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Chapter 8International Investment and Diversification : 

1 Chapter 8International Investment and Diversification

Slide 2: 

2 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

Outline : 

3 Outline Introduction Why international diversification makes theoretical sense Foreign exchange risk Investments in emerging markets Political risk Other topics related to international diversification

Introduction : 

4 Introduction The marketplace of the twenty-first century is global U.S. equities represent only about 51% of the world’s equity capitalization Over the period 1980-2000, the U.S. was the best-performing market only once In September 1999, each of the 66 U.S. pension funds had more than $1 billion in actively managed international investment portfolios

Introduction (cont’d) : 

5 Introduction (cont’d) International investments carry additional sources of risk Managers can reduce total portfolio risk via global investment

Why International Diversification Makes Sense : 

6 Why International Diversification Makes Sense Remembering Evans and Archer Remembering capital market theory

Remembering Evans and Archer : 

7 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

Remembering Evans and Archer (cont’d) : 

8 Remembering Evans and Archer (cont’d) Total risk contains both systematic and unsystematic risk Evans and Archer show that holding 15 to 20 equity securities substantially reduces the unsystematic risk

Remembering Capital Market Theory : 

9 Remembering Capital Market Theory Utility, risk, and return Variance of a linear combination Relationship of world exchanges Fundamental logic of diversification Other considerations

Utility, Risk, and Return : 

10 Utility, Risk, and Return 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 invest will reduce risk if given the opportunity

Variance of A Linear Combination : 

11 Variance of A Linear Combination As long as assets are less than perfectly correlated, there will be diversification benefits More pronounced the lower the correlation No two shares move in perfect lockstep Diversification benefits accrue every time we add a new position to a portfolio

Relationship of World Exchanges : 

12 Relationship of World Exchanges For U.S. securities, market risk account for about 25% 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

Relationship of World Exchanges (cont’d) : 

13 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

Relationship of World Exchanges (cont’d) : 

14 Relationship of World Exchanges (cont’d) Number of Securities Portfolio Variance U.S. Securities: Systematic Risk 27% International Securities: Systematic Risk 11.7%

Fundamental Logic of Diversification : 

15 Fundamental Logic of Diversification Investors are, on average, rational 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

Fundamental Logic of Diversification (cont’d) : 

16 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

Other Considerations : 

17 Other Considerations Optimum portfolio size involves a trade-off between: The benefits of additional diversification Commissions and capital constraints

Foreign Exchange Risk : 

18 Foreign Exchange Risk Definition Business example Investment example From whence cometh the risk? Dealing with the risk The eurobond market Combining the currency and market decisions Key issues in foreign exchange risk management

Definition : 

19 Definition Foreign exchange risk refers to the changing relationships among currencies Modest changes in exchange rates can result in significant dollar differences

Business Example : 

20 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?

Business Example (cont’d) : 

21 Business Example (cont’d) Solution: If the spot rate does not change, the cost to the importer is: 40 x NZ$110 x $0.5855 = $2,576.20 If the spot rate is $0.5500: 40 x NZ$110 x $0.5500 = $2,420.00 If the spot rate is $0.6200: 40 x NZ$110 x $0.6200 = $2,728.00

Investment Example : 

22 Investment Example You just purchased 1,000 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?

Investment Example (cont’d) : 

23 Investment Example (cont’d) Solution: The purchase price in U.S. dollars is: 1,000 x AUD1.45 x $0.7735 = $1,121.58 If the Australian dollar depreciates and you sell the shares, you will receive: 1,000 x AUD1.95 x $0.7000 = $1,365.00 The holding period return is: ($1,365.00 - $1,121.58)/$1,121.58 = 21.7%

From Whence Cometh the Risk? : 

24 From Whence Cometh the Risk? Role of interest rates Forward rates Interest rate parity Covered interest arbitrage Purchasing power parity

Role of Interest Rates : 

25 Role of Interest Rates Real rate of interest Inflation premium Risk premium

Real Rate of Interest : 

26 Real Rate of Interest 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

Inflation Premium : 

27 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

Risk Premium : 

28 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

Forward Rates : 

29 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

Forward Rates (cont’d) : 

30 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

Forward Rates (cont’d) : 

31 Forward Rates (cont’d) Forward rate premium or discount:

Forward Rates (cont’d) : 

32 Forward Rates (cont’d) Example On June 12, 2002, the British pound had a spot rate of $1.4728. The 3-month forward rate of the pound was $1.4645 on that date. What is the forward premium or discount?

