- 1. 1 Chapter 7 International Investment and Diversification
www.StudsPlanet.com
2. 2 Outline Introduction Why international diversification
makes theoretical sense Foreign exchange risk Investments in
emerging markets Political risk Other topics related to
international diversification www.StudsPlanet.com 3. 3 Introduction
The marketplace of the twenty-first century is global U.S. equities
represent only about 51% of the worlds equity capitalization Over
the period 1980-2000, the U.S. was the best-performing market only
once In September 1999, each of the 66 U.S. pension funds had more
than $1 billion in actively managed international investment
portfolios www.StudsPlanet.com 4. 4 Introduction (contd)
International investments carry additional sources of risk Managers
can reduce total portfolio risk via global investment
www.StudsPlanet.com 5. 5 Why International Diversification Makes
Sense (Evans and Archer) Portfolio theory works to the investors
benefit even if he selects securities at random Ideally, the
portfolio manager selects securities because of their fit with the
rest of the portfolio By choosing poorly correlated securities, a
manager can reduce total portfolio risk www.StudsPlanet.com 6. 6
Why International Diversification Makes Sense (Evans and Archer
Contd) Total risk contains both systematic and unsystematic risk
Evans and Archer show that holding 15 to 20 equity securities
substantially reduces the unsystematic risk www.StudsPlanet.com 7.
7 Utility, Risk, and Return Unsystematic risk reduction is possible
with more than 20 securities For a given level of return, any
reduction in risk, no matter how small, is a worthy goal A rational
invest will reduce risk if given the opportunity
www.StudsPlanet.com 8. 8 Variance of A Linear Combination As long
as assets are less than perfectly correlated, there will be
diversification benefits More pronounced the lower the correlation
No two shares move in perfect lockstep Diversification benefits
accrue every time we add a new position to a portfolio
www.StudsPlanet.com 9. 9 Relationship of World Exchanges For U.S.
securities, market risk account for about 25% of a securitys total
risk For less developed countries, market risk tends to be higher
because: Fewer securities make up the market The securities are
exposed to more extreme economic and political events
www.StudsPlanet.com 10. 10 Relationship of World Exchanges (contd)
International capital markets continue to show independent price
behavior International diversification offers potential advantages
Repeating the Evans and Archer methodology for international
securities should result in a lower level of systematic risk
www.StudsPlanet.com 11. 11 Relationship of World Exchanges (contd)
Number of Securities Portfolio Variance U.S. Securities: Systematic
Risk 27% International Securities: Systematic Risk 11.7%
www.StudsPlanet.com 12. 12 Fundamental Logic of Diversification
Investors are, on average, rational Rational people do not like
unnecessary risk By holding one more security, an investor can
reduce portfolio risk without giving up any expected return
Rational investors, therefore, will hold as many securities as they
can www.StudsPlanet.com 13. 13 Fundamental Logic of Diversification
(contd) The most securities investors can hold is all of them The
collection of all securities makes up the world market portfolio
Rational investors will hold some proportion of the world market
portfolio www.StudsPlanet.com 14. 14 Other Considerations Optimum
portfolio size involves a trade-off between: The benefits of
additional diversification Commissions and capital constraints
www.StudsPlanet.com 15. 15 Foreign Exchange Risk Definition
Business example Investment example From whence cometh the risk?
Dealing with the risk The eurobond market Combining the currency
and market decisions Key issues in foreign exchange risk management
www.StudsPlanet.com 16. 16 Definition Foreign exchange risk refers
to the changing relationships among currencies Modest changes in
exchange rates can result in significant dollar differences
www.StudsPlanet.com 17. 17 Business Example A U.S. importer has
agreed to purchase 40 New Zealand leather vests at a price of
NZ$110 each. The vests will take two months to produce, and payment
is due before the vests are shipped. The current spot rate of the
NZ$ is $0.5855. What is the price of the vests to the importer if
the spot rate remains unchanged in the next two months? If it is
$0.5500? If it is $0.6200? www.StudsPlanet.com 18. 18 Business
Example (contd) Solution: If the spot rate does not change, the
cost to the importer is: 40 x NZ$110 x $0.5855 = $2,576.20 If the
spot rate is $0.5500: 40 x NZ$110 x $0.5500 = $2,420.00 If the spot
rate is $0.6200: 40 x NZ$110 x $0.6200 = $2,728.00
www.StudsPlanet.com 19. 19 Investment Example You just purchased
1,000 of Kangaroo Lager trading on the Sydney Stock Exchange for
AUD1.45 per share. The exchange rate for the Australian dollar at
the time of purchase was $0.7735. What is the U.S. dollar purchase
price? If Kangaroo Lager stock rises to AUD1.95 per share and if
the Australian dollar depreciates to $0.7000, what is your holding
period return if you sell the shares? www.StudsPlanet.com 20. 20
Investment Example (contd) Solution: The purchase price in U.S.
