International Finance Presentation

Vihang Errunza, McGill University*

*FMA Doctoral Consortium, 2002

Introduction

What Makes International Finance Different?

• Deviations From PPP

• Barriers to Investment

Implications

Domestic CAPM Does Not Hold

Separation Theorems Do Not Hold

FEX Risk and Market Integration Key Concepts

International Asset pricing Models

• Under perfect financial markets, and identical consumption opportunity sets, an investor can achieve same expected lifetime utility regardless of residence.

• However, PPP deviations are significant and suggest the heterogeneity of national consumption tastes as a foundation for international finance.

Solnik (1974) • asset pricing model where exchange risk is priced.

The risk premium of a security over its national risk free rate is proportional to the risk premium of the world market over an average international bond rate.

Adler and Dumas (1983)• Investors will attempt to hedge against inflation.

• The optimal portfolio is the combination of - Portfolio of a logarithmic investor which is the same for all investors, and a investor specific portfolio that provides best possible hedge against inflation.

Stulz (1981) • The consumption baskets may differ across investors,

investment opportunity set can change over time

The expected excess real return of a risky asset is proportional to the covariance of the home currency return of that asset with changes in world real consumption rate.

Is FEX Risk Priced?• Dumas & Solnik (1995) The hypothesis of zero price on

exchange rate risk for conditional IAPM is rejected • DeSantis & Gerrard (1998) Components of the risk

premiums vary significantly over time and across markets. The average premium for currency risk appears to be only a small fraction of the sum of market and currency premiums.

• Karolyi & Stulz (2002) In equilibrium, in a symmetric world where consumption opportunity sets differ across countries, exposures to foreign exchange rates will be priced in stocks.

Models of perfect international financial markets have severe limitations. -An asset whose excess return has a zero covariance with the return on world market portfolio, does not seem to have an expected excess return equal to zero.-The home bias puzzle and the high volatility of equity flows is inconsistent with models where investors have the same information across countries and where financial markets are assumed to be perfect.

Although, global financial markets have become more open to foreign investors, barriers remain. Models that do not take into account barriers are suspect.

• Tax proportional to the absolute value of domestic

investors’ holdings of risky foreign assets.

• Barriers decrease trade in assets that do not provide

expected return large enough to offset the cost of barriers.

• E(R) on foreign assets is higher than implied by CI

• The world portfolio of stocks can not be efficient for any

investor.

• Adding foreign assets to a portfolio of domestic assets is not necessarily a good thing.

Stulz (1981)

Errunza and Losq (1985)

• Limiting case of Stulz (1981). Unequal access assumption. Yields a closed-form solution for the equilibrium Risk-Return trade-off

• Lends to the analysis of a continuum of market structures

• Freely traded securities are priced as if the market was not segmented -- only global risk premium

• Ineligible securities command a super risk premium which is conditional on the availability of substitute assets. With perfect substitutes in the world market, super risk premium vanishes.

MILD SEGMENTATION Limiting Case of Stulz (1981) Yields a closed-form solution for the equilibrium Risk-Return trade-off

MILD SEGMENTATION Limiting Case of Stulz (1981) Yields a closed-form solution for the equilibrium Risk-Return trade-off

FreelyTraded

E I

E IV

E II

E III

Lends itself to analysis of a continuum of market structures

Are Markets Integrated, Segmented or Mildly Segmented !

Markets fall somewhere in between CS & CI• Major markets largely integrated• EMs mildly segmented - Local risk most relevant

• Cross-listings have played an important integrating role even under the presence of barriers

• Impropriety of using RAW correlations of marketwide index returns as a measure of market integration.

• Financial market development and removal of barriers to foreign portfolio investment play a role in integrating EMs

The Estimated Integration Index-MEXICO CF-6/81, Liber. 1989

Source: Carrieri, Errunza and Hogan (2002)

-0.2

0

0.2

0.4

0.6

0.8

1

77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00

Integration Index

World Correlations

Where do we go in Asset Pricing!

• To-date, the conditional tests of FEX premia and market integration have been based on unconditional IAPMs eventhough an intertemporal IAPM is called for.

• The intertemporal IAPM of Chang, Errunza, Hogan & Hung (2002) prices market hedging risk and exchange rate hedging risk in addition to market risk and exchange rate risk.

However, much remains.

Other Factors

Fama-French Factors

• Fama-French (1998) :Size, Book to Market, PE, Divd. Yield - different pricing across EMs – Weak results

• Griffin (2001): Country specific F-F factors better explain time series variation in international stock returns

• Serra (2000): Weak results for Attributes and Liquidity

Need further research

Corporate Governance• La Porta, Lopez-De-Silanes, Shleifer and Vishny (1997)

show that countries with poor legal environment, measured by rules and quality of enforcement have smaller and narrower capital markets.

• Bhattacharya & Daouk (2002) C.O.C. does not change after the introduction of insider trading laws, but decreases significantly after the first prosecution.

