Chapter 7 International Investment and Diversification

1. Chapter 7International Investment and Diversification

2. Outline • Introduction • Why international diversification makes theoretical sense • Foreign exchange risk • Investments in emerging markets • Political risk • Other topics related to international diversification

3. Introduction • The marketplace of the twenty-first century is global • U.S. equities represent only about 51% of the world’s equity capitalization • Over the period 1980-2000, the U.S. was the best-performing market only once • In September 1999, each of the 66 U.S. pension funds had more than $1 billion in actively managed international investment portfolios

4. Introduction (cont’d) • International investments carry additional sources of risk • Managers can reduce total portfolio risk via global investment

5. Why International Diversification Makes Sense (Evans and Archer) • Portfolio theory works to the investor’s benefit even if he selects securities at random • Ideally, the portfolio manager selects securities because of their fit with the rest of the portfolio • By choosing poorly correlated securities, a manager can reduce total portfolio risk

6. Why International Diversification Makes Sense (Evans and Archer Cont’d) • Total risk contains both systematic and unsystematic risk • Evans and Archer show that holding 15 to 20 equity securities substantially reduces the unsystematic risk

7. Utility, Risk, and Return • Unsystematic risk reduction is possible with more than 20 securities • For a given level of return, any reduction in risk, no matter how small, is a worthy goal • A rational invest will reduce risk if given the opportunity

8. Variance of A Linear Combination • As long as assets are less than perfectly correlated, there will be diversification benefits • More pronounced the lower the correlation • No two shares move in perfect lockstep • Diversification benefits accrue every time we add a new position to a portfolio

9. Relationship of World Exchanges • For U.S. securities, market risk account for about 25% of a security’s total risk • For less developed countries, market risk tends to be higher because: • Fewer securities make up the market • The securities are exposed to more extreme economic and political events

10. Relationship of World Exchanges (cont’d) • International capital markets continue to show independent price behavior • International diversification offers potential advantages • Repeating the Evans and Archer methodology for international securities should result in a lower level of systematic risk

11. Relationship of World Exchanges (cont’d) Portfolio Variance U.S. Securities: Systematic Risk 27% International Securities: Systematic Risk 11.7% Number of Securities

12. Fundamental Logic of Diversification • Investors are, on average, rational • Rational people do not like unnecessary risk • By holding one more security, an investor can reduce portfolio risk without giving up any expected return • Rational investors, therefore, will hold as many securities as they can

13. Fundamental Logic of Diversification (cont’d) • The most securities investors can hold is all of them • The collection of all securities makes up the “world market portfolio” • Rational investors will hold some proportion of the world market portfolio

14. Other Considerations • Optimum portfolio size involves a trade-off between: • The benefits of additional diversification • Commissions and capital constraints

15. Foreign Exchange Risk • Definition • Business example • Investment example • From whence cometh the risk? • Dealing with the risk • The eurobond market • Combining the currency and market decisions • Key issues in foreign exchange risk management

16. Definition • Foreign exchange risk refers to the changing relationships among currencies • Modest changes in exchange rates can result in significant dollar differences

17. Business Example A U.S. importer has agreed to purchase 40 New Zealand leather vests at a price of NZ$110 each. The vests will take two months to produce, and payment is due before the vests are shipped. The current spot rate of the NZ$ is $0.5855. What is the price of the vests to the importer if the spot rate remains unchanged in the next two months? If it is $0.5500? If it is $0.6200?

18. Business Example (cont’d) Solution: If the spot rate does not change, the cost to the importer is: 40 x NZ$110 x $0.5855 = $2,576.20 If the spot rate is $0.5500: 40 x NZ$110 x $0.5500 = $2,420.00 If the spot rate is $0.6200: 40 x NZ$110 x $0.6200 = $2,728.00

19. Investment Example You just purchased 1,000 of Kangaroo Lager trading on the Sydney Stock Exchange for AUD1.45 per share. The exchange rate for the Australian dollar at the time of purchase was $0.7735. What is the U.S. dollar purchase price? If Kangaroo Lager stock rises to AUD1.95 per share and if the Australian dollar depreciates to $0.7000, what is your holding period return if you sell the shares?

20. Investment Example (cont’d) Solution: The purchase price in U.S. dollars is: 1,000 x AUD1.45 x $0.7735 = $1,121.58 If the Australian dollar depreciates and you sell the shares, you will receive: 1,000 x AUD1.95 x $0.7000 = $1,365.00 The holding period return is: ($1,365.00 - $1,121.58)/$1,121.58 = 21.7%

21. From Whence Cometh the Risk? • Role of interest rates • Forward rates • Interest rate parity • Covered interest arbitrage • Purchasing power parity

22. Real Rate of Interest • The real rate of interest reflects the rate of return investors demand for giving up the current use of funds • In a world of no risk and no inflation, the real rate indicates people’s willingness to postpone spending their money

23. Inflation Premium • The inflation premium reflects the way the general price level is changing • Inflation is normally positive • The inflation premium measures how rapidly the money standard is losing its purchasing power

