International Financial Markets Prices and Policies

Second Edition ©2001 Richard M. Levich 15



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International Asset Portfolios: Equity Portfolios

Overview

 Size and Institutional Features of Global Equity Markets  Market Capitalization Measures  Institutional Aspects of Global Equity Markets  International Investment Vehicles  Direct Purchase of Foreign Shares  American Depositary Receipts  Closed-End and Open-End Mutual Funds

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Overview

 Risk and Return in International Equity Markets  Calculating the Unhedged Returns on Foreign Equity in US$ Terms  Portfolio Risk in Domestic and International Stocks  Pricing Determinants  Empirical Evidence on Pricing

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Overview

 Policy Matters - Private Investors  Factors Favoring Overweighting Foreign Markets in Portfolios  Factors Favoring Overweighting Home Markets in Portfolios  Is Investment in MNCs a Close Substitute for International Investment?

 Can Investors Create “Homemade” International Diversification?

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Overview

 Can Investors Count on International Diversification Gains in the Future?

 Are Emerging Markets Integrated with World Capital Markets?

 Policy Matters - Public Policymakers  Equity Market Trading Arrangements  Diversity in Accounting Principles and Disclosure Practices

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World Market Capitalization

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20 15 10 5 0 40 35 30 25

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$36.0

8.4% 24.6% $3.4

4.2% 15.2% 19.4% 7.1% 54.1% $9.7

5.0% 18.2% 40.2% 7.9% 28.7% $14.1

11.6% 21.9% 21.3% 8.2% 37.0% 1984 U.S.

U.K.

1988 Japan 12.6% 8.1% 46.2% 1993 Other Developed 1999 Emerging 

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Institutional Aspects of Global Equity Markets

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 Global equity markets differ in other dimensions.

 A market with a large number of firms is inviting, but it may imply a large expense either to conduct fundamental investment analysis or to identify a subset of firms that tracks the local market index.

 If the market concentration is high, investors may be able to mimic the market easily by owning a small number of firms.

 Investment is also facilitated by high trading volume, low transaction costs, and fast and efficient settlement of transactions.

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International Investment Vehicles

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Direct Purchase of Foreign Shares

 This route is usually reserved for large institutional investors because of the additional considerations involved.

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International Investment Vehicles

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American Depositary Receipts (ADRs)

 After a U.S. bank has taken custody of foreign shares in its foreign office, ADRs can be issued as claims against the foreign shares.

 The issuing bank services the ADRs by collecting all dividends, rights offerings, etc., and distributing the proceeds in US$ to the ADR owners.

 In a

sponsored ADR

, the foreign firm pays a fee to the depositary bank to cover the cost of the ADR program, while in an

unsponsored ADR

, the issuance of the ADR is demand driven.

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International Investment Vehicles

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

Level 1 ADRs

trade on “pink sheets” in the over-the counter market.

 If the company meets disclosure requirements,

Level 2 ADRs

may be listed for trading.  If the firm complies fully with U.S. accounting principles and disclosure requirements, it may raise equity capital in the U.S. through a public offering of

Level 3 ADRs

.

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International Investment Vehicles

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Closed-End and Open-End Mutual Funds

 Mutual funds that invest in foreign stocks can be grouped into several categories from a U.S. perspective: 

Global - Investing in U.S. and non-U.S. shares.



International - Investing in non-U.S. shares only.



Regional - Investing in a geographic area.



Country - Investing in a single country.



Specialty - International investments in an industry group such as telecommunications, or special themes such as newly privatized firms.

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International Investment Vehicles

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 An open-end fund stands ready to issue and redeem shares at prices reflecting the net-asset-value of the underlying foreign shares.

 A closed-end fund issues a fixed number of shares against an initial capital offering. The shares then trade in a secondary market at prices reflecting a premium or discount relative to the net-asset-value of the underlying foreign shares.

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International Investment Vehicles

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World Equity Benchmark Shares (WEBS)

 WEBS represent shares in an index fund that is intended to track the performance of a single country index.

 Like an open-end fund, the size of the WEBS fund can grow without limit, but the shares are traded on an exchange at any time of the day like a closed-end fund.

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Risk and Return in International Equity Markets

Calculating the Unhedged Returns on Foreign Equity in US$ Terms

Let

E t

be the initial purchase price of the foreign equity in foreign currency (FC) terms.

Let

S t

be the spot exchange rate, in $/FC terms, on the purchase date.

Then

E t S t

equity.

is the US$ purchase price of the foreign

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Risk and Return in International Equity Markets

~ Let

E t

+1 ~

E t

 1 

E t

be the value of the bond after one period.



t

 1 

D t

 1 where

E t

= the initial equity price

t

 1

D t

 1 = the price change over the period = dividends ~

E t

 1 ~

S t

 1 period in US$ terms.

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Risk and Return in International Equity Markets

The continuous rate of return on the equity ~

R

$,

U

measured in US$ and on an unhedged basis is:  ln( ~

E t

 1 ~

S t E t S t

 1 )  ln( ~

E t E t

 1 )  ln( ~

S t S t

 1 )  ~

E

FC  ~

S

US$, FC Note that the unhedged US$ return on the foreign equity has two pieces:  ~ the return on the equity shares in FC terms (

E

FC ), &  shares (

S

US$,FC ).

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Risk and Return in International Equity Markets

The variance of the returns reflects the variance of each term and the covariance between the returns on the foreign equity and the returns on  spot foreign exchange: 2 ( ~

R

$,

U

)   2 ( ~

E

FC )   2 ( ~

S

US$, FC )  2 Cov ( ~

E

FC ; ~

S

US$, FC ) Note that the covariance of equity returns and currency returns can be either positive or negative.

