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International Portfolio Investment (chapter 15 in Eun and Resnick) Risks of investing in international markets Risks of investing in international markets Risks of ... – PowerPoint PPT presentation

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Title: International%20Portfolio

  • International Portfolio
  • Investment
  • (chapter 15 in Eun and Resnick)

Developed vs Emerging Markets
  • Factors that are used to classify the worlds
    financial markets
  • in developed and emerging markets
  • the size and scope of the equity, fixed income
    and derivatives markets
  • the sophistication of the local market
  • liquidity and transaction costs
  • quality and quantity of financial information
  • financial regulations, business laws, ethics,
    investor protection

Market Capitalization
  • Almost 90 of the total market capitalization of
    the worlds equity markets is accounted for by
    the market capitalization of the developed world
  • The other 10 is accounted for by the market
    capitalization of developing countries in
    emerging markets.
  • Latin America
  • Asia
  • Eastern Europe
  • Mideast/Africa

Risks of investing in international markets
  • sovereign (political) risk
  • Sovereign governments have the right to regulate
    the movement of goods, capital, and people
    across their borders
  • in general, financial managers and investors
    incorporate a political risk premium when foreign
    activities are being evaluated
  • Ex ethnic strife in Indonesia currency controls
    in Malayasia expropriation in Africa and Central
    America changes in taxes and regulations

Risks of investing in international markets
  • liquidity risk refers to how quickly an asset
    can be sold without a major price concession
  • - The equity markets of the developed world tend
    to be much more liquid than emerging markets
  • - Emerging markets have limited investability

Risks of investing in international markets
  • Information risk most investors prefer to invest
    in assets that
  • are more familiar with
  • foreign language
  • limited access to information
  • lack of disclosure
  • unfamiliar accounting system

Risks of investing in international markets
  • Foreign Exchange Risk
  • - Foreign operations are conducted in foreign
  • - When firms and individuals are engaged in
    cross-border transactions they are exposed to
    foreign exchange (FX) risk.
  • - The foreign currency profits, costs, revenues
    in dollar terms depends on exchange rate
  • - FX risk affects the cost of capital and the
    capital structure of a MNC firm

International Correlation Structure and
  • Correlations between countries are not stable
    through time
  • Security returns are much less correlated across
    countries than within a country.

The Optimal International Portfolio
Effects of Changes in the Exchange Rate
  • The realized dollar return for a U.S. resident
    investing in a foreign market is given by
  • Ri (1 Ri)(1 ei) 1
  • Ri ei Riei

Where Ri is the local currency return in the ith
market ei is the rate of change in the exchange
rate between the local currency and the dollar
Effects of Changes in the Exchange Rate
  • For example, if a U.S. resident just sold shares
    in a British firm that had a 15 return (in
    pounds) during a period when the pound
    depreciated 5, his dollar return is 9.25
  • Ri (1 .15)(1 0.05) 1 0.925
  • .15 -.05 .15(-.05) 0.0925

International Diversification through
International Mutual Funds
  • A U.S. investor can easily achieve international
    diversification by investing in a U.S.-based
    international mutual fund.
  • The advantages include
  • Savings on transaction and information costs.
  • Circumvention of legal and institutional barriers
    to direct portfolio investments abroad.
  • Professional management and record keeping.

International Diversification through Country
  • Recently, country funds have emerged as one of
    the most popular means of international
  • A country fund invests exclusively in the stocks
    of a single country. This allows investors to
  • Speculate in a single foreign market with minimum
  • Construct their own personal international
  • Diversify into emerging markets that are
    otherwise practically inaccessible.
  • ETFs (Exchange Traded Funds)/ World Equity
    Benchmark Shares (WEBS or iShares)
  • Country-specific baskets of stocks designed to
    replicate the country indexes

Trading in International Equities
  • During the 1980s world capital markets began a
    trend toward greater global integration
  • Diversification, reduced regulation, improvements
    in computer and communications technology,
    increased demand from MNCs for global issuance.
  • Cross-Listing refers to a firm having its equity
    shares listed on one or more foreign exchanges.
  • Foreign stocks often trade on U.S. exchanges as
  • It is a receipt that represents the number of
    foreign shares that are deposited at a U.S. bank.
  • The bank serves as a transfer agent for the ADRs

American Depository Receipts
  • There are many advantages to trading ADRs as
    opposed to direct investment in the companys
  • ADRs are denominated in U.S. dollars, trade on
    U.S. exchanges and can be bought through any
  • Dividends are paid in U.S. dollars.
  • Most underlying stocks are bearer securities, the
    ADRs are registered.

Why Home Bias in Portfolio Holdings?
  • Home bias refers to the extent to which portfolio
    investments are concentrated in domestic
  • Explanations for home bias

Learning outcomes
  • discuss the characteristics that differentiate
    the developed from emerging markets
  • discuss the following risks of investing in
    international markets sovereign, liquidity,
    foreign exchange , information
  • what are the benefits and risks of investing
  • know how to calculate the dollar return of a
    foreign investment (see slides 10 and 11)
  • discuss how an investor can diversify
    internationally through mutual funds, ETFs,
    country funds and ADRs
  • explain what is an ADR and why investors invest
    in them
  • what is home bias and factors that affect it
  • End of chapter recommended questions 1, 2, 5,
    10, 11
  • End of chapter recommended problems 1, 4