Chapter Twenty Five

International Diversification
(48 slides)

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Top=Nasdaq, middle=S&P500, bottom=SSE (value
in 2019
if you invest $1 in 2010)

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 Index performance

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 Background

• By 2011, 52 • Total mkt. cap of corporate

countries have stock equity in 2011 was $38.2
markets with a mkt. trillion (U.S. = 36.4%).
cap over $1 billion. • Top six countries make up
• U.S. accounts for 64% of the world portfolio.
<40% • But is this diversified enough?
• Developed countries
account for 85%

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Distribution of countries with largest stock markets worldwide as of January 2021, by share of total
world equity market value
Countries with largest stock markets globally 2021

Market share of total world equity market value

0% 10% 20% 30% 40% 50% 60%

U.S. 55.9%
Japan 7.4%
China 5.4%
UK 4.1%
France 2.9%
Switzerland 2.6%
Germany 2.6%
Canada 2.4%
Australia 2.1%
South Korea 1.8%
Taiwan 1.7%

Note(s): Worldwide; January 2021

Further information regarding this statistic can be found on page 8.
2 Source(s): Credit Suisse; FTSE; MSCI; S&P Global; ID 710680
Table 25.1, Market Capitalization of
Stock Exchanges in Developed
Countries

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Table 25.2, Market Capitalization of
Stock Exchanges in Emerging
Markets

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 U.S. UK HONG KONG China
Rate (April Rate (April
Instrument Instrument Rate (Sep 2013) Instrument Instrument Rate (Sep 2013)
2003) 2003)
U.S. T-bills UK 5 Year Bond 2-year
Yield 1-year National
(2021/09/13 3 0.06% Government
(20210913) Bond (20210914)0.098%
Debt (20210913)
months) 0.42% 2.284%
Banker’s Banker’s Banker’s
1.22
acceptances acceptances acceptances 3.24%
Commercial Commercial
1.21
paper paper
1-year
Certificates of
Negotiable CDs 1.24 Certificates of
Deposit
0.86% [0-3y] Deposits 2.86%
Eurodollar 0% [no interest isEuro deposits
1.23 Euro deposits Euro deposits
deposits paid] 0.08% 0.70%
Tied to prime
Commercial Commercial Commercial Commercial
(4.25%) or 9.66%[1y]/5.25%
loans loans loans loans
LIBOR (1.29%) 7.90% [lowest] 0.051
10-year
U.S. T-notes UK Gilt 10 Year 10-year
0.0504 Government
and T-bonds Yield National Debt
2.84% Bond 2.93 4.44%
3.59% 2
Mortgages 5.57 Mortgages years/4.39% 5 Mortgages Mortgages
years 2.40% 6%
Municipal
4.84 Municipal bonds 地方债
bonds 2.90%
3.19%
Corporate Corporate Corporate
5.91 [7-10Y]/3.73%[1 corporate Bond
(AAA) bonds Bonds Bonds
0y+] 4.41% [7-10y] 4.5-5.72%
Preferred
6 to 9% Preferred stocks
stocks 5%-8%
Common Common Common
Common stocks
stocks 9 to 15% stocks stocks
(expected)
(expected) 2%-8% (expected) 3-7% (expected) 2%-8%
Weath
Foreign
Investment
exchange fund
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0.39% | products ( 理财产
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 Impossible Trinity
• Impossible Trinity is the conceptual structure in the
international economic sectors that mainly controls the cash
flow in and out of any country. This entire concept was
developed by John Marcus Flemming and Robert Alexander
Mundell in the year between 1960 and 1962. There have been
three dimensions mentioned in the structure which are as
follows-
• Fixed foreign exchange rate (for example RMB/US$)
• Free movement of capital (for example remit money abroad)
• Independent monetary policy (for example interest rate)

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 Background

• Clearly, U.S. stocks do not comprise a fully

diversified equity portfolio.
• International investing provides greater
diversification opportunities.
• It also carries some special risks.

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 Issues

• A developed stock market enriches the

population (Figure 25.1). However, certain issues
still remain.
• Home-country bias:
– Investors frequently overweight home-country
stocks.

