Country Portfolios Research Articles

DO FOREIGN INVESTORS PRICE FOREIGN EXCHANGE RISK DIFFERENTLY?

AbstractWe test whether foreign investors price foreign exchange risk differently from local investors. Drawing from the closed‐end country fund literature, we argue that both differential access to information by foreign versus local investors and different sources of exchange risk that investors face (economic or translation exposure) will lead to different pricing of the exchange risk associated with American Depositary Receipt (ADR) investments. We apply a two‐step method to country portfolios of ADRs of Australia, France, Japan, and the United Kingdom traded on the New York Stock Exchange. Our results show that foreign investors generally price exchange risk differently from local investors, and that the source and magnitude of differences in exchange risk pricing vary significantly across countries. Although significant differences in pricing exchange risk between foreign and local investors are observed for Australia, France, and Japan, no such pricing difference is noticed for the United Kingdom. Furthermore, the pricing differences observed for Australian and French ADRs are mainly attributed to the exchange risk of underlying share returns (economic exposure), whereas the pricing differences for Japanese ADRs are mainly attributed to the exchange risk associated with currency translation (translation exposure). We offer some explanations for our findings.

How to Diversify Internationally? A Comparison of Conditional and Unconditional Asset Allocation Methods

To obtain the maximum benefits from diversification, financial theory suggests that investors should invest internationally because of the larger potential for risk reduction. The question that we raise in this paper is how to select the optimal portfolio of countries? This article synthesizes the major international asset allocation methods based on mean-variance analysis that have been proposed so far in the literature. In particular it compares two types of conditional asset allocation with unconditional methods. The different policies are simulated in a truly ex-ante framework that reflects exactly the uncertainty faced by the portfolio manager at the moment he has to decide upon his future investments. The asset allocation methods are implemented from a Swiss perspective over the period 1988-2001. We find that conditional methods based on direct predictability of expected returns outperform all other asset allocation methods.

Country Portfolios

Capital flows to developing countries are small and mostly take the form of loans rather than direct foreign investment. We build a simple model of North–South capital flows that highlights the interplay between diminishing returns, production risk, and sovereign risk. This model generates a set of country portfolios and a world distribution of capital stocks that resemble those in the data.

A view of the European Union as an evolving country portfolio

We apply portfolio theory to assess the consequences in terms of risk sharing of the evolution of the industry mix of European Union countries between 1986 and 1997, and of the changes in the membership configurations of both economic and monetary unions. We compute a measure of risk-return performance for EU countries, by considering countries as collections of industries, and observe that risk-return performance improved in most countries. We find that the EU9 is marginally more efficient than the other historical EU groupings and that the Euro Zone might slightly benefit from the inclusion of the United Kingdom.

Individual Equity Return Data from Thomson Datastream: Handle with Care!

We compare individual equity return data from Thomson Datastream (TDS) for one large national equity market, the United States, to the source most often used by academics, the Center for Research in Security Prices (CRSP) for the period 1975-2002. Our purpose is not to advocate for the use of a particular source of U.S. equity data but to evaluate the suitability of TDS for use in studies involving large numbers of individual equities in markets outside the U.S. We discover important issues of coverage, classification, and data integrity and find that naive use of TDS data can have a large impact on economic inferences, particularly earlier in the period of coverage and among smaller stocks. We show that after careful screening of the TDS data that although differences still remain, inferences drawn from TDS data are similar to those drawn from CRSP. We also apply our screens to a sample of four European equity markets and show that screening the data has a measurable impact on the time series of country portfolio returns.

Destination Country Portfolio Analysis: The Evaluation of National Tourism Destination Marketing Programs Revisited

The analysis of destination country portfolios is essential for evaluating the overall competitive position of tourist destinations. An evaluation scheme based on indices of market share and change in market share is developed for 24 destination countries and 21 origin countries. It is clear that there are marked differences in performance among the various tourist destinations. The driving force with regard to market share increases appears to be the percentage of tourism demand being generated from markets with above-average income elasticities.

