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Chapter 8 International Investment and Diversification


As long as assets are less than perfectly correlated, there will be diversification benefits ... International diversification offers potential advantages ... – PowerPoint PPT presentation

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Title: Chapter 8 International Investment and Diversification

Chapter 8 International Investment and
  • All the people like us are We,
  • And everyone else is They.
  • And They live over the sea,
  • While We live over the way.
  • But would you believe it?
  • They look upon We
  • As only a sort of They.
  • - Rudyard Kipling

  • Introduction
  • Why international diversification makes
    theoretical sense
  • Foreign exchange risk
  • Investments in emerging markets
  • Political risk
  • Other topics related to international

  • The marketplace of the twenty-first century is
  • 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

Introduction (contd)
  • International investments carry additional
    sources of risk
  • Managers can reduce total portfolio risk via
    global investment

Why International Diversification Makes Sense
  • Remembering Evans and Archer
  • Remembering capital market theory

Remembering 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
  • By choosing poorly correlated securities, a
    manager can reduce total portfolio risk

Remembering 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

Remembering Capital Market Theory
  • Utility, risk, and return
  • Variance of a linear combination
  • Relationship of world exchanges
  • Fundamental logic of diversification
  • Other considerations

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

Variance of A Linear Combination
  • As long as assets are less than perfectly
    correlated, there will be diversification
  • 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

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

Relationship of World Exchanges (contd)
  • International capital markets continue to show
    independent price behavior
  • International diversification offers potential
  • Repeating the Evans and Archer methodology for
    international securities should result in a lower
    level of systematic risk

Relationship of World Exchanges (contd)
Portfolio Variance
U.S. Securities Systematic Risk 27
International Securities Systematic Risk 11.7
Number of Securities
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

Fundamental Logic of Diversification (contd)
  • The most securities investors can hold is all of
  • The collection of all securities makes up the
    world market portfolio
  • Rational investors will hold some proportion of
    the world market portfolio

Other Considerations
  • Optimum portfolio size involves a trade-off
  • The benefits of additional diversification
  • Commissions and capital constraints

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

  • Foreign exchange risk refers to the changing
    relationships among currencies
  • Modest changes in exchange rates can result in
    significant dollar differences

Business Example
  • A U.S. importer has agreed to purchase 40 New
    Zealand leather vests at a price of NZ110 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?

Business Example (contd)
  • Solution If the spot rate does not change, the
    cost to the importer is
  • 40 x NZ110 x 0.5855 2,576.20
  • If the spot rate is 0.5500
  • 40 x NZ110 x 0.5500 2,420.00
  • If the spot rate is 0.6200
  • 40 x NZ110 x 0.6200 2,728.00

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?

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

From Whence Cometh the Risk?
  • Role of interest rates
  • Forward rates
  • Interest rate parity
  • Covered interest arbitrage
  • Purchasing power parity

Role of Interest Rates
  • Real rate of interest
  • Inflation premium
  • Risk premium

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

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

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

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
  • Typically quoted on the basis of 1, 2, 3, 6, and
    12 months

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

Forward Rates (contd)
  • Forward rate premium or discount

Forward Rates (contd)
  • Example
  • On June 12, 2002, the British pound had a spot
    rate of 1.4728. The 3-month forward rate of the
    pound was 1.4645 on that date.
  • What is the forward premium or discount?

Forward Rates (contd)
  • Example (contd)
  • Solution The forward premium or discount is
    calculated as follows
  • There is a forward discount of 2.25.

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

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.

Example of CIA
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

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

Purchasing Power Parity (contd)
  • Relative purchasing power parity states that
    differences in countries inflation rates
    determine exchange rates

Purchasing Power Parity (contd)
  • A country with an increase in inflation will
    experience a depreciation of its currency
  • Exports decline
  • Imports increase
  • There is less demand for goods from that country

Dealing With the Risk
  • The concept of exposure
  • Dealing with the exposure

The Concept of Exposure
  • Definition
  • Accounting exposure
  • Transaction exposure
  • Translation exposure
  • Economic exposure

  • 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

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

Transaction Exposure
  • FASB Statement No. 8 addresses transaction
  • 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

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

Economic Exposure
  • Economic exposure measures the risk that the
    value of a security will decline due to an
    unexpected change in relative foreign exchange
  • Security analysts should include expected changes
    in exchange rates in forecasted cash flows

Dealing With the Exposure
  • Ignore the exposure
  • Reduce or eliminate the exposure
  • Hedge the exposure

Ignore the Exposure
  • Ignoring the exposure may be appropriate for an
    investor if
  • Foreign exchange movements are expected to be
  • 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

