international portfolio management final

8/3/2019 International Portfolio Management Final

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Submitted by:Srijan Saxena (4601)

Raghav Bhatnagar (4624)

Akshay Kharbanda (4627)Vineeth Vijayan (4644)

BBS- 3FA

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ACKNOWLEDGEMENT

We would like to express our deep sense of intellectual debt to our mentor and teacherMr. Kumar Bijoy, who provided valuable comments and suggestions from time to time as

to methodology, style and substance that went a long way in completion of the term paperin its present form. Without his help, guidance and encouragement, the making of thisproject would not have been possible.

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TABLE OF CONTENTS

Ridiculed in the west for a long time but with his firm making headway withpositive net returns in both the 1998 and the present crash Nassim Nicholas Taleb

(born 1960) is a literary essayist, epistemologist, researcher, and former practitionerof mathematical finance. Taleb is a specialist in financial derivatives. Universa,where Taleb is adviser, made returns of 65% to 115% in October 2008 in itsapproximately $2 billion Black Swan Protection Protocol Higher frequency ......34-Limited human knowledge ....................................................................................... 34

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INTRODUCTION

The topic given to us for our international finance assignment is international portfoliomanagement-risk. During the course of this project we have tried to analyze and study the

various issues related to the subject and derive conclusions from the same. Initially wehave looked into the basic principles of the investment portfolio management and howdifferent mathematical tools are applied in it. Then we moved on to the relative meritsand the risks that have been found in the international portfolio that are managed. In thenext step we have gone a step ahead and talked about the specific country to countrycorrelation and how it affects the diversification risk of a portfolio with an in-depthcomprehensive study of one major mutual fund. In addition a comprehensive study of thedifferent risk management was also done with a look into the investment strategy of amajor SWF.

At first sight, the idea of investing internationally seems exciting and full of promise

because of the many benefits of international portfolio investment. By investing inforeign securities, investors can participate in the growth of other countries, hedge theirconsumption basket against exchange rate risk, realize diversification effects, and takeadvantage of market segmentation on a global scale. Even though these advantages mightappear attractive, the risks of and constraints for international portfolio investment mustnot be overlooked. In an international context, financial investments are not only subjectto currency risk and political risk, but there are many institutional constraints andbarriers, significant among them a host of tax issues. These constraints, while beingreduced by technology and policy, support the case for internationally segmentedsecurities markets, with concomitant benefits for those who manage to overcome thebarriers in an effective manner.

In recent years, economic activity has been characterized by a dramatic increase in theinternational dimensions of business operations. National economies in all parts of theworld have become more closely linked by way of a growing volume of cross-bordertransactions, not only in terms of goods and services but even more so with respect tofinancial claims of all kinds. Reduced regulatory barriers between countries, lower cost ofcommunications as well as travel and transportation have resulted in a higher degree ofmarket integration.

Alongside the increase in international trade one can easily observe the globalization offinancial activity. Indeed, the growth of cross-border, or international, flows offinancial assets has outpaced the expansion of trade in goods and services. Thesedevelopments are underpinned by advances in communication and transportationtechnology. As a consequence, investment opportunities are no longer restricted todomestic markets, but financial capital can now seek opportunities abroad with relativeease.

Indeed, international competition for funds has caused an explosive growth ininternational flows of equities as well as fixed-income and monetary instruments.

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Emerging markets, in particular, as they have become more and more accessible, havebegun to offer seemingly attractive investment alternatives to investors around the globe.International capital flows are further driven by a divergence in population trends between developed and developing countries. The underlying demand for savingsvehicles is further reinforced by the necessary shift from pay-as-you-go pension schemes

towards capital market-based arrangements. By the same token, developing countrieswith their relatively young populations require persistent and high levels of investment inorder to create jobs and raise standards of living in line with the aspirations of theirimpatient populations. All this provides significant incentives for the growth ofinternational markets for all kinds of financial claims in general and securities inparticular.

While the environment has undoubtedly become more conducive to internationalportfolio investment (IPI), the potential benefits for savers investors have lost none oftheir attractions. There are the less-than-perfect correlations between national economies,the possibility of hedging an increasingly international consumption basket, and the

participation in exceptional growth opportunities abroad, which can now be takenadvantage of through IPI.

Furthermore, there is not only additional upside potential, but there are also some extrarisks involved in IPI. Such unique risks arise especially from unfavorable changes inexchange and interest rates as well as regulatory developments. Even though it might on balance look attractive to the investor to purchase some foreign securities for hisportfolio, this might not easily be feasible due to institutional constraints imposed on IPI.Obstacles like taxation withholding tax, taxation of foreign income and multipletaxation., exchange controls, capital market regulations and, last but not least,transactions cost can represent valid reasons why the scope and thus the potential of IPImight be limited.

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PRINCIPLES OF INTERNATIONAL PORTFOLIO INVESTMENT

An important issue that arises if portfolios are composed of securities from differentcountries is the choice of a numeraire for measuring risk and expected return. The Capital

Asset Pricing Model (CAPM) has been developed with respect to major capital marketsin the world. It is well accepted and widely used by professional portfolio managers toanalyze the pricing of securities in national financial markets.

In the CAPM, the rate of return required for an asset in market equilibrium depends onthe systematic risk associated with returns on the asset, that is, on the covariance of thereturns on the asset and the aggregate returns to the market. Risk in asset returns that isuncorrelated with aggregate market returns is called 'specific risk', 'diversifiable risk', or'idiosyncratic risk'. Given diversified holdings of assets, each individual investorsexposure to idiosyncratic risk associated with any particular asset is small anduncorrelated with the rest of their portfolio. Hence, the contribution of idiosyncratic risk

to the riskiness of the portfolio as a whole is negligible. It follows that only systematicrisk needs to be taken into account.

Particularly, as there are many barriers and obstacles to IPI, mean-variance efficiency ofall securities cannot be assumed automatically. There is no common real risk-free rate ofinterest, because of real exchange risk caused by deviations from purchasing powerparity. By the same token, it is difficult to determine a global market portfolio. Fornational capital markets the use of value-weighted portfolios as benchmarks is quitedefensible, but this might not be true in an international context, where(a) Financial markets are still segmented to some degree;(b) Investors have different risk preferences; and(c) Expected risk and return change over time.

Beta measures only systematic risk, while standard deviation is a measure of total risk(systematic or market risk, and unsystematic risk, the risk of the security) .The twocomponents of international diversification are Potential for risk reduction throughdiversification and Added foreign exchange risk

We can illustrate the use of expected risk and the correlation to find out the risk that canarise from the total transaction as given below.

The standard deviation and the expected return of a portfolio with 40% invested in thefollowing Indian equity and 60% invested in the following US equity index.

Expected Return Expected Risk ()Indian equity index (IND) 14% 15%US equity index (US) 18% 20%Correlation coefficient (US,GER) 0.34

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2 2 2 2,2P US US GER GER US GER US GER US GERw w w w = + +

2 2 2 2(40%) (15%) (60%) (20%) 2(40%)(60%)(.34)(15%)(20%) 15.13%P = + + =

( ) ( ) ( )P US US GER GERE R w E R w E R= +

( ) (40%)(14%) (60%)(18%) 16.4%P

E R = + =

Alternative Portfolio Profiles

Domestic Only

Portfolio

Minimum Risk

Combination

Initial Portfolio

Maximum Risk and

Maximum Return

Portfolio

14.00%

15.00%

16.00%

17.00%

18.00%

19.00%

Expected portfolio risk

Ex

pectedp

ortfolior

eturn

-Effects of Changes in the Exchange RateReturns to investors investing in foreign markets depend on two factors:a) The return on the foreign asset or security, andb) The change in the exchange rate relative to the domestic currency.

