Transcript Risks in International Investing

Chapter 19
Globalization
and
International
Investing
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
19.1 Global Markets for
Equities
19-2
Background
• Global market
– US stock exchanges make up approximately
40% of all markets
– Emerging market development
– Market capitalization and GDP
19-3
Stock Market Cap Developed
Countries
19-4
Stock Market Cap Emerging
Markets
19-5
Per Capita GDP and Market Capitalization
as a % of GDP Log Scale, 2003
19-6
Per Capita GDP and Market Capitalization
as a % of GDP Log Scale, 2007
19-7
19.2 Risk Factors in
International Investing
19-8
Risks in International Investing
• What are the risks involved in investment
in foreign securities?
– Exchange rate risk
– Country specific risk
19-9
Exchange Rate Risk
• Variation in return related to changes in
the relative value of the domestic and
foreign currency
• Total Return is a function of
1. Investment return &
2. Change in the value of the foreign currency
19-10
Returns with Foreign Exchange
E1
1  r(US)  [1  r(For)] 
E0
r(US) = return on the foreign investment in
US Dollars
r(FM) = return on the foreign market in local
currency
E0 = original exchange rate
E1 = subsequent exchange rate
19-11
Return Example: Dollar
Depreciates Relative to the Pound
E1
1  r(US)  [1  r(For)] 
E0
If you invest in a British Security and earn 10%,
find the return in US Dollars given:
Initial Exchange rate : £ = $2.00
Final Exchange rate: £$2.10
= $2.10
1  r(US)  1.10 
$2.00
r(US )  15.5%
19-12
Return Example: Dollar
Appreciates Relative to the Pound
E1
1  r(US)  [1  r(For)] 
E0
If you invest in a British Security and earn
10%, find the return in US Dollars given:
Initial Exchange rate : £ = $2.00
Final Exchange rate: £ = $1.85
$1.85
1  r(US)  1.10 
$2.00
r(US )  1.75%
19-13
Figure 19.2 Stock Market Returns in US
Dollars and Local Currencies for 2007
19-14
Table 19.3 Rates of Change in the US Dollar
Against Major World Currencies, 20032007(monthly data)
19-15
The Carry Trade
• Suppose the yen LIBOR = 0.24% and U.S.
$ LIBOR = 3.75%.
• An astute investor may borrow yen at the
yen rate, convert the borrowed funds to
dollars and invest at $ LIBOR.
• What can go wrong with this strategy?
– Default
– Yen increases in value by  3.75% - 0.24% =
3.51% or more.
19-16
Covered Interest Arbitrage (1)
U.S. interest rates are 6.15% and British interest
rates are at 10% when the exchange rate is
$2.00 / £. The one year forward exchange rate
for the pound is $1.95/£.
• How can you earn a riskless arbitrage profit
based on these quotes?
1.Borrow $1 at 6.15%: Will owe $1.0615 in one year
2.Convert $1 to pounds: $1 / $2.00/£ = £0.50
3.Invest £0.50 at 10%: Will yield £.50 x 1.10 = £0.55.
4.Sell pound forward at $1.95: £55 x $1.95 = $1.0725
5.Net: $1.0725 - $1.0615 = $0.011 / dollar
19-17
Covered Interest Arbitrage (2)
U.S. interest rates are 6.15% and British
interest rates are at 10% when the exchange
rate is $2.00 / £. The one year forward
exchange rate for the pound is $1.90/£.
• How can you earn a riskless arbitrage profit
based on these quotes?
1.Borrow £1 at 10%: Will owe £1.10 in one year
2.Convert £1 to $ at $2.00/£ = $2
3.Invest $2 at 6.15%: Will yield $2 x 1.0615 =$2.123
4.Buy pound forward at $1.90: Will cost £1.10 x $1.90
= $2.09
5.Net profit = $2.123 - $2.09 = $0.033
19-18
Covered Interest Parity
The spot-futures exchange rate relationship
that prevents arbitrage opportunities.
1  r(US)
F1

1  r(For)
E0
If the interest rates and exchange rates are
in this relationship no arbitrage is possible.
19-19
Other Risks in International
Investing
• Imperfect exchange rate risk hedging
– Difficult to hedge out equities with variable
rates of return
• Country Specific Risk
– Composition
• Political
– Unfavorable regulations or rules changes
» Taxes on withdrawals, expropriation, repatriation
restrictions, etc.
