19 Globalization and International Investing Bodie, Kane and Marcus Essentials of Investments 9th Global Edition 19.1 GLOBAL MARKETS FOR EQUITIES Background Global market U.S. stock exchanges make up roughly 40% of all markets Emerging market development Market capitalization and GDP TABLE 19.1 MARKET CAPITALIZATION OF STOCK EXCHANGES, DEVELOPED COUNTRIES Market Capitalization Billions of U.S. Dollars 2000 WORLD US JAPAN UK CANADA FRANCE HONG KONG GERMANY SWITZERLAND AUSTRALIA KOREA SPAIN ITALY SWEDEN NETHERLANDS MEXICO NORWAY CHILE BELGIUM DENMARK TURKEY FINLAND ISRAEL POLAND AUSTRIA IRELAND PORTUGAL CZECH REP. NEW ZEALAND LUXEMBURG GREECE HUNGARY SLOVENIA 27,473 12,900 3,140 2,566 615 1,278 564 1,061 783 349 123 331 716 274 680 112 52 44 159 99 50 280 46 27 28 82 64 12 20 28 72 12 2 2011 38,200 13,917 3,289 2,794 1,581 1,455 1,369 1,177 1,062 1,039 763 546 460 440 376 372 238 229 216 176 164 139 119 112 85 65 59 39 35 34 29 19 6 Percent of World 2000 100% 47.0 11.4 9.3 2.2 4.7 2.1 3.9 2.9 1.3 0.4 1.2 2.6 1.0 2.5 0.4 0.2 0.2 0.6 0.4 0.2 1.0 0.2 0.1 0.1 0.3 0.2 0.0 0.1 0.1 0.3 0.0 0.0 2011 100% 36.4 8.6 7.3 4.1 3.8 3.6 3.1 2.8 2.7 2.0 1.4 1.2 1.2 1.0 1.0 0.6 0.6 0.6 0.5 0.4 0.4 0.3 0.3 0.2 0.2 0.2 0.1 0.1 0.1 0.1 0.0 0.0 Annual Growth (%) GDP GDP per Capita 2000-2011 2010 2010 2.8 0.6 0.4 0.7 8.2 1.1 7.7 0.9 2.6 9.5 16.4 4.2 -3.6 4.0 -4.8 10.5 13.5 14.7 2.6 4.9 10.4 -5.7 8.3 12.5 9.8 -1.9 -0.6 10.4 5.0 1.7 -7.1 4.1 11.2 63,124 14,587 5,459 2,249 1,577 2,560 225 3,281 528 925 1,015 1,407 2,051 459 779 1,035 413 213 469 310 734 239 217 469 379 211 229 192 136 53 301 129 47 9,228 47,199 42,831 36,144 46,236 39,460 31,758 40,152 67,464 42,131 20,757 30,542 33,917 48,936 46,915 9,123 84,538 12,431 43,144 55,891 10,094 44,512 28,504 12,293 45,209 47,170 21,505 18,245 31,067 105,438 26,600 12,852 22,851 Market Capitalizatio n as % of GDP 2010 68 98 69 133 114 70 701 43 224 132 86 44 28 118 60 39 61 136 54 67 34 86 80 34 33 30 35 23 35 79 21 22 18 TABLE 19.2 MARKET CAPITALIZATION OF STOCK EXCHANGES, EMERGING MARKETS BRAZIL INDIA RUSSIA CHINA TAIWAN SINGAPORE SOUTH AFRICA MALAYSIA INDONESIA THAILAND COLOMBIA PHILIPPINES PERU ARGENTINA PAKISTAN SRI LANKA ROMANIA VENEZUELA CYPRUS BULGARIA Market Capitalization Billions of U.S. Dollars Percent of World 2000 2011 2000 2011 180 1,056 0.7 2.8 107 868 0.4 2.3 19 694 0.1 1.8 13 499 0.0 1.3 177 455 0.6 1.2 136 428 0.5 1.1 104 83 21 23 4 20 5 24 5 1 0 6 9 0 405 330 301 219 191 141 77 36 26 14 14 6 3 2 0.4 0.3 0.1 0.1 0.0 0.1 0.0 0.1 0.0 0.0 0.0 0.0 0.0 0.0 1.1 0.9 0.8 0.6 0.5 0.4 0.2 0.1 0.1 0.0 0.0 0.0 0.0 0.0 Growth (%) 2000-2011 15.9 19.0 34.9 35.2 8.2 10.1 GDP 2010 2,088 1,727 1,480 5,927 430 209 12.0 12.1 24.8 20.7 37.3 17.6 25.9 3.6 15.2 27.5 36.9 -0.2 -9.7 29.6 364 238 707 319 288 200 157 369 177 50 162 392 23 48 Market GDP Capitalizati per on as % of Capita GDP 2010 2010 10,710 66 1,475 69 10,440 58 4,428 11 18,300 134 41,122 241 7,275 8,373 2,946 4,608 6,225 2,140 5,401 9,124 1,019 2,375 7,538 13,590 28,779 6,325 134 135 41 70 70 67 64 15 17 31 