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1
Chapter 7International Investment and
Diversification
2
Outline

• Introduction
• Why international diversification makes
  theoretical sense
• Foreign exchange risk
• Investments in emerging markets
• Political risk
• Other topics related to international
  diversification

3
Introduction

• The marketplace of the twenty-first century is
  global
• U.S. equities represent only about 51 of the
  worlds equity capitalization
• Over the period 1980-2000, the U.S. was the
  best-performing market only once
• In September 1999, each of the 66 U.S. pension
  funds had more than 1 billion in actively
  managed international investment portfolios

4
Introduction (contd)

• International investments carry additional
  sources of risk
• Managers can reduce total portfolio risk via
  global investment

5
Why International Diversification Makes Sense
(Evans and Archer)

• Portfolio theory works to the investors benefit
  even if he selects securities at random
• Ideally, the portfolio manager selects securities
  because of their fit with the rest of the
  portfolio
• By choosing poorly correlated securities, a
  manager can reduce total portfolio risk

6
Why International Diversification Makes Sense
(Evans and Archer Contd)

• Total risk contains both systematic and
  unsystematic risk
• Evans and Archer show that holding 15 to 20
  equity securities substantially reduces the
  unsystematic risk

7
Utility, Risk, and Return

• Unsystematic risk reduction is possible with more
  than 20 securities
• For a given level of return, any reduction in
  risk, no matter how small, is a worthy goal
• A rational invest will reduce risk if given the
  opportunity

8
Variance of A Linear Combination

• As long as assets are less than perfectly
  correlated, there will be diversification
  benefits
• More pronounced the lower the correlation
• No two shares move in perfect lockstep
• Diversification benefits accrue every time we add
  a new position to a portfolio

9
Relationship of World Exchanges

• For U.S. securities, market risk account for
  about 25 of a securitys total risk
• For less developed countries, market risk tends
  to be higher because
• Fewer securities make up the market
• The securities are exposed to more extreme
  economic and political events

10
Relationship of World Exchanges (contd)

• International capital markets continue to show
  independent price behavior
• International diversification offers potential
  advantages
• Repeating the Evans and Archer methodology for
  international securities should result in a lower
  level of systematic risk

11
Relationship of World Exchanges (contd)
Portfolio Variance
U.S. Securities Systematic Risk 27
International Securities Systematic Risk 11.7
Number of Securities
12
Fundamental Logic of Diversification

• Investors are, on average, rational
• Rational people do not like unnecessary risk
• By holding one more security, an investor can
  reduce portfolio risk without giving up any
  expected return
• Rational investors, therefore, will hold as many
  securities as they can

13
Fundamental Logic of Diversification (contd)

• The most securities investors can hold is all of
  them
• The collection of all securities makes up the
  world market portfolio
• Rational investors will hold some proportion of
  the world market portfolio

14
Other Considerations

• Optimum portfolio size involves a trade-off
  between
• The benefits of additional diversification
• Commissions and capital constraints

15
Foreign Exchange Risk

• Definition
• Business example
• Investment example
• From whence cometh the risk?
• Dealing with the risk
• The eurobond market
• Combining the currency and market decisions
• Key issues in foreign exchange risk management

16
Definition

• Foreign exchange risk refers to the changing
  relationships among currencies
• Modest changes in exchange rates can result in
  significant dollar differences

17
Business Example

• A U.S. importer has agreed to purchase 40 New
  Zealand leather vests at a price of NZ110 each.
  The vests will take two months to produce, and
  payment is due before the vests are shipped.
• The current spot rate of the NZ is 0.5855.
• What is the price of the vests to the importer if
  the spot rate remains unchanged in the next two
  months? If it is 0.5500? If it is 0.6200?

18
Business Example (contd)

• Solution If the spot rate does not change, the
  cost to the importer is
• 40 x NZ110 x 0.5855 2,576.20
• If the spot rate is 0.5500
• 40 x NZ110 x 0.5500 2,420.00
• If the spot rate is 0.6200
• 40 x NZ110 x 0.6200 2,728.00

19
Investment Example

• You just purchased 1,000 of Kangaroo Lager
  trading on the Sydney Stock Exchange for AUD1.45
  per share. The exchange rate for the Australian
  dollar at the time of purchase was 0.7735.
• What is the U.S. dollar purchase price? If
  Kangaroo Lager stock rises to AUD1.95 per share
  and if the Australian dollar depreciates to
  0.7000, what is your holding period return if
  you sell the shares?

