Transcript MSF-CHP25

International Diversification
Chapter 25
McGraw-Hill/Irwin
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
Background
DCs are defined as developed (high income)
countries with per capital exceeding $9,300
(in year 2000).
EMs; Active portfolios will include many
stocks and indexes of EMs. 20 EMs made up
of 16% of the world GDP, together with 25
DCs make 95% of GDP.China, Brazil and
Korea are the largest EMs in the world.
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Largest markets in the world are; U.S,
Japan, UK, France, Germany and
Switzerland. Global market
US Market is 40% - 49% of all markets
Improved access & technology
New instruments
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Issues
What are the risks involved in
investment in foreign securities?
How do you measure benchmark
returns on foreign investments?
Are there benefits to diversification in
foreign securities?
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Foreign Exchange Risk
Foreign Exchange Risk
Variation in return related to changes in
the relative value of the domestic and
foreign currency.
Total return = investment return & return
on foreign exchange
It’s not possible to completely hedge a
foreign investment.
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Returns with Foreign Exchange
Return in US is a function of two factors:
1. Return in the foreign market
2. Return on the foreign exchange
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Returns with Foreign Exchange: Example
Condition: U.S. Investor invests in the British
Market
Initial Conditions:
Initial Investment : $20,000
Initial Exchange: $2.00/ Pound
Initial Investment in Pound: 10,000
Risk Free Rate in U.K.: 10%
Future Value in Pound : 11,000
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Returns with Foreign Exchange
Pound Depreciates to $1.80
11,000 * 1.8 = $19,800
Return in US$ (-200 / 20,000) = -1%
Pound Remains at $2.00
11,000 * 2.0 = $22,000
Return in US$ (2,000 / 20,000) = 10%
Pound Appreciates to $2.20
11,000 * 2.20 = $24,200
Return in US$ ( 4,200 / 20,000) = 21%
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Returns with Foreign Exchange
Movements in foreign exchange can have a
major influence
From Figure 25.2
New Zealand nearly 50% of return is from foreign
exchange
Australia virtually all of the return is from foreign
exchange
Returns from U.K. and Switzerland are mostly
from returns in local currency
Both factors must be considered in
international investing
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Country Specific Risk
Political Risk Services Group Ratings
Rank countries with respect to political
risk, financial risk and economic risk
Assign composite rating from very high
risk to very low risk based on the above
elements of risk
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PRS Risk Variables
Political Risk Variables
Government stability, corruption etc
Financial Risk Variables
Foreign debt (%GDP), Exchange rate
stability etc
Economic Risk Variables
GDP per capita, annual inflation etc
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Diversification Benefits
Evidence shows international
diversification is beneficial.
It’s possible to expand the efficient
frontier above domestic only frontier.
It’s possible to reduce the systematic
risk level below the domestic only level.
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Gains From International Diversification
Int’l
Return
** *
*
*
*
*
Dom
*
Risk
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Systematic Risk Level with International
Risk
Dom
Int’l
Securities
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International Investment Choices
Direct stock purchases
Depository receipts
Investment companies
Open-end funds
Closed-end funds
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Is Exchange Rate Risk is Important in Inter Portfolios
Changes in Exchange rates are not
highly correlated across countires.
When int port are well diversified, the
exchange rate risk can be diminished.
Hedging currency is not a significant
issue in diversification.
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Benefits from Int Diversification
Correlations of retuns in US dollars
(when currency risk is not hedged) and
correlations of returns in local currency
(when the exchange risk is hedged) are
very similar, then hedging is not a
significant issue in diversifying
internationally. (Table 25.11)
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Measuring Benchmark Returns
EAFE Index
Other possibilities
Country and Region Funds
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Performance Attribution with International
Currency selection: contribution of the
exchange rate fluctuations relative to a
benchmark currency.
Country selection: cont. of investing better
stock markets of the world.
Stock selection: measured as the weighed
ave. Of the stock returns in excess of the
equity index.
Cash and bond selection
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