1. 19 Globalization and International Investing Bodie, Kane, and Marcus
Essentials of Investments, 9th Edition

2. 19.1 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

3. Market Capitalization Market Capitalization as % of GDP
Table 19.1 Market Capitalization of Stock Exchanges, Developed Countries
Market Capitalization
GDP
GDP per Capita
Market Capitalization as % of GDP
Billions of U.S. Dollars
Percent of World
Annual Growth (%)
2000
2011
2010
WORLD
27,473
38,200
100%
2.8
63,124
9,228 68 US
12,900
13,917
47.0
36.4
0.6
14,587
47,199 98
JAPAN
3,140
3,289
11.4
8.6
0.4
5,459
42,831 69 UK
2,566
2,794
9.3
7.3
0.7
2,249
36,144
133
CANADA
615
1,581
2.2
4.1
8.2
1,577
46,236
114
FRANCE
1,278
1,455
4.7
3.8
1.1
2,560
39,460 70
HONG KONG
564
1,369
2.1
3.6
7.7
225
31,758
701
GERMANY
1,061
1,177
3.9
3.1
0.9
3,281
40,152 43
SWITZERLAND
783
1,062
2.9
2.6
528
67,464
224
AUSTRALIA
349
1,039
1.3
2.7
9.5
925
42,131
132
KOREA
123
763
2.0
16.4
1,015
20,757 86
SPAIN
331
546
1.2
1.4
4.2
1,407
30,542 44
ITALY
716
460
-3.6
2,051
33,917 28
SWEDEN
274
440
1.0
4.0
459
48,936
118
NETHERLANDS
680
376
2.5
-4.8
779
46,915 60
MEXICO
112
372
10.5
1,035
9,123 39
NORWAY 52
238
0.2
13.5
413
84,538 61
CHILE
229
14.7
213
12,431
136
BELGIUM
159
216
469
43,144 54
DENMARK 99
176
0.5
4.9
310
55,891 67
TURKEY 50
164
10.4
734
10,094 34
FINLAND
280
139
-5.7
239
44,512
ISRAEL 46
119
0.3
8.3
217
28,504 80
POLAND 27
0.1
12.5
12,293
AUSTRIA 85
9.8
379
45,209 33
IRELAND 82 65
-1.9
211
47,170 30
PORTUGAL 64 59
-0.6
21,505 35
CZECH REP. 12
0.0
192
18,245 23
NEW ZEALAND 20
5.0
31,067
LUXEMBURG
1.7 53
105,438 79
GREECE 72 29
-7.1
301
26,600 21
HUNGARY 19
129
12,852 22
SLOVENIA 2 6
11.2 47
22,851 18

4. Table 19.2 Market Capitalization of Stock Exchanges, Emerging Markets
GDP
GDP per Capita
Market Capitalization as % of GDP
Billions of U.S. Dollars
Percent of World
Growth (%)
2000
2011
2010
BRAZIL
180
1,056
0.7
2.8
15.9
2,088
10,710 66
INDIA
107
868
0.4
2.3
19.0
1,727
1,475 69
RUSSIA 19
694
0.1
1.8
34.9
1,480
10,440 58
CHINA 13
499
0.0
1.3
35.2
5,927
4,428 11
TAIWAN
177
455
0.6
1.2
8.2
430
18,300
134
SINGAPORE
136
428
0.5
1.1
10.1
209
41,122
241
SOUTH AFRICA
104
405
12.0
364
7,275
MALAYSIA 83
330
0.3
0.9
12.1
238
8,373
135
INDONESIA 21
301
0.8
24.8
707
2,946 41
THAILAND 23
219
20.7
319
4,608 70
COLOMBIA 4
191
37.3
288
6,225
PHILIPPINES 20
141
17.6
200
2,140 67
PERU 5 77
0.2
25.9
157
5,401 64
ARGENTINA 24 36
3.6
369
9,124 15
PAKISTAN 26
15.2
1,019 17
SRI LANKA 1 14
27.5 50
2,375 31
ROMANIA
36.9
162
7,538 9
VENEZUELA 6
-0.2
392
13,590 3
CYPRUS
-9.7
28,779 28
BULGARIA 2
29.6 48
6,325