20
Investment Example (contd)

• Solution The purchase price in U.S. dollars is
• 1,000 x AUD1.45 x 0.7735 1,121.58
• If the Australian dollar depreciates and you sell
  the shares, you will receive
• 1,000 x AUD1.95 x 0.7000 1,365.00
• The holding period return is
• (1,365.00 - 1,121.58)/1,121.58 21.7

21
From Whence Cometh the Risk?

• Role of interest rates
• Forward rates
• Interest rate parity
• Covered interest arbitrage
• Purchasing power parity

22
Real Rate of Interest

• The real rate of interest reflects the rate of
  return investors demand for giving up the current
  use of funds
• In a world of no risk and no inflation, the real
  rate indicates peoples willingness to postpone
  spending their money

23
Inflation Premium

• The inflation premium reflects the way the
  general price level is changing
• Inflation is normally positive
• The inflation premium measures how rapidly the
  money standard is losing its purchasing power

24
Risk Premium

• The risk premium is the component of interest
  rates that reflects compensation for risk to
  risk-averse investors
• The risk premium is a function of how much risk a
  security carries
• E.g., common stock vs. T-bills

25
Forward Rates

• The forward rate is a contractual rate between a
  commercial bank and a client for the future
  delivery of a specified quantity of foreign
  currency
• Typically quoted on the basis of 1, 2, 3, 6, and
  12 months

26
Forward Rates (contd)

• The forward rate is the best estimate of the
  future spot rate
• If the forward rate indicates the dollar will
  strengthen, importers should delay payment
• If the forward rate indicates the dollar will
  weaken, importers should lock in a rate now

27
Forward Rates (contd)

• Forward rate premium or discount

28
Forward Rates (contd)

• Example
• On April 29, 2005, the British pound had a spot
  rate of 1.9146. The 3-month forward rate of the
  pound was 1.9041 on that date.
• What is the forward premium or discount?

29
Forward Rates (contd)

• Example (contd)
• Solution The forward premium or discount is
  calculated as follows
• There is a forward discount of 2.19.

30
Interest Rate Parity

• Interest rate parity states that differences in
  national interest rates will be reflected in the
  currency forward market
• Two securities of similar risk and maturity will
  show a difference in their interest rates equal
  to the forward premium or discount, but with the
  opposite sign

31
Interest Rate Parity Formula
32
Example

• Six-month German Treasury Bills yield 2.60
  (annualized rate)
• Spot exchange rate is 0.6051 / DM
• Six-month Forward rate is 0.6095 / DM
• RUS2.60100(0.6095-0.6051)(12/6)/0.6051
• RUS4.05

33
Covered Interest Arbitrage

• Covered interest arbitrage is possible when the
  conditions of interest rate parity are violated
• If the foreign interest rate is too high, convert
  dollars to the foreign currency and invest in the
  foreign country
• If the U.S. interest rate is too high, borrow the
  foreign currency and invest in the U.S.

34
Example of CIA

• Six-month Swiss rate is 1.00 (annualized rate)
• Six-month US Treasury Bills yield 2.00
  (annualized rate)
• Spot exchange rate is 0.8542 / CHF
• Six-month Forward rate is 0.8610 / CHF
• What arbitrage strategy can you implement ?

35
Example of CIA
36
Purchasing Power Parity

• Purchasing power parity (PPP) refers to the
  situation in which the exchange rate equals the
  ratio of domestic and foreign price levels
• A relative change in the prevailing inflation
  rate in one country will be reflected as an equal
  but opposite change in the value of its currency

37
Purchasing Power Parity (contd)

• Absolute purchasing power parity follows from
  the law of one price
• A basket of goods in one country should cost the
  same in another country after conversion to a
  common currency
• Not very accurate due to
• Transportation costs
• Trade barriers
• Cultural differences

38
Purchasing Power Parity (contd)

• Relative purchasing power parity states that
  differences in countries inflation rates
  determine exchange rates

39
Purchasing Power Parity (contd)

• A country with an increase in inflation will
  experience a depreciation of its currency
  because
• Exports decline
• Imports increase
• There is less demand for goods from that country

40
The Concept of Exposure

• Definition
• Accounting exposure
• Transaction exposure
• Translation exposure
• Economic exposure

41
Definition

• Exposure is a measure of the extent to which a
  person faces foreign exchange risk
• In general, there are two types of exposure
  accounting and economic
• Economic exposure is more important

42
Accounting Exposure

• Accounting exposure is
• Of concern to MNCs that have subsidiaries in a
  number of foreign countries
• Important to people who hold foreign securities
  and must prepare dollar-based financial reports
• U.S. firms must prepare consolidated financial
  statements in U.S. dollars

