1

International Finance

Chapter 21:

Financial Globalization:

Opportunity and Crisis

Preview

• Gains from trade

• Portfolio diversification

• Players in the international capital markets

• Attainable policies with international capital markets

• Offshore banking and offshore currency trading

• Regulation of international banking

• Tests of how well international capital markets allow portfolio diversification, allow intertemporal trade, and transmit information

3

International Capital Markets

• International asset (capital) markets are a group of markets (in London, Tokyo, New York, Singapore, and other financial cities) that trade different types of financial and physical assets (capital), including– stocks

– bonds (government and private sector)

– deposits denominated in different currencies

– commodities (like petroleum, wheat, bauxite, gold)

– forward contracts, futures contracts, swaps, options contracts

– real estate and land

– factories and equipment

Figure 1: The Three Types of International Transaction Trade

Gains from International Trade

• The theory of comparative advantage describes the gains from trade of goods and services for other goods and services.

• The theory of intertemporal trade describes the gains from trade of goods and services for assets, of goods and services today for claims to goods and services in the future (today’s assets).

• The theory of portfolio diversification describes the gains from trade in assets of different risk profiles.

Classification of Assets

Assets can be classified as either

1. Debt instruments– Examples include bonds and deposits.

– They specify that the issuer must repay a fixed amount regardless of economic conditions.

or

2. Equity instruments– Examples include stocks or a title to real estate.

– They specify ownership (equity = ownership) of variable profits or returns, which vary according to economic conditions.

International Capital Markets

The participants:

1. Commercial banks and other depository institutions

2. Nonbank financial institutions such as securities firms, pension funds, insurance companies, mutual funds

3. Private firms

4. Central banks and government agencies

Offshore Banking

• Offshore banking refers to banking outside of the boundaries of a country.

• There are at least 3 types of offshore banking institutions, which are regulated differently:

1. An agency office in a foreign country makes loans and transfers, but does not accept deposits, and is therefore not subject to depository regulations in either the domestic or foreign country.

Offshore Banking (cont.)

2. A subsidiary bank in a foreign country follows the regulations of the foreign country, not the domestic regulations of the domestic parent.

3. A foreign branch of a domestic bank is often subject to both domestic and foreign regulations, but sometimes may choose the more lenient regulations of the two.

International Money Market

• Eurocurrency is a time deposit in an international bank located in a country different than the country that issues the currency.– For example, Eurodollars are U.S. dollar-

denominated time deposits in banks located abroad.– Euroyen are yen-denominated time deposits in

banks located outside of Japan.– The foreign bank doesn’t have to be located in

Europe.– Reserve requirements

Eurocurrency Market

• Most Eurocurrency transactions are interbank transactions in the amount of $1,000,000 and up.

• Common reference rates include– LIBOR the London Interbank Offered Rate– PIBOR the Paris Interbank Offered Rate– SIBOR the Singapore Interbank Offered Rate

• A new reference rate for the new euro currency– EURIBOR the rate at which interbank time deposits of

€ are offered by one prime bank to another.

Eurocredits

• Eurocredits are short- to medium-term loans of Eurocurrency.

• The loans are denominated in currencies other than the home currency of the Eurobank.

• Often the loans are too large for one bank to underwrite; a number of banks form a syndicate to share the risk of the loan.

• Eurocredits feature an adjustable rate. On Eurocredits originating in London the base rate is LIBOR.

Regulation of International Banking

• Banks fail because they do not have enough or the right kind of assets to pay for their liabilities.

– The principal liability for commercial banks and other depository institutions is the value of deposits, and banks fail when they cannot pay their depositors.

– If the value of assets decline, say because many loans go into default, then liabilities could become greater than the value of assets and bankruptcy could result.

• In many countries there are several types of regulations to avoid bank failure or its effects.

Regulation of International Banking (cont.)

1. Deposit insurance

- Moral Hazard

2. Reserve requirements

3. Capital requirements and asset restrictions

4. Bank examination

5. Lender of last resort

6. Government-organized bailouts

International Regulatory Cooperation

• Basel accords (in 1988 and 2006) provide standard regulations and accounting for international financial institutions.

– 1988 accords tried to make bank capital measurements standard across countries.

– They developed risk-based capital requirements, where more risky assets require a higher amount of bank capital.

• Core principles of effective banking supervision was developed by the Basel Committee in 1997 for countries without adequate banking regulations and accounting standards.

International Portfolio Investment

• International Correlation Structure and Risk Diversification

• Optimal International Portfolio Selection

• Effects of Changes in the Exchange Rate

• International Diversification through Country Funds, ADRs, ETFs, and Hedge Funds

• Why Home Bias in Portfolio Holdings?

