Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Eighth Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 3
Selecting Investments in a
Global Market
Questions to be answered:
 Why should investors have a global perspective
regarding their investments?
 What has happened to the relative size of U.S. and
foreign stock and bond markets?
 What are the differences in the rates of return on
domestic and foreign securities markets?
 How can changes in currency exchange rates affect the
returns that domestic investors experience on foreign
securities?
Questions to be Answered
 Is there an additional advantage of diversifying in
international markets beyond the benefits of domestic
diversification?
 What alternative securities are available? What are
their cash flow and risk properties?
 What is the historical return and risk characteristics of
the major investment instruments?
 What is the relationship among returns for foreign and
domestic investment instruments? What is the
implication of these relationships for portfolio
diversification?
Three Reasons for the expansion
of foreign investment
opportunities
1.
2.
3.
Growth and development of foreign financial markets
Advances in telecommunications technology
Mergers of firms and security exchanges
•
•
•
•
•
•
1999 - Vancouver & Alberta Stock Exchanges merge to form the
Canadian Venture Exchange (CDNX)
1999 – CDNX acquires The Canadian Dealing Network, Winnipeg
Stock Exchange & the equities portion of the Montreal Exchange
2001 – TSX acquires CDNX to form TSX Venture Exchange
NASDAQ merged with American Stock Exchange in 1998
NYSE acquired EuroNext, the second largest Exchange in Europe in a
$20 Billion dollar deal (June, 2006)
On Dec 13, 2006, NASDAQ launched a $5.3 B hostile take-over offer
to purchase a majority of shares in the London Stock Exchange (it
already owns 28.75% of LSE shares)
Ten Reasons Canadians Should
Invest Abroad
1.
2.
Canada is a small market
The S&P/TSX is dominated by energy & financial
services
3. Some industry sectors are not represented in the
S&P/TSX
4. The Canadian market is highly cyclical
5. International markets provide diversification
6. International valuations look attractive
7. Higher dividend yields can be found abroad
8. International structural trends are positive
9. Growth opportunities in emerging markets
10. FX volatility should not deter foreign investing
Source: TD Economics, Special Report, Sept 5, 2006
Canadian Ownership of Foreign
Securities: 2006
Canadian
holdings of
foreign mutual
funds peaked
at 38% in
2000. Since
then, it has
fallen to 22% of
total mutual
fund assets.
Source: TD Economics, Special Report, Sept 5, 2006
Canada is a Small Market
1.
2.
3.
4.
The share of the U.S. in world stock and bond markets
has dropped from about 65 percent of the total in 1969 to
about 51 percent in 2003
Overall value of the total global capital market has
increased from $2.3 Trillion in 1969 to $70.9 Trillion in
2003.
Canada’s capital markets comprise approximately 3.5%
of the total global capital market and the Canadian
economy is approximately 2% of the global economy.
The growing importance of foreign securities in world
capital markets is likely to continue (see next page
dealing with IPOs)
E&Y: Global IPO Trends Report 2006
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Capital raised around the world rose by one-third to hit $167 billion, the highest
level since 2000, while deal numbers remained steady at 1,537, compared to 1,516
in 2004.
2005 was a watershed year for IPO activity in the Middle East and Africa: soaring
liquidity from oil revenues contributed to many big ticket IPOs raising more than
$500 million each.
In the next few years, assuming the necessary political stability, the Middle East is
likely to become an important source of IPO activity as oil revenues are recycled
into the local economy.
Asia continues to be a hotbed of activity. Towed along by mainland China and Hong
Kong’s continuing strength, other economies in the area displayed vigorous IPO
activity.
One of the three biggest deals to date this year was Lotte, the South Korean
Department Store, which raised $3.5 billion when it dual-listed in London and
Seoul.
Many Indian IPOs have been oversubscribed 20 to 30 times in markets that have
been scaling record levels. Following Jet Airways’ successful launch — one of the
most successful Indian IPOs of recent times — a number of state-run airlines are
poised to float in the near future.