dollars is: 1,000 x AUD1.45 x $0.7735 = $1,121.58 If the Australian
dollar depreciates and you sell the shares, you will receive: 1,000
x AUD1.95 x $0.7000 = $1,365.00 The holding period return is:
($1,365.00 - $1,121.58)/$1,121.58 = 21.7% www.StudsPlanet.com 21.
21 From Whence Cometh the Risk? Role of interest rates Forward
rates Interest rate parity Covered interest arbitrage Purchasing
power parity www.StudsPlanet.com 22. 22 Real Rate of Interest The
real rate of interest reflects the rate of return investors demand
for giving up the current use of funds In a world of no risk and no
inflation, the real rate indicates peoples willingness to postpone
spending their money www.StudsPlanet.com 23. 23 Inflation Premium
The inflation premium reflects the way the general price level is
changing Inflation is normally positive The inflation premium
measures how rapidly the money standard is losing its purchasing
power www.StudsPlanet.com 24. 24 Risk Premium The risk premium is
the component of interest rates that reflects compensation for risk
to risk-averse investors The risk premium is a function of how much
risk a security carries E.g., common stock vs. T-bills
www.StudsPlanet.com 25. 25 Forward Rates The forward rate is a
contractual rate between a commercial bank and a client for the
future delivery of a specified quantity of foreign currency
Typically quoted on the basis of 1, 2, 3, 6, and 12 months
www.StudsPlanet.com 26. 26 Forward Rates (contd) The forward rate
is the best estimate of the future spot rate If the forward rate
indicates the dollar will strengthen, importers should delay
payment If the forward rate indicates the dollar will weaken,
importers should lock in a rate now www.StudsPlanet.com 27. 27
Forward Rates (contd) Forward rate premium or discount: Forward
rate - Spot rate 12 100 Spot rate where the contract length in
months n n = www.StudsPlanet.com 28. 28 Forward Rates (contd)
Example On April 29, 2005, the British pound had a spot rate of
$1.9146. The 3-month forward rate of the pound was $1.9041 on that
date. What is the forward premium or discount? www.StudsPlanet.com
29. 29 Forward Rates (contd) Example (contd) Solution: The forward
premium or discount is calculated as follows: There is a forward
discount of 2.19%. %19.2 100 3 12 9146.1$ 9146.1$9041.1$ 100 12
rateSpot rateSpot-rateForward = = n www.StudsPlanet.com 30. 30
Interest Rate Parity Interest rate parity states that differences
in national interest rates will be reflected in the currency
forward market Two securities of similar risk and maturity will
show a difference in their interest rates equal to the forward
premium or discount, but with the opposite sign www.StudsPlanet.com
31. 31 Interest Rate Parity Formula domestic foreign where
annualized domestic risk-free rate annualized foreign risk-free
rate F=Forward (contract) rate [value of foreign currency expressed
in units of domestic currency] S=Spot exchange R R = = rate [value
of foreign currency expressed in units of domestic currency]
domestic foreign 365F S R R S n = + www.StudsPlanet.com 32. 32
Example Six-month German Treasury Bills yield 2.60% (annualized
rate) Spot exchange rate is $ 0.6051 / DM Six-month Forward rate is
$ 0.6095 / DM RUS=2.60+100(0.6095-0.6051)(12/6)/0.6051 RUS=4.05 %
www.StudsPlanet.com 33. 33 Covered Interest Arbitrage Covered
interest arbitrage is possible when the conditions of interest rate
parity are violated If the foreign interest rate is too high,
convert dollars to the foreign currency and invest in the foreign
country If the U.S. interest rate is too high, borrow the foreign
currency and invest in the U.S. www.StudsPlanet.com 34. 34 Example
of CIA Six-month Swiss rate is 1.00 % (annualized rate) Six-month
US Treasury Bills yield 2.00 % (annualized rate) Spot exchange rate
is $ 0.8542 / CHF Six-month Forward rate is $ 0.8610 / CHF What
arbitrage strategy can you implement ? www.StudsPlanet.com 35. 35
Example of CIA www.StudsPlanet.com 36. 36 Purchasing Power Parity
Purchasing power parity (PPP) refers to the situation in which the
exchange rate equals the ratio of domestic and foreign price levels
A relative change in the prevailing inflation rate in one country
will be reflected as an equal but opposite change in the value of
its currency www.StudsPlanet.com 37. 37 Purchasing Power Parity
