LECTURE 6 :

INTERNATIONAL
PORTFOLIO
DIVERSIFICATION /
PRACTICAL ISSUES

(Asset Pricing and Portfolio

Theory)
Contents
 International Investment
– Is there a case ?
– Importance of exchange rate
– Hedging exchange rate risk ?
 Practical issues
 Portfolio weights and the standard
error
 Rebalancing
Introduction
 The market portfolio
 International investments :
– Can you enhance your risk return profile ?
– Some facts
 US investors seem to overweight US stocks
 Other investors prefer their home country
 Home country bias
 International diversification is easy (and
‘cheap’)
– Improvements in technology (the internet)
– ‘Customer friendly’ products : Mutual funds,
investment trusts, index funds
Relative Size of World
Stock Markets (31st Dec.
2003)
US
UK
Japan
France
Germany
Switzerland
Canada
US Stock Australia
Market Holland
53% Italy
Spain
next 5 largest
10%
others
International
Investments
Benefits of
International
Diversification
Risk (%)
Non Diversifiable Risk

domestic

international

Number of Stocks
Benefits and Costs of
International
Investments
 Benefits :
– Interdependence of domestic and
international stock markets
– Interdependence between the foreign
stock returns and exchange rate
 Costs :
– Equity risk : could be more (or less than
domestic market)
– Exchange rate risk
– Political risk
– Information risk
The Exchange Rate
International
Investment
Investment horizon : 1 year

Domestic Investment rUS / ERUSD

$ $
(e.g. equity, bonds, etc.)

International Investment Euro rEuro / EREuro Euro

(e.g. equity, bonds, etc.) $
$
Example : Currency
Risk
 A US investor wants to invest in a British firm
currently selling for £40. With $10,000 to invest and
an exchange rate of $2 = £1
 Question :
– How many shares can the investor buy ? – A : 125
– What is the return under different scenarios ?
(uncertainty : what happens over the next year ?)
 Different returns on investment (share price falls to £ 35, stays at £40
or increases to £45)
 Exchange rate (dollar) stays at 2($/£), appreciate to 1.80($/£),
depreciate to 2.20 ($/£).
Example : Currency
Risk (Cont.)
Share £-Return $-Return $-Return $-Return
Price (£) S=1.80($/£) S=2.00($/£) S=2.20($/£)

£ 35 -12.5% -21.25% -12.5% 3.75%

£ 40 0% -10% 0% 10%

£ 45 +12.5% 1.25% 12. 5% 23.75%

How Risky is the
Exchange Rate ?
 Exchange rate provides additional dimension
for diversification if exchange rate and foreign
returns are not perfectly correlated
 Expected return in domestic currency (say £)
on foreign investment (say US)
– Expected appreciation of foreign currency ($/£)
– Expected return on foreign investment in foreign
currency (here US Dollar)
Return : E(Rdom ) = E(SApp ) + E(Rfor )
Risk : Var(Rdom ) = var(SApp ) + Var(Rfor ) + 2Cov(SApp , Rfor )
 Variance of USD
Returns
Country Ex. Rate Local 2 Cov
Ret.
Canada 4.26 84.91 10.83
France 29.66 61.79 8.55

Germany 38.92 41.51 19.57

Japan 31.85 47.65 20.50
Switzerl. 55.17 30.01 14.81
UK 32.35 51.23 16.52
Eun and Resnik (1988)
Practical
Considerations
Portfolio Theory :
Practical Issues
(General)
 All investors do not have the same views about expected
returns and covariances. However, we can still use this
methodology to work out optimal proportions / weights
for each individual investor.
 The optimal weights will change as forecasts of returns
and correlations change
 Lots of weights might be negative which implies short
selling, possibly on a large scale (if this is impractical you
can calculate weights where all the weights are forced to
be positive).
 The method can be easily adopted to include transaction
costs of buying and selling and investing ‘new’ flows of
money.
Portfolio Theory :
Practical Issues
(General)
 To overcome the sensitivity problem :
… choose the weights to minimise portfolio variance
(weights are independent of ‘badly measured’
expected returns).
… choose ‘new weights’ which do not deviate from
existing weights by more than x% (say 2%)
… choose ‘new weights’ which do not deviate from
‘index tracking weights’ by more than x% (say 2%)
… do not allow any short sales of risky assets (only
positive weights).
… limit the analysis to only a number (say 10) countries.
No Short Sales
Allowed (i.e. wi > 0)

