Modern Portfolio Theory and Investment Analysis, 9th Edition

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International Diversification

The investment models developed in the preceding chapter are often applied to and tested on U.S. capital market data. In fact, investors face a much broader opportunity set. International investing has a very long history, particularly in Europe, where foreign participation in the fixed income and equity markets has been active for nearly three centuries. By contrast, for much of the last century, American investors, as well as those of several other countries, manifested a well-documented “home country bias,” which was seen an empirical puzzle. Proposed solutions to the puzzle included barriers to cross-border investing as well as behavioral biases.¹

With increasing globalization of capital markets over the last several decades, U.S. and Asian investors have gained more access to international markets, and this has made the question of how best to diversify all the more important. In this chapter we discuss cross-border investing from the perspective of market integration, the benefits of diversification, and the exposure to institutional risks and frictions. We present ways to calculate the expected returns to cross-border investments, the effect of exchange rates, and approaches to hedging foreign exchange risk.

By almost any measure, cross-border investing has grown dramatically in the last two decades. A 2011 McKinsey report on world capital markets observes that “investment in foreign assets [in 2010] reached $96 trillion, nearly ten times ...