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 Figure 25.1 Per Capita GDP and
Market Capitalization as Percentage
of GDP

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 Risk Factors in International
Investing
Foreign Exchange Risk
• Variation in return due to changes in the
exchange rate.
• Foreign investments may yield more or less
home currency than expected.
• A foreign investment is simultaneously an
investment in an overseas asset and in a
foreign currency.

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 Risk Factors in International
Investing

Two sources of variation

or risk:

1. Return expressed in local currency

2. Return obtained when local currency is

exchanged for home currency.

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 Example 25.1 Exchange Rate
Risk
• Suppose the risk-free rate in U.K. is 10% and the
current exchange rate is $2/£1.
• A U.S. investor with $20,000 can buy £10,000 and
invest them in risk free English assets to obtain
£11,000 in one year.
• If the £ depreciates to $1.80, the investment will
yield only $19, 800, a $200 loss(20,000-19,800).
• The investment was not risk free to a U.S.
investor even though invested in risk free English
assets!
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 Example 25.1 Exchange Rate
Risk
• The equation shows that the return to the U.S.
investor is:
– The pound-denominated return
– Multiplied by
– The exchange rate “return” (E1=exchange rate at period 1
and E0=current exchange rate[for example $2/pound],
– E1=1.8)
E1
1  r (US )   1  r f (UK ) 
E0

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 Figure 25.2 Stock Market Returns
in U.S. Dollars and Local Currencies
for 2010

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 Hedging Exchange Rate Risk

• Futures or forward (F0=current forward rate) markets

are used to hedge the risk.
• The U.S. investor can make a riskless dollar return
either by investing in UK bills and hedging exchange
rate risk or by investing in riskless U.S. assets.
F0
 1  rf (UK )  1  rf (US )
E0
rearranged:
F0 1  rf (US )

E0 1  rf (UK )
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 Political Risk

• In principle, security analysis at the

macroeconomic, industry, and firm-specific
level is similar in all countries.
• In practice, getting good information about
foreign investments can be more difficult.
• PRS Group (Political Risk Services) assesses
political risk by country. (next 3 slides, Russian stock
market, restriction imposed by Indian govt on Chinese
companies)

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Global stock market "Black
Tuesday": Russia fell another 10%,
the Asia-Pacific collectively fell,
European stocks opened low! The
situation in Russia and Ukraine has
escalated, and the Chinese
Ministry of Foreign Affairs: Once
again calls on all parties to
exercise restraint
2022-02-22 18:05:38 Source: Securities
Times (Russia recognizes the independence
of two Ukraine republics) 25-20
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February 17, 2022 19:38 Securities Daily
Reporter Jia Li

In response to the news that the Indian government

has launched a tax investigation against Huawei, on
February 17, Huawei relevant people told the
Securities Daily reporter: "At present, colleagues in
relevant departments have begun to deal with this
matter, and Huawei's operation in India strictly
complies with all laws and regulations."

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 Table 25.5 Variables used in PRS’s
Political Risk Score

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Table 25.6 Current Risk Ratings and Composite Risk
Forecasts (U.S. and Turkish data in next 3 slides)

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2022/2/2 MOSCOW (Sputnik) -
The national debt of the United
States has reached a record high
of $30.012 trillion amid a
significant increase in
government borrowings due to
the COVID-19 pandemic and
additional costs of supporting
health care, according to data
released by the US Department
of the Treasury.

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 February 3, 2022 Kakiforex.com
Jeremy Grantham believes US stock market may collapse by 50%

• Renowned investor Jeremy Grantham, who has previously predicted

market bubbles and their collapses, said that the US stock market crash
had already begun.
• He believes that many stocks and stock indices will lose at least 50% of
their maximum value. Grantham called the US stock market a "super
bubble". He thinks it is bound to burst as it was in 2000 or 2008.
• As evidence, Grantham produced several arguments.
• First, he focused on the Cathie Wood Ark Invest fund, specializing in high-
tech stocks. The fund's stock has sunk 52% over the past year.
• Second, Grantham pointed to the Russell 2000 Index, which contains
stocks of mid-cap companies.

