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