Investment Enhance: international diversification, alternatives, use of derivatives

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a. Analyze the effects of international portfolio diversification on an investment portfolio:

In today's extremely volatile financial marketplace, international portfolio diversification has become a major strategy to diversify the portfolio and hedge it by investing in securities offered by the financial markets in other countries. International portfolio diversification allows investors to hedge their portfolio via exposure to foreign securities and also allows them to exploit earning/growth opportunities offered by numerous emerging and attractive markets across the world.

However, it is also to be noted that as financial markets are becoming highly interdependent and correlated due to increasing volume of trade, flow of investment and financial transactions among countries, international diversification will result in risk reduction for a given return as long as the correlation coefficient between the domestic and the foreign market is less than one (i.e., less than 100 percent). Lower future correlation will provide deeper risk reduction. Based on our results, a U.S. investor having a portfolio of U.S. stocks will experience a small diversification benefit (risk reduction) by investing in German stocks since the cross correlation coefficients with the German market are rather large. On the other hand, the same U.S. investor will have better diversification benefit by investing in the Japanese market. The same is true for a German investor. This is so because a Germany-Japan combination will yield better diversification than will a Germany-U.S. combination. Similarly, investors in Japan can achieve equally desirable portfolio diversification benefits when they invest in Germany or the U.S.

Reference: http://gbr.pepperdine.edu/072/diversification.html

By investing in foreign securities, investors can participate in the growth of other countries, hedge their consumption basket against ex-change rate risk, realize diversification effects and take advantage of market segmentation on a global scale. Even though these advantages might appear attractive, the risks of and constraints for international portfolio investment must not be overlooked. In an ...