INTERNATIONAL FINANCE

BA, BAIT, BFB & BEF

TOPIC SIX
INTERNATIONAL PORTFOLIO THEORY

6.1 Portfolio theory

6.1.1. Meaning of a portfolio and international Portfolio.
A portfolio’s meaning can be defined as a collection of financial assets and investment tools that are held
by an individual, a financial institution or an investment firm. To develop a profitable portfolio, it is essential
to become familiar with its fundamentals and the factors that influence it. As per portfolio definition, it is
a collection of a wide range of assets that are owned by investors. The said collection of financial assets
may also be valuables ranging from gold, stocks, funds, derivatives, property, cash equivalents, bonds,
etc. Individuals put their money in such assets to generate revenue while ensuring that the original equity
of the asset or capital does not erode. Depending on one’s know-how of the investment market,
individuals may either manage their portfolio or seek the assistance of professional financial advisors for
the same. As per financial experts, diversification is a vital concept in portfolio management.

An international portfolio is a selection of stocks and other assets that focuses on foreign markets rather
than domestic ones. If well designed, an international portfolio gives the investor exposure to emerging
and developed markets and provides diversification. Multinational firms should advisedly allocate and
invest the financial resources at their disposal in different countries to minimise not only country specific
risk but also particular country’s market risk, which remains undiversifiable with domestic diversification.
This is viably possible because the macro- economic factors do not generally move in the same direction
at the same time in all countries. Holding investments in various countries would then be beneficial such
that bad news from one country could be compensated with good news from the other. Additionally, the
international investment offers a much broader range of opportunities than domestic investment alone. It
is worth noting; however, that the international diversification of projects and investments is being made
possible by globalisation, shrinkage of economic space and sophistication of capital markets.

6.1.2 The Portfolio theory

The Modern Portfolio Theory (MPT) refers to an investment theory that allows investors to assemble an
asset portfolio that maximizes expected return for a given level of risk. The theory assumes that investors
are risk-averse; for a given level of expected return, investors will always prefer the less risky portfolio.
Hence, according to the Modern Portfolio Theory, an investor must be compensated for a higher level of
risk through higher expected returns. MPT employs the core idea of diversification – owning a portfolio
of assets from different classes is less risky than holding a portfolio of similar assets.

Diversification is a portfolio allocation strategy that aims to minimize idiosyncratic risk by holding assets
that are not perfectly positively correlated. Correlation is simply the relationship that two variables share,
and it is measured using the correlation coefficient, which lies between -1≤ρ≤1.
A correlation coefficient of -1 demonstrates a perfect negative correlation between two assets. It means
that a positive movement in one is associated with a negative movement in the other. A correlation
coefficient of 1 demonstrates a perfect positive correlation. Both assets move in the same direction in

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response to market movements. A perfect positive correlation between assets within a portfolio increases
the standard deviation/risk of the portfolio. Diversification reduces idiosyncratic risk by holding a portfolio
of assets that are not perfectly positively correlated.

6.2 International Diversification

International diversification is referred as to holding investments of securities or assets in more than one
country with a view of minimising risks for targeted return level or maximising return for a given level of
risk.
This is an attempt to reduce risk by investing assets – locating projects in various nations of the world
and especially those whose economic cycles are not perfectly correlated. The international diversification
can be considered a viable strategy for risk reduction because correlation coefficients across markets
(countries) are reasonably low. As such it naturally accepted that the economic, political, institutional and
even psychological factors affecting securities’ (assets’) returns tend to vary a great deal across countries
which in turn results in relatively low correlations among international assets. More importantly the
broader the diversification the more stable the returns and the more diffuse the risks are expected to be.

The efficiency and effectiveness of international diversification as risk reduction strategy is influenced
and depends on the three main factors.
These factors are
(i) Intercountry correlations – whereby a reasonably low correlation across markets is expected
to be better off in realising benefits of international diversification
(ii) The variance (risk) of returns for each country’s assets (securities), and
(iii) The expected return in each individual country.
Highly asynchronous countries could contribute to low international correlations and hence benefits of
international diversification. It follows that, closely related countries in terms of economic, legal and
political settings cannot bring about benefits from assets diversified in those countries. This is because
the factors would influence the returns of such assets in the similar way – due to positive relationships
coefficients. In general, the international correlation structure strongly suggests that international
diversification can sharply reduce risk (Solnik, 1974). While a fully diversified domestic portfolio is as risky
as a typical individual stock, a fully diversified international portfolio is relatively less risky than typical
individual stock. This implies that when fully diversified an international portfolio can be less than half as
risky as a purely domestic portfolio. This is however, dependent on the correlation coefficients of returns
of assets allocated in different countries. The low correlations would suggest ability of the international
portfolio to reduce risks.

