19-3 Background Global market –US stock exchanges make up approximately 40% of all markets –Emerging market development –Market capitalization and GDP
19-4 Stock Market Cap Developed Countries
19-5 Stock Market Cap Emerging Markets
19-6 Per Capita GDP and Market Capitalization as a % of GDP Log Scale, 2003
19-7 Per Capita GDP and Market Capitalization as a % of GDP Log Scale, 2007
Risk Factors in International Investing
19-9 Risks in International Investing What are the risks involved in investment in foreign securities? –Exchange rate risk –Country specific risk
19-10 Exchange Rate Risk Variation in return related to changes in the relative value of the domestic and foreign currency Total Return is a function of 1.Investment return & 2.Change in the value of the foreign currency
19-11 Returns with Foreign Exchange r(US) = return on the foreign investment in US Dollars r(FM) = return on the foreign market in local currency E 0 = original exchange rate E 1 = subsequent exchange rate
19-12 Return Example: Dollar Depreciates Relative to the Pound If you invest in a British Security and earn 10%, find the return in US Dollars given: Initial Exchange rate : £ = $2.00 Final Exchange rate: £ = $2.10 Why is your return > 10%?
19-13 Return Example: Dollar Appreciates Relative to the Pound If you invest in a British Security and earn 10%, find the return in US Dollars given: Initial Exchange rate : £ = $2.00 Final Exchange rate: £ = $1.85
19-14 Figure 19.2 Stock Market Returns in US Dollars and Local Currencies for 2007
19-15 Table 19.3 Rates of Change in the US Dollar Against Major World Currencies, (monthly data)
19-16 The Carry Trade Suppose the yen LIBOR = 0.24% and U.S. $ LIBOR = 3.75%. An astute investor may borrow yen at the yen rate, convert the borrowed funds to dollars and invest at $ LIBOR. What can go wrong with this strategy? –Default –Yen increases in value by 3.75% % = 3.51% or more.
19-17 Covered Interest Arbitrage (1) U.S. interest rates are 6.15% and British interest rates are at 10% when the exchange rate is $2.00 / £. The one year forward exchange rate for the pound is $1.95/£. How can you earn a riskless arbitrage profit based on these quotes? 1.Borrow $1 at 6.15%: Will owe $ in one year 2.Convert $1 to pounds: $1 / $2.00/£ = £ Invest £0.50 at 10%: Will yield £.50 x 1.10 = £ Sell pound forward at $1.95: £55 x $1.95 = $ Net: $ $ = $0.011 / dollar
19-18 Covered Interest Arbitrage (2) U.S. interest rates are 6.15% and British interest rates are at 10% when the exchange rate is $2.00 / £. The one year forward exchange rate for the pound is $1.90/£. How can you earn a riskless arbitrage profit based on these quotes? 1.Borrow £1 at 10%: Will owe £1.10 in one year 2.Convert £1 to $ at $2.00/£ = $2 3.Invest $2 at 6.15%: Will yield $2 x =$ Buy pound forward at $1.90: Will cost £1.10 x $1.90 = $ Net profit = $ $2.09 = $0.033
19-19 Covered Interest Parity The spot-futures exchange rate relationship that prevents arbitrage opportunities. If the interest rates and exchange rates are in this relationship no arbitrage is possible.
19-20 Other Risks in International Investing Imperfect exchange rate risk hedging –Difficult to hedge out equities with variable rates of return Country Specific Risk –Composition Political –Unfavorable regulations or rules changes »Taxes on withdrawals, expropriation, repatriation restrictions, etc.
19-21 Other Risks in International Investing Country – Specific Risk –Composition Macro Financial Risk –Ability to pay its debts, domestic and foreign Economic –Growth rate, stability and vulnerabilities Data availability problems can be severe –Composite Ratings Political Risk Services (PRS) publishes the International Country Risk Guide and rates countries from 0 (most risky) to 100 (least risky)
19-22 Variables Used in the PRSs Political Risk Scores
19-23 Composite Ratings for July 2008 vs August 2007
19-24 Current Risk Ratings and Composite Forecasts
19-25 Political Risk by Component July 2008
International Investing: Risk, Return, and Benefits From Diversification
19-27 International Investment Choices Direct Stock Purchases –Difficult for individual investors due to currency and tax issues. Mutual Funds –Open End World versus international funds Higher expenses –Closed End Country or regional funds –WEBS
19-28 Questions on Assessing Performance in US Dollars in Foreign Markets Are emerging markets riskier?
19-29 Annualized Standard Deviation of Investments Across the Globe ($ returns)
19-30 Figure 19.4 Betas of country returns in $
19-31 Questions on Assessing Performance in US Dollars in Foreign Markets Are average returns higher in emerging markets?
19-32 Figure 19.5 Average $ excess returns
19-33 X-Section Country Monthly Return Stats
19-34 Questions on Assessing Performance in US Dollars in Foreign Markets Is exchange rate risk important in international portfolios?
19-35 Standard Deviation of Investments Across the Globe in US Dollars versus Local Currency
19-36 Beta in $US versus Local Currency
19-37 Correlation of Returns in $US and Local Currencies
19-38 Avg. monthly returns in $ and local currency
19-39 Questions on Assessing Performance in US Dollars in Foreign Markets Are there diversification benefits to international investing?
19-40 Diversification Benefits Evidence shows international diversification is beneficial Possible to expand the efficient frontier above domestic only frontier Possible to reduce the systematic risk level below the domestic only level
19-41 International Diversification. Portfolio Diversification as a Percentage of the Average Standard Deviation of a One-Stock Portfolio
19-42 Hedged & Unhedged Correlations
19-43 Ex Post Efficient Frontier of Country Portfolios
19-44 Figure 19.12a Efficient Frontier of Country Portfolios (world expected excess return =.3% per month)
19-45 Figure 19.12b Efficient Frontier of Country Portfolios (world expected excess return =.6% per month)
19-46 Are diversification benefits preserved in bear markets?
19-47 Figure 19.13A Regional Indexes Around the Crash, October 14 – 26, 1987
19-48 Figure 19.13B Beta and of portfolios against deviation of month return from Sep-Dec 2008 from avg
19-49 Conclusions A passive investment in all countries would not have lowered risk at all during the recent crisis. Hedging currencies has little effect either. A U.S. stock market crash appears to be a systemic factor that cannot be diversified away from in a crisis. Correlations are on the increase due to globalization, nevertheless we still expect modest international diversification benefits in normal markets.
How to Go about International Diversification and the Benefit We Can Expect Choosing a Practical Internationally Diversified Portfolio
19-51 of various portfolios
19-52 Active Management First level: –Security selection and asset allocation within each market to identify a country portfolio superior to country index. Second level –Optimize allocations across country portfolios to maximize diversification.
19-53 Monthly Returns & Performance for Index Portfolios
International Investing And Performance Attribution
19-55 Performance Attribution The Bogey or benchmark –EAFE index (non-U.S. stocks) Currency Selection –Contribution to performance due to currency movements Country Selection –Contribution to performance due to choosing better performing countries
19-56 Performance Attribution Stock Selection –This ability is measured as the weighted average of equity returns in excess of the equity index in each country. Cash / Bond Selection –Excess return due to weighting bonds and bills differently from benchmark weights.