R5: : Market Risk Diversification

Can Market Risk be Diversified

1. Introduction

The literature on investing says total risk of investment is sum of systematic risk and unsystematic risk. Unsystematic risk is also known as company specific risk and can be diversified, whereas systematic risk or market risk affects the overall market not just particular stock or an industry of the country and is considered undiversified risk. The political risk, exchange rate risk, interest rate risk, commodity risk, equity risk and liquidity risk are all form of a market risk as they impact the overall performance of all sectors of the economy. Historically market risk is generally managed in two ways-

1- By adjusting the weight of investment in stocks and in bonds.

2- By selling stocks with high Beta and buying stock with low beta.

Globalization has affected the way investors look at their portfolios. Increase in cross-border financial activity has increased. Investors are trying to enhance their risk-adjusted returns by diversifying their portfolios internationally and are seeking out the best investment opportunities from a wider range of industries, countries, and currencies. Since the markets are integrated most of the economies of the world are highly correlated with each other as such downturn of one economy is affecting the other. Moreover by diversifying internationally investors still face exchange rate risk.

With respect to pricing of risky assets, the Capital Asset Pricing Model (CAPM) is widely used to determine the suitable required rate of return of an asset. Sharpe (1964), Lintner (1965), Mossin (1966) and Black (1972), who contributed towards the development of CAPM, asserts that the expected return required on any security is related only to the beta (b) -free rate (R_f) and the expected market return (R_m). This implies that security return is only dependent on the responsiveness to the general market movements.

In this paper we purpose to test that whether by investing in foreign stock exchanges helps in diversification of market risk or is the movement of one stock exchange is highly correlated with other. We will test whether investors are really compensated for taking on Exchange rate risk, i.e. whether there is any relationship between economic cycle of a country and real returns on equity investment. Whether investors are compensated for holding securities over the long run then we will have to examine the validity of foreign equity investment as a measure of exchange rate risk.

2. Objectives of the Study

· Test whether by investing in foreign stock exchanges helps in diversifying market risk.

· Check whether beta can be used as an asset allocation tool in foreign investments.

· Check whether exchange rate can be used as an asset allocation tool.

3. Data and Methodology

We have used daily index data of 22 major stock exchanges of the world. The time frame of our study is from January 2000 to December 2014. The data has be collected from Bloomberg.

We have selected the top 22 major stock exchanges of the world. Top 22 stock exchanges will help us to minimize liquidity risk. Each year five exchanges are selected on the basis of Coefficient of variation. Equal investment in a portfolio of 5 stock exchanges is done by converting dollar value to the currency of the country where investment is done by using spot exchange rate.

After every year the return on the investment is converted to dollars and dollar value of real return is calculated by using average inflation rate of US of that year. This dollar value is reinvested in 5 stock exchanges shortlisted by converting it again to currency of the respective country stock exchange. In this way dollar value of real return + initial investment earned is rebalanced and this process is repeated from 2000 to 2014.

At the end of the 2014 we will check whether the dollar value real returns by investing in portfolio of 5 foreign exchange rebalanced every year, helps in earning superior returns compared with the long term investment of 14 years in S&P 500 years. If the answer to the above question is yes, than we can conclude that by investing globally market risk can be diversified.

4. Overall Result-

The above chart show the inflation adjusted value of $100 invested in portfolio of 5 stock exchanges according to coefficient of variation from 2000 till 2014 and $100 invested in S&P 500. As one can see from the chart that S&P500 have underperformed the portfolio. S&P 500 over the period 2000 to 2014 generated an inflation adjusted CAGR of -2.240%, whereas portfolio generated as Inflation adjusted CAGR of 6.834%. Chart and descriptive statistics of inflation adjusted yearly returns of portfolio and S&P 500 are presented below

In this paper we tested whether the market risk can be diversified by cross border investment.

For forward looking approach the objective is to test whether Index movements can be predicted with the help of leading indicators-

- Ease doing business index

- Corruption Perception index

- Gini Index

- Yield Curve

- Estimated GDP growth Rate

Etc.…..

Appendix

Stock Exchanges-
North America- Dow Jones Industrial Average (USA) S&P/TSX (Canada) MEXBOL(Mexico) South America- IBOV (Brazil)	Asia- SHCOMP (China) HIS (Hong Kong) STI (Singapore) BSE (India) NKY(Japan) FBMKLCI (Malaysia) RTSI$ (Russia)
Australia- AS51 (Australia) Africa- TOP40 JSE (SA	Europe- CAC (France) DAX (Germany) FTSEMIB (Italy) AEX(Netherland) IBEX (Spain) OMX 30 (Sweden) FTSE 100 (U.K) SMI (Switzerland)