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CHAPTER
TWENTY-FIVE
INTERNATIONAL
INVESTING
THE TOTAL INVESTABLE
INTERNTATIONAL CAPITAL MARKET
PORTFOLIO

GLOBAL DISTRIBUTION OF CAPITAL
(by market in trillions of US$)
• Non-U.S. Bond & Equity Markets
• Total World Portfolio
• Fixed Income securities
=$25
= 49.1
= 25.9
THE TOTAL INVESTABLE
INTERNTATIONAL CAPITAL MARKET
PORTFOLIO

GLOBAL DISTRIBUTION OF CAPITAL
(by country in trillions of US$)
• Largest Market for common stock = U.S.
• U.S & Japanese Assets as %Total = 63.4%
• U.S.,Japan, Germany,UK, France =82.9%
THE TOTAL INVESTABLE
INTERNTATIONAL CAPITAL MARKET
PORTFOLIO

GLOBAL EQUITY INDICES
• MOST CLOSELY WATCHED:
FTSE100
NIKKEI225
TSE 300
THE TOTAL INVESTABLE
INTERNTATIONAL CAPITAL MARKET
PORTFOLIO
• INTERNATIONAL
EAFE (Morgan Stanley)
IFC (International Finance Corporation)
THE TOTAL INVESTABLE
INTERNTATIONAL CAPITAL MARKET
PORTFOLIO

EMERGING MARKETS
• COMMON FEATURES:
securities improved political and economic
stability
available to foreign ownership
convertible currency
relatively low level of per capita GDP
THE TOTAL INVESTABLE
INTERNTATIONAL CAPITAL MARKET
PORTFOLIO
• EMERGING MARKET INDICES
Morgan Stanley
IFC: Emerging Market Index, national
RISK AND RETURN FROM
FOREIGN INVESTING

THE ADDITIONAL RISKS
• POLITICAL RISK
DEFINITION:
refers to the uncertainty about
the ability of an investor to convert foreign
currency into local
RISK AND RETURN FROM
FOREIGN INVESTING

THE ADDITIONAL RISKS
• EXCHANGE RATE RISK
DEFINITION:
refers to uncertainty about the
rate at which a foreign currency can be
exchanged for the investor’s local currency in
the future
RISK AND RETURN FROM
FOREIGN INVESTING

MANAGING EXCHANGE RATE RISK
• involves using hedge instruments such as
currency forward contracts
currency options
currency futures
RISK AND RETURN FROM
FOREIGN INVESTING

MANAGING EXCHANGE RATE RISK
• TWO APPROACHES:
passive currency management
RISK AND RETURN FROM
FOREIGN INVESTING

MANAGING EXCHANGE RATE RISK
• TWO APPROACHES:
active currency management
RISK AND RETURN FROM
FOREIGN INVESTING

passive currency management
• involves a strategy of permanently
controlling a portfolio’s exposure to risk
RISK AND RETURN FROM
FOREIGN INVESTING

active currency management
• involves a strategy of frequently changing
currency exposures to take advantage of
perceived short-run mispricings
FOREIGN AND DOMESTIC
RETURNS

THE DOMESTIC RETURN
• FORMULA
p1  p0
rD 
p0
FOREIGN AND DOMESTIC
RETURNS

THE FOREIGN RETURN
• FORMULA
x1 p1  x0 p0
rF 
x0 p0
FOREIGN AND DOMESTIC
RETURNS

FOREIGN INVESTMENT
• Two Parts:
the investment in the country’s firm(s)
the currency exposure
FOREIGN AND DOMESTIC
RETURNS

Calculating the return on foreign
currency
x1 x0
rc 
x0
FOREIGN AND DOMESTIC
RETURNS
we know
and
1rF 1rD1rc
rF  rD  rc
FOREIGN AND DOMESTIC
RETURNS

Calculating the return on foreign
currency
• the return on a foreign security ( rF ) can
be estimated by summing the domestic
with the currency returns
EXPECTED RETURNS

ON A FOREIGN SECURITY
• FORMULA
rF  rD  rc
• If expected return differential exists,
interest rate parity equates the two rates
EXPECTED RETURNS

ON A FOREIGN SECURITY: An Example
Assume an investor can buy either a
5% U.S. Treasury bond or a 7%
German bond, which gives a better
return?
If the German mark is expected to
depreciate by 2% against the U.S.$, neither bond
offers a better return
FOREIGN AND DOMESTIC
RISK

Calculating Portfolio Risk
• Formula:
2
2
2
sF sD sc  2rDcsDsc
where
sF= the risk of the foreign portfolio
sD = the risk of the foreign stock
sC = the risk of the foreign currency
rDC= the correlation between the
currency change and the asset
returns
FOREIGN AND DOMESTIC
RISK

PORTFOLIO RISK
• the smaller the value of the correlation
coefficient, the lower the foreign portfolio
risk
END OF CHAPTER 25