Global Investing

1. Global Investing Chapter 18 Chapter 18: Global Investing

2. Background • International investing increases each year • Due to high returns available in other countries • Offers international diversification • Involves all the same risks as domestic investing plus additional risks • Foreign exchange risk • Sovereign risk • International liquidity risk • International information risk Chapter 18: Global Investing

3. Sovereign Risk • Sovereign risk involves the possibility that • The foreign country’s government may collapse • Its legal system is inadequate • Its police force can not maintain order • The settlement process may occasionally break down • Other political upheaval may occur • Euromoney magazine ranks countries’ sovereign risk • As of March 2000 Luxembourg ranked as the country with lowest risk and Afghanistan as the highest Chapter 18: Global Investing

4. Sovereign Risk • Multinational investors require a higher rate of return from riskier countries • Large investors may be able to obtain a guarantee from government officials • Mostly, however, investors refuse to invest unless they expect a higher return to compensate them for the international risk premium Chapter 18: Global Investing

5. International Liquidity Risk • Emerging financial markets often lack liquidity due to • Modest trading volume—significant intervals between transactions • Inexperienced and/or undercapitalized market-makers • Insufficient legal systems • Inability to quickly and economically clear security transactions • Lack of access to international cash flows Chapter 18: Global Investing

6. Example: The 1999 Russian Crisis • During 1996-1997 Russian stocks earned 143% • By 1998 Russia was experiencing • A decline in oil revenues • A ballooning budget deficit • Poor tax collections • In 1999 the ruble was devalued • Inflation zoomed to 56% • Many businesses were bankrupt • Government offered tax credit to pay for services • Corporations used bartering to pay for services Chapter 18: Global Investing

7. Example: The 1999 Russian Crisis • Rubles were used less than IOUs, barter and other payment methods • Companies paid workers with chits to be used in company-owned shops or with product (to be used for barter) • Many Russians kept savings in the form of U.S. dollars Chapter 18: Global Investing

8. Example: The 1999 Russian Crisis • Russian government allowed its biggest oil company, Lukoil, to pay ½ its taxes with IOUs or veksels • Lukoil would later redeem for oil • Government paid for its goods and services with these veksels • Veksel brokers developed • Bought veksels for rubles and resold to customers • Usually for 50% of face value Chapter 18: Global Investing

9. International Information Risk • More difficult to obtain information on international investments due to: • Language differences • Currency differences • Different weight and measurement systems • Different political systems • Length of time to deliver international mail • Unfamiliar geography • Different financial reporting techniques • Easier for an ‘insider’ to obtain information than an ‘outsider’ Chapter 18: Global Investing

10. Most of these investments involve foreign currency risk. Foreign Exchange Risk • Currency exchange rates fluctuate continuously Contains no foreign exchange risk—the investment was made in the country’s local currency. Chapter 18: Global Investing

11. Simple International Diversification • A few dozen securities in your portfolio is sufficient for simple diversification • Diversifying across industries within a single country doesn’t offer additional diversification benefits • Competing firms within a country tend to have high positive correlation • Even though barriers to entry exist, international market segmentation tends to make international diversification beneficial • Solnik (1974) studied international diversification Chapter 18: Global Investing

12. Solnik’s Diversification Study • Examined stock returns from 8 countries over 5 years • Used random selection and equal weighting • Only invested using U.S. dollars—thus returns also include foreign exchange risk • Results indicate • Randomly selecting stocks across countries is superior to only investing in U.S. stocks • Randomly selecting stocks across countries and across both countries and industries is superior to diversifying across industries • Portfolios that are hedged against foreign exchange risk have only slightly less risk than unhedged portfolios Chapter 18: Global Investing

13. Portfolio Analysis of Two-Country Diversification • The lower (or more negative) the correlation coefficient between securities within a portfolio the more diversification benefits • In general, correlations between counties are fairly low • Correlations between emerging markets are lower than correlations in developing markets • Some negative correlation occurs between emerging markets Chapter 18: Global Investing

14. International Efficient Frontiers • Consider the following international efficient frontiers • Some theoretically optimal portfolios may be unobtainable due to government-imposed policies Emerging markets only—dominates developed markets due to low correlations and some very high returns during sample period. All opportunities U.S. markets only Developed markets only Chapter 18: Global Investing

15. Correlation Coefficient Between Different Countries • Solnik, Boucrelle & Fur (1996) [SBF] analyzed over 30 years of data from 4 countries and conclude • Correlations across countries are not stable over time • Correlations seem to be tending upward • World’s financial markets are becoming more integrated • Standard deviations are also somewhat unstable • When financial markets’ volatility increases, correlations between countries tends to increase temporarily Chapter 18: Global Investing

16. Correlation Coefficient Between Different Countries • SBL analyzed returns to a U.S. investor investing in Japan Trend is toward an increasing . s fluctuate between positive and negative values. Chapter 18: Global Investing

17. Fundamental Reasons for Low Inter-Country  • Different countries have different • Political systems • Capitalism vs. socialism • Currencies • Foreign exchange regulations • Fixed vs. floating exchange rates • Trade restrictions • Import/export limitations • Political alliances • Different countries may be at different stages in their business cycles • War vs. peace • Inflation, monetary/fiscal policies • Due to above issues, different countries’ security markets are not highly positively correlated Chapter 18: Global Investing

