International Finance

1
International Finance

• Chapter 21
• Financial Globalization
• Opportunity and Crisis

2
Preview

• Gains from trade
• Portfolio diversification
• Players in the international capital markets
• Attainable policies with international capital
  markets
• Offshore banking and offshore currency trading
• Regulation of international banking
• Tests of how well international capital markets
  allow portfolio diversification, allow
  intertemporal trade, and transmit information

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International Capital Markets

• International asset (capital) markets are a group
  of markets (in London, Tokyo, New York,
  Singapore, and other financial cities) that trade
  different types of financial and physical assets
  (capital), including
• stocks
• bonds (government and private sector)
• deposits denominated in different currencies
• commodities (like petroleum, wheat, bauxite,
  gold)
• forward contracts, futures contracts, swaps,
  options contracts
• real estate and land
• factories and equipment

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Figure 1 The Three Types of International
Transaction Trade
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Gains from International Trade

• The theory of comparative advantage describes the
  gains from trade of goods and services for other
  goods and services.
• The theory of intertemporal trade describes the
  gains from trade of goods and services for
  assets, of goods and services today for claims to
  goods and services in the future (todays
  assets).
• The theory of portfolio diversification describes
  the gains from trade in assets of different risk
  profiles.

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Classification of Assets

• Assets can be classified as either
• Debt instruments
• Examples include bonds and deposits.
• They specify that the issuer must repay a fixed
  amount regardless of economic conditions.
• or
• Equity instruments
• Examples include stocks or a title to real
  estate.
• They specify ownership (equity ownership) of
  variable profits or returns, which vary according
  to economic conditions.

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International Capital Markets

• The participants
• Commercial banks and other depository
  institutions
• Nonbank financial institutions such as securities
  firms, pension funds, insurance companies, mutual
  funds
• Private firms
• Central banks and government agencies

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Offshore Banking

• Offshore banking refers to banking outside of the
  boundaries of a country.
• There are at least 3 types of offshore banking
  institutions, which are regulated differently
• An agency office in a foreign country makes loans
  and transfers, but does not accept deposits, and
  is therefore not subject to depository
  regulations in either the domestic or foreign
  country.

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Offshore Banking (cont.)

1. A subsidiary bank in a foreign country follows
   the regulations of the foreign country, not the
   domestic regulations of the domestic parent.
2. A foreign branch of a domestic bank is often
   subject to both domestic and foreign regulations,
   but sometimes may choose the more lenient
   regulations of the two.

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International Money Market

• Eurocurrency is a time deposit in an
  international bank located in a country different
  than the country that issues the currency.
• For example, Eurodollars are U.S.
  dollar-denominated time deposits in banks located
  abroad.
• Euroyen are yen-denominated time deposits in
  banks located outside of Japan.
• The foreign bank doesnt have to be located in
  Europe.
• Reserve requirements

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Eurocurrency Market

• Most Eurocurrency transactions are interbank
  transactions in the amount of 1,000,000 and up.
• Common reference rates include
• LIBOR the London Interbank Offered Rate
• PIBOR the Paris Interbank Offered Rate
• SIBOR the Singapore Interbank Offered Rate
• A new reference rate for the new euro currency
• EURIBOR the rate at which interbank time deposits
  of are offered by one prime bank to another.

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Eurocredits

• Eurocredits are short- to medium-term loans of
  Eurocurrency.
• The loans are denominated in currencies other
  than the home currency of the Eurobank.
• Often the loans are too large for one bank to
  underwrite a number of banks form a syndicate to
  share the risk of the loan.
• Eurocredits feature an adjustable rate. On
  Eurocredits originating in London the base rate
  is LIBOR.

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Regulation of International Banking

• Banks fail because they do not have enough or the
  right kind of assets to pay for their
  liabilities.
• The principal liability for commercial banks and
  other depository institutions is the value of
  deposits, and banks fail when they cannot pay
  their depositors.
• If the value of assets decline, say because many
  loans go into default, then liabilities could
  become greater than the value of assets and
  bankruptcy could result.
• In many countries there are several types of
  regulations to avoid bank failure or its effects.

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Regulation of International Banking (cont.)

• Deposit insurance
• Moral Hazard
• Reserve requirements
• Capital requirements and asset restrictions
• Bank examination
• Lender of last resort
• Government-organized bailouts

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International Regulatory Cooperation

• Basel accords (in 1988 and 2006) provide standard
  regulations and accounting for international
  financial institutions.
• 1988 accords tried to make bank capital
  measurements standard across countries.
• They developed risk-based capital requirements,
  where more risky assets require a higher amount
  of bank capital.
• Core principles of effective banking supervision
  was developed by the Basel Committee in 1997 for
  countries without adequate banking regulations
  and accounting standards.

