1. Chapter 13 International Portfolio Investment

2. Chapter 13: International Portfolio Investment1 13.ARisks and Benefits of International Equity Investing (1)  Risks to international investing –Changes in currency exchange rate – dividends received on or proceeds from the sale of international investments may be reduced or increased when the dividends or proceeds are converted into dollars. –Currency controls may restrict or delay an investor’s ability to move currency out of a country. –Dramatic changes in foreign market value –Political, economic, and social events influence foreign markets. –Lack of liquidity – foreign markets may have lower trading volumes, fewer listed companies, abbreviated hours of operation, and restrictions on the amount and type of stocks investors may purchase. –Less information – Disclosure policies are often more lax in foreign countries than in the U.S.

3. Chapter 13: International Portfolio Investment2 13.ARisks and Benefits of International Equity Investing (2)  Risk to international investing, continued –Legal recourse – even if investors have legal recourse in the U.S., judgments may not be enforceable in foreign countries. Thus, investors may have to rely on the legal system of the foreign company’s home country. –Different market operations Foreign markets may have different periods for clearance and settlement and may not report stock trades as quickly as U.S. markets. Shares may not be protected if the custodian bank has credit problems.  Benefit to international investing –International investments offer greater opportunities than domestic investments. More than half the world’s market capitalization is in non-U.S. companies. Most global manufacturers are overseas. More than 80% of all cars, 85% of all stereos, and 99% of 35mm cameras are produced abroad.

4. Chapter 13: International Portfolio Investment3 13.ARisks and Benefits of International Equity Investing (3)  International diversification –Basic rule of portfolio diversification – the broader the diversification, the more stable the returns and the more diffuse the risks. –The expanded universe of international securities implies the possibility of achieving a better risk-return tradeoff than investing solely in U.S. securities. –While nearly 75% of investment risk can be eliminated in a fully diversified U.S. portfolio, all companies in a country are subject to the same cyclical economic fluctuations (systematic risk), which cannot be diversified out. –By diversifying across countries whose economic cycles are not perfectly aligned (e.g., an oil price shock that hurts the U.S. economy helps oil-exporting countries), investors may further reduce risk by diversifying out some systematic risk.

5. Chapter 13: International Portfolio Investment4 13.ARisks and Benefits of International Equity Investing (4)  International diversification, continued –Annualized returns and standard deviations of returns for various developed and emerging stock markets from 1988 to 2006 indicate that emerging markets generally have higher risks and returns than developed markets. –The Morgan Stanley Capital International (MSCI) Europe, Australia, Far East (EAFE) Index (reflecting the 20 major stock markets outside the U.S.) has had lower risk than most of its individual country components. –The MSCI World Index (which combines EAFE countries with North America), has lower risk than any of its components except for the U.S.

6. Chapter 13: International Portfolio Investment5 13.ARisks and Benefits of International Equity Investing (10)  Correlations and gains from diversification, continued –Benefits of diversification depend on relatively low correlations among assets. Experts assume that as their underlying economies become more closely integrated and cross-border financial flows accelerate, national capital markets will become more highly correlated, thus reducing the benefits (reductions in systematic risk) of international diversification. Empirical evidence supports this assumption. –The correlations between the U.S. and non-U.S. stock markets are generally higher today than they were during the 1970s. –The correlation between the EAFE Index and the U.S. market increased from about 0.4 in the mid-1990s to about 0.84 in 2006. As markets decline, correlations appear to increase as market volatility increases, reducing the benefits of international diversification. Benefits still exist, particularly for long-term investors.

7. Chapter 13: International Portfolio Investment6 13.ARisks and Benefits of International Equity Investing (11)  Investing in emerging markets –Emerging markets with volatile economic and political prospects offer the greatest degree of diversification and highest expected returns. –High returns come with high risk. –Despite high risk, emerging markets reduce portfolio risk because of their low correlations with returns in developed markets (even though correlations are rising over time). Shifting to a portfolio 100% invested in the MSCI World Index to one containing up to 10% invested in the IFC Emerging Markets Index reduces risk while simultaneously increasing expected return. Beyond a 10% investment, risk increases. Thus, even if emerging markets are not expected to outperform developed country markets, risk reduction would dictate an investment of up to 10% in emerging markets. –Caveat – the IFC database does not include emerging markets that fail to reach a certain threshold of capitalization. Thus, the IFC Index is biased against low-return markets.

