Globalization and International Investing Chapter 19 Globalization and International Investing Describes the financial instruments traded in primary and secondary markets. Discusses Market indexes. Discusses options and futures. McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. 1

19.1 Global Markets for Equities

Background Global market US stock exchanges make up approximately 40% of all markets Emerging market development Market capitalization and GDP Emerging markets are providing additional investment opportunities and may provide higher potential excess returns. Market cap and GDP are related, as countries grow and develop there is generally more need for equity financing. The relationship between market cap and GDP is loose however. More to the point here is that non U.S. market cap is growing in absolute terms and as a percent. 2

Stock Market Cap Developed Countries Look at growth of non U.S. markets. The major point here is that investing only in the U.S. omits an increasingly large and important part of the possible risky portfolio and sticking only to the U.S. is likely to lead to under diversification. The so called home country bias still exists.

Stock Market Cap Emerging Markets The top four are the BRICs (Brazil, India, Russia and China) that are sometimes categorized separately from the rest as having more growth potential and political clout. China’s market grew by more the 3,000% between 2002 and 2007. Active strategies will want to include investments in these high growth countries.

Per Capita GDP and Market Capitalization as a % of GDP Log Scale, 2003 2003 data

Per Capita GDP and Market Capitalization as a % of GDP Log Scale, 2007 2007 data, Notice how the BRICs have moved up, The data for both these graphs is from Table 19.1

19.2 Risk Factors in International Investing

Risks in International Investing What are the risks involved in investment in foreign securities? Exchange rate risk Country specific risk 3

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 Investment return & Change in the value of the foreign currency 5

Returns with Foreign Exchange r(US) = return on the foreign investment in US Dollars r(FM) = return on the foreign market in local currency E0 = original exchange rate E1 = subsequent exchange rate 7

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%? The return is better because while you were invested in the pound, the pound increased in value 5% 8

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 The return is poorer because while you were invested in the pound, the pound decreased in value 7.5% 8

Figure 19.2 Stock Market Returns in US Dollars and Local Currencies for 2007 Exchange rate movements have material affects on dollar returns in some countries

Table 19.3 Rates of Change in the US Dollar Against Major World Currencies, 2003-2007(monthly data) Standard deviations indicate that currency risk is quite high. Exchange rate risk is roughly the same magnitude as the standard deviation of stocks. The point is that if you find an undervalued foreign security and invest in it, you should hedge out the exchange rate risk unless you also have a favorable foreign exchange forecast. Active managers should consider exchange rate risk. However the low correlations indicate that much exchange rate risk is diversifiable. Thus passive investors with well-diversified international portfolios need not be overly concerned with their foreign currency exposure, at least if you have a longer time horizon.

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% - 0.24% = 3.51% or more. 3.51% is an approximation because these transactions aren’t linear. The carry trade was profitable with the yen for several years but began to unwind when the yen started to rise as U.S. financial problems began and some investors fled to the yen for safety, driving up its value. The weakening of Japan’s economy in 2009 brought the yen back down. The term carry trade is not in the text.

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? Borrow $1 at 6.15%: Will owe $1.0615 in one year Convert $1 to pounds: $1 / $2.00/£ = £0.50 Invest £0.50 at 10%: Will yield £.50 x 1.10 = £0.55. Sell pound forward at $1.95: £55 x $1.95 = $1.0725 Net: $1.0725 - $1.0615 = $0.011 / dollar This works because the currency % change is ($1.95 - $2.00) / $2.00 = -2.5% (pound depreciation) is not enough to offset the higher British interest rate. In doing so we gain 10% - 6.15% = 3.85% on the interest rates and we lose on 2.5% on the currency depreciation. It is riskless if step 3 and 4can be done simultaneously.

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? Borrow £1 at 10%: Will owe £1.10 in one year Convert £1 to $ at $2.00/£ = $2 Invest $2 at 6.15%: Will yield $2 x 1.0615 =$2.123 Buy pound forward at $1.90: Will cost £1.10 x $1.90 = $2.09 Net profit = $2.123 - $2.09 = $0.033 This works because the currency % change is ($1.90 - $2.00) / $2.00 = -5% (pound depreciation) is more than enough to offset the higher British interest rate so we borrow at the British rate and invest in the dollar. We lose 6.15% – 10% = 3.85% on the rates but we gain 5% in the drop in value of the pound.

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. The intuition here is that the difference in interest rates is just matched by the difference between the forward and spot rate so you can’t exploit the lower interest rate. If the U.S. rate is higher then F1 < E0 implying that the dollar is depreciating. The converse also holds. Covered interest parity does tend to hold because this is how banks set their forward rates.

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. 4

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) 4

Variables Used in the PRSs Political Risk Scores

Composite Ratings for July 2008 vs August 2007

Current Risk Ratings and Composite Forecasts

Political Risk by Component July 2008

19.3 International Investing: Risk, Return, and Benefits From Diversification

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 Recall that WEBS are ADRs on portfolios. 14

Questions on Assessing Performance in US Dollars in Foreign Markets Are emerging markets riskier? Attempt to answer this through the graphs that follow.

Annualized Standard Deviation of Investments Across the Globe ($ returns) According to the standard deviation investments in emerging markets are generally riskier than in developed countries.

