i) Comparing the expected return and standard deviation of various assets in the portfolio, we have analyzed the following characteristics:
a) Australia Shares on account of total risk of almost 22% is capable of providing return of 16%
b) Australian Bonds with risk accounting to 7% provides return of 11.5% to the investor.
c) Cash being the most liquid asset and least risky asset with risk factor of only 4.4%, provides return of 9.25%.
d) As for international shares, despite the high risk factor of 22.62% and relatively low return of 14.88% as compared to asutralians shares, the offshore stock is included in the portfolio on account of diversification benefit it provides to the portfolio.
e)Listed Property Trust seems to be the most ;ucrative investment which is capable of providing reasonable return of 14.27% for risk contribution of 12.82%.
b) Characteristics and Risk Factors of different asset classes:
Shares are the most preferred source of long term investments around the globe that offers high returns to the investors for bearing the risk. Risk associated with investment in shares involves:
Default Risk: Common Shareholders are exposed to default risk as they are entitled to claim their investment at the time of liquidation ,only after other the claims of other creditors are settled.
Unexpected Events : Contingent events like bad news about the company in the market, unfavorable change in government policy can affect share price and thus the return of the investor.
Bonds are the fixed income securities classified as Debt Investments. These investments pay a stream of semi-annual payments for a given number of years and then repay the borrowed amount at the maturity date. The contract that specifies all the rights and obligations of the issuer and the owners of a fixed income security is called the bond indenture.
However, just like any other investment class, bonds also have risk factors associated with it:
Interest Rate Risk:
It refers to the effect of change in the prevailing market rate of interest on bond values. When interest rates rises, bond value falls. This is the source of interest rate risk which is approximated by a measure called duration.
Yield Curve Risk:
It arises from the possibility of changes in the shape of the yield curve.
This risk arises from the fact when interest rates fall, a callable bond investor’s principal may be returned and must be reinvested at new lower rates.
This risk is attributed to the fact that sale of bonds might be at a price less than fair value becuase of a lack of liquidity for a particular issue.
Cash is the most liquid asset that can be held in a portfolio of investments. Cash can both be in hand or at bank. Cash is a risk free asset class.
Shares which are listed in off shore financial markets are called international shares. These kind of asset classes are known to provide high diversification benefit to the investor on account of low correlation among stocks of global financial markets.
Following are the risk associated with International Shares:
Risk associated with forex fluctuation is the major cocnern in regard to investment in international shares. The total return from international investment does not depend not only on asset performance but also the performance of related foreign exchange. Thus, if a Treasury Security is risk free for a domestic investor it may still be risky for an alien investor on account of foreign exchange risk.
Liquidity Risk is another risk associated with International equity investment but is mainly confined to investment in emerging markets. The major concern of this risk is not being able to sell the share at its fair value.
These are the asset classes that can be included in the form of Estate Investments. Real Estate Investment Trust(REIT) is the most popular asset class under Listed Property Trust.
Following are the risk associated with Property Trust:
It refers to the risk in consideration of asset being funded with interest bearing liabilities.In other words, debt used for purchasing property might expose the trust to financing and interest risks.
Borrowing facilities due to expire in an operating cycle is also a significant risk factor, particularly in periods when credit is more difficult and expensive to obtain.
Following is the Geometric Mean and Arithmetic Mean for average annual yield of the asset classes:
Efficient frontier represents the set of portfolio that the set of portfolio that offers maximum rate of return for a given level of risk or minimum risk for every level of return.
The above graph represents efficient frontier that shows that both Portfolio A and B dominates Portfolio C as they offer better returns and risk combination compared to Portfolio C. However there are some problems related to use of Efficient Frontier, which are particularly related to violation of its assumptions:
Differential Borrowing Rates and Lending Rates:
One of the first assumption of Portfolio Theory that investors could borrow and lend any amount at risk free rate. Howeevr, in reality it is unreasonable to assume that any investor or lender is ready to lend his funds at risk free rate. Because of this unequal borrowing and lending rates, the efficient frontier attains a kink.
b) Heterogeneous Expectations and Planning Periods:
IF investors have different risk and return expectations or project their exepctations over different time horizons, then every investor have a unique view of Effecient Frontier and resulting Capital Market Line.
