The Association Between the Level of International Diversification and Risk

This study analyzes the association between the degree of international involvement (DOI) and risk. Both systematic risk (measured by the market model beta) and total risk (measured by variance of return) are analyzed. Betas of fully diversified foreign stock portfolios are shown to be lower than betas of domestic portfolios. Therefore, if the beta of a foreign investment by a U.S. firm is equal to the average beta of an investment in the foreign market, then overall firm beta will decrease as DOI increases (hypothesis). While total risk might be decreased due to the diversification provided by increasing DOI, currency, political, and other risks could cause total risk to increase. Briefly, the results of this study suggest that (1) systematic risk is negatively related to DOI even after controlling for other factors known to be associated with systematic risk, (2) intertemporal changes in systematic risk are negatively related to intertemporal changes in DOI, and (3) in contrast to the results of previous research, DOI is not negatively related to total risk and, in fact, intertemporal changes in total firm risk are marginally positively related to intertemporal changes in DOI.
Our results suggest that increasing DOI decreases systematic risk but increases total risk. Year to year changes in both beta and variance of return appear to be related to year to year changes in DOI. While currency, political, and other risks of international operations increase total risk, these risks apparently can be diversified away resulting in a beta that behaves as a blending of its previous level and the beta of a fully diversified investment in the foreign market.