free asset return of Rf to a point of tangency along the internationally diversified efficient frontier.

The benefits are obvious in that a higher expected portfolio return with a lower portfolio risk can be obtained when compared to the domestic portfolio alone.

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Exhibit 17.5 The Gains from International Portfolio Diversification

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International Diversification and Risk

An investor can reduce investment risk by holding risky assets in a portfolio. As long as the asset returns are not perfectly positively correlated, the investor can reduce risk, because some of the fluctuations of the asset returns will offset each other.

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Exhibit 17.6 Alternative Portfolio Profiles Under Varying Asset Weights

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National Markets and Asset Performance

Asset portfolios are traditionally constructed using both interest bearing risk-free assets and risky assets. For the 100 year period ending in 2000, the risk of investing in equity assets has been rewarded with substantial returns. The true benefits of global diversification, however, arise from the fact that the returns of different stock markets around the world are not perfectly positively correlated. This is because the are different industrial structures in different countries, and because different economies do not exactly follow the same business cycle.

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Exhibit 17.7 Real Returns and Risks on the Three Major Asset Classes, Globally, 19002000

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Exhibit 17.8 Correlation Coefficients between World Equity Markets, 1900 2000

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National Markets and Asset Performance

Interestingly, markets that are contiguous or nearcontiguous (geographically) seemingly demonstrate the higher correlation coefficients for the past century. It is often said that as capital markets around the world become more and more integrated over time, the benefits of diversification will be reduced.

Analysis of market data supports this idea (although the correlation coefficients between markets are still far from 1.0).

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Exhibit 17.10 Comparison of Selected Correlation Coefficients between Stock Markets for Two Time Periods (dollar returns)

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Market Performance Adjusted for Risk: The Sharpe and Treynor Performance Measures
To consider both risk and return in evaluating portfolio performance, we introduce two measures:

The Sharpe Measure (SHP) = SHPi = Ri Rf

i

The Treynor Measure (TRN) = TRNi = Ri Rf

i

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Market Performance Adjusted for Risk: The Sharpe and Treynor Performance Measures
Though the equations of the Sharpe and Treynor measures look similar, the difference between them is important. If a portfolio is perfectly diversified (without any unsystematic risk), the two measures give similar rankings, because the total portfolio risk is equivalent to the systematic risk. If a portfolio is poorly diversified, it is possible for it to show a high ranking on the basis of the Treynor measure, but a lower ranking on the basis of the Sharpe measure.

As the difference is attributable to the low level of portfolio diversification, the two measures therefore provide complimentary but different information.
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Exhibit 17.9 Summary Statistics of the Monthly Returns for 18 Major Stock Markets, 19771996 (all returns converted into U.S. dollars and include all dividends paid)

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Chapter 17

Additional Chapter Exhibits

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Mini-Case Questions: Is Modern Portfolio Theory Outdated?

Why might the bell curve not be helpful when trying to construct and manage modern financial portfolios?
What risks are created if most of the major market agents are using the same models at the same times? Since the time of the article, the world economy has suffered a significant crisis. What elements of the article may have proved correct?
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