Forward Rates (cont’d) : 

33 Forward Rates (cont’d) Example (cont’d) Solution: The forward premium or discount is calculated as follows: There is a forward discount of –2.25%.

Interest Rate Parity : 

34 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

Covered Interest Arbitrage : 

35 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.

Example of CIA : 

36 Example of CIA

Purchasing Power Parity : 

37 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

Purchasing Power Parity (cont’d) : 

38 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

Purchasing Power Parity (cont’d) : 

39 Purchasing Power Parity (cont’d) Relative purchasing power parity states that differences in countries’ inflation rates determine exchange rates:

Purchasing Power Parity (cont’d) : 

40 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

Dealing With the Risk : 

41 Dealing With the Risk The concept of exposure Dealing with the exposure

The Concept of Exposure : 

42 The Concept of Exposure Definition Accounting exposure Transaction exposure Translation exposure Economic exposure

Definition : 

43 Definition 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

Accounting Exposure : 

44 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

Transaction Exposure : 

45 Transaction Exposure FASB Statement No. 8 addresses transaction exposure: “A transaction involving purchase or sale of goods or services with the price states in foreign currency is incomplete until the amount in dollars necessary to liquidate a related payable or receivable is determined”

Translation Exposure : 

46 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

Economic Exposure : 

47 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

Dealing With the Exposure : 

48 Dealing With the Exposure Ignore the exposure Reduce or eliminate the exposure Hedge the exposure

Ignore the Exposure : 

49 Ignore the Exposure Ignoring the exposure may be appropriate for an investor if: Foreign exchange movements are expected to be modest The dollar mount of the exposure is small relative to the cost of inconvenience of hedging The U.S. dollar is expected to depreciate relative to the foreign currency

Reduce or Eliminate the Exposure : 

50 Reduce or Eliminate the Exposure If the dollar is expected to appreciate dramatically, an investor may reduce or eliminate foreign currency holdings

Hedge the Exposure : 

51 Hedge the Exposure Definition Hedging with forward contracts Hedging with futures contracts Hedging with foreign currency options

Definition : 

52 Definition Hedging involves taking one position in the market that offsets another position Covering foreign exchange risk means hedging foreign exchange risk

Hedging With Forward Contracts : 

53 Hedging With Forward Contracts A forward contract is a private, non-negotiable 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

Hedging With Futures Contracts : 

54 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

Hedging With Futures Contracts (cont’d) : 

55 Hedging With Futures Contracts (cont’d) To hedge an investment, sell foreign currency futures To hedge a liability, buy foreign currency futures

Hedging With Foreign Currency Options : 

56 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

Hedging With Foreign Currency Options (cont’d) : 

57 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

Hedging With Foreign Currency Options (cont’d) : 

58 Hedging With Foreign Currency Options (cont’d) The disadvantage of hedging with currency options is that the hedger must pay a premium to established the hedge Options provide more precision than futures contracts Options are more expensive than futures contracts

The Eurobond Market : 

59 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

The Eurobond Market (cont’d) : 

60 The Eurobond Market (cont’d) About 75% 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.

Combining the Currency and Market Decisions : 

61 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

Key Issues in Foreign Exchange Risk Management : 

62 Key Issues in Foreign Exchange Risk Management The steps in foreign exchange risk management: Define and measure foreign exchange exposure Organize a system that monitors this exposure and exchange rate changes Assign responsibility for hedging Formulate a strategy for hedging

Investments in Emerging Markets : 

63 Investments in Emerging Markets Overview Background Adding value Reducing risk Following the crowd Special risks Asymmetric correlations Market microstructure considerations

Overview : 

64 Overview 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

Background : 

65 Background Over $20 billion is invested globally in securities issued in underdeveloped countries Pension funds’ largest emerging market exposure is in: Asia (39.1%) Latin America (32.7%)

Background (cont’d) : 

