In this paper, ex ante efficient portfolio selection strategies are developed to realize potential gains from international diversification under flexible exchange rates. It is shown that exchange rate uncertainty is a largely nondiversiflable factor adversely affecting the performance of international portfolios. Therefore, it is essential to effectively control exchange rate volatility. For that purpose, two methods of exchange risk reduction are simultaneously employed: multicurrency diversification and hedging via forward exchange contracts. The empirical findings show that international portfolio selection strategies designed to control both estimation and exchange risks almost consistently outperform the U.S. domestic portfolio in out-of-sample periods. SINCE GRUBEL [11] APPLIED MODERN portfolio theory (MPT) to international investment, various authors, such as Levy and Sarnat [17], Solnik [20], and Lessard [16], have examined the gains from international diversification of investment portfolios. For the purpose of establishing the gains from international diversification, these studies constructed international portfolios using historical risk and return data from a period of fixed or relatively stable exchange rates and showed that internationally diversified portfolios dominated purely domestic portfolios in terms of mean-variance efficiency. From the standpoint of today's investors, however, the previous studies fail to offer operational guidance for international diversification for two important reasons. First, it is now questionable whether the past findings are still relevant under the current flexible exchange rate regime. Second, by being "ex post" in nature, the past studies ignored the issue of estimation risk, or parameter uncertainty, and therefore may have overstated the realizable portion of the potential gains from international diversification.Fluctuating exchange rates are likely to mitigate the potential gains from international diversification by making investment in foreign securities more risky. As will be shown later, a fluctuating exchange rate contributes to the risk of foreign investment not only through its own variance but also through its "positive" covariances with the local stock market returns. During our sample period of 1980 through 1985, for example, exchange rate volatility is found to account for about fifty percent of the volatility of dollar returns from investment in the stock markets of such major countries as Germany, Japan, and the U.K. Furthermore, the exchange rate changes vis-'a-vis the U.S. dollar are found to be

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In this paper, we analyze the gains from international diversification of investment portfolios from the Japanese as well as the U.S. perspectives. The major findings of this paper include: First, the 'potential' gains from international, as opposed to purely domestic, diversification are much greater for U.S. investors than for Japanese investors. For U.S. investors, the gains accrue not so much in terms of lower risk as in terms of higher return, and the opposite holds for Japanese investors. Second, using various 'ex ante' international investment strategies designed to control parameter uncertainty, U.S. investors can realize substantial gains from international diversification in out-of-sample periods. Japanese investors, however, can gain relatively little. Third, hedging exchange risk generally allows the U.S., but not Japanese, investors to benefit more from international diversification. For U.S. investors, the international bond diversification with exchange risk hedging offers a superior risk-return trade-off than the international stock diversification, with or without hedging.portfolio diversification, U.S.A., Japan

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