International Portfolio Diversification Essay Example | Topics and Well Written Essays - 2750 words

International Portfolio Diversification - Essay Example Investing on the stock market can be a very risky venture. According to Yavas (2007), both the Capital Asset Pricing Model (CAPM) and the Modern Portfolio Theory (MPT) indicates that investors should hold a well diversified portfolio in order to reduce risk. Beta is used to measure risk. A stocks beta indicates the sensitivity of the stock’s returns to the market returns (Madura 2006, p. 304). Madura (2006, p. 304) states that investors who have a diversified portfolio use beta to determine how well their portfolio reflects movements in the market. Investors believe that favourable characteristics that are related specifically to a particular firm will offset unfavourable characteristics of other firms. This is also true for industries and so it implies that a wide range of stocks spanning various industries should be held. It is expected that certain factors affecting securities on the stock market are either firm or industry specific and so in order to reduce unsystematic ri sk holding securities from a wide range of industries is recommended. This is also true in relation to national securities. Certain risks are country specific and so in order to reduce risk international portfolio diversification is recommended. This paper examines how International portfolio diversification can result in a reduction in portfolio risk. It looks at various elements of risk that are associated with portfolio. It looks at market returns in five countries and shows how correlation between these markets can impact negatively on portfolio risk reduction. An analysis is also carried out to determine whether of the returns on stock markets in Japan and Canada are integrated based on their trade relationships over the years. The findings from other studies are also explored to determine how they concur with the results from this research. How can international diversification reduce risk? There are differences in the level of economic growth among countries. Some are develop ed while others are developing. Yavak (2007) states that these differences can lead to portfolio risk reduction as the timing of business cycles are usually different. According to Eiteman et al (2007) the case for international portfolio diversification can be broken down into two components. They are the potential risk reduction benefits of holding international securities and the potential foreign exchange risks that comes with it. Portfolio risk reduction The risk associated with a portfolio of securities is measured by the ratio of the variance of the return on the portfolio in relation to the variance of the market return (Eiteman et al 2007). As noted earlier, this is represented by beta. As the number of securities in the portfolio increases the portfolios beta approaches the market beta. A portfolio that is fully diversified would have a beta that is equal to 1. Therefore the risk that is associated with holding a particular stock can be reduced through diversification. How ever, risk cannot be eliminated totally (Eiteman et al 2007). This can be explained by the fact that the total risk of a portfolio comprises a systematic and a non-systematic element. The systematic element is associated with the market and unsystematic element is related to the individual elements in the portfolio. Increasing the number of securities in the portfolio reduces the unsystematic element (Eiteman et al 2007). This same approach can be taken in the form of investing in various stock markets across the globe. When investors hold securities in several countries they are able to cushion their portfolio from shocks in any one market. Therefore, if economic conditions in one country are affected by unfavorable factors, any resultant reduction in stock market returns may be offset somewhat by gains in other stock markets or at least be cushioned by the relative weight of other securities held in other parts of the world. This is however, assuming that the markets are not highl y