International Correlation Structure and Risk Diversification

• Security returns are much less correlated across countries than within a country.– This is so because economic, political,

institutional, and even psychological factors affecting security returns tend to vary across countries, resulting in low correlations among international securities.

– Business cycles are often high asynchronous across countries.

Figure 3: Domestic vs. International Diversification

Por

tfol

io R

isk

(%)

Number of Stocks

1 10 20 30 40 50

Swiss stocks

U.S. stocks

International stocks

When fully diversified, an international portfolio can be less than half as risky as a purely U.S. portfolio.

A fully diversified international portfolio is only 12 percent as risky as holding a single security.

Summary Statistics for Monthly Returns 1980-2007 ($U.S.)

Stock Market Correlation Coefficient Mean (%)

SD (%)

CN FR GM JP UK

Canada (CN)           1.07 5.55 1.00

France (FR) 0.49         1.20 6.00 1.04

Germany (GM)

0.46 0.73       1.19 6.29 1.03

Japan (JP) 0.34 0.40 0.32     0.92 6.53 1.10

United Kingdom

0.59 0.61 0.56 0.42   1.19 5.20 0.97

United States 0.72 0.55 0.52 0.31 0.61 1.11 4.25 0.88

Country stock

market vs. world

Figure 4: Optimal International Portfolio

Efficient frontier

2.0%

1.5%

1.0%

0.5%

0.0%Monthly Standard Deviation

0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10%

Mon

thly

Ret

urn

OIP

US

JP

HKSD

ITGM

CNSWUK

NL

Rf

Composition of the OIP for a U.S. Investor(Holding Period: 1980—2007)

Australia

Hong Kong

4.82%

8.76%

Italy 6.60%

Netherlands 31.11%

Sweden 28.01%

U.S. 20.70%

Total 100.00%

Gains from International Diversification

ODP

1.40%

1.11%

• For a U.S. investor, OIP has more return and more risk. The Sharpe measure is 30% higher, suggesting that an equivalent-risk OIP would have more return per unit of risk than a domestic portfolio.

  OIP ODP

Mean Return

1.40% 1.11%

Standard Deviation

4.74% 4.25% risk

retu

rn

OIP

4.25%4.74%

Effects of Changes in the Exchange Rate

• The realized dollar return for a U.S. resident investing in a foreign market will depend not only on the return in the foreign market but also on the change in the exchange rate between the U.S. dollar and the foreign currency.

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

Effects of Changes in the Exchange Rate

• The risk for a U.S. resident investing in a foreign market will depend not only on the risk in the foreign market but also on the risk in the exchange rate between the U.S. dollar and the foreign currency.

Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + Var

The Var term represents the contribution of the cross-product term, Riei, to the risk of foreign investment.

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 county. This allows investors to:

1. Speculate in a single foreign market with minimum cost.

2. Construct their own personal international portfolios.3. Diversify into emerging markets that are otherwise

practically inaccessible.

International Diversification through American Depository Receipts

• There are many advantages to trading ADRs as opposed to direct investment in the company’s 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. Adding ADRs to domestic portfolios has a substantial

risk reduction benefit.

International Diversification with Exchange Traded Funds

• Using exchange traded funds (ETFs) like WEBS and spiders, investors can trade a whole stock market index as if it were a single stock.

• Being open-end funds, WEBS trade at prices that are very close to their net asset values. In addition to single country index funds, investors can achieve global diversification instantaneously just by holding shares of the S&P Global 100 Index Fund that is also trading on the AMEX with other WEBS.

Home Bias in Portfolio Holdings

• As previously documented, investors can potentially benefit a great deal from international diversification.

• The actual portfolios that investors hold, however, are quite different from those predicted by the theory of international portfolio investment.

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

Home Bias in Equity Portfolios

Country Share in World Market Value

Proportion of Domestic Equities in Portfolio

France 2.6% 64.4%

Germany 3.2% 75.4%

Italy 1.9% 91.0%

Japan 43.7% 86.7%

Spain 1.1% 94.2%

Sweden 0.8% 100.0%

United Kingdom 10.3% 78.5%

United States 36.4% 98.0%

Total 100.0%  

Why Home Bias in Portfolio Holdings?

• Three explanations come to mind:

1. Domestic equities may provide a superior inflation hedge.

2. Home bias may reflect institutional and legal restrictions on foreign investment.

3. Extra taxes and transactions/information costs for foreign securities may give rise to home bias.

National Saving and Investment

• In an open economy (with international borrowing and lending), should national saving and investment be highly correlated?

• If some countries borrow for investment projects (for future production and consumption) while others lend to these countries, then national saving and investment levels should not be highly correlated.

• In reality, national saving and investment levels are highly correlated.

Figure 5: Saving and Investment Rates for 24 Countries, 1990–2007 Averages