International Investments

1
International Investments

• I)Factors affecting Risk and Return
• II) Size of Global Equity Markets
• III) Global market Correlations
• Correlation over time - constant vs. non-constant
• Implications on portfolio diversification

2
International Investments

• IV) Studies on Causality and Transmission of risk
• V) Gains from International Diversification.

3
Factors affecting Risk and Return

• World Bank projects that 70 of the growth of the
  worlds real GDP during the next 20 years will
  come from developing economies in Asia, Latin
  America, Eastern Europe and Africa.
• January 1987 to may 1993 Stock market growth in
  Turkey 637 Argentina 1,374 Mexico 960
  (Source Investors Guide to Emerging Markets).

4
Factors affecting Risk and Return

• There are more people abroad whose incomes are
  growing faster (China , India, for example)
• Vast need for infrastructure and technology
  investment in the emerging economies

5
Factors affecting Risk and Return

• Risk
• Currency Risk- pegged to US , mitigates risk if
  invested in single country hedge currency
  exposure (www.msci.com).
• Political Risk stemming from coups, civil
  unrest, dictatorship Govt policy risk

6
Factors affecting Risk and Return

• change in policy regarding franchise agreement,
  taxation on foreign investment
• appropriation risk nationalization.
• Market VolatilityDiscuss Table 3
• Inadequate Accounting
• Liquidity risk Loss due to thin trading
  higher market impact cost larger bid and ask
  spread brokerage commission, currency
  translation cost etc. high in emerging markets.

7
Factors affecting Risk and Return

• Higher costs - market less efficient, higher
  transaction cost, fund manager incur additional
  travel costs etc.,

8
Consider the following exchange rates Spot rate
Forward Rate Cross rate Spot Rate (July 17,
2003)
Direct Quotation

• Indirect quotationUnits of foreign currency per
  U.S. dollar
• British pound 1/1.5958 0.6266
• Swish krona 1/.1222 8.813

9
What is the difference between spot rates and
forward rates?

• A spot rate is the rate applied to buy currency
  for immediate delivery.
• A forward rate is the rate applied to buy
  currency at some agreed-upon future date.

10
When is the forward rate at a premium to the spot
rate?

• If the U.S. dollar buys fewer units of a foreign
  currency in the forward than in the spot market,
  the foreign currency is selling at a premium.
• In the opposite situation, the foreign currency
  is selling at a discount.
• The primary determinant of the spot/forward rate
  relationship is relative interest rates.

11
Forward premium/ discount

• F- S premium (FS) or discount (F
• Annual percentage rate premium/discount
• (F-S)/S x (12/N) x 100
• N number of months of F
• Premium/discount on 30 day pound
• D (1.5927-1.5958)/1.5958 x (12/1) x 100
• - 0.19
• British pound is selling at a discount relative
  to dollar.

12
What is a cross rate?

• A cross rate is the exchange rate between any two
  currencies not involving U.S. dollars.
• In practice, cross rates are usually calculated
  from direct or indirect rates. That is, on the
  basis of U.S. dollar exchange rates.

13
Calculate the two cross rates between pounds and
yens.
Pounds Dollars Dollar Yen

• Cross rate x
• .6266 x 0.008461 .00530 pounds/yen.
• Cross rate x
• 118.19 x 1.595 188.51 yens/pound.

Yens Dollars Dollar Pound
14
What is exchange rate risk?

• Exchange rate risk is the risk that the value of
  a cash flow in one currency translated from
  another currency will decline due to a change in
  exchange rates.
• For example, a weakening krona (strengthening
  dollar) would lower the dollar profit.

15
Managing Foreign Exchange Risk

• Translation Risk MNCs foreign assets and
  liabilities, denominated in foreign currency, are
  exposed to gain or losses due to changing
  exchange rates.
• Transaction Risk MNCs gains or losses resulting
  from international transactions.

16
What is purchasing power parity?

• Purchasing power parity implies that the level of
  exchange rates adjusts so that identical goods
  cost the same amount in different countries.
• Ph Pf(Spot rate),
• or
• Spot rate Ph/Pf.

17
If grapefruit juice costs 2.00/liter in the U.S.
and purchasing power parity holds, what is price
in Canada?
Spot rate Ph/Pf. 0.727 2.00/Pf
Pf 2.00/0.727 2.75
Canadian dollars.

• Do interest rate and purchasing power parity
  hold exactly at any point in time?

18
What is interest rate parity?

• Interest rate parity implies that investors
  should expect to earn the same return on
  similar-risk securities in all countries
• Here,
• kh periodic interest rate in the home country.
• kf periodic interest rate in the foreign
  country.

19
Assume 1 Canadian dollar 0.7199 in the 30-day
forward market and 30-day risk -free rate is 6
in the U.S. and 4 in Canada.Does interest rate
parity hold?
Forward rate 0.7199. kh 6/12 0.500. kf
4/12 0.333.
20
Interest Rate Parity
1 kh 1 kf
Forward rate Spot rate

0.7199 Spot rate
1.00500 1.00333

Spot rate 0.7187.
If interest rate parity holds, the computed spot
rate would be 0.7187 dollar/Canadian dollar.
However, the observed spot rate is 0.7212
dollar/Canadian dollar.
21
Which 30-day security (U.S.or Canadian)offers the
higher return?

• A U.S. investor could directly invest in the U.S.
  security and earn an annualized rate of 6.
• Alternatively, the U.S. investor could convert
  dollars to Canadian dollars, invest in the
  Canadian security, and then convert profit back
  into dollars. If the return on this strategy is
  higher than 6, then the Canadian security has
  the higher rate.

22
What is the return to a U.S. investor in the
Canadian Security?

• Buy 1,000 worth of Canadian dollars in the spot
  market
• 1,000(1.3866/CD) 1,386.6 CD.
• Canadian investment return (in CD)
• 1,386.6(1.00333)1,391.21 CD.

23

• Buy contract today to exchange 1,391.21 CD
  pesetas in 30 days at forward rate of 0.7199
  dollars/CD.
• At end of 30 days, convert peseta investment to
  dollars
• 1,391.21(0.7199) 1,0001.53.
• Calculate the rate of return
• 1.53/1,000 0.153 per 30 days.

24
The Canadian security has the lower return,
return it has a lower interest rate.

• U.S. 30-day rate is 0.500 Canadian securities
  at 0.153 offer a lower rate of return to U.S.
  investors.
• But could such a situation exist for very long?

25
Arbitrage

• Traders could borrow at the Canadian rate,
  convert to US dollars at the spot rate, and
  simultaneously lock in the forward rate and
  invest in US securities.
• This would produce arbitrage a positive cash
  flow, with no risk and none of the traders own
  money invested.

26
Size of Global Equity Marketsand correlations

• Explain the size of the Japanese market in 1987,
  88, and 89.
• See Tables 1 and 2.
• Global market Correlations
• See Table 5

27
Causality and Transmission of risk

• Explain test of causality. Markets analyzed CAN,
  GER, FRA, NETH,SWI, UK, JAP, US.
• Time period 1980-1989, Subperiod 1 1980-85III,
  and 1985IV-89.
• Findings - Markets are not completely integrated
  
• 1st subperiod Direction is from Foreign to US
  May be caused by higher .
• 2nd subperiod Direction is from US to Foreign.

28
Gains from International Diversification.

• Rationale international equity market has
  higher E(R) than the US market and can
  substantially diversify US portfolio.
• Asset pricing models do not argue that risk
  factors have geographically different E(R).
• In the US market, value and size explain the
  difference in E(R) across equity portfolio
• International value stocks and small stocks
  diversify US portfolio more than EAFE.