International Investment and Diversification

OutlineIntroductionWhy international diversification makes theoretical senseForeign exchange riskInvestments in emerging marketsPolitical riskOther topics related to international diversification

IntroductionThe marketplace of the twenty-first century is globalU.S. equities represent only about 51% of the worlds equity capitalizationOver the period 1980-2000, the U.S. was the best-performing market only onceIn September 1999, each of the 66 U.S. pension funds had more than $1 billion in actively managed international investment portfolios

Introduction (contd)International investments carry additional sources of risk

Managers can reduce total portfolio risk via global investment

Why International Diversification Makes Sense (Evans and Archer)Portfolio theory works to the investors benefit even if he selects securities at randomIdeally, the portfolio manager selects securities because of their fit with the rest of the portfolioBy choosing poorly correlated securities, a manager can reduce total portfolio risk

Why International Diversification Makes Sense (Evans and Archer Contd)Total risk contains both systematic and unsystematic riskEvans and Archer show that holding 15 to 20 equity securities substantially reduces the unsystematic risk

Utility, Risk, and ReturnUnsystematic risk reduction is possible with more than 20 securitiesFor a given level of return, any reduction in risk, no matter how small, is a worthy goal

A rational invest will reduce risk if given the opportunity

Variance of A Linear CombinationAs long as assets are less than perfectly correlated, there will be diversification benefitsMore pronounced the lower the correlation

No two shares move in perfect lockstepDiversification benefits accrue every time we add a new position to a portfolio

Relationship of World ExchangesFor 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 marketThe securities are exposed to more extreme economic and political events

Relationship of World Exchanges (contd)International capital markets continue to show independent price behaviorInternational diversification offers potential advantages

Repeating the Evans and Archer methodology for international securities should result in a lower level of systematic risk

Relationship of World Exchanges (contd)Number of SecuritiesPortfolio VarianceU.S. Securities: Systematic Risk 27%International Securities: Systematic Risk 11.7%

Fundamental Logic of DiversificationInvestors are, on average, rationalRational people do not like unnecessary riskBy holding one more security, an investor can reduce portfolio risk without giving up any expected returnRational investors, therefore, will hold as many securities as they can

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

Other ConsiderationsOptimum portfolio size involves a trade-off between:The benefits of additional diversification

Commissions and capital constraints

Foreign Exchange RiskDefinitionBusiness exampleInvestment exampleFrom whence cometh the risk?Dealing with the riskThe eurobond marketCombining the currency and market decisionsKey issues in foreign exchange risk management

DefinitionForeign exchange risk refers to the changing relationships among currencies Modest changes in exchange rates can result in significant dollar differences

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?

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

40 x NZ$110 x $0.5855 = $2,576.20

If the spot rate is $0.5500:

40 x NZ$110 x $0.5500 = $2,420.00

If the spot rate is $0.6200:

40 x NZ$110 x $0.6200 = $2,728.00

Investment ExampleYou 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?

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%

From Whence Cometh the Risk?Role of interest ratesForward ratesInterest rate parityCovered interest arbitragePurchasing power parity

Real Rate of InterestThe 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

Inflation PremiumThe inflation premium reflects the way the general price level is changing

Inflation is normally positiveThe inflation premium measures how rapidly the money standard is losing its purchasing power

Risk PremiumThe 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 carriesE.g., common stock vs. T-bills

Forward RatesThe forward rate is a contractual rate between a commercial bank and a client for the future delivery of a specified quantity of foreign currencyTypically quoted on the basis of 1, 2, 3, 6, and 12 months

Forward Rates (contd)The forward rate is the best estimate of the future spot rateIf 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

Forward Rates (contd)Forward rate premium or discount:

Forward Rates (contd)Example

On April 29, 2005, 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?

Forward Rates (contd)Example (contd)

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

There is a forward discount of 2.19%.

Interest Rate ParityInterest rate parity states that differences in national interest rates will be reflected in the currency forward marketTwo 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

Interest Rate Parity Formula

ExampleSix-month German Treasury Bills yield 2.60% (annualized rate)Spot exchange rate is $ 0.6051 / DMSix-month Forward rate is $ 0.6095 / DM

RUS=2.60+100(0.6095-0.6051)(12/6)/0.6051RUS=4.05 %

Covered Interest ArbitrageCovered interest arbitrage is possible when the conditions of interest rate parity are violatedIf 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.

Example of CIASix-month Swiss rate is 1.00 % (annualized rate)Six-month US Treasury Bills yield 2.00 % (annualized rate)Spot exchange rate is $ 0.8542 / CHFSix-month Forward rate is $ 0.8610 / CHF

What arbitrage strategy can you implement ?

