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100
F I G U R E 21.3
90 Developed countries
Standard deviation (%)




80 Annualized standard
Emerging markets
deviation of
70
investments across
60
the globe,
50
1997“2001.
40
30
20
10
0
5 10 15 20 25
Rank
Developed countries and emerging markets are ranked from low to high standard deviation



737
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition




738 Part SIX Active Investment Management




Average annualized return (%)
F I G U R E 21.4 40
Annualized average 30 Developed countries
return of investments Emerging markets
20
across the globe,
1997“2001. 10
0
10
20
30
5 10 15 20 25
Rank
Developed countries and emerging markets are ranked from low to high standard deviation




Are Average Returns in Emerging Markets Greater?
Figure 21.4 repeats the previous exercise for average returns. The graphs show that investing in
emerging markets generally provided lower returns than investing in developed countries. Of
course these data are far from conclusive since five-year averages are still subject to consider-
able imprecision. The fact that a number of markets averaged a negative rate of return is proof
positive that expectations were not realized over the period and hence these data are inadequate
for risk-return analysis. But regardless of these qualifications, we should not even expect any
clear relationship since the higher standard deviation of emerging market equities is not an
adequate measure of risk. In the context of a diversified international portfolio, the risk of
any single market is measured by its covariance with the overall portfolio. Assessment of the
proportion of systematic risk in country portfolios can be gleaned from the correlation matrix
that we will examine shortly. First, we inquire about the role of exchange rate risk in overall
country risk.

Is Exchange Rate Risk Important in International Portfolios?
Table 21.3 revealed that changes in exchange rates are not highly correlated across countries.
This feature suggests that when international portfolios are well diversified, the exchange rate
component of overall risk will be effectively diminished. Another feature that would render
exchange rate risk diversifiable is low correlation between changes in exchange rates and
country stock returns in local currencies.
In Figure 21.5, all 45 stock markets are ordered from low to high standard deviation of re-
turns in U.S. dollars. The figure contrasts the graph of standard deviation of returns in local
currency with that of returns in U.S. dollars. The graphs are quite close in most cases, rein-
forcing the notion that hedging exchange rate risk is not crucial in well-diversified interna-
tional portfolios.

Benefits from International Diversification
Table 21.11 presents correlations between returns on stock and long-term bond portfolios in
various countries. Panel A shows correlation of returns in U.S. dollars, that is, returns to a U.S.
investor when currency risk is not hedged. Panel B shows correlation of returns in local cur-
rencies, that is, returns to a U.S. investor when the exchange risk is hedged. As noted earlier,
the correlation coefficients of the hedged (local currency) and unhedged (U.S. dollars) returns
are very similar, confirming that hedging currencies is not a significant issue in diversifying
internationally.
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition




739
21 International Investing




F I G U R E 21.5
100
90 Standard deviation of
Standard deviation of the US dollar return
Standard deviation (%)




investments across
80 Standard deviation of return in local currency
the globe in U.S.
70
dollars vs. local
60
currency,
50
1997“2001.
40
30
20
10
0
0 10 20 30 40 45
Rank
Developed countries and emerging markets are ranked from low to high standard deviation




The correlation coefficients between a stock index of one country and bond portfolios of
another are very low, suggesting that income portfolios that are balanced between stocks and
bonds would greatly benefit from international diversification. The correlation among
unhedged stock portfolios of the countries in Table 21.11A is much larger, in the range of .45
(Japan“Germany) to .89 (France“Germany). These correlation coefficients are much larger
than conventional wisdom; they suggest that cross-border correlation of stock indexes has
been increasing. For another, independent example, Table 21.12 shows the correlation of
various country indexes with U.S. stocks using monthly excess returns over the period
1970“1989, next to the same coefficients estimated over 1996“2001. The marked increase in
correlation with 17 stock indexes and the world portfolio is uniform.
These results raise the question of whether the increase in correlation is an artifact of the
sample period or a result of globalization and increased capital market integration that would
be expected to increase cross-border correlation. While there is no question that a five-year
sample period is quite short and limits precision, the fact that we find the increase in correla-
tion across the board suggests that globalization and market integration are the more plausible
cause, as discussed in the nearby box.
The observed high correlation across markets brings into question the conventional wisdom
of large diversification benefits from international investing. This conventional wisdom is de-
picted in Figure 21.6, which is based on data for the period 1961“1975. Figure 21.6 suggests
that international diversification can reduce the standard deviation of a domestic portfolio by as
much as half (from about 27% to about 12%). This improvement may well be exaggerated if
correlation across markets has markedly increased as data from recent years suggest. Still, ben-
efits from international diversification are significant, as we will show shortly. But first it is
well to dispose of a misleading, yet widespread, representation of benefits from diversification.

