International Capital Market Equilibrium

Two risks of investing abroad:

• Return of the international asset in its local currency.
• Variations in the value of the foreign currency relative to investor's currency.
• Return of investment = return of asset + return of currency

Sharpe ratios:

• measured as the average excess return relative to the volatility of the return.
• Risk adjusted excess return.

Nonsystematic variance = idiosyncratic variance (changes over time --> implication on how many firms it takes to diversify)
Systematic variance = Beta.
p < 1; the lower the better, firms more diversify.

What drive correlation of returns?

• Trade
• Geographic proximity
• Industrial structure: firms in the same industry --> buffeted by the same shocks, their systematic risk also move together.
• Irrational investors : contagion phenomenon.

Investment hurdle rates --> lowest possible expected return that allows for an improvement in the Sharpe ratio when they invest in that foreign market.

Risk premium of the market --> how much the market compensates investors for systematic risk.

Home bias --> local investors hold a disproportionately large share of local assets compared to global assets.

• Issues: Investors should not hold foreign equities because they are more volatile and have been yielding lower return than US stocks. --> False. 
• You should add foreign equities as soon as the foreign sharpe ratio exceeds the American sharpe ratio times the correlation between US portfolio and foreign security retun.
• Issues: Home bias arises because investors face an additional risk when investing internationally - currency risk. Because currency risk makes return more volatile but does not lead to a higher expected return, investing more in domestic assets is rational.
• Issues: Home bias arises because investors have a non-traded domestic assets that they care about as well - namely human capital. The returns to this asset can be thought of as labor income.