43
Transaction Exposure

• FASB Statement No. 8 addresses transaction
  exposure
• A transaction involving purchase or sale of
  goods or services with the price states in
  foreign currency is incomplete until the amount
  in dollars necessary to liquidate a related
  payable or receivable is determined

44
Translation Exposure

• Translation exposure results from the holding of
  foreign assets and liabilities that are
  denominated in foreign currencies
• E.g., foreign real estate and mortgage holdings
  must be translated to U.S. dollars before they
  are incorporated into a U.S. balance sheet

45
Economic Exposure

• Economic exposure measures the risk that the
  value of a security will decline due to an
  unexpected change in relative foreign exchange
  rates
• Security analysts should include expected changes
  in exchange rates in forecasted cash flows

46
Dealing With the Exposure

• Ignore the exposure
• Reduce or eliminate the exposure
• Hedge the exposure

47
Ignore the Exposure

• Ignoring the exposure may be appropriate for an
  investor if
• Foreign exchange movements are expected to be
  modest
• The dollar mount of the exposure is small
  relative to the cost of inconvenience of hedging
• The U.S. dollar is expected to depreciate
  relative to the foreign currency

48
Reduce or Eliminate the Exposure

• If the dollar is expected to appreciate
  dramatically, an investor may reduce or eliminate
  foreign currency holdings

49
Hedge the Exposure

• Definition
• Hedging with forward contracts
• Hedging with futures contracts
• Hedging with foreign currency options

50
Definition

• Hedging involves taking one position in the
  market that offsets another position
• Covering foreign exchange risk means hedging
  foreign exchange risk

51
Hedging With Forward Contracts

• A forward contract is a private, non-negotiable
  transaction between a client and a commercial
  bank
• No money changes hands until the foreign currency
  is delivered, but the rate is determined now
• The forward rate reflects relative interest rates
  and associated risks

52
Hedging With Futures Contracts

• A futures contract is a promise to buy or sell a
  specified quantity of a particular good at a
  predetermined price by a specified delivery date
• On the delivery date, there will be a gain or
  loss in the futures market that will offset the
  gain or loss experienced when converting the
  foreign currency

53
Hedging With Futures Contracts (contd)

• To hedge an investment, sell foreign currency
  futures
• To hedge a liability, buy foreign currency
  futures

54
Hedging With Foreign Currency Options

• There are two types of foreign currency options
• Call options give their owner the right to buy a
  set quantity of foreign currency
• Put options give their owner the right to sell a
  set quantity of foreign currency
• The price at which you have the right to buy or
  sell is the strike (exercise) price

55
Hedging With Foreign Currency Options (contd)

• Currency option characteristics
• A call option with an exercise price quoted in
  dollars for the purchase of euros is the same as
  a put option on dollars with an exercise price
  quoted in euros
• Put-call parity for foreign currency options is a
  restatement of interest rate parity

56
Hedging With Foreign Currency Options (contd)

• The disadvantage of hedging with currency options
  is that the hedger must pay a premium to
  established the hedge
• Options provide more precision than futures
  contracts
• Options are more expensive than futures contracts

57
The Eurobond Market

• Eurobonds are debt agreements that are
  denominated in a currency other than that of the
  country in which they are held
• E.g., a bond denominated in yen sold in the
  United Kingdom
• A foreign bond is denominated in the local
  currency but is issued by a foreigner
• E.g., a bond denominated in yen sold in Japan,
  issued by a firm in the United Kingdom

58
The Eurobond Market (contd)

• About 75 of eurobonds are denominated in U.S.
  dollars
• Firms issuing dollar-denominated Eurobonds pay a
  slightly lower interest rate than they would pay
  in the U.S.

59
Combining the Currency and Market Decisions

• It is often desirable to cross-hedge a foreign
  investment into a different currency
• E.g., a U.S. investor might invest in Japan, use
  the forward market to sell yen for British pounds
  and convert the pounds back to dollars
• The currency return comes from the forward market
  premium or discount and the actual change in the
  exchange rate

60
How to do it

• Select the market with the highest risk-premium,
  not the highest absolute return.
• Why?
• Because due to non-arbitrage, investing in
  riskless securities of various countries will
  yield the same returns once the proceeds are
  translated back into the domestic currency
  (either always true if use forward contracts or
  true on average if use currency spot market to
  repatriate the funds).
• Thus what matters (what differentiates markets)
  is the return expected ABOVE the risk-free rate.

