Transcript Lecture 16

Lecture 11
International Investing
Alternative Ways of
Investing Internationally
Foreign securities in the firm’s local
stock market.
 Mutual funds that specialize in foreign
securities.
 U.S. based multinational corporations.
 Foreign firms with dual listings on
U.S. exchanges.
 American Depository Receipts.

Advantage - Diversification

Including international assets in a
portfolio can increase its expected
return and reduce its risk.

Consider the data from
the efficient portfolio
assignment.
Advantage - Diversification

Correlations between
the returns on
securities in different
countries.

Some international
factors affecting
security returns.
Potential Disadvantages
Information about companies is less
reliable and harder to obtain.
 Accounting principles differ across
across countries.
 Security markets are less liquid.
 Transaction costs are higher.
 Political risk.
 Exchange rate risk.

Exchange Rate Risk

When you purchase a foreign
security, you invest in the security
and the currency in which the
security is denominated.

The return depends upon the
return on the security in the
foreign market and the return
from holding foreign currency.
Return On A Foreign Investment
E1
r $  1  r £   1
E0
r($) = return in US dollars.
 r(£) = return in British pounds.
 E0 = initial exchange rate ($/£).
 E1 = end of period exchange rate.
 E1/E0 = 1 + return from holding
foreign currency.

Example 1
Purchase 100 shares of Rolls Royce
stock at £2.40 per share. Exchange
rate is $1.60/£.
 Receive dividend of £0.10. Sell at
£2.50. Exchange rate is $1.40/£.

 2.50  .10  1.40 
r US   

 1
 2.40  1.60 
 1.0830.875  1  5.2%
Example 2
Purchase 100 shares of Mitsubishi
stock at 1,000 yen per share.
Exchange rate is 150 yen/$.
 Receive dividend of 30 yen. Sell
stock for 920 yen per share.
Exchange rate is 120 yen/$.
1


920

30


 150   1
r US   
 1

 1000 
 120 
 0.9501.25  1  18.75%

Exchange Rate Risk

The variance of the return in dollars.
var(r$) = var(rf)+var(rC)+2cov(rf rC).
r$ = return in dollars.
rf = return on the assets in the
foreign market.
rC = E1/E0 – 1 = return on the
foreign currency investment.
Exchange Rate Risk
Market risk and currency risk are not
additive.
 There is a weak and sometimes
negative correlation between
currency and market movements.

Exchange Rate Risk
Exchange rate risk may be desirable.
> Provide opportunities for profit.
> Hedge local price variation of
foreign consumption goods.
> Hedge domestic monetary risk.
 Currency risk gets partly diversified
away in a well diversified portfolio.
 Currency risk can be hedged.

Hedging Exchange Rate Risk

Forward exchange contracts.
> An agreement made today to
exchange one currency for
another currency at a specified
exchange rate and future date.
> The rate specified in the forward
contract is called the forward
exchange rate.
Risk-Free Return
F0
r US   1  r  f   1
E0
r(US) = return in US dollars.
 r(f) = return in foreign country.
 F0 = forward exchange rate today.
 E0 = spot exchange rate today.

Hedging Example
Buy a one year German gov’t bill
paying 10% interest for DM 10,000.
 Enter a forward contract to sell DM
11,000 in one year at a forward
exchange rate of $0.49/DM.
 You have locked in a risk-free return.

 0.49 
r US   1.10
 1
 0.50 
 1.100.98  1  7.8%
Interest Rate Parity

Interest rate parity relationship or
covered interest arbitrage relationship.
F0 1  r US 

E0 1  r  f 

A risk-free arbitrage profit opportunity
exists if this relationship does not
hold.
Arbitrage Example 1
One year German government bill
pays 10% interest.
 One year US Treasury bill pays 7.8%
interest.
 The current spot exchange rate is
$0.50/DM.
 The one year ahead forward
exchange rate is $0.50/DM.

