Transcript 0324665105_140440.ppt

Chapter 7
International Investment and
Diversification
Portfolio Construction, Management, & Protection, 5e, Robert A. Strong
Copyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.
1
All the people like us are We,
And everyone else is They.
And They live over the sea,
While We live over the way.
But—would you believe it?—
They look upon We
As only a sort of They.
Rudyard Kipling
2
Introduction

Institutional investors are well aware of the
possibilities international investments offer
• U.S. equities represent only about 45 percent of the
world’s equity capitalization
• Over the period 1980–2000, the U.S. was the bestperforming market only once
• William M. Morse, an investment consulting firm
reports
– Target allocation for international equity: 15-20%
– Actual allocation for international equity: 10-20%
3
Why International Diversification
Makes Theoretical Sense
 International
investments carry additional
sources of risk
 Managers
can reduce total portfolio risk via
global investment
4
Remembering
Evans and Archer
Portfolio theory works to the investor’s benefit
even if he selects securities at random
 Ideally, the portfolio manager selects securities
because of their fit with the rest of the portfolio

• By choosing poorly correlated securities, a manager can
reduce total portfolio risk

Total risk contains both systematic and
unsystematic risk
• Evans and Archer show that holding 15 to 20 equity
securities substantially reduces the unsystematic risk
5
Remembering
Capital Market Theory
 Unsystematic
risk reduction is possible with
more than 20 securities
• For a given level of return, any reduction in
risk, no matter how small, is a worthy goal
• A rational investor will reduce risk if given the
opportunity
6
Variance of
a Linear Combination
 As
long as assets are less than perfectly
correlated, there can be diversification
benefits
• More pronounced the lower the correlation
• No two shares move in perfect lockstep
– Diversification benefits generally accrue every time
we add a new position to a portfolio
7
Relationship of
World Exchanges
 For
U.S. securities, market risk accounts for
about one-fourth of a security’s total risk
 For
less developed countries, market risk
tends to be higher because:
• Fewer securities make up the market
• The securities are exposed to more extreme
economic and political events
8
Relationship of
World Exchanges (cont’d)
 International
capital markets continue to
show independent price behavior
• International diversification offers potential
advantages
• Repeating the Evans and Archer methodology
for international securities should result in a
lower level of systematic risk
9
Relationship of
World Exchanges (cont’d)
Portfolio Variance
U.S. Securities: Systematic Risk 27%
International Securities: Systematic Risk 11.7%
Number of Securities
10
Fundamental
Logic of Diversification
 Investors are, on average, rational people
 Rational people do not like unnecessary
risk
 By holding one more security, an investor
can reduce portfolio risk without giving up
any expected return
 Rational investors, therefore, will hold as
many securities as they can
11
Fundamental Logic of
Diversification (cont’d)
 The most securities investors can hold is
all of them
 The collection of all securities makes up
the “world market portfolio”
 Rational investors will hold some
proportion of the world market portfolio
12
Other Considerations
 Optimum
portfolio size involves a trade-off
between:
• The benefits of additional diversification
• Commissions and capital constraints
• There also is a limit to an investor’s time
13
Foreign Exchange Risk
 Foreign
exchange risk refers to the
changing relationships among currencies
