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Chapter 7

International Investment and Diversification

Portfolio Construction, Management, & Protection, 5e, Robert A. StrongCopyright ©2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.

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All the people like us are We,And everyone else is They.And They live over the sea,While We live over the way.

But—would you believe it?—They look upon We

As only a sort of They.

Rudyard Kipling

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Introduction Institutional investors are well aware of the

possibilities international investments offer• U.S. equities represent only about 45 percent of the

world’s equity capitalization

• Over the period 1980–2000, the U.S. was the best-performing market only once

• William M. Morse, an investment consulting firm reports

– Target allocation for international equity: 15-20%

– Actual allocation for international equity: 10-20%

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Why International Diversification Makes Theoretical Sense

International investments carry additional sources of risk

Managers can reduce total portfolio risk via global investment

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Remembering Evans and Archer

Portfolio theory works to the investor’s 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 Total risk contains both systematic and

unsystematic risk• Evans and Archer show that holding 15 to 20 equity

securities substantially reduces the unsystematic risk

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Remembering Capital Market Theory

Unsystematic risk reduction is possible with more than 20 securities• For a given level of return, any reduction in

risk, no matter how small, is a worthy goal

• A rational investor will reduce risk if given the opportunity

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Variance of a Linear Combination

As long as assets are less than perfectly correlated, there can be diversification benefits• More pronounced the lower the correlation

• No two shares move in perfect lockstep– Diversification benefits generally accrue every time

we add a new position to a portfolio

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Relationship of World Exchanges

For U.S. securities, market risk accounts for about one-fourth of a security’s 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

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Relationship of World Exchanges (cont’d)

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

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Relationship of World Exchanges (cont’d)

Number of Securities

Portfolio Variance

U.S. Securities: Systematic Risk 27%

International Securities: Systematic Risk 11.7%

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Fundamental Logic of Diversification

Investors are, on average, rational people 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

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Fundamental Logic of Diversification (cont’d)

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

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Other Considerations Optimum portfolio size involves a trade-off

between:• The benefits of additional diversification

• Commissions and capital constraints

• There also is a limit to an investor’s time

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Foreign Exchange Risk Foreign exchange risk refers to the

changing relationships among currencies • Modest changes in exchange rates can result in

significant dollar differences

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Business ExampleA U.S. importer has agreed to purchase 40 New Zealand leather vests at a price of NZ$110 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?

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Business Example (cont’d)Solution: If the spot rate does not change, the cost to the importer is:

40 × NZ$110 × $0.5855/NZ$ = $2,576.20

If the spot rate is $0.5500:

40 × NZ$110 × $0.5500/NZ$ = $2,420.00

If the spot rate is $0.6200:

40 × NZ$110 × $0.6200/NZ$ = $2,728.00

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An Investment ExampleYou just purchased 1,000 shares 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?

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An Investment Example (cont’d)

Solution: The purchase price in U.S. dollars is:

1,000 × AUD1.45 × $0.7735/AUD = $1,121.58

If the Australian dollar depreciates and you sell the shares, you will receive:

1,000 × AUD1.95 × $0.7000/AUD = $1,365.00

The holding period return is:

($1,365.00 – $1,121.58)/$1,121.58 = 21.7%

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The Role of Interest Rates in Risk 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 people’s willingness to postpone spending their money

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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

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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

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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

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Forward Rates (cont’d) 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

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Forward Rates (cont’d) Forward rate premium or discount:

Forward rate - Spot rate 12100

Spot rate

where the contract length in months

n

n

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Forward Rates (cont’d)Example

On April 29, 2008, the British pound had a spot rate of $1.9146. The 3-month forward rate of the pound was $1.9041 on that date.

What is the forward premium or discount?

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Forward Rates (cont’d)Example (cont’d)

Solution: The forward premium or discount is calculated as follows:

There is a forward discount of –2.19%.

%19.2

1003

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9146.1$

9146.1$9041.1$100

12

rateSpot

rateSpot - rate Forward

n

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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

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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.

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Example of CIA

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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

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Purchasing Power Parity (cont’d)

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

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Purchasing Power Parity (cont’d)

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

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1

where change in the spot exchange rate

foreign country inflation rate

domestic country inflation rate

F

D

F

D

IS

I

S

I

I

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Purchasing Power Parity (cont’d)

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

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International Risk Exposure 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

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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

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Transaction Exposure FASB Statement No. 8 addresses

transaction exposure:• “A transaction involving purchase or sale of

goods or services with the price stated in foreign currency is incomplete until the amount in dollars necessary to liquidate the related payable or receivable is determined”

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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

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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

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Means to Deal With the Exposure Ignore the Exposure Reduce or Eliminate the Exposure Hedge the Exposure

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Ignore the Exposure Ignoring the exposure may be appropriate

for an investor if:• Foreign exchange movements are expected to

be modest• The dollar amount of the exposure is small

relative to the cost or inconvenience of hedging• The U.S. dollar is expected to depreciate

relative to the foreign currency

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Reduce or Eliminate the Exposure

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

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Hedge the Exposure Hedging involves taking one position in the

market that offsets another position• Covering foreign exchange risk means hedging

foreign exchange risk

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Hedging with Forward Contracts

A forward contract is a private, nonnegotiable 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

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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

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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

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Hedging with Foreign Currency Options (cont’d)

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

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Hedging with Foreign Currency Options (cont’d)

The disadvantage of hedging with currency options is that the hedger must pay a premium to establish the hedge• Options provide more precision than futures

contracts

• Options are more expensive than futures contracts

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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

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The Eurobond Market (cont’d) About 75 percent 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.

