CHAPTER - 18 International Equity Investment International Financial Management P G Apte
Introduction • The twentieth century has seen massive cross-border flows of capital. Cross border equity investment is a relatively recent phenomenon. • The initial thrust to cross border flows of equity investment came from the desire on the part of institutional investors to diversify their portfolios globally in search of both higher return and risk reduction. • Financial deregulation and elimination of exchange controls in a number of developed countries at the beginning of eighties permitted large institutional investors to increase their exposure to foreign equities.
Introduction • The decade of 1990's witnessed opening up of equity markets of developing countries like South Korea, Taiwan, Indonesia and India to foreign investors albeit with some restrictions • The trend towards global integration of equity markets is unmistakable though it is punctuated by intermittent crises and consequent investor retreat • We investigate the determinants of foreign equity investment decision and address the issues related to capital market integration and valuation of foreign equities
ANNOUNCED INTERNATIONAL EQUITY ISSUES (US $ BILLION) ISSUERS FROM 2006 2007 2008 2009Q1 All Countries 371 499 392 57 Developed Countries 225 256 306 43 Developing Countries 124 216 79 9.5 China 52 62.4 15.6 6.4 India 10.3 22.9 12.0 0.0 S.Korea 7.4 5.3 1.2 1.0 Brazil 10.9 38.0 14.9 1.0
$36.0 8.4% 24.6% 12.6% 8.1% US$ Trillions $14.1 11.6% 21.9% 21.3% 8.2% 37.0% $9.7 5.0% 18.2% 40.2% 7.9% 28.7% 4.2% 15.2% 19.4% 7.1% 54.1% 46.2% $3.4 World Market Capitalization
India - Inward Investment(US $ million) Item2000-01 2001-02 2002-03 2003-04 2004-05 Direct 4029 6130 5035 4673 5535 Investment Portfolio 2760 2021 979 11377 8909 Investment GDRs/ADRs 831 477 600 459 613 FIIs ** 1847 1505 377 10918 8280 Offshore 82 39 2 --- 16 Funds and others TOTAL 6789 8151 6014 16050 14444
OverviewA Private Investor’s Viewpoint • Policy Matters - Private Investors • What Factors Favor Overweighting Foreign Markets in Portfolios? • What Factors Favor Overweighting Home Markets in Portfolios? • Is Investment in MNCs a Close Substitute for International Investment? • Can Investors Create “Homemade” International Diversification?
OverviewA Private Investor’s Viewpoint • Can Investors Count on International Diversification Gains in the Future? • Are Emerging Markets Integrated with World Capital Markets? • Policy Matters - Public Policymakers • Equity Market Trading Arrangements • Diversity in Accounting Principles and Disclosure Practices
International Investment Vehicles Direct Purchase of Foreign Shares • This route is usually reserved for large institutional investors because of the additional considerations involved.
International Investment Vehicles Depositary Receipts (ADRs, GDRs) • After a bank has taken custody of foreign shares in its foreign office, ADRs/GDRs can be issued as claims against the foreign shares. • The issuing bank services the ADRs/GDRs by collecting all dividends (in the issuing company’s home currency), rights offerings, etc., and distributing the proceeds to investors in a convertible currency such as USD. • In a sponsored ADR, the foreign firm pays a fee to the depositary bank to cover the cost of the ADR program, while in an unsponsored ADR, the issuance of the ADR is demand driven. • ADRs are directed at US based investors and issued in US while GDRs are issued outside US and are targeted at global investors. The main difference is in regulatory framework, disclosure requirements, accounting standards etc.
International Investment Vehicles Closed-End and Open-End Mutual Funds • Mutual funds that invest in foreign stocks can be grouped into several categories from a U.S. perspective: • Global - Investing in U.S. and non-U.S. shares. • International - Investing in non-U.S. shares only. • Regional - Investing in a geographic area. • Country - Investing in a single country. • Specialty - International investments in an industry group such as telecommunications, or special themes such as newly privatized firms.
International Investment Vehicles • An open-end fund stands ready to issue and redeem shares at prices reflecting the net-asset-value of the underlying foreign shares. • A closed-end fund issues a fixed number of shares against an initial capital offering. The shares then trade in a secondary market at prices reflecting a premium or discount relative to the net-asset-value of the underlying foreign shares.
International Investment Vehicles World Equity Benchmark Shares (WEBS) • WEBS represent shares in an index fund that is intended to track the performance of a single country index. • Like an open-end fund, the size of the WEBS fund can grow without limit, but the shares are traded on an exchange at any time of the day like a closed-end fund.
