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International Investing

Department of Banking and Finance. SPRING 200 7 -0 8. International Investing. by Asst. Prof. Sami Fethi. Background. Global Market US Market is approx. 50% of all markets Improved access & technology New Instruments Emphasis for our investigation Risk Assessment Diversification.

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International Investing

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  1. Department of Banking and Finance SPRING 2007-08 International Investing by Asst. Prof. Sami Fethi

  2. Background • Global Market • US Market is approx. 50% of all markets • Improved access & technology • New Instruments • Emphasis for our investigation • Risk Assessment • Diversification

  3. 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?

  4. Risks in International Investing: Foreign Exchange • Exchange rate: The rate at which domestic currency can be converted into foreign currency Exchange Rate Risk • Variation in return related to changes in the relative value of the domestic and foreign currency • Total Return = Investment return plus return on foreign exchange • Not possible to completely hedge a foreign investment

  5. Example 1-Exchange rate risk • Consider an investment in risk-free government bill paying 10% annual interest in British pounds. Suppose the current exchange rate is $ 2 per pound, and the US investor starts with $20,000. • What happens if the dollar-pound exchange rate varies over the year?

  6. Solution 1-Exchange rate risk • The amount can be exchanged for £10,000 and invested at a riskless 10% rate in the UK to provide £11,000 in one year. The depreciation of pound to dollar is 1.80. • 10000(10%)=1000 total; £11000 11000(1.80)=£19800 $ 200 relative to $20000 200/20000=0.01 or 1%.

  7. Example 2-Exchange rate risk • Using the figures in example 1, calculate the rate of return in dollars to a US investor holding the British bill if the year-end exchange rate is; • A) E1=$2.00/£ • B) E1=$2.20/£

  8. Solution 2-Exchange rate risk • The following formula can be applied: (1 + rUS) = [1 + rUK]E1 /Eo • A) (1 + rUS) = [1 + 0.1]2 /2 rUS=1.1-1.0=0.1 or 10% • B) (1 + rUS) = [1 + 0.1]2.20 /2 rUS=1.21-1.0=0.21 or 21%

  9. Example 3-Hedging Exchange rate risk • Suppose the future exchange rate was $1.93/£ when the investment was made. The US investor could have assured a riskless dollar-denominated return by locking in the year-end exchange rate at $ 1.93/£. Referring to example 1 and • A) Calculate the riskless US return • B) Calculate total amount of end-year proceeds in dollar.

  10. Solution 3-Hedging Exchange rate risk • The following formula can be applied: (1 + rUS) = [1 + rUK]Fo/Eo • A) (1 + rUS) = [1 + 0.1]1.93 /2.00 rUS=0.0615 or 6.15% • B) (11000) (1.93) $21,230

  11. Example 4-covered interest rate • Suppose rf(US) is 6.15%, futures price is $1.90/£ rather than being $1.93/£ • What are the arbitrage strategy and associated profits?

  12. Action ICF CF in one Year Borrow 1 UK pound. Repay in one year. $2.00 -E1(1.10) Convert the pound to $2 and lend in USA $-2.00 2.00(1.0615) Enter a contract to purchase 1.10 pound at a future price of $1.90/£ 0 1.10(E1-1.90) total $ 0 $ 0.033 Solution 4-covered interest rate

  13. Example 5-covered interest rate • Suppose rf(US) is 6.15%, futures price is $1.95/£ rather than being $1.93/£ • What are the arbitrage strategy and associated profits?

  14. Action ICF CF in one Year Borrow $2 USA pound.. $2.00 Convert the dollar to $2 and lend in UK at 10 % interest rate $-2.00 -E1(1.10) Enter a contract to sell 1.10 pound at a future price of $1.95/£ 0 1.10(E1-1.90) total $ 0 $ 0.022 Solution 5-covered interest rate -2.00(1.0615)

  15. Returns with FX • Return in US is a function of two factors 1. Return in the foreign market 2. Return on the foreign exchange

  16. Returns with FX (1 + rUS) = (1 + rFM) (1 + rFX) rUS = return on the foreign investment in US Dollars rFM = return on the foreign market in local currency rFX = return on the foreign exchange

  17. Return Example-6: Dollar Depreciates Relative to the Pound Initial Investment : $100,000 Initial Exchange: $2.00/ Pound Sterling Final Exchange:$2.10/ Pound Sterling Return in British Security: 10% Return in US Dollars (1 + rUS) = (1.10) (1.05) = (1.155) rUS = 15.5%

  18. Return Example-7: Dollar Appreciates Relative to the Pound Initial Investment : $100,000 Initial Exchange: $2/ Pound Sterling Final Exchange: $1.85/ Pound Sterling Return in British Security: 10% Return in US Dollars (1 + rUS) = (1.10) (.9250) = (1.0175) rUS = 1.75%

