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Chapter 7

International Investment and Diversification

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Outline Introduction Why international diversification makes

theoretical sense Foreign exchange risk Investments in emerging markets Political risk Other topics related to international

diversification

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Introduction The marketplace of the twenty-first century

is global• U.S. equities represent only about 51% of the

world’s equity capitalization• Over the period 1980-2000, the U.S. was the

best-performing market only once• In September 1999, each of the 66 U.S. pension

funds had more than $1 billion in actively managed international investment portfolios

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Introduction (cont’d) International investments carry additional

sources of risk

Managers can reduce total portfolio risk via global investment

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Why International Diversification Makes Sense (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

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Why International Diversification Makes Sense (Evans and Archer Cont’d)

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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Utility, Risk, and Return 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 invest 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 will be diversification benefits• More pronounced the lower the correlation

• No two shares move in perfect lockstep– Diversification benefits 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 account for about 25% 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 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

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Foreign Exchange Risk Definition Business example Investment example From whence cometh the risk? Dealing with the risk The eurobond market Combining the currency and market decisions Key issues in foreign exchange risk management

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Definition 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 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

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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?

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Investment Example (cont’d)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%

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From Whence Cometh the Risk?

Role of interest rates Forward rates Interest rate parity Covered interest arbitrage Purchasing power parity

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Real Rate of Interest 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, 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?

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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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Interest Rate Parity Formula

domestic

foreign

where

annualized domestic risk-free rate

annualized foreign risk-free rate

F=Forward (contract) rate [value of foreign currency expressed in units of domestic currency]

S=Spot exchange

R

R

rate [value of foreign currency expressed in units of domestic currency]

domestic foreign

365F SR R

S n

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Example Six-month German Treasury Bills yield

2.60% (annualized rate) Spot exchange rate is $ 0.6051 / DM Six-month Forward rate is $ 0.6095 / DM

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

RUS=4.05 %

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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 Six-month Swiss rate is 1.00 % (annualized rate) Six-month US Treasury Bills yield 2.00 %

(annualized rate) Spot exchange rate is $ 0.8542 / CHF Six-month Forward rate is $ 0.8610 / CHF

What arbitrage strategy can you implement ?

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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:

11

1

where change in the spot exchange rate

foreign country inflation rate

domestic country inflation rate

D

F

F

D

IS

S 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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The Concept of Exposure Definition Accounting exposure Transaction exposure Translation exposure Economic exposure

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Definition 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 states in foreign currency is incomplete until the amount in dollars necessary to liquidate a 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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Dealing 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 mount of the exposure is small

relative to the cost of 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 Definition Hedging with forward contracts Hedging with futures contracts Hedging with foreign currency options

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Definition 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, non-negotiable 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 Futures Contracts (cont’d)

To hedge an investment, sell foreign currency futures

To hedge a liability, buy foreign currency futures

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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 strike (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 established 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% 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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How to do it Select 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.

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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.

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The return to maximize is the sum of

Chosen 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.

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Example A 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%

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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.

future date/ / / /

Japan Germany/ /

[ ]Yen DM Yen DM Yen DM Yen DM

Yen DM Yen DM

F S E S Sr r

S S

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Investments in Emerging Markets

Overview Background Adding value Reducing risk Following the crowd Special risks Asymmetric correlations Market microstructure considerations

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Overview 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 Over $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%)

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Background (cont’d) Dollars invested in emerging markets has

increased at a compound rate of almost 50% over the last 10 years

Private sector growth in emerging markets• E.g., Hungary and Poland after 1989

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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 have greater expected

growth and are 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 must invest in emerging markets

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Special Risks 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

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Incomplete Accounting Information (cont’d)

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 Foreign exchange securities 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, “bucket” shops

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

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Weak Legal System 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

order to buy and to sell

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Trading Costs Foreign market trading costs are more than

1% higher than domestic trading costs• E.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

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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 Introduction Factors contributing to political risk Macro risk versus micro risk Dealing with political risk

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Introduction 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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Introduction (cont’d) Real (direct) investment is an investment

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

Portfolio investment refers to foreign investment via the securities market• E.g., buying a number of shares of a foreign

company

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

investment:• A requirement that a minimum percentage of

supervisory positions be held by locals• Changes in operating rules• Restrictions on repatriation of capital

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Factors Contributing to Political Risk

“Buy local” attitude Public attitude Government attitude

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“Buy Local” Attitude Buy 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

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Public Attitude In emerging markets, people may see no

opportunity to improve their standard of living• Foreign subsidiaries may contribute to this attitude with

luxury items

The gap between the public’s aspirations and its expectations contributes to political risk

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Government Attitude Unstable governments can lead to foreign

investors being a volatile political issue• Foreign investors can be blamed for local

problems

• Foreign governments can suspend a firm’s ability to send funds back to its home country

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Macro Risk Versus Micro Risk Macro 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

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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

• Giving the impression of natural resource exploitation

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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 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

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

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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