Global Diversification

For Risk Reduction or Return Enhancement

Foreign assets are more risky because of

1. Asset volatility
2. Currency volatility

Correlation is not necessarily constant

Factors affecting correlations:

1. Government regulations
2. Monetary policy
3. Fiscal policy
4. Cultural
5. Technology specialization

International Bond Market correlation is usually low especially when the government has extreme policies

International Bond has low correlation with equity. So combining international bond and equity together will further lower the risk

Currency hedging is also important. With that, correlation is further reduced.

Since total return:

R_d = R_l + s + s(R_l)

s is the gain in local currency

The risk of total return is:

~Var(R_l)+Var(s)+2Sigma(R_I)Sigma(s)*correlation

Contribution of currency risk = sigma(R_d) – sigma(R_l)

Currency risk (sd) ~ 0.5 of foreign stocks

Currency risk (sd) ~ 2 of foreign bonds

Currency risk can be hedged

Currency risk can be diversified by hold multi-national currencies

Currency risk and asset risk are not addictive

Diversification may fail:

1. Correlation is increasing (due to multinational companies, free trades, integration, investors are active in international markets)
2. Correlation is highest when there is high volatility!
3. However, pt 2 may not be true as in econometrics, higher returns (absolute) equates to higher correlation: Need to do cross section plot to confirm

Barrier to Global Investments:

1. Transaction costs:
1. higher brokerage fee
2. price impact cost
3. custodial cost
4. record-keeping cost
5. Management cost – need to deal with different accounting system
2. Regulations: Due to both foreign and local (e.g. pension rules)
3. Tax: Some foreign countries with hold taxes
4. Currency risk –extra cost to deal with hedging and accounting
5. Political Risk
6. Market Efficiency
1. Liquidity
2. Availability of information
7. Lack of familiarity

International Investing: Only diversifying across countries

Global Investing: Diversifying countries and industries (because due to more integration globally, international investing is not enough. Also, industry are more narrowly focus on a single industry)

In developed countries, currency moves in opposite to stocks (e.g. devaluation makes products more competitive)

In developing countries, currency moves in the same direction (in crisis, foreign investors flee the country)

Investability in Emerging Markets

1. Discriminatory tax rules
2. Repatriation limitation
3. Illiquid causing price pressure
4. Limited free float
5. Restriction of foreign floating
6. Limited currency conversion

If fully integrated, emerging market return should be priced corresponding to the additional risk to the global portfolio