Gains from Portfolio Diversification into Less Developed Countries' Securities: A Reply
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* Giventhe natureof James Bicksler'scomment, itwouldbe appropriatefirstto review brieflythe most importantworksin the area of internationalportfolioinvestments.
Inthe past, there have been two distincttypes of contributions.
MAJOR STUDIESTO DATE
We first discuss the studies which extend domestic capital asset pricing theory to I. Extensions of explain internationalpricingof riskand indicate gains frominternationalportfoliodiver- Domestic Capital sification. Since the Capital Asset Pricing Model (CAPM)is expressed in terms of Asset Pricing expectations which are unobservable, a special structureof returns(for both national Theory and internationaltests of the theory),widely knownas the "MarketModel,"is generally postulated. Using stock price indices of developed countries and the international marketmodel, Lessard1shows considerableriskreductionthroughinternationaldimension. However,his methodology suffersfroma numberof complicationsas discussed by Bicksler.2 Solnik, on the other hand,3 explicitlydevelops the InternationalAsset Pricing Model (IAPM)and tests the internationalmarketstructureusing both nationalisticand multinationalindex models. His resultsindicatethatthe securitiesare pricedaccording to their internationalsystematic riskwhich is much smallerthanthe domestic nondiversifiable risk,thereby indicatingpotentialgains frominternationaldiversification. The most importanttheoreticalcontribution,whichformedthe basis of his study above, belongs to Solnik.4Undera highlycontroversialset of assumptions, he shows that all investors would hold a portfolioof all riskyassets, includingforeign bonds (portfolio compositionwould depend on investor'snationality)and theirdomestic risk-freeasset. Further,all investorswillbe indifferenttoward holdingportfoliosof individualassets or choosing among three funds; namely, a portfolioof stocks hedged against exchange risk, a portfolioof bonds exposed to exchange risk,and the domestic risk-freeasset. These results depend heavilyon the assumptions of perfectcapital markets,no transaction costs, no capital controls, unlimitedshort selling, availabilityof risk-freeinterest rate in each countrywithno restrictionson lending or borrowingat the given rate, and that investor consumption is limitedto home country. His most crucial assumption requireshomogeneous investorexpectations about exchange ratevariationsand security returndistributionswithcontinuous trading in assets and currencies. This is tantamountto assuming homogeneous expectations about asset returnsin any given currency,which, underflexibleexchange rates and costless hedging, means all investors face the same investmentopportunityset subject to no exchange risk.Further,no efficiency tests on less developed country(LDC)stock marketshave appeared inthe literature.In fact, studies on marketsoutside NorthAmericaare ratherlimitedand far fromconclusive.5Unlimitedshort selling opportunitiesare unrealisticeven inthe U.S.6 In many LDCs,explicit restrictionsare imposed on such transactions.The unrestricted borrowingand lendingopportun
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