Return on foreign asset depends on the performance of the asset and the performance ofthe foreign currency.

Rate of Return in Dollars (R$) RF + e ( % Spot Rate),{where RF is the foreign return in foreign or local currency (%);e is % change in the foreign currency over the holding period.}

If the foreign currency appreciated (depreciated), e is pos. (neg.) and increases(decreases) the effective dollar return to the investor.

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E.g.:- Japanese stock market increases by 4% and the Yen appreciates by 5% (USD return =9%)- British security increases by 15% and the BP depreciates by 5% (USD return = 10%)

Holding a foreign security is like having two assets:a) The foreign security andb) The foreign currency.Exchange rate changes affect the risk(variability) of a foreign investment as follows:

Var (R$) = Var (Rf) + Var (e) + 2 COV (Rf, e)

If exchange-rates were certain, or fixed (or unified), the terms with e would be zero, andthe only risk would be the Var (Rf), the variability of the foreign asset.

E.g.:

- U.S. investment in Argentina (under 1:1 peg) or Ecuador ($), German investment inFrance, U.S. investment in Panama ($), etc.With ex-rate uncertainty, currency risk would contribute to the riskiness of foreigninvestments by:1) Exchange rate volatility: Var (e).2) Covariance between ex-rates and the local market stock returns COV(Rf, e), could bepos or negative.

For further details please refer to appendix 3

-International Bond MarketWe know that U.S. bond market is highly correlated with Canada (.76), less so withFrance, Germany, Japan, Switzerland, and UK (all around .30 correlations). We can usethe same approach to calculate the OIP for bonds for say, U.S. investor,Fixed income securities are heavily exposed to currency risk, but can still benefit fromdiversification (higher returns, lower risk) if they can manage FX risk. Also, hedgingstrategies could control, minimize or reduce currency risk, boosting returns/lowering risk,improving intl. bond investment performance, e.g., Forwards, futures, options, etc.

Recent change: Euro currency would eliminate FX risk for Eurozone countries, enhanceand increase the use of non-Euro Swiss and British bonds for fixed-incomediversification.

-International Mutual Funds: PerformanceU.S. investors can cost-effectively diversify internationally by buying one of more than1000 international mutual funds: 1) at very low transaction cost, 2) without legal and

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institutional barriers compared to investing directly in foreign market, and 3) with thebenefit of professional fund managers.Point: International diversification increases risk-adjusted returns. Note also that theMSCI World Index SHP outperformed the Average, .186 vs. .150, suggesting that furtherdiversification would be good, e.g., World Index fund.

Alternative strategy to well-diversified international mutual fund: Invest in a singlemarket country fund (China, Russia, Turkey, Brazil, India, etc.), often sold as a closed-end country fund (CECF), a portfolio of a fixed number of shares, which are thenexchange-traded on NYSE, see Exhibit 15.12 on p. 371. For some emerging markets thismight be the only way to invest in these segmented markets, at least at a low cost. Unlikemost mutual funds, CECFs don't always trade at Net Asset Value of the securities.

The reason for this that CFs are generated in foreign currency outside the U.S., but thesecurities are traded in U.S. Market value in U.S. usually different than the NAV, andsell at a premium or discount.

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THE BENEFITS FROM INTERNATIONAL PORTFOLIO INVESTMENT

There are several potential benefits that make it attractive for investors to internationalizetheir portfolios. These perceived advantages are the driving force and motivation to

engage in IPI and will, therefore, be dealt with first, i.e., before looking at the risks andconstraints. Specifically, the attractions of IPI are based on: The participation in the growth of other (foreign) Markets; Hedging of the investors consumption basket; Diversification effects and, possibly; and Abnormal returns due to market segmentation.

All else being equal, an investor will benefit from having a greater proportion of wealthinvested in foreign securities because: expected return higher variation of returns lower lower correlation of returns of foreign securities with the investors home market,and possibly, Greater share of imported goods and services in his consumption.

-Participation in Growth of Foreign Markets

High economic growth usually goes hand in hand with high growth in the countryscapital market and thus attracts investors from abroad. IPI allows investors to participatein the faster growth of other countries via the purchase of securities in foreign capitalmarkets. This condition applies particularly to the so-called emerging markets ofEurope, Latin America, Asia, the Middle-east and Africa. Countries are classified as

emerging if they have low or medium income according to World Bank statistics, butenjoy rapid rates of economic growth. Typical examples are Mexico or Turkey as well asnewly industrialized countries such as Korea or Taiwan. Driven by the general economicexpansion, the financial markets in these countries have exhibited tremendous growth.This means that the security holdings of investors attained values several times worth theoriginal investment after just a few years.

-Hedging Of Consumption Basket

Since the international investor is at the same time a consumer of real goods and services,the return of his financial investment must be related to his consumption pattern. This

implies that goods are perfect substitutes domestically as well as internationally. If oneassumes, realistically, that goods are not perfect substitutes, then deviations fromPurchasing Power Parity (PPP) and Law of One Price (LOP) are possible. *

Consumer-investors who consume purely domestic goods and have no internationalportfolio investment are exposed to unexpected change in domestic inflation, but not toforeign inflation risk or foreign exchange rate risk.

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If consumer-investors consume some imported goods something that will be true formany investors today, but have no foreign securities in their portfolio, they face domesticinflation, foreign inflation, and exchange risk. However, if PPP holds exactly over theinvestment horizon, then the combination of foreign inflation and exchange rate changeswill always be equal to the domestic inflation rate. Thus, consumer-investors only face

the domestic inflation risk. In these examples, whenever PPP holds, exchange risk is nota barrier to international portfolio investment.

Finally, in case consumer-investors have some foreign assets in their portfolios and alsoconsume foreign goods, they face domestic inflation, foreign inflation, and exchange risk,because the consumption pattern includes some imported goods. The exchange risk,however, can be hedged through appropriate foreign investment. Therefore, exchangerisk on the consumption side could serve as an incentive for international portfolioinvestment. Again, when PPP holds, the exchange risk is the same as the inflation riskand, thus, there is no incentive for international portfolio investment. Nevertheless, ifconsumer & investors consume some imported goods and have proportionately matching.

International portfolio investments, they are able to hedge the exchange risk. Therefore,regardless of whether PPP holds, they may be able to avoid exchange risk

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BENEFITS FROM INTERNATIONAL PORTFOLIO DIVERSIFICATION

It has been shown, that the crucial factor determining portfolio risk for a given level ofreturn is the correlation between the returns of the securities that make up that portfolio.

Risk adverse investors will try to make use of the effect of diversification and selectsecurities with low correlation. Investors benefit from diversification, both domesticallyand internationally.

Since perfect negative correlation between different securities is rare, the lowestcorrelations possible will be chosen. This is the point where foreign securities come into play. Investors who compose their portfolio only of domestic securities restrictthemselves to a smaller number of securities to choose from. Since they exclude the largeset of foreign stocks, bonds and other securities, they limit the power of diversification apriori and forgo the possibility of further reducing portfolio risk by picking some foreignstocks that exhibit very low correlation with the domestic portfolio.

Securities returns are less correlated across countries than within countries.Because of the fact that political and institutional, factors vary across countries - e.g.,currency markets, regulation/deregulation, general economic conditions, businesscycle differences, political issues, central bank issues, fiscal policy, industry structure,etc.