The international stock and bond diversification can therefore provide substantially higher returns with
less risk than investment in a global market. International diversification is not cost or risk free. As such
the investments of assets in different countries and holding of such investments in different foreign
currencies render the Multinational Corporations (MNCs) and other firms operating internationally with
peculiar risks such as different levels of inflation ( arising from different price levels across countries),
currency risks (due to changes in exchange rates) and political risks (changes in legal, institutional and
political conditions) which can to a great extent affect the prices and returns of international diversified
assets.

6.3 Return and Risks of International Portfolio.

6.3.1. Risk of a portfolio
Following MPT, risk can be lowered in a portfolio by investing in non-correlated assets. That is, an
investment that might be considered risky on its own can actually lower the overall risk of a portfolio

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because it tends to rise when other investments fall. This reduced correlation can reduce the variance of
a theoretical portfolio. In this sense, an individual investment's return is less important than its overall
contribution to the portfolio in terms of risk, return, and diversification.

The level of risk in a portfolio is often measured using standard deviation, which is calculated as the
square root of the variance. If data points are far away from the mean, the variance is high and the overall
level of risk in the portfolio is high as well.

To calculate the portfolio variance of securities in a portfolio, multiply the squared weight of each security
by the corresponding variance of the security and add two multiplied by the weighted average of the
securities multiplied by the covariance between the securities.

To calculate the variance of a portfolio with two assets, multiply the square of the weighting of the first
asset by the variance of the asset and add it to the square of the weight of the second asset multiplied
by the variance of the second asset. Next, add the resulting value to two multiplied by the weights of the
first and second assets multiplied by the covariance of the two assets.

The general formula is

Portfolio variance = w12σ12 + w22σ22 + 2w1w2Cov1,2

Where:

• w1 = the portfolio weight of the first asset

• w2 = the portfolio weight of the second asset
• σ1= the standard deviation of the first asset
• σ2 = the standard deviation of the second asset
• Cov1,2 = the covariance of the two assets, which can thus be expressed as p(1,2)σ1σ2,
where p(1,2) is the correlation coefficient between the two assets.

Example 1
Assume you have a portfolio containing two assets, stock in Company A and stock in Company B. While
60% of your portfolio is invested in Company A, the remaining 40% is invested in Company B.
The annual variance of Company A's stock is 20%, while
the variance of Company B's stock is 30%.
The wise investor seeks an efficient frontier, that's the lowest level of risk at which a target return can be
achieved.
The correlation between the two assets is 2.04.
To calculate the covariance of the assets, multiply the square root of the variance of Company A's stock
by the square root of the variance of Company B's stock.
Covariance (cov 1,2)= correlation x Standard deviation of company B x Standard deviation of company
a
=2.04x √0.2 x √0.3
= 0.499
=0.5
The resulting covariance is 0.5.

Portfolio variance = w12σ12 + w22σ22 + 2w1w2Cov1,2

=((0.6)2* (√0.2) 2 + (0.4) 2 * (√0.3) 2 + (2 * 0.6 * 0.4 * 0.5)).
= 0.072 + 0.048+ 0.24

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= 0.36
The resulting portfolio variance is 0.36, or

Standard deviation is √variance

SD= √0.36
=0.6
=60
Therefore, the risk of the portfolio is 0.6 0r 60%

If you consider that the investor wants to invest on a similar company with a similar risk portfolio as
company A or B but it should be allocated at a different county making the correlation of the two assets
zero (0)

The new risk of the portfolio will be

Covariance (cov 1,2)= correlation x Standard deviation of company B x Standard deviation of company
a
=0x √0.2 x √0.3
=0
=0
The resulting covariance is 0.

Portfolio variance = w12σ12 + w22σ22 + 2w1w2Cov1,2

=((0.6)2* (√0.2) 2 + (0.4) 2 * (√0.3) 2 + (2 * 0.6 * 0.4 * 0).
= 0.072 + 0.048+ 0
= 0.12
The resulting portfolio variance is 0.12, or 12?%

Standard deviation is √variance

SD= √0.12
=0.346
=0.35
Therefore, the risk of the portfolio is 0.35 0r 35%.
The risk of the same portfolio has reduced from 60% to 35% due to international diversification

NB: There for it is right to conclude that an international diversification of a portfolio reduces the
portfolio risk while retaining the same level of returns. The reduced risk is direct related to the effect of
the diversification on the correlation of the assets in that portfolio. Thus any international diversification
that reduced the correlation of assets in it will reduce the portfolio risk.