19-20
Other Risks in International
Investing
• Country – Specific Risk
– Composition
• Macro Financial Risk
– Ability to pay its debts, domestic and foreign
• Economic
– Growth rate, stability and vulnerabilities
• Data availability problems can be severe
– Composite Ratings
• Political Risk Services (PRS) publishes the
International Country Risk Guide and rates
countries from 0 (most risky) to 100 (least risky)
19-21
Variables Used in the
PRSs Political Risk Scores
19-22
Composite Ratings for July 2008 vs
August 2007
19-23
Current Risk Ratings
and Composite Forecasts
19-24
Political Risk by Component
July 2008
19-25
19.3 International Investing:
Risk, Return, and Benefits
From Diversification
19-26
International Investment
Choices
• Direct Stock Purchases
– Difficult for individual investors due to
currency and tax issues.
• Mutual Funds
– Open End
• World versus international funds
• Higher expenses
– Closed End
• Country or regional funds
– WEBS
19-27
Questions on Assessing
Performance in US Dollars in
Foreign Markets
• Are emerging markets riskier?
19-28
Annualized Standard Deviation of
Investments Across the Globe ($ returns)
19-29
Figure 19.4 Betas of country returns in $
19-30
Questions on Assessing
Performance in US Dollars in
Foreign Markets
• Are average returns higher in emerging
markets?
19-31
Figure 19.5 Average $ excess returns
1999-2008
19-32
X-Section Country Monthly Return
Stats
19-33
Questions on Assessing
Performance in US Dollars in
Foreign Markets
• Is exchange rate risk important in
international portfolios?
19-34
Standard Deviation of Investments Across
the Globe in US Dollars versus Local
Currency
19-35
Beta in $US versus Local
Currency
19-36
Correlation of Returns in $US and Local
Currencies 1999 - 2008
19-37
Avg. monthly returns in $ and local
currency 1999-2008
19-38
Questions on Assessing
Performance in US Dollars in
Foreign Markets
• Are there diversification benefits to
international investing?
19-39
Diversification Benefits
• Evidence shows international
diversification is beneficial
• Possible to expand the efficient frontier
above domestic only frontier
• Possible to reduce the systematic risk
level below the domestic only level
19-40
International Diversification. Portfolio
Diversification as a Percentage of the Average
Standard Deviation of a One-Stock Portfolio
19-41
Hedged & Unhedged Correlations
19-42
Ex Post Efficient
Frontier of Country Portfolios 1999-2003
19-43
Figure 19.12a Efficient Frontier of Country
Portfolios (world expected excess return =
.3% per month)
19-44
Figure 19.12b Efficient Frontier of Country
Portfolios (world expected excess return =
.6% per month)
19-45
Are diversification benefits preserved in bear
markets?
19-46
Figure 19.13A Regional Indexes Around
the Crash, October 14 – 26, 1987
19-47
Figure 19.13B Beta and  of portfolios against
deviation of month return from Sep-Dec 2008
from avg. 1999-2008
19-48
Conclusions
• A passive investment in all countries would not
have lowered risk at all during the recent crisis.
• Hedging currencies has little effect either. A U.S.
stock market crash appears to be a systemic
factor that cannot be diversified away from in a
crisis.
• Correlations are on the increase due to
globalization, nevertheless we still expect
modest international diversification benefits in
normal markets.
19-49
19.4 How to Go about
International
Diversification and the
Benefit We Can Expect
Choosing a Practical Internationally
Diversified Portfolio
19-50
 of various portfolios
19-51
Active Management
• First level:
– Security selection and asset allocation within
each market to identify a country portfolio
superior to country index.
• Second level
– Optimize allocations across country portfolios
to maximize diversification.
19-52
Monthly Returns & Performance for
Index Portfolios 1999-2008
19-53
19.5 International Investing
And Performance
Attribution
19-54
Performance Attribution
• The “Bogey” or benchmark
– EAFE index (non-U.S. stocks)
• Currency Selection
– Contribution to performance due to currency
movements
• Country Selection
– Contribution to performance due to choosing
better performing countries
19-55
Performance Attribution
• Stock Selection
– This ability is measured as the weighted
average of equity returns in excess of the
equity index in each country.
• Cash / Bond Selection
– Excess return due to weighting bonds and
bills differently from benchmark weights.
19-56