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

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

7. 19.2 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

8. 19.2 Risk Factors in International Investing

9. 19.2 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

10. 19.2 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

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

12. Table 19. 3 Rates of Change, U. S
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 %)
11.04
9.32
11.94
9.13
13.87
10.04
B. Correlation matrix
0.63 1
0.83
0.51
0.27
0.08
0.42
0.75
0.6
0.61
0.05
0.49
0.37
-0.02
0.72
C. Average annual returns from rolling over one-month LIBOR rates (%)
Return in
Expected
Actual
Surprise
Local
Gain from
Actual Return
Component
SD of Annual
Country
Currency
in U.S. dollars
of Return
Return
U.S. $
2.18
Euro €
2.38
-0.20
4.38
6.77
4.58
U.K.
3.51
-1.32
1.09
4.60
2.41 SF
0.90
1.28
6.46
7.36
5.17
Japan
0.24
1.94
5.75
5.99
3.81
Australia A$
5.25
-3.07
7.94
13.19
11.01
Canada C$
2.50
-0.31
5.01
7.51
5.32

13. 19.2 Risk Factors in International Investing
Carry Trade
Suppose yen LIBOR = .24%, USD LIBOR = %
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% = % or more

14. 19.2 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 = $1.0725
Net: $ − $ = $.011/dollar

15. 19.2 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

16. Table 19.4 Composite Risk Ratings for 01/2011, 02/2010
Rank in January 2011
Country
Composite Risk Rating January 2011
Composite Risk Rating February 2012
January 2011 versus February 2010
Rank in February 2010
Very low risk 1
Norway
90.5
90.00
0.50 11
Germany
83.5
83.50
0.00 5 13
Canada
82.8
82.75 6 16
Qatar
82.0
81.25
0.75 19
Japan
81.0
80.00
1.00 17
Low risk 31
United Kingdom
77.3
73.75
3.50 39 32
United States
77.0
77.25
-0.25 26
China, Peoples' Rep.
75.0
76.25
-1.25 30 44
Brazil
74.5
72.75
1.75 46 68
Spain
70.0
71.00
-1.00 58
Moderate risk 78
Indonesia
68.5
67.25
1.25 81 86
India
67.3
70.50
-3.25 62
104
Egypt
64.5
66.50
-2.00 84
111
Turkey
63.3
63.50
100
High risk
124
Venezuela
59.5
53.75
5.75
133
127
Iraq
58.5
59.25
-0.75
119
129
Pakistan
57.3
57.00
0.25
125
Very high risk
138
Haiti
48.5
49.75
137
140
Somalia
41.5
36.75
4.75

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

18. Table 19.6 Current Risk Ratings and Composite Risk Forecasts
Composite Ratings
Current Ratings
Year Ago
Current
Political
Risk
Financial
Economic
Country
February 2010
January 2011
Norway
90.00
90.50
88.5
46.5
46.0
Canada
82.75
86.5
40.0
39.0
Japan
80.00
81.00
78.5
44.0
39.5
United States
77.25
77.00
81.5
37.0
35.5
China, Peoples' Rep.
76.25
75.00
62.5
48.0
India
70.50
67.25
58.5
43.5
32.5
Turkey
63.50
63.25
57.0
34.5
35.0

19. Table 19.7 Risk Forecasts Composite Risk Forecasts
Current
One Year Ahead
Five Years Ahead
Country
Rating January 2011
Worst Case
Best Case
Risk Stability
Norway
90.5
88.3
93.3
5.0
83.3
92.8
9.5
Canada
82.8
78.3
84.3
6.0
75.3
86.5
11.3
Japan
81.0
77.0
7.3
72.5
87.5
15.0
United States
73.3
80.3
7.0
69.5
83.0
13.5
China, Peoples' Rep.
75.0
70.8
79.0
8.3
61.3
82.0
20.8
India
67.3
64.0
72.3
57.5
19.5
Turkey
63.3
57.8
67.5
9.8
53.8
71.5
17.8
Political Risk Forecasts
Current
One Year Ahead
Five Years Ahead
Country
Rating 01/11
Worst Case
Best Case
Risk Stability
Norway
88.5
88.0
92.0
4.0
86.0
89.5
3.5
Canada
86.5
83.0
5.5
81.5
8.0
Japan
78.5
75.5
84.0
8.5
72.0
16.0
United States
77.5
85.5
76.0
87.0
11.0
China, Peoples' Rep.
62.5
58.5
68.5
10.0
55.0
73.0
18.0
India
64.0
9.0
53.5
71.0
17.5
Turkey
57.0
52.5
63.5
51.5
69.0