• Modest changes in exchange rates can result in
significant dollar differences
14
Business Example
A U.S. importer has agreed to purchase 40 New Zealand
leather vests at a price of NZ$110 each. The vests will take
two months to produce, and payment is due before the
vests are shipped.
The current spot rate of the NZ$ is $0.5855.
What is the price of the vests to the importer if the spot
rate remains unchanged in the next two months? If it is
$0.5500? If it is $0.6200?
15
Business Example (cont’d)
Solution: If the spot rate does not change, the cost to the importer is:
40 × NZ$110 × $0.5855/NZ$ = $2,576.20
If the spot rate is $0.5500:
40 × NZ$110 × $0.5500/NZ$ = $2,420.00
If the spot rate is $0.6200:
40 × NZ$110 × $0.6200/NZ$ = $2,728.00
16
An Investment Example
You just purchased 1,000 shares of Kangaroo Lager
trading on the Sydney Stock Exchange for AUD1.45 per
share. The exchange rate for the Australian dollar at the
time of purchase was $0.7735.
What is the U.S. dollar purchase price? If Kangaroo
Lager stock rises to AUD1.95 per share and if the
Australian dollar depreciates to $0.7000, what is your
holding period return if you sell the shares?
17
An Investment Example
(cont’d)
Solution: The purchase price in U.S. dollars is:
1,000 × AUD1.45 × $0.7735/AUD = $1,121.58
If the Australian dollar depreciates and you sell the shares, you will
receive:
1,000 × AUD1.95 × $0.7000/AUD = $1,365.00
The holding period return is:
($1,365.00 – $1,121.58)/$1,121.58 = 21.7%
18
The Role of Interest Rates in Risk
 The
real rate of interest reflects the rate of
return investors demand for giving up the
current use of funds
 In
a world of no risk and no inflation, the
real rate indicates people’s willingness to
postpone spending their money
19
Inflation Premium
 The
inflation premium reflects the way the
general price level is changing
 Inflation
is normally positive
• The inflation premium measures how rapidly
the money standard is losing its purchasing
power
20
Risk Premium
 The
risk premium is the component of
interest rates that reflects compensation for
risk to risk-averse investors
 The
risk premium is a function of how
much risk a security carries
• e.g., common stock vs. T-bills
21
Forward Rates
 The
forward rate is a contractual rate
between a commercial bank and a client for
the future delivery of a specified quantity of
foreign currency
• Typically quoted on the basis of 1, 2, 3, 6, and
12 months
22
Forward Rates (cont’d)
 The
forward rate is the best estimate of the
future spot rate
• If the forward rate indicates the dollar will
strengthen, importers should delay payment
• If the forward rate indicates the dollar will
weaken, importers should lock in a rate now
23
Forward Rates (cont’d)
 Forward
rate premium or discount:
Forward rate - Spot rate 12
 100
Spot rate
n
where n  the contract length in months
24
Forward Rates (cont’d)
Example
On April 29, 2008, the British pound had a spot rate of
$1.9146. The 3-month forward rate of the pound was
$1.9041 on that date.
What is the forward premium or discount?
25
Forward Rates (cont’d)
Example (cont’d)
Solution: The forward premium or discount is
calculated as follows:
Forward rate - Spot rate 12
$1.9041  $1.9146 12
 100 
 100
Spot rate
n
$1.9146
3
 2.19%
There is a forward discount of –2.19%.
26
Interest Rate Parity
 Interest
rate parity states that differences
in national interest rates will be reflected in
the currency forward market
• Two securities of similar risk and maturity will
show a difference in their interest rates equal to
the forward premium or discount, but with the
opposite sign
27
Covered Interest Arbitrage
 Covered
interest arbitrage is possible
when the conditions of interest rate parity
are violated
• If the foreign interest rate is too high, convert
