Transcript Chapter 1

Chapter 13
International Portfolio Investment
13.A Risks and Benefits of International Equity
Investing (1)

Risks to international investing
– Changes in currency exchange rate – dividends received on or
proceeds from the sale of international investments may be reduced or
increased when the dividends or proceeds are converted into dollars.
– Currency controls may restrict or delay an investor’s ability to move
currency out of a country.
– Dramatic changes in foreign market value
– Political, economic, and social events influence foreign markets.
– Lack of liquidity – foreign markets may have lower trading volumes,
fewer listed companies, abbreviated hours of operation, and restrictions
on the amount and type of stocks investors may purchase.
– Less information – Disclosure policies are often more lax in foreign
countries than in the U.S.
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13.A Risks and Benefits of International Equity
Investing (2)
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Risk to international investing, continued
– Legal recourse – even if investors have legal recourse in the U.S.,
judgments may not be enforceable in foreign countries. Thus, investors
may have to rely on the legal system of the foreign company’s home
country.
– Different market operations
• Foreign markets may have different periods for clearance and settlement and
may not report stock trades as quickly as U.S. markets.
• Shares may not be protected if the custodian bank has credit problems.
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Benefit to international investing
– International investments offer greater opportunities than domestic
investments.
• More than half the world’s market capitalization is in non-U.S. companies.
• Most global manufacturers are overseas.
• More than 80% of all cars, 85% of all stereos, and 99% of 35mm cameras
are produced abroad.
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13.A Risks and Benefits of International Equity
Investing (3)
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International diversification
– Basic rule of portfolio diversification – the broader the diversification,
the more stable the returns and the more diffuse the risks.
– The expanded universe of international securities implies the possibility
of achieving a better risk-return tradeoff than investing solely in U.S.
securities.
– While nearly 75% of investment risk can be eliminated in a fully
diversified U.S. portfolio, all companies in a country are subject to the
same cyclical economic fluctuations (systematic risk), which cannot be
diversified out.
– By diversifying across countries whose economic cycles are not
perfectly aligned (e.g., an oil price shock that hurts the U.S. economy
helps oil-exporting countries), investors may further reduce risk by
diversifying out some systematic risk.
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13.A Risks and Benefits of International Equity
Investing (4)
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International diversification, continued
– Annualized returns and standard deviations of returns for various
developed and emerging stock markets from 1988 to 2006 indicate
that emerging markets generally have higher risks and returns than
developed markets.
– The Morgan Stanley Capital International (MSCI) Europe, Australia,
Far East (EAFE) Index (reflecting the 20 major stock markets outside
the U.S.) has had lower risk than most of its individual country
components.
– The MSCI World Index (which combines EAFE countries with North
America), has lower risk than any of its components except for the
U.S.
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13.A Risks and Benefits of International Equity
Investing (10)
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Correlations and gains from diversification, continued
– Benefits of diversification depend on relatively low correlations among
assets.
• Experts assume that as their underlying economies become more closely
integrated and cross-border financial flows accelerate, national capital
markets will become more highly correlated, thus reducing the benefits
(reductions in systematic risk) of international diversification.
• Empirical evidence supports this assumption.
– The correlations between the U.S. and non-U.S. stock markets are
generally higher today than they were during the 1970s.
– The correlation between the EAFE Index and the U.S. market increased
from about 0.4 in the mid-1990s to about 0.84 in 2006.
• As markets decline, correlations appear to increase as market volatility
increases, reducing the benefits of international diversification.
• Benefits still exist, particularly for long-term investors.
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13.A Risks and Benefits of International Equity
Investing (11)
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Investing in emerging markets
– Emerging markets with volatile economic and political prospects offer the
greatest degree of diversification and highest expected returns.
– High returns come with high risk.
– Despite high risk, emerging markets reduce portfolio risk because of their
low correlations with returns in developed markets (even though
correlations are rising over time).
• Shifting to a portfolio 100% invested in the MSCI World Index to one
containing up to 10% invested in the IFC Emerging Markets Index reduces
risk while simultaneously increasing expected return.
• Beyond a 10% investment, risk increases.
• Thus, even if emerging markets are not expected to outperform developed
country markets, risk reduction would dictate an investment of up to 10% in
emerging markets.
