Encyclopedic Dictionary of International Finance and Banking Phần 6 pdf

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can be used to estimate the required return on foreign projects, taking into account the world

market risk.

INTERNATIONAL CAPITAL BUDGETING

See ANALYSIS OF FOREIGN INVESTMENTS.

INTERNATIONAL CASH MANAGEMENT

See INTERNATIONAL MONEY MANAGEMENT.

INTERNATIONAL DEVELOPMENT ASSOCIATION

The International Development Association (IDA), a part of the World Bank Group, was

created in 1959 (and began operations in November 1990) to lend money to developing

countries at no interest and for a long repayment period. IDA provides development assistance

through soft loans to meet the needs of many developing countries that cannot afford devel￾opment loans at ordinary rates of interest and in the time span of conventional loans. The

Association’s headquarters are in Washington, D.C.

See also WORLD BANK.

INTERNATIONAL DIVERSIFICATION

International diversification is an attempt to reduce the multinational company’s risk by

operating facilities in more than one country, thus lowering the country risk. It is also an

effort to reduce risk by investing in more than one nation. By diversifying across nations

whose business cycles do not move in tandem, investors can typically reduce the variability

of their returns. Adding international investments to a portfolio of U.S. securities diversifies

and reduces your risk. This reduction of risk will be enhanced because international invest￾ments are much less influenced by the U.S. economy, and the correlation to U.S. investments

is much less. Foreign markets sometimes follow different cycles from the U.S. market and

from each other. Although foreign stocks can be riskier than domestic issues, supplementing

a domestic portfolio with a foreign component can actually reduce your portfolio’s overall

volatility. The reason is that by being diversified across many different economies which are

at different points in the economic cycle, downturns in some markets may be offset by superior

performance in others.

There is considerable evidence that global diversification reduces systematic risk (beta)

because of the relatively low correlation between returns on U.S. and foreign securities.

Exhibit 69 illustrates this, comparing the risk reduction through diversification within the

United States to that obtainable through global diversification. A fully diversified U.S.

portfolio is only 27% as risky as a typical individual stock, while a globally diversified

portfolio appears to be about 12% as risky as a typical individual stock. This represents about

44% less than the U.S. figure.

Exhibit 70 demonstrates the effect over the past ten years. Notice how adding a small

percentage of foreign stocks to a domestic portfolio actually decreased its overall risk while

increasing the overall return. The lowest level of volatility came from a portfolio with about

30% foreign stocks and 70% U.S. stocks. And, in fact, a portfolio with 60% foreign holdings

and only 40% U.S. holdings actually approximated the risk of a 100% domestic portfolio,

yet the average annual return was over two percentage points greater.

The benefits of international diversification can be estimated by considering the portfolio

risk and portfolio return in which a fraction, w, is invested in domestic assets (such as stocks,

bonds, investment projects) and the remaining fraction, 1 − w, is invested in foreign assets:

INTERNATIONAL CAPITAL BUDGETING

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EXHIBIT 69

Risk Reduction from International Diversification

EXHIBIT 70

How Foreign Stocks Have Benefitted a Domestic Portfolio

80

100

60

40

20

10 20 30 40 50

U.S. stocks

International stocks

18

17

16

15

Average Annual Returns (6/29/84—6/30/94)

Low Overall Portfolio Volatility High

100% U.S.

20% Foreign/80% U.S.

60% Foreign/40% U.S.

80% Foreign/20% U.S.

100% Foreign

40% Foreign/60% U.S.

INTERNATIONAL DIVERSIFICATION

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The expected portfolio return is calculated as follows:

rp = wrd + (1 − w)rf

where rd = return on domestic assets and rf = return on foreign assets.

The expected portfolio standard deviation is calculated as follows:

where σd and σf = standard deviation on domestic and foreign assets, respectively, and ρdf =

correlation coefficient between domestic and foreign assets.

The risk of an internationally diversified portfolio is less than the risk of a fully diversified

domestic portfolio.

EXAMPLE 71

Suppose that three projects are being considered by U.S. Minerals Corporation: Nickel projects

in Australia and South Africa and a zinc mine project in Brazil. The firm wishes to invest in two

plants, but it is unsure of which two are preferred. The relevant data are given below.

Possible portfolios and their portfolio returns and risks are the following:

Component Projects

Nickel Projects Zinc Mine

Australia South Africa Brazil

Mean return 0.20 0.25 0.20

Standard deviation 0.10 0.25 0.12

Correlation coefficient 0.8

0.2

0.2

A. Australian and South African Nickel Operations:

Mean return = 0.5(0.20) + 0.5(0.25) = 0.225 = 22.5%

Standard deviation

B. Australian Nickel Operation and Brazil Zinc Mine:

Mean return = 0.5(0.20) + 0.5(0.20) = 0.20 = 20%

Standard deviation

C. South African Nickel Operation and Brazil Zinc Mine:

Mean return = 0.5(0.25) + 0.5(0.20) = 0.225 = 22.5%

Standard deviation

σp w2

σd

2 ( ) 1 – w 2

σ f

2 2ρd.f

2 = + + w( ) 1 – w σdσf

( ) 0.5 2

( ) 0.10 2 ( ) 0.5 2

( ) 0.25 2 = + + 2 0.8 ( )( ) 0.5 ( ) 0.5 ( ) 0.10 ( ) 0.25

= 0.168 16.8% 0.028125 = =

( ) 0.5 2

( ) 0.10 2 ( ) 0.5 2

( ) 0.25 2 = + + 2 0.2 ( )( ) 0.5 ( ) 0.5 ( ) 0.10 ( ) 0.12

= 0.085 8.5% 0.0073 = =

( ) 0.5 2

( ) 0.10 2 ( ) 0.5 2

( ) 0.25 2 = + + 2 0.2 ( )( ) 0.5 ( ) 0.5 ( ) 0.25 ( ) 0.12

= 0.149 14.9% 0.02223 = =

INTERNATIONAL DIVERSIFICATION

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