Equity Financing in Global Markets • Since many Indian companies have accessed the global equity market primarily for establishing their image as global companies, the major consideration has been visibility and post-issue considerations related to investor relations, liquidity of the stock (or instruments based on the stock such as depository receipts which are listed and traded on foreign stock exchanges) in the secondary market and regulatory matters pertaining to reporting and disclosure
Equity Financing in Global Markets • Other relevant considerations are the price at which the issue can be placed, costs of issue and factors related to taxation • With segmented markets, the price that can be obtained would vary from one market to another • When the issue size is large, the issuer may consider a simultaneous offering in two or more markets
Equity Financing in Global Markets • Issue costs are an important consideration • Shares of many firms are traded indirectly in the form of depository receipts e.g. GDR and ADR . • After a hesitant start in 1992 following the experience of the first ever GDR issue by an Indian corporate, a fairly large number of Indian companies haveraised equity capital in international markets • In recent years, a major driving force has been the desire of Indian IT companies to make acquisitions in the US. The ADS are used as “acquisition currency” in share swaps. For this purpose the ADRs must be listed and actively traded
Subscribers, Lead Managers etc Company Depository Custodian GDR Holders Nominee for Euroclear and Cedel Hold the American GDR and Register it in the Name of DTC Equity Financing in the International Markets The GDR Mechanism
Equity Financing in Global Markets • From the point of view of the issuer, GDRs and ADRs represent non-voting stock with a distinct identity which do not figure in its books • There is no exchange risk for the issuing firm since dividends are paid by the issuer in its home currency. Exchange risk is borne by the investors. • Apart from imparting global visibility, the device allows the issuer to broaden its capital base by tapping large foreign equity markets
GDRs / ADRs Year No. of Issues Amount(Rs.Crore) Amount($ mln) 2004-2005 14 4435.45 915.47 2005-2006 56 15895.91 3280.89 2006-2007 21 4922.50 1016.00 2007-2008 33 30949.26 6387.88 2008-2009 12 893.42 184.40 2009-2010(Till Jul,09) 7 11990.47 2474.81
Indian ADRs Trading in US Dr. Reddy's Laboratories Ltd. HDFC Bank Ltd. ICICI Bank Ltd. Infosys Technologies Limited Mahanagar Telephone Nigam Limited Rediff.com India Ltd Satyam Computer Services Limited Sify Ltd. Videsh Sanchar Nigam Limited Wipro Ltd
Indian GDRs Arvind Mills, Ashok Leyland,Bajaj Auto,Ballarpur Ind.,Bombay Dye,BSES Ltd,Century Textiles,CESC,Core Parent, Crompton Greaves,DCW,Dr. Reddy's,E. I. Hotels,EID Parry,Finolex Cab, Flex Industries,G.E. Shipping,G.N.F.C,GAIL,Garden Silk, Grasim (1st),Grasim (2nd),Guj Ambuja ,Himachal Futuri,Hindalco (1st),Hindalco (2nd),Hindustan Dev,India Cements, Indian Alum.,Indian Hotels,Indian Rayon,Indo Gulf,Indo Rama,ICICI,Infosys,IPCL,ITC,J.K. Corp,Jain Irrig,JCT Ltd.,Kesoram Ind,L & T (1st),L & T (2nd)Mah & Mah,MTNL,NEPC Micon,Nippon Denro,Oriental Hotels,Ranbaxy Labs,Raymond Woolen,Reliance,Reliance (2nd),Reliance Petroleum,S.A.I.L.,Satyam Infoway,S.I.E.L.,Sanghi Poly,SIV Ind ,SPIC,SBI,Sterlite India,Tata Electric,Telco (1st),Telco (2nd),Tube Invest,United Phos.,Usha Beltron,Videocon Int.,VSNL,Wockhardt
Equity Financing in Global Markets • From the investors' point of view, they achieve portfolio diversification while acquiring an instrument which is denominated in a convertible currency and is traded on developed stock markets • The investors bear exchange risk and all the other risks borne by an equity holder • They have all the rights and privileges of ordinary stockholders except the voting rights.
GDRs and ADRs GDRs could be offered to US investors only if very stringent requirements of registration with the SEC are complied with. However, under an exemption granted by Rule 144A of the securities act, securities can be offered to Qualified Institutional Buyers without going through the registration process. As to ADRs, offereings at various levels are possible with more and more stringent accounting and disclosure requirements as one goes from lower to higher levels. There are four types of ADRs : Unsponsored and Levels I to III
·American Depository Receipts (ADRs) ·Unsponsored Depositary Receipts These are issued by one or more depositaries in response to market demand, but without a formal agreement with the company. Today, unsponsored Depositary Receipts are considered obsolete. ·Sponsored Level I Depositary Receipts Level I Depositary Receipts are traded in the U.S. OTC market and on some exchanges outside the United States. The company does not have to comply with U.S. GAAP or full SEC disclosure. Essentially, a Sponsored Level I Depositary Receipt program allows companies to enjoy the benefits of a publicly traded security without changing its current reporting process.
