Sunday, February 8, 2009

Benefits of International Diversification

“An argument often heard is that correlations between international equity returns are higher during bear markets than during bull markets, and bear market moves are greater than bull market moves.1 This would suggest that the benefits of international diversification are less impressive than conventional wisdom predicts. This argument is potentially very important since it may help explain the “home bias puzzle,” arguably one of the most important puzzles in international finance. If the diversification benefits from international investing are not forthcoming at the time that investors need them the most (when their home market experiences a downturn), international investing may not be worth the trouble” (Ang & Bekaert, 2000, p. 3). Ang and Bekaert (2000) conclude that the volatility of the bear market does not “negate the benefits of international diversification” (p. 28). They offer three main results as evidence: “there are always large benefits to international diversification”; “the costs of ignoring regime switching may be small or large depending on the presence of a conditionally risk-free asset”; and, “intertemporal hedging demands under regime switches are economically negligible and statistically insignificant” (Ang & Bekaert, 2000, pp. 27-28).
Ang. A. and Bekaert, G. (2000). International asset allocation with regime shifts. White Paper. Retrieved January 27, 2009 from

Home Bias and IAS

It seems that home-bias is a repetitive buzz word within the discussion of international diversification and understandably so. Covrig et. al.(2007) conducted a study on home bias, foreign mutual fund holdings and the adoption of International Accounting Standards(IAS) and how these constructs or variables interact. One of the positives resulting from adopting the IAS is the “enhanced ability to attract foreign capital, consistent with IAS reducing foreign investors’ home bias” (Covrig et. al., 2007, p. 2). Home-bias exists when investors are hesitant to invest internationally due to the high cost of information regarding these transactions. It would benefit firms to take actions to reduce home bias and attract foreign investment to improve investor diversification, lower investor risk, and reduce cost of capital (Covrig et. al., 2007). Covrig et. al. (2007) also posits that greater foreign investment increases firms’ investor base and increases share liquidity. Covrig et. al. (2007) hypothesize that firms employing IAS have higher foreign ownership than those that only use local accounting standards. Their sample size is more than 25,000 observations across 29 countries from 1999-2002. Their analysis does in fact bolster their hypothesis that “firms adopting IAS in poorer information environments, or firms with lower investor visibility, have higher levels of foreign mutual fund investment” (Covrig et. al. , 2007, p. 4).
Covrig, V.M., Defond, M.L., and Hung, M. (2007). Home bias, foreign mutual fund holdings, and the voluntary adoption of international accounting standards. Retrieved January 28, 2009 from EBSCOhost Database.

Global Diversification: International Investing

Historically, the United States has been “narrow-minded when it came to investment opportunities” due to geographic isolation, dominant political and economic positions, and strong market returns (Financial Web, 2009). As a result of these culminating factors, diversification has not been highly sought, however, in our recent turn of events, there has been a dramatic shift in international markets outperforming. The contributing factors to the international transformation include “the widespread adoption of democracy, capitalism, and the rule of law among these nations” and as these “trends continue, the emerging markets will continue” on their upward trajectory (Financial Web, 2009). In addition to these preceding factors “overseas companies are typically subject to less government regulation” whereas “U.S.-based businesses face a formidable amount of government regulation” and while regulation is necessary and protective in some regard it can create competitive disadvantage relative to foreign competition (Financial Web, 2009). Foreign competitors with less governmental regulation benefit from lower operating costs and lower labor costs. Government regulation (i.e. trade embargos) for U.S. organizations prohibits them from playing in the field and leaves them sitting on the bench while the game is played by foreign competitors who step in, in their stead to reap the profits and score big.
Financial Web (2009). Global Diversification. Retrieved January 29, 2009 from

Purchasing Power Parity

Purchasing power parity affects the international financial environment because under ideal conditions, the exchange rate between currencies of different countries equalize, in other words, the purchasing power is equal. The foundation of PPP is the “law of one price” (Antweiler, 2008). Three caveats exist with this law of one price: transportation costs, barriers to trade, and other transaction costs, can be significant; there must be competitive markets for the goods and services in both countries; and, it only applies to tradeable goods (Antweiler, 2008). There are two versions of PPP: absolute PPP which is the equalization of price across countries and relative PPP where change rates of price levels is equal to inflation rates (Antweiler, 2008). Specifically, relative PPP “states that the rate of appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country” for example, if Canada’s inflation rate was 1% and the U.S. inflation rate was 3%, the USD would depreciate against the Canadian dollar by 2% annually (Antweiler, 2008).
Antweiler, W. (2008). Purchasing Power Parity. The University of British Columbia. Retrieved February 1, 2009 from