Reduce or Eliminate the Exposure
  • If the dollar is expected to appreciate
    dramatically, an investor may reduce or eliminate
    foreign currency holdings

Hedge the Exposure
  • Definition
  • Hedging with forward contracts
  • Hedging with futures contracts
  • Hedging with foreign currency options

  • Hedging involves taking one position in the
    market that offsets another position
  • Covering foreign exchange risk means hedging
    foreign exchange risk

Hedging With Forward Contracts
  • A forward contract is a private, non-negotiable
    transaction between a client and a commercial
  • 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

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

Hedging With Futures Contracts (contd)
  • To hedge an investment, sell foreign currency
  • To hedge a liability, buy foreign currency

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 striking (exercise) price

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

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
  • Options are more expensive than futures contracts

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

The Eurobond Market (contd)
  • About 75 of eurobonds are denominated in U.S.
  • Firms issuing dollar-denominated Eurobonds pay a
    slightly lower interest rate than they would pay
    in the U.S.

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

Key Issues in Foreign Exchange Risk Management
  • The steps in foreign exchange risk management
  • Define and measure foreign exchange exposure
  • Organize a system that monitors this exposure and
    exchange rate changes
  • Assign responsibility for hedging
  • Formulate a strategy for hedging

Investments in Emerging Markets
  • Overview
  • Background
  • Adding value
  • Reducing risk
  • Following the crowd
  • Special risks
  • Asymmetric correlations
  • Market microstructure considerations

  • Emerging market investments
  • Offer substantial potential rewards to the
    careful investor in added return and risk
  • Are accompanied by special risks
  • Foreign exchange risk
  • High political and economic risk
  • Unreliable investment information
  • High trading costs

  • 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)

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

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

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

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

Special Risks
  • Incomplete accounting information
  • Foreign currency risk
  • Fraud and scandals
  • Weak legal system

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

Incomplete Accounting Information (contd)
  • Accounting standards differ substantially across
  • 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

Foreign Currency Risk
  • Foreign exchange securities are denominated in a
    foreign currency
  • Introduces foreign exchange risk for foreign
  • E.g., Mexican peso crisis and Asian crisis
  • In emerging markets, traditional hedging vehicles
    may be unavailable

Fraud and Scandals
  • Emerging markets carry a substantial risk of
  • E.g., accounting misstatements, counterfeit
    securities, bucket shops
  • Redress available to victims of a scandal in a
    developing country may be inadequate

Weak Legal System
  • Low confidence in a countrys legal system
  • Leads to increased uncertainty
  • Leads to an increased risk premium required by

Asymmetric Correlations
  • Correlation between emerging and developed
  • 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

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

Market Microstructure Considerations
  • Liquidity risk
  • Trading costs
  • Market pressure
  • Marketability risk
  • Country risk

Liquidity Risk
  • Some emerging markets investors are mostly
  • 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

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
  • This indicates an investment must appreciate more
    to show a given net return

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

Marketability Risk
  • An investor may be unable to close out a position
    at a reasonable price

Country Risk
  • Country risk refers to a countrys ability and
    willingness to meet its foreign exchange
  • Especially important in emerging markets
  • Country risk has two components
  • Political risk
  • Economic risk

Political Risk
  • Introduction
  • Factors contributing to political risk
  • Macro risk versus micro risk
  • Dealing with political risk

  • Political risk is a measure of a countrys
    willingness to honor its foreign obligations
  • A function of
  • The stability of the governments and its
  • Attitudes of labor unions
  • The countrys ideological background
  • The countrys past history with foreign investors

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

Introduction (contd)
  • Extreme forms of country risk for portfolio
  • Government takeover of a company
  • Political unrest leading to work stoppages
  • Physical damage to facilities
  • Forced renegotiation of contracts

Introduction (contd)
  • Modest forms of country risk for portfolio
  • A requirement that a minimum percentage of
    supervisory positions be held by locals
  • Changes in operating rules
  • Restrictions on repatriation of capital

Factors Contributing to Political Risk
  • Buy local attitude
  • Public attitude
  • Government attitude

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

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

Government Attitude
  • Unstable governments can lead to foreign
    investors being a volatile political issue
  • Foreign investors can be blamed for local
  • Foreign governments can suspend a firms ability
    to send funds back to its home country

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

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

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

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

Other Topics
  • Multinational corporations
  • American depository receipts
  • International mutual funds

Multinational Corporations
  • Investing in a multinational corporation may
    provide a ready-made means of getting the
    risk-reduction benefits of international
  • Research is unclear whether MNCs are better
    investments than purely domestic firms

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
  • 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.

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