Lectures 12 and 13 International Asset Portfolios

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Lectures 12 and 13International Asset Portfolios

• Galina A Schwartz
• Department of Finance
• University of Michigan
• Business School

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Plan of Lectures 12 13

• Levich, Chapters 14 and 15
• Bond portfolio
• Risks hedge or not to hedge?
• Equity portfolio
• major types of equity portfolios
• cross-country differences
• Home country bias
• over-investment in domestic assets
• common for both types of
• international portfolios

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Bond Portfolio I

• Two components of associated risk for un-hedged
  foreign bond
• 1. Variability in foreign bond prices
• country interest rate risk
• 2. Variability in foreign exchange rate
• central bank risk
• and the covariance between them
• Levich, p. 495
• exposure to changes in
• credit risk, exchange controls the risk of
  default
• Empirics Facts
• International bond returns are weakly correlated
• Three heavily concentrated markets
• US, EU countries, Japan

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Bond portfolio II

• Terms Jargon
• Non-hedged portfolios under-perform
• Passively hedged portfolios
• Passively hedged portfolios under-perform
• Actively hedged portfolios tactical or overlay
• Brady Bonds (1989)
• to resolve emerging market debt issues
• http//www.bradynet.com

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Bond Portfolio III Brady bonds

• Why Brady bond mechanism was possible?
• collateralization of the debt was the key
• Emerging market defaults were the reality
• The market value of the outstanding debt was ?
• Overall this market was small ( 150 billion )

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Brady Mechanism Russian crisis of 1998

• Why Brady mechanism was not used with Russia?
• 1. Debt collateralization is essential for
  Brady mechanism
• It was hardly an option in Russia
• 2. Volume of Russian debt high ( 150 billion
  )
• 3. Russian government capacity to service
  its debt?
• questionable

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Equity portfolio I

• Associated risks similar to bond portfolios
• Levich, p. 539 compare to p. 495
• Institutional aspects
• Market size
• market concentration
• trading volume
• Transaction taxes
• Transaction costs
• clearing procedures ( costs)
• settlement procedures ( costs)

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Equity portfolio II

• Main types of Funds
• Close-End and Open-End Funds
• Country Baskets (CBs)
• World Equity Benchmark Shares (WEBS)
• Regional Funds
• Industry Funds
• Why do we observe the variety of Funds types?

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Equity portfolio III

• Pricing, Levich, pp. 544-549
• Generalized capital asset pricing model (CAPM)
• Somewhat unrealistic assumptions
• (no transaction costs taxes,
• returns are in nominal terms
• existence of a risk-free asset
• investor utility depends only on
• expected return and risk)
• Arbitrage pricing theory (APT)
• (a set of factors drives equity returns)
• Importance of financial variables as factors

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Home country biasPossible explanations

• Barriers to international investment
• Regulatory and tax reasons uncertainty
• High share of non-tradables in consumption
• Substitution of investment in foreign assets by
  investment in multinational corporations (MNC)
• Informational imperfections
• Endogenous exchange rate risk
• Risk increases in the volume of foreign
  exchange market, see midterm 2.2. 2.3

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To hedge or not to hedge?

• Different incentives of bond equity holders
• w.r.t. hedging foreign exchange risk exposure
• Levich, p. 588, box 16. 1
• Bond holders hedge
• Equity holders do not hedge

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Bonds and Equity international portfolios

• Common issues
• Exposure to exchange rate risk
• Exposure to country risk
• Cross country regulatory tax differences
• Robust home country bias

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Summary of Lectures 12 13, I

• Bonds and Equity international portfolio
• Current trends
• Increased correlation of returns in mature
  markets
• Increased market volatility
• its correlation with high correlation of returns
• ? Lower gains from diversification into
• mature markets

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Summary of Lectures 12 13, II

• Bonds and Equity international portfolio
• Current trends (continued)
• Low correlation of returns in
• mature emerging markets
• ? diversification into emerging markets is
  profitable
• difficulty ratings are not reliable.
• To diversify profitably one have to
• acquire information

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Next week (Lectures 14 and 15)

• Importance of Financial Institutions
• Summary of what we have learned
• Final Exam will be distributed on Monday
  12/11/2000 due 12/20/2000 (or 12/22/2000?)