A.Why is international diversification attractive to an investor who already has

Question

A.Why is international diversification attractive to an investor who already has a welldiversified domestic portfolio?

b. The Committee is considering two international funds. The funds are Compak, Canadian Small Cap fund, and ACME Emerging Market Growth fund. A fellow committee member voiced her opinion that the Canadian securities would not be particularly effective risk-reducing investments and will favor inclusion of ACME Emerging Market fund to the plan. Is she correct? Discuss the logic behind her opinion.

Explanation / Answer

A)

It is well known that stock market investing is risky. Both practitioners and theoreticians recommend holding a well-diversified portfolio to reduce risk. While mutual funds offer a quick and relatively inexpensive way to diversify, the purpose of this article is to address the issue of risk reduction through international diversification.[1] The article also provides support for the hypothesis that international market correlations increase after unexpected exogenous shocks. The implication is that diversification benefits may be reduced after such events. The tests of stability of market co-movements are based on before and after analyses of the September 11, 2001, terrorist events in the United States.

The paper considers an important problem that may interest retail and institutional investors, portfolio managers, corporate executives and policy makers. Knowing the correlations between the returns of various national markets is important for the process of allocating investments among these markets.

All of the major U.S. indices ended the year 2006 having logged double-digit gains. However, even though Standard & Poor’s 500 index turned in a 13.6 percent performance, an investor would have done better had he or she ventured outside the U.S. Using averages, domestic stock funds gained 12.6 percent in 2006 compared to 25.5 percent for international stock funds

Not surprisingly, Charles Schwab, a leading U.S.-based broker, recommends that its customers rebalance their portfolios in favor of foreign equities.[2] Many other financial advisors are also advising their clients to consider investment opportunities in overseas markets. While these recommendations by brokers may be specific to the current market conditions, globalization aided by advances in communication technology, abolition of capital and exchange controls, and deregulation in recent years, seem to have increased access to foreign markets.

CAPM and MPT Theories of Finance

Two well-known theories in the finance literature, the Capital Asset Pricing Model (CAPM) and the Modern Portfolio Theory (MPT), suggest that individual and institutional investors should hold a well-diversified portfolio to reduce risk. An institutional investor can achieve a well-diversified portfolio because the amount of funds in the portfolio is large enough for in-house diversification. Individual investors with limited wealth will have to find another way that does not require substantial funds to diversify their portfolios. Mutual funds offer a quick and relatively inexpensive way to diversify for small investors and others.

It is also argued that since differences exist in levels of economic growth and timing of business cycles among various countries, international portfolio diversification can be used as a means of reducing risk. In fact, the 1990s witnessed an explosion of international portfolio investment, especially among emerging markets. Mutual fund companies such as Janus and Templeton achieved phenomenal rates of return on their investments during the mid to late 1990s. It should be made clear that while performances of these mutual funds over the long haul vary, it is still true that diversification reduces risk at a given level of return.

Market Integration Influences

National economies have recently become more closely linked, not only because of growing international trade and investment flows, but also due to terms of international financial transactions. Influences contributing to an increased general level of correlation among markets and markets integration include the following:

1.    Development of global and multinational companies and organizations,

2.    Advances in information technology,

3.    Deregulation of the financial systems of the major industrialized countries,

4.    Explosive growth in international capital flows, and

5.    Abolishment of foreign exchange controls.

While some controversy exists among investment professionals regarding the benefits and costs of international portfolio investment, there is agreement that international equity portfolio diversification recommendations are based on the existence of low correlations among national stock markets.

On the other hand, if it is true, as some recent studies have shown, that cross-country correlation is increasing, due perhaps to the growing interdependence among the international markets, then benefits of international portfolio diversification may be overstated. In this article we aim to shed light on international equity market interdependence by utilizing data from three major equity markets for a relatively short time period. In examining the co-movements of American, Japanese, and German equity markets, we seek to identify diversification opportunities for international investors with the aim of lowering the investment risk. We also investigate the stability of the relationships among the markets after an unexpected, exogenous event.

Research on Markets

Research reveals that stock markets across the world are becoming more integrated. Madura found that correlations markedly increased over time.[3] Forbes and Rigobon tested the stock market contagion during the 1997 East Asian crisis, the 1994 Mexican Peso collapse, and the 1987 U.S. stock market crash.[4]

Research on the stability of market integration, on the other hand, indicates that volatility affects cross market correlations. Interested readers should consult Longin and Solnik[5] and Meric and Meric.[6] Their results indicate that the co-movements of equity markets increased significantly after the crash, implying that the benefits of international diversification decreased considerably.

Data and Methodology

We use the daily closing values of the Standard & Poor’s 500 Index (S&P 500), the Nikkei 225 Index, and the DAX 30 to represent the respective stock markets of the U.S., Japan, and Germany during the period of January 4, 1999 to February 28, 2002.

First, we examine trading in Japan, followed by the opening of the markets in Germany after the close of the Japanese market. The German market has a one-hour overlap with the U.S. stock market. Therefore, global information is already incorporated in the non-U.S. markets prior to the opening of the U.S. market. However, the developments in Germany and in the U.S. are not reflected in Japan until the following day.

We next focus our attention on the influence of the German market on that of the U.S. We close the loop by studying lagged correlations in terms of the U.S. market’s influence on Japan and Germany.

B)

Here there are 2 funds

    Committee members suggested ACME growth fund than Canadian small cap fund. Because he is in the opinion that That Canadian small cap fund would not effective risk reducing investments. The logic behind this is like. If you invest in growth plan and if you have a long term growth in that fund. I t is very helpful to you reinvest in the same fund.

One more logic is like suppose if you are expecting 15% return if your fund is giving 12% Than it is better to come out from the fund and invest in some other plan. If your fund is giving 18% return it is better to reinvest the return what you are getting from fund in the same fund.

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