Example of CIA

Purchasing Power ParityPurchasing power parity (PPP) refers to the situation in which the exchange rate equals the ratio of domestic and foreign price levelsA 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

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 currencyNot very accurate due to:Transportation costsTrade barriersCultural differences

Purchasing Power Parity (contd)Relative purchasing power parity states that differences in countries inflation rates determine exchange rates:

Purchasing Power Parity (contd)A country with an increase in inflation will experience a depreciation of its currency because:Exports declineImports increaseThere is less demand for goods from that country

The Concept of ExposureDefinitionAccounting exposureTransaction exposureTranslation exposureEconomic exposure

DefinitionExposure is a measure of the extent to which a person faces foreign exchange risk

In general, there are two types of exposure: accounting and economicEconomic exposure is more important

Accounting ExposureAccounting exposure is:Of concern to MNCs that have subsidiaries in a number of foreign countriesImportant 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

Transaction ExposureFASB 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

Translation ExposureTranslation exposure results from the holding of foreign assets and liabilities that are denominated in foreign currenciesE.g., foreign real estate and mortgage holdings must be translated to U.S. dollars before they are incorporated into a U.S. balance sheet

Economic ExposureEconomic 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

Dealing With the ExposureIgnore the exposureReduce or eliminate the exposureHedge the exposure

Ignore the ExposureIgnoring the exposure may be appropriate for an investor if:Foreign exchange movements are expected to be modestThe dollar mount of the exposure is small relative to the cost of inconvenience of hedgingThe U.S. dollar is expected to depreciate relative to the foreign currency

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

Hedge the ExposureDefinitionHedging with forward contractsHedging with futures contractsHedging with foreign currency options

DefinitionHedging involves taking one position in the market that offsets another positionCovering foreign exchange risk means hedging foreign exchange risk

Hedging With Forward ContractsA forward contract is a private, non-negotiable transaction between a client and a commercial bankNo 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

Hedging With Futures ContractsA 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

Hedging With Futures Contracts (contd)To hedge an investment, sell foreign currency futures

To hedge a liability, buy foreign currency futures

Hedging With Foreign Currency OptionsThere are two types of foreign currency options:Call options give their owner the right to buy a set quantity of foreign currencyPut options give their owner the right to sell a set quantity of foreign currencyThe price at which you have the right to buy or sell is the strike (exercise) price

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

Hedging With Foreign Currency Options (contd)The disadvantage of hedging with currency options is that the hedger must pay a premium to established the hedgeOptions provide more precision than futures contracts

Options are more expensive than futures contracts

The Eurobond MarketEurobonds are debt agreements that are denominated in a currency other than that of the country in which they are heldE.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 foreignerE.g., a bond denominated in yen sold in Japan, issued by a firm in the United Kingdom

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.

Combining the Currency and Market DecisionsIt is often desirable to cross-hedge a foreign investment into a different currencyE.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

How to do itSelect the market with the highest risk-premium, not the highest absolute return.Why? Because due to non-arbitrage, investing in riskless securities of various countries will yield the same returns once the proceeds are translated back into the domestic currency (either always true if use forward contracts or true on average if use currency spot market to repatriate the funds).Thus what matters (what differentiates markets) is the return expected ABOVE the risk-free rate.

Which Currency to Cross-Hedge ?What is relevant is the total rate of return, after including the return in the selected local market (foreign equity), the cost/benefit of holding the currency, and the expected return on that currency.

So instead of mechanically hedging the local currency with the US Dollar (domestic), we should look for a third currency for cross-hedging purposes so as to maximize the total expected return.

The return to maximize is the sum ofChosen Market Equity Return (where we chose to invest)Forward market premium/discount (riskless rate in country selected for cross-hedging minus riskless rate in country where we chose to invest).Expected return in currency of country where we chose to invest.

ExampleA US investor chooses to invest in German stocks and then cross-hedges with the Japanese Yen:

Forecasted German equity returns: 10 %Forecasted change in Japanese Yen: 2.5 %Japanese riskless rate (Eurobond rate): 2 %German riskless rate (Eurobond rate): 4.5 %

Forecasted total return: 10% + (2% - 4.5%) + 2.5%Total (Expected) Return = 10%

The riskless (Eurobond) rate differential comes from the fact that we have:

This means that the expected percentage change in the DM value (expressed in Yen) is the riskless rate differential. When using forward contracts, we get the forward rate instead of the spot rate due to the fact that we need to wait for that future date before transforming the DM into Japanese Yen.Therefore the amount in DM that gets converted to Yen in the end is subject to a change in value since the forward rate F is different than the spot rate S.