66 Background (cont’d) Dollars invested in emerging markets has increased at a compound rate of almost 50% over the last 10 years Private sector growth in emerging markets E.g., Hungary and Poland after 1989

Adding Value : 

67 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 have greater expected growth and are cheaper

Reducing Risk : 

68 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

Following the Crowd : 

69 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 must invest in emerging markets

Special Risks : 

70 Special Risks Incomplete accounting information Foreign currency risk Fraud and scandals Weak legal system

Incomplete Accounting Information : 

71 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

Incomplete Accounting Information (cont’d) : 

72 Incomplete Accounting Information (cont’d) 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

Foreign Currency Risk : 

73 Foreign Currency Risk Foreign exchange securities 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

Fraud and Scandals : 

74 Fraud and Scandals Emerging markets carry a substantial risk of fraud E.g., accounting misstatements, counterfeit securities, “bucket” shops Redress available to victims of a scandal in a developing country may be inadequate

Weak Legal System : 

75 Weak Legal System Low confidence in a country’s legal system: Leads to increased uncertainty Leads to an increased risk premium required by investors

Asymmetric Correlations : 

76 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

Asymmetric Correlations (cont’d) : 

77 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

Market Microstructure Considerations : 

78 Market Microstructure Considerations Liquidity risk Trading costs Market pressure Marketability risk Country risk

Liquidity Risk : 

79 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 order to buy and to sell

Trading Costs : 

80 Trading Costs Foreign market trading costs are more than 1% higher than domestic trading costs E.g., bid/ask spread is an average of 95 basis points for Barings’ Securities emerging market index This indicates an investment must appreciate more to show a given net return

Market Pressure : 

81 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

Marketability Risk : 

82 Marketability Risk An investor may be unable to close out a position at a reasonable price

Country Risk : 

83 Country Risk Country risk refers to a country’s ability and willingness to meet its foreign exchange obligations Especially important in emerging markets Country risk has two components: Political risk Economic risk

Political Risk : 

84 Political Risk Introduction Factors contributing to political risk Macro risk versus micro risk Dealing with political risk

Introduction : 

85 Introduction Political risk is a measure of a country’s willingness to honor its foreign obligations 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

Introduction (cont’d) : 

86 Introduction (cont’d) Real (direct) investment is an investment over which the investor retains control E.g., a plant in a foreign country Portfolio investment refers to foreign investment via the securities market E.g., buying a number of shares of a foreign company

Introduction (cont’d) : 

87 Introduction (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

Introduction (cont’d) : 

88 Introduction (cont’d) Modest forms of country risk for portfolio investment: A requirement that a minimum percentage of supervisory positions be held by locals Changes in operating rules Restrictions on repatriation of capital

Factors Contributing to Political Risk : 

89 Factors Contributing to Political Risk “Buy local” attitude Public attitude Government attitude

“Buy Local” Attitude : 

90 “Buy Local” Attitude Buy local campaigns seek to make foreign consumers buy local goods instead of goods produced by a foreign firm or its subsidiaries Contributes to political risk

Public Attitude : 

91 Public Attitude In emerging markets, people may see no opportunity to improve their standard of living Foreign subsidiaries may contribute to this attitude with luxury items The gap between the public’s aspirations and its expectations contributes to political risk

Government Attitude : 

92 Government Attitude Unstable governments can lead to foreign investors being a volatile political issue Foreign investors can be blamed for local problems Foreign governments can suspend a firm’s ability to send funds back to its home country

Macro Risk Versus Micro Risk : 

93 Macro Risk Versus Micro Risk Macro risk refers to government actions that affect all foreign firms in a particular industry 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

Dealing With Political Risk : 

94 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

Dealing With Political Risk (cont’d) : 

95 Dealing With Political Risk (cont’d) Avoid engaging in behavior that stirs up trouble with the host people or government: Constructing flamboyant office buildings Giving the impression of natural resource exploitation

Economic Risk : 

96 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

Other Topics : 

97 Other Topics Multinational corporations American depository receipts International mutual funds

Multinational Corporations : 

98 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

American Depository Receipts : 

99 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 By 2000, 1,534 ADRS from dozens of countries traded in the U.S.

International Mutual Funds : 

100 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

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