International Investments Diversification
International Investments Diversification
The term global portfolio refers to a group of investments, assets and securities held in foreign markets rather that the domestic market. Traditionally, investors have preferred to focus on international portfolio investment when it comes to the investment in marketable securities. As opposed to the only domestic portfolios, the international portfolio yields more value for the same level of risk. Ideally, an investor should analyze the global stock market to identify the markets that are related to their domestic stock/ securities market in terms of risks and rewards (Agati, 2007). This helps investors reduce their anxiety about such risks as economic and political risks in the foreign countries that could affect the performance of their international portfolio. This paper seeks to establish the effects of international portfolio diversification on an investment portfolio as well as some of the alternative investment tools/vehicles that could be used to reduce the risk in international portfolio diversification.
The basis of international portfolio diversification is to combine securities, equities or other investment vehicles that are negatively correlated, which allows the investors reduce the risk in their portfolio. This is so since positively correlated investment vehicles could mean a higher risk as the investor could incur losses if there were a drop in the positively related investments.
Herein, an effect of international portfolio diversification can be drawn. In times of economic changes in the different foreign markets, that an investor places their investments in, it is unlikely that the negatively related investment vehicles move in the same direction (Agati, 2007). This means that the investors can reduce the risk of loss in their investments in times of uncertainties both in the domestic and international markets.
Over the past few decades, the international financial market scene has been characterized by an increase in correlation between various domestic financial markets in the international scene.
Research shows that this has been caused by the benefits of investing in the international financial market. Although the intended effect of increasing the correlation of the players of the global financial markets is the reduction of the portfolio risks, this could lead to negative effects during unexpected economic recessions. For example, most European countries have formed an integrated policy concerning the operations of financial markets in the region. Although the intention, which has proved useful over the last few decades, is the reduction of the volatilities of the international financial markets, sudden changes in the politics of the region have sure had a negative effect on the value of the investments.
With the advent of global financial investment, the focus has been laid on the benefits or the effects of the latter on the economy of the developed countries mainly in the USA and European countries. With the increase in technology and globalization, individual investors, as well as institutional investors, have been able to penetrate to the developing countries/ economies. The risk of investment here is high due to a relatively high volatility f the economy or due to political risks (Driessen & Laeven, 2004). As such, the advent of international investments diversification has led to the effect of higher yields for investments placed in the developing economies due to the high risk of investment here.
The overall effect on international investments diversification is the increase in the value of the investments as well as spreading the portfolio risk. This is because holding an international investment portfolio helps an investor combine the benefits of investing in the different foreign markets. Additionally, it helps the investors alight their portfolio such as it includes negatively related characteristics of the stock/securities market, which in turn helps reduce the portfolio risk.
Alternative Investment Vehicles
In the international financial markets, various investment vehicles are available for the choosing of the different investors. Investment vehicles carry different risks and consequently have different rewards after the expiration of the investment period. Among the many investment vehicles that characterize the international financial markets, derivatives are the most common. Fundamentally, a derivative is an investment vehicle that derives its value from underlying assets say stock, commodities, currencies, or interest rates (Bellalah, 2010). Both individual and business investors in the international financial markets due to their ability to reduce the investment risk favor financial derivatives. Derivative investors gain value due to the fluctuation in the worth of the underlying assets/ market indices while ensuring a return on the value of the initial investment.
The most common forms of derivatives available in the international financial markets are Forward contracts, futures contracts, and options. These form the alternative types of investment vehicles that investors can choose. It is, however, imperative that investors understand the nature of each of these investment vehicles before embarking on investing on the same. Below is a brief examination of the various types of derivatives:
1. Forward contracts. This is a type of derivative where two parties agree to buy or sell a certain asset on a specified future date. Forward contracts are non-standardized meaning they are not subject to external influences. It is only subject to change depending on the choices of the contract parties (Bellalah, 2010).
2. Futures contracts. Futures contracts are similar to forward contracts if the trading parties agree to sell/buy an asset on a given future date. Futures are, however, standardized meaning the terms of the agreement are subject to scrutiny by a third party. This factor makes futures less risky to invest relative to forward contacts (Bellalah, 2010).
3. Options. This is a derivative that allows the holder of an asset to exercise their right over the latter at the expiration of the contract period. As such, at maturity of an options contract, the owner has the right to buy or sell the underlying assets depending on the market conditions.
4. Swaps. Swaps are derivatives that allow the holders to exchange or undertake various transactions on their investments before the expiration/maturation of the contract.
How Derivatives Enhance Portfolio's Performance
Currently, the development of the international financial markets is facilitating the increase in the use of the above derivatives or a combination of the same. The increase in the popularity in the use of derivatives in the international portfolio diversification is associated with the ability of the derivatives to improve the performance of the international portfolio. Derivatives derive significant returns due to the anticipation of a positive gain in value of the underlying assets (Bellalah, 2010). For instance, changes in interest rates and equity markets in different foreign markets could lead to a high return on the value of the investment.
Other factors that make derivatives attractive to include in international portfolio development is the fluctuations in international currencies and the changes in supply and demand of various commodities in the global market. The use of different derivative instruments such as swaps allows investors to take advantage of variations in the value of the underlying assets, therefore releasing massive profits. As such, various derivatives not only helps reduce the risk of investment but also allows the investors take advantage of changes in the value of the underlying assets in different markets. This in itself helps improve the value and performance of an international portfolio.
References
Agati , A. (2007). The Effects of International Diversification on Portfolio Risk. The Effects of International Diversification on Portfolio Risk, 1-26.
Driessen, J., & Laeven, L. (2004). International Portfolio Diversification Benefits. Cross-Country Evidence from a Local Perspective, 1-40.
Bellalah, M. (2010 ). Derivatives, Risk Management & Value. London: World Scientific.