A Portfolio View of the U.S. Current Account Deficit

FROM 1971 TO 1982 THE U.S. current account balance as a share of U.S. GNP averaged roughly zero.(1) Starting in 1983, however, the United States experienced increasingly large current account deficits, which reached 3.3 percent and 3.4 percent of GNP in 1986 and 1987, respectively. This tendency toward larger deficits was reversed gradually during the rest of the decade, and by 1991 the current account was near zero again. But starting in 1993 the current account again began to record increasingly large deficits, which grew to 3.6 percent of GNP in 1999 and 4.4 percent in 2000. This history of the current account prompts several questions: What is the source of the large current account deficits of the 1990s? Are they likely to remain with us indefinitely? If not, should we expect them to fade away slowly as they did in the 1980s? Or should we expect instead a sharp reversal in the near future? In this essay I interpret these trends in the U.S. current account from a perspective that focuses on the behavior of the country portfolio. The country portfolio is defined as the sum of all productive assets located in the United States, plus the U.S. net foreign asset position (that is, the sum of all claims on foreign assets held by U.S. residents minus the sum of all claims on U.S. assets owned by foreign residents). By the composition of the U.S. portfolio I mean the share of the net foreign asset position in it.(2) According to the portfolio view, it is useful to separate changes in the current account into two components: changes in the size of the country portfolio, which I call portfolio growth effects, and changes in the composition of the country portfolio, or portfolio rebalancing effects. A simple application of this approach reveals a clear picture: the recent current account deficits are mostly the manifestation of the spectacular increase in U.S. wealth experienced in the 1990s. Contrary to a widely held belief, these deficits do not reflect a rebalancing of portfolios toward U.S. assets and away from foreign assets. A natural question follows: Why did U.S. wealth increase so much in the 1990s? I explore two alternative hypotheses. The first views the increase in wealth as reflecting a rapid accumulation of an intangible form of capital. The second is based on the notion that the 1990s were characterized by the appearance and growth of a bubble in the U.S. stock market. Although both explanations exhibit interesting elements, neither is fully satisfactory. Our inability to account for the growth in wealth makes the task of predicting the future direction of the U.S. current account quite difficult, if not impossible. Nevertheless, each of these stories has a different ending, and I discuss them below.(3) A Portfolio View of the Current Account The point of departure for a portfolio view of the current account is the celebrated mean-variance theory of Harry Markowitz and James Tobin.(4) According to this theory, investors choose their portfolios by optimally trading off risk and return. The optimal or mean-variance-efficient portfolio contains the risk-free asset and an optimal combination of risky assets (OCRA). A strong result of the theory is that the OCRA is the same for all investors with access to the same menu of assets, regardless of their attitudes toward risk and their level of wealth. That is, the share of each asset in the OCRA depends only on the distribution of asset returns. Another strong result of the theory is that the weights that mean-variance investors assign to the risk-free asset and the OCRA depend only on their risk aversion and the distribution of asset returns. They do not depend on the investors' wealth.(5) Moving from the optimal investor portfolio to the average or country portfolio requires an additional assumption, namely, that the average risk aversion and the distribution of asset returns are both independent of wealth. This is a strong assumption, and its validity is an empirical issue that is far from settled. …

The European Union as a country portfolio

This paper applies portfolio principles to explore potential diversification benefits of the European Union (EU). We apply the portfolio approach to judge whether a particular membership configuration of the EU dominates alternative possibilities based on growth rates and growth rate volatilities. Our conclusions are that, for the original six members of the EU (the EU6), no subset of countries would have dominated in growth/volatility terms, and that few portfolio benefits have been realized by expansion of the EU beyond the original six members. We also conclude that adding Turkey or Norway, whose economies are different from other EU members, would improve the growth and stability of the EU's portfolio of countries. Lastly, we find that the original EU6 was not far from an efficient portfolio.

Incorporating Estimation Risk in Portfolio Choice

We propose a new adjustment in mean-variance portfolio weights to incorporate uncertainty caused by the fact that, in general, we have to use estimated expected returns when determining optimal portfolios. The adjustment amounts to using a higher pseudo risk-aversion rather than the actual risk-aversion and has a straightforward interpretation. The difference between the actual and the pseudo risk-aversion depends on the sample size, the number of assets in the portfolio, and the curvature of the mean-variance frontier. We show how short sales constraints and time-varying expected returns are incorporated in our framework. Applying the adjustment to international portfolios, we show that the adjustments are nontrivial for G5 country portfolios and that they are even more important when emerging markets are included. The exclusion of short sales is found to have a further important impact on the adjusted portfolio weights. In case expected country returns are time- varying, our adjustment induces a significantly smaller variability in portfolio weights that is commonly found.