1. 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

2. 19-2 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. 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 (%) 20002011200020112000-20112010 WORLD27,47338,200100% 2.863,1249,22868 US12,90013,91747.036.40.614,58747,19998 JAPAN3,1403,28911.48.60.45,45942,83169 UK2,5662,7949.37.30.72,24936,144133 CANADA6151,5812.24.18.21,57746,236114 FRANCE1,2781,4554.73.81.12,56039,46070 HONG KONG5641,3692.13.67.722531,758701 GERMANY1,0611,1773.93.10.93,28140,15243 SWITZERLAND7831,0622.92.82.652867,464224 AUSTRALIA3491,0391.32.79.592542,131132 KOREA1237630.42.016.41,01520,75786 SPAIN3315461.21.44.21,40730,54244 ITALY7164602.61.2-3.62,05133,91728 SWEDEN2744401.01.24.045948,936118 NETHERLANDS6803762.51.0-4.877946,91560 MEXICO1123720.41.010.51,0359,12339 NORWAY522380.20.613.541384,53861 CHILE442290.20.614.721312,431136 BELGIUM1592160.6 2.646943,14454 DENMARK991760.40.54.931055,89167 TURKEY501640.20.410.473410,09434 FINLAND2801391.00.4-5.723944,51286 ISRAEL461190.20.38.321728,50480 POLAND271120.10.312.546912,29334 AUSTRIA28850.10.29.837945,20933 IRELAND82650.30.2-1.921147,17030 PORTUGAL64590.2 -0.622921,50535 CZECH REP.12390.00.110.419218,24523 NEW ZEALAND20350.1 5.013631,06735 LUXEMBURG28340.1 1.753105,43879 GREECE72290.30.1-7.130126,60021 HUNGARY12190.0 4.112912,85222 SLOVENIA260.0 11.24722,85118

4. 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 (%) 20002011200020112000-20112010 BRAZIL1801,0560.72.815.92,08810,71066 INDIA1078680.42.319.01,7271,47569 RUSSIA196940.11.834.91,48010,44058 CHINA134990.01.335.25,9274,42811 TAIWAN1774550.61.28.243018,300134 SINGAPORE1364280.51.110.120941,122241 SOUTH AFRICA1044050.41.112.03647,275134 MALAYSIA833300.30.912.12388,373135 INDONESIA213010.10.824.87072,94641 THAILAND232190.10.620.73194,60870 COLOMBIA41910.00.537.32886,22570 PHILIPPINES201410.10.417.62002,14067 PERU5770.00.225.91575,40164 ARGENTINA24360.1 3.63699,12415 PAKISTAN5260.00.115.21771,01917 SRI LANKA1140.0 27.5502,37531 ROMANIA0140.0 36.91627,5389 VENEZUELA660.0 -0.239213,5903 CYPRUS930.0 -9.72328,77928 BULGARIA020.0 29.6486,3254

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

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

7. 19-7 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. 19-8 19.2 Risk Factors in International Investing

9. 19-9 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. 19-10 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. 19-11 Figure 19.2 Stock Returns, U.S. Dollars and Local Currencies, 2010

12. 19-12 Table 19.3 Rates of Change, U.S. Dollar versus World Currencies, 2002-2011 Euro (€)U.K. (£) Switzerland (SF)Japan (¥) Australia (A$) Canada (C$) A. Standard deviation (annualized %)11.049.3211.949.1313.8710.04 B. Correlation matrix Euro (€)U.K. (£) Switzerland (SF)Japan (¥) Australia (A$) Canada (C$) U.K. (£) 0.631 Switzerland (SF) 0.830.511 Japan (¥) 0.270.080.421 Australia (A$) 0.750.60.610.051 Canada (C$) 0.510.490.37-0.020.721 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€2.38-0.204.386.774.5811.04 U.K.£3.51-1.321.094.602.419.32 SF 0.901.286.467.365.1711.94 Japan¥0.241.945.755.993.819.13 AustraliaA$5.25-3.077.9413.1911.0113.87 CanadaC$2.50-0.315.017.515.3210.04

