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8/14/2019 Internationtal Diversification
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International Diversification
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Global market
US Market is 40% - 49% of all markets
Improved access & technologyNew instruments
Emphasis for our investigation
Risk assessment
Diversification
Background
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What are the risks involved in investment inforeign securities?
How do you measure benchmark returns onforeign investments?
Are there benefits to diversification in foreignsecurities?
Issues
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Foreign Exchange Risk
Variation in return related to changes in therelative value of the domestic and foreign
currency.Total return = investment return & return on
foreign exchange
Its not possible to completely hedge a foreign
investment.
Foreign Exchange Risk
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Return in US is a function of two factors:
1. Return in the foreign market
2. Return on the foreign exchange
Returns with Foreign
Exchange
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Condition: U.S. Investor invests $10,000 in theBritish Market
Initial Conditions:
Initial Investment : $20,000
Initial Exchange: $2.00/ Pound Sterling
Initial Investment in Pound Sterling: 10,000
Risk Free Rate in U.K.: 10%
Future Value in Pound Sterling: 11,000
Returns with Foreign Exchange:
Example
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Pound Depreciates to $1.80
11,000 * 1.8 = $19,800Return in US$ (-200 / 20,000) = -1%
Pound Remains at $2.00
11,000 * 2.0 = $22,000Return in US$ (2,000 / 20,000) = 10%
Pound Appreciates to $2.2011,000 * 2.20 = $24,200Return in US$ ( 4,200 / 20,000) = 21%
Returns with Foreign
Exchange
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Returns with Foreign
ExchangeMovements in foreign exchange can
have a major influenceFrom Figure 25.2New Zealand nearly 50% of return is from
foreign exchange
Australia virtually all of the return in fromforeign exchange
Returns from U.K. and Switzerland are
mostly from returns in local currencyBoth factors must be considered in
international investing
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Political Risk Services Group Ratings
Rank countries with respect to political risk,
financial risk and economic risk
Assign composite rating from very high risk
to very low risk based on the above
elements of risk
Country Specific Risk
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PSR Risk VariablesPolitical Risk Variables (country specific risk)
Government stability, corruption, changes inpolicies, etc
Financial Risk VariablesForeign debt (%GDP), Exchange rate stability
etc
Economic Risk VariablesGDP per capita, annual inflation etc
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Evidence shows international diversification is
beneficial.
Its possible to expand the efficient frontier
above domestic only frontier.
Its possible to reduce the systematic risk
level below the domestic only level.
Diversification Benefits
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Return
Risk
* *
*
**
* *
*Dom
Intl
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Risk
Securities
Intl
Dom
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Direct stock purchases
American depository receipts
Mutual Funds
Open-end funds
Closed-end funds
WEBS (World Equity Benchmarks)
International Investment
Choices
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Indexes
EAFE Index (Europe, Australia, Far East
index)
Issues in measuring performance
Weighting
Cross-Holdings
Other possibilities
Country and Region Funds
Measuring Benchmark
Returns
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Performance Attribution with
InternationalExtension to consider additional factors
Currency selection
Country selection
Stock selection
Cash and bond selection
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Efficient Market Hypothesis
(EMH)
Do security prices reflect information ?
Why look at market efficiency?
Implications for business and corporate
finance
Implications for investment
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SecurityPrices
Time
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Random Price ChangesWhy are price changes random?
Prices react to information
Flow of information is random
Therefore, price changes are random
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EMH and CompetitionStock prices fully and accurately reflect
publicly available information.Once information becomes available,
market participants analyze it.
Competition assures prices reflect
information.
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Forms of the EMH Weak
Semi-strong
Strong
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Types of Stock AnalysisTechnical Analysis - using prices and volume
information to predict future prices.
Weak form efficiency & technical analysis
Fundamental Analysis - using economic and
accounting information to predict stock prices.
Semi strong form efficiency & fundamentalanalysis
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Active or Passive
ManagementActive Management
Security analysis
Timing
Passive Management
Buy and HoldIndex Funds
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Market Efficiency & Portfolio
ManagementEven if the market is efficient a role exists for
portfolio management:
Appropriate risk level
Tax considerations
Other considerations
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Empirical Tests of Market
EfficiencyEvent studies
Assessing performance of professional
managers
Testing some trading rule
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How Tests Are Structured1. Examine prices and returns over time
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0 +t-t
Announcement Date
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How Tests Are Structured
(contd)2. Returns are adjusted to determine if they areabnormal.
Market Model approach
a. Rt= a
t+ b
tR
mt+ e
t
(Expected Return)
b. Excess Return =
(Actual - Expected)
et= Actual - (a
t+ b
tR
mt)
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How Tests Are Structured
(contd)2. Returns are adjusted to determine if they are
abnormal.
Market Model approach
c. Cumulate the excess returns overtime:
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Issues in Examining the
ResultsMagnitude Issue
Selection Bias Issue
Lucky Event Issue
Possible Model Misspecification
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What Does the Evidence
Show?Technical Analysis
Short horizon
Long horizon
Fundamental Analysis
Anomalies Exist
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AnomaliesSmall Firm Effect (January Effect)
Neglected Firm
Market to Book Ratios
Reversals
Post-Earnings Announcement Drift
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Explanations of
AnomaliesMay be risk premiums
Behavioral Explanations
Information Processing Errors
Behavioral BiasesLimits to Arbitrage
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Information ProcessingForecasting Errors
Overconfidence
Conservatism
Sample Neglect and Representativeness
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Behavioral BiasesAnchoringMental Accounting
Confirmation & Hindsight bias
Gamblers fallacyHerd behaviour
Over confidence
Overreaction and availability bias
Prospect theory
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Limits to ArbitrageFundamental Risk
Implementation Costs
Model Risk
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Mutual Fund PerformanceSome evidence of persistent positive and
negative performance.
Potential measurement error forbenchmark returns.
Style changes
May be risk premiums