Report on International Diversification

Question: Write about the Report on International Diversification. Answer: Benefits of International Diversification Investing in the foreign equity provides opportunity to the investor to take advantages of the international diversification. The diversification of portfolio by investing in the foreign equities reduces the risk (volatility) of the returns of portfolio. However, this is possible only when economies of two countries are running on different cycles, for example, economy of USA may be stagnant and that of China, it may be running with high GDP growth rate (Elton et al., 2009). The advantages of international diversification may turn into disadvantages when two economies run on same economic cycles. For instance, in the current case, the economy of USA and EAFE are running on same economic cycle which is depicted from positive correlation between the returns of SP and EAFE. The correlation (annualized returns) between SP and EAFE is 75.14% (Excel Exhibit-14). Arguments against International Equity Investment Though investing in foreign equities provides greater diversification to the portfolio, however, it could also be disadvantageous (Elton et al., 2009). For instance, the adverse movement in foreign exchange rates could wipe out the returns earned on the investments made in local equity. For instance, in the year 1997, a US investor earned 13.82% return on investment in foreign equity (EAFE) however, the loss on account of foreign exchange amounted to 11.76%, which reduced the net return to 2.06% (Excel Exihibit-10). Impact of Currency Movements on Returns As could be observed from the above discussion that the risk of foreign exchange is increased when the investor invests in foreign equities and due to the increase in foreign exchange risk, the net return on investment could go down (Elton et al., 2009). Drivers and Consequences of Correlation The correlation between the returns of two assets depicts a relationship between the returns. The positive correlation depicts that the return of two assets runs in the same direction while the negative correlation depicts that the return of two assets runs in opposite direction. In order to achieve better risk diversification, it is essential to have negative correlation between the returns of two assets (Mayo, 2016). References Elton, E.J., Gruber, M.J., Brown, S.J., and Goetzmann, W.N. 2009. Modern Portfolio Theory and Investment Analysis. John Wiley Sons. Mayo, H.B. 2016. Investments: An Introduction. Cengage Learning.