International Corporate Finance Chp 16:International portfolio theory and diversification Xin Chen Visiting Associate Professor Aarhus School of Business
1 International Corporate Finance Chp 16: International portfolio theory and diversification Xin Chen Visiting Associate Professor Aarhus School of Business
Classical portfolio theory Maximize expected portfolio return per unit of expected portfolio risk. Separate total risk of a portfolio into two components systematic risk and unsystematic risk. --Systematic risk is the risk of the market itself(non- diversifiable). --Unsystematic risk is the risk of individual securities within the market and the portfolio (diversifiable). Increasing the number of securities in the portfolio reduces and ultimately eliminates the unsystematic risk the risk of the individual securities leaving only the risk of the market,the systematic risk
Classical portfolio theory Maximize expected portfolio return per unit of expected portfolio risk. Separate total risk of a portfolio into two components ： systematic risk and unsystematic risk. --Systematic risk is the risk of the market itself (non- diversifiable). --Unsystematic risk is the risk of individual securities within the market and the portfolio (diversifiable). Increasing the number of securities in the portfolio reduces and ultimately eliminates the unsystematic risk - the risk of the individual securities - leaving only the risk of the market, the systematic risk
Exhibit 16.1 Portfolio Risk Reduction Through Diversification Percent Variance of portfolio return risk Variance of market return 100 80 Total risk =Diversifiable risk+Market risk (unsystematic) (systematic) 60 40 Portfolio of U.S.stocks 27%… 20 Total risk Systematic risk 1 10 20 30 40 50 Number of stocks in portfolio When the portfolio is diversified,the variance of the portfolio's return relative to the variance of the market's return(beta)is reduced to the level of systematic risk-the risk of the market itself
Exhibit 16.1 Portfolio Risk Reduction Through Diversification
International Diversification and foreign exchange Risk The foreign exchange risks of a portfolio,whether it be a securities portfolio or the general portfolio of activities of the MNE,are reduced through international diversification. Purchasing assets in foreign markets,in foreign currencies may alter the correlations associated with securities in different countries (and currencies). 分 This provides portfolio composition and diversification possibilities that domestic investment and portfolio construction may not provide. The risk associated with international diversification,when it includes currency risk,is very complicated when compared to domestic investments
International Diversification and foreign exchange Risk The foreign exchange risks of a portfolio, whether it be a securities portfolio or the general portfolio of activities of the MNE, are reduced through international diversification. Purchasing assets in foreign markets, in foreign currencies may alter the correlations associated with securities in different countries (and currencies). This provides portfolio composition and diversification possibilities that domestic investment and portfolio construction may not provide. The risk associated with international diversification, when it includes currency risk, is very complicated when compared to domestic investments
EXHIBIT 15.2 Portfolio Risk Reduction Through International Diversification Percent_Variance of portfolio return risk Variance of market return 100 80 60 40 Portfolio of U.S.stocks 27%心… 20 Portfolio of international stocks 12% 1 10 20 30 40 50 Number of stocks in portfolio When the portfolio is diversified internationally,the portfolio's beta-the level of systematic risk that cannot be diversified away-is lowered