24. Risk Premium • The risk premium is the component of interest rates that reflects compensation for risk to risk-averse investors • The risk premium is a function of how much risk a security carries • E.g., common stock vs. T-bills

25. Forward Rates • The forward rate is a contractual rate between a commercial bank and a client for the future delivery of a specified quantity of foreign currency • Typically quoted on the basis of 1, 2, 3, 6, and 12 months

26. Forward Rates (cont’d) • The forward rate is the best estimate of the future spot rate • If the forward rate indicates the dollar will strengthen, importers should delay payment • If the forward rate indicates the dollar will weaken, importers should lock in a rate now

27. Forward Rates (cont’d) • Forward rate premium or discount:

28. Forward Rates (cont’d) Example On April 29, 2005, the British pound had a spot rate of $1.9146. The 3-month forward rate of the pound was $1.9041 on that date. What is the forward premium or discount?

29. Forward Rates (cont’d) Example (cont’d) Solution: The forward premium or discount is calculated as follows: There is a forward discount of –2.19%.

30. Interest Rate Parity • Interest rate parity states that differences in national interest rates will be reflected in the currency forward market • Two securities of similar risk and maturity will show a difference in their interest rates equal to the forward premium or discount, but with the opposite sign

31. Interest Rate Parity Formula

32. Example • Six-month German Treasury Bills yield 2.60% (annualized rate) • Spot exchange rate is $ 0.6051 / DM • Six-month Forward rate is $ 0.6095 / DM • RUS=2.60+100(0.6095-0.6051)(12/6)/0.6051 • RUS=4.05 %

33. Covered Interest Arbitrage • Covered interest arbitrage is possible when the conditions of interest rate parity are violated • If the foreign interest rate is too high, convert dollars to the foreign currency and invest in the foreign country • If the U.S. interest rate is too high, borrow the foreign currency and invest in the U.S.

34. Example of CIA • Six-month Swiss rate is 1.00 % (annualized rate) • Six-month US Treasury Bills yield 2.00 % (annualized rate) • Spot exchange rate is $ 0.8542 / CHF • Six-month Forward rate is $ 0.8610 / CHF • What arbitrage strategy can you implement ?

35. Example of CIA

36. Purchasing Power Parity • Purchasing power parity (PPP) refers to the situation in which the exchange rate equals the ratio of domestic and foreign price levels • A relative change in the prevailing inflation rate in one country will be reflected as an equal but opposite change in the value of its currency

37. Purchasing Power Parity (cont’d) • Absolute purchasing power parity follows from “the law of one price:” • A basket of goods in one country should cost the same in another country after conversion to a common currency • Not very accurate due to: • Transportation costs • Trade barriers • Cultural differences

38. Purchasing Power Parity (cont’d) • Relative purchasing power parity states that differences in countries’ inflation rates determine exchange rates:

39. Purchasing Power Parity (cont’d) • A country with an increase in inflation will experience a depreciation of its currency because: • Exports decline • Imports increase • There is less demand for goods from that country

40. The Concept of Exposure • Definition • Accounting exposure • Transaction exposure • Translation exposure • Economic exposure

41. Definition • Exposure is a measure of the extent to which a person faces foreign exchange risk • In general, there are two types of exposure: accounting and economic • Economic exposure is more important

42. Accounting Exposure • Accounting exposure is: • Of concern to MNCs that have subsidiaries in a number of foreign countries • Important to people who hold foreign securities and must prepare dollar-based financial reports • U.S. firms must prepare consolidated financial statements in U.S. dollars

43. Transaction Exposure • FASB Statement No. 8 addresses transaction exposure: • “A transaction involving purchase or sale of goods or services with the price states in foreign currency is incomplete until the amount in dollars necessary to liquidate a related payable or receivable is determined”

44. Translation Exposure • Translation exposure results from the holding of foreign assets and liabilities that are denominated in foreign currencies • E.g., foreign real estate and mortgage holdings must be translated to U.S. dollars before they are incorporated into a U.S. balance sheet

45. Economic Exposure • Economic exposure measures the risk that the value of a security will decline due to an unexpected change in relative foreign exchange rates • Security analysts should include expected changes in exchange rates in forecasted cash flows

46. Dealing With the Exposure • Ignore the exposure • Reduce or eliminate the exposure • Hedge the exposure

47. Ignore the Exposure • Ignoring the exposure may be appropriate for an investor if: • Foreign exchange movements are expected to be modest • The dollar mount of the exposure is small relative to the cost of inconvenience of hedging • The U.S. dollar is expected to depreciate relative to the foreign currency

48. Reduce or Eliminate the Exposure • If the dollar is expected to appreciate dramatically, an investor may reduce or eliminate foreign currency holdings

49. Hedge the Exposure • Definition • Hedging with forward contracts • Hedging with futures contracts • Hedging with foreign currency options

50. Definition • Hedging involves taking one position in the market that offsets another position • Covering foreign exchange risk means hedging foreign exchange risk