8. Chapter 13: International Portfolio Investment7 13.ARisks and Benefits of International Equity Investing (12)  Barriers to international diversification –Benefits of international diversification will be limited because of barriers to investing overseas. –Barriers include Lack of liquidity Currency controls Tax regulations Relatively less-developed capital markets abroad Exchange risk Lack of readily accessible and comparable information on foreign securities Home bias –Home bias – the vast majority of U.S. investor portfolios consists of domestic stocks. The same bias applies to foreign investors.

9. Chapter 13: International Portfolio Investment8 13.ARisks and Benefits of International Equity Investing (13)  Barriers to international diversification, continued –How to diversify into foreign securities Some foreign firms (< 100) are listed on the New York Stock Exchange or American Stock Exchange. Buy U.S.-traded foreign stocks in the form of American depository receipts (ADRs) –Negotiable certificates issued by U.S. banks evidencing ownership of ADSs. –ADS – a dollar-denominated security representing foreign company shares held for the ADS owner by a custodian bank in the issuing company’s home country. ADRADS Shares of foreign stock Issued by U.S. bankHeld by custodian bank in issuing company’s home country Proof of ownershipRepresents –ADR investors absorb handling costs through transfer and handling charges. –ADRs eliminate custodian safekeeping charges in the issuer’s home country, reduce settlement delays, and facilitate prompt dividend payments.

10. Chapter 13: International Portfolio Investment9 13.ARisks and Benefits of International Equity Investing (14)  Barriers to international diversification, continued –How to diversify into foreign securities, continued Buy global depository receipts (GDRs) –Similar to ADRs but generally traded on two or more markets outside the foreign issuer’s home market. –Generally structured as a combination of a Rule 144A ADR (which trades in the U.S. private placement market and can be sold only to qualified institutional buyers) and a public offering outside the U.S. –Enable foreign companies to raise capital in two or more markets simultaneously and broaden their shareholder bases. Buy global depository shares (GDSs, or global shares) –Similar to an ordinary share but traded on any stock exchange in the world where it is registered and in the local currency. –Less expensive to trade than ADRs. –Currently only four global share issues – DaimlerChrysler, Celanese, UBS, and Deutsche Bank.

11. Chapter 13: International Portfolio Investment10 13.ARisks and Benefits of International Equity Investing (15)  Barriers to international diversification, continued –How to diversify into foreign securities, continued The easiest way to invest abroad is to buy shares in an internationally diversified mutual fund. Four basic categories: –Global funds – invest anywhere in the world, including the U.S. –International funds – invest only outside the U.S. –Regional funds – focus on specific geographical areas overseas, such as Asia or Europe. –Single-country funds – invest in individual countries, such as Germany or Taiwan. Greater diversification of the global and international funds reduces risk but also reduces the chance of high returns should a single country’s market increase substantially.

12. Chapter 13: International Portfolio Investment11 13.COptimal International Asset Allocation (1)  Research indicates that expanding investments to include domestic and foreign stocks and bonds provides benefits. –Performances of various investment strategies were compared over the period 1970-1980. –Conclusions International stock diversification yields a substantially better risk-return tradeoff than does holding only domestic stock. International diversification combining stock and bond investments results in substantially less risk than international stock diversification alone. A substantial improvement in the risk-return tradeoff can be realized by investing in internationally diversified stock and bond portfolios whose weights do not conform to relative market capitalizations (i.e., market indices used to measure world stock and bond portfolios do not lie on the efficient frontier).

13. Chapter 13: International Portfolio Investment12  Hedging currency risk –Stock portfolios During 1980-1985, the dollar was rising, and during 1986-1996, the dollar was generally falling. Over the period 1980-1985, risk-adjusted returns on hedged stock portfolios exceeded those on unhedged portfolios. Over the period 1986-1996, this result reversed. The reversal occurred because of changes over time in the standard deviations and correlation coefficients of national stock market returns expressed in dollars. –Bond portfolios The returns on hedged, internationally diversified bond portfolios exhibited lower volatility than the returns on unhedged bond portfolios over both above-discussed periods. However, the lower standard deviation of hedged bond returns is generally matched by lower returns. 13.EMeasuring Exchange Risk on Foreign Securities (2)