Global Investing

1
Global Investing

• Chapter 18

2
Background

• International investing increases each year
• Due to high returns available in other countries
• Offers international diversification
• Involves all the same risks as domestic investing
  plus additional risks
• Foreign exchange risk
• Sovereign risk
• International liquidity risk
• International information risk

3
Sovereign Risk

• Sovereign risk involves the possibility that
• The foreign countrys government may collapse
• Its legal system is inadequate
• Its police force can not maintain order
• The settlement process may occasionally break
  down
• Other political upheaval may occur
• Euromoney magazine ranks countries sovereign
  risk
• As of March 2000 Luxembourg ranked as the country
  with lowest risk and Afghanistan as the highest

4
Sovereign Risk

• Multinational investors require a higher rate of
  return from riskier countries
• Large investors may be able to obtain a guarantee
  from government officials
• Mostly, however, investors refuse to invest
  unless they expect a higher return to compensate
  them for the international risk premium

5
International Liquidity Risk

• Emerging financial markets often lack liquidity
  due to
• Modest trading volumesignificant intervals
  between transactions
• Inexperienced and/or undercapitalized
  market-makers
• Insufficient legal systems
• Inability to quickly and economically clear
  security transactions
• Lack of access to international cash flows

6
Example The 1999 Russian Crisis

• During 1996-1997 Russian stocks earned 143
• By 1998 Russia was experiencing
• A decline in oil revenues
• A ballooning budget deficit
• Poor tax collections
• In 1999 the ruble was devalued
• Inflation zoomed to 56
• Many businesses were bankrupt
• Government offered tax credit to pay for services
• Corporations used bartering to pay for services

7
Example The 1999 Russian Crisis

• Rubles were used less than IOUs, barter and other
  payment methods
• Companies paid workers with chits to be used in
  company-owned shops or with product (to be used
  for barter)
• Many Russians kept savings in the form of U.S.
  dollars

8
Example The 1999 Russian Crisis

• Russian government allowed its biggest oil
  company, Lukoil, to pay ½ its taxes with IOUs or
  veksels
• Lukoil would later redeem for oil
• Government paid for its goods and services with
  these veksels
• Veksel brokers developed
• Bought veksels for rubles and resold to customers
• Usually for 50 of face value

9
International Information Risk

• More difficult to obtain information on
  international investments due to
• Language differences
• Currency differences
• Different weight and measurement systems
• Different political systems
• Length of time to deliver international mail
• Unfamiliar geography
• Different financial reporting techniques
• Easier for an insider to obtain information
  than an outsider

10
Foreign Exchange Risk

• Currency exchange rates fluctuate continuously

Contains no foreign exchange riskthe investment
was made in the countrys local currency.
11
Simple International Diversification

• A few dozen securities in your portfolio is
  sufficient for simple diversification
• Diversifying across industries within a single
  country doesnt offer additional diversification
  benefits
• Competing firms within a country tend to have
  high positive correlation
• Even though barriers to entry exist,
  international market segmentation tends to make
  international diversification beneficial
• Solnik (1974) studied international
  diversification

12
Solniks Diversification Study

• Examined stock returns from 8 countries over 5
  years
• Used random selection and equal weighting
• Only invested using U.S. dollarsthus returns
  also include foreign exchange risk
• Results indicate
• Randomly selecting stocks across countries is
  superior to only investing in U.S. stocks
• Randomly selecting stocks across countries and
  across both countries and industries is superior
  to diversifying across industries
• Portfolios that are hedged against foreign
  exchange risk have only slightly less risk than
  unhedged portfolios

13
Portfolio Analysis of Two-Country Diversification

• The lower (or more negative) the correlation
  coefficient between securities within a portfolio
  the more diversification benefits
• In general, correlations between counties are
  fairly low
• Correlations between emerging markets are lower
  than correlations in developing markets
• Some negative correlation occurs between emerging
  markets

14
International Efficient Frontiers

• Consider the following international efficient
  frontiers
• Some theoretically optimal portfolios may be
  unobtainable due to government-imposed policies

Emerging markets onlydominates developed markets
due to low correlations and some very high
returns during sample period.
All opportunities
U.S. markets only
Developed markets only
15
Correlation Coefficient Between Different
Countries

• Solnik, Boucrelle Fur (1996) SBF analyzed
  over 30 years of data from 4 countries and
  conclude
• Correlations across countries are not stable over
  time
• Correlations seem to be tending upward
• Worlds financial markets are becoming more
  integrated
• Standard deviations are also somewhat unstable
• When financial markets volatility increases,
  correlations between countries tends to increase
  temporarily

16
Correlation Coefficient Between Different
Countries

• SBL analyzed returns to a U.S. investor investing
  in Japan

Trend is toward an increasing ?.
?s fluctuate between positive and negative values.
17
Fundamental Reasons for Low Inter-Country ?

