International%20Portfolio

1

• International Portfolio
• Investment
• (chapter 15 in Eun and Resnick)

2
Developed vs Emerging Markets

• Factors that are used to classify the worlds
  financial markets
• in developed and emerging markets
• the size and scope of the equity, fixed income
  and derivatives markets
• the sophistication of the local market
  professionals
• liquidity and transaction costs
• quality and quantity of financial information
• financial regulations, business laws, ethics,
  investor protection

3
Market Capitalization

• Almost 90 of the total market capitalization of
  the worlds equity markets is accounted for by
  the market capitalization of the developed world
• The other 10 is accounted for by the market
  capitalization of developing countries in
  emerging markets.
• Latin America
• Asia
• Eastern Europe
• Mideast/Africa

4
Risks of investing in international markets

• sovereign (political) risk
• Sovereign governments have the right to regulate
  the movement of goods, capital, and people
  across their borders
• in general, financial managers and investors
  incorporate a political risk premium when foreign
  activities are being evaluated
• Ex ethnic strife in Indonesia currency controls
  in Malayasia expropriation in Africa and Central
  America changes in taxes and regulations

5
Risks of investing in international markets

• liquidity risk refers to how quickly an asset
  can be sold without a major price concession
• - The equity markets of the developed world tend
  to be much more liquid than emerging markets
• - Emerging markets have limited investability

6
Risks of investing in international markets

• Information risk most investors prefer to invest
  in assets that
• are more familiar with
• foreign language
• limited access to information
• lack of disclosure
• unfamiliar accounting system

7
Risks of investing in international markets

• Foreign Exchange Risk
• - Foreign operations are conducted in foreign
  currencies.
• - When firms and individuals are engaged in
  cross-border transactions they are exposed to
  foreign exchange (FX) risk.
• - The foreign currency profits, costs, revenues
  in dollar terms depends on exchange rate
  movements.
• - FX risk affects the cost of capital and the
  capital structure of a MNC firm

8
International Correlation Structure and
Diversification

• Correlations between countries are not stable
  through time
• Security returns are much less correlated across
  countries than within a country.

9
The Optimal International Portfolio
OIP
1.53
JP
UK
FR
US
GM
CN
4.2
10
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
11
Effects of Changes in the Exchange Rate

• For example, if a U.S. resident just sold shares
  in a British firm that had a 15 return (in
  pounds) during a period when the pound
  depreciated 5, his dollar return is 9.25
• Ri (1 .15)(1 0.05) 1 0.925
• .15 -.05 .15(-.05) 0.0925

12
International Diversification through
International Mutual Funds

• A U.S. investor can easily achieve international
  diversification by investing in a U.S.-based
  international mutual fund.
• The advantages include
• Savings on transaction and information costs.
• Circumvention of legal and institutional barriers
  to direct portfolio investments abroad.
• Professional management and record keeping.

13
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 country. 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.

• ETFs (Exchange Traded Funds)/ World Equity
  Benchmark Shares (WEBS or iShares)
• Country-specific baskets of stocks designed to
  replicate the country indexes

14
Trading in International Equities

• During the 1980s world capital markets began a
  trend toward greater global integration
• Diversification, reduced regulation, improvements
  in computer and communications technology,
  increased demand from MNCs for global issuance.
• Cross-Listing refers to a firm having its equity
  shares listed on one or more foreign exchanges.
• Foreign stocks often trade on U.S. exchanges as
  ADRs.
• It is a receipt that represents the number of
  foreign shares that are deposited at a U.S. bank.
• The bank serves as a transfer agent for the ADRs

15
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.

16
Why Home Bias in Portfolio Holdings?

• Home bias refers to the extent to which portfolio
  investments are concentrated in domestic
  equities.
• Explanations for home bias

17
Learning outcomes

• discuss the characteristics that differentiate
  the developed from emerging markets
• discuss the following risks of investing in
  international markets sovereign, liquidity,
  foreign exchange , information
• what are the benefits and risks of investing
  internationally
• know how to calculate the dollar return of a
  foreign investment (see slides 10 and 11)
• discuss how an investor can diversify
  internationally through mutual funds, ETFs,
  country funds and ADRs
• explain what is an ADR and why investors invest
  in them
• what is home bias and factors that affect it
• End of chapter recommended questions 1, 2, 5,
  10, 11
• End of chapter recommended problems 1, 4