(contd) Absolute purchasing power parity follows from the law of
one price: A basket of goods in one country should cost the same in
another country after conversion to a common currency Not very
accurate due to: Transportation costs Trade barriers Cultural
differences www.StudsPlanet.com 38. 38 Purchasing Power Parity
(contd) Relative purchasing power parity states that differences in
countries inflation rates determine exchange rates: 1 1 1 where
change in the spot exchange rate foreign country inflation rate
domestic country inflation rate D F F D IS S I S I I + = + = = =
www.StudsPlanet.com 39. 39 Purchasing Power Parity (contd) A
country with an increase in inflation will experience a
depreciation of its currency because: Exports decline Imports
increase There is less demand for goods from that country
www.StudsPlanet.com 40. 40 The Concept of Exposure Definition
Accounting exposure Transaction exposure Translation exposure
Economic exposure www.StudsPlanet.com 41. 41 Definition Exposure is
a measure of the extent to which a person faces foreign exchange
risk In general, there are two types of exposure: accounting and
economic Economic exposure is more important www.StudsPlanet.com
42. 42 Accounting Exposure Accounting exposure is: Of concern to
MNCs that have subsidiaries in a number of foreign countries
Important to people who hold foreign securities and must prepare
dollar-based financial reports U.S. firms must prepare consolidated
financial statements in U.S. dollars www.StudsPlanet.com 43. 43
Transaction Exposure FASB Statement No. 8 addresses transaction
exposure: A transaction involving purchase or sale of goods or
services with the price states in foreign currency is incomplete
until the amount in dollars necessary to liquidate a related
payable or receivable is determined www.StudsPlanet.com 44. 44
Translation Exposure Translation exposure results from the holding
of foreign assets and liabilities that are denominated in foreign
currencies E.g., foreign real estate and mortgage holdings must be
translated to U.S. dollars before they are incorporated into a U.S.
balance sheet www.StudsPlanet.com 45. 45 Economic Exposure Economic
exposure measures the risk that the value of a security will
decline due to an unexpected change in relative foreign exchange
rates Security analysts should include expected changes in exchange
rates in forecasted cash flows www.StudsPlanet.com 46. 46 Dealing
With the Exposure Ignore the exposure Reduce or eliminate the
exposure Hedge the exposure www.StudsPlanet.com 47. 47 Ignore the
Exposure Ignoring the exposure may be appropriate for an investor
if: Foreign exchange movements are expected to be modest The dollar
mount of the exposure is small relative to the cost of
inconvenience of hedging The U.S. dollar is expected to depreciate
relative to the foreign currency www.StudsPlanet.com 48. 48 Reduce
or Eliminate the Exposure If the dollar is expected to appreciate
dramatically, an investor may reduce or eliminate foreign currency
holdings www.StudsPlanet.com 49. 49 Hedge the Exposure Definition
Hedging with forward contracts Hedging with futures contracts
Hedging with foreign currency options www.StudsPlanet.com 50. 50
Definition Hedging involves taking one position in the market that
offsets another position Covering foreign exchange risk means
hedging foreign exchange risk www.StudsPlanet.com 51. 51 Hedging
With Forward Contracts A forward contract is a private, non-
negotiable transaction between a client and a commercial bank No
money changes hands until the foreign currency is delivered, but
the rate is determined now The forward rate reflects relative
interest rates and associated risks www.StudsPlanet.com 52. 52
Hedging With Futures Contracts A futures contract is a promise to
buy or sell a specified quantity of a particular good at a
predetermined price by a specified delivery date On the delivery
date, there will be a gain or loss in the futures market that will
offset the gain or loss experienced when converting the foreign
currency www.StudsPlanet.com 53. 53 Hedging With Futures Contracts
(contd) To hedge an investment, sell foreign currency futures To
hedge a liability, buy foreign currency futures www.StudsPlanet.com
54. 54 Hedging With Foreign Currency Options There are two types of