• Lang, Lins & Miller (2002) Cross-listed firms have greater analyst coverage, and higher valuations from improved information environment

Corporate Governance (Contd.)• Stulz and Williamson (2001) country’s principal religion

helps predict the cross-sectional variation in creditor rights better than a country’s openness to international trade, its language, its income per capita, or the origin of its legal system.

• Dyck & Zingales (2002) minority shareholder protection, enforcement of laws and extra-legal protections are

associated with lower control premium. We have just begun to understand the relation between development, governance and performance.

Impact of Market liberalization

• Results are consistent with predictions of IAPMs

• The cost of equity capital decreases around liberalization. Firm level results of Errunza & Miller (2000), are consistent with market level studies of Bekaert & Harvey (2000), Henry (2000)

• The decline in the cost of capital is driven by the pre-announcement diversification potential of the foreign firm

• Theoretical and empirical results for the impact of introduction of CFs support C.O.C. hypothesis

Analyze liberalization impact at sector/firm level.

International Diversification

Should We Diversify Internationally?DeSantis & Gerard (1997)

• On average, the expected gains from international diversification are equal to 2.11 percent on an annual basis

Errunza, Hogan & Hung (1999)• Index level correlations overstate the gains from investing

in securities that only trade abroad.• Gains beyond those attainable through home-made

diversification are statistically and economically insignificant. Investors no longer need to trade abroad to achieve an internationally mean-variance efficient portfolio.

Equity Home Bias• Lewis (1999): Hedging home risk with home equity &

Diversification costs that exceed the gains• Stulz, Dahlquist, Pinkowitz & Williamson (2002)

Prevalence of closely held firms in countries with poor investor protection explains part of U.S. home bias

What about U.S. studies!• Coval and Moskowitz (1999): Geographic bias of U.S.

investors • Grinblatt and Keloharju (1999): Household portfolios are

concentrated and are under-diversified

Further studies are called for

Industrial Structure & Diversification

• Roll (1992), Arshanapalli, Doukas and Lang (1997) : Industry factors are important• Heston and Rouwenhorst (1994), Griffin and Karolyi (1998) : Industry factors are

not important • Griffin and Stulz (2001):Industries which produce internationally traded goods may

have a sizable exposure to industry-specific shocks. • Carrieri, Errunza & Sarkissian (2002) : The global industry risk is priced for certain

industries. Gains are larger with industry-specific global diversification

Corporate International Diversification

• Errunza & Senbet (1981): MNCs provide a vehicle for international portfolio diversification which in equilibrium results in a price premium for the MNC. Further, there exists a systematic positive relationship between current degree of international involvement and excess market value.

• Bodnar, Tang & Weintrop (1997): Report positive effect of corporate international diversification on firm value and a significant international diversification premium.

• Denis, Denis & Yost (2001): Report significant diversification discounts for both single-segment and multiple-segment MNCs.

Need to resolve the differences based on THEORY and new EMPIRICS

MORE EMPIRICAL THAN THEORETICAL

• Difficult to model complex nature of World market

• Need simplifying assumptions

• Aggregation problem unresolved

• Capturing realism, tractability, intuitive clarity,

testability

• Difficult to publish theory in top journals

• If you can do it you will be famous.

Empirics have barely scratched the surface

• Solnik and Adler-Dumas variants for DMs

• Errunza-Losq variants for EMs

• Most work related to investments

• New data set availability - DMs & EMs

• Conditional Tests

• Very little work on Corp. Finance

References International Asset Pricing - Theory Adler, M. and B. Dumas, 1983, International portfolio selection and corporation finance: a synthesis, Journal of Finance, 38, 925-984. Solnik, B., 1974, An equilibrium model of the international capital market, Journal of Economic Theory, 8, 500-524. Stulz, R.M., 1981, A model of international asset pricing, Journal of Financial Economics, 9, 383-406. Karolyi A. & R.M.Stulz 2002, Are financial assets priced locally or globally?, W.P., Ohio State UniversityChang, J.R., V., Errunza, K. Hogan & M.W. Hung, 2002, An Intertemporal International Asset Pricing Model: Theory and Empirical Evidence, W.P.,McGill Univ. International Asset Pricing - Tests Wheatley, S., 1988, Some Tests of International Equity Market Integration, Journal of Financial Economics 21, 177--213. Harvey, C. R., 1991, The world price of covariance risk, Journal of Finance , 46, 111-157. Ferson, W.E. and C. Harvey, 1993, The risk and predictability of international equity returns, Review of Financial Studies 6, 527-566. Foreign Exchange RiskDumas, B. and B. Solnik, 1995, The world price of foreign exchange risk, Journal of Finance, 50, 445-479. De Santis G. and Gerard B., 1998, How big is the premium for currency risk?, Journal of Financial Economics , 49, 375-412. Carrieri, F., 2001, The Effects of Liberalization on Market and Currency Risk in the European Union, European Financial Management. International Asset Pricing Under Market Imperfections - TheoryStulz, R. M., 1981, On the effects of barriers to international investment, Journal of Finance 36, 923-934. Errunza, V., and E. Losq, 1985, International asset pricing under mild segmentation: theory and test, Journal of Finance 40, 105-124. Eun, C., and S. Janakiramanan, 1986, A Model of International Asset Pricing with a Constraint on the Foreign Equity Ownership, Journal of Finance 41, 897--914.