Indeed, there is reason to expect the correlation of returns between foreign securitiesand domestic securities to be lower than that between only domestic securities. In thelatter case, all returns will be partially affected by purely national events, such as realinterest rates rising due to a particular governments anti-inflation policy. Within anysingle country, a strong tendency usually exists for economic phenomena to movemore or less in unison, giving rise to periods of relatively high or low economicactivity. The reason for this is that the same political authority is responsible for theformulation of economic policies in a particular country. For example, the monetary,fiscal, trade, tax, and industrial policies are all the same for the entire country, butmay vary considerably across countries. Thus, regional economic shocks inducelarge, country-specific variation of returns.

A second explanation for international diversification consists of the industrialdiversification argument which is based on the observation that the industrialcomposition of national markets varies across countries; e.g., the Swiss market has ahigher proportion of banks than other markets. As industries are less than perfectlycorrelated, investing in different markets enables the investor to take advantage ofdiversification effects simply because of the composition of his portfolio with respectto different industries.

E.g.: U.S. market performance in 2006 was about 10%, stock markets in othercountries have done much better, e.g., Mexico (+35%), Brazil (+22%), China(+44%), India (+40%), Spain (+32%), etc.

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Gains from international portfolio diversification depend on the degree of correlation (-1 +1) between the home country and a foreign country. As a general rule: thegreater (or lower) the degree of correlation between two countries' markets, the lower (orgreater) the benefit of combing those countries in a portfolio.E.g.: Canada and U.S. arehighly correlated, better for U.S. investor to combine U.S. + China or India, versus U.S. +

Canada.Inter-country correlations for U.S. and other countries (bottom row of Exhibit 15.2) isfrom .137 (Japan) to .304 (Australia), all less than .439 (intra-country). Point: Stockshave a lower correlation between countries than within a country. Implication: Intl.diversification can benefit investors, by reducing risk.

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UNIQUE RISKS FOR INTERNATIONAL PORTFOLIO INVESTMENT

-Currency Risk

The major point is that improved portfolio performance as a result of international

portfolio investment must be shown after allowing for these risk and cost components.For convenience as well as analytical clarity, the unique international risk can be dividedinto two components: exchange risk (broadly defined) and political (or country) risk.E.g.: if an investor considers U.S. dollar-denominated and EUR-denominated Eurobondslisted on the Singapore Exchange, one class of risks is attached to the currency ofdenomination, dollar or euro, and another is connected with the political jurisdictionwithin which the securities are issued or traded.

As foreign assets are denominated, or at least expressed, in foreign currency terms, aportfolio of foreign securities is usually exposed to unexpected changes in the exchangerates of the respective currencies (exchange rate risk or currency risk). These changes can

be a source ofadditionalrisk to the investor, but by the same token can reduce risk forthe investor. The net effect depends, first of all, on how volatility is measured, inparticular whether it is measured in real terms against some index of consumption goods,or in nominal terms, expressed in units of a base currency. In any case, the effectultimately depends on the specifics of the portfolio composition, the volatility of theexchange rates, most importantly on the correlation of returns of the

Securities and exchange rates, and finally on the correlation between the currenciesinvolved. If total risk of a foreign security is decomposed into the components currencyrisk and volatility in local-currency value, exchange risk contributes significantly to thetotal volatility of a security.

Nevertheless, total risk is less than the sum of market and currency risk. For equities,currency risk represents typically between 10% and 15% of total risk when measured innominal terms, and the relative contribution is generally even higher for bonds.But by following different methods currency risks can be reduced. In addition todiversification which can be followed easily, exchange risk can also be reduced by meansof hedging, i.e., establishing short or long positions via the use of currency futures andforwards, which represent essentially long or short positions of fixed income instruments,typically with maturities of less than one year

Basically, the issue boils down to the nature of the correlation between returns ofsecurities and currencies in the short and the long run. With respect to large industrializedcountries with reputations for monetary discipline, currency values and returns onsecurities, especially equities, tend to exhibit positive correlation. In contrast, in countrieswhere monetary policy seems to have an inflationary bias, returns on equities andexternal currency values tend to be negatively correlated. To make things even morecomplex, countries do not stay immutably in one category or the other over longerperiods of time. It is not surprising, therefore, that prescriptions as to the proper hedgeratio as well as the empirical findings are found in all ranges.

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INSTITUTIONAL CONSTRAINTS FOR INTERNATIONAL PORTFOLIO

INVESTMENT

Institutional constraints are typically government-imposed, and include taxes, foreign

exchange controls, and capital market controls, as well as factors such as weak ornonexistent laws protecting the rights of minority stockholders, the lack of regulation toprevent insider trading, or simply inadequate rules on timely and proper disclosure ofmaterial facts and information to security holders. Their effect on international portfolioinvestment appears to be sufficiently important that the theoretical benefits may provedifficult to obtain in practice. This is, of course, the very reason why segmented marketspresent opportunities for those able to overcome the barriers.

-Taxation

When it comes to international portfolio investment, taxes are both an obstacle as well as

an incentive to cross-border activities. Not surprisingly, the issues are complex- in largepart because rules regarding taxation are made by individual governments, and there aremany of these, all having very complex motivations that reach far beyond simply revenuegeneration.

Since tax laws are national, it is individual countries that determine the tax rates paid onvarious returns from portfolio investment, such as dividends, interest and capital gains.All these rules differ considerably from country to country. Countries also differ in termsof institutional arrangements for investing in securities, but in all countries there areinstitutional investors which may be tax exempt (e.g., pension funds) or have theopportunity for extensive tax deferral (insurance companies). However, countries do nottax returns from all securities in the same way. Income from some securities tends to beexempt in part or totally from income taxes.

Interest paid on securities issued by state and municipal entities in the United States, forexample, is exempt from Federal income taxes. A number of countries, e.g., Japan,provide exemptions on interest income up to a specified amount, but only on interestreceived from certain domestic securities. Almost all countries tax their residenttaxpayers on returns from portfolio investment, whether the underlying securities havebeen issued and are held abroad or at home. This is known as the worldwide incomeconcept.

-Foreign Exchange Controls

While the effect of taxation as an obstacle to international portfolio investment is onlyincidental to its primary purpose, which is to raise revenue, exchange controls arespecifically intended to restrain capital flows. Balance of payment reasons or the effort toreserve financial capital for domestic uses lead to these controls. They are accomplishedby prohibiting the conversion of domestic funds for foreign moneys for the purpose ofacquiring securities abroad. Purchases of securities are usually the first category of

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international financial transactions to be subjected to, and the last to be freed from,foreign exchange controls. While countries are quite ready to restrict undesired capitalinflows and outflows, they prove reluctant to remove controls when the underlyingproblem has ceased to exist, or even when economic trends have rev ersed themselves.The classic example is provided by Japan where, during the early seventies, exchange

controls prevented Japanese investors from purchasing foreign securities. At the sametime, new measures were taken to prevent a further increase in Japanese liabilitiesthrough foreign purchases of Japanese securities. At times, countries have resorted tomore drastic measures by requiring residents to sell off all or part of their foreignholdings and exchange the foreign currency proceeds for domestic funds.