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

21. International Investment Choices
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

22. Figure 19.3 Monthly Standard Deviation of Excess Returns, Developed and Emerging Markets, 2002-2011
Rank Legend
Rank
Developed Emerging
1 U.S. Malaysia
2 Japan Morocco
3 Switzerland Jordan
4 U.K. Chile
5 Israel Mexico
6 New Zealand Philippines
7 Canada Taiwan
8 Hong Kong Czech Republic
9 Denmark South Africa
10 Singapore China
11 Portugal Thailand
12 Australia Colombia
13 France Korea
14 Netherlands India
15 Italy Peru
16 Belgium Indonesia
17 Spain Pakistan
18 Ireland Poland
19 Germany Egypt
20 Sweden Russia
21 Austria Hungary
22 Finland Brazil
23 Norway Sri Lanka
24 Greece Argentina
25 Turkey

23. Figure 19.4 Beta against U.S. Market of Developed and Emerging Markets, 2002-2011
Rank Legend
Rank
Developed Emerging
1 Japan Pakistan
2 Switzerland Jordan
3 Israel Morocco
4 New Zealand Sri Lanka
5 Hong Kong Malaysia
6 U.K. Philippines
7 U.S. Egypt
8 Portugal Chile
9 Singapore Colombia
10 Denmark Thailand
11 Canada Argentina
12 Australia Czech Republic
13 Italy Peru
14 Belgium China
15 Spain Taiwan
16 France South Africa
17 Ireland Indonesia
18 Netherlands India
19 Austria Mexico
20 Greece Russia
21 Finland Korea
22 Sweden Hungary
23 Germany Poland
24 Norway Brazil
25 Turkey

24. Figure 19.5 Average Excess Dollar-Denominated Returns, Developed and Emerging Markets, 2002-2011
Rank Legend
Rank
Developed Emerging
1 Greece Taiwan
2 Ireland Jordan
3 Finland Malaysia
4 U.S. Morocco
5 Italy Poland
6 Japan Hungary
7 Belgium Philippines
8 Portugal Mexico
9 France Argentina
10 U.K. Korea
11 Netherlands China
12 Israel Chile
13 Germany Russia
14 Switzerland India
15 Hong Kong South Africa
16 Spain Turkey
17 Austria Sri Lanka
18 Sweden Pakistan
19 New Zealand Thailand
20 Denmark Czech Republic
21 Canada Brazil
22 Singapore Egypt
23 Australia Peru
24 Norway Indonesia
25 Colombia

25. Figure 19.6 Information Ratios, Developed and Emerging Markets versus U.S. Dollar-Denominated Returns,
Rank Legend
Rank
Developed Emerging
1 Ireland Taiwan
2 Greece Jordan
3 Finland Argentina
4 Italy Hungary
5 Belgium Turkey
6 Japan Poland
7 Portugal Russia
8 France Sri Lanka
9 Netherlands Philippines
10 U.K. India
11 Germany Korea
12 Israel China
13 Austria Pakistan
14 Spain Morocco
15 Hong Kong Egypt
16 Switzerland Malaysia
17 Sweden Brazil
18 New Zealand South Africa
19 Singapore Chile
20 Norway Thailand
21 Denmark Mexico
22 Canada Peru
23 Australia Czech Republic
24 Indonesia
25 Colombia