foreign currency options: Call options give their owner the right
to buy a set quantity of foreign currency Put options give their
owner the right to sell a set quantity of foreign currency The
price at which you have the right to buy or sell is the strike
(exercise) price www.StudsPlanet.com 55. 55 Hedging With Foreign
Currency Options (contd) Currency option characteristics: A call
option with an exercise price quoted in dollars for the purchase of
euros is the same as a put option on dollars with an exercise price
quoted in euros Put-call parity for foreign currency options is a
restatement of interest rate parity www.StudsPlanet.com 56. 56
Hedging With Foreign Currency Options (contd) The disadvantage of
hedging with currency options is that the hedger must pay a premium
to established the hedge Options provide more precision than
futures contracts Options are more expensive than futures contracts
www.StudsPlanet.com 57. 57 The Eurobond Market Eurobonds are debt
agreements that are denominated in a currency other than that of
the country in which they are held E.g., a bond denominated in yen
sold in the United Kingdom A foreign bond is denominated in the
local currency but is issued by a foreigner E.g., a bond
denominated in yen sold in Japan, issued by a firm in the United
Kingdom www.StudsPlanet.com 58. 58 The Eurobond Market (contd)
About 75% of eurobonds are denominated in U.S. dollars Firms
issuing dollar-denominated Eurobonds pay a slightly lower interest
rate than they would pay in the U.S. www.StudsPlanet.com 59. 59
Combining the Currency and Market Decisions It is often desirable
to cross-hedge a foreign investment into a different currency E.g.,
a U.S. investor might invest in Japan, use the forward market to
sell yen for British pounds and convert the pounds back to dollars
The currency return comes from the forward market premium or
discount and the actual change in the exchange rate
www.StudsPlanet.com 60. 60 How to do it Select the market with the
highest risk-premium, not the highest absolute return. Why? Because
due to non-arbitrage, investing in riskless securities of various
countries will yield the same returns once the proceeds are
translated back into the domestic currency (either always true if
use forward contracts or true on average if use currency spot
market to repatriate the funds). Thus what matters (what
differentiates markets) is the return expected ABOVE the risk-free
rate. www.StudsPlanet.com 61. 61 Which Currency to Cross-Hedge ?
What is relevant is the total rate of return, after including the
return in the selected local market (foreign equity), the
cost/benefit of holding the currency, and the expected return on
that currency. So instead of mechanically hedging the local
currency with the US Dollar (domestic), we should look for a third
currency for cross-hedging purposes so as to maximize the total
expected return. www.StudsPlanet.com 62. 62 The return to maximize
is the sum of Chosen Market Equity Return (where we chose to
invest) Forward market premium/discount (riskless rate in country
selected for cross-hedging minus riskless rate in country where we
chose to invest). Expected return in currency of country where we
chose to invest. www.StudsPlanet.com 63. 63 Example A US investor
chooses to invest in German stocks and then cross-hedges with the
Japanese Yen: Forecasted German equity returns: 10 % Forecasted
change in Japanese Yen: 2.5 % Japanese riskless rate (Eurobond
rate): 2 % German riskless rate (Eurobond rate): 4.5 % Forecasted
total return: 10% + (2% - 4.5%) + 2.5% Total (Expected) Return =
10% www.StudsPlanet.com 64. 64 The riskless (Eurobond) rate
differential comes from the fact that we have: This means that the
expected percentage change in the DM value (expressed in Yen) is
the riskless rate differential. When using forward contracts, we
get the forward rate instead of the spot rate due to the fact that
we need to wait for that future date before transforming the DM
into Japanese Yen. Therefore the amount in DM that gets converted
to Yen in the end is subject to a change in value since the forward
rate F is different than the spot rate S. future date / / / / Japan
Germany / / [ ]Yen DM Yen DM Yen DM Yen DM Yen DM Yen DM F S E S S
r r S S = = www.StudsPlanet.com 65. 65 Investments in Emerging
