FINM7008 Chap.8 International Diversification and Its Risks
International Diversification and Its Risks
Diversifying across countries
International diversification applies the same logic at the country level.
The chapter sets out where the world's equity capitalisation sits, the home-country bias of pension and superannuation funds, and how a foreign return combines the local return with the change in the exchange rate.
Two extra risks
It explains exchange-rate risk and how to hedge it, and political risk, illustrated with the cases and country ratings from the lecture.
What the evidence shows
The lecture's figures make three points.
The world market is concentrated, with the United States holding about half and six markets over two thirds; national pension and superannuation funds lean heavily towards home; and currency moves added only modestly to the volatility of major equity markets over 2017 to 2021.
What this chapter covers
- 01
World market capitalisation by country
- 02
Benefits and costs of investing abroad
- 03
Home-country bias
- 04
Currency-adjusted returns
- 05
Hedging exchange-rate risk
- 06
Political and geopolitical risk
- 07
Country risk ratings
Worked example · free
A US Treasury bill held by an Australian investor
- 1Currency factor: 1.44 / 1.50 = 0.96, so the US dollar falls 4%.
- 1Home return: 1.04 × 0.96 − 1 = −0.16%.
- 1The 4% currency loss on the grown balance, 4.16 points, more than offsets the bill's 4% interest.
Key terms
- Home-Country Bias
- The tendency to overweight domestic assets and underweight foreign ones.
- Exchange-Rate Risk
- Uncertainty in the home value of a foreign investment caused by currency movements.
- Political Risk
- The risk that government action or unrest in a country reduces an investment's returns.
- Currency Hedge
- A forward, futures or hedged index position that fixes the home value of foreign proceeds.
International Diversification and Its Risks FAQ
Do currency movements make foreign shares much riskier?
Generally not for diversified equity holdings. The lecture's data for 2017 to 2021 show average monthly standard deviations of 4.5% in local currency and 4.9% in US dollars, a small difference, although currency can dominate a low-risk foreign asset.
How can an investor hedge exchange-rate risk?
By using a currency forward or futures contract to fix the conversion rate in advance, or by buying a world equity index that is hedged to the home currency. Political risk has no comparable contract and must be assessed country by country.
How large is home bias in Australian superannuation?
The lecture puts the average super fund at about 45.5% domestic equities, while Australia makes up roughly 1.4% of world market capitalisation. That is about thirty times its market weight.
What share of world equity does the United States represent?
About half. The lecture puts world market capitalisation at roughly $152 trillion at the end of 2025, with the United States holding around half, developed countries 71% to 76% and the six largest markets more than two thirds of the total.
How is political risk assessed?
It requires expertise in each country's economic, legal, tax and political environment, so investors often rely on specialist ratings. The PRS Group's composite scores and BlackRock's Geopolitical Risk Indicator, which tracks attention to specific risks in reports and news, are the lecture's examples.
Why might a risk-free foreign bill lose money at home?
Its interest is fixed in the foreign currency, but the proceeds must be converted back. If the foreign currency falls by more than the interest earned, the home-currency return is negative even though the bill itself paid exactly as promised.
Does investing abroad always reduce portfolio risk?
It widens the set of imperfectly correlated assets, which moves the efficient frontier left, but it also adds exchange-rate and political risk. For diversified equity portfolios the lecture finds the currency effect on volatility small; for low-risk holdings it can dominate.
Exam move
Practise the currency-adjusted return formula in both directions, from rates to return and from a return back to the implied rate. Then prepare one example of each kind of political risk. Add one hedging answer: explain how a currency forward fixes the conversion rate and which risk it leaves untouched.
Keep the home-bias figures as a set of three, China, Japan and Australia, so that one comparison can support a whole short answer.
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