  19. Example 8-Sell Forward • How many pounds would the investor in example 3 need to sell forward to hedge exchange rate risk if • A) r(uk)=20% • B) r(uk)=30%

  20. Solution 8-Sell Forward • Sell in the forward as an amount of foreign currency equal to (INV) [1+r(foreign)] • A) (10000) (1.20)= 12000 pounds • B) (10000) (1.30)= 13000 pounds

  21. Other Risks in International Investing Country - Specific • Composition • Political • Financial • Economic • Composite Ratings

  22. Int’l Investment Choices • Direct Stock Purchases • Mutual Funds • Open End • Closed End • WEBS

  23. 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

  24. Efficient Frontier with International Diversification 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 Int’l Return Dom * * * * * * * * Risk

  25. Systematic Risk Level with International Diversification Risk • This figure suggests that international diversification can reduce the standard deviation of domestic portfolio by as much as half Dom Int’l Securities

  26. Constructing benchmark portfolio of foreign assets • Active or passive international investing requires a benchmark portfolio. One widely used index of non-US stock is European, Australian, Far East (EAFE) index. This index is constructed or computed by Morgan and Stanley.

  27. Factors in Assessing Active International Investment Performance • Currency Selection • Country Selection • Stock Selection • Cash / Bond Selection

  28. Currency Selection • This measures the contribution to total portfolio performance attributable to exchange rate fluctuations relative to the investor’s benchmark currency, which we will take to be the US dollar. We might use a benchmark like the EAFE index to compare a portfolio’s currency selection for a particular period to a passive benchmark.

  29. Country Selection • This measures the contribution to performance attributable to investing in better-performing stock markets of the world. It can be measured as weighted average of equity index returns of each country using as weights the share of the manager’s portfolio in each country

  30. Stock Selection-Cash / Bond Selection • Stock Selection: choice of specific stocks within a country’s equity market. • Cash / Bond Selection: choice between money market and longer-term bonds.

  31. EAFE Weight Return on Equity Index Currency.App E1/E0-1 Manager’s Weight Manager’s Return Europe 0.30 10% 10% 0.35 8% Australia 0.10 5% -10% 0.10 7% Far East 0.60 15% 30% 0.55 18% Example 9- performance Attribution

  32. Example 9- performance Attribution • Using the information given in the above table. Here, all exchange rates are expressed as unit of foreign currency that can be purchased with one U.S. dollar. • a) Calculate the overall performance for both EAFE and Manager and state the situation whether there exists loss or contribution relative to EAFE. • b) Calculate the currency selection for both EAFE and Manager and state the situation whether there exists loss or contribution relative to EAFE.

  33. Example 9- performance Attribution • c) Calculate the country selection for both EAFE and Manager and state the situation whether there exists loss or contribution relative to EAFE. • d) Calculate the stock selection for both EAFE and Manager and state the situation whether there exists loss or contribution relative to EAFE.

  34. Solution 9- performance Attribution • OP: Dollar return=return on index+ curr. Appri. • a) EAFE: .30(10+10)+.10(5-10) + .60(15+30)=32.5% MANAGER: .35(8+10)+.10(7-10) + .55(18+30)=32.4% Conclusion: Loss of .10% relative to EAFE • CS: Dollar return=(weight) (curr. Appri.) • b) EAFE: (.30x10%)+(.10x-10%) + (.60x30)=20% MANAGER: (.35x10%)+(.10x-10%) + (.55x30)=19% Conclusion: Loss of 1% relative to EAFE

  35. Solution 9- performance Attribution • CS: Dollar return=(return on index) (weight.) • c) EAFE: (.30x10%)+(.10x5%) + (.60x15%)=12.5% MANAGER: (.35x10%)+(.10x5%) + (.55x15%)=12.25% Conclusion: Loss of 0.25% relative to EAFE • SS: MW(MR-ROEI) • d) (8%-10%) .35+ (7%-5%) .10+ (18%-15%) .55=1.15% Conclusion: contribution of 1.15 % relative to EAFE

  36. Example 10- performance Attribution • Using the same data given in the previous table as portfolio weights change to 40% in Europe, 20% in Australia, and 40% in the far East and repeat all parts in the example 9.

