Lecture 131 International Portfolio Investment I.The Rationale for International Portfolio Investment II. Avenues for International Investment

Lecture 132 International Portfolio Investment cont’d I.The Rationale for International Portfolio Investment ** Internationally diversified portfolio less risky than purely domestic portfolio Reason: Securities are less correlated across countries than within a country Preliminaries: Measuring Risk and Return Single Securities: Expected Return Variance of Returns (Standard Deviation of Returns) Covariance of Returns Correlation between Returns

Lecture 133 International Portfolio Investment cont’d Portfolio Risk and Returns: * Risk-averse investors hold well-diversified portfolio (not single securities) Expected Return of a Portfolio Variance (and standard deviation) - Example - Two-asset case

Lecture 134 International Portfolio Investment cont’d Aside: The Variance, Covariances and Expected returns are based on the future. Computing variances, covariances and returns based on historical data: Average (historical) return as proxy for Expected Return Historical Variance as proxy for (expected) Variance Historical Covariance as proxy for (expected) Covariance

Lecture 135 International Portfolio Investment cont’d Principles of Diversification: Generally, Riskiness of Portfolio (  p ) falls, as # securities increases The degree of risk reduction depends on the degree of correlation among security returns Example: Three Cases –Case 1: Perfect Negative Correlation (  = -1) »Risk can be eliminated –Case 2: Perfect Positive Correlation (  = 1) »No benefit from diversification –Case 3: Imperfect Correlation ( -1 <  < 1) »Diversification reduces risk The less correlated component securities, the less risky the portfolio Distinction between firm-specific and systematic risks Importance of covariance (reflection of systematic risk)

Lecture 136 International Portfolio Investment cont’d

Lecture 137 International Portfolio Investment cont’d Correlation Structure of International Assets Returns display much lower correlations across countries than within a country –Risk reduction higher through international diversification The dynamic behavior of Correlations across countries –Correlation changes over time and varies across countries –Does it increase over time? –Evidence that correlation increases during volatile periods –Impact on the potential diversification benefit Currency Risk and the Diversification Benefit –International investing involves risk of currency fluctuation –Is the additional currency risk large enough to eliminate the diversification benefit? Market and currency risks not additive currency risk can be hedged currency risk lower in longer investment horizon

Lecture 138 International Portfolio Investment cont’d

Lecture 139 International Portfolio Investment cont’d

Lecture 1310 International Portfolio Investment cont’d

Lecture 1311 International Portfolio Investment cont’d Another Look at the Case for International Investment: International Investment Expands the set of Profitable Investment Opportunities –improves the return-risk trade-off –may reflect higher growth of economies, currency gains etc. Optimal International Portfolios and Measuring the gains from international investment –The Efficient Frontier: Domestic vs International –Sharpe Ratio: Excess return of a portfolio above the risk free asset per unit of portfolio risk –Optimal international portfolios vary across countries (see Exhibit 11-13) –Gain from international investment positive (see Exhibit 11-13)

Lecture 1312 International Portfolio Investment cont’d

Lecture 1313 International Portfolio Investment cont’d II. Avenues for International Investment Direct Purchase of Foreign Shares –High Transaction costs involved foreign exchange conversion, account custody, settlement, dividend collection etc. –Information Problems - poor accounting and financial disclosure –Illiquid markets - difficult to divest –Not feasible for small investors Cross-Listed Companies American Depository Receipts (ADR) and (Global Depository Receipts (GDR)): –Negotiable certificates issued by a U.S bank in U.S. to represent the underlying shares of stock, held in trust at a foreign custodian bank. –Sold, registered, and transferred in U.S. in same way as any shares –Prices of the share and the ADR consistent with each other (ADR exchangeable with the shares)

Lecture 1314 International Portfolio Investment cont’d –Advantages to investor include convenience –avoid costs and difficulties of trading abroad –avoid currency conversions conformity with the stringent U.S. reporting requirements –Drawbacks include less liquidity (and high bid-ask spread) Limited number of Emerging Market ADRs ADRs traded in OTC - with less stringent reporting requirements Mutual Funds Open-End vs Closed-End Funds Diversified vs Regional vs Country Funds

Lecture 1315 International Portfolio Investment cont’d Closed-End Country Funds (CECF) - an investment vehicle for buying stocks of a particular market (e.g. Korean Fund - an actively managed portfolio consisting of stocks of Korean companies) - fixed number of shares, non-redeemable to the fund - shares listed and traded in national market (price determined by demand and supply) - fund’s market price may differ from its Net Asset Value (NAV) FV = NAV + Premium/discount NAV - value of underlying securities held in the portfolio Premium/discount - excess of fund price over its net asset value

Lecture 1316 International Portfolio Investment cont’d Advantages of Closed-End Country funds include: - Provide a simple way for accessing local markets - overcomes trading difficulties - Overcome foreign investment restrictions - in countries where - The closed-end status provides the funds more control on the timing of purchases and sale of securities - particularly important for emerging markets Disadvantage of CECF include - fund price not NAV and the uncertainty of premium

Lecture 1317 International Portfolio Investment cont’d Open End Mutual Funds -shares redeemable from the fund -fund value equals NAV Advantages (to shareholders): - no premium to pay on shares Disadvantage: - risk that fund should liquidate its NAV if investors redeem shares => problematic in illiquid emerging markets - managers impose high bid-ask spread, and limit redemption Available only in liquid markets.

Lecture 1318 International Portfolio Investment cont’d World Equity Benchmark Securities (WEBS) - an index portfolio designed to track country indices (MSCI indices) - covers mostly developed country markets (currently includes Hong Kong, Malaysia, Singapore, Mexico) - listed and traded on AMEX WEBS vs other funds: - Like closed-end funds, traded and listed on exchange - unlike closed-end funds, no premium or discount WEBS can be redeemed in kind (i.e they are open-end funds), which eliminates potential premium/discount –if WEBS trade at discount, investor can claim constituent shares, sell in open market and earn profit –The arbitrage mechanism prevents occurrence of premium/discount –Like index funds, WEBS invest passively Expense ratio lower than closed-end funds Reference:

Lecture 1319 International Portfolio Investment cont’d Stocks of Multinational Firms –MNCs have internationally diversified operations –An investor may reap the diversification benefit through holding securities of MNCs –Depends on nature and extent of international involvement whether MNCs returns move more closely with domestic or foreign markets Returns of U.S. MNCs closely related to US stock market than foreign markets –poor diversification vehicles (Jacquillat and Solnik(1978) Provide better diversification benefits in –economically less diversified countries or –countries with controls on cross-border portfolio investment

Lecture 1320 International Portfolio Investment cont’d Foreign Stock Index Futures and Other Derivatives –Future contracts on country stock indices (e.g. Hong Kong, South Africa –Cost-effective way for short-term investment horizons –marking to market –margin requirements, 5-10% of contract value –Advantages include: High liquidity –provide market exposure through single purchase –faster tactical asset allocation (market timing) decisions (compared to cash markets) –lower settlement (delivery failure etc) risks (because, transactions settled by cash) Low cost –transaction costs cheaper than in cash markets (e.g. U.S.) –particularly significant for emerging markets where transaction costs of cash markets are much higher

Lecture 1321 International Portfolio Investment cont’d –no custody costs –no withholding taxes help avoid foreign ownership restrictions –Shortcomings include costly for long-term investment –maintenance costs limited number of emerging markets stock future indexes –Other derivatives include: index options, stock index swaps etc.