The relation between exchange rate movements and asset returns is central to understanding the concept of international asset valuation. Considering the diversification benefits that international asset brings to the portfolio returns, a lot of investors globally are giving up home bias and are including international securities in their portfolio. Not only diversification benefits, investment in offshore assets also leads to opportunity to invest in high yield assets. However, presence of exchange risk in international investment can have significant impact on total return that an investor expects to earn. In other words, exchange risk arises from the uncertainty about the value of foreign currency cash flows to an investor in terms of his home country currency. For Instance, a US Treasury Bill may be almost risk free investment class for an American Investor however, the value of T-Bill to a european investor will be reduced if US Dollar depreciated as against Euro.
Thus, the total return of investment in international assets will depend on the performance of not only the asset itself but also the relative foreign currency. Thus for a US Investor, rate of return she will earn in terms of dollar from investing in offshore assets the success of foreign investment rests on the performances of both the foreign security market and the foreign currency. Formally, the rate of return in dollar terms from investing in the ith foreign market, Ri$ , is given by
Ri$ = (1 + Ri)(1 + ei) 1
= Ri + ei + Ri.ei
where Ri, is the local currency rate of return from the ith foreign market and ei is the rate of change in the exchange rate between the local currency and the dollar; ei will be positive (negative) if the foreign currency appreciates (depreciates) against the dollar. Suppose that a U.S. resident just sold shares of British Petroleum (BP) she had purchased a year ago, and that the share price of BP rose 15 percent in terms of the British pound (i.e., R = .15), whereas the British pound depreciated 5 percent against the dollar over the oneyear period (i.e., e = .05). Then the rate of return, in dollar terms, from this investment will be calculated as: Ri$ = (1 + .15)(1 .05) 1 = .0925, or 9.25 percent.
The above expression suggests that exchange rate changes affect the risk of foreign investment as follows:
Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri , ei) + ΔVar
where the ΔVar term represents the contribution of the crossproduct term, Ri ei to the risk of foreign investment. Should the exchange rate be certain, only one term, Var(Ri), would remain in the right hand side of the equation. Equation 11.5 demonstrates that exchange rate fluctuations contribute to the risk of foreign investment through three possible channels:
1. Its own volatility, Var(ei).
2. Its covariance with the local market returns, Cov(Ri ei).
3. The contribution of the crossproduct term, ΔVar.
Exhibit 11.8 provides the breakdown of the variance of dollar returns into different components for both the bond and stock markets of six major foreign countries: Canada, France, Germany, Japan, Switzerland, and the United Kingdom. Let us first examine the case of bond markets, The exhibit clearly indicates that a large portion of the risk associated with investing in foreign bonds arises from exchange rate uncertainty. Consider investing in a U.K. bond. As can be seen from the exhibit, the variance of U.K. bond returns is only 8.88 percent squared in terms of the British pound, but jumps to 27.67 percent squared when measured in dollar terms. This increase in volatility is due to the volatility of the exchange rate, Var(ei) = 12.39. as well as its covariance with the local bond market returns, that is 2Cov(Ri ei) = 6.08. As can be expected, the crossproduct term contributes little. The Swiss market provides an extreme example; the local bond market returns account for only 5.39 percent of the volatility of returns in dollar terms. This means that investing in Swiss bonds largely amounts to investing in Swiss currency.
With the exception of Canada, exchange rate volatility is much greater than bond market volatility. And without exception, exchange rate changes are found to covary positively with local bond market returns. Empirical evidence regarding bond markets suggests that it is essential to control exchange risk to enhance the efficiency of international bond portfolios.
Compared with bond markets, the risk of investing in foreign stock markets is, to a lesser degree, attributable to exchange rate uncertainty. Again, consider investing in the U.K. market. The variance of the U.K. stock market is 29.27 percent squared in terms of the British pound, but it increases to 40.96 percent squared when measured in terms of the U.S. dollar. The local market return volatility accounts for 71.46 percent of the volatility of U.K. stock market returns in dollar terms. In comparison, exchange rate volatility accounts for 30.25 percent of the dollar return variance, still a significant portion. Interestingly, the exchange rate covaries negatively with local stock market returns, partially offsetting the effect of exchange rate volatility. Exhibit 11. 8 indicates that while exchange rates are somewhat less volatile than stock market returns, they will contribute substantially to the risk of foreign stock investments.