In Latin America, Brazil saw an increase in both the amount of capital raised and the
number of transactions on the previous year. Brazilian companies currently account
for one-third of all Latin American listings on the New York Stock Exchange.
Foreign Markets Can Add Return
Germany is the
world’s largest
exporter,
exceeding
even China,
with exports
last year of
over US $1
Trillion.
Source: TD Economics, Special Report, Sept 5, 2006
Canadian Markets are Highly
Concentrated
Over the last 4
years, energy has
been responsible
for 50% of the
increase in the
TSX. Financials
have accounted
for 1/3 of the gain,
leaving the other
8 major industry
groups
contributing less
than 20%
Source: TD Economics, Special Report, Sept 5, 2006
Correlations Between TSX &
International Indices
To reduce risk,
must diversify
among securities
with low
correlations.
Because the
Canadian market
is highly
concentrated,
diversification is
difficult.
Source: TD Economics, Special Report, Sept 5, 2006
Dividend Yields Can Be Higher
Abroad
Dividend yields in
N.A. have
averaged 1.5 –
2% over the last
decade, while the
FTSE 100
generally returns
a dividend yield
of twice that.
Source: TD Economics, Special Report, Sept 5, 2006
Dividends as a % of Total Return
Over a 20 year
period in
Canada, the
U.K. and the
U.S.,
reinvested
dividends
accounted for
2/3 of the total
return on
equities.
Source: TD Economics, Special Report, Sept 5, 2006
International Structural Changes are
Positive
Productivity
growth is
dramatically
higher in many
countries than in
Canada.
Japanese firms
have cut costs,
reduced excess
capacity &
reduced
liabilities.
Source: TD Economics, Special Report, Sept 5, 2006
Emerging Markets & High Growth
India’s benchmark
index has had a
225% return,
measured from the
trough in 2002 to Q2,
2006. China has
been the world’s
fastest growing
country for much of
the last 20 years but
the Shanghai index
has had an average
annual return of only
4.3% over the last
four years.
Source: TD Economics, Special Report, Sept 5, 2006
Some Foreign Indexes: 5 Years
Source: Yahoo Finance
FX Volatility
FX volatility can
either enhance or
reduce a foreign
return. Foreign
returns are
enhanced when the
domestic currency
depreciates against
the foreign currency.
Domestic returns are
reduced when the
domestic currency
appreciates against
the foreign currency.
Source: TD Economics, Special Report, Sept 5, 2006
Domestic Returns & Foreign Assets
 The domestic return is equal to the percentage
return in the foreign market times the percentage
change in the foreign exchange rate.
 For example, you earn a 30% return in a foreign
market. Over the same period, the Canadian
dollar appreciates against the foreign currency by
10%. What is the percentage Canadian dollar
return?
Solution
 To calculate the domestic dollar return
RDomestic  1  RForeign  1  Dep ' n in Exchange Rate   1
 1.30  0.90   1
 1.17  1
 17%
Global Investment Choices
1. Fixed-income investments
• bonds and preferred stocks
2. Equity investments
3. Special equity instruments
• warrants and options
4. Futures contracts
5. Investment companies
6. Real assets
Municipal Bonds
 Issued by US state and local governments,
usually to finance infrastructural projects.
 Exempt from taxation by the US federal
government and by the state that issued the
bond, provided the investor is a resident of
that state
 Two types:
• General obligation bonds (GOs)
• Revenue bonds
International Bond Investing
 Eurobond
• An international bond denominated in a
currency other than the currency of the country
where the bond is issued.
