1® 1999 South-Western College Publishing

Chapter 11International Investing

2® 1999 South-Western College Publishing

Benefits Of International Investing

• Portfolio Risk ReductionPortfolio Risk Reduction

• Enhancement of Portfolio Expected ReturnEnhancement of Portfolio Expected Return

• Essentially Riskless Investment Essentially Riskless Investment OpportunitiesOpportunities

3® 1999 South-Western College Publishing

1996 World Stock Markets

0

1000

2000

3000

4000

5000

6000

7000U

.S.

Japa

n

U.K

.

Ger

man

y

Fra

nce

Swit

zerl

and

Can

ada

Hon

g K

ong

Billions Of Dollars

4® 1999 South-Western College Publishing

Risk Reduction With International Diversification

% Risk

Number of Stocks

100

80

60

40

20

011.7

U.S. Stocks

International Stocks

1 10 20 30

5® 1999 South-Western College Publishing

Currency Risk

• Weaker $ Enhances ReturnWeaker $ Enhances Return

– Of U.S. investors abroadOf U.S. investors abroad

• Eliminate Currency RiskEliminate Currency Risk

– HedgingHedging

– Forward transactionsForward transactions

6® 1999 South-Western College Publishing

Foreign Exchange

Major InfluenceMajor Influence

on theon the

Performance Performance

of of

U.S. Investments AbroadU.S. Investments Abroad

7® 1999 South-Western College Publishing

Points Of ViewPoints Of View

ForFor

German InvestorsGerman Investors

American InvestorsAmerican Investors

Japanese InvestorsJapanese Investors

Efficient

Frontier

Minimum Variance Portfolio

8® 1999 South-Western College Publishing

International Parity Relationships

• Purchasing Power Parity (PPP)Purchasing Power Parity (PPP)

• International Fisher Relationship (IFR)International Fisher Relationship (IFR)

• Foreign Exchange Expectations (FEE)Foreign Exchange Expectations (FEE)

• Interest Rate Parity (IRP)Interest Rate Parity (IRP)

9® 1999 South-Western College Publishing

PPP• Relationship BetweenRelationship Between

– InflationInflation– Foreign exchange ratesForeign exchange rates

• Estimated Exchange Rates BasedEstimated Exchange Rates Based– On expected inflation ratesOn expected inflation rates

• Factors to ConsiderFactors to Consider– Trade cost and barriersTrade cost and barriers– Requires knowing the future inflation Requires knowing the future inflation

differentialdifferential

10® 1999 South-Western College Publishing

IFR

• Links Nominal Interest Rates and Inflation Links Nominal Interest Rates and Inflation Rates in Different CountriesRates in Different Countries

• Uses the Expected Inflation Rates to Uses the Expected Inflation Rates to Estimate Exchange RatesEstimate Exchange Rates

11® 1999 South-Western College Publishing

FEE

• Identifies the Relationship BetweenIdentifies the Relationship Between

– Current forward exchange rateCurrent forward exchange rate

– Expected foreign exchange rateExpected foreign exchange rate

12® 1999 South-Western College Publishing

IRP

• Links Changes in Forward Foreign Links Changes in Forward Foreign Exchange Rates and Nominal Interest RatesExchange Rates and Nominal Interest Rates

– No arbitrageNo arbitrage

13® 1999 South-Western College Publishing

Spot Exchange

Interest Rates

Inflation Forward Exchange

PPP

IFR

FEE

IRP

Linear Relationship