McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Globalization and International Investing 19 Bodie, Kane, and Marcus Essentials of Investments, 9 th Edition

Global Markets for Equities Background Global market U.S. stock exchanges make up roughly 40% of all markets Emerging market development Market capitalization and GDP

19-3 Table 19.1 Market Capitalization of Stock Exchanges, Developed Countries Market Capitalization GDP GDP per Capita Market Capitalizatio n as % of GDP Billions of U.S. DollarsPercent of WorldAnnual Growth (%) WORLD27,47338,200100% 2.863,1249,22868 US12,90013, ,58747,19998 JAPAN3,1403, ,45942,83169 UK2,5662, ,24936, CANADA6151, ,57746, FRANCE1,2781, ,56039,46070 HONG KONG5641, , GERMANY1,0611, ,28140,15243 SWITZERLAND7831, , AUSTRALIA3491, , KOREA ,01520,75786 SPAIN ,40730,54244 ITALY ,05133,91728 SWEDEN , NETHERLANDS ,91560 MEXICO ,0359,12339 NORWAY ,53861 CHILE , BELGIUM ,14454 DENMARK ,89167 TURKEY ,09434 FINLAND ,51286 ISRAEL ,50480 POLAND ,29334 AUSTRIA ,20933 IRELAND ,17030 PORTUGAL ,50535 CZECH REP ,24523 NEW ZEALAND ,06735 LUXEMBURG ,43879 GREECE ,60021 HUNGARY ,85222 SLOVENIA ,85118

19-4 Table 19.2 Market Capitalization of Stock Exchanges, Emerging Markets Market Capitalization GDP GDP per Capita Market Capitalization as % of GDP Billions of U.S. DollarsPercent of WorldGrowth (%) BRAZIL1801, ,08810,71066 INDIA ,7271,47569 RUSSIA ,48010,44058 CHINA ,9274,42811 TAIWAN , SINGAPORE , SOUTH AFRICA , MALAYSIA , INDONESIA ,94641 THAILAND ,60870 COLOMBIA ,22570 PHILIPPINES ,14067 PERU ,40164 ARGENTINA ,12415 PAKISTAN ,01917 SRI LANKA ,37531 ROMANIA ,5389 VENEZUELA ,5903 CYPRUS ,77928 BULGARIA ,3254

19-5 Figure 19.1A Per Capita DGP and Market Capitalization as Percent of GDP, Log Scale 2000

19-6 Figure 19.1B Per Capita GDP and Market Capitalization as Percent of GDP, Log Scale 2010

Risk Factors in International Investing Risks in Foreign Security Investment Exchange rate risk Uncertainty in asset returns due to movements in exchange rates between U.S. dollar and foreign currency Country-specific risk Political risk: Possibility of expropriation of assets, changes in tax policy, restrictions on exchange of foreign currency for domestic, etc. Imperfect exchange rate risk hedging Hard to hedge equities with variable rates of return

Risk Factors in International Investing

Risk Factors in International Investing Dollar Depreciation Relative to Pound If you invest in a British security and earn 10%, find the return in U.S. dollars given Initial exchange rate: £ = $2 Final exchange rate: £ = $2.10

Risk Factors in International Investing Dollar Appreciation Relative to Pound If you invest in a British security and earn 10%, find the return in U.S. dollars given Initial exchange rate: £ = $2 Final exchange rate: £ = $1.85

19-11 Figure 19.2 Stock Returns, U.S. Dollars and Local Currencies, 2010

19-12 Table 19.3 Rates of Change, U.S. Dollar versus World Currencies, Euro (€)U.K. (£) Switzerland (SF)Japan (¥) Australia (A$) Canada (C$) A. Standard deviation (annualized %) B. Correlation matrix Euro (€)U.K. (£) Switzerland (SF)Japan (¥) Australia (A$) Canada (C$) U.K. (£) Switzerland (SF) Japan (¥) Australia (A$) Canada (C$) C. Average annual returns from rolling over one-month LIBOR rates (%) Return inExpectedActualSurprise LocalGain from Actual ReturnComponent SD of Annual CountryCurrency in U.S. dollarsof ReturnReturn U.S.$2.18 Euro€ U.K.£ SF Japan¥ AustraliaA$ CanadaC$

Risk Factors in International Investing Carry Trade Suppose yen LIBOR =.24%, USD LIBOR = 3.75% An astute investor may borrow yen at the yen rate, convert the borrowed funds to dollars, and invest at dollar LIBOR What can go wrong with this strategy? Default Yen increases in value by  3.75% −.24% = 3.51% or more