• Example: Shogun bond – denominated in Yen but
issued outside of Japan
 Foreign bond
• Issued by a foreign company but in the
currency of the country where it is issued
• Yankee bondMatilda bond
• Samurai bond
Bulldog bond
• Matador bond
Acquiring Foreign Equities
1. Purchase of American Depository Receipts
(ADRs)
2. Direct purchase of foreign shares listed on a
stock exchange
3. Purchase of international mutual funds
American Depository Receipts
(ADRs)
 Easiest way to directly acquire foreign shares
 Certificates of ownership issued by a U.S. bank that
represents indirect ownership of a certain number of shares
of a specific foreign firm on deposit in a U.S. bank
 As of January, 2007, 305 ADRs are listed on the NYSE &
3 on the American Stock Exchange.
 Buy and sell in U.S. dollars
 Dividends in U.S. dollars
 May represent multiple shares
 Listed on U.S. exchanges
 Very popular
 To check www.globeinvestor.com Then use Filters
Direct Purchase or Sale of
Foreign Shares
 Direct investment in foreign equity
markets - difficult and complicated due
to administrative issues, lack of
information, taxation issues and market
efficiency problems
 Purchase foreign stocks listed on a
Canadian or U.S. exchange – limited
choice
Purchase or Sale of Global Mutual
Funds or ETFs
 Global funds - invest in both domestic and foreign
stocks
 International funds - invest mostly outside of
Canada
 Funds can specialize
•
•
•
•
Diversification across many countries
Concentrate in a segment of the world
Concentrate in a specific country
Concentrate in types of markets
 Exchange-traded funds or ETFs are a recent
innovation in the world of index products (see
next page)
Exchange Traded Funds
 DIAMONDs Shares in an ETF that tracks the Dow Jones
Industrial Average. The fund is structured as a unit investment
trust.
 iShares A group of ETFs advised and marketed by Barclays
Global Investors. iShares are structured as open-end mutual
funds.
 HOLDRs Holding company depository receipts, a type of ETF
marketed by Merrill Lynch. Unlike other ETFs, HOLDRs can
only be bought and sold in 100-share increments. Investors may
exchange 100 shares of a HOLDR for its underlying stocks at
any time. Existing HOLDRs focus on narrow industry groups.
Each initially owns 20 stocks, but they are unmanaged, and so can
become more concentrated due to mergers, or the disparate
performance of their holdings.
Exchange Traded Funds
 Qubes (QQQ) The Nasdaq-100 tracking stock, an
ETF that tracks the Nasdaq 100 index. The
popular name, Qubes, derives from the ETF's
ticker symbol, QQQ. Qubes are by far the most
heavily traded ETF.
 Spiders SPDRs, or Standard & Poors' Depository
Receipts. A group of ETFs that track a variety of
Standard & Poors' indexes. SPDR Trust, Series 1,
usually referred to as "Spiders," tracks the S&P
500 index. Select Sector SPDRs track various
sector indices that carve up the S&P 500 index
into separate industry groups.
Exchange Traded Funds
 Horizons BetaPro S&P/TSX 60 Bear Plus ETF &
Horizons BetaPro S&P/TSX 60 Bull Plus ETFs
began trading January 9, 2007.
 Using derivatives, the funds are designed to return
a positive return equal to twice the percentage
change in the S&P/TSX 60 Index (before fees &
expenses)
 For example, the Bear ETF should have a 4%
positive return given a 2% drop in the Index.
 The Bull ETF should have a 4% positive return
given a 2% increase in the Index.
Special Equity Instruments
 Warrants are similar to long call options written by the
company whose stock can be acquired
 Rights are similar to short call options written by the company
whose stock can be acquired
 Call options give the buyer the right but not the obligation to
purchase a stock for a given period of time for a fixed price
 Put options give the buyer the right but not the obligation to
sell a stock for a given period of time for a fixed price
Futures & Forwards
 Allows both buyer and seller to lock in a
price today for an exchange to take place in
the future.
 Futures and forwards are economically
identical but they differ in their institutional
characteristics.
 Commodities trading is largely in futures
contracts
 Current price depends on expectations
Real Estate
 Negative correlation between residential
and farm real estate and stocks
 Low positive correlation between
commercial real estate and stocks
 Potential for diversification