232 PART 2 Important Financial Concepts
political risk
Risk that arises from the
possibility that a host govern-
ment will take actions harmful to
foreign investors or that political
turmoil in a country will
endanger investments there.
Note that only in the case of perfect negative correlation can the risk be
reduced to 0.Also note that as the correlation becomes less positive and more
negative (moving from the top of the figure down), the ability to reduce risk
improves. The amount of risk reduction achieved depends on the proportions in
which the assets are combined. Although determining the risk-minimizing combi-
nation is beyond the scope of this discussion, it is an important issue in develop-
ing portfolios of assets.International Diversification
The ultimate example of portfolio diversification involves including foreign assets
in a portfolio. The inclusion of assets from countries with business cycles that are
not highly correlated with the U.S. business cycle reduces the portfolio’s respon-
siveness to market movements and to foreign currency fluctuations.Returns from International Diversification
Over long periods, returns from internationally diversified portfolios tend to be
superior to those of purely domestic ones. This is particularly so if the U.S. econ-
omy is performing relatively poorly and the dollar is depreciating in value against
most foreign currencies. At such times, the dollar returns to U.S. investors on a
portfolio of foreign assets can be very attractive. However, over any single short
or intermediate period, international diversification can yield subpar returns, par-
ticularly during periods when the dollar is appreciating in value relative to other
currencies. When the U.S. currency gains in value, the dollar value of a foreign-
currency-denominated portfolio of assets declines. Even if this portfolio yields a
satisfactory return in local currency, the return to U.S. investors will be reduced
when translated into dollars. Subpar local currency portfolio returns, coupled
with an appreciating dollar, can yield truly dismal dollar returns to U.S. investors.
Overall, though, the logic of international portfolio diversification assumes
that these fluctuations in currency values and relative performance will average
out over long periods. Compared to similar, purely domestic portfolios, an inter-
nationally diversified portfolio will tend to yield a comparable return at a lower
level of risk.Risks of International Diversification
U.S. investors should also be aware of the potential dangers of international
investing. In addition to the risk induced by currency fluctuations, several other
financial risks are unique to international investing. Most important is political
risk,which arises from the possibility that a host government will take actions
harmful to foreign investors or that political turmoil in a country will endanger
investments there. Political risks are particularly acute in developing countries,
where unstable or ideologically motivated governments may attempt to block
return of profits by foreign investors or even seize (nationalize) their assets in the
host country. An example of political risk was the heightened concern after
Desert Storm in the early 1990s that Saudi Arabian fundamentalists would take
over and nationalize the U.S. oil facilities located there.