dollars to the foreign currency and invest in the
foreign country
• If the U.S. interest rate is too high, borrow the
foreign currency and invest in the U.S.
28
Example of CIA
29
Purchasing Power Parity
 Purchasing
power parity (PPP) refers to
the situation in which the exchange rate
equals the ratio of domestic and foreign
price levels
• A relative change in the prevailing inflation rate
in one country will be reflected as an equal but
opposite change in the value of its currency
30
Purchasing Power
Parity (cont’d)
 Absolute
purchasing power parity follows
from “the law of one price:”
• A basket of goods in one country should cost
the same in another country after conversion to
a common currency
• Not very accurate due to:
– Transportation costs
– Trade barriers
– Cultural differences
31
Purchasing Power
Parity (cont’d)
 Relative
purchasing power parity states
that differences in countries’ inflation rates
determine exchange rates:
1 IF
S 
1
1 ID
where S  change in the spot exchange rate
I F  foreign country inflation rate
I D  domestic country inflation rate
32
Purchasing Power
Parity (cont’d)
 A country
with an increase in inflation will
experience a depreciation of its currency
because:
• Exports decline
• Imports increase
• There is less demand for goods from that
country
33
International Risk Exposure
 Exposure
is a measure of the extent to
which a person faces foreign exchange risk
 In
general, there are two types of exposure:
accounting and economic
• Economic exposure is more important
34
Accounting Exposure
 Accounting
exposure is:
• Of concern to MNCs that have subsidiaries in a
number of foreign countries
• Important to people who hold foreign securities
and must prepare dollar-based financial reports
 U.S.
firms must prepare consolidated
financial statements in U.S. dollars
35
Transaction Exposure
 FASB
Statement No. 8 addresses
transaction exposure:
• “A transaction involving purchase or sale of
goods or services with the price stated in
foreign currency is incomplete until the amount
in dollars necessary to liquidate the related
payable or receivable is determined”
36
Translation Exposure
 Translation
exposure results from the
holding of foreign assets and liabilities that
are denominated in foreign currencies
• e.g., foreign real estate and mortgage holdings
must be translated to U.S. dollars before they
are incorporated into a U.S. balance sheet
37
Economic Exposure
 Economic
exposure measures the risk that
the value of a security will decline due to an
unexpected change in relative foreign
exchange rates
 Security
analysts should include expected
changes in exchange rates in forecasted
cash flows
38
Means to Deal With the Exposure
 Ignore
the Exposure
 Reduce or Eliminate the Exposure
 Hedge the Exposure
39
Ignore the Exposure
 Ignoring
the exposure may be appropriate
for an investor if:
• Foreign exchange movements are expected to
be modest
• The dollar amount of the exposure is small
relative to the cost or inconvenience of hedging
• The U.S. dollar is expected to depreciate
relative to the foreign currency
40
Reduce or Eliminate
the Exposure
 If
the dollar is expected to appreciate
dramatically, an investor may reduce or
eliminate foreign currency holdings
41
Hedge the Exposure
 Hedging
involves taking one position in the
market that offsets another position
• Covering foreign exchange risk means hedging
foreign exchange risk
42
Hedging with
Forward Contracts
 A forward
contract is a private,
nonnegotiable transaction between a client
and a commercial bank
• No money changes hands until the foreign
currency is delivered, but the rate is determined
now
• The forward rate reflects relative interest rates
and associated risks
43
Hedging with
Futures Contracts