26. Figure 19.7 Standard Deviation of Excess Returns, Dollar-Denominated and Local Currencies, 2002-2011
Rank Legend
Rank Country Rank Country
1 U.S Czech Republic
2 Japan 28 South Africa
3 Switzerland 29 Sweden
4 Malaysia 30 China
5 U.K Thailand
6 Morocco 32 Colombia
7 Israel 33 Korea
8 New Zealand 34 Austria
9 Jordan 35 Finland
10 Canada 36 Norway
11 Hong Kong 37 India
12 Denmark 38 Peru
13 Chile 39 Indonesia
14 Singapore 40 Pakistan
15 Portugal 41 Greece
16 Australia 42 Poland
17 France 43 Egypt
18 Netherlands 44 Russia
19 Mexico 45 Hungary
20 Italy 46 Brazil
21 Philippines 47 Sri Lanka
22 Taiwan 48 Argentina
23 Belgium 49 Turkey
24 Spain
25 Ireland
26 Germany

27. Figure 19. 8 Market Beta against U. S
Figure 19.8 Market Beta against U.S. Using Dollar-Denominated and Local-Currency Excess Returns,
Rank Legend
Rank Country Rank Country
1 Pakistan 27 Indonesia
2 Jordan 28 Australia
3 Morocco 29 India
4 Sri Lanka 30 Mexico
5 Japan 31 Italy
6 Malaysia 32 Belgium
7 Philippines 33 Spain
8 Switzerland 34 France
9 Israel 35 Ireland
10 Egypt 36 Netherlands
11 New Zealand 37 Russia
12 Chile 38 Korea
13 Hong Kong 39 Austria
14 U.K Greece
15 Colombia 41 Finland
16 Thailand 42 Sweden
17 Argentina 43 Germany
18 Portugal 44 Norway
19 Czech Republic 45 Hungary
20 Peru 46 Poland
21 Singapore 47 Brazil
22 China 48 Turkey
23 Denmark
24 Canada
25 Taiwan
26 South Africa

28. Figure 19.9 Average Dollar-Denominated and Local-Currency Excess Returns, 2002-2011
Rank Legend
Rank Country Rank Country
1 Greece 27 Morocco
2 Ireland 28 Poland
3 Finland 29 Hungary
4 U.S Philippines
5 Italy 31 Mexico
6 Japan 32 Argentina
7 Belgium 33 Korea
8 Portugal 34 Norway
9 France 35 China
10 U.K Chile
11 Netherlands 37 Russia
12 Taiwan 38 India
13 Israel 39 South Africa
14 Germany 40 Turkey
15 Jordan 41 Sri Lanka
16 Switzerland 42 Pakistan
17 Hong Kong 43 Thailand
18 Spain 44 Czech Republic
19 Austria 45 Brazil
20 Sweden 46 Egypt
21 New Zealand 47 Peru
22 Denmark 48 Indonesia
23 Canada 49 Colombia
24 Singapore
25 Malaysia
26 Australia

29. Diversification Benefits
19.3 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

30. Figure 19. 10 Information Ratios against U. S
Figure Information Ratios against U.S. Computed from Dollar-Denominated and Local Currency Returns,
Rank Legend
Rank Country Rank Country
1 Ireland 27 Philippines
2 Greece 28 Singapore
3 Finland 29 India
4 Italy 30 Korea
5 Belgium 31 China
6 Japan 32 Pakistan
7 Portugal 33 Norway
8 France 34 Denmark
9 Netherlands 35 Morocco
10 Taiwan 36 Canada
11 U.K Egypt
12 Germany 38 Malaysia
13 Israel 39 Brazil
14 Austria 40 South Africa
15 Jordan 41 Australia
16 Spain 42 Chile
17 Argentina 43 Thailand
18 Hungary 44 Mexico
19 Hong Kong 45 Peru
20 Turkey 46 Czech Republic
21 Poland 47 Indonesia
22 Switzerland 48 Colombia
23 Russia
24 Sweden
25 Sri Lanka
26 New Zealand

31. Figure 19.11 International Diversification

32. Table 19. 10 Correlation of Foreign Investments with U. S
Table Correlation of Foreign Investments with U.S. Returns over Time

33. Figure 19.12 Ex-Post Efficient Frontier of Country Portfolios

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

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

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

37. 19.14B Beta and  of Portfolios against Deviation of Monthly Return, 9/08-12/08

38. 19.3 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

39. 19.3 International Investing: Risk, Return, and Benefits from Diversification
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

40. 19.5 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

41. 19.5 International Investing and Performance Attribution
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