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International Portfolio Diversification

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A. Analyze the effects of international portfolio diversification on an investment portfolio
b. Examine alternative investment vehicles.
c. Explain how the use of derivative securities can further enhance a portfolio's performance

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

One of the main puzzles in international economics is the failure of standard portfolio models to explain the observed patterns of international portfolio diversification. As the literature has amply documented, individuals do not appear to do a good job at diversifying risks across countries: they hold too little of their wealth in foreign assets, much less than predicted by conventional risk-return portfolio equilibrium models.

Is there any diversification logic driving international portfolio choice? French and Poterba [1991], documenting the existence of a "home bias in portfolio", pointed at a failure of this logic: due to the variance-covariance structure of home and foreign returns, investors would typically benefit from holding more assets abroad.

Investors should tilt their international holdings towards countries that provide a good hedge for their domestic risk, i.e.
countries whose stock market indices have little correlation with their home stock index. Assets that are highly correlated with the domestic asset are less attractive. Being over-exposed on their domestic risk, investors want to hedge this risk by holding assets that have low correlation with their domestic asset.

In general, an important result of holding a diversified portfolio is that:
- A diversified portfolio follows the market very closely, while an individual stock or a ...