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In the international economic field, international portfolio persification plays a dominant role. However, this particular investment vehicle of international investments has not taken off and there has not been a sufficient explanation as to the reasons for such abysmal performance of the international portfolio in the total investment spectrum. As has been researched and concluded by many scholars and authors of several academic works, inpiduals do not favour much the idea of making their investments in foreign assets, thereby persifying the risks of investments across the countries. They hold too little of their wealth in foreign assets, much less than that predicted by the conventional risk-return portfolio equilibrium models.
However international portfolio persification has long been advocated as an effective way to achieve higher risk-adjusted returns than domestic investment alone. It may be noted that to the extent different countries are subject to shocks, international persification facilitates risk sharing among global investors .With this background, this paper analyses the effect of international portfolio persification on an investment portfolio. The paper while examining the available alternative investment vehicles, also explains the use of derivative securities in enhancing a portfolio’s performance.
The benefits of international portfolio persification differ across countries from the perspective of a local investor. It has been found out that the benefits of investing abroad are larger for investors in developing countries. For such investors, the value of their investments in cross country stocks and securities gets enhanced by the effects of favourable currency fluctuations. “Most of the benefits are obtained from investing outside the region of the home country. These global persification benefits remain large when controlling for short-sales constraints in developing stock markets.” (Joost Driessen) and Luc Laeven 2005)
The governments of different nations often place restrictions in the investments by the Institutional investors in the foreign countries. However with the advent of globalization this trend has changed in the recent past and there has been a change in the outlook of different countries with respect to the international investments. Even in the absence of such restrictions the investor typically would invest large amounts of their money in domestic stocks only. This so called home-bias of financial assets has been studied by several scholars to identify the possible reasons behind such investment decisions. (Black 1974)
Out of the various studies on the subject the following situations emerge
There is substantial regional and global persification benefits for domestic investors in spite of the fact that the investors cannot short sell stocks in developing countries
The benefits of international portfolio persification are larger for developing countries relative to developed countries.
Hedging funds can be looked at as alternative investment vehicles in the international investment arena. “The low correlation between hedge funds' performance and the market's ups and downs is the main reason why such funds are valued as alternate investment vehicles. They essentially exploit market inefficiencies, using long or short positions to offset market risks.” (Darrell Duffie 2001)
Hedging funds are private investment vehicles and have more freedom and flexibility than mutual funds which represent the more common form of pooled investment. Moreover hedging funds are exempt from various registration and disclosure requirements in US securities laws. Investment advisers warn that this greater freedom also amounts to a greater risk of fraud, especially as the number of funds multiplies.
Apart from the hedging funds derivatives can also be considered as alternative investment vehicles.
Derivatives have been an expanding and controversial feature of the financial markets since the late 1980s. They are used by a wide range of manufacturers and investors to manage risk. The derivatives play a very predominant role in the investment portfolio management. The value of the derivatives is reflected or derived from the financial product or instrument underlying the futures or options contract which are widely known as derivatives. There is no transfer of ownership. Instead a contract spells out the terms under which the underlying product or instrument is to be purchased or sold some date in the future. “Derivatives are complex investments. Gains or losses depend on predictions of the short- or mid-term future movement of the market for the underlying product or instrument. Purchases are often on margin, significantly increasing the risk of losing capital.” (Article on derivatives)
Thus derivatives are financial instruments with a rate of return or value that is determined from some underlying security, commodity or asset. Options, futures and swaps are the most common derivatives. Many derivatives are listed and traded on public exchanges such as the Chicago Board of Trade or the New York Stock Exchange. Other most customized and complex derivatives are negotiated directly between financial institutions and their customers. Derivatives as an investment portfolio is suitable only to those “organizations that both raise capital and invest funds in the financial markets face risk, risk that adverse market moves will reduce the value of their investments” (John M. Aderholdt and Robert H. Rasmussen 1996)
Alternatively, the manager of an organization's investment portfolio, worried about the possibility of sharp declines in the value of the organization's holdings, might seek an efficient form of insurance against market downturns and would invest in the derivatives.
Form the foregoing discussion; it becomes evident that there are distinct advantages of an investor in the developing countries for making his investment portfolio as an internationally persified one. Similarly the hedging funds can be used as an alternative investment portfolio as also the derivatives. But derivatives as an investment portfolio functions more as an insurance against any possible future losses anticipated by increase in interest rates or for any other reason.
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