Risk Factors in International Investing Covered Interest Arbitrage U.S. interest rates 6.15%, British rates 10%, exchange rate $2/£; 1-year forward exchange rate for pound is $1.95/£ How can you earn a riskless arbitrage profit based on these quotes? Borrow $1 at 6.15%: will owe $ in 1 year Convert $1 to pounds: $1/($2/£) = £.50 Invest £.50 at 10%: Will yield £.50 x 1.10 = £.55 Sell pound forward at $1.95: £55 x $1.95 = $ Net: $ − $ = $.011/dollar

Risk Factors in International Investing 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

19-16 Table 19.4 Composite Risk Ratings for 01/2011, 02/2010 Rank in January 2011Country Composite Risk Rating January 2011 Composite Risk Rating February 2012 January 2011 versus February 2010 Rank in February 2010 Very low risk 1Norway Germany Canada Qatar Japan Low risk 31United Kingdom United States China, Peoples' Rep Brazil Spain Moderate risk 78Indonesia India Egypt Turkey High risk 124Venezuela Iraq Pakistan Very high risk 138Haiti Somalia

19-17 Table 19.5 Variables Used in PRS’s Political Risk Score

19-18 Table 19.6 Current Risk Ratings and Composite Risk Forecasts Composite RatingsCurrent Ratings Year AgoCurrent Political Risk Financial Risk Economic Risk CountryFebruary 2010January 2011 Norway Canada Japan United States China, Peoples' Rep India Turkey

19-19 Table 19.7 Risk Forecasts Composite Risk Forecasts CurrentOne Year AheadFive Years Ahead CountryRating January 2011Worst CaseBest CaseRisk StabilityWorst CaseBest CaseRisk Stability Norway Canada Japan United States China, Peoples' Rep India Turkey Political Risk Forecasts CurrentOne Year AheadFive Years Ahead CountryRating 01/11Worst CaseBest CaseRisk StabilityWorst CaseBest CaseRisk Stability Norway Canada Japan United States China, Peoples' Rep India Turkey

19-20 Table 19.8 Political Risk Points by Component, 1/2011

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

19-22 Figure 19.3 Monthly Standard Deviation of Excess Returns, Developed and Emerging Markets,

19-23 Figure 19.4 Beta against U.S. Market of Developed and Emerging Markets,

19-24 Figure 19.5 Average Excess Dollar-Denominated Returns, Developed and Emerging Markets,

19-25 Figure 19.6 Information Ratios, Developed and Emerging Markets versus U.S. Dollar-Denominated Returns,

19-26 Figure 19.7 Standard Deviation of Excess Returns, Dollar- Denominated and Local Currencies,

19-27 Figure 19.8 Market Beta against U.S. Using Dollar-Denominated and Local-Currency Excess Returns,

19-28 Figure 19.9 Average Dollar-Denominated and Local- Currency Excess Returns,

International Investing: Risk, Return, and Benefits from Diversification 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

19-30 Figure Information Ratios against U.S. Computed from Dollar-Denominated and Local Currency Returns,

19-31 Figure International Diversification

19-32 Table Correlation of Foreign Investments with U.S. Returns over Time

19-33 Figure Ex-Post Efficient Frontier of Country Portfolios

19-34 Figure 19.13A Efficient Frontier of Country Portfolios (World Expected Excess Return =.3% per Month)

19-35 Figure 19.13B Efficient Frontier of Country Portfolios (World Expected Excess Return =.6% per Month)

19-36 Figure 19.14A Regional Indexes around the Crash, 10/14/87-10/26/87

B Beta and  of Portfolios against Deviation of Monthly Return, 9/08-12/08

International Investing: Risk, Return, and Benefits from Diversification Conclusions Passive investment in all countries would not have lowered risk during recent crisis Hedging currencies has little effect; U.S. stock market crash appears to be systemic factor that cannot be diversified away from in crisis Correlations are increasing due to globalization; nevertheless, we still expect modest international diversification benefits in normal markets

19-39 Active Management First level Security selection and asset allocation within each market to identify country portfolio superior to country index Second level Optimize allocations across country portfolios to maximize diversification 19.3 International Investing: Risk, Return, and Benefits from Diversification

International Investing and 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

19-41 Stock Selection Measured as weighted average of equity returns in excess of equity index in each country Cash/Bond Selection Excess return due to weighting bonds and bills differently from benchmark weights 19.5 International Investing and Performance Attribution