Level II Depositary Receipts These are listed on a US stock exchange but no new capital is raised. Level III Depositary Receipts These are listed on a US stock exchange and are used to raise new capital. Companies that wish to either list their securities on an exchange in the U.S. or raise capital use sponsored Level II or III Depositary Receipts respectively. These types of Depositary Receipts can also be listed on some exchanges outside the United States. Each level requires different SEC registration and reporting, plus adherence to U.S. GAAP. The companies must also meet the listing requirements of the national exchange (New York Stock Exchange, American Stock Exchange) or NASDAQ, whichever it chooses.
American Depository Receipts • ·Sponsored Level II And III Depositary Receipts • Companies that wish to either list their securities on an exchange in the U.S. or raise capital use sponsored Level II or III Depositary Receipts respectively. • These types of Depositary Receipts can also be listed on some exchanges outside the United States. Each level requires different SEC registration and reporting, plus adherence to U.S. GAAP. • The companies must also meet the listing requirements of the national exchange (New York Stock Exchange, American Stock Exchange) or NASDAQ, whichever it chooses.
American Depository Receipts Each higher level of Depositary Receiptprogram generally increases the visibility and attractivenessof the Depositary Receipt. Level II is used when the company does not wish to raise funds i.e. just acquire listing while level III is used when funds are to be raised. For Level II issue the issuing firm converts some of its existing stock into ADRs.
Rule 144a Depositary Receipts These are also used to raise new capital but are privately placed with Qualified Institutional Buyers in the United States. Because of the sophisticated investor base to which these Depositary Receipts are restricted, the US Securities Exchange Commission imposes fewer reporting and registration requirements on the issuer than for a public offering and Rule 144a ADRs can therefore be a quicker and simpler way to access the US market than Level III ADRs.
Equity Financing in Global Markets • A major problem and concern with international equity issues used to be that of flowback i.e. the investors will sell the shares back in the home stock market of the issuing firm. Initially GOI had imposed a minimum time limit before which conversion and sale in home market was not permitted. After FIIs were allowed into Indian markets, this was abolished.
Foreign Equity Investment Risk-Return • Comparing Investments in a Risk-Neutral World • The expected annual dividend yields in the two investments are US and IN, the expected annual average rates of capital appreciation are US and IN. The (INR/USD) exchange rate is S0, dollars per rupee. After k years, a dollar invested in the US company is expected to accumulate to $(1 + US + US)k • a dollar invested in the Indian shares is expected to accumulate to $(1/S0)(1 + IN + IN)k(Se)k
Foreign Equity Investment - Risk-Return • The investor would invest in the Indian stock if • and in the US stock if the reverse inequality holds • Let ŝe denotes the expected annual proportionate rate of change of the exchange rate S expressed as USD per INR. Then • [(Se)k/S0] = (1 + ŝe)k
Foreign Equity Investment - Risk-Return • Substitute, simplify, ignore cross products to get that US investor would invest in India if • ŝe > (US - IN) + (US - IN) • Thus even with lower dividend yield and capital gains, foreign equities can be attractive if the foreign currency is expected to appreciate strongly • Presence of differential tax treatment of ordinary income and capital gains can reinforce the bias in favor of foreign equities if exchange gains are treated as capital gains and capital gains are taxed at a lower rate
Foreign Equity Investment - Risk-Return • Let y and k be tax rates for ordinary income and capital gains respectively with y > k • After-tax returns on the US and Indian investments are, respectively (1-y)US + (1-k)US and (1-y)IN + (1-k)(IN+ Ŝe) • Latter will exceed the former if
Risk and Returnin International Equity Markets Calculating the Unhedged Returns on Foreign Equity in home currency Terms Let Et be the initial purchase price of the foreign equity in foreign currency (FC) terms. Let St be the spot exchange rate, in FC/HC terms, on the purchase date. Then EtSt is the HC purchase price of the foreign equity.
where = the initial equity price = the price change over the period = dividends Then is the value of the equity after one period in HC terms. Risk and Return in International Equity Markets ~ Let Et+1 be the FC value of the stock after one period.
