1. 1 Chapter 8 International Investment and Diversification

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

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

4. 4 Introduction u 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

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

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

7. 7 Remembering Evans and Archer u Portfolio theory works to the investor’s benefit even if he selects securities at random u 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

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

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

10. 10 Utility, Risk, and Return u 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

11. 11 Variance of A Linear Combination u 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

12. 12 Relationship of World Exchanges u For U.S. securities, market risk account for about 25% of a security’s total risk u 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

13. 13 Relationship of World Exchanges (cont’d) u 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

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

15. 15 Fundamental Logic of Diversification uInvestors are, on average, rational uRational people do not like unnecessary risk uBy holding one more security, an investor can reduce portfolio risk without giving up any expected return uRational investors, therefore, will hold as many securities as they can

16. 16 Fundamental Logic of Diversification (cont’d) uThe most securities investors can hold is all of them uThe collection of all securities makes up the “world market portfolio” uRational investors will hold some proportion of the world market portfolio

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

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

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

20. 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?

21. 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

22. 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?

23. 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%

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

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

26. 26 Real Rate of Interest u The real rate of interest reflects the rate of return investors demand for giving up the current use of funds u In a world of no risk and no inflation, the real rate indicates people’s willingness to postpone spending their money

27. 27 Inflation Premium u The inflation premium reflects the way the general price level is changing u Inflation is normally positive The inflation premium measures how rapidly the money standard is losing its purchasing power

28. 28 Risk Premium u The risk premium is the component of interest rates that reflects compensation for risk to risk-averse investors u The risk premium is a function of how much risk a security carries E.g., common stock vs. T-bills

29. 29 Forward Rates u 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

30. 30 Forward Rates (cont’d) u 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

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

32. 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?

33. 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%.

34. 34 Interest Rate Parity u 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

35. 35 Covered Interest Arbitrage u 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.

36. 36 Example of CIA

37. 37 Purchasing Power Parity u 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

38. 38 Purchasing Power Parity (cont’d) u 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

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

40. 40 Purchasing Power Parity (cont’d) u 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

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

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

43. 43 Definition u Exposure is a measure of the extent to which a person faces foreign exchange risk u In general, there are two types of exposure: accounting and economic Economic exposure is more important

44. 44 Accounting Exposure u 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 U.S. firms must prepare consolidated financial statements in U.S. dollars

45. 45 Transaction Exposure u 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”

46. 46 Translation Exposure u 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

47. 47 Economic Exposure u Economic exposure measures the risk that the value of a security will decline due to an unexpected change in relative foreign exchange rates u Security analysts should include expected changes in exchange rates in forecasted cash flows

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

49. 49 Ignore the Exposure u 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

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

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

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

53. 53 Hedging With Forward Contracts u 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

54. 54 Hedging With Futures Contracts u 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 u 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

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

56. 56 Hedging With Foreign Currency Options u 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

57. 57 Hedging With Foreign Currency Options (cont’d) u 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

58. 58 Hedging With Foreign Currency Options (cont’d) u 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

59. 59 The Eurobond Market u 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 u 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

60. 60 The Eurobond Market (cont’d) u About 75% of eurobonds are denominated in U.S. dollars u Firms issuing dollar-denominated Eurobonds pay a slightly lower interest rate than they would pay in the U.S.

61. 61 Combining the Currency and Market Decisions u 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

62. 62 Key Issues in Foreign Exchange Risk Management u 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

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

64. 64 Overview u 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

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

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

67. 67 Adding Value u 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

68. 68 Reducing Risk u 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

69. 69 Following the Crowd u Some professional money managers carefully analyze emerging markets for: Profit potential Portfolio risk reduction u Some professional money managers “follow the crowd” because they must invest in emerging markets

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

71. 71 Incomplete Accounting Information u 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

72. 72 Incomplete Accounting Information (cont’d) u Accounting standards differ substantially across countries u Accounting information is frequently unavailable for an emerging market security u Some emerging market brokerage firms focus on the income statement but ignore the balance sheet

73. 73 Foreign Currency Risk u Foreign exchange securities are denominated in a foreign currency Introduces foreign exchange risk for foreign investors E.g., Mexican peso crisis and Asian crisis u In emerging markets, traditional hedging vehicles may be unavailable

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

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

76. 76 Asymmetric Correlations u 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

77. 77 Asymmetric Correlations (cont’d) u 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

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

79. 79 Liquidity Risk u Some emerging markets’ investors are mostly foreign Increases political risk Sets the stage for a market collapse if everyone pulls out at once u Some emerging markets lack depth The bid/ask spread tends to be wide with few standing order to buy and to sell

80. 80 Trading Costs u 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

81. 81 Market Pressure u 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

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

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

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

85. 85 Introduction u 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

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

87. 87 Introduction (cont’d) u 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

88. 88 Introduction (cont’d) u 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

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

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

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

92. 92 Government Attitude u 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

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

94. 94 Dealing With Political Risk u 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

95. 95 Dealing With Political Risk (cont’d) u 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

96. 96 Economic Risk u 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

97. 97 Other Topics u Multinational corporations u American depository receipts u International mutual funds

98. 98 Multinational Corporations u 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

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

100. 100 International Mutual Funds u 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