-Capital Market Regulations

Regulations of primary and secondary security markets typically aim at protecting thebuyer of financial securities and try to ensure that transactions are carried out on a fairand competitive basis. These functions are usually accomplished through an examining

and regulating body, such as the Securities & Exchange Board of India(SEBI), Securitiesand Exchange Commission(SEC).in the United States, or the Committee des Bourses etValeurs in France. Supervision and control of practices and information disclosure by arelatively impartial body is important for maintaining investors confidence in a market;it is crucial for foreign investors who will have even less direct knowledge of potentialabuses, and whose ability to judge the conditions affecting returns on securities may bevery limited. Most commonly, capital market controls manifest themselves in form ofrestrictions on the issuance of securities in national capital markets by foreign entities,thereby making foreign securities unavailable to domestic investors. Moreover, somecountries put limits on the amount of investment local investors can do abroad orconstrain the extent of foreign ownership in national companies. While few industrializedcountries nowadays prohibit the acquisition of foreign securities by private investors,institutional investors face a quite different situation. Indeed, there is almost no countrywhere financial institutions, insurance companies, pension funds, and similar fiduciariesare not subject to rules and regulations that make it difficult for them to invest in foreignsecurities.

-Transaction Costs

Transaction costs associated with the purchase of securities in foreign markets tend to besubstantially higher compared to buying securities in the domestic market. Clearly, thisfact serves as an obstacle to IPI. Trading in foreign markets causes extra costs forfinancial intermediaries, because access to the market can be expensive. The same is truefor information about prices, market movements, companies and industries, technicalequipment and everything else that is necessary to actively participate in trading.Moreover, there are administrative overheads, costs for the data transfer between thedomestic bank and its foreign counterpart be it a bank representative or a local partnerinstitution. etc. Therefore, financial institutions try to pass these costs on to theircustomers, i.e., the investor. Simply time differences can be a costly headache, due to thefact that someone has to do transactions at times outside normal business hours.

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-Familiarity with Foreign Markets

Finally, investing abroad requires some knowledge about and familiarity with foreignmarkets. Cultural differences come in many manifestations and flavors such as the waybusiness is conducted, trading procedures, time zones, reporting customs, etc. In order toget a full understanding of the performance of a foreign company and its economic

context, a much higher effort has to be made on the investors side. He might ace highcost of information, and the available information might not be of the same type as athome due to deviations in accounting standards and methods e.g., with regard todepreciation, provisions, pensions., which make their interpretation more difficult.

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CAPITAL FLOWS KEY ASPECTS

As an economy becomes more sophisticated, we need to recognise that as other countriesfind it profitable to invest in India, we too can benefit from selective investments abroad.

It is in this context that we have to view Indian investments abroad. It is erroneous toequate all capital outflows with capital flight. In fact, selective investments abroad whichare being progressively liberalized could ultimately make a significant contribution to theresilience of Indian industry.

Self-reliance relates more to the strengthening of the economy and building a capacity towithstand vulnerabilities to external or domestic shocks, rather than merely concentratingon achieving self-sufficiency. In other words, self reliance now acquires an outwardlooking bias rather than the earlier inward looking orientation

Traditionally, capital flow was usually in direction of relatively less developed countries

(EMEs). International capital movements should respond to differences in expected ratesof return on capital across countries, therefore typically there should be a flow from high-income countries to developing countries, boosting growth for some years and allowingdeveloping countries to run current account deficits. This trend continued for over acentury, but now some emerging market economies themselves have contributed to thesignificant increase in global liquidity by channeling their excess of domestic saving overinvestment abroad.

The World Bank (2007) reported that, since 2004, FDI flows from India into UK haveexceeded flows in the opposite direction, though a significant portion of FDI flows intoIndia from different countries are routed through Mauritius due to tax benefits.

Capital flows are known to be volatile as a shock in investing countries and those inwhich investments are made, contribute to volatility.While a country goes through the transformation, from being a developing country to arelatively developed one, a change a registered in disbursement of its capital inflows fromfiscal deficit financing or sustaining private consumption to capital formation.

Table 1:

Capital flows in EMEs: various episodes compared1In billions of US dollars Inflows Outflows Forex reserves

changeCurrent account

balance1993-96

280 110 90 -85

1997-2001

269 193 89 21

2002-07

951 818 584 429

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1 All EMEs as defined in the IMF World Economic Outlookplus Hong Kong SAR, Korea,Israel, Singapore and Taiwan (China); annual average.Sources: IMF,Balance of Payments Statistics; Central Bank of China (Taiwan).

The table makes a comparison of capital inflows and outflows of all EMEs over a periodof 44 years .Outflows as a percentage of inflows has risen from 39% in 1993-96 to 72% in 1997-2001and further increased to 86% in 2002-07.This indicates a global trend of EMEs making more and more investment abroad tosatisfy their objectives as they become economically stronger.

-Broad factors affecting investment

These factors can be observed as: External

(a) When ample liquidity is available in a country, it would push money towardsforeign investment options. The liquidity would generally be associated with a widerange of price and quantity measures of the monetary stance in industrial economies.For example: fall in interest rate in G3 countries in early 1990s and 2000s caused ahigher investment in emerging markets. However despite an increase in the realinterest rates investment may increase if they still remain comparatively low.

(b) Industrial cycle in investor country: a slow down in investor country would affectthe country in which investment is made both positively and negatively.

(c) Portfolio diversification: Risk diversification by global investor through holding

of different asset classes would in turn lead to a more stable trend growth in capitalflows to the economy.

InternalA major element that pulls international capital to the growing economies is the

higher expected risk-adjusted returns.

-Affects on financial stability of economy with composition of investment

involved:

1. Equity vs. DebtEquity form of investment serve to transfer risk to the supplier of the funds and awayfrom the user of the funds.

2. Short-term vs. Long termBorrowers reliant on long- term debt to finance long-term projects are less vulnerableto interest rate and refinancing risks.

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3. Investment vs. ConsumptionInflows associated with increased real fixed capital formation are more relevant andthus more welcomed than those used to finance private consumption.

4. Foreign vs. Domestic currency

Foreign currency inflows should be used to invest in foreign currency earning assets,otherwise the country faces currency mismatches.

-Current scenario

Indian investors are investing more and more in foreign equity and debt. RBI raisedthe limit for international investment to $200,000 a year for individuals. Indianinvestment in overseas equity and debt has immensely increased from a dismal$20/7m in 2006-07 to $144.7m in 2007-08, which has further increased to $151.4m in2008-09.According to a newspaper article, mostly equity as an asset class received a lot of

interest than debt which was mostly through Mutual Funds because there is an activefund management process.

-Analyzing the net international position

Gross foreign assets held by India are $340,264mn (Dec 08), whereas the foreignliabilities are at $420,311m which makes Indias net position at -$80,047m. Thisfigure has deteriorated from Dec 07 when Indias net position was -$73,612m,predominantly as a result of fall in portfolio investments made abroad which werevery volatile especially due to the global economic meltdown.

-Challenges faced by India in managing its capital flows:1. Ensuring stability of inflows

Controlling volatility arising due to global factors.

2. Monetary management challengeThe challenges for monetary policy with an open capital account are exacerbatedif domestic inflation rises. In the event of demand pressures building up, increasesin interest rates might be advocated to sustain growth in a non-inflationarymanner, but such action increases the possibility of further capital inflows if asignificant part of these flows is interest sensitive and explicit policies to

moderate flows are not undertaken. These flows could potentially reduce theefficacy of monetary policy tightening by enhancing liquidity.

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COUNTRY BETA & CORRELATION FOR FOREIGN INVESTMENTS

Market participants may observe that world markets have been moving in a synchronizedfashion due to technical reasons such as capital flows as well as the increasingly

interconnected nature of country-specific macro economic environments.Can we properly measure individual country risks? Or, has the country risk become lessimportant given the global roller coaster nature of the financial markets?

