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International Investments

I)Factors affecting Risk and ReturnII) Size of Global Equity MarketsIII) Global market Correlations

–Correlation over time - constant vs. non-constant–Implications on portfolio diversification

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International Investments

IV) Studies on Causality and Transmission of riskV) Gains from International Diversification.

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Factors affecting Risk and Return

–World Bank projects that 70% of the growth of the world’s real GDP during the next 20 years will come from developing economies in Asia, Latin America, Eastern Europe and Africa.– January 1987 to may 1993: Stock market growth in Turkey 637%; Argentina 1,374%; Mexico 960% (Source: Investor’s Guide to Emerging Markets).

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Factors affecting Risk and Return

•There are more people abroad whose incomes are growing faster (China , India, for example)• Vast need for infrastructure and technology investment in the emerging economies

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Factors affecting Risk and Return

Risk• Currency Risk- pegged to US $, mitigates risk if invested in single country; hedge currency exposure (www.msci.com).• Political Risk: stemming from coups, civil unrest, dictatorship; Gov’t policy risk;

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Factors affecting Risk and Return

– change in policy regarding franchise agreement, taxation on foreign investment;– appropriation risk – nationalization.

•Market Volatility:Discuss Table 3• Inadequate Accounting• Liquidity risk: Loss due to thin trading; higher market impact cost – larger bid and ask spread; brokerage commission, currency translation cost etc. high in emerging markets.

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Factors affecting Risk and Return

• Higher costs - market less efficient, higher transaction cost, fund manager incur additional travel costs etc.,

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Indirect quotation:Units of foreign currency per U.S. dollarBritish pound: 1/1.5958 = 0.6266Swish krona : 1/.1222 = 8.813

Consider the following exchange rates:Spot rate; Forward Rate; Cross rate

Spot Rate: (July 17, 2003)

0.1222Swedish krona1.5958British pound 1 Unit

U.S. $ to buyDirect Quotation

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A spot rate is the rate applied to buy currency for immediate delivery.A forward rate is the rate applied to buy currency at some agreed-upon future date.

What is the difference between spot rates and forward rates?

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When is the forward rate at a premium to the spot rate?If the U.S. dollar buys fewer units of a foreign currency in the forward than in the spot market, the foreign currency is selling at a premium.In the opposite situation, the foreign currency is selling at a discount.The primary determinant of the spot/forward rate relationship is relative interest rates.

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Forward premium/ discountF- S = premium (F>S) or discount (F<S)Annual percentage rate premium/discount:

•(F-S)/S x (12/N) x 100•N = number of months of F

Premium/discount on 30 day pound:D = (1.5927-1.5958)/1.5958 x (12/1) x 100 = - 0.19%

British pound is selling at a discount relative to dollar.

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What is a cross rate?A cross rate is the exchange rate between any two currencies not involving U.S. dollars.In practice, cross rates are usually calculated from direct or indirect rates. That is, on the basis of U.S. dollar exchange rates.

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Cross rate = x

= .6266 x 0.008461= .00530 pounds/yen.

Cross rate = x

= 118.19 x 1.595= 188.51 yens/pound.

Calculate the two cross rates between pounds and

yens.Pounds Dollars Dollar Yen

Yens Dollars Dollar Pound

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Exchange rate risk is the risk that the value of a cash flow in one currency translated from another currency will decline due to a change in exchange rates.For example, a weakening krona (strengthening dollar) would lower the dollar profit.

What is exchange rate risk?

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Translation Risk: MNC’s foreign assets and liabilities, denominated in foreign currency, are exposed to gain or losses due to changing exchange rates.Transaction Risk: MNC’s gains or losses resulting from international transactions.

Managing Foreign Exchange Risk

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What is purchasing power parity?

Purchasing power parity implies that the level of exchange rates adjusts so that identical goods cost the same amount in different countries. Ph = Pf(Spot rate), or Spot rate = Ph/Pf.

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If grapefruit juice costs $2.00/liter in the U.S. and purchasing power parity holds, what is price in Canada?

Spot rate = Ph/Pf. $0.727 = $2.00/Pf

Pf = $2.00/$0.727 = 2.75 Canadian dollars.

Do interest rate and purchasing power parity hold exactly at any point in time?

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What is interest rate parity?

Interest rate parity implies that investors should expect to earn the same return on similar-risk securities in all countries:

Here,kh = periodic interest rate in the home country.

kf = periodic interest rate in the foreign country.

Forward rateSpot rate

=1 + kh

1 + kf

.

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Forward rate = $0.7199.kh = 6%/12 = 0.500%.kf = 4%/12 = 0.333%.

Assume 1 Canadian dollar = $0.7199 in the 30-day forward market and 30-day risk -free rate is 6% in the U.S. and 4% in Canada.

Does interest rate parity hold?

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0.7199 Spot rate

If interest rate parity holds, the computed spot rate would be 0.7187 dollar/Canadian dollar. However, the observed spot rate is 0.7212 dollar/Canadian dollar.

Forward rateSpot rate =

1 + kh

1 + kf

=1.005001.00333

Spot rate = 0.7187.

Interest Rate Parity

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A U.S. investor could directly invest in the U.S. security and earn an annualized rate of 6%.Alternatively, the U.S. investor could convert dollars to Canadian dollars, invest in the Canadian security, and then convert profit back into dollars. If the return on this strategy is higher than 6%, then the Canadian security has the higher rate.

Which 30-day security (U.S.or Canadian)offers the higher return?

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What is the return to a U.S. investor in the Canadian Security?

Buy $1,000 worth of Canadian dollars in the spot market:

1,000(1.3866$/CD) = 1,386.6 CD.Canadian investment return (in CD):

1,386.6(1.00333)=1,391.21 CD.

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Buy contract today to exchange 1,391.21 CD pesetas in 30 days at forward rate of 0.7199 dollars/CD.At end of 30 days, convert peseta investment to dollars:

1,391.21(0.7199) = $1,0001.53.Calculate the rate of return:

$1.53/$1,000 = 0.153% per 30 days.

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U.S. 30-day rate is 0.500%; Canadian securities at 0.153% offer a lower rate of return to U.S. investors.But could such a situation exist for very long?

The Canadian security has the lower return, return it has a lower interest rate.

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Arbitrage

Traders could borrow at the Canadian rate, convert to US dollars at the spot rate, and simultaneously lock in the forward rate and invest in US securities.

This would produce arbitrage: a positive cash flow, with no risk and none of the traders own money invested.

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Size of Global Equity Marketsand correlations

• Explain the size of the Japanese market in 1987, 88, and 89.• See Tables 1 and 2.

• Global market Correlations

•See Table 5

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Causality and Transmission of risk•Explain test of causality. Markets analyzed: CAN, GER, FRA, NETH,SWI, UK, JAP, US.

–Time period: 1980-1989, Subperiod 1: 1980-85III, and 1985IV-89.–Findings - Markets are not completely integrated; –1st subperiod: Direction is from Foreign to US; May be caused by higher $.–2nd subperiod: Direction is from US to Foreign.

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Gains from International Diversification.

Rationale: international equity market has higher E(R) than the US market and can substantially diversify US portfolio.

–Asset pricing models do not argue that risk factors have geographically different E(R).–In the US market, value and size explain the difference in E(R) across equity portfolio–International value stocks and small stocks diversify US portfolio more than EAFE.