Investments, tenth edition

 Figure 25.13 

Efficient frontier of country portfolios (world expected excess 

return  5  .6% per month)  

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910

P A R T   V I I

  Applied Portfolio Management

 Figure 25.14 

Regional indexes around the crash, October 14–October 26, 1987 

  Source: From Richard Roll, “The International Crash of October 1987,”  Financial Analysts Journal,  

September–October 1988. Copyright 1995, CFA Institute. Reproduced from  Financial Analysts Journal  

with permission from the CFA Institute. 

Value of One Currency Unit

1.05

Tick Marks on October Date, 4:00 P.M., U.S. Eastern Standard Time

12

14

16

18

20

22

24

26

Symbols Positioned

at Market Close

Local Time

North America

0.65

0.7

0.75

0.8

0.85

0.9

0.95

1

Australia/New Zealand

Asia

Small Europe

Large Europe

Ireland, So. Africa, U.K.

exactly when they are needed the most. For example, a study by Roll of the crash of 

October 1987 shows that all 23 country indexes studied declined over the crash period 

of October 12–26.  

7

   This correlation is reflected in the movements of regional indexes 

depicted in   Figure 25.14 . Roll found that the beta of a country index on the world index 

(estimated prior to the crash) was the best predictor of that index’s response to the 

October crash of the U.S. stock market. This suggests a common factor underlying the 

movement of stocks around the world. This model predicts that a macroeconomic shock 

would affect all countries and that diversification can only mitigate country-specific 

events.

   

 The 2008 crash of stock markets around the world allows us to test Roll’s prediction. 

The data in  Figure  25.15  include average monthly rates of return for both the 10-year 

period 1999–2008 and the crisis period corresponding to the last 4 months of 2008, as well 

as the beta on the U.S. market and monthly standard deviation for several portfolios. The 

graph shows that both beta against the U.S. and the country-index standard deviation help 

explain the difference between crisis period returns and overall period averages. Market 

behavior during the 1987 crisis, that is, larger correlations in extreme bad times, repeated 

itself in the crisis of 2008, vindicating Roll’s prediction.     

7

 Richard Roll, “The International Crash of October 1987,”  Financial Analysts Journal,  September–October 1988.  

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  C H A P T E R  

2 5

 International 

Diversification 

911

    25.4 

Assessing the Potential 

of International Diversification