Chapter 15 • International aspects of business finance
80 per cent. So even diversification by a holder of UK equities into Dutch shares would
seem likely to yield some risk reduction, and diversification into Japanese ones would
seem likely to lead to a fairly substantial amount of it.
Mathur, Singh and Gleason (2004) examined the accounting-based measures of per-
formance of a set of chemical industry businesses that had diversified internationally
over three years. They found strong support for gains from international diversifica-
tion. Ferreira and Ferreira (2006) looked at businesses operating in the countries that
were members of the European Economic and Monetary Union (EMU) before 2001
and then took up the euro in 2001. The researchers found that, both before and after
2001, the risk reduction benefits of international diversification were significant.
Before 2001, international diversification was more effective at risk reduction than was
diversifying investments between different industries. After 2001, the two types of
diversification were similar to one another in their effectiveness. Of course, there is
no reason why investors should not diversify their equity investment both between
countries and between industries. The rational investor will do this.International investment at the portfolio level
It can be argued that in view of the shareholders’ ability to eliminate specific risk
by internationalising their portfolios, businesses should not feel that it is worthwhile
spending money to avoid specific risks associated with international activities.
Exchange rate risk provides a very good example of a specific risk. By the nature of
things, currencies weaken and strengthen relative to one another. If the US dollar is
weakening against sterling, sterling is strengthening against the dollar. Exchange
rate risk cannot be, on an international basis, a systematic risk since a decline in the
strength of one currency cannot possibly go in step with a decline in all other currencies.Figure 15.2
The risk of various
sized, randomly
selected portfolios,
comparing a
domestic share
portfolio with an
international one
As the size of the portfolio is increased the level of risk diminishes, but at a decreasing rate
such that, for a portfolio consisting of 15 to 20 securities, adding more securities does little
or nothing to reduce total risk further. This is true for both domestic and international
portfolios, but the level of risk reduction is significantly greater with the international portfolio.