E(Rp) Unconstraint efficient frontier

(short selling allowed)

Constraint efficient frontier

(with no short selling allowed)
- always lies within unconstraint
efficient frontier or on it
- deviates more at high levels of ER and σ

σ p
Jorion, P. (1992) ‘Portfolio
Optimisation in Practice’,
FAJ
Jorion (1992) - The
Paper
Bond markets (US investor’s point of view)

 Sample period : Jan. 1978-Dec. 1988

 Countries :
USA, Canada, Germany, Japan, UK, Holland, France
 Methodology applied :
MCS, optimum portfolio risk and return calculations
 Results :
– Huge variation in risk and return
– Zero weights :
US 12% of MCS
Japan 9% of MCS
other countries at least 50% of the MCS
Monte Carlo
Simulation and
Portfolio Theory
 Suppose k assets (say k = 3)
(1.) Calculate the expected returns, variances and
covariances for all k assets (here 3), using n-observations of
‘real data’.
(2.) Assume a model which forecasts stock returns :

Rt = µ + ε t

(3.) Generate (nxk) multivariate normally distributed

random numbers with the characteristics of the ‘real data’
(e.g. mean = 0, and variance covariances).
(4.) Generate for each asset n-‘simulated returns’ using the
model above.
Monte Carlo Simulation
and Portfolio Theory
(Cont.)
(5.) Calculate the portfolio SD and return of the
optimum portfolio using the ‘simulated returns
data’.
(6.) Repeat steps (3.), (4.) and (5.) 1,000 times
(7.) Plot an xy scatter diagram of all 1,000 pairs
of SD and returns.
Jorion (1992) - Monte
Carlo Results

True Optimal Portfolio

Annual Returns(%)

UK

Germany
US

Volatility (%)
Britton-Jones (1999) –
Journal of Finance
Britton-Jones (1999) –
The Paper
 International diversification : Are the optimal
portfolio weights statistically significantly
different from ZERO ?
 Returns are measured in US Dollars and fully
hedged
 11 countries : US, UK, Japan, Germany, …
 Data : monthly data 1977 – 1996 (two
subperiods : 1977–1986, 1986–1996)
 Methodology used :
– Regression analysis
– Non-negative restrictions on weights not used
Britten-Jones (1999) :
Optimum Weights
1977-1996 1977-1986 1987-1996
weights t-stats weights t-stats weights t-stats

Australia 12.8 0.54 6.8 0.20 21.6 0.66

Austria 3.0 0.12 -9.7 -0.22 22.5 0.74

Belgium 29.0 0.83 7.1 0.15 66 1.21
Canada -45.2 -1.16 -32.7 -0.64 -68.9 -1.10
Denmark 14.2 0.47 -29.6 -0.65 68.8 1.78

France 1.2 0.04 -0.7 -0.02 -22.8 -0.48

Germany -18.2 -0.51 9.4 0.19 -58.6 -1.13

Italy 5.9 0.29 22.2 0.79 -15.3 -0.52

Summary
 A case for International
diversification ?
– Empirical (academic) evidence : Yes
– Need to consider the exchange rate
 Portfolio weights
– Very sensitive to parameter inputs
– Seem to have large standard errors
 Suggestions to make portfolio theory
workable in practice.
References
 Cuthbertson, K. and Nitzsche, D.
(2001) ‘Investments : Spot and
Derivatives Markets’, Chapter 18
References
 Jorion, P. (1992) ‘Portfolio Optimization in
Practice’, Financial Analysts Journal, Jan-
Feb, p. 68-74
 Britton-Jones, M. (1999) ‘The Sampling
Error in Estimates of Mean-Variance
Efficient Portfolio Weights’, Journal of
Finance, Vol. 52, No. 2, pp. 637-659
 Eun, C.S. and Resnik, B.G. (1988)
‘Exchange Rate Uncertainty, Forward
Contracts and International Portfolio
Selection’, Journal of Finance, Vol XLII,
No. 1, pp. 197-215.
END OF LECTURE