Note that the unhedged HC return on the foreign equity has two pieces: • the return on the equity shares in FC terms (EFC), & • the return on the foreign currency used to buy the shares (SHC,FC). ~ ~ Risk and Return in International Equity Markets The continuous rate of return on the equity measured in HC and on an unhedged basis is:
Risk and Return in International Equity Markets The variance of the returns reflects the variance of each term and the covariance between the returns on the foreign equity and the returns on spot foreign exchange: Note that the covariance of equity returns and currency returns can be either positive or negative. Thus from a foreign investor’s viewpoint the risk has three components: local market risk, exchange rate risk, covariance risk – what’s the correlation between local market performance and local currency exchange rate against investor’s home currency.
Decomposition of the Total Variance of US Dollar Returns on Individual Foreign Stock Markets ________________________________________________________ Country % Contribution to Total Variance from ______________________________________ Exchange Rate Local Return Covariance Variance Variance _________________________________________________________________ Canada 4.26 84.91 10.83 France 29.66 61.79 8.55 Germany 38.92 41.51 19.57 Japan 31.85 47.65 20.50 Switzerland 55.17 30.01 14.81 U.K. 32.35 51.23 16.52 __________________________________________________________________
Volatility of Returns on Selected Developing Country Stock Markets __________________________________________________________________________ Developing Countries Annual Standard Deviation (%) Argentina 108 Brazil 74 Chile 29 HongKong 31 India 31 Indonesia 39 Korea 29 Mexico 56 Singapore 33 Taiwan 63 Thailand 31 Developed Countries Japan 22 U.K. 19 U.S. 17 ___________________________________________________________
Combinations of Currency Market and Stock Market Returns Currency Market Returns Negative Positive Stock Market Prices Spot FX Stock Market Prices Spot FX Stock Market Prices Spot FX Stock Market Prices Spot FX Negative Stock Market Returns (A) (D) (B) (C) Positive Risk and Return in International Equity Markets
Risk and Return from Foreign Equity Investment • Since countries differ in their economic and industrial structures and since business cycles in different parts of the world are not synchronous, one would expect further risk reduction to be possible through diversification beyond national boundaries • For a given expected return, an internationally (optimally) diversified portfolio should afford smaller risk than a purely national optimal portfolio
Risk and Return from Foreign Equity Investment • Prima facie equity investment in emerging markets appears to present substantial opportunities for risk reduction from the point of view of investors in the developed countries • Total risk of an internationally diversified portfolio can once again be broken down into three components • Exchange Rate Risk • Local Returns Risk • Local Returns-Exchange Rates Covariance Risk
Risk and Return from Foreign Equity Investment • General agreement that international diversification does pay in terms of risk reduction. Some ambiguity remains. One additional source of risk viz. exchange rate. • Availability of products to hedge exchange rate risk further reinforces this conclusion • However, it is not clear whether exchange risk hedging would reduce expected returns at the same time as it reduces risk
The International Capital Asset Pricing Model • CAPMlinks the expected (excess) returns on a risky asset to its risk in an efficient portfolio • The expected excess return on a risky asset or a portfolio of assets is its expected return over and above the risk-free return • A portfolio is said to be efficient if among all possible portfolios with the same excess return it has the lowest variance
The International CAPM • Consider a portfolio consisting of assets i = 1, 2....N • A necessary condition for a portfolio to be efficient is • where ri* and rp* denote, respectively return on asset i and the portfolio
The International CAPM • The numerator is the contribution of asset i to the portfolio's excess return while the denominator is the contribution of asset i to the portfolio's varianceor risk • The parameter is known as the investor's relative risk aversion and is a measure of his or her attitude towards risk
The International CAPM • “Two fund theorem" says that in equilibrium all investors will hold some combination of the risk-free asset and the so-called "tangency portfolio" • One of the crucial ingredients in the CAPM is the notion of Market Portfolio • Now let rp be the market portfolio. Denote the return on market portfolio by rm • For the market portfolio to be efficient we must have
The International CAPM This can be written as follows (1) (2) When (2) is applied to the market portfolio E(rm* - r) = 2m (3)
The International CAPM Rewriting = [E(rm* - r)/m2] • Replace [m2] by E(rm* - r) and recall the definition of the beta of asset i to get • E(ri* - r) = i E(rm* - r) • This is the one country CAPM • The only source of systematic risk is the market risk.
The International CAPM • im denotes the covariance between the returns on asset i and the market portfolio and m2 denotes the variance of the return on the market portfolio • The expression [im/m2] is the familiar "Beta" of the asset i, denoted i which measures the covariance of asset i with the market portfolio