Chapter 8 International Investment and Diversification

1
Chapter 8International 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
Remembering 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
Remembering 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
Remembering Capital Market Theory

• Utility, risk, and return
• Variance of a linear combination
• Relationship of world exchanges
• Fundamental logic of diversification
• Other considerations

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
Role of Interest Rates

• Real rate of interest
• Inflation premium
• Risk premium

23
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

24
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

25
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

26
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

27
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

28
Forward Rates (contd)

• Forward rate premium or discount

29
Forward Rates (contd)

• Example
• On June 12, 2002, the British pound had a spot
  rate of 1.4728. The 3-month forward rate of the
  pound was 1.4645 on that date.
• What is the forward premium or discount?

30
Forward Rates (contd)

• Example (contd)
• Solution The forward premium or discount is
  calculated as follows
• There is a forward discount of 2.25.

31
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

32
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.

33
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

34
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

35
Purchasing Power Parity (contd)

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

36
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

37
The Concept of Exposure

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

38
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

39
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

40
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

41
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

42
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

43
Dealing With the Exposure

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

44
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

45
Reduce or Eliminate the Exposure

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

46
Hedge the Exposure

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

47
Definition

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

48
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

49
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

50
Hedging With Futures Contracts (contd)

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

51
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 striking (exercise) price

52
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

53
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

54
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

55
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.

56
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

57
Key Issues in Foreign Exchange Risk Management

• The steps in foreign exchange risk management
• Define and measure foreign exchange exposure
• Organize a system that monitors this exposure and
  exchange rate changes
• Assign responsibility for hedging
• Formulate a strategy for hedging

58
Investments in Emerging Markets

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

59
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

60
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)

61
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

62
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

63
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

64
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

65
Special Risks

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

66
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

67
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

68
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

69
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

70
Weak Legal System

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

71
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

72
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

73
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

74
Political Risk

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

75
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

76
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

77
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

78
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

79
Factors Contributing to Political Risk

• Buy local attitude
• Public attitude
• Government attitude

80
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

81
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

82
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

83
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

84
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

85
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

86
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