Markets Overview Background Adding value Reducing risk Following
the crowd Special risks Asymmetric correlations Market
microstructure considerations www.StudsPlanet.com 66. 66 Overview
Emerging market investments: Offer substantial potential rewards to
the careful investor in added return and risk reduction Are
accompanied by special risks: Foreign exchange risk High political
and economic risk Unreliable investment information High trading
costs www.StudsPlanet.com 67. 67 Background Over $20 billion is
invested globally in securities issued in underdeveloped countries
Pension funds largest emerging market exposure is in: Asia (39.1%)
Latin America (32.7%) www.StudsPlanet.com 68. 68 Background (contd)
Dollars invested in emerging markets has increased at a compound
rate of almost 50% over the last 10 years Private sector growth in
emerging markets E.g., Hungary and Poland after 1989
www.StudsPlanet.com 69. 69 Adding Value Prices in developing
markets often contain significant inefficiencies Tend to sell for
lower price/earnings multiples than do firms in developed markets
Emerging market firms have greater expected growth and are cheaper
www.StudsPlanet.com 70. 70 Reducing Risk Low correlations are
attractive as a means of reducing portfolio variability Emerging
markets show low correlation with developed markets Emerging
markets show low correlation with each other www.StudsPlanet.com
71. 71 Following the Crowd Some professional money managers
carefully analyze emerging markets for: Profit potential Portfolio
risk reduction Some professional money managers follow the crowd
because they must invest in emerging markets www.StudsPlanet.com
72. 72 Special Risks Incomplete accounting information Foreign
currency risk Fraud and scandals Weak legal system
www.StudsPlanet.com 73. 73 Incomplete Accounting Information In
some countries, financial statements are more than 6 months old
when they become available The acquisition of reliable investment
information generally requires on-site security analysts
www.StudsPlanet.com 74. 74 Incomplete Accounting Information
(contd) Accounting standards differ substantially across countries
Accounting information is frequently unavailable for an emerging
market security Some emerging market brokerage firms focus on the
income statement but ignore the balance sheet www.StudsPlanet.com
75. 75 Foreign Currency Risk Foreign exchange securities are
denominated in a foreign currency Introduces foreign exchange risk
for foreign investors E.g., Mexican peso crisis and Asian crisis In
emerging markets, traditional hedging vehicles may be unavailable
www.StudsPlanet.com 76. 76 Fraud and Scandals Emerging markets
carry a substantial risk of fraud E.g., accounting misstatements,
counterfeit securities, bucket shops Redress available to victims
of a scandal in a developing country may be inadequate
www.StudsPlanet.com 77. 77 Weak Legal System Low confidence in a
countrys legal system: Leads to increased uncertainty Leads to an
increased risk premium required by investors www.StudsPlanet.com
78. 78 Asymmetric Correlations Correlation between emerging and
developed markets: Increases during bear markets Is low during bull
markets The extent of portfolio managers diversification depends on
whether they are experiencing an up or a down market
www.StudsPlanet.com 79. 79 Asymmetric Correlations (contd)
Investment returns show: Homogeneity within emerging markets
Securities tend to move as a group within a single emerging market
Heterogeneity across emerging markets Emerging markets show low
correlation across markets www.StudsPlanet.com 80. 80 Market
Microstructure Considerations Liquidity risk Trading costs Market
pressure Marketability risk Country risk www.StudsPlanet.com 81. 81
Liquidity Risk Some emerging markets investors are mostly foreign
Increases political risk Sets the stage for a market collapse if
everyone pulls out at once Some emerging markets lack depth The
bid/ask spread tends to be wide with few standing order to buy and
to sell www.StudsPlanet.com 82. 82 Trading Costs Foreign market
trading costs are more than 1% higher than domestic trading costs
E.g., bid/ask spread is an average of 95 basis points for Barings
Securities emerging market index This indicates an investment must
appreciate more to show a given net return www.StudsPlanet.com 83.
