Business

Chapter Objectives

Chapter 10

To explain how the international flow of funds is influenced by economic factors and other factors; and To explain the potential benefits and risks of foreign investments.

International Investment and Capital Flows

Portfolio Investment

Differences in the returns on various countries’ assets provide an incentive for capital flows. Interest rate differs in different countries due to risk differs from one asset to another.

Risk of holding a diversified portfolio An investor facing a world with two investment opportunities : Asset A and B The investor will hold a portfolio of A and B, with share of the portfolio devoted to A denoted by a and the share devoted to B denoted by b. Thus, if the investor holds only A, then a=1 and b=0, If only B is held, then a=0 and b=1. Most likely the investor will choose some amount of diversification by holding both A and B.

Yet even with constant interest rates internationally, there would still be an incentive for international capital flows. This additional incentive is provided by the desire to hold diversified portfolios.

Diversification leads to the two-way flows of capital between countries. Besides the return on an investment, investors are concerned with the risk attached to the investment.

Risk of holding a diversified portfolio

The return of portfolio (Rp) : Rp =aRA+bRB Expected future Return on the portfolio (Rp*): Rp* =aRA*+bRB* Where Rp* , RA* and RB* are the expected values of the portfolio and individual asset returns, respectively. The variance of the portfolio will depend on the share of the portfolio held by each asset and the variance of the individual assets, as well as their covariance, i.e., var (Rp)=a2 var (RA) + b2 (RB ) + 2ab cov (RA,RB ) The substantially lower risk achieved by diversification will lead investor to hold many different assets, including assets from different countries.

Home Bias in International Investment Many studies has demonstrated the gain from...