There are various ways and methodologies of measuring country risks. Yet as far as stockmarket movements are concerned, we should keep in mind that as markets are moreintegrated than ever, it is very likely that stocks of many of these countries will go up anddown depending on the daily momentum observed in the world markets. When Asianmarkets have a good day, it may be an extension of the good mood in the U.S., whichmay or may not be followed by European markets. The trend may continue or change

course depending on global economic developments of the day. Also percentage movesup or down are generally sharper and more volatile than those observed in the worldmarkets in general.

If you have been following a foreign market closely, you may have noticed similarobservations. Certain country performances have been more volatile than others. Also asthe global markets have become more volatile, the correlations between countries haveincreased.

- The International Capital Asset Pricing Model

In the Capital Asset Pricing Model, a stocks beta signifies the risk of that stock withrespect to the market. Beta is directly proportional to the correlation of the stock return tothat of the market as well as its relative volatility with respect to the market. Its ameasure of the stock risk for one unit of market risk. The higher the risk of stock withrespect to the market, the higher the expected compensation of the investor with respectto the particular stock.

To keep the matters simple, a high beta signifies high risk, while a low beta signifies lowrisk. The beta of the market itself is one.

The International Capital Asset Pricing Model is the extension of the Capital AssetPricing Model where the risk of a specific country can be specified in a likewise fashionwith respect to a chosen world index.

We wanted to compare the daily moves of all markets and calculate the observed countryrisks in terms of betas to see how risky one country is with respect to another. That waywe would have a valid methodology to rank countries because I could quantify marketrisks. The easiest way for us to come up with the betas was to regress the equity returnsof individual countries to the world index of my choice. We wanted to keep the variables

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as simple as possible in order to include as many countries as possible in this study. Wewished to come up with a risk-ranking system for the stock markets of all countries forwhich there is trading data available.

Calculating country betas is not the only way to compare country risks and it is entirely

dependent on past stock returns as well as the global market index returns one chooses tocompare the performances to. There are many criticisms of the beta measurement as wellas the CAPM theory in general, and I will state a few of them here. For instance, beta willvary depending on the time frame chosen, which may make it unreliable depending onthe degree of change. Beta also captures systematic risk only, and thus it may give anincomplete picture of the total risk that includes unsystematic risk.

While there is no guarantee that the future beta will look like the past data, its areasonable indicator (as good as any) of the risks one can expect in a certain market.

There are different ways of calculating country betas, and they may involve more

sophisticated models than the good-old fashioned OLS regression that readers may haveseen in an econometrics class. We wish to keep this article accessible by many, so wewill keep such terminology to a minimum. But suffice it to say that such models mayexplicitly state a countrys degree of non-integration to the world market and involvevarious country-specific factors ranging from the level of interest rates, inflation and thelike. They may also include other global information variables to further specify worldrisk.

Yet the more sophisticated the model is, the stronger the false sense of security becomesand the more difficult it is to evaluate its shortcomings. Not to mention that suchcomplexities in the model specification would have led me to decrease the number ofcountries in the study because of data issues, and the depth of the model would havenecessitated concentrating on a region or a limited number of countries. We wantedbreadth rather than depth.

So what we have done was still data intensive, but more straightforward.

-Data, Methodology and Results

We used index data available at the Standard & Poors Index Services where they keepdaily data for closing index prices of many countries for which trading data exists. Forthe series of regressions to be performed, I calculated daily returns of all countries interms of U.S. dollars.

The country betas are calculated by regressing each index return against the globalequity portfolio. Beta is estimated as the slope of the fitted line from the linear least-squares calculation.

We wanted to experiment with data that was available. Knowing that markets havebecome more volatile in the past year or more, we calculated each country beta in two

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ways: 2-year betas involved 522 observations (daily returns) covering the past two yearsfrom December 4, 2006 until December 2, 2008. 10-year betas, on the other hand,involved 2610 observations from December 2, 1998 until December 2, 2008.

Given the lack of data for some of these periods, we calculated betas for those countries

for which there were adequate observations. However, either due to lack of significant t-values to validate the beta coefficients, or due to other extraordinary issues such as thecollapse of the Icelandic market we decided to exclude these countries from the variousdata matrices we designed. Luxembourg was excluded due to the fact that the equityindex houses 10 stocks with 3 firms making up more than 60% of the index and some45% of the weighting belongs to bank stocks headquartered in Belgium, thus making thecalculated beta meaningless. (Note: the weights may have shifted but the idea is that the beta of such an index is not representing the risk associated with the country ofLuxembourg).

In order to make sure that there were no errors within the Excel regression package, we

checked the betas by multiplying the correlation coefficients of all countries (with respectto the world index) by the relative standard deviation of the each country. This was also agood way to see the composition of the beta of each country.An example of the display for the country of Brazil is given below:

Note: This regression is done with daily beta, thus the standard deviations seen aboverepresent daily numbers. Numbers are rounded to two decimal points, so if you do themath above you may find that the Brazilian beta is 1.79. This error is due to rounding.Brazilian markets indeed exhibited the highest daily beta for the last two years. Series ofregressions covering the ten-year time frame also put Brazil at the top of the list in termsof beta.

Another interesting but predictable observation is that two-year betas for almost allcountries are considerably higher than their respective ten-year betas. This is due to thefact that both correlations as well as individual country standard deviations haveincreased recently. But note that the global standard deviation placed at the denominatorhas also increased. If you look at the composition of the betas, you may see thecontribution of various parts of the equation to the betas themselves.

Notable observations include high-beta countries, specifically Brazil, Hungary andTurkey. The emerging nature of these markets attract attention, however some developedmarkets have also registered riskier betas such as Norway, Austria, Sweden. On the otherhand, Mexico, Russia and Argentina are also among the notable emerging markets withhigher than average betas. All of these high-beta countries exhibit higher correlations aswell as higher than average standard deviations.

A lot of European markets have registered a beta closer to one, which indicates that thesemarkets exhibit an average risk with respect to the rest of the world. The U.S. market

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with a beta of 1.06 seems to exhibit average risk with respect to the rest of the world aswell. However, this is mainly due to the fact that American stock market is the largestconstituent of the global market index. Indeed, when the U.S. stock returns are regressedagainst a global index that excludes the U.S., the resulting beta is 0.57 with an observedcorrelation of 0.49 as opposed to the high correlation of 0.84 of the original regression.

This indicates that the U.S. market beta above is overstating the U.S. market risk.According to the beta of the second regression, the U.S. is actually towards the bottom ofthe list of these countries.

Asian countries are the winners of this exercise in terms of lower risks associated withtheir markets. It is remarkable that some of the emerging markets of the Asian regionhave registered lower betas associated with a lower degree of risk, among them Thailand,Philippines, Taiwan, and Malaysia. Hong Kong showed a lower beta than we expected,and the presence of Japan towards the bottom of the list with a beta of 0.41 was anothersurprise for us.

Among the lower beta countries were those of the Middle East and North Africa, namelyIsrael, Egypt, and Morocco. We must add that Jordan, Pakistan, and also Nigeria wouldhave made it into the bottom of the list if we had included the results we were able getfrom the regressions we ran (notwithstanding some insignificant t-statistics associatedwith the regressions). We may include these countries in a following write-up if I am ableto get hold of more complete data sets.

Ten-year table country betas are strikingly lower than their respective two-year betas.There are a few exceptions: Finland occupies the second place in the ten-year list with abeta of 1.29 whereas during the last two years, its beta has decreased to 1.10 placing ittowards the middle of the same list. Even more interesting is the fact that Israel registereda beta of 0.78 for the last ten years whereas its beta has fallen to 0.42 during the presenttime when the world has become a more volatile place. Japan seems to have resisted thetrend somewhat but its ten-year beta of 0.46 is not strikingly different from its two-yearbeta of 0.41.