6.3.1. Return of a portfolio

An investor's expected return is the total amount of money they expect to gain or lose on a particular
investment or portfolio. Investors commonly use the expected return to help them make key decisions on
whether to invest in new vehicles or continue to hold on to their existing investments. The expected return
is generally based on historical returns. As such, it doesn't indicate the potential for future performance
and shouldn't be used as the only decision-making tool. This metric can, however, give investors a
reasonable expectation of what they may expect in the short- and long-run.

The expected return is calculated by multiplying the weight of each asset by its expected return.

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Then add the values for each investment to get the total expected return for your portfolio. Hence, the
formula:
Expected Portfolio Return = (Asset 1 Weight x Expected Return) + (Asset 2 Weight x Expected
Return)...

Example 2
The table below shows a portfolio with three different investments, each with different weightings and
expected returns.

Asset Weight Expected Return

A 35% 6%
B 25% 7%
C 40% 10%

Expected Portfolio Return = (Asset 1 Weight x Expected Return) + (Asset 2 Weight x Expected
Return)...
=(35% x 6%) + (25% x 7%) + (40% x 10%) = 7.85%
The expected return of the overall portfolio would be 7.85%.

6.3.3 Expected return and risk of internationally diversified portfolio

International portfolio is comprised of assets allocated in different countries. The returns and risks from
internationally diversified assets are generally measured in similar manner as those of domestic portfolio
except that the consideration is on the securities invested in different nations. To arrive at an expected
return of international portfolio one should consider the risks and returns in each market and the weights
of investment in each of those markets.
In a simplified manner, consider a world portfolio consisting two assets a fraction of which
- Wd is invested in domestic country’s stocks and the remaining fraction
- Wf) invested in foreign stocks.
Further, E (Rd) and E (Rf) is defined as returns on the domestic country and foreign country’s stock
respectively.
The expected return of international portfolio E (RP) can be calculated as:
E (RP) = WdE (Rd) + WfE (Rf)

Similarly, the standard deviation of international portfolio (σp), can be derived from the general formula
for the standard deviation of a two-asset portfolio with weights w1 and w2 (w1 + w2 = 1).

This is given as portfolio standard deviation (σp) =√ [w12Ó12 + w22Ó22 + 2w1w2r12Ó1Ó2]1/2.

Where; Ó12 and Ó22 are the respective variances of the two assets, Ó1 and Ó2 are their standard
deviations and
r12is their correlation.
To measure the risk of internationally diversified portfolio, the same formula can be applied by treating
the domestic and foreign portfolio as separate assets.
This yields an international portfolio standard deviation Óp equal to:
σp =√ [wd2Ódf + wf2Ó22 + 2wdwfrdfÓdÓf]

Example 3
Kilimanjaro Inc. Limited is a multinational company that has investments in five different developing
countries. One of the objectives of the Company is to reduce risk through international diversifications.
The Company however believes that the return on any investment from investment in five countries is

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not correlated with the return on any other investment. The details of investment such as the estimated
risk and return and the value in of each of the five investments are shown below

Required:
Estimate the risk and return of the portfolio of the five investments, and briefly explain the significance
of your results.
Solution
The Portfolio return – can be determined as the weighted average returns from the five investments.
It is given that:
Return from Rwanda (RRw) = 14%;
Return from Namibia (RNam) = 16%;
Return from Kenyan (RKe) = 12%;
Return from Tanzania (RTz) = 9%, and
Return from Lesotho (RLes) = 22%

The expected return of the international portfolio will be given as

Expected Portfolio Return = (Asset 1 Weight x Expected Return) + (Asset 2 Weight x Expected
Return)...
= [(0.25 *14%) + (0.20*16%) + (0.20* 12% + (0.25* 9%) + (0.10* 22%)]
= 13.55%.

Estimation of the portfolio risk (σp)

Given the weights of investment in each of the five countries, and the fact that the correlation coefficient
of the portfolio equals to 0 (The returns from the five countries is not correlated).
The risk of international portfolio can be estimated as follows:
= √[0.25² σ²rw + 0.2²σ²nam + 0.2²σ²ke + 0.25²σ²Tz +0.1²σ²les]
= √ [0.25²8² + 0.2²10² + 0.2²7² + 0.25²4² +0.1²16²]
= 3.7%

Significance of the results:

With a portfolio of only five investments the benefit or diversification have reduced portfolio risk, measured
by the standard deviation of expected returns, to approximately that of the lowest risk individual
investment. This portfolio risk reduction is quite large because of the lack of correlation between the
investments. The further away the correlation coefficient is from +1, the greater the risk reduction through
diversification.

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