International Diversification and Currency Risk

Portfolio risk falls as more assets are added — but domestic diversification has a floor. Once a portfolio contains roughly 100 domestic stocks, idiosyncratic risk is essentially eliminated and only systematic risk (correlated with the domestic market) remains. The question is whether adding foreign stocks can push the floor lower. The answer depends entirely on how correlated international markets are with each other. If Japanese and German equities move independently of the US market, a US investor gains diversification benefit by including them. If they move in lockstep — as they tend to during global financial crises — the benefit disappears.

This note develops the quantitative framework for international diversification: how to compute the return a domestic investor earns on a foreign asset (including currency effects), how to decompose the total risk into domestic and exchange components, and what the data say about how much risk reduction international diversification has historically provided — and when it fails. This analysis sets up the global view of the market portfolio that the CAPM needs: if investors can hold any asset in the world, the market portfolio is global, and the market risk premium is the return on the global market above the global riskless rate.

• compute the return on a foreign investment expressed in the investor's home currency, separating domestic and exchange components;
• derive the approximation for the expected return and variance of a foreign investment;
• explain why exchange risk does not simply add to domestic risk (the correlation effect);
• interpret empirical data on cross-country correlations and describe the trend toward higher correlations under globalisation;
• explain the crisis correlation problem and its implication for international diversification as a tail-risk hedge.

1. Return on a foreign investment
2. Expected return and variance of a foreign investment
3. Empirical risk and correlation data
4. Measuring the benefit of international diversification
5. Market integration and the CAPM