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Risk and Return in International Equity Markets

Combinations of Currency Market and Stock Market Returns

Currency Market Returns

Negative Positive

Stock Market

Negative

Returns

Positive

Stock Market Prices



Spot FX



(A) Stock Market Prices



Spot FX



(D) Stock Market Prices



Spot FX



(C) Stock Market Prices



Spot FX



(B)

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Portfolio Risk in Domestic and International Stocks

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 A fundamental result in portfolio theory is that the idiosyncratic risks of individual securities can be reduced by investing in a broadly diversified portfolio of many securities.

 Various empirical studies indicate that:  For the same portfolio size, randomly selected international stocks offered more diversification than randomly selected U.S. stocks.

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Portfolio Risk in Domestic and International Stocks

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 Currency hedging further reduced portfolio risks, but by a fairly small amount compared with the results observed for foreign bonds.

 Diversification across countries reduced risk more than diversification across industries within a single country.

 The world portfolio offered a risk/return trade-off at least as favorable, and often considerably more favorable, than any individual country.

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Pricing Determinants



Are national equity markets integrated?

 A similar pricing formula can be used in all markets.

 Equity risks can be priced differently across markets.



Are national equity markets efficient?

 An equilibrium pricing model such as the CAPM may provide a reasonable explanation for equity prices.

 Other factors play a role in asset pricing.

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Pricing Determinants



Does purchasing power parity (PPP) hold?

 The exchange rate does not introduce a new element of risk that markets must price.

 If nondiversifiable, the new element of risk would be priced by equity markets.



Do the assumptions of the capital asset pricing model (CAPM) apply, or is arbitrage pricing theory (APT) more appropriate?

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Pricing Determinants

 The traditional CAPM hypothesizes that returns for an individual equity (

R

i ) in excess of the risk-free rate (

R

F ) are proportional to the systematic risk of the equity (  iM ) times the expected market risk premium:

R

i –

R

F =  iM [

E

(

R

M ) –

R

F ] where

E

(

R

M ) is the expected return on the market portfolio.

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Pricing Determinants

 The traditional CAPM is a useful paradigm for thinking about an individual capital market, but it does not incorporate the diversity of international markets with

N

countries each having its own risk-free rates.

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Pricing Determinants

 In the APT framework, the returns on a security are related to a set of

k

factors. Arbitrage is possible between securities, and in equilibrium, the market arrives at an amount of compensation, a risk premium (

RP k

), for each factor that is priced in the market:

E

(

R i

) =

R 0

+  1

RP

1 +  2

RP

2 + … + 

k RP k

where

R

0 is the risk-free rate and the coefficients (  1 … 

k

) measure the sensitivity of security

i

to each factor.

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Pricing Determinants

 Data for 23 countries suggest that different markets pay substantially different prices for earnings, cash flows, and book values.  However, these first impressions are inaccurate.

 Wide differences exist in generally accepted accounting practices (GAAP) across countries.

 The economic growth rates of different countries may vary.

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Pricing Determinants

 The results of APT-style tests showed that while world, industry, and currency factors may affect stock returns, the domestic factor appeared to matter the most.

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Policy Matters - Private Enterprises

 There is an inconsistency between the theoretical case for international diversification and the revealed tendency for investors to hold portfolios with a home country bias.

 Factors favoring overweighting foreign markets in portfolios:  The investor earns labor income in the domestic economy, and this return on human capital, which is a nontraded asset, is highly correlated with the return on domestic assets.

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Policy Matters - Private Enterprises

 Factors favoring overweighting home markets in portfolios:  The production of nontraded goods (like legal and medical services) may rely intensively on nontraded, domestic factors of production.

 Allowing for deviations from PPP, long positions in domestic securities are a better hedge than foreign securities against exchange rate uncertainty.

 Transaction costs and taxes may also help explain home country bias.

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Policy Matters - Private Enterprises

 Is investment in MNCs a close substitute for international investment?

 Data from various studies reject the hypothesis:  The returns on MNCs were most closely connected with the domestic market index.

 A portfolio of U.S. MNCs did not produce a smaller total risk than a portfolio of U.S. stocks with mostly domestic activities.

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Policy Matters - Private Enterprises

 Can investors create “homemade” international diversification?

 Using data from 1973 to 1993 for seven developed and nine emerging markets, a study found that a set of domestically traded assets, including market indices, industry portfolios, 30 MNCs, closed-end country funds and ADRs, was successful at mimicking the gains from international portfolio diversification.

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Policy Matters - Private Enterprises

 Can investors count on international diversification gains in the future?

 Globalization in all aspects of economic activity has continued, raising the prospect that real business cycles are growing more synchronized and that the correlation of financial market returns is increasing.

 There is some evidence that the average correlation of the U.S. market with other major markets has risen over the last 30 years, and that the correlation among markets tends to increase when markets are more volatile.

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Policy Matters - Private Enterprises

 Are emerging markets integrated with world capital markets?

 The correlation of returns on major markets with returns on emerging markets remains relatively low, raising the issue that emerging market returns may be driven by factors different from those that drive the more developed financial markets.

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Policy Matters - Public Policymakers

Equity Market Trading Arrangements

 Historical patterns of investment and equity financing have helped to fragment markets and raise barriers to international investing.

 Regulatory arbitrage, whereby some countries permit new forms of trading (such as electronic trading systems and the commoditization of trading services), will be an important force to widen the markets for shares, reduce the cost of transacting, and help to internationalize investors’ portfolios and firms’ shareholder base.

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Policy Matters - Public Policymakers

Diversity in Accounting Principles and Disclosure Practices

 The term accounting diversity refers to cross country differences in accounting principles and disclosure practices.

 Recently, more attention has been focused on accounting diversity to determine whether it is a significant barrier to international investment, and whether public policy reforms, such as the harmonization of accounting, issuing, and listing standards, are advisable.

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