Global Investing

1
Global Investing

• Why
• Principles of Exchange Rate Theory
• How Can One Hedge X-Rate Risk

2
Why Invest Globally

• Terms International versus Global
• Potential for Higher Returns
• Potential for Diversification
• Note In CAPM theory, one should invest in all
  risky assets in proportion to the percentage the
  asset represents of the total value of all risky
  assets.

3
Unit Value Growth of Major IndexesSince 1968
4
Correlation Coefficients Security
Class Tbills Gbonds SP500 EAFE Tbills 1.0 Gbonds
-.007 1.0 SP500 .009 .462 1.0 EAFE -.222 .245 .
569 1.0
Efficient Diversification
5
Traded World Bonds Equities(1994)
Values represent of Total
6
Sources of International Returns

• When you invest in a foreign country, you are
  purchasing two assets1. the foreign
  securities2. the foreign currency
• Thus, your return will be the compound affect of
  returns on both assets.
• 1 RI (1 RD) (1 RX)
• RI Return on international Investment
• RD Return on Domestic securities (in foreign
  country)

7
Example of International Return
(1 RD) 300 / 240 1.25 (a 25
gain) During year, yen lost value. So rate of
return on yen is negative. (1 RX) 120 / 130
0.923 (a 7.7 loss) RI (1.25 0.923)
- 1.0 15.375
8
Direct versus Indirect Currency Quotations
9
Exchange Rate Theory

• Current Spot Rates
• Absolute Purchase Power Parity
• Changes in Spot Rates
• The Big Mac Test
• Forward Exchange Rates

10
Current Spot Rates

• S(d/f) the spot exchange rate, the number of
  units of the domestic currency that can be
  obtained with 1.0 units of the foreign currency
• P(d) price per unit of production in the
  domestic economy
• P(f) price per unit of production in the
  foreign economy
• Absolute Purchasing Power Parity
• S(d/f) P(d) / P(f)
• P(d) P(f) S(d/f)

11
Simple Example of PPP

• Country A Country B
• Rice production 100 100
• Money Units in circulation 200Azz
  400Bzz
• Local price of one rice unit 2 Azz
  4 Bzz
• Simple logic suggests that the exchange rate
  should be
• 2 Bzz per 1 Azz (1/2 Azz per 1 Bzz)
• Assume that A is your domestic economy
• PPP says S(d/f) P(d) / P(f)
• 1/2Azz per 1 Bzz 2 / 4

12
Which is the better transaction?

• Country A Country B
• Own 10 Azz 10 Bzz
• Buy 2.5 units of rice
• _at_ 1 unit per 4 Bzz
• 2.5 Rice Units 2.5 Rice Units
• sell rice at 2 Azz per unit
• 5 Azz
• Country A Country B
• Own 10 Azz 10 Bzz
• Buy 5 units of rice
• _at_ 1 unit per 2 Azz
• 5 Rice Units 5 Rice Units
• sell rice at 4 Bzz per unit
• 20 Azz

exchange into 10 Bzz
Ship rice back to A
exchange into 10 Azz
Ship rice back to B
13
Result of Arbitrage

• As arbitrageurs sell Bzz and buy Azz,
• the spot value of Bzzs will fall relative to
  Azzs
• until the equilibrium spot exchange rate is
• 1/2 Azz per 1 Bzz (2 Bzz per 1 Azz)

14
Changes in Spot Rates

• Spot rates will change as prices change in each
  economy. Price changes represent inflation.
• Let S1 be spot X-rate at end of period 1 and
  S0 be spot X-rate at start of period 1.
• S1(d/f) P1(d) / P1 (f) P0 (d) 1
  Inflation(d)
• P0 (f) 1 Inflation(f)
• S0 1 Inflation(d)
• 1 Inflation(f)

15
Example

• Say Inflation in A is 20 during period 1
• Inflation in B is 10 during period 1
• S1(d/f) 2 1.2 1/2 1.2
• 4 1.1 1.1
• 0.54545 Azz per 1.0 Bzz
• Currency value of Azz has fallen relative to Bzz
  due to higher inflation in Country A than in
  Country B

16
The Hamburger Standard

• Based on study published in the Economist, April
  15, 1995
• Big Mac Price in
• Local U. S.
• Currency Dollars Country
• 2.32 2.32 United States
• 1.74 pound 2.80 Britain
• 9 Yuan 1.05 China
• 26.75DKr 4.92 Denmark

Clearly, strict PPP does not work if you believe
this study.
17
Forward Exchange Rates

• The forward rate is a price contracted today at
  which two parties agree to trade at a specified
  future date (the forward contracts delivery
  date)
• Forward contracts can eliminate all uncertainty
  about the future amount of money one will have
  (or receive) from a future trade.
• To be a Perfect Hedge, the following must be
  true
• 1. The good traded via the forward must be
  identical to the spot good you will have to
  trade.
• 2. The quantity traded under the forward must be
  identical to the quantity of the spot good you
  will have to trade.
• 3. The delivery date of the forward be be
  identical to the date at which you wish to trade
  the spot good.

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Perfect Hedge Rules Shortened

• SAME GOOD
• SAME QUANTITY
• SAME DATE

19
Forward Exchange Rate Pricing

• The are a number of ways to derive these
  relationships. We will pass the prove and only
  look at the results.
• F(d/f) S(d/f) 1 E(inflation(d) / 1
  E(inflation(f)
• S(d/f) 1 RF(d) / 1 RF(f)

Nominal risk-free rate in domestic and foreign
countries
These equilibrium relationships imply that the
real risk-free rate in the domestic and foreign
country are identical!
20
Forward rate example (assume domestic is )

• Assume RF(d) 10, RF(f) 15, S(d/f) 0.5
• F(d/f) 0.6
• Nominal Risk-free return from domestic investment
  of 100
• 100 (1.1) 110
• Nominal Risk-free return from investment in
  foreign of 100
• Buy currency
• 100 2.0 200f
• Ending value of risk-free foreign security
• 200f (1.15) 230F
• Transfer 230f back to domestic currency at
  forward rate
• 230f 0.6 138

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Conclusion

• Since the nominal risk-free rate is greater from
  investing in foreign country, domestic investors
  would chose to invest in the foreign country.
• This would affect- RF in domestic,- RF in
  foreign,- forward X-rate, and maybe- current
  spot X-rate.
• The net result would be that these prices would
  change until the nominal risk free rate for an
  investor in country A would be identical to the
  nominal risk free rate from investing in any
  other country (note that this requires a trade in
  forwards to be risk-free).

Important Point
22
Hedging foreign currency positions

• Have identical asset and liabilities denominated
  in foreign currency- widely used by
  corporations-not reasonable for investors
  (unless they intend to consume in foreign
  country)
• Trade in forwards (and Futures)- only short-term
  contracts are available- presently not possible
  to obtain very LT hedge- can only hedge
  expected future values
• Diversify broadly- most accepted approach by
  institutional investment managers