It has been proved in many scholary findings that adding an international asset to the portfolio is likely to produce international diversification on account of low correlation between domestic stocks and international stocks. The efficient frontier below shows how adding an international asset to the asset portfolio will create more bulge in the efficient frontier on account of lower correlation between home country stocks and offshore stocks. Thus more is the number of international asset included in the portfolio, the well diversified portfolio will get closer to the broad market standard deviation.
**The amount of bulge(diversification benefit) is a function of the correlation between to stocks.
However, during the times of financial crisis tendency of stocks to move in same direction has reduced the diversification benefit s on account of positive correlation. Correlation is an important term in portfolio management context whether domestic or international. Portfolio diversification refers to the strategy of reducing risk by combining many different types of assets into a portfolio. Portfolio variance falls as more assets are added to the portfolio because not all assets prices move in same direction at the same time. A rational investor always consider the correlation factor amongst asset classes included in his portfolio. This is because lower the correlation between assets more is the diversification benefits the investor attains and vice versa.
In other words, as the correlation between two assets increases, the benefits of diversification decreases and this increase the tendency of stocks to move together. The similar movement of each stock in global financial market tends to increase the volatility of a portfolio to a level that will reduce the diversification benefits.
For every rational investor, diversification is an important consideration at the time of asset allocation decision. Still there is less agreement among investors to include foreign assets in their portfolio and felt safe in being home bias. Home bias is a tendency of a domestic investor to restrict their investment in domestic assets despite of being aware fully aware of diversification benefit that foreign asset can introduce to their portfolio.
Home Bias is an important area of study for the portfolio managers around the world and also scholary researchers as investors intentionally skew their investments to local market at the expense of foreign securities.
For Australian market, indeed the investors are into home bias but definitely it is not a good idea in terms of portfolio management as they are losing on diversification benefits. Also expectations by the market analysts that later half of 2013 will not be good for portfolios heavily invested in local shares, investors in Australia are encouraged to include offshore assets in their portfolios.
Principle causes of Home Bias:
Investors generally perform Home Bias as they expect higher future returns from their home markets. This was proved by French and Poterba(1991) in their scholary research.
Familiarity and Comfort Zone in Domestic Market:
Investors generally feel more comfortable in their domestic market and thus restrict their investments to the domicile asset class. However, many studies has concluded that such bias behavior results in poor risk return trade off for the portfolio and limits diversification benefits. For example, Strong and Xu (2003) showed that investors tend to be more optimistic about their domestic economies than foreign investors.
High transaction cost and less lucid information about foreign securities is another factor that cause home bias.
Many investors have to hedge certain liabilities and this leads to home bias investment. Although liability hedging is primarily confined to fixed income investments but is also found in equities. Also since domestic investors are more inclined to local interest rates, adding a foreign asset may not fulfill their portfolio objective.
Foreign Exchange Risk:
The currency risk is the most important consideration for an investor while considering a foreign asset in his portfolio. Investors usually refrain from investing in foreign equities on account of high risk involved despite they offers diversification benefit. The risk is attributed to foreign exchange risk and investor preference to avoid such risk is the reason it enters home bias.
Investment in Multinational Companies:
Since domestic companies are operating in multi national boundaries, investors feel that investment in these companies provide them much needed diversification benefits. But as global economies are interconnected many studies have concluded that performance of companies is highly correlated to its domestic market, regardless of where the operations are carried out.
Frank Reily and Keith Brown (2011) 'Introduction to Asset Pricing Model', in CFA Institute (ed.) Portfolio Management. Boston: Custom, pp. 267-287
Frank Reily and Keith Brown (2011) 'Introduction to Portfolio Management ', in CFA Institute (ed.) Portfolio Management. Boston: Custom, pp. 242-266.
Stern School of Business, New York University (2012) International Portfolio, New York: New York University.
Vanguard Research (2013) The role of Home Bias in Global Asset Allocation Decision, Available at: https://advisors.vanguard.com/iwe/pdf/ICRRHB.pdf (Accessed: 11th October 2013).
Frank Reily and Keith Brown (2012) 'International Asset Pricing', in CFA Institute (ed.)Portfolio Management. Boston: Custom, pp. 321-345.
Frank Reily and Keith Brown (2012) 'Risk Associated with Investment Classes', in CFA Institute (ed.) Portfolio Management. Boston: Custom, pp. 23-45.