A futures contract is a promise to buy or sell a
specified quantity of a particular good at a
predetermined price by a specified delivery date

On the delivery date, there will be a gain or loss in
the futures market that will offset the gain or loss
experienced when converting the foreign currency
44
Hedging with
Foreign Currency Options
 There
are two types of foreign currency
options:
• Call options give their owner the right to buy a
set quantity of foreign currency
• Put options give their owner the right to sell a
set quantity of foreign currency
• The price at which you have the right to buy or
sell is the striking (exercise) price
45
Hedging with Foreign
Currency Options (cont’d)
 Currency
option characteristics:
• A call option with an exercise price quoted in
dollars for the purchase of euros is the same as
a put option on dollars with an exercise price
quoted in euros
• Put-call parity for foreign currency options is a
restatement of interest rate parity
46
Hedging with Foreign
Currency Options (cont’d)
 The
disadvantage of hedging with currency
options is that the hedger must pay a
premium to establish the hedge
• Options provide more precision than futures
contracts
• Options are more expensive than futures
contracts
47
The Eurobond Market

Eurobonds are debt agreements that are
denominated in a currency other than that of the
country in which they are held
• e.g., a bond denominated in yen sold in the United
Kingdom

A foreign bond is denominated in the local
currency but is issued by a foreigner
• e.g., a bond denominated in yen sold in Japan, issued
by a firm in the United Kingdom
48
The Eurobond Market (cont’d)
 About
75 percent of eurobonds are
denominated in U.S. dollars
 Firms
issuing dollar-denominated
Eurobonds pay a slightly lower interest rate
than they would pay in the U.S.
49
Combining the Currency and
Market Decisions
 It
is often desirable to cross-hedge a foreign
investment into a different currency
• e.g., a U.S. investor might invest in Japan, use
the forward market to sell yen for British
pounds, and convert the pounds back to dollars
• The currency return comes from the forward
market premium or discount and the actual
change in the exchange rate
50
Key Issues in Foreign
Exchange Risk Management

The steps in foreign exchange risk
management:
1) Define and measure foreign exchange
exposure
2) Organize a system that monitors this exposure
and exchange rate changes
3) Assign responsibility for hedging
4) Formulate a strategy for hedging
51
Investment in Emerging Markets
 Emerging
market investments:
• Offer substantial potential rewards to the
careful investor in added return and risk
reduction
• Are accompanied by special risks:
– Foreign exchange risk
– High political and economic risk
– Unreliable investment information
– High trading costs
52
Background
 According
to the Emerging Markets Traders
Association, $2.043 trillion in debt traded
during the first half of 2004
• 85 percent of Eurobond trading was in
sovereign issues, with the remainder in
corporate bonds
 Disparity
exists in national equity market
returns
• Foreign price-to-book ratios tend to be lower
53
Adding Value
 Prices
in developing markets often contain
significant inefficiencies
• Tend to sell for lower price/earnings multiples
than do firms in developed markets
– Emerging market firms may have greater expected
growth and may be cheaper
54
Reducing Risk
 Low
correlations are attractive as a means
of reducing portfolio variability
• Emerging markets show low correlation with
developed markets
• Emerging markets show low correlation with
each other
55
Following the Crowd
 Some
professional money managers
carefully analyze emerging markets for:
• Profit potential
• Portfolio risk reduction
 Some
professional money managers “follow
the crowd” because they feel they must
invest in emerging markets
56
Additional Risks Arising
from Foreign Investment
 Incomplete Accounting
Information
 Foreign
Currency Risk
 Fraud and Scandals
 Weak Legal System
57
Incomplete
Accounting Information

In some countries, financial statements are more
than 6 months old when they become available
• The acquisition of reliable investment information
generally requires on-site security analysts
• Accounting standards differ substantially across
countries
• Accounting information is frequently unavailable for an
emerging market security
• Some emerging market brokerage firms focus on the
income statement but ignore the balance sheet
58
Foreign Currency Risk
 Securities
traded on a foreign exchange are
denominated in a foreign currency
• Introduces foreign exchange risk for foreign
investors
• e.g., Mexican peso crisis and Asian crisis
 In
emerging markets, traditional hedging
vehicles may be unavailable
59
Fraud and Scandals

Emerging markets carry a substantial risk of fraud
• e.g., accounting misstatements, counterfeit securities,
pyramid schemes
 Redress
available to victims of a scandal in a
developing country may be inadequate
 Low confidence in a country’s legal system:
• Leads to increased uncertainty
• Leads to an increased risk premium required by
investors
60
Asymmetric Correlations
 Correlation
between emerging and
developed markets:
• Increases during bear markets
• Is low during bull markets
• The extent of portfolio managers’
diversification depends on whether they are
experiencing an up or a down market
61
Asymmetric
Correlations (cont’d)
 Investment
returns show:
• Homogeneity within emerging markets
– Securities tend to move as a group within a single
emerging market
• Heterogeneity across emerging markets
– Emerging markets show low correlation across
markets
62
Market
Microstructure Considerations
 Liquidity
Risk
 Trading Costs
 Market Pressure
 Marketability Risk
 Country Risk
63
Liquidity Risk

Some emerging markets’ investors are mostly
foreign
• Increases political risk
• Sets the stage for a market collapse if everyone pulls
out at once