Brazil occupies the first place in both tables as the riskiest of the bunch. Furthermore, aquick look at the former ranks at the ten-year table shows that Turkey, Hungary, Russia,and Norway have gained significant risk in terms of their respective betas during the lasttwo-years. Turkey and Russia deserve extra attention in terms of their standard deviationsfor the last ten years. Despite the fact that Turkey registered the highest daily standarddeviation of 3.33% during the last ten years, its relatively low correlation of 0.32managed to keep the country from occupying a higher rank. This was also true for Russiawho had the second highest standard deviation of 2.65% and a somewhat lowercorrelation of 0.41. However, during the last two years, the correlations of these twocountries have increased to 0.69 and 0.62 respectively, thus placing their betas higher onthe two-year list.

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The higher beta associated with the U.S. is misleading in this list as well. Indeed, whenten-year U.S. returns are regressed against global returns excluding the U.S., the resultingbeta is 0.57 (same as the two-year beta) with a correlation coefficient of 0.46.Asian countries occupy lower ranks in the ten-year list as well. Among them areemerging (or so classified) markets of India, Indonesia, Thailand, Taiwan, Philippines,

and Malaysia, besides the developed markets of Japan, Hong Kong, and New Zealand.Egypt and Morocco occupy the last two places in the ten-year list similar to the patternobserved in the two-year list.

-Conclusion

An obvious conclusion of this exercise is that country risks have increased over the pasttwo years when compared with ten years of data.

It would be interesting to do the same study with weekly or monthly data as well, andperhaps by going back further in time. However, going back further in time risks

capturing certain fundamentals or situations that no longer exist in todays marketplace.Increased correlations due to the effects of globalization are examples of suchfundamental or regime changes.

Another notable observation of this exercise is that certain countries manifest higher riskthan others on a consistent basis. The results of this exercise have captured what has beenfamiliar to careful observers of world markets.

As the Capital Asset Pricing Theory suggests, higher risk results in higher returnexpectations on the part of investors. Thus a higher risk should be evaluated according toreturn expectations of these countries. Conclusively, it may be a valid decision to investin countries (or stocks) that exhibit higher levels of risk depending on long-term growthexpectations, cheap valuations exhibited by fundamentals, or both.

Yet another remarkable observation of this exercise is that there are emerging marketswith higher expectations of return that also manifest lower risk. Certain emergingmarkets of Asia as well as North Africa and the Middle East have exhibited lower risks asmeasured by their betas.

An inference of this study (or so we reckon) is that if all else is equal, it is more advisableto invest in nations with higher than average growth potential that also show a low degreeof risk with respect to the world markets. The diversification effects are also valuable. Ofcourse, all else is never equal and such quantitative studies should always becomplemented by fundamental analysis as well as due diligence.

A disclaimer related to this exercise should be announced in the sense that todays high-risk countries may become tomorrows low-risk ones as well. Nevertheless, given whatwe can observe in the world markets today, investors should evaluate whether their returnexpectations are worth the risks.

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SOVEREIGN WEALTH FUND (SWF) AND INTERNATIONAL PORTFOLIO

A sovereign wealth fund (SWF) is a state-owned investment fund composed of financialassets such as stocks, bonds, property, precious metals, or other financial instruments.

Sovereign wealth funds invest globally. Some of them have grabbed attention makingbad investments in several Wall Street financial firms including Citigroup, MorganStanley, and Merrill Lynch. These firms needed a cash infusion due to losses resultingfrom mismanagement and the sub prime mortgage crisis.Some sovereign wealth funds are held solely by a central bank, which accumulate thefunds in the course of their management of a nation's banking system; this type of fund isusually of major economic and fiscal importance. The accumulated funds may have theirorigin in, or may represent foreign currency deposits, gold, SDRs and InternationalMonetary Fund reserve positions held by central banks and monetary authorities, alongwith other national assets such as pension investments, oil funds, or other industrial andfinancial holdings.

The reason why sovereign wealth funds came into limelight for its international portfolioconstruction was when suddenly many major funds like those of Kuwait, Norway andchina which suffered in hands of the global meltdown and suffered drop in performance.Overall performance for international institutional investors during 2008-09 fell.In the face of this systematic crisis, which has affected even large institutional investors,many traditional investment methods have been invalidated. Strategies that were effectiveand complementary under normal conditions did not work this time.

These included the Assets allocation strategy, investment strategy and investment portfolios

The use of Beta and Alpha investment strategies Strategies for hedging against inflation and deflation.

All we see is one result: a slumping stock market and most companies sufferingenormous losses or even bankruptcy, affecting Wall Street as well as Main Street.Among major institutional investors, mutual funds and pension funds have suffered thelargest losses, as their strategies are based on diversification, also known as passiveinvestment. Comparatively, as sovereign wealth funds and donations funds took ratheractive management and larger adjustment, losses were overall less severe.For example, the Norwegian pension fund enjoyed sound investment returns for years buthit a negative return at -23.3 percent in 2008, a loss about US$ 90 billion. All investment

earnings since the fund was established 12 years ago suddenly evaporated. Indeed, only 1percent hedge funds made money by adopting some unusual strategies.Among investment types, only government bonds issued by developed countries wereprofitable last year, as they served as a temporary safe harbor that raised values.Regarding the performance of sovereign wealth funds them as a model system formanaging sovereign assets and during a half-century of development, sovereign wealthfunds have contributed to their home countries as well as the countries targeted by their

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investments. They are long-term investors and pursue long-term returns with a capacityfor controllable risk.

In this section we try and study how one of the worlds biggest SWF china investmentcorporation allocates its funds and manages its risks in its international portfolio

management.

China Investment Corporation (CIC) is a sovereign wealth fund responsible for managingpart of the People's Republic of China's foreign exchange reserves. CIC was establishedin 2007 with approximately US$200 billion of assets under management, making it oneof the largest sovereign wealth funds. Since then, CIC's assets have grown to $298 billion

at the end of 2008.

CICs mission is to diligently seek long-term investments that maximize returns whilemaintaining a rigorous approach to managing risks for the benefit of shareholders. Thus,through its management style, CIC sticks with a commercial orientation that maximizesfinancial returns. In terms of risk tolerance, CIC can afford rather high, short-term riskfluctuations to maximize long-term returns.

In strategic assets allocation, CIC is more aggressive than traditional central banks inmanaging forex reserves by investing both traditional equity and fixed-incomeinvestments that have rather low liquidity but are forecast for rather high investment

returns.

Affected by limited talent and capital, CIC developed an investment strategy based onan investment approach that is a mixture of international financial products, with mostassets invested in public market products and the rest invested in alternative assets.Meanwhile, direct investment should not be abandoned. Investments are mainly madethrough external fund managers with a gradual increasing weight of proprietaryinvestments.

In the past year, the global financial crisis has had impact on the immature CIC in termsof all its businesses, especially overseas financial products investments. But CIC is young

and has a relatively limited investment volume at this early stage.

Meanwhile, studying some of the material we can on CIC and based on our talks we haveobserved that it has worked hard to analyze and understand the global financial marketand macroeconomic trends. The fund made timely adjustments to annual assets allocationby slowing equity-product investments and ensuring a prudent, cash-management-ledinvestment strategy esp. In the wake of the global economic slowdown. The fund holds arather high percentage of cash assets to prevent major risk and losses.