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International Portfolio Investment

• International Correlation Structure and Risk
  Diversification
• Optimal International Portfolio Selection
• Effects of Changes in the Exchange Rate
• International Diversification through Country
  Funds, ADRs, ETFs, and Hedge Funds
• Why Home Bias in Portfolio Holdings?

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International Correlation Structure and Risk
Diversification

• Security returns are much less correlated across
  countries than within a country.
• This is so because economic, political,
  institutional, and even psychological factors
  affecting security returns tend to vary across
  countries, resulting in low correlations among
  international securities.
• Business cycles are often high asynchronous
  across countries.

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Figure 3 Domestic vs. International
Diversification
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Summary Statistics for Monthly Returns 1980-2007
(U.S.)
Country stock market vs. world
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Figure 4 Optimal International Portfolio
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Composition of the OIP for a U.S.
Investor(Holding Period 19802007)
Australia Hong Kong 4.82 8.76
Italy 6.60
Netherlands 31.11
Sweden 28.01
U.S. 20.70
Total 100.00
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Gains from International Diversification
ODP
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Effects of Changes in the Exchange Rate

• The realized dollar return for a U.S. resident
  investing in a foreign market will depend not
  only on the return in the foreign market but also
  on the change in the exchange rate between the
  U.S. dollar and the foreign currency.

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Effects of Changes in the Exchange Rate

• The realized dollar return for a U.S. resident
  investing in a foreign market is given by
• Ri (1 Ri)(1 ei) 1
• Ri ei Riei

Where Ri is the local currency return in the ith
market ei is the rate of change in the exchange
rate between the local currency and the dollar
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Effects of Changes in the Exchange Rate

• The risk for a U.S. resident investing in a
  foreign market will depend not only on the risk
  in the foreign market but also on the risk in the
  exchange rate between the U.S. dollar and the
  foreign currency.
• Var(Ri) Var(Ri) Var(ei) 2Cov(Ri,ei) ?Var

The ?Var term represents the contribution of the
cross-product term, Riei, to the risk of foreign
investment.
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International Diversification through Country
Funds

• Recently, country funds have emerged as one of
  the most popular means of international
  investment.
• A country fund invests exclusively in the stocks
  of a single county. This allows investors to
• Speculate in a single foreign market with minimum
  cost.
• Construct their own personal international
  portfolios.
• Diversify into emerging markets that are
  otherwise practically inaccessible.

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International Diversification through American
Depository Receipts

• There are many advantages to trading ADRs as
  opposed to direct investment in the companys
  shares
• ADRs are denominated in U.S. dollars, trade on
  U.S. exchanges and can be bought through any
  broker.
• Dividends are paid in U.S. dollars.
• Most underlying stocks are bearer securities, the
  ADRs are registered.
• Adding ADRs to domestic portfolios has a
  substantial risk reduction benefit.

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International Diversification with Exchange
Traded Funds

• Using exchange traded funds (ETFs) like WEBS and
  spiders, investors can trade a whole stock market
  index as if it were a single stock.
• Being open-end funds, WEBS trade at prices that
  are very close to their net asset values. In
  addition to single country index funds, investors
  can achieve global diversification
  instantaneously just by holding shares of the SP
  Global 100 Index Fund that is also trading on the
  AMEX with other WEBS.

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Home Bias in Portfolio Holdings

• As previously documented, investors can
  potentially benefit a great deal from
  international diversification.
• The actual portfolios that investors hold,
  however, are quite different from those predicted
  by the theory of international portfolio
  investment.
• Home bias refers to the extent to which portfolio
  investments are concentrated in domestic equities.

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Home Bias in Equity Portfolios
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Why Home Bias in Portfolio Holdings?

• Three explanations come to mind
• Domestic equities may provide a superior
  inflation hedge.
• Home bias may reflect institutional and legal
  restrictions on foreign investment.
• Extra taxes and transactions/information costs
  for foreign securities may give rise to home bias.

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National Saving and Investment

• In an open economy (with international borrowing
  and lending), should national saving and
  investment be highly correlated?
• If some countries borrow for investment projects
  (for future production and consumption) while
  others lend to these countries, then national
  saving and investment levels should not be highly
  correlated.
• In reality, national saving and investment levels
  are highly correlated.

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Figure 5 Saving and Investment Rates for 24
Countries, 19902007 Averages