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Understanding International Investing: Benefits, Risks, and Market Integration

This chapter emphasizes the importance of world markets and highlights the benefits of international diversification in investing. It explores various international investment options such as direct stock purchases, American Depository Receipts (ADRs), and mutual funds while assessing risks that include political and foreign exchange risks. The chapter examines the significant role of the U.S. market, which constitutes about 50% of global markets, and discusses how international diversification can enhance returns and reduce systematic risk. Practical examples and risk management strategies are also covered.

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Understanding International Investing: Benefits, Risks, and Market Integration

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  1. Chapter 22 International Investing

  2. Chapter Summary • Objective: To show the importance of world markets and the benefits of international diversification. • International investments • Risk issues in international investing • Measurement of international investing • Integration of Markets

  3. Background • Global market • US Market represents about 50% of all markets • Canadian market, although the sixth-largest one, represents only 2.5% • Improved access & technology • New instruments • Emphasis for our investigation • Risk assessment • Diversification

  4. 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?

  5. Diversification Benefits • Evidence shows international diversification is beneficial • It is possible to expand the efficient frontier above domestic-only frontier • Possible to reduce the systematic risk level below the domestic-only level

  6. Int’l Return Domestic * * * * * * * * Risk Efficient Frontier with International Diversification

  7. Risk Domestic International Securities Systematic Risk Level with International Diversification

  8. International Investment Choices • Direct stock purchases (institutional investors) • American Depository Receipts (ADRs) • International mutual funds • Open-end funds • Closed-end funds

  9. Summary Reminder • Objective: To show the importance of world markets and the benefits of international diversification. • International investments • Risk issues in international investing • Measurement of international investing • Integration of Markets

  10. Risks in International Investing Political Risks • Expropriation of assets • Restrictions on foreign exchange • Political instability

  11. Risks in International Investing 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 is not possible to completely hedge a foreign investment

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

  13. Returns with FX (1 + rCAN) = (1 + rFM) (1 + rFX) rCAN = return on the foreign investment in Canadian Dollars rFM = return on the foreign market in local currency rFX = return on the foreign exchange

  14. Return Example: Dollar Appreciates Initial Investment : $20,000 Initial Exchange: $2.00/ Pound Sterling Final Exchange:$1.80/ Pound Sterling Return in British Security: 10% Return in Canadian Dollars (1 + rCAN) = (1.10) (.90) = .99 rCAN = -1%

  15. Return Example: Dollar Depreciates Initial Investment : $20,000 Initial Exchange: $2.00/ Pound Sterling Final Exchange: $2.10/ Pound Sterling Return in British Security: 10% Return in Canadian Dollars (1 + rCAN) = (1.10) (1.05) = 1.155 rCAN = 15.5%

  16. Hedging Foreign Exchange Risk • Canadian firm wants to protect against a decline in profit that would result from a decline in the UK pound • Estimated profit loss of $200,000 if the pound declines by $.10 • Short or sell pounds for future delivery to avoid the exposure

  17. Hedge Ratio in pounds $200,000 per $.10 change in the pound/dollar exchange rate $.10 profit per pound delivered per $.10 in exchange rate = 2,000,000 pounds to be delivered Hedge Ratio for Foreign Exchange Example Hedge Ratio in contacts Each contract is for 62,500 pounds or $6,250 per a $.10 change $200,000 / $6,250 = 32 contracts

  18. Summary Reminder • Objective: To show the importance of world markets and the benefits of international diversification. • International investing • Risk issues in international investing • Measurement of international investing • Integration of Markets

  19. Measuring Benchmark Returns • Indexes • EAFE Index • Issues in measuring performance • Weighting • Cross-Holdings • Other possibilities • Country and Region Funds

  20. Performance Attribution with International Investment Extension to consider additional factors • Currency selection • Country selection • Stock selection • Cash and bond selection

  21. Security Analysis with International Investments • Accounting rules and conventions complicate security analysis • Depreciation • Reserves • Consolidation • Taxes • P/E ratios

  22. Summary Reminder • Objective: To show the importance of world markets and the benefits of international diversification. • International investing • Risk issues in international investing • Measurement of international investing • Integration of Markets

  23. Integration of Security Markets • Integration - two markets respond to common factors (risk-return) • Segmentation – two markets respond to different factors • Canadian and U.S. markets are largely integrated (not entirely) • International markets are increasingly integrated – still segmented

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