Misleading Representation of Diversification Benefits
The baseline technique for constructing efficient portfolios is the efficient frontier. A useful ef-
ficient frontier is constructed from expected returns and an estimate of the covariance matrix of
returns. This frontier, combined with cash assets generates the capital allocation line, the set of
efficient complete portfolios, as elaborated in Chapter 6 and the first section of Chapter 7. The
benefit from this efficient diversification is reflected in the curvature of the efficient frontier.
Other things equal, the lower the covariance across stocks, the greater the curvature of the effi-
cient frontier and the greater the risk reduction for any desired expected return. So far, so good.
740
TA B L E 21.11
Correlations for asset returns; unhedged and hedged currencies

A. Correlation of month™s asset return 1997“2001 in $U.S. (unhedged currencies)
Stocks Bonds
Fifth Edition




Asset/Country U.S. Germany U.K. Japan Australia Canada France U.S. Germany U.K. Japan Australia Canada France
Bodie’Kane’Marcus:




U.S. 1.00
Essentials of Investments,




Germany 0.75 1.00
U.K. 0.83 0.80 1.00
Japan 0.58 0.45 0.57 1.00
Australia 0.71 0.62 0.73 0.60 1.00
Canada 0.82 0.74 0.73 0.52 0.67 1.00
Management




France 0.70 0.89 0.82 0.49 0.57 0.70 1.00
U.S. Treas. 0.09 0.17 0.08 0.00 0.11 0.11 0.08 1.00
VI. Active Investment




Germany 0.00 0.06 0.03 0.25 0.19 0.01 0.02 0.77 1.00
U.K. 0.11 0.17 0.13 0.07 0.08 0.00 0.06 0.83 0.76 1.00
Japan 0.02 0.09 0.12 0.04 0.06 0.04 0.02 0.80 0.57 0.72 1.00
Australia 0.00 0.12 0.04 0.01 0.08 0.15 0.01 0.88 0.70 0.71 0.71 1.00
Canada 0.00 0.08 0.00 0.03 0.05 0.12 0.03 0.88 0.75 0.65 0.64 0.90 1.00
France 0.06 0.03 0.07 0.24 0.18 0.04 0.05 0.69 0.98 0.66 0.46 0.63 0.72 1.00

B. Correlation of monthly asset return 1997“2001 in local currency (hedged currencies)
21. International Investing




Stocks Bonds

Asset/Country U.S. Germany U.K. Japan Australia Canada France U.S. Germany U.K. Japan Australia Canada France

Stocks
U.S. 1.00
Germany 0.78 1.00
U.K. 0.83 0.78 1.00
Japan 0.55 0.51 0.46 1.00
Australia 0.72 0.60 0.73 0.47 1.00
Canada 0.80 0.75 0.77 0.47 0.66 1.00
France 0.75 0.90 0.82 0.51 0.56 0.74 1.00
Bonds
U.S. 0.09 0.22 0.06 0.05 0.03 0.12 0.13 1.00
Companies, 2003




Germany 0.02 0.11 0.01 0.19 0.08 0.01 0.03 0.82 1.00
© The McGraw’Hill




U.K. 0.13 0.18 0.12 0.07 0.02 0.05 0.10 0.85 0.79 1.00
Japan 0.06 0.18 0.12 0.01 0.02 0.06 0.11 0.82 0.66 0.78 1.00
Australia 0.05 0.19 0.06 0.01 0.04 0.16 0.10 0.92 0.81 0.77 0.77 1.00
Canada 0.02 0.12 0.01 0.03 0.01 0.11 0.04 0.89 0.85 0.71 0.67 0.95 1.00
France 0.05 0.08 0.05 0.20 0.09 0.00 0.00 0.76 0.98 0.70 0.57 0.76 0.83 1.00
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition




741
21 International Investing


Sample Period
TA B L E 21.12 (monthly excess returns in $U.S.)
Correlation of U.S.
1967“2001* 1970“1989**
equity returns with

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