International Finance and Accounting Handbook

returns in each market. This is the subject of the next section of the chapter. One of
the major sources of risk in international investment are changes in exchange rates.
The impact of exchange risk on international diversification and the possibility of
eliminating part of the risk through hedging is examined next. Sections 11.3 and 11.4
examine the key role of return expectations in determining the benefits of interna-
tional diversification. Break-even returns are derived and evidence is presented from
actively managed international portfolios. After discussing the reasonableness of in-
ternational diversification, we focus on active and passive strategies for international
investment.

11.2 WORLD PORTFOLIO. In discussing the size of capital markets it is interest-
ing to employ the concept of world portfolio. The world portfolio represents the total
market value of all stocks (or bonds) that an investor would own if he or she bought
the total of all marketable stocks on all the major stock exchanges in the world. Ex-
hibit 11.1 shows the percentage that each nation’s equity securities represented of the

11 • 2 INTERNATIONAL DIVERSIFICATION

Area or Country Percent of Totala

Austria 0.1%

Belgium 0.4%

Denmark 0.4%

Finland 1.6%

France 5.5%

Germany 4.3%

Ireland 0.2%

Italy 2.1%

Netherlands 2.5%

Norway 0.2%

Portugal 0.2%

Spain 1.3%

Sweden 1.6%

Switzerland 2.8%

U.K. 9.7%

Europe 32.8%

Australia 1.1%

Hong Kong 1.0%

Japan 12.6%

Malaysia 0.5%

New Zealand 0.1%

Singapore 0.4%

Pacific 15.5%

Canada 2.1%

United States 49.5%

North America 51.6%

Total 100.0%

Source:FromMorgan Stanley Capital International Perspec-

tives, June 2000.

aSince the Morgan Stanley index does not include all shares

traded in a market the proportions are approximate. Column

sums may not equal totals because of rounding.

Exhibit 11.1. Comparative Sizes of World Equity Markets 2000.