Exchange Rate Risk and International Equity Portfolio Diversification: A South African Investor’s Perspective

Muteba Mwamba, John Weirstrass and Tchuinkam Djemo, Charles Raoul (2019): Exchange Rate Risk and International Equity Portfolio Diversification: A South African Investor’s Perspective.

Abstract

This paper examines the impact of foreign exchange rate risk on the expected return of a South African investor’s portfolio. A GJR-GARCH based Value at Risk (VaR) model was used to compute the upside and downside risk measures. Data sample of ten emerging stock markets were utilized: from 1 January 2000 to 6 March 2019. The tails of negative and positive asset returns were modelled with the help of the generalized Pareto distribution (GPD) method in order to separate left tail risk from right tail risk. Our findings reveal that international diversification substantially enhances the South African investor’s portfolio return, with a noticeable yield increase in China, Brazil, Argentina, Mexico, and Russia. Furthermore, the Singaporean dollar and Chinese Yuan are found to have a negative impact on the portfolio return, while the rest of the currencies have a positive impact on the portfolio return. Also, we found that exchange rate risk is underestimated when using the variance-covariance method as it fails to capture the swing movement of currency in the minimum- value at risk optimization.

• Item Type: MPRA Paper
• Language: English
• Keywords: International Diversification, Exchange Rate Risk, Portfolio Selection, Value at Risk
• Subjects: F - International Economics > F3 - International Finance; F - International Economics > F3 - International Finance > F31 - Foreign Exchange; F - International Economics > F3 - International Finance > F37 - International Finance Forecasting and Simulation: Models and Applications; G - Financial Economics > G1 - General Financial Markets; G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency ; Event Studies ; Insider Trading; G - Financial Economics > G1 - General Financial Markets > G17 - Financial Forecasting and Simulation

References

Abidin, s. Z., Ariff, m., Nassir, a. M. & Mohamad, s. 2004. International portfolio diversification: a Malaysian perspective. Investment management and financial innovations, 3, 51-68.

Adler, m. & Dumas, b. 1984. Exposure to currency risk: definition and measurement. Financial management, 41-50.

Akdogan, h. 1996. A suggested approach to country selection in international portfolio diversification. The journal of portfolio management, 23, 33-39.

Biger, n. 1979. Exchange risk implications of international portfolio diversification. Journal of international business studies, 64-74.

Choi, j. J. 1989. Diversification, exchange risk, and corporate international investment. Journal of international business studies, 145-155.

Culp, c. L., Mensink, r. & neves, a. M. 1998. Value at risk for asset managers. Derivatives Quarterly, 5, 21-33.

Chummun, B.Z. (2017) Mobile microinsurance and financial inclusion: the case of developing African countries. Africagrowth Agenda 2017 (Jul/Sep 2017), 12-16

Chummun, Z.B., and Bisschoff, C.A. (2014) A Theoretical Model to Measure the Business Success of Micro-insurance (MI) in South Africa. Journal of Economics 5 (1), 87-96

Danielsson, j. & De Vries, c. G. 2000. Value-at-risk and extreme returns. Annales d'economie et de statistique, 239-270.

Domínguez, j. M. F. & Alfonso, m. D. O. 2004. Applying stress-testing on value at risk (var) methodologies. investment management and financial innovations, 62-73.

Dowd, k. 2015. Central bank stress tests: mad, bad, and dangerous. Cato j., 35, 507.

Engle, r. F. 1982. Autoregressive conditional heteroscedasticity with estimates of the variance of united kingdom inflation. Econometrica: Journal of the econometric society, 987-1007.

Engle, r. F. & Manganelli, s. 2001. Value at risk models in finance. Ecb working paper.

Eun, c. S. & Resnick, b. G. 1988. Exchange rate uncertainty, forward contracts, and international portfolio selection. The journal of finance, 43, 197-215.

Eun, c. S. & Resnick, b. G. 1994. International diversification of investment portfolios: us and japanese perspectives. Management science, 40, 140-161.

Fidora, m., Fratzscher, m. & Thimann, c. 2007. Home bias in global bond and equity markets: the role of real exchange rate volatility. Journal of international money and finance, 26, 631-655.

Grubel, h. G. 1968. Internationally diversified portfolios: welfare gains and capital flows. The American economic review, 58, 1299-1314.

Hauser, s., Marcus, m. & Yaari, u. 1994. Investing in emerging stock markets: is it worthwhile hedging foreign exchange risk? The journal of portfolio management, 20, 76-81.

Horobeţ, a. & Ilie, l. 2010. International investments with exchange rate risk: the case of central and eastern Europe currencies. Studies in business & economics, 5.

Ibragimov, r. 2009. Portfolio diversification and value at risk under thick-tailedness. Quantitative finance, 9, 565-580.

Janabi, M. A. 2006. Foreign-exchange trading risk management with value at risk: case analysis of the Moroccan market. The journal of risk finance, 7, 273-291.

Janabi, m. A. 2008. A practical approach to market risk analysis and control: empirical test of the Mexican foreign exchange and stock markets. International journal of risk assessment and management, 9, 70-103.

Jun, s.-g., Marathe, a. & Shawky, h. A. 2003. Liquidity and stock returns in emerging equity markets. Emerging markets review, 4, 1-24.

Kabundi, a. Muteba Mwamba, j. M. 2012. Applying a genetic algorithm to international diversification of equity portfolios: a South African investor perspective. South African Journal of Economics, 80, 91-105.

Kang, s., Kim, s. & Lee, j. W. 2016. Reexamining the exchange rate exposure puzzle by classifying exchange rate risks into two types. Global economic review, 45, 116-133.

Kaplanis, e. & Schaefer, s. M. 1991. Exchange risk and international diversification in bond and equity portfolios. Journal of economics and business, 43, 287-307.

Kiani, k. M. 2011. Relationship between portfolio diversification and value at risk: empirical evidence. Emerging markets review, 12, 443-459.

Kupiec, p. H. 1995. Techniques for verifying the accuracy of risk measurement models. The Journal of Derivatives, 3, 73-84.

Nelson, d. B. 1991. Conditional heteroskedasticity in asset returns: a new approach. Econometrica: Journal of the econometric society, 347-370.

Ramazan, g. & Faruk, s., 2004. Extreme value theory and value at risk relative performance in emerging markets. International journal of forecasting, 20, 287-303.

Rejeb, a. B., Salha, o. B. & Rrjeb, j. B. 2012. Value-at-risk analysis for the Tunisian foreign exchange market: a comparative study. Theoretical & applied economics, 19.

Rufino,c.c. & de Guia,e.g .2011.empirical comparison of extreme value theory vis-à-vis other methods of var estimation using asean+exchange rates.business and economics review,20.2,9-22

Semper, j. D. C. & Clemente, i. M. 2003. Value at risk calculation through arch factor methodology: proposal and comparative analysis. European journal of operational research, 150, 516-528.

Virdi, n. K. 2011. A review of backtesting methods for evaluating value-at-risk. International review of business research papers, 7, 14-24.

Wang, z., Wu, w., Chen, c. & Zhou, y. 2010. The exchange rate risk of Chinese yuan: using var and es based on extreme value theory. Journal of applied statistics, 37, 265-282.