International Securities
Markets
Diversification and Globalization
The World Equity Market

World equity markets grew rapidly from 1992
to 2006

Market capitalization (value) of developed
countries stock markets was $33 trillion at
year end 1999. By year end 2002 it was
$20.9 trillion

By 2005 the developed markets had
recovered and their market capitalization
reached $36.5 trillion
2
The World Equity Market





Markets fluctuate with economic activity
Over time markets recover with the economy
World markets had a strong recovery in 2003
and continued into 2007.
Developed world securities markets continue
to expand
Major growth also in the “emerging” markets
• Argentina - Brazil - China – Taiwan -- Mexico
3
Emerging Markets Share
2002 and 2005






2002 2005
Mideast and Africa
18% > 31%
South Asia
12% > 14%
East Asia
48% < 29%
Eastern/Central Europe 7% > 11%
Latin America
15% = 15%
4
Diversification Benefits

Invest in foreign markets for diversification
Foreign markets do NOT move in harmony with each
other

Diversified portfolio from many countries is less

volatile than domestic portfolio - could even have a
higher rate of return
As the world markets become more global,
returns between countries may become more
harmonized.
5
Diversification Benefits cont.



Correlation between the historical returns of
different countries is less than 1.0
Richard Roll: Most significant factor relating
to the size of the market decline in each
country was the beta, β, of that market to
the world market index
No country continually outperforms the
others on an annual basis
6
Risk Reduction with International Securities
Risk Reduction with International Stocks
Standard Deviation of Portfolio
1
0.9
0.8
0.7
0.6
Domestic Portfolio
0.5
0.4
0.3
International Portfolio
0.2
0.1
0
1
11
21
31
41
Number of Securities in Portfolio
51
7
Degree of Diversification

Measure correlation of stock movements
Correlation Coefficient:
Measures movement of one series of data
over time to another series of data in this case stock market returns
8
 1  Coefficien t Correlatio n  1
Coefficient Relationship Implication
1
Perfect
positive
Two variables move
together up and down
-1
Perfect
negative
Two variables move
opposite of each other
0
No
relationship
Assets with correlation coefficient
of less than 1 reduce amount of risk
9
Correlation Coefficients Between Foreign Markets
and U.S. Markets in $ rates of Return
1985-2003
2000-2005
Country
Correlation
Correlation
Australia
0.48
0.72
Canada
0.77
0.80
France
0.58
0.87
Germany
0.54
0.89
Italy
0.37
0.77
Japan
0.31
0.36
Netherlands
0.66
0.86
Spain
0.55
0.82
Switzerland
0.53
0.72
United Kingdom
0.64
0.82
10
Average
0.55
0.78
Correlations of Total Return between U.S. Markets and
Emerging Markets in U.S. Dollars 2000-2005
Correlation Coefficients
Argentina
0.34
Brazil
0.72
Mexico
0.73
China
0.40
India
0.49
Taiwan
0.44
Russia
0.45
South Africa
0.39
11
Return Potential in International Markets
International
diversification
Less risk exposure
+
Possible higher returns
1. Several countries had long-term growth
rates superior to U.S. in terms of real GDP:
• Norway
• Singapore
• China
12
Returns in Developed Markets In U.S. $
United States
Japan
United Kingdom
France
Canada
Germany
Hong Kong
Spain
Switzerland
Italy
2002
-21.4%
2003
31.9%
2004
12.5%
2005
6.6%
-8.7
-14.2
-18.6
38.6
34.2
42.8
16.9
21.3
20.8
28.0
9.1
11.9
-10.8
-29.9
-16.3
56.7
65.2
45.3
24.7
16.9
23.2
28.6
11.4
11.6
-11.8
-10.9
-6.3
59.9
36.3
41.3
30.1
15.9
32.2
6.7
17.0
13
4.1
5 Yr. Returns in Emerging Markets
in U.S. $ 2000-2005
United States
3.12%
Japan
7.68%
United Kingdom
6.36%
France
6.00%
Canada
14.60%
Germany
6.60%
Hong Kong
8.40%
Spain
13.20%
Switzerland
6.00%
Italy
7.68%
14
Return Potential in International Markets
2. Many countries are highly competitive in
automobiles, steel, & consumer electronics
3.
 Germany
 Japan
 France
 Canada
Enjoy higher
individual
savings rates
than U.S.
Capital formation and
potential investment opportunity
15
Annualized rates of return of world
indexes over 32-yr. period 1969-2001
16
Current Quotations on Foreign
Market Performance

