Nov 26, 2020 in Coursework

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International Portfolio Diversification

Introduction

An investor chooses international portfolio investment since international portfolio diversification of assets assists in attaining higher risk attuned return. This implies that an investor is capable of reducing the risk and increase return via international investment (Gregoriou, 2007, p. 67).

Benefits of International Portfolio Diversification

Spread of Risks: Relationship between National Asset Markets

Due to risk repugnance, investors normally demand huge anticipated returns for taking up investments with higher risks. It is a clearly stated proposition in the theory of portfolio that risk is abridged by simply maintaining part of the wealth in a person's asset each time there is a faulty correlation between returns of assets. In general, an investor can attain minimum or maximum risk for a given expected portfolio return by choosing a portfolio as per anticipated returns, return variances, and the relationship between returns. In addition, with all factors constant, the lower the correlation between returns on various assets is, the higher the portfolio diversification benefits are. Since there are diverse structures in various nations and economies fail to outline similar business cycles, there is a basis for a meager relationship between anticipated returns and investments in several diverse states than in any single state. This implies that foreign investment provides diversification benefits that can only be enjoyed when people invest at home and in other states (Cai & Warnock, 2006, p. 143).

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Augmented Gain Size from Stock Diversification

A research study carried out by Bruno Solnik provides the gain size indication form together with foreign stocks in a portfolio. Bruno calculated the risk of arbitrarily chosen portfolios of x securities for diverse values of x in terms of portfolio volatility. For instance, a bigger portfolio number of two randomly chosen companies were created and their volatility and return computed. Then three randomly chosen companies' portfolios were created, and their volatility and return computed. As anticipated, it was shown that the volatility reduced as the inclusion of additional stocks increased. Besides, Bruno revealed that an international stocks portfolio has approximately half as much risk as a similar size portfolio having U.S. stocks only (Gregoriou, 2006, p. 45).

When Bruno considered other nations which possess meager stock markets, he noted that international diversification gains were not astonishingly much bigger than for the United States. In smaller states, there exist fewer chances to expand within the state than in bigger states. For instance, in the United States, it is reasonable to invest in almost all industries, which you cannot risk doing in smaller states such as Egypt or Denmark. Moreover, in bigger states including Britain and the US, there are frequently various multinational companies buying and selling their stock markets. This implies that investors holding local stocks attain international diversification in some way due to the extensive foreign activities of the companies in their countries. Nevertheless, the proof shows that there exist opportunities for extra diversification by venturing into overseas stock markets for the US (Cai & Warnock, 2006, p. 35).

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Abridged Risk from Exchange Rates

While there are benefits from international diversification in the independence between domestic and foreign stock profits, there is a possibility of extra risk from unexpected modifications in exchange rates when overseas stocks are seized. It is imperative to corroborate if this fully nullifies international diversification benefits from the existence of certain independence between returns of stock markets in various states. The answer is no. First, it is possible to expand globally without totting up the exchange rate disclosure by fiddling through forwarding the market, borrowing overseas currencies, or using currency or future options. The get-around should be based on the exposure in every money, as the regression coefficients give. Second, international portfolio diversification is helpful despite different exchange rates because even without reducing the dollar return variance, stocks that are internationally diversified remain lesser than the dollar return variance of the anticipated dollar return invested in the local stock market (Cai & Warnock, 2006, p. 34).

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How Global Funds Have Used the Concept of International Portfolio Diversification to Invest

A common investor can use many methods to invest in overseas markets without challenges.

American Depositary Receipt

American Depository Receipt (ADR) is negotiable security of non-US corporations that trade in the financial markets of US foreign companies. Several non-US companies shares trade on the stock exchange of the US through ADRs. American depositary shares are denominated and pay dividends in form of US dollars. They can be traded similarly to normal stocks. ADRs which are over the counter can only trade during the extended hours period. ADRs are utilized by overseas nations incapable of listing the NASDAQ or NYSE, which include regulations of the local country (Gregoriou, 2007, p. 65).

According to Hoffmeister, ADR returns are more volatile than the stocks of the US because of the added exchange rate uncertainty implicit in ADR prices. However, combined portfolios of ADRs and stocks of the United States exhibited notably lower variance as compared to mainly the US stocks portfolio. These findings are consistent with those of the international diversification analysis. Hence, ADRs have the capability to empower United States investors to cut on risks. ADRs can be sufficient substitutes during straight investment in overseas stocks (Cai & Warnock, 2006, p. 120).

International Funds

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International funds may be the finest means for a company to diversify globally. Investors can buy such funds shares with little investment like $1000. Investment Management Corporation regularly provides a variety of open-end global mutual funds. Some provide controlled portfolios, while others indexed funds. Others give global diversification without or with stocks of the US (Cai & Warnock, 2006, p. 89).

Investment in Multinational Corporation

Investment functions of at least two countries can be considered as a portfolio of several smaller companies (secondary) spread across the continent. Multinational Corporations (MNCs) should always be protected from their respective local markets since a notable part of their functions are in other states. The US stock-based MNC is not global; it can potentially serve as a passable surrogate for an international stock portfolio since they are undemanding for the person to invest in. MNCs seem to be an attractive way to diversify internationally. Solnik and Jacquillat tested if stocks of MNCs are a rational surrogate for overseas stocks (Gregoriou, 2007, p.45).

Conclusion

The benefits of international portfolio diversification include abridged risk from exchange rates, augmented gain size from stock diversification, and spread of risks among many others. Global funds such as American depositary receipt, international funds, and investment in Multinational corporations have always successfully used international portfolio diversification to invest.

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