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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

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Key Issues in Foreign Exchange Risk Management

The steps in foreign exchange risk management:

1) Define and measure foreign exchange exposure

2) Organize a system that monitors this exposure and exchange rate changes

3) Assign responsibility for hedging

4) Formulate a strategy for hedging

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Investment in Emerging Markets 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

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Background According to the Emerging Markets Traders

Association, $2.043 trillion in debt traded during the first half of 2004• 85 percent of Eurobond trading was in

sovereign issues, with the remainder in corporate bonds

Disparity exists in national equity market returns• Foreign price-to-book ratios tend to be lower

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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 may have greater expected

growth and may be cheaper

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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

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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 feel they must invest in emerging markets

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Additional Risks Arising from Foreign Investment

Incomplete Accounting Information Foreign Currency Risk Fraud and Scandals Weak Legal System

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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• 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

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Foreign Currency Risk Securities traded on a foreign exchange 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

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Fraud and Scandals Emerging markets carry a substantial risk of fraud

• e.g., accounting misstatements, counterfeit securities, pyramid schemes

Redress available to victims of a scandal in a developing country may be inadequate

Low confidence in a country’s legal system:• Leads to increased uncertainty

• Leads to an increased risk premium required by investors

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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

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Asymmetric Correlations (cont’d)

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

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Market Microstructure Considerations Liquidity Risk Trading Costs Market Pressure Marketability Risk Country Risk

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Liquidity Risk Some emerging markets’ investors are mostly

foreign• Increases political risk

• Sets the stage for a market collapse if everyone pulls out at once

Some emerging markets lack depth• The bid/ask spread tends to be wide with few standing

orders to buy and to sell

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Trading Costs Foreign market trading costs are more than

1 percent higher than domestic trading costs• e.g., bid/ask spread is an average of 95.4 basis

points for Barings’ Securities emerging market index

– They reach as high a 171 basis points in Turkey

• This indicates an investment must appreciate more to show a given net return

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Market Pressure An order to buy or sell a large number of

shares might cause a substantial supply/demand imbalance• Causes the price to move adversely from the

investor’s perspective

• Indicates that emerging market investments should be viewed as long-term investments rather than a source of trading profits

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Marketability Risk An investor may be unable to close out a

position at a reasonable price

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Country Risk Country risk refers to a country’s ability

and willingness to meet its foreign exchange obligations• Especially important in emerging markets

Country risk has two components:• Political risk• Economic risk

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Political Risk Political risk is a measure of a country’s

willingness to honor its foreign obligations• A function of:

– The stability of the governments and its leadership

– Attitudes of labor unions

– The country’s ideological background

– The country’s past history with foreign investors

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Political Risk (cont’d) Real (direct) investment is an investment

over which the investor retains control• e.g., a plant in a foreign country

Portfolio (financial) investment refers to foreign investment via the securities market• e.g., buying a number of shares of a foreign

company

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Political Risk (cont’d) 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

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Political Risk (cont’d) Modest forms of country risk for portfolio

investment:• Establishment of a requirement that a minimum

percentage of supervisory positions be held by local nationals

• Changes in operating rules• Restrictions on repatriation of capital

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Factors Contributing to Political Risk

“Buy Local” Attitude• Makes foreign consumers buy local goods instead of

goods produced or obtained elsewhere Public Attitude

• Local citizens may observe a gap between its aspirations and potential standard of living

Government Attitude• Unstable governments may blame foreign investors for

local problems• May suspend ability to send funds back to home

country

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Macro Political Risk Macro risk refers to government actions

that affect all foreign firms in a particular industry

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Micro Political Risk 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

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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

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Dealing with Political Risk (cont’d)

Avoid engaging in behavior that stirs up trouble with the host people or government:• Constructing flamboyant office buildings in

poor areas

• Giving the impression of natural resource exploitation contrary to the host country’s best interests

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Economic Risk Economic risk is a measure of a country’s

ability to pay• Assess economic risk by:

– Using coverage ratios

– Assessing the country’s capital base

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Other Topics Related to International Diversification

Multinational Corporations American Depository Receipts International Mutual Funds

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Multinational Corporations Investing in a multinational corporation

may provide a ready-made means of getting the risk-reduction benefits of international diversification• Research is unclear whether MNCs are better

investments than purely domestic firms

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American Depository Receipts American depository receipts (ADRs) are

receipts representing shares of stock that are held on the ADR holder’s behalf in a bank in the country of origin• An alternative to purchasing shares in a foreign

company directly on the foreign exchange

Several American depository receipts have market capitalizations exceeding $100 billion

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International Mutual Funds Mutual funds permit diversification to an extent

that would not otherwise be possible• Some mutual funds invest only in securities issued

outside the U.S.

• Buying an international mutual fund is a good way to achieve international diversification

• Managers of well-diversified international funds outperform MSCI benchmarks