• Different countries have different
• Political systems
• Capitalism vs. socialism
• Currencies
• Foreign exchange regulations
• Fixed vs. floating exchange rates
• Trade restrictions
• Import/export limitations
• Political alliances
• Different countries may be at different stages in
  their business cycles
• War vs. peace
• Inflation, monetary/fiscal policies
• Due to above issues, different countries
  security markets are not highly positively
  correlated

18
Do Multinational Corporations Provide
International Diversification?

• The largest corporations in the world are
  multinational corporations (MNCs)
• Will investing in MNCs offer a quick (and easy)
  method for diversifying internationally?
• No! The variability in a MNCs stock returns are
  largely determined by variations in the domestic
  stock market
• Between 69-93 of the variability is explained by
  domestic stock market index
• However, as the MNCs sales outside its domestic
  country increase, the correlation with its
  domestic stock market tends to decrease

19
American Depository Receipts (ADRs)

• Several fairly easy methods for obtaining
  international diversification include
• American Depository Receipts
• Evidence of ownership in a foreign corporation
• Created by J.P. Morgan in 1927
• Removes foreign exchange complications from
  international investing
• Bank collects dividends in foreign currency and
  converts to U.S. dollars

• Some high volume ADRs include
• BP-Amoco
• Volvo
• Nestle S.A.
• Toyota
• Nokia

20
Problems with ADRs

• Some ADRs are highly liquid
• If issued by well known international
  corporations
• Sponsored by the issuer
• Pay the ADR fees
• Listed on an organized U.S. stock exchange
• If the stock issuer does not sponsor the ADR
• Investors must pay the ADR fees
• May not provided financial statements in English
• If trade OTC may not be very liquid
• Some corporations purposely have their ADRs trade
  OTC
• Avoids costly disclosure requirements and
  stringent U.S. accounting conventions

21
Problems with ADRs

• Corporate control can be an issue
• Some depository banks are allowed to vote on
  behalf of ADR shareholders
• Price volatility may be high in the ADR issuers
  domestic country
• Foreign income is typically subject to more
  complicated tax regulations
• May be more difficult to follow foreign news
• Still subject to exchange rate risk
• Risk is hidden since the investor does not have
  to deal with it directly

22
Global Depository Receipts

• Patterned after ADRs except most are not
  denominated in U.S. dollars
• Can be issued in any country and denominated in
  any currency
• First issued in 1993
• GDRs and ADRs represent only a small portion of
  publicly traded foreign corporations
• Thus, an investor might consider investing in
  international mutual funds
• None of these methods eliminates foreign exchange
  risk

23
International Investment Companies

• Some mutual funds specialize in international
  investments
• Global fundsinvest in both foreign and domestic
  securities
• International funds or foreign fundsinvest
  primarily in foreign securities
• Regional foreign fundsinvest only in foreign
  securities from specific regions (Price New Asia
  Fund)
• International style fundsinvest in unique
  categories of foreign securities (Fidelity
  Emerging Markets Fund)
• Foreign index funds (Vanguard International
  Equity Index Fund for Europe)
• Country fundsconfine investments to securities
  in a single country (Korea Fund)

24
International Index Funds

• iShares MSCIshares in a mutual fund indexed to a
  stock market in a single foreign country
• 17 different iShares MSCI mutual funds exist
• Each converts U.S. dollar investment into foreign
  currency, buys the stocks making up the countrys
  MSCI index, managers the fund, collect cash
  dividends and converts them to U.S. dollars, etc.
• Allows investors the ability to diversify
  internationally without dealing with foreign
  exchange transactions and stock-picking in a
  foreign market

25
Homemade International Diversification

• Erunza, Hogan Hung (1999) EHH analyzed how
  much international diversification a U.S.
  investor could achieve without leaving U.S.
  markets
• Compared results to 7 developed markets and 9
  emerging markets
• Conclude that U.S. investors are able to achieve
  significant diversification
• Able to mimic all developed markets and all but 2
  of the emerging markets

26
International Security Market Line

• If international financial markets are fully
  integrated, an assets international beta can be
  calculated as

• Can use the MSCI world market index as a
  surrogate for the world market portfolio
• Could calculate country betas
• If all individual security betas in each separate
  country were averaged
• Problemall the worlds financial markets are not
  fully integrated
• Even the U.S. and Canadian markets are not fully
  integrated

27
International Arbitrage Pricing Theory

• Home bias occurs due to barriers to entry
• Thus, international risk premiums exist for each
  country
• APT model can easily be extended to include
  international risk factors
• Home bias can be included
• Country-to-country PPP violations can be included

28
The Bottom Line

• International investors face additional risks
  compared to domestic investors
• Country (or sovereign) risk
• Liquidity risk
• Especially in emerging markets
• Foreign exchange risk
• Lack of information
• Buying shares in iShares MSCI or international
  mutual funds allows investors to passively
  diversify internationally
• ADRs, GDRs and international mutual funds allow
  investors to invest internationally without
  dealing with foreign exchange transactions

29
The Bottom Line

• If the worlds financial markets were fully
  integrated, the international SML would be be the
  same as the domestic SML
• However, investors demand international risk
  premiums
• International diversification offers advantages
  that outweigh the costs
• Offers the dominant Markowitz efficient frontier
• Caveats
• Correlations between countries are unstable
  through time
• Correlations are likely to rise as world markets
  become more fully integrated
• Correlations increase as financial markets become
  more volatile