Arbitrage Example 1
$ Cash Flows
Initial
End of Year
Borrow at US rate
$5,102
-$5,500
Buy German bill
-$5,000
DM 11,000E1
$0
$5,500
- DM 11,000E1
$102
$0
Enter forward
contract to deliver
DMs
Net cash flow
Arbitrage Example 2
One year German government bill
pays 10% interest.
 One year US Treasury bill pays 7.8%
interest.
 Current spot exchange rate is
$0.50/DM.
 One year ahead forward exchange
rate is $0.48/DM.

Arbitrage Example 2
$ Cash Flows
Initial
Borrow at German
rate
Buy US T-bill
End of Year
$5,000 - DM 11,000E1
- $4,898
$5,280
Enter forward
contract to buy
DMs
$0
DM 11,000E1
- $5,280
Net cash flows
$102
$0
Purchasing Power Parity

The law of one price.

If the prices of goods rise in one
country relative to another, then the
country’s exchange rate will
depreciate to maintain similar prices
for the goods in the two countries.
Purchasing Power Parity,
Real World Impairments

Future inflation and exchange
rates are uncertain.

Shipping costs are high.

Tariffs.

Import and export restrictions.
Purchasing Power Parity,
Empirical Evidence

Purchasing power parity does not
hold in the short run.

It takes several years before
deviations from purchasing power
parity are corrected.

This gives opportunities for
increasing expected return.
Expected Inflation and
Currency Forward Rates

Nominal interest rates, nr, depend
upon the real rate, rr, and the
expected rate of inflation, p.

1 + nr$ = (1 + rr$)(1 + p$])

1 + nrf = (1 + rrf )(1 + pf ])
Expected Inflation and
Currency Forward Rates

Real default-free interest rates tend
to be identical in all countries if:
(1) capital is allowed to flow freely
between countries,
(2) taxes are identical, and
(3) currency exchange rates are
flexible.
Expected Inflation and
Currency Forward Rates

If the real default-free rates are equal
in two countries, then interest rate
parity implies that
F0 1  nr$ 1  p $


E0 1  nrf 1  p f
Expected Inflation and
Currency Forward Rates

Two important equilibrium
relationships.
1. Differences in nominal default-free
rates between US and, say, UK
reflect differences in the expected
rate of inflation in US and UK.
Expected Inflation and
Currency Forward Rates
2. The forward $/£ exchange rate will
be higher (lower) than the current
spot $/£ exchange rate if the
expected rate of inflation in the US
is greater (less) than the expected
rate of inflation in UK.
Arbitrage Pricing Theory

Potential factors.
> World economic activity.
> Domestic real growth rate.
> Currency movements.
> Industry-wide conditions.

Specific forecasts for each factor
can be used to improve estimates
of expected returns.
Investment Analysis
Asset allocation between classes of
assets and countries is critical.
 Stocks trading in a foreign market
tend to have similar dollar returns
because of:
> The dominance of the domestic
factor.
> Exchange rate movement.

Investment Analysis
Astute currency and market
allocation is more important than
astute security selection.
 The advantages of international
diversification can be achieved with
only a few securities in each asset
class.
 Avoid politically risky markets and
illiquid securities.

Closed-End Funds
Closed-end funds typically sell at a
discount from the net asset value.
 The average closed-end fund is
initially priced at a premium of
10%.
 The price is temporarily supported
by the fund sponsors.
 Within 120 days the average fund
is trading at a 10% discount.

Closed-End Funds
Closed-end fund discounts vary over
time and across funds.
 BKM’s Figure 4.1—On 6/28/1993
premiums on specialty equity funds
averaged –8.1% with a range of
–31.8% to 17.1%.
 Returns on closed-end funds are more
volatile than returns on the
underlying assets.

Closed-End Funds
Closed-end funds are primarily held
by individuals.
 Closed-end fund discounts are an
indicator of investor sentiment.
 Premiums on U.S. closed-end funds
move with returns on U.S. markets,
but net asset values do not.
 German fund after the fall of the
Berlin Wall.