18. Do Multinational Corporations Provide International Diversification? • The largest corporations in the world are multinational corporations (MNCs) • Will investing in MNCs offer a quick (and easy) method for diversifying internationally? • No! The variability in a MNC’s stock returns are largely determined by variations in the domestic stock market • Between 69-93% of the variability is explained by domestic stock market index • However, as the MNC’s sales outside its domestic country increase, the correlation with its domestic stock market tends to decrease Chapter 18: Global Investing

19. American Depository Receipts (ADRs) • Several fairly easy methods for obtaining international diversification include: • American Depository Receipts • Evidence of ownership in a foreign corporation • Created by J.P. Morgan in 1927 • Removes foreign exchange complications from international investing • Bank collects dividends in foreign currency and converts to U.S. dollars • Some high volume ADRs include: • BP-Amoco • Volvo • Nestle S.A. • Toyota • Nokia Chapter 18: Global Investing

20. Problems with ADRs • Some ADRs are highly liquid • If issued by well known international corporations • Sponsored by the issuer • Pay the ADR fees • Listed on an organized U.S. stock exchange • If the stock issuer does not sponsor the ADR • Investors must pay the ADR fees • May not provided financial statements in English • If trade OTC may not be very liquid • Some corporations purposely have their ADRs trade OTC • Avoids costly disclosure requirements and stringent U.S. accounting conventions Chapter 18: Global Investing

21. Problems with ADRs • Corporate control can be an issue • Some depository banks are allowed to vote on behalf of ADR shareholders • Price volatility may be high in the ADR issuer’s domestic country • Foreign income is typically subject to more complicated tax regulations • May be more difficult to follow foreign news • Still subject to exchange rate risk • Risk is hidden since the investor does not have to deal with it directly Chapter 18: Global Investing

22. Global Depository Receipts • Patterned after ADRs except most are not denominated in U.S. dollars • Can be issued in any country and denominated in any currency • First issued in 1993 • GDRs and ADRs represent only a small portion of publicly traded foreign corporations • Thus, an investor might consider investing in international mutual funds • None of these methods eliminates foreign exchange risk Chapter 18: Global Investing

23. International Investment Companies • Some mutual funds specialize in international investments • Global funds—invest in both foreign and domestic securities • International funds or foreign funds—invest primarily in foreign securities • Regional foreign funds—invest only in foreign securities from specific regions (Price New Asia Fund) • International style funds—invest in unique categories of foreign securities (Fidelity Emerging Markets Fund) • Foreign index funds (Vanguard International Equity Index Fund for Europe) • Country funds—confine investments to securities in a single country (Korea Fund) Chapter 18: Global Investing

24. International Index Funds • iShares MSCI—shares in a mutual fund indexed to a stock market in a single foreign country • 17 different iShares MSCI mutual funds exist • Each converts U.S. dollar investment into foreign currency, buys the stocks making up the country’s MSCI index, managers the fund, collect cash dividends and converts them to U.S. dollars, etc. • Allows investors the ability to diversify internationally without dealing with foreign exchange transactions and stock-picking in a foreign market Chapter 18: Global Investing

25. Homemade International Diversification • Erunza, Hogan & Hung (1999) [EHH] analyzed how much international diversification a U.S. investor could achieve without leaving U.S. markets • Compared results to 7 developed markets and 9 emerging markets • Conclude that U.S. investors are able to achieve significant diversification • Able to mimic all developed markets and all but 2 of the emerging markets Chapter 18: Global Investing

26. International Security Market Line • If international financial markets are fully integrated, an asset’s international beta can be calculated as: • Can use the MSCI world market index as a surrogate for the world market portfolio • Could calculate country betas • If all individual security betas in each separate country were averaged • Problem—all the world’s financial markets are not fully integrated • Even the U.S. and Canadian markets are not fully integrated Chapter 18: Global Investing

27. International Arbitrage Pricing Theory • Home bias occurs due to barriers to entry • Thus, international risk premiums exist for each country • APT model can easily be extended to include international risk factors • Home bias can be included • Country-to-country PPP violations can be included Chapter 18: Global Investing

28. The Bottom Line • International investors face additional risks compared to domestic investors • Country (or sovereign) risk • Liquidity risk • Especially in emerging markets • Foreign exchange risk • Lack of information • Buying shares in iShares MSCI or international mutual funds allows investors to passively diversify internationally • ADRs, GDRs and international mutual funds allow investors to invest internationally without dealing with foreign exchange transactions Chapter 18: Global Investing

29. The Bottom Line • If the world’s financial markets were fully integrated, the international SML would be be the same as the domestic SML • However, investors demand international risk premiums • International diversification offers advantages that outweigh the costs • Offers the dominant Markowitz efficient frontier • Caveats • Correlations between countries are unstable through time • Correlations are likely to rise as world markets become more fully integrated • Correlations increase as financial markets become more volatile Chapter 18: Global Investing