61
Which Currency to Cross-Hedge ?

• What is relevant is the total rate of return,
  after including the return in the selected local
  market (foreign equity), the cost/benefit of
  holding the currency, and the expected return on
  that currency.
• So instead of mechanically hedging the local
  currency with the US Dollar (domestic), we should
  look for a third currency for cross-hedging
  purposes so as to maximize the total expected
  return.

62
The return to maximize is the sum of

• Chosen Market Equity Return (where we chose to
  invest)
• Forward market premium/discount (riskless rate in
  country selected for cross-hedging minus riskless
  rate in country where we chose to invest).
• Expected return in currency of country where we
  chose to invest.

63
Example

• A US investor chooses to invest in German stocks
  and then cross-hedges with the Japanese Yen
• Forecasted German equity returns 10
• Forecasted change in Japanese Yen 2.5
• Japanese riskless rate (Eurobond rate) 2
• German riskless rate (Eurobond rate) 4.5
• Forecasted total return 10 (2 - 4.5) 2.5
• Total (Expected) Return 10

64

• The riskless (Eurobond) rate differential comes
  from the fact that we have
• This means that the expected percentage change in
  the DM value (expressed in Yen) is the riskless
  rate differential. When using forward contracts,
  we get the forward rate instead of the spot rate
  due to the fact that we need to wait for that
  future date before transforming the DM into
  Japanese Yen.
• Therefore the amount in DM that gets converted to
  Yen in the end is subject to a change in value
  since the forward rate F is different than the
  spot rate S.

65
Investments in Emerging Markets

• Overview
• Background
• Adding value
• Reducing risk
• Following the crowd
• Special risks
• Asymmetric correlations
• Market microstructure considerations

66
Overview

• Emerging market investments
• Offer substantial potential rewards to the
  careful investor in added return and risk
  reduction
• Are accompanied by special risks
• Foreign exchange risk
• High political and economic risk
• Unreliable investment information
• High trading costs

67
Background

• Over 20 billion is invested globally in
  securities issued in underdeveloped countries
• Pension funds largest emerging market exposure
  is in
• Asia (39.1)
• Latin America (32.7)

68
Background (contd)

• Dollars invested in emerging markets has
  increased at a compound rate of almost 50 over
  the last 10 years
• Private sector growth in emerging markets
• E.g., Hungary and Poland after 1989

69
Adding Value

• Prices in developing markets often contain
  significant inefficiencies
• Tend to sell for lower price/earnings multiples
  than do firms in developed markets
• Emerging market firms have greater expected
  growth and are cheaper

70
Reducing Risk

• Low correlations are attractive as a means of
  reducing portfolio variability
• Emerging markets show low correlation with
  developed markets
• Emerging markets show low correlation with each
  other

71
Following the Crowd

• Some professional money managers carefully
  analyze emerging markets for
• Profit potential
• Portfolio risk reduction
• Some professional money managers follow the
  crowd because they must invest in emerging
  markets

72
Special Risks

• Incomplete accounting information
• Foreign currency risk
• Fraud and scandals
• Weak legal system

73
Incomplete Accounting Information

• In some countries, financial statements are more
  than 6 months old when they become available
• The acquisition of reliable investment
  information generally requires on-site security
  analysts

74
Incomplete Accounting Information (contd)

• Accounting standards differ substantially across
  countries
• Accounting information is frequently unavailable
  for an emerging market security
• Some emerging market brokerage firms focus on the
  income statement but ignore the balance sheet

75
Foreign Currency Risk

• Foreign exchange securities are denominated in a
  foreign currency
• Introduces foreign exchange risk for foreign
  investors
• E.g., Mexican peso crisis and Asian crisis
• In emerging markets, traditional hedging vehicles
  may be unavailable

76
Fraud and Scandals

• Emerging markets carry a substantial risk of
  fraud
• E.g., accounting misstatements, counterfeit
  securities, bucket shops
• Redress available to victims of a scandal in a
  developing country may be inadequate

77
Weak Legal System

• Low confidence in a countrys legal system
• Leads to increased uncertainty
• Leads to an increased risk premium required by
  investors

78
Asymmetric Correlations

• Correlation between emerging and developed
  markets
• Increases during bear markets
• Is low during bull markets
• The extent of portfolio managers diversification
  depends on whether they are experiencing an up or
  a down market

79
Asymmetric Correlations (contd)

• Investment returns show
• Homogeneity within emerging markets
• Securities tend to move as a group within a
  single emerging market
• Heterogeneity across emerging markets
• Emerging markets show low correlation across
  markets

80
Market Microstructure Considerations

• Liquidity risk
• Trading costs
• Market pressure
• Marketability risk
• Country risk

