risk and return from foreign investing

CHAPTER TWENTY-FIVE

INTERNATIONAL INVESTING

THE TOTAL INVESTABLE INTERNTATIONAL CAPITAL MARKET PORTFOLIO GLOBAL DISTRIBUTION OF CAPITAL

(by market in trillions of US$)•Non-U.S. Bond & Equity Markets

=$25•Total World Portfolio = 49.1•Fixed Income securities =

25.9

THE TOTAL INVESTABLE INTERNTATIONAL CAPITAL MARKET PORTFOLIO GLOBAL DISTRIBUTION OF CAPITAL

(by country in trillions of US$)•Largest Market for common stock =

U.S.•U.S & Japanese Assets as %Total =

63.4%•U.S.,Japan, Germany,UK, France

=82.9%

THE TOTAL INVESTABLE INTERNTATIONAL CAPITAL MARKET PORTFOLIO GLOBAL EQUITY INDICES

•MOST CLOSELY WATCHED:FTSE100NIKKEI225TSE 300

THE TOTAL INVESTABLE INTERNTATIONAL CAPITAL MARKET PORTFOLIO

•INTERNATIONAL EAFE (Morgan Stanley)IFC (International Finance Corporation)

THE TOTAL INVESTABLE INTERNTATIONAL CAPITAL MARKET PORTFOLIO EMERGING MARKETS

•COMMON FEATURES:securities improved political and

economic stabilityavailable to foreign ownershipconvertible currencyrelatively low level of per capita GDP

THE TOTAL INVESTABLE INTERNTATIONAL CAPITAL MARKET PORTFOLIO

•EMERGING MARKET INDICESMorgan StanleyIFC: Emerging Market Index, national

RISK AND RETURN FROM FOREIGN INVESTING THE ADDITIONAL RISKS

•POLITICAL RISKDEFINITION: refers to the uncertainty

about the ability of an investor to convert foreign currency into local

RISK AND RETURN FROM FOREIGN INVESTING THE ADDITIONAL RISKS

•EXCHANGE RATE RISKDEFINITION: refers to uncertainty about

the rate at which a foreign currency can be exchanged for the investor’s local currency in the future

RISK AND RETURN FROM FOREIGN INVESTING MANAGING EXCHANGE RATE RISK

•involves using hedge instruments such ascurrency forward contractscurrency optionscurrency futures

RISK AND RETURN FROM FOREIGN INVESTING MANAGING EXCHANGE RATE RISK

•TWO APPROACHES:passive currency management

RISK AND RETURN FROM FOREIGN INVESTING MANAGING EXCHANGE RATE RISK

•TWO APPROACHES:active currency management

RISK AND RETURN FROM FOREIGN INVESTING passive currency management

•involves a strategy of permanently controlling a portfolio’s exposure to risk

RISK AND RETURN FROM FOREIGN INVESTING active currency management

•involves a strategy of frequently changing currency exposures to take advantage of perceived short-run mispricings

FOREIGN AND DOMESTIC RETURNS THE DOMESTIC RETURN

•FORMULA

0

01

ppprD

FOREIGN AND DOMESTIC RETURNS THE FOREIGN RETURN

•FORMULA

00

0011

pxpxpxrF

FOREIGN AND DOMESTIC RETURNS FOREIGN INVESTMENT

•Two Parts:the investment in the country’s firm(s)the currency exposure

FOREIGN AND DOMESTIC RETURNS Calculating the return on foreign

currency

0

01

xxxrc

FOREIGN AND DOMESTIC RETURNS

we know

and cDF rrr 111

cDF rrr

FOREIGN AND DOMESTIC RETURNS Calculating the return on foreign

currency•the return on a foreign security ( rF )

can be estimated by summing the domestic with the currency returns

EXPECTED RETURNS ON A FOREIGN SECURITY

•FORMULA

•If expected return differential exists, interest rate parity equates the two rates

cDF rrr

EXPECTED RETURNS ON A FOREIGN SECURITY: An

ExampleAssume an investor can buy either a 5% U.S. Treasury bond or a 7% German bond, which gives a better return?If the German mark is expected to depreciate by 2% against the U.S.$, neither bond offers a better return

FOREIGN AND DOMESTIC RISK Calculating Portfolio Risk

•Formula:

where F= the risk of the foreign portfolio D = the risk of the foreign stock C = the risk of the foreign currency DC= the correlation between the currency change and the asset returns

cDDccDF 2222

FOREIGN AND DOMESTIC RISK PORTFOLIO RISK

•the smaller the value of the correlation coefficient, the lower the foreign portfolio risk

END OF CHAPTER 25