Some emerging markets lack depth
• The bid/ask spread tends to be wide with few standing
orders to buy and to sell
64
Trading Costs
 Foreign
market trading costs are more than
1 percent higher than domestic trading costs
• e.g., bid/ask spread is an average of 95.4 basis
points for Barings’ Securities emerging market
index
– They reach as high a 171 basis points in Turkey
• This indicates an investment must appreciate
more to show a given net return
65
Market Pressure
 An
order to buy or sell a large number of
shares might cause a substantial
supply/demand imbalance
• Causes the price to move adversely from the
investor’s perspective
• Indicates that emerging market investments
should be viewed as long-term investments
rather than a source of trading profits
66
Marketability Risk
 An
investor may be unable to close out a
position at a reasonable price
67
Country Risk
risk refers to a country’s ability
and willingness to meet its foreign
exchange obligations
 Country
• Especially important in emerging markets
 Country
risk has two components:
• Political risk
• Economic risk
68
Political Risk
risk is a measure of a country’s
willingness to honor its foreign obligations
 Political
• A function of:
– The stability of the governments and its leadership
– Attitudes of labor unions
– The country’s ideological background
– The country’s past history with foreign investors
69
Political Risk (cont’d)
 Real
(direct) investment is an investment
over which the investor retains control
• e.g., a plant in a foreign country
 Portfolio
(financial) investment refers to
foreign investment via the securities market
• e.g., buying a number of shares of a foreign
company
70
Political Risk (cont’d)
 Extreme
forms of country risk for portfolio
investment:
•
•
•
•
Government takeover of a company
Political unrest leading to work stoppages
Physical damage to facilities
Forced renegotiation of contracts
71
Political Risk (cont’d)
 Modest
forms of country risk for portfolio
investment:
• Establishment of a requirement that a minimum
percentage of supervisory positions be held by
local nationals
• Changes in operating rules
• Restrictions on repatriation of capital
72
Factors Contributing
to Political Risk
 “Buy
Local” Attitude
• Makes foreign consumers buy local goods instead of
goods produced or obtained elsewhere

Public Attitude
• Local citizens may observe a gap between its
aspirations and potential standard of living

Government Attitude
• Unstable governments may blame foreign investors for
local problems
• May suspend ability to send funds back to home
country
73
Macro Political Risk
 Macro
risk refers to government actions
that affect all foreign firms in a particular
industry
74
Micro Political Risk
 Micro
risk refers to politically motivated
changes in the business environment
directed to selected fields of business
activity or to foreign enterprises with
specific characteristics
75
Dealing with Political Risk
 Seek
a foreign investment guarantee from
the Overseas Private Investment
Corporation
• Provides coverage against:
– Loss due to expropriation
– Nonconvertibility of profits
– War or civil disorder
76
Dealing with Political Risk
(cont’d)
 Avoid
engaging in behavior that stirs up
trouble with the host people or government:
• Constructing flamboyant office buildings in
poor areas
• Giving the impression of natural resource
exploitation contrary to the host country’s best
interests
77
Economic Risk
 Economic
risk is a measure of a country’s
ability to pay
• Assess economic risk by:
– Using coverage ratios
– Assessing the country’s capital base
78
Other Topics Related to
International Diversification
 Multinational
Corporations
 American Depository Receipts
 International Mutual Funds
79
Multinational Corporations
 Investing
in a multinational corporation
may provide a ready-made means of getting
the risk-reduction benefits of international
diversification
• Research is unclear whether MNCs are better
investments than purely domestic firms
80
American Depository Receipts

American depository receipts (ADRs) are
receipts representing shares of stock that are held
on the ADR holder’s behalf in a bank in the
country of origin
• An alternative to purchasing shares in a foreign
company directly on the foreign exchange

Several American depository receipts have market
capitalizations exceeding $100 billion
81
International Mutual Funds

Mutual funds permit diversification to an extent
that would not otherwise be possible
• Some mutual funds invest only in securities issued
outside the U.S.
• Buying an international mutual fund is a good way to
achieve international diversification
• Managers of well-diversified international funds
outperform MSCI benchmarks
82