Chapter (25).

Dr. Muath Asmar
Investment & Portfolio
Management
AN-NAJAH
NATIONAL UNIVERSITY
Faculty of Graduate Studies

INVESTMENTS | BODIE, KANE, MARCUS
©2021 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Chapter Twenty Five
International
Diversification

• U.S. equities represent about 40% of world equities
and a far smaller fraction of total world wealth
• International investing
• Similar to earlier treatment of portfolio selection, except a
larger menu of assets
• Pose some problems not encountered in domestic markets
• E.g., exchange rate risk, restrictions on capital flows across national
boundaries, an added dimension of political risk and country-
specific regulations, and differing informational transparency in
different countries
Overview
©2021 McGraw-Hill Education 25-3

• By 2018, more than 25 countries had stock
markets with market capitalization above $100
billion
• U.S. accounts for 40.6% of world stock market
capitalization
• Developed countries account for 56% of world
GDP and 76.8% of world market capitalization
• Portfolio of equities of just the six countries with
the largest capitalization would make up over
two-thirds of the world portfolio
Global Markets for Equities

Market Capitalization and GDP of
Developed Countries

Market Capitalization of
Stock Exchanges in Emerging Markets

• Development of equity markets will serve as a
catalyst for enrichment of the population
• Developed code of business laws, institutions, and
regulations that allow citizens to legally own,
capitalize, and trade capital assets is an important
requirement for economic advancement
• Countries with larger capital markets also tend
to have higher levels of per capita GDP
Market Capitalization and GDP

Per Capita GDP vs. Market Cap as a
Multiple of GDP

• Investors everywhere tend to overweight
investments in their home countries (relative
to representation in the world portfolio) and
underweight investments in foreign assets
• This patterns holds true for investors around
the world, not just U.S. investors
Home-Country Bias

• When a U.S. investor invests abroad, the
dollar-denominated return depends on two
factors:
1. Performance of the investment in the local
currency
2. Exchange rate at which that investment can be
brought back into dollars
Exchange Rate Risk and
International Diversification

• The dollar-denominated return on the
investment in British bills is the following:
The pound-denominated return
The exchange rate “return”
Exchange Rate Risk
(1 of 2)
1
0
(1 )1 ( ) fr UK
E
E
r US      

• Exchange rate risk arises from uncertainty in
exchange rate fluctuations
• Currency volatility can be quite high, as evidenced
by the data in Table 25.3
• However, exchange rate risk may be mostly
diversifiable
• Investors can hedge exchange rate risk using a
forward or futures contract in foreign exchange
Exchange Rate Risk
(2 of 2)

• Interest rate parity relationship (or covered
interest arbitrage relationship)
Hedging Exchange Rate Risk
0
0
0
0
1 ( ) 1 ( )
rearranged:
1 ( )
1 ( )
f f
f
f
F
r UK r US
E
r USF
E r UK
    




Stock Market Returns

Exchange Rate Volatility

• Recall that estimates of mean returns are
extremely unreliable without very long data
series
• Estimates of volatility can be informed by
return variation within the sample period
• Increasing frequency of observations can increase
accuracy of risk estimates, which means precise
estimates are feasible even with relatively short
sample periods
Investment Risk in International
Markets

Stock Market Volatility

Index Model Regressions

• Benefits from diversification depend on the
correlation structure among securities
• International correlations have increased over time
• However, even naïve diversification provides
considerable benefit
• CAL supposed by the U.S. index has a Sharpe
ratio of 0.217, which is the highest ratio of any
country or region in the sample
• Despite this, its Sharpe ratio is considerably less
than the tangency portfolio
International Diversification

International Diversification:
Portfolio Standard Deviation

Efficient Frontier and CAL using
Country and Regional Stock Indexes

• Some studies suggest that correlation in country
portfolio returns increases during periods of
turbulence in capital markets
• If so, benefits from diversification would be lost exactly
when they are needed the most
• Roll’s findings suggest a common factor underlying
the movement of stocks around the world
• Market behavior repeated itself in the crisis of 2008,
vindicating Roll’s prediction from his study of the October
1987 crash
Are Benefits from International
Diversification Preserved in Bear Markets?

Regional Indexes around the Crash,
October 14–October 26, 1987

Beta and SD of Portfolios

• In principle, security analysis at the
macroeconomic, industry, and firm-specific
levels is similar in all countries
• In practice, getting information about foreign
assets can be quite difficult
• PRS Group (Political Risk Services) assesses
political risk by country
• Provide country composite risk ratings on a scale
of 0 (most risky) to 100 (least risky)
Political Risk

Composite Risk Ratings

Variables used in PRS’s
Political Risk Score

Country Risk Ranking by Category

Political Risk Points by Component

• Performance attribution
1. Currency selection
2. Country selection
3. Stock selection
4. Cash/bond selection
International Investing and
Performance Attribution

Example of Performance Attribution:
International

Chapter (25).

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