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MIS 4500 (31)

Chapter 27.docx

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University of Manitoba
Management Info. Systems
MIS 4500
Pourang Irani

Chapter 27: The Case for International Diversification Traditional case: risk reduction (from low2correl2tio2) and 2upe2ior expected returns  Portfolio variance of return: σ =pw σ + 1 σ 1 2w w 2 σ 2 ;Portf1li2 1,2 1 2d deviation of return: σ =pw σ 1 w 1 + 2w 2 ρ 2 σ 1 2 1,2 1 2 $  currency: return in $: r = r + s + (r x s); r is return in local currency and s is exchange rate movement; cross product usually ignored  var(r ) = var(r+s) = var(r) + var(s) + 2cov(r,s) = σ = σ + σ + 2ρσσ ; (ignoring cross 2 f2 s s 2 product); σ fs the variance of foreign asset in $; σ is variance in local currency; σ is s variance of exchange rate; and ρ is correlation of local currency asset return and exchange rate movement o contribution of currency risk is the difference between the combined standard deviation and the local currency equity return standard deviation.  historical correlation experience: o equity: generally low correlations across equity markets with or without currency hedging o bonds: low correlations when unhedged; regional blocs exist; hedged different b/c existence of “leaning against the wind” policies of raising interest rates to defend currencies  leads and lags: some lagged correlation but can be explained by differences in time zones and not by some international market inefficiency that is exploitable, and drastically reduced correlations for longer periods  Returns: int’l investing increases Sharpe ratios (both numerator and denominator effects) o consider active vs. passive; costs and benefits of both  Optimization must be based on forward-looking / expected returns: real growth; economic flexibility; o forecasts may already be reflected in asset prices  Currency risk: less than local equity risk but more than local bond risk o market and currency risks are not additive o currency risk can be hedged o should be measured for whole portfolio rather than individual markets; offsets o contribution of currency risk decreases as time period increases (PPP and mean reversion) Low correlations: factors causing equity market correlations across countries to be relatively low are independence of different nations’ economies and gov’t policies, technological specialization, independent fiscal and monetary policies, and cultural and sociological differences  for bonds: differences in national monetary and budgetary policies Case against int’l diversification:  increase in correlations: correlations have tre
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