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International Financial Diversification

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The appeal of investments into international financial assets is founded on the perceived benefits of an international diversification strategy. In the search for lower volatility without a corresponding fall in returns, the interdependence of domestic and international markets and between foreign stock returns and exchange rates may support an improvement of the risk-adjusted performance of domestic portfolios. This is due to the strong positive correlation between domestic securities. Including international assets may raise the mean-variance efficient frontier above and to the left of that for domestic-only investment portfolios.

The expansion of international trade in goods and services, increasing economic and capital inter-dependence and advances in the choice of financial products and vehicles has resulted in a growing trend towards internationalising investment choices. Fundamentally therefore, it is increasingly easier and often wiser to look to the benefits of a diversified investment portfolio.

The International Capital Asset Pricing Model (ICAPM) equilibrium asserts that the expected return on a security will be the sum of all foreign currency risk premiums in addition to the market risk premium: ERi = Rf + βiw*RPw + γi1*RP1 + γi2*RP2 + γik*RPk and is also applicable to exchange rates, using the home currency as base. This infers that the opportunity to combine imperfectly correlated securities, strengthened through a global investment strategy, may push the frontier even higher. To explain the advantages of international diversification it’s fair to acknowledge the unrealistic ICAPM assumptions; firstly that all investors have identical consumption baskets and secondly that Purchasing Power Parity (PPP)1) holds.

This actually implies that the real exchange rate will not subsist, but instead exchange rates will just imitate inflation differentials. The importance of this lays in the fact that deviations from PPP are the main reason for variations in exchange rates, so exploiting the benefits of international investments in the real markets cannot be done without consideration of any persisting exchange rate risks. Notwithstanding, investors willing to appreciate and deal with any currency uncertainties may be able to capitalise on an international asset allocation. Diversification may be a good reason to invest globally because at least in theory benefits will come via either risk-reduction or greater returns. The simplified risk-return depiction below illustrates the basic returns advantage at a given level of risk:2)

risk_return.jpg

The reduction of specific volatility without affecting expected returns may be boosted in the case of international diversification. It should be possible to achieve exposure to only non-diversifiable risk in a faster time and more consistently. This is because the correlation coefficient structure between assets will demonstrate a broadly greater imperfect or negative form than within a solely domestic investment portfolio, with uncorrelated markets providing contrasting movement. Even with high standard deviations of non-domestic returns due to exchange rate risks, a small amount of international diversification tends to lower risk3). The implication of these theories is that where future exchange rates are certain, by holding an optimal combination of the risk-free asset in the home currency and the world market portfolio4) benchmark one is partly hedged against currency risk.

The empirical evidence that international diversification reduces risk and strengthens the risk-return trade off remains uniform and widespread. In simple terms this is evident in the proportions of capital market investment that have shifted into previously less attractive economies. Many of the portfolio selection studies, including Jorian (1985, 1986) have demonstrated the importance of controlling uncertainty parameters in order to achieve the potential benefits of international diversification. In addition, it has been shown that hedging foreign exchange risk can increase these gains further. However, justification of the role of investments into international financial assets becomes contentious where neither of these risks are controlled adequately, in which case investors should stick to domestic investments.

Much of the useful empirical analysis has been undertaken by Solnik. His studies in 1974 supported the notion that internationally diversified investments may achieve lower risk for a given number of securities held due to the correlation structure explained previously. He found the level of non-diversifiable risk among international stocks to be much lower than that for US stocks alone, at 11.7 percent and 27 percent respectively.

Jacquillat and Solnik (1978) tested to see if US investors could maintain investments within the domestic market and hope to receive the benefits of international diversification via the purchase of stocks of multinationals. Their conclusions went against this assertion, and found that the share prices behaved very much like domestic stocks and were largely unaffected by overseas elements.

Many studies5) have researched the form of hedging that will offer optimal results for international portfolios. One important and intuitive conclusion is that a currency hedge ratio, 'the proportion of the value of the portfolio that is currently hedged', will not necessarily be unitary but is generally specific to the assets and currencies in question.

Odier and Solnik (1993) assessed the correlation between markets. Their empirical evidence suggests that there is a clear potential advantage of international diversification. Equity markets evidenced a correlation of about 0.6 or less and the bond markets evidenced a correlation of about 0.5 or less. Notably, they conclude by promoting the advantages of diversifying both across industries and across countries. For example, a US stock investor should look towards the foreign bond market.

Cavaglia, Melas and Miyashita (1994) found that diversifying into overseas equity markets, across the then G-7 nations, could enhance risk – return trade-offs without bearing currency risks. In addition, the gains from investments across industries and countries were greater than those for simple country index replication strategies.

Elton and Gruber (1991 - 2000) present evidence that internationally diversified investments offer very low correlation coefficients relative to those found within a domestic market. Looking at monthly returns on market indices, their studies found the average correlation coefficient on foreign investments to be lower than that between a pair of US common stocks or between US indices.

An array of empirical studies has looked at potential gains and risks across countries and markets. Home country bias and other psychological, political and institutional factors appear to be significant determinants over investment choices, and evidence continues to highlight the benefits that may arise from an increased exposure to overseas markets. Significantly, the timing of the business cycle may explain the lower correlations between international markets across time. Other studies suggest there are potentially larger gains for smaller countries.