9 3 28 4 FIGURE 19.1A PER CAPITA DGP AND MARKET CAPITALIZATION AS PERCENT OF GDP, LOG SCALE 2000 FIGURE 19.1B PER CAPITA GDP AND MARKET CAPITALIZATION AS PERCENT OF GDP, LOG SCALE 2010 19.2 RISK FACTORS IN INTERNATIONAL INVESTING • Risks in Foreign Security Investment Exchange rate risk • • Uncertainty in asset returns due to movements in exchange rates between U.S. dollar and foreign currency Country-specific risk • • Political risk: Possibility of expropriation of assets, changes in tax policy, restrictions on exchange of foreign currency for domestic, etc. Imperfect exchange rate risk hedging • • Hard to hedge equities with variable rates of return 19.2 RISK FACTORS IN INTERNATIONAL INVESTING • 19.2 RISK FACTORS IN INTERNATIONAL INVESTING • Dollar Depreciation Relative to Pound If you invest in a British security and earn 10%, find the return in U.S. dollars given • • • Initial exchange rate: £ = $2 Final exchange rate: £ = $2.10 1 r (US) 1.10 $2.10 $2 r (US) 15 . 5 % 19.2 RISK FACTORS IN INTERNATIONAL INVESTING Dollar Appreciation Relative to Pound If you invest in a British security and earn 10%, find the return in U.S. dollars given Initial exchange rate: £ = $2 Final exchange rate: £ = $1.85 1 r (US) 1.10 $1.85 $2 r (US) 1 . 75 % FIGURE 19.2 STOCK RETURNS, U.S. DOLLARS AND LOCAL CURRENCIES, 2010 5.10 4.83 China 1.72 Brazil Return in Local Currencies 6.81 20.30 19.40 Russia 16.22 India 20.95 Pakista n 27.06 UK 8.80 German y 29.05 12.22 16.91 9.32 12.51 11.82 Norway Australi a 0.66 Japan 0.71 0 14.73 15.59 5 10 15 20 25 30 TABLE 19.3 RATES OF CHANGE, U.S. DOLLAR Switzerland Australia Canada VERSUS WORLD Euro CURRENCIES (€) U.K. (£) (SF) , 2002-2011 Japan (¥) (A$) (C$) A. Standard deviation (annualized %) 11.04 9.32 11.94 9.13 13.87 10.04 B. Correlation matrix Euro (€) U.K. (£) Switzerland (SF) Japan (¥) Australia (A$) Canada (C$) U.K. (£) Switzerland (SF) Japan (¥) Australia (A$) 0.63 1 0.83 0.51 1 0.27 0.08 0.42 1 0.75 0.6 0.61 0.05 1 0.51 0.49 0.37 -0.02 0.72 C. Average annual returns from rolling over one-month LIBOR rates (%) Return in Expected Actual Surprise Gain Gain Actual Compone Local from from Return nt Currenc in U.S. Country Currency Currency Currency y dollars of Return U.S. $ 2.18 2.18 Euro € 2.38 -0.20 4.38 6.77 4.58 U.K. £ 3.51 -1.32 1.09 4.60 2.41 SF SF 0.90 1.28 6.46 7.36 5.17 Japan ¥ 0.24 1.94 5.75 5.99 3.81 Australia A$ 5.25 -3.07 7.94 13.19 11.01 Canada C$ 2.50 -0.31 5.01 7.51 5.32 SD of Annual Return 11.04 9.32 11.94 9.13 13.87 10.04 Canada (C$) 1 19.2 RISK FACTORS IN INTERNATIONAL INVESTING Carry Trade Suppose yen LIBOR = .24%, USD LIBOR = 3.75% An astute investor may borrow yen at the yen rate, convert the borrowed funds to dollars, and invest at dollar LIBOR What can go wrong with this strategy? Default Yen increases in value by 3.75% − .24% = 3.51% or more 19.2 RISK FACTORS IN INTERNATIONAL INVESTING • Covered Interest Arbitrage U.S. interest rates 6.15%, British rates 10%, exchange rate $2/£; 1-year forward exchange rate for pound is $1.95/£ • How can you