81
Liquidity Risk

• Some emerging markets investors are mostly
  foreign
• Increases political risk
• Sets the stage for a market collapse if everyone
  pulls out at once
• Some emerging markets lack depth
• The bid/ask spread tends to be wide with few
  standing order to buy and to sell

82
Trading Costs

• Foreign market trading costs are more than 1
  higher than domestic trading costs
• E.g., bid/ask spread is an average of 95 basis
  points for Barings Securities emerging market
  index
• This indicates an investment must appreciate more
  to show a given net return

83
Market Pressure

• An order to buy or sell a large number of shares
  might cause a substantial supply/demand imbalance
• Causes the price to move adversely from the
  investors perspective
• Indicates that emerging market investments should
  be viewed as long-term investments rather than a
  source of trading profits

84
Marketability Risk

• An investor may be unable to close out a position
  at a reasonable price

85
Country Risk

• Country risk refers to a countrys ability and
  willingness to meet its foreign exchange
  obligations
• Especially important in emerging markets
• Country risk has two components
• Political risk
• Economic risk

86
Political Risk

• Introduction
• Factors contributing to political risk
• Macro risk versus micro risk
• Dealing with political risk

87
Introduction

• Political risk is a measure of a countrys
  willingness to honor its foreign obligations
• A function of
• The stability of the governments and its
  leadership
• Attitudes of labor unions
• The countrys ideological background
• The countrys past history with foreign investors

88
Introduction (contd)

• Real (direct) investment is an investment over
  which the investor retains control
• E.g., a plant in a foreign country
• Portfolio investment refers to foreign investment
  via the securities market
• E.g., buying a number of shares of a foreign
  company

89
Introduction (contd)

• Extreme forms of country risk for portfolio
  investment
• Government takeover of a company
• Political unrest leading to work stoppages
• Physical damage to facilities
• Forced renegotiation of contracts

90
Introduction (contd)

• Modest forms of country risk for portfolio
  investment
• A requirement that a minimum percentage of
  supervisory positions be held by locals
• Changes in operating rules
• Restrictions on repatriation of capital

91
Factors Contributing to Political Risk

• Buy local attitude
• Public attitude
• Government attitude

92
Buy Local Attitude

• Buy local campaigns seek to make foreign
  consumers buy local goods instead of goods
  produced by a foreign firm or its subsidiaries
• Contributes to political risk

93
Public Attitude

• In emerging markets, people may see no
  opportunity to improve their standard of living
• Foreign subsidiaries may contribute to this
  attitude with luxury items
• The gap between the publics aspirations and its
  expectations contributes to political risk

94
Government Attitude

• Unstable governments can lead to foreign
  investors being a volatile political issue
• Foreign investors can be blamed for local
  problems
• Foreign governments can suspend a firms ability
  to send funds back to its home country

95
Macro Risk Versus Micro Risk

• Macro risk refers to government actions that
  affect all foreign firms in a particular industry
• Micro risk refers to politically motivated
  changes in the business environment directed to
  selected fields of business activity or to
  foreign enterprises with specific characteristics

96
Dealing With Political Risk

• Seek a foreign investment guarantee from the
  Overseas Private Investment Corporation
• Provides coverage against
• Loss due to expropriation
• Nonconvertibility of profits
• War or civil disorder

97
Dealing With Political Risk (contd)

• Avoid engaging in behavior that stirs up trouble
  with the host people or government
• Constructing flamboyant office buildings
• Giving the impression of natural resource
  exploitation

98
Economic Risk

• Economic risk is a measure of a countrys ability
  to pay
• Assess economic risk by
• Using coverage ratios
• Assessing the countrys capital base

99
Other Topics

• Multinational corporations
• American depository receipts
• International mutual funds

100
Multinational Corporations

• Investing in a multinational corporation may
  provide a ready-made means of getting the
  risk-reduction benefits of international
  diversification
• Research is unclear whether MNCs are better
  investments than purely domestic firms

101
American Depository Receipts

• American depository receipts (ADRs) are receipts
  representing shares of stock that are held on the
  ADR holders behalf in a bank in the country of
  origin
• An alternative to purchasing shares in a foreign
  company directly on the foreign exchange
• By 2000, 1,534 ADRS from dozens of countries
  traded in the U.S.

102
International Mutual Funds

• Mutual funds permit diversification to an extent
  that would not otherwise be possible
• Some mutual funds invest only in securities
  issued outside the U.S.
• Buying an international mutual fund is a good way
  to achieve international diversification