This paper analyzes international portfolio selection with exchange rate risk based on behavioural portfolio theory (BPT). We characterize the conditions under which the BPT problem with a single foreign market has an optimal solution, and show that the optimal portfolio contains the traditional mean–variance efficient portfolio without consideration of exchange rate risk, and an uncorrelated component constructed to hedge against exchange rate risk. We illustrate that the optimal portfolio must be mean–variance efficient with exchange rate risk, while the same is not true from the perspective of local investors unless certain conditions are satisfied. We further establish that international portfolio selection in the BPT with multiple foreign markets consists of two sequential decisions. Investors first select the optimal BPT portfolio in each market, overlooking covariances among markets, and then allocate funds across markets according to a specific rule to achieve mean–variance efficiency or to minimize the loss in efficiency.

This study employs the Gerneralised Autoregressive Conditional Heteroskedasticity (GARCH) model to investigate the sensitivity of Chinese bank stock returns to market, interest rate and foreign exchange rate risks. Daily data are used to model these risks over the period 2007 to 2010. The results suggest that market risk is an important factor of Chinese bank stock returns, along with foreign exchange risk. However, interest rates risk tends to be insignificant factors in Chinese bank equity pricing process over the period considered.