References (Contd.)International Asset Pricing Under Market Imperfections - TestsErrunza, V., E. Losq, and P. Padmanabhan, 1992, Tests of integration, mild segmentation and segmentation hypotheses, Journal of Banking and Finance 16, 949-972. Bekaert, G. and C. Harvey, 1995, Time-varying world market integration, Journal of Finance 50, 403-445. Dumas,B., C. Harvey & P. Ruiz, 2002, Are Correlations of Stock Returns Justified by Subsequent Changes in National Output? Forthcoming, Journal of International Money and Finance Carrieri, F., V. Errunza, K. Hogan, 2002, Characterizing world market integration through time, W.P.,McGill Univ. Correlations and International DiversificationLongin, F. and B. Solnik, 1995, Is the correlation in international equity returns constant: 1960-1990?, Journal of International Money and Finance 14, 3-26. Karolyi A. and R.M. Stulz, 1996, Why do markets move together? An investigation of U.S.-Japan stock return comovements, Journal of Finance, 51, 951-986. De Santis G. and Gerard B. 1997, International asset pricing and portfolio diversification with time-varying risk, Journal of Finance , 52, 1881-1912. Errunza, V., K. Hogan and M-W. Hung, 1999, Can the gains from international diversification be achieved without trading abroad, Journal of Finance 54, 2075-2107. Lewis, K., 1999, Trying to explain home bias in equities and consumption, Journal of Economic Literature 37, 571-608. Corporate International DiversificationErrunza, V., and L. Senbet, 1981, The effects of international operations on the market value of the firm: Theory and evidence, Journal of Finance 36, 401-417. Bodnar, G., C. Tang, and J. Weintrop, 1997, Both sides of corporate diversification: The value impacts of geographic and industrial diversification, mimeo. Denis, D., D. Denis, and K. Yost, 2001, “Global Diversification, Industrial Diversification, and Firm Value”, forthcoming, Journal of Finance.

References (Contd.) Geographic versus Industrial DiversificationRoll, R., 1992, Industrial structure and the comparative behavior of international stock market indexes, Journal of Finance 47, 3-42. Heston, S. and K.G. Rouwenhorst, 1994, Does industrial structure explain the benefits of international diversification? Journal of Financial Economics 36, 3-27. Griffin, J. and G.A. Karolyi, 1998, Another look at the role of the industrial structure of markets for international diversification strategies, Journal of Financial Economics 50, 351-373. Griffin, J. and R. Stulz, 2001, International competition and exchange rate shocks: A cross-country industry analysis of stock returns, Forthcoming, Review of Financial Studies. Carrieri, F.,V. Errunza and S. Sarkissian, 2001, Industry Risk and Market Integration,W.P.,McGill Univ. Market Liberalization, C.O.C., Volatility and CorrelationBekaert, G. and C. Harvey, 2000, Foreign speculators and emerging equity markets, Journal of Finance 55, 565-613. Henry, P. B., 2000, Stock market liberalization, economic reform, and emerging market equity prices, Journal of Finance 55, 529-564. Errunza, V. and D. Miller, 2000, Market segmentation and the cost of capital in international equity markets, Journal of Financial and Quantitative Analysis, 35, 577-600. Stulz, R. M., 1999, Globalization of equity markets and the cost of capital, W.P., Ohio State University

References (Contd.) Corporate GovernanceLa Porta, R., F. Lopez-De-Silanes, A. Shleifer and R. Vishny, 1997, “Legal Determinants of External Finance,” Journal of Finance, 52, pp.1131-1150.Bhattacharya U. & H. Daouk, 2002, The World Price of Insider Trading, Journal of Finance 57,75-108Stulz, R.and R. Williamson (2001), Culture, Openness, and Finance, W.P., Ohio State University. Dyck A.& L. Zingales, 2002, Private benefits of control: An international comparison, Mimeo. Lang,M., K. Lins & D. Miller, 2002, ADRs,analysts and accuracy: Does cross listing in the U.S. improve a firms information environment and increase market value?, Mimeo. Fama-French Factors Fama E. & K. French, 1998, Value versus Growth: The International Evidence, Journal of Finance Griffin J., 2001, Are the Fama and French factors global or country specific?, Review of Financial Studies 15, 783-803Serra, A.P., 2000, The cross-sectional determinants of returns: Evidence from Emerging markets’ stocks, Mimeo.