earn a riskless arbitrage profit based on these quotes? • • • • • • Borrow $1 at 6.15%: will owe $1.0615 in 1 year Convert $1 to pounds: $1/($2/£) = £.50 Invest £.50 at 10%: Will yield £.50 x 1.10 = £.55 Sell pound forward at $1.95: £55 x $1.95 = $1.0725 Net: $1.0725 − $1.0615 = $.011/dollar 19.2 RISK FACTORS IN INTERNATIONAL INVESTING Covered Interest Parity The spot-futures exchange rate relationship that prevents arbitrage opportunities If the interest rates and exchange rates are in this relationship, no arbitrage is possible 1 r (US) 1 r (For) F1 E0 TABLE 19.4 COMPOSITE RISK RATINGS FOR 01/2011, 02/2010 Rank in January 2011 1 11 13 16 19 31 32 39 44 68 78 86 104 111 124 127 129 138 140 Country Very low risk Norway Germany Canada Qatar Japan Low risk United Kingdom United States China, Peoples' Rep. Brazil Spain Moderate risk Indonesia India Egypt Turkey High risk Venezuela Iraq Pakistan Very high risk Haiti Somalia Composite Composite January 2011 Risk Rating Risk Rating versus Rank in January 2011 February 2012 February 2010 February 2010 90.5 83.5 82.8 82.0 81.0 90.00 83.50 82.75 81.25 80.00 0.50 0.00 0.00 0.75 1.00 1 5 6 11 17 77.3 77.0 75.0 74.5 70.0 73.75 77.25 76.25 72.75 71.00 3.50 -0.25 -1.25 1.75 -1.00 39 26 30 46 58 68.5 67.3 64.5 63.3 67.25 70.50 66.50 63.50 1.25 -3.25 -2.00 -0.25 81 62 84 100 59.5 58.5 57.3 53.75 59.25 57.00 5.75 -0.75 0.25 133 119 125 48.5 41.5 49.75 36.75 -1.25 4.75 137 140 TABLE 19.5 VARIABLES USED IN PRS’S POLITICAL RISK SCORE TABLE 19.6 CURRENT RISK RATINGS AND COMPOSITE RISK FORECASTS Composite Ratings Year Ago Country Current Political Risk Current Ratings Financial Economic Risk Risk February 2010 January 2011 January 2011 January 2011 January 2011 Norway 90.00 90.50 88.5 46.5 46.0 Canada 82.75 82.75 86.5 40.0 39.0 Japan 80.00 81.00 78.5 44.0 39.5 United States 77.25 77.00 81.5 37.0 35.5 China, Peoples' Rep. 76.25 75.00 62.5 48.0 39.5 India 70.50 67.25 58.5 43.5 32.5 Turkey 63.50 63.25 57.0 34.5 35.0 TABLE 19.7 RISK FORECASTS Composite Risk Forecasts Current Country One Year Ahead Rating January 2011 Worst Case Five Years Ahead Best Case Risk Stability Worst Case Best Case Risk Stability Norway 90.5 88.3 93.3 5.0 83.3 92.8 9.5 Canada 82.8 78.3 84.3 6.0 75.3 86.5 11.3 Japan 81.0 77.0 84.3 7.3 72.5 87.5 15.0 United States China, Peoples' Rep. 77.0 73.3 80.3 7.0 69.5 83.0 13.5 75.0 70.8 79.0 8.3 61.3 82.0 20.8 India 67.3 64.0 72.3 8.3 57.5 77.0 19.5 Turkey 63.3 57.8 67.5 9.8 53.8 71.5 17.8 Political Risk Forecasts Current One Year Ahead Five Years Ahead Country Rating 01/11 Worst Case Best Case Risk Stability Worst Case Norway 88.5 88.0 92.0 4.0 86.0 89.5 3.5 Canada 86.5 83.0 88.5 5.5 81.5 89.5 8.0 Japan 78.5 75.5 84.0 8.5 72.0 88.0 16.0 United States China, Peoples' Rep. 81.5 77.5 85.5 8.0 76.0 87.0 11.0 62.5 58.5 68.5 10.0 55.0 73.0 18.0 India 58.5 55.0 64.0 9.0 53.5 71.0 17.5 Turkey 57.0 52.5 63.5 11.0 51.5 69.0 17.5 Best Case Risk Stability TABLE 19.8 POLITICAL RISK POINTS BY COMPONENT, 1/2011 19.3 INTERNATIONAL INVESTING RISK, RETURN, AND