– Caveat – the IFC database does not include emerging markets that fail to
reach a certain threshold of capitalization. Thus, the IFC Index is biased
against low-return markets.
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13.A Risks and Benefits of International Equity
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Barriers to international diversification
– Benefits of international diversification will be limited because of barriers
to investing overseas.
– Barriers include
• Lack of liquidity
• Currency controls
• Tax regulations
• Relatively less-developed capital markets abroad
• Exchange risk
• Lack of readily accessible and comparable information on foreign securities
• Home bias
– Home bias – the vast majority of U.S. investor portfolios consists of
domestic stocks. The same bias applies to foreign investors.
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13.A Risks and Benefits of International Equity
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Barriers to international diversification, continued
– How to diversify into foreign securities
• Some foreign firms (< 100) are listed on the New York Stock Exchange or American
Stock Exchange.
• Buy U.S.-traded foreign stocks in the form of American depository receipts (ADRs)
– Negotiable certificates issued by U.S. banks evidencing ownership of ADSs.
– ADS – a dollar-denominated security representing foreign company shares held
for the ADS owner by a custodian bank in the issuing company’s home country.
Proof of ownership
Represents
ADR
ADS
Issued by U.S. bank
Held by custodian bank
in issuing company’s
home country
Shares of
foreign stock
– ADR investors absorb handling costs through transfer and handling charges.
– ADRs eliminate custodian safekeeping charges in the issuer’s home country,
reduce settlement delays, and facilitate prompt dividend payments.
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13.A Risks and Benefits of International Equity
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Barriers to international diversification, continued
– How to diversify into foreign securities, continued
• Buy global depository receipts (GDRs)
– Similar to ADRs but generally traded on two or more markets outside the
foreign issuer’s home market.
– Generally structured as a combination of a Rule 144A ADR (which trades in
the U.S. private placement market and can be sold only to qualified
institutional buyers) and a public offering outside the U.S.
– Enable foreign companies to raise capital in two or more markets
simultaneously and broaden their shareholder bases.
• Buy global depository shares (GDSs, or global shares)
– Similar to an ordinary share but traded on any stock exchange in the world
where it is registered and in the local currency.
– Less expensive to trade than ADRs.
– Currently only four global share issues – DaimlerChrysler, Celanese, UBS,
and Deutsche Bank.
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13.A Risks and Benefits of International Equity
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Barriers to international diversification, continued
– How to diversify into foreign securities, continued
• The easiest way to invest abroad is to buy shares in an internationally
diversified mutual fund. Four basic categories:
– Global funds – invest anywhere in the world, including the U.S.
– International funds – invest only outside the U.S.
– Regional funds – focus on specific geographical areas overseas, such
as Asia or Europe.
– Single-country funds – invest in individual countries, such as Germany
or Taiwan.
• Greater diversification of the global and international funds reduces risk but
also reduces the chance of high returns should a single country’s market
increase substantially.
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13.C Optimal International Asset Allocation (1)
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Research indicates that expanding investments to include
domestic and foreign stocks and bonds provides benefits.
– Performances of various investment strategies were compared over
the period 1970-1980.
– Conclusions
• International stock diversification yields a substantially better risk-return
tradeoff than does holding only domestic stock.
• International diversification combining stock and bond investments results
in substantially less risk than international stock diversification alone.
• A substantial improvement in the risk-return tradeoff can be realized by
investing in internationally diversified stock and bond portfolios whose
weights do not conform to relative market capitalizations (i.e., market
indices used to measure world stock and bond portfolios do not lie on the
efficient frontier).
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13.E Measuring Exchange Risk on Foreign
Securities (2)
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Hedging currency risk
– Stock portfolios
• During 1980-1985, the dollar was rising, and during 1986-1996, the dollar
was generally falling.
• Over the period 1980-1985, risk-adjusted returns on hedged stock portfolios
exceeded those on unhedged portfolios.
• Over the period 1986-1996, this result reversed.
• The reversal occurred because of changes over time in the standard
deviations and correlation coefficients of national stock market returns
expressed in dollars.
– Bond portfolios
• The returns on hedged, internationally diversified bond portfolios exhibited
lower volatility than the returns on unhedged bond portfolios over both
above-discussed periods.
• However, the lower standard deviation of hedged bond returns is generally
matched by lower returns.
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