13. 19-13 19.2 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

14. 19-14 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 $1.0615 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: $1.0725 − $1.0615 = $.011/dollar

15. 19-15 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. 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 1Norway90.590.000.501 11Germany83.583.500.005 13Canada82.882.750.006 16Qatar82.081.250.7511 19Japan81.080.001.0017 Low risk 31United Kingdom77.373.753.5039 32United States77.077.25-0.2526 39China, Peoples' Rep.75.076.25-1.2530 44Brazil74.572.751.7546 68Spain70.071.0058 Moderate risk 78Indonesia68.567.251.2581 86India67.370.50-3.2562 104Egypt64.566.50-2.0084 111Turkey63.363.50-0.25100 High risk 124Venezuela59.553.755.75133 127Iraq58.559.25-0.75119 129Pakistan57.357.000.25125 Very high risk 138Haiti48.549.75-1.25137 140Somalia41.536.754.75140

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

18. 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 Norway90.0090.5088.546.546.0 Canada82.75 86.540.039.0 Japan80.0081.0078.544.039.5 United States77.2577.0081.537.035.5 China, Peoples' Rep.76.2575.0062.548.039.5 India70.5067.2558.543.532.5 Turkey63.5063.2557.034.535.0

19. 19-19 Table 19.7 Risk Forecasts Composite Risk Forecasts CurrentOne Year AheadFive Years Ahead CountryRating January 2011Worst CaseBest CaseRisk StabilityWorst CaseBest CaseRisk Stability Norway90.588.393.35.083.3 92.89.5 Canada82.878.384.36.075.3 86.511.3 Japan81.077.084.37.372.5 87.515.0 United States77.073.380.37.069.5 83.013.5 China, Peoples' Rep.75.070.879.08.361.3 82.020.8 India67.364.072.38.357.5 77.019.5 Turkey63.357.867.59.853.8 71.517.8 Political Risk Forecasts CurrentOne Year AheadFive Years Ahead CountryRating 01/11Worst CaseBest CaseRisk StabilityWorst CaseBest CaseRisk Stability Norway88.588.092.04.086.0 89.53.5 Canada86.583.088.55.581.5 89.58.0 Japan78.575.584.08.572.0 88.016.0 United States81.577.585.58.076.0 87.011.0 China, Peoples' Rep.62.558.568.510.055.0 73.018.0 India58.555.064.09.053.5 71.017.5 Turkey57.052.563.511.051.5 69.017.5

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

21. 19-21 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. 19-22 Figure 19.3 Monthly Standard Deviation of Excess Returns, Developed and Emerging Markets, 2002-2011

23. 19-23 Figure 19.4 Beta against U.S. Market of Developed and Emerging Markets, 2002-2011

24. 19-24 Figure 19.5 Average Excess Dollar-Denominated Returns, Developed and Emerging Markets, 2002-2011

25. 19-25 Figure 19.6 Information Ratios, Developed and Emerging Markets versus U.S. Dollar-Denominated Returns, 2002-11

26. 19-26 Figure 19.7 Standard Deviation of Excess Returns, Dollar- Denominated and Local Currencies, 2002-2011

27. 19-27 Figure 19.8 Market Beta against U.S. Using Dollar-Denominated and Local-Currency Excess Returns, 2002-11

28. 19-28 Figure 19.9 Average Dollar-Denominated and Local- Currency Excess Returns, 2002-2011

29. 19-29 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. 19-30 Figure 19.10 Information Ratios against U.S. Computed from Dollar-Denominated and Local Currency Returns, 2002-2011

31. 19-31 Figure 19.11 International Diversification

32. 19-32 Table 19.10 Correlation of Foreign Investments with U.S. Returns over Time

33. 19-33 Figure 19.12 Ex-Post Efficient Frontier of Country Portfolios

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

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

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

37. 19-37 19.14B Beta and  of Portfolios against Deviation of Monthly Return, 9/08-12/08

38. 19-38 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. 19-39 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

40. 19-40 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. 19-41 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