Investments in Emerging MarketsOverviewBackgroundAdding valueReducing riskFollowing the crowdSpecial risksAsymmetric correlationsMarket microstructure considerations

OverviewEmerging market investments:Offer substantial potential rewards to the careful investor in added return and risk reductionAre accompanied by special risks:Foreign exchange riskHigh political and economic riskUnreliable investment informationHigh trading costs

BackgroundOver $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%)

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 marketsE.g., Hungary and Poland after 1989

Adding ValuePrices in developing markets often contain significant inefficienciesTend to sell for lower price/earnings multiples than do firms in developed marketsEmerging market firms have greater expected growth and are cheaper

Reducing RiskLow correlations are attractive as a means of reducing portfolio variabilityEmerging markets show low correlation with developed markets

Emerging markets show low correlation with each other

Following the CrowdSome professional money managers carefully analyze emerging markets for:Profit potentialPortfolio risk reduction

Some professional money managers follow the crowd because they must invest in emerging markets

Special RisksIncomplete accounting informationForeign currency riskFraud and scandalsWeak legal system

Incomplete Accounting InformationIn some countries, financial statements are more than 6 months old when they become availableThe acquisition of reliable investment information generally requires on-site security analysts

Incomplete Accounting Information (contd)Accounting standards differ substantially across countriesAccounting information is frequently unavailable for an emerging market securitySome emerging market brokerage firms focus on the income statement but ignore the balance sheet

Foreign Currency RiskForeign exchange securities are denominated in a foreign currencyIntroduces foreign exchange risk for foreign investorsE.g., Mexican peso crisis and Asian crisis

In emerging markets, traditional hedging vehicles may be unavailable

Fraud and ScandalsEmerging markets carry a substantial risk of fraudE.g., accounting misstatements, counterfeit securities, bucket shops

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

Weak Legal SystemLow confidence in a countrys legal system:Leads to increased uncertainty

Leads to an increased risk premium required by investors

Asymmetric CorrelationsCorrelation 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

Asymmetric Correlations (contd)Investment returns show:Homogeneity within emerging marketsSecurities tend to move as a group within a single emerging market

Heterogeneity across emerging marketsEmerging markets show low correlation across markets

Market Microstructure ConsiderationsLiquidity riskTrading costsMarket pressureMarketability riskCountry risk

Liquidity RiskSome emerging markets investors are mostly foreignIncreases political riskSets the stage for a market collapse if everyone pulls out at once

Some emerging markets lack depthThe bid/ask spread tends to be wide with few standing order to buy and to sell

Trading CostsForeign market trading costs are more than 1% higher than domestic trading costsE.g., bid/ask spread is an average of 95 basis points for Barings Securities emerging market index

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

Market PressureAn order to buy or sell a large number of shares might cause a substantial supply/demand imbalanceCauses the price to move adversely from the investors perspective

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

Marketability RiskAn investor may be unable to close out a position at a reasonable price

Country RiskCountry risk refers to a countrys ability and willingness to meet its foreign exchange obligationsEspecially important in emerging markets

Country risk has two components:Political riskEconomic risk

Political RiskIntroductionFactors contributing to political riskMacro risk versus micro riskDealing with political risk

IntroductionPolitical risk is a measure of a countrys willingness to honor its foreign obligationsA function of: The stability of the governments and its leadershipAttitudes of labor unionsThe countrys ideological backgroundThe countrys past history with foreign investors

Introduction (contd)Real (direct) investment is an investment over which the investor retains controlE.g., a plant in a foreign country

Portfolio investment refers to foreign investment via the securities marketE.g., buying a number of shares of a foreign company

Introduction (contd)Extreme forms of country risk for portfolio investment:Government takeover of a companyPolitical unrest leading to work stoppagesPhysical damage to facilitiesForced renegotiation of contracts

Introduction (contd)Modest forms of country risk for portfolio investment:A requirement that a minimum percentage of supervisory positions be held by localsChanges in operating rulesRestrictions on repatriation of capital

Factors Contributing to Political RiskBuy local attitudePublic attitudeGovernment attitude

Buy Local AttitudeBuy 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

Public AttitudeIn emerging markets, people may see no opportunity to improve their standard of livingForeign subsidiaries may contribute to this attitude with luxury items

The gap between the publics aspirations and its expectations contributes to political risk

Government AttitudeUnstable governments can lead to foreign investors being a volatile political issueForeign investors can be blamed for local problems

Foreign governments can suspend a firms ability to send funds back to its home country

Macro Risk Versus Micro RiskMacro 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

Dealing With Political RiskSeek a foreign investment guarantee from the Overseas Private Investment CorporationProvides coverage against:Loss due to expropriation

Nonconvertibility of profits

War or civil disorder

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

Economic RiskEconomic risk is a measure of a countrys ability to payAssess economic risk by:Using coverage ratios

Assessing the countrys capital base

Other TopicsMultinational corporationsAmerican depository receiptsInternational mutual funds

Multinational CorporationsInvesting in a multinational corporation may provide a ready-made means of getting the risk-reduction benefits of international diversificationResearch is unclear whether MNCs are better investments than purely domestic firms

American Depository ReceiptsAmerican depository receipts (ADRs) are receipts representing shares of stock that are held on the ADR holders behalf in a bank in the country of originAn alternative to purchasing shares in a foreign company directly on the foreign exchange

By 2000, 1,534 ADRS from dozens of countries traded in the U.S.

International Mutual FundsMutual funds permit diversification to an extent that would not otherwise be possibleSome mutual funds invest only in securities issued outside the U.S.

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