Figure 19.4 Betas of country returns in $ If we are adding international investments to a well diversified portfolio it is beta that matters. Notice the imperfect correlation between standard deviation and beta. The evidence of lower betas indicates that there may be diversification benefits from including international investments into a U.S. portfolio.

Questions on Assessing Performance in US Dollars in Foreign Markets Are average returns higher in emerging markets?

Figure 19.5 Average $ excess returns 1999-2008 Emerging markets generally have higher excess returns. Since some had returns below the risk free rate we can reaffirm that risky returns may fall short of expectations over long time periods. Students may notice that many countries with lower beta had higher excess returns. This seems counterintuitive. Either the betas aren’t good risk measures or we simply don’t have enough data. The standard deviations are large enough to indicate a lot of variability in results can be expected over even a 10 year period.

X-Section Country Monthly Return Stats This is for the whole sample of 49 countries but it is broken out different ways. The main findings are that beta and size are significant and the text indicates that investors pay more for securities in markets that have more transparency, enforcement of business law and better regulations. The World Bank published a similar finding about growth several years ago. Note that the correlation between country capitalization and SD is high so it may be difficult to say much about these coefficients.

Questions on Assessing Performance in US Dollars in Foreign Markets Is exchange rate risk important in international portfolios?

Standard Deviation of Investments Across the Globe in US Dollars versus Local Currency Local currency SDs are slightly lower than SDs of dollar returns, so there is only a small amount of exchange rate risk.

Beta in $US versus Local Currency Betas are also only slightly lower for local currency returns. The reason for this is in the next slide.

Correlation of Returns in $US and Local Currencies 1999 - 2008 Notice the nearly identical correlations of country returns with U.S. returns in U.S. dollars and in local currency returns.

Avg. monthly returns in $ and local currency 1999-2008 In 1999 the dollar appears to have been overvalued since over the following 10 years, returns in local currency (which may be considered hedged returns so that the change in the value of the dollar did not affect performance) outperformed unhedged returns (returns when converted to U.S. dollars). The point is that hedging currency risk can materially affect returns, particularly if a currency is over or undervalued against many other currencies. The choice to hedge or not now becomes one of the decision variables for an active manager.

Questions on Assessing Performance in US Dollars in Foreign Markets Are there diversification benefits to international investing?

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 But as we will see, the benefits are less than generally thought. 11

International Diversification International Diversification. Portfolio Diversification as a Percentage of the Average Standard Deviation of a One-Stock Portfolio Diversifying internationally eliminates about another 15% that is certainly economically material but this is from dated results.

Hedged & Unhedged Correlations These correlations indicate that international diversification benefits will be significant and material. Note the negative correlations between bonds and stocks. This indicates that adding bonds to a portfolio will result in substantial diversification benefits.

Ex Post Efficient Frontier of Country Portfolios 1999-2003 Unfortunately the authors did not update this graph. However it indicates the benefits of international investing.

Figure 19.12a Efficient Frontier of Country Portfolios (world expected excess return = .3% per month) This graph indicates only modes benefits from international diversification from including developed markets.

Figure 19.12b Efficient Frontier of Country Portfolios (world expected excess return = .6% per month) Changing the expected excess return in this way makes the slope of the CML larger because a higher excess return simply shifts the curve upward. This graph also indicates only modest benefits from international diversification from including developed markets.

Are diversification benefits preserved in bear markets? There is an old saying that in a crash ,“All correlations go to 1.” If so then diversification fails just when you need it most. This was certainly true for the hedge fund Long Term Capital Management.

Figure 19.13A Regional Indexes Around the Crash, October 14 – 26, 1987 We should note that this is from Richard Roll’s work. As you might expect, some events affect all stocks globally and you can’t diversify away from those factors. Some macro shocks such as the financial crisis of 2008 are likely to tank all stocks, though not all equally. Roll (1988) found that the beta of the country index on the world index predicted that index’s response to the ‘87 crash.

Figure 19.13B Beta and  of portfolios against deviation of month return from Sep-Dec 2008 from avg. 1999-2008 Both beta against the U.S. and the country index standard deviation explain the deviation of crisis returns from the overall period averages. This largely confirms Roll’s predictions.

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.

19.4 How to Go about International Diversification and the Benefit We Can Expect Choosing a Practical Internationally Diversified Portfolio

 of various portfolios The U.S. only standard deviation (SD) of monthly returns is 4.81%. The minimum variance portfolio is to diversify into all countries and allows short sales. This yields a SD of 1.9%. Disallowing short sales, moves the SD to 3.44%, still quite low. The problem with this portfolio is that the U.S. comprises only 2% of it while risky countries like Malaysia and Sri Lanka comprise 31% of the portfolio! Nobody is going to invest that way, because we know it is too risky. The index portfolios consists mostly of large markets (44%) and Australia plus the Far East (18%). The two large markets added are Japan (31%) and China (16%). According to these results passive international diversification is less effective than generally thought.

Active Management First level: Second 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. The alphas and information ratios in Table 19.9B (next slide) indicate that even noisy forecasts of these variables may be able to generate portfolios with greatly superior performance.

Monthly Returns & Performance for Index Portfolios 1999-2008 The alphas and information ratios in Table 19.9B indicate that even noisy forecasts of these variables may be able to generate portfolios with greatly superior performance.

19.5 International Investing And Performance Attribution

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 The EAFE is the European, Australian, Far East index

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.