83 Market Pressure An order to buy or sell a large number of shares
might cause a substantial supply/demand imbalance Causes the price
to move adversely from the investors perspective Indicates that
emerging market investments should be viewed as long-term
investments rather than a source of trading profits
www.StudsPlanet.com 84. 84 Marketability Risk An investor may be
unable to close out a position at a reasonable price
www.StudsPlanet.com 85. 85 Country Risk Country risk refers to a
countrys ability and willingness to meet its foreign exchange
obligations Especially important in emerging markets Country risk
has two components: Political risk Economic risk
www.StudsPlanet.com 86. 86 Political Risk Introduction Factors
contributing to political risk Macro risk versus micro risk Dealing
with political risk www.StudsPlanet.com 87. 87 Introduction
Political risk is a measure of a countrys willingness to honor its
foreign obligations A function of: The stability of the governments
and its leadership Attitudes of labor unions The countrys
ideological background The countrys past history with foreign
investors www.StudsPlanet.com 88. 88 Introduction (contd) Real
(direct) investment is an investment over which the investor
retains control E.g., a plant in a foreign country Portfolio
investment refers to foreign investment via the securities market
E.g., buying a number of shares of a foreign company
www.StudsPlanet.com 89. 89 Introduction (contd) Extreme forms of
country risk for portfolio investment: Government takeover of a
company Political unrest leading to work stoppages Physical damage
to facilities Forced renegotiation of contracts www.StudsPlanet.com
90. 90 Introduction (contd) Modest forms of country risk for
portfolio investment: A requirement that a minimum percentage of
supervisory positions be held by locals Changes in operating rules
Restrictions on repatriation of capital www.StudsPlanet.com 91. 91
Factors Contributing to Political Risk Buy local attitude Public
attitude Government attitude www.StudsPlanet.com 92. 92 Buy Local
Attitude Buy local campaigns seek to make foreign consumers buy
local goods instead of goods produced by a foreign firm or its
subsidiaries Contributes to political risk www.StudsPlanet.com 93.
93 Public Attitude In emerging markets, people may see no
opportunity to improve their standard of living Foreign
subsidiaries may contribute to this attitude with luxury items The
gap between the publics aspirations and its expectations
contributes to political risk www.StudsPlanet.com 94. 94 Government
Attitude Unstable governments can lead to foreign investors being a
volatile political issue Foreign investors can be blamed for local
problems Foreign governments can suspend a firms ability to send
funds back to its home country www.StudsPlanet.com 95. 95 Macro
Risk Versus Micro Risk Macro risk refers to government actions that
affect all foreign firms in a particular industry Micro risk refers
to politically motivated changes in the business environment
directed to selected fields of business activity or to foreign
enterprises with specific characteristics www.StudsPlanet.com 96.
96 Dealing With Political Risk Seek a foreign investment guarantee
from the Overseas Private Investment Corporation Provides coverage
against: Loss due to expropriation Nonconvertibility of profits War
or civil disorder www.StudsPlanet.com 97. 97 Dealing With Political
Risk (contd) Avoid engaging in behavior that stirs up trouble with
the host people or government: Constructing flamboyant office
buildings Giving the impression of natural resource exploitation
www.StudsPlanet.com 98. 98 Economic Risk Economic risk is a measure
of a countrys ability to pay Assess economic risk by: Using
coverage ratios Assessing the countrys capital base
www.StudsPlanet.com 99. 99 Other Topics Multinational corporations
American depository receipts International mutual funds
www.StudsPlanet.com 100. 100 Multinational Corporations Investing
in a multinational corporation may provide a ready-made means of
getting the risk-reduction benefits of international
diversification Research is unclear whether MNCs are better
investments than purely domestic firms www.StudsPlanet.com 101. 101
American Depository Receipts American depository receipts (ADRs)
are receipts representing shares of stock that are held on the ADR
holders behalf in a bank in the country of origin An alternative to
purchasing shares in a foreign company directly on the foreign
exchange By 2000, 1,534 ADRS from dozens of countries traded in the
U.S. www.StudsPlanet.com 102. 102 International Mutual Funds Mutual
funds permit diversification to an extent that would not otherwise
be possible Some mutual funds invest only in securities issued
outside the U.S. Buying an international mutual fund is a good way
to achieve international diversification www.StudsPlanet.com