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The annual inflation rate in Turkey accelerated for the
8th consecutive month to 48.69% in January of 2022,
the highest rate since April of 2002 and above market
forecasts of 46.68%. It compares with a much lower
rate of 14.91% a year earlier, as the lira remains
weak. Transportation prices recorded the biggest
increase (68.9%), followed by food and non-alcoholic
beverages (55.6%) and furnishings and household
equipment (54.53%). On a monthly basis, consumer
prices surged 11.1%. source:
Turkish Statistical Institute

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 Table 25.7 Composite and Political
Risk Forecasts

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 Table 25.7 Interpretation
• The table captures country risk through
scenario analysis.

• Risk stability is based on the difference in the

rating between the best- and worst-case
scenarios.

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 Table 25.8 Political Risk Points by
Component

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 Foreign Investment
Avenues
• Purchase securities directly in the capital
markets of other countries.
• American depository receipts (ADR)
• International mutual funds
• International ETFs (example next slide)

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International Stock (from U.S.News) 2/22 1st
China Region
• #1Franklin FTSE China ETF FLCH
• #2WisdomTree China ex-State-Owd Entpr ETF CXSE
• #3SPDR® S&P China ETF GXC
SEE THE FULL RANK LIST
Diversified Emerging Mkts
• #1Invesco BLDRS Emerging Markets 50 ADR ADRE
• #2SPDR® MSCI Em Mkts Fossil Fuel Free ETF EEMX
• #3Invesco S&P Emerging Markets Low Vol ETF EELV
Diversified Pacific/Asia
• #1iShares Core MSCI Pacific ETF IPAC
• #2Vanguard FTSE Pacific ETF VPL
SEE THE FULL RANK LIST
Europe Stock
• #1Franklin FTSE Europe ETF FLEE
• #2SPDR® Portfolio Europe ETF SPEU
• #3iShares MSCI Europe Small-Cap ETF IEUS

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 Risk and Return: Summary Statistics

• Analysis focuses on excess returns over the

risk-free rate, but differs across countries.
• Aggregated country-index portfolios, via value-
weighted portfolios of developed and
emerging markets based on mkt. cap.

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 Risk and Return: Summary Statistics

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 Are Investments in Emerging
Markets Riskier?
• For the overall portfolio, standard deviation of
excess returns is the appropriate measure of
risk.

• For an asset to be added to the current

portfolio, beta (covariance with U.S. portfolio)
is the appropriate measure of risk. Why?

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 Figure 25.3 Monthly Std Deviation of Excess
Returns (return in excess of T-bill rate) in
Developed, Emerging Markets

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 Figure 25.4 Index Dollar Return Beta
on U.S. Stocks, 2002–2011

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 Figure 25.5 Average Dollar-
Denominated Excess Returns

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 Average Country-Index Returns and
Capital Asset Pricing Theory

• Figure 25.5 shows a clear advantage to

investing in emerging markets.
• Results are consistent with risk ranking by
standard deviation, but not with ranking by
beta.
• Beta rankings may fail because of home-
country bias, which dominates international
investing.

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 Benefits from International
Diversification
•

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 Figure 25.11 International
Diversification

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 Figure 25.13 Efficient Frontier of
Country Portfolios

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 Are Benefits Preserved in Bear
Markets?
• Correlations between • Prediction:
countries may increase Diversification only
in a crisis. protects against
• Roll’s model suggests a country-specific events.
common factor • What happened in 1987
underlying the (Black Monday)? In
movement of stocks 2008 (financial tsunami)
around the world. ?

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 Figure 25.14 Regional Indexes
around the Crash, October 14–
October 26, 1987

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 Figure 25.15 Beta and SD of
Portfolios

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 Three Rules of Thumb
To passively diversify your portfolio, include
country indexes in order of:

1.Market capitalization (from high to low)

2.Beta against the U.S. (from low to high)
3.Country index standard deviation (from high
to low)

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 Figure 25.16 Risks and rewards of
international portfolios, 2000–2009

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 Performance Attribution

• The EAFE (Europe, Australia and the Far East)

index is a commonly used benchmark for
portfolio performance.
• Measure the contribution of:
1. Currency selection
2. Country selection
3. Stock selection
4. Cash/bond selection

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 Table 25.12 Example of
Performance Attribution:
International

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