BENEFITS FROM DIVERSIFICATION • International • Direct Investment Choices stock purchases • Difficult for individual investors due to currency and tax issues • Mutual funds • Open end • World versus international funds • Higher expenses • Closed end • Country or regional funds • WEBS FIGURE 19.3 MONTHLY STANDARD DEVIATION OF EXCESS RETURNS, DEVELOPED AND EMERGING MARKETS, 2002-2011 FIGURE 19.4 BETA AGAINST U.S. MARKET OF DEVELOPED AND EMERGING MARKETS, 20022011 FIGURE 19.5 AVERAGE EXCESS DOLLARDENOMINATED RETURNS, DEVELOPED AND EMERGING MARKETS, 2002-2011 FIGURE 19.6 INFORMATION RATIOS, DEVELOPED AND EMERGING MARKETS VERSUS U.S. DOLLARDENOMINATED RETURNS, 2002-11 FIGURE 19.7 STANDARD DEVIATION OF EXCESS RETURNS, DOLLAR-DENOMINATED AND LOCAL CURRENCIES, 2002-2011 FIGURE 19.8 MARKET BETA AGAINST U.S. USING DOLLAR-DENOMINATED AND LOCAL-CURRENCY EXCESS RETURNS, 2002-11 FIGURE 19.9 AVERAGE DOLLAR-DENOMINATED AND LOCAL-CURRENCY EXCESS RETURNS, 2002-2011 19.3 INTERNATIONAL INVESTING: RISK, RETURN, AND BENEFITS FROM DIVERSIFICATION 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 FIGURE 19.10 INFORMATION RATIOS AGAINST U.S. COMPUTED FROM DOLLAR-DENOMINATED AND LOCAL CURRENCY RETURNS, 2002-2011 FIGURE 19.11 INTERNATIONAL DIVERSIFICATION TABLE 19.10 CORRELATION OF FOREIGN INVESTMENTS WITH U.S. RETURNS OVER TIME FIGURE 19.12 EX-POST EFFICIENT FRONTIER OF COUNTRY PORTFOLIOS FIGURE 19.13A EFFICIENT FRONTIER OF COUNTRY PORTFOLIOS (WORLD EXPECTED EXCESS RETURN = .3% PER MONTH) FIGURE 19.13B EFFICIENT FRONTIER OF COUNTRY PORTFOLIOS (WORLD EXPECTED EXCESS RETURN = .6% PER MONTH) FIGURE 19.14A REGIONAL INDEXES AROUND THE CRASH, 10/14/87-10/26/87 19.14B BETA AND OF PORTFOLIOS AGAINST DEVIATION OF MONTHLY RETURN, 9/0812/08 19.3 INTERNATIONAL INVESTING: RISK, RETURN, AND BENEFITS FROM DIVERSIFICATION Conclusions Passive investment in all countries would not have lowered risk during recent crisis Hedging currencies has little effect; U.S. stock market crash appears to be systemic factor that cannot be diversified away from in crisis Correlations are increasing due to globalization; nevertheless, we still expect modest international diversification benefits in normal markets 19.3 INTERNATIONAL INVESTING: RISK, RETURN, AND BENEFITS FROM DIVERSIFICATION Active Management First level Security selection and asset allocation within each market to identify country portfolio superior to country index Second level Optimize allocations across country portfolios to maximize diversification 19.5 INTERNATIONAL INVESTING AND PERFORMANCE ATTRIBUTION The “Bogey” or Benchmark Currency Selection EAFE index (non-U.S. stocks) Contribution to performance due to currency movements Country Selection Contribution to performance due to choosing betterperforming countries 19.5 INTERNATIONAL INVESTING AND PERFORMANCE ATTRIBUTION Stock Selection Measured as weighted average of equity returns in excess of equity index in each country Cash/Bond Selection Excess return due to weighting bonds and bills differently from benchmark weights