  37. Solution 10- performance Attribution • OP: Dollar return=return on index+ curr. Appri. • a) EAFE: .30(10+10)+.10(5-10) + .60(15+30)=32.2% MANAGER: .40(8+10)+.20(7-10) + .40(18+30)=25.8% Conclusion: Loss of 6.7% relative to EAFE • CS: Dollar return=(weight) (curr. Appri.) • b) EAFE: (.30x10%)+(.10x-10%) + (.60x30)=20% MANAGER: (.40x10%)+(.20x-10%) + (.40x30)=14% Conclusion: Loss of 6% relative to EAFE

  38. Solution 10- performance Attribution • CS: Dollar return=(return on index) (weight.) • c) EAFE: (.30x10%)+(.10x5%) + (.60x15%)=12.5% MANAGER: (.40x10%)+(.20x5%) + (.40x15%)=11% Conclusion: Loss of 1.5% relative to EAFE • SS: MW(MR-ROEI) • d) (8%-10%) .40+ (7%-5%) .20+ (18%-15%) .40=0.8% Conclusion: contribution of 0.8 % relative to EAFE

  39. Example 11- Buying & Selling • What is the cost of buying Mexican peso 100000? • What is the cost of purchasing $ 1million? • How much do we received from selling $ 150000? • How much do we received from the sale of Mexican peso 10 million? • Note: MP/$ is 2.5010/2.5075

  40. Solution 11- Buying & Selling • MP 100000/2.5010=$ 39984 • $ 1mnx2.5070= MP 2.5075mn • $ 150000x2.5010= MP 375150 • MP 10mn/2.5075=$ 3988036

  41. Example & Solution 12- Cross rates • Suppose you want the £/$ cross rate and you are given: Y/$=154.33; Y/£=235.20, what is the £/$ cross rate ? • Y/$/ Y/£=Y/$x£/Y=154.33/235.20=0.6562

  42. Example 13- Discounts and premiums • Suppose that the following data are given as a rate of discount on the spot rate: • $/£ spot 1.5840-1.5860 • 1 month forward 4.50c-4.75c discount • 3 month forward 6.85c-7.0c discount • What is the actual forward rate for both 1 and 3 months?

  43. Solution 13- Discounts and premiums • Spot 1.5840 1.5860 • + 450 475 • 1 month forward= 1.6290 1.6335 • Spot 1.5840 1.5860 • + 685 700 • 3 month forward= 1.6525 1.6560

  44. Example 14- Depreciation-Appreciation • Suppose you have the following information: • $/£ spot 1.5345 • 12 months forward 5c premium • Calculate the 12 months forward rate? • Calculate the forward rates for the next five years? • If depreciation 5% for the next two years and Appreciation 7% for the rests. • Note: • spot $/£ x (1-rate of appreciation)= forward $/£

  45. Solution 14- Depreciation-Appreciation • Forward rate appreciation in dollar is: • 5/1.6580=3.25% • Spot $ 1.5345x(1-0.0325)=$ 1.4846 12 month forward • 1.5345x(1+0.05)=$ 1.6112 one year fwd • 1.6112x(1+0.05)=$ 1.6918 two year fwd • 1.6918 x(1-0.07)=$ 1.5734 three year fwd • 1.5734x(1-0.07)=$ 1.4632 four year fwd • 1.4632 x(1-0.07)=$ 1.3608 five year fwd

  46. Example 15- interest rates • Suppose that you have the spot $/£ is 1.5840-1.5860 and 12 months forward $/£ is 1.5370-1.5400. Also, UK and US treasury bills are 8% and 5% respectively. • What is the percentage change in the $ • Calculate the 12 month forward rate.

  47. Solution 15- interest rates • $ interest-£ interest/(1+£ interest) • (0.05-0.08)/(1.08)=2.78%. This is appreciation in the $ (- represents app. and + represents dep.) • 1.5840(1-0.0278)=1.5400 • This 12 months forward $/£.

  48. Example 16- forecasting exchange rates • Suppose the current Y/£ spot rate for buying Y is 224.20 and estimates of UK and Japanese inflation rates over the next three years are as follows: • Inflation rates • UK Japan • Year 1 3% 5% • Year 2 4.5% 2% • Year 1 3% 3% • Calculate the forecasting exchange rates for the relevant years.

  49. Solution 16- forecasting exchange rates • At Year 1 (0.05-0.03)/(1.03)=0.0194 Y will depreciate by 1.94 % • Y 224.2(1+0.0194)=Y 228.55 year 1 spot. • At Year 2 (0.02-0.045)/(1.045)=-0.023 Y will appreciate by 2.3% • Y 228.55(1-0.023)=Y 223.81year 2 spot. • At Year 3 (0.03-0.03)/(1.03)=0: No change in the Y/£ spot rate • Y 223.81 Year 3 spot.

  50. Purchasing power parity and Interest rate parity • PPP (1+IF)/(1+ ID) • IRP (1+rF)/(1+ rD)

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