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Overall CIC posted minor, book-value losses for outsourced investment in 2008. Butoverall financial conditions were stable and basically met the goals set in early 2008 bythe board of directors. Its financial conditions were far better than for some othersovereign wealth funds.

In addition, CIC has strengthened its corporate governance system to provide the skillsand supervisory mechanism for managing market risks.

CIC established clear investment guidelines, a risk framework, governance structure, andoperational mechanism by using all kinds of resources to ensure systemized riskmanagement. Since its establishment, CICs operations have been based on economic andfinancial interests.

One thing that deserves emphasis is that CIC seeks financial returns for outsourceinvestments; it does not take over companies or resources. CIC hopes to achieve win-win

solutions so that the fund receives necessary investment returns, while the companies thatreceive its investments can develop and benefit, making CIC a fund thats welcomed bygovernments.

-Investments

China has invested two-thirds of its reserves in US dollars, mostly US treasury bonds andagency bonds. The US dollar's devaluation on world currency markets has provided poorreturns, prompting the Chinese to create the CIC to manage China's investment inequities.

Credit Suisse predicted CIC would only take a 5-10% stake in each company, remaininga passive investor to avoid political hassles in overseas markets. CIC bought a $3 billionstake in Blackstone, one of the largest US private equity firms. CIC has refrained frominfluencing Blackstone's investment strategy. The company will mainly pursue combinedinvestments in overseas financial markets.

CIC is thought to engage in building influence for the government by buying upsignificant stakes in companies that have influence in western governments includingairline companies as also target firms that have heavily invested in China. Theinvestments would help the government to influence the policies of multinationalcompanies and to protect China's interests in international spheres.

Market watchdogs want to know what would happen if China, Russia and Arab countrieswere to systematically acquire significant holdings in sensitive industries such astelecommunications, energy and defense. Based on our readings we can say that it could prove difficult to draw the line between sound government policies and neo-protectionism.

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The new fund has been placed under the authority of Chinese Premier Wen Jiabao. Louhas been assigned the rank of a minister. During daily operations, he will answer to a hostof other agencies, including the powerful National Development and ReformCommission, a successor to the former influential State Planning Commission. Lou saidCIC will operate on the principle of "commercial operation", and will abide by local laws

of countries where it invests.Based on some reports published earlier some state owned company will invest $67bn tobuy the assets of Central Huijin, the investment arm of the central bank which holdsshares in most state-run banks. It was later reported that Huijin was acquired by CIC fromthe State Administration of Foreign Exchange for $200 billion.China's leadership has debated the right strategy for the government investment fund.Vice PremierZeng Peiyan has suggested that China should invest in natural resources toincrease its strategic reserves. Other high-ranking party officials would rather see thecountry acquire shares in high-tech companies to help China more rapidly close the gapwith leading industrialized nations.

Three years ago, dealers working for China Aviation Oil in Singapore, China's solesupplier of aviation fuel, suffered losses of $500 million from miscalculations and risingoil prices. Last year, news leaked out that the former head of the Communist Party inShanghai and his subordinates had illegally siphoned off hundreds of millions of dollarsfrom the state pension fund and channeled the money into projects run by corporatecronies.CIC bought a US $3 billion stake of Blackstone Group in June and a 9.9% stake ofMorgan Stanley worth US$ 5 billion on December 19, 2007.The Chinese Internet community regularly vents its anger over government losses of thepeople's money, and there is widespread skepticism among Chinese party leaders and the public over the extent to which the country should get involved in global equitiesinvestments Western investment banks Goldman Sachs and Morgan Stanley will provideexpert knowledge to China's state-sponsored venture capitalists.On March 2, 2009, Chinese media reported that the CIC was shifting its investmentstrategy to focus more on real estate, resources, and other areas more tied to the "realeconomyOverall as we can observe through the details are rather sketchy with the deals being keptsecret china has followed the policy of avoiding systematic risks by carefully investing inhigh beta countries like US in large number and complimenting it with investments ineuro zone and now moving to real economy by investing in real assets they are trying tospread their risk and lock in their earnings in direct proportion to that of the real growthof highly lucrative yet volatile industries like real estate, natural resources in Africa andmiddle east and infrastructure bonds in developing countries.

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PORTFOLIO ANALYSIS

Based on our study, we analysed the portfolio of Birla Sun Life Opportunity A-G mutualfund, which served as a perfect example of an internationally diversified portfolio.

Following are our findings in relation to the investment pattern of the fund.In Asia, out of the 8 foreign equities in which the mutual fund have invested, 4 are fromChina, having 2-year country beta 1.02, which cater to the Infrastructure, Telecom & OilSector(China Oilfield Services, the Stock that earned Warren Buffet Billions) in China, basically the sectors catering to the mass markets. In rest of Asia, other than 2investments in Hong Kong in major Infrastructure Companies which alone constitute10% of the the top 25 holdings, there is investment in 2 Manufacturing Companies, inTaiwan (country beta .48) & India.

Most of the funds investments are concentrated in North America, which alone

constitute 38% of the top 25 holdings, with 10 equity investments in USA & 1 in Texas.In the USA, its investment is quite diversified in terms of the sectors invested in, as itsinvestment in the USA range from FMCG & healthcare to Software & Capital GoodsIndustry. In Texas, it has invested in Exxon Mobil Corporation.

Coming to Europe, which have only 4 equity investments out of the 25 top holdings, have2 investments in Industrial Goods Sector & 1 each in Health-Care & FMCG. Till31/07/2009, all these 4 holdings of the fund were green showing the fact that the fundmanager has been very selective in terms of the quality of Investment in Europe,carefully doing the EIC analysis & properly analyzing the most rewarding sectors of eacheconomy.

In rest of the world, it has invested in Middle-East in a Pharmaceutical Company, well-established for long, in Israel(country beta .42) & largest Banking Company of Brazil, acountry which has the highest beta on our list of 1.80, but both these stocks were in greentill 31/07/2009 according to the Portfolios report.

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Table: Region-wise Investment Percentages

Country Region

Europe 4 13.

North America 11 27.

Asia 8 24.

Middle East 1 4.South America 1 2.

72.

Europe 18.6%

North America 37.6%

Asia 34.4%

Middle East 5.6%

18.6%

37.6%

4.4%

5.6%

3.9%

Europe

North Ameri

Asia

Middle East

South Ameri

Sector Weightings

As on 31/07/09% Net Assets

FMCG 13.11

Financial 12.40

Diversified 7.09

Construction 3.49

Energy 3.36

Chemicals 2.64

Cons Durable 2.60

Metals 2.24

Textiles 1.55

Engineering 1.49

-For the list of holdings, please refer to Appendix-5.

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That way, sudden and unexpected stock market downturns wont do you muchharm; at the same time, you give yourself some chance of gaining from the nextworld changing technological breakthrough or from Harry Potters successor.

Fund managers can benefit from "skewed bets, that is, to try to benefit from rareevents, events that do not tend to repeat themselves frequently, but, accordingly,present a large payoff when they occur. Simply because rare events are not fairlyvalued, and that the rarer the event, the more undervalued it will be in price."

So portfolio managers must actually try to benefit from the rare events, not avoidthem. This can be done by placing bets on rare events with a large payoff. And thiscan further be synthesized by doing a country correlation risk analysis as discussed inother sections and using mathematical modals like CAPM to understand and derivethe basic thrust of investments.

