International Portfolio and the Diversification of Risk

Abstract

This chapter continues our study from Chap. 9 and Chaps. 12-13. We want to explore the particular question: to what extent one can diversify risk through an international portfolio of assets. There are two types of risks. The first type of risk is exchange rate risk. The second type of risk is asset specific risk in different countries. There are earlier studies on an international CAPM. Important mile-stones include work by Grubel (1966) who pursued studies on international equity markets in order to explore potential gains for U.S. investors from an international portfolio due to low correlations between equity indices of national markets. Here dividends are not included in the returns and only small samples were explored. Grubel’s work indicated a significant reduction in risk through international diversification. The work was pursued on the basis of the mean-variance framework as introduced in Chap. 9. Furthermore, Solnik (1973, 2000) extensively computed international portfolios and compared them to national portfolios. He also computed efficient frontiers of international portfolios. In recent times in particular Levich’s (2001) work has been concerned with international equity as well as bond portfolios. Here, as above mentioned, one of the major issues is the volatility of exchange rates. We thus first explore exchange rate risk arising from volatility of exchange rates.