Some other important findings relate to currency risk. Research has found this risk is generally smaller than stock market risk but larger than bond market risk. This is because currency and market risk are not 'additive', with weak or negative correlation existing between currency and market movements:6) σ²F = σ²D + σ²C + 2ρσDσC. Thus, the contribution of currency risk should be measured for the total portfolio and not for individual markets and securities; although other findings show that the role of exchange rate risk in the total risk of a portfolio that includes a small proportion of foreign assets is insignificant.

Under the previous, and convenient, assumptions including no inflation, a combination of the domestic risk-free asset and the identical world equity market portfolio will hedge against exchange rate risk. This risk parameter arises because exchange rate fluctuations clearly impact upon the return to an investor on a foreign investment. By entering into a contract for future delivery of a security at a price fixed today using the forward market, it is possible to partially protect against these international monetary instabilities, but at best this may be only the expected outcome. Evidence within the foreign exchange markets suggests that historical and current pricing factors are actually better risk forecast determinants than the expected forward price. Without any element of hedging, or risk-transferral, against these fluctuations, an investor will simply be speculating on currencies.

Therefore, the task of assessing whether international diversification itself will be a useful strategy in the future must involve analysis of how low expected returns in foreign countries must be for an investor not to gain via international diversification.7) There are clear economic factors to consider. These include the taxation levels of overseas assets, differential taxation and transactions costs. This last factor alone may push the exchange rate above the free market rate. Over short time periods, the effects of currency cash-flow risks on international portfolios are more significant. This is because in the long-term, appreciation of one currency offsets the depreciation in another.

With exchange rates notoriously difficult to forecast, yet such a major factor in the determinant of other economic variables, research suggests the importance of focusing on the contribution of this troublesome risk parameter to the total risk of portfolio, as outlined above. An obvious first step would be to diversify securities across a range of currencies. Estimations of the risk and return dichotomy of international investments break down into two considerations. The first is an analysis of the home economy and effects on domestic financial assets in the home currency. The second is an analysis of the overall changes in exchange rates. This enables returns to be measured in both overseas and home currencies, and thus the market and exchange uncertainties may be better assessed via adoption of the chosen hedging technique.

Futures contracts are simply delayed purchases of securities, founded on assumed movements of the underlying, which involve agreements to trade particular securities at a specified price at a certain time in the future. They are useful devices for hedging because they lock in prices, thereby reducing uncertainty. Currencies can also form the underlying in a futures contract, and allow investors to enter into contracts in foreign currencies and hedge themselves against the risk of being on the down-side of a change in a cross rate. Cavaglia et al (1994) showed that the use of index futures overlays greatly improved the trade-off of risk and return across countries and across industries. The maximal reward to volatility ratio of 0.833 for a well diversified UK equity portfolio was distinctly lower than the respective ratio of 4.223 for the internationally diversified strategy.

Trading in options gives the buyer the right, but not the obligation, to buy or sell the underlying asset for a specified time period at a specified price. Call options give the investor the right to buy an asset at a specified price and put options give the investor the right to sell options at a specified price. If an option is in the money it can be sold to lock in a profit or, if it is believed that the option will continue to increase in value, it can be held until the option expires.

A swap is really a long dated forward commitment; simply an agreement to exchange future cash flows. To hedge against long-run exchange rate risks, a currency swap sets up an exchange of fixed cash flows in one currency for fixed cash flows in another, but the permutations are endless and depend on the investors’ risk profile, investment horizon and objectives.

Having established the desired risk-return profile, the choice of hedging means will consist of analysing the portfolio to determine the existence of symmetric and/or asymmetric risk (e.g. asset with embedded option) positions. By borrowing in the foreign currency, either futures, forwards or swaps will generally be used to hedge against symmetric risk, whereas the nature of options profiles lends themselves to the neutralisation of asymmetric risk.

References

Elton, E & Gruber, M Modern Portfolio Theory and Investment Analysis 6th Edition
Fabozzi, F.J (1999) Investment Management
Jacquillat, B & Solnik, B (1978) Multi-nationals are Poor Tools for Diversification Journal of Portfolio Management, 4, No.2, pp. 4-23
Larsen, G & Resnik, B (2000) The Optimal Construction of Internationally Diversified Equity Portfolios Hedged against Exchange Rate Uncertainty European Financial management Vol. 6, No. 4, 479-514
Solnik, B (1994) Lessons for International Asset Allocation Financial Analyst Journal, July


Finance

1) Defined as real prices of consumption goods being identical in all countries at all times
2) Where E(R) represents expected return and σ represents risk
3) Elton and Gruber, 1999-2000
4) Representing the total market value of all assets an investor would own if they purchased the total of all marketable assets on all the main global exchanges
5) Including those by Filatov and Rappoport (1992)
6) Where σF = foreign investment risk, σD = domestic market risk, σC = currency risk, and σF < σD + σC , because ρ < 1
7) Elton & Gruber Modern Portfolio Theory and Investment Analysis

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