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BIBLIOGRAPHY

-E-books

International Portfolio Investment: Theory, Evidence & Institutional Framework

(Sohnke M. Bartram and Gunter Dufey)

Asymmetric risk and international portfolio choice (Susan Thorpe and George Milinthropovich)

Sources of Gains from International Portfolio Diversification (Jose Manuel Campa & Nuno Fernandes)

Black swan ( Nassim Nicholas Talib)

-Websites

http://www.china-inv.cn/cicen/investment/investment_investment.html

http://www.sovereignwealthfundwatch.com/

http://www.bis.org/publ/bppdf/bispap44m.pdfhttp://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=57

http://www.rbi.org.in

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APPENDICE

APPENDIX-1: CAPM MODEL AND OTHER COMPONENTS

The transfer of the CAPM logic to a global perspective leads to the International Capital

Asset Pricing Model (ICAPM), which can be formally stated as:

[ ] =

++=K

k

Kik

ww

ifi RPyRPBRRE1

{whereRPw andRPkare the risk premia on the world market portfolio and the relevantcurrencies, respectively;RFis the risk-free interest rate.}

It rests on the assumption that investors make investment decisions based on risk andreturn in their home currency. Although this approach seems to be straightforward, thereare subtle problems inherent in the ICAPM, because of the likelihood that many of the

assumptions underlying the national market CAPM become very tenuous in aninternational context.

Over time, more sophisticated models have been developed to accommodate specialfactors of the international context or to improve the realism of the model in general.Whereas the traditional CAPM is based on constant values for the parameters of equities(expected) return and variance, there exists increasing evidence to support the hypothesisthat these characteristics are time-dependent. Therefore, conditional models have beenused to model time-variant measures, i.e., expected return and variance are not assumedto be constant over time. This is because of the assumption that historical information andpossibly expectations about interest rates, equity prices etc. are available to the investor,

which means in technical terms that, e.g., the estimated conditional variance for time t-1depends on the information set available at time t.

The simplest of these models are autoregressive conditional heteroscedasticity (ARCH)models, in which the conditional variance is calculated as a weighted average of pastsquared forecasting errors. In generalized ARCH or GARCH models, the conditionalvariance depends on past error terms as well as on historic conditional variances.

Overall, empirical evidence for an international CAPM is mixed, although there seems tobe increasing support for this concept. The Approaches taken include conditional andunconditional models and the use of instrumental variables and Generalized GARCH-M

methods. Testing the ICAPM is difficult because:

1. There is limited long-term historical data available on international capital markets;2. An international benchmark portfolio is hard to specify; and3. It is a challenge to capture the time-variation of the securities characteristics.

Beta is a measure of the extent to which the returns of a given stock move with the stockmarket. (i.e. market risk)

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i

i im

m

=

Or

2

covimi

m

=

{Where, the Greek letterrho, ( im), is the correlation coefficient for the stock i and themarket m.

covimim

i m

= }

Therefore, the formula for the covariance of the stock with the market cov im is:

covim im i m =

Beta measures only systematic risk, while standard deviation is a measure of total risk(systematic or market risk, and unsystematic risk, the risk of the security)

The calculation for the estimated standard deviation is given below:

( )2

1

1

n

t

i

r r

n =

=

This is used to find out the total returns we can generate out of a given portfolio.For example as given below we have tried to find out the returns that we can generatefrom a hypothetical portfolio with international exposure.

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APPENDIX-2: OPTIMAL INTERNATIONAL PORTFOLIOS

Portfolio theory, developed by Harry Markowitz (Nobel Prize 1990), can be used todetermine the optimal intl. portfolio, taking into account risk-return trade off.

For U.S., mean monthly return is 1.26% (15.12%/year), risk = std. dev = 4.43%. Cross-country correlations with U.S. range from .29 (Italy) to .74 (Canada). Notice U.S. vs.Netherlands (.62). Netherlands has much higher correlation on average than U.S. Why?High Degree of internationalization in Dutch economy. Neighboring countries havehigher correlations [US and Canada (.74) vs. US and Italy (.29)] than countries far away.Highest return? Sweden (1.71) Highest risk? Hong Kong.

World Beta is given for each country, measures the co-movement between the returns ina country's stock market with the returns for the world stock market returns.

Beta = % Change in a Country's Stock Market

% Change in World Stock MarketBeta for U.S. market is .86, means that when the world stock market goes up (down) by10%, the U.S. market goes up (down) by 8.6% (-8.6%). Betas range from .85 (Switz.) to1.20 (Japan). Japan's market is most sensitive to world market. And U.S. and Switz. areleast sensitive.

The Sharpe ratio calculates the per unit average return over and above the risk-free rate ofreturn for the portfolio. The Sharpe ratio measures how much excess return (return abovethe risk-free rate) an investor each per unit of portfolio risk.

The formula for the Sharpe measure is shown below:

i f

i

i

R RSharpe measure SHP

= =

The Treynor measure looks at the systematic risk of the portfolio (beta) and compares itto the world market. The formula for the Treynor measure is shown below:

i f

i

i

R RTreynor measure TRN

= =

To illustrate its application we give below a hypothetical example of hong kong and howusing its different indicators we arrive at our decision.

Country Mean return rf

Hong Kong 1.5% 9.61% .42% 1.09

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1.5% .42%0.113

9.61%i f

i

i

R RSharpe measure SHP

= = = =

1.5% .42%0.0099

1.09

i f

i

i

R RTreynor measure TRN

= = = =

The risk-free rate is the annual risk-free rate of 5% divided by 12, (.42%).

From the above we can observe that the country with the highest Sharpe and Treynormeasures have the best reward for the risk.

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APPENDIX-3: TABLE-1 COUNTRY BETAS: TWO YEAR RETURNS

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TABLE-2 COUNTRY BETAS: TEN YEAR RETURNS

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APPENDIX-5: LIST OF TOP HOLDINGS OF THE PORTFOLIO

Top Holdings As on 31/07/09

Name of Holding Instrument % Net Assets

MTR Corporation (HK) Foreign - Equity 4.37

Taiwan Semiconductor Manufacturing (Taiwan) Foreign - Equity 4.30

Nestle S.A (Switzerland) Foreign - Equity 4.27

Coca Cola Co. (US) Foreign - Equity 4.08

Teva Pharmaceutical Industries (Israel) Foreign - Equity 4.07

China Construction Bank Corporation Foreign - Equity 3.83

Pride International Inc (US) Foreign - Equity 3.66

Statoilhydro Asa (Norway) Foreign - Equity 3.33

Bayer (Germany) Foreign - Equity 3.31

Wharf Holdings (HK) Foreign - Equity 3.26

Procter & Gamble (USA) Foreign - Equity 3.15Itau Unibanco Holding SA Foreign - Equity 2.80

Ind.& Commercial Bank of China Foreign - Equity 2.68

Akzo Nobel Nv (Sweden) Foreign - Equity 2.64

China Mobile Foreign - Equity 2.60

Northrop Grumman Co. (US) Foreign - Equity 2.58

Noble Corporation (US) Foreign - Equity 2.29

Sterlite Industries Foreign - Equity 2.24

Microsoft Corportion (US) Foreign - Equity 2.22

Oracle Corporation (US) Foreign - Equity 2.15

Wal-Mart Stores (US) Foreign - Equity 2.09

Aetna Inc New (US) Foreign - Equity 1.75

Foster Wheeler AG (Foreign) Foreign - Equity 1.69

China Oilfield Services Foreign - Equity 1.69

Exxon Mobil Corporation (Texas) Foreign - Equity 1.64

Indicates an increase or decrease or no change in holding since last portfolioIndicates a new holding since last portfolio

international portfolio management final

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