Track performance of selected world markets
www.msci.com
Instructions to navigate msci website: on Power Point
tool bar click View, choose Notes Page
 1st index EAFE =Europe, Australia, FarEast
 Quotes are in local currencies & in U.S. $
 U.S. investors compare returns in U.S.
against an investment in U.S. stock market
17
Other Market Differences

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Culture
Willingness to take risk
Desire for dividend income versus growth in
share value
Number & type of companies available to
stockholders
Bureaucratic differences
18
Other Market Differences cont.



Accounting conventions
Government regulation of markets
Problem with comparing P/E ratios:
Earnings calculated differently according
to local or regional accounting
19
Currency Fluctuations and
Rates of Return


Tracking foreign markets requires
adjustments
Reported returns adjusted for
foreign currency effects


How important is the foreign currency effect
in relation to overall return performance in
foreign currency?
Do foreign exchanges overpower actual
return on investments in foreign countries?
20
Currency Fluctuations and
Rates of Return

Foreign currency effect is about 10 to 20%
as significant as the actual return
performance in the foreign currency

If dollar is rising/falling rapidly over a short
period the impact can be much greater
21
Currency Fluctuations and
Rates of Return
 Investment in Switzerland: 10% return
 CHF declines by 5% against U.S. $
 CHF profits are worth less in $
Gain on investment:
 110% (Investment with 10% profit)
 Adjusted value of CHF relative to U.S. $
= 0.95 =1.00 - 0.05 decline in currency
 104.5% (= 110 x 0.95) of original investment
 Actual return in U.S. $ 4.5% instead of 10%
Swiss franc = CHF
22
Currency Fluctuations and
Rates of Return




Examine currency effects in Sweden YTD
Return in local currency 4.58% (3rd column)
Return in U.S. $............. 6.31% (7th column)
Change in $/SEK made a positive return in
kronor become a negative return in U.S. $
See Table 19-8 next 2 slide
Swedish currency Krona (pl. Kronor) symbol SEK
23
Currency Fluctuations and
Rates of Return
Computed returns:
 104.58% (Investment with 4.58% profit)
 (Adjusted value of the SEK to U.S. $)
0.896 (1.000 - 0.104 decline in currency)
 93.7% (= 104.58 x 0.896) of original investment
See Table 19-8 next slide
24
25
Other Obstacles to International
Investments

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
Political Risks
Tax Problems
Lack of Market Efficiency
Administrative Problems
Information Problems
Corruption
26
Political Risks

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Danger of nationalization of foreign firms
Restriction of capital flows to investors
Violent overthrow of political party in power
Not meeting their foreign debt obligations
Check the political/economic climate
27
Tax Problems

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Foreign countries may impose 15 to 30%
withholding tax against dividends or interest
paid to nonresidents
Tax-exempt U.S. investors can secure
exemption or rebate
Taxable U.S. investors can claim a U.S. tax
credit for taxes paid in foreign countries
Inconvenience rather than loss of funds
28
Lack of Market Efficiency



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
U.S. capital markets the most liquid &
efficient in the world
Investors accustomed to trading on NYSE will
find it difficult to adjust to foreign markets
Larger spread between bid (sell) & ask (buy)
price
Difficulty executing large transaction
Higher commission rates
29
Elkins/McSherry Global Universe of
Transaction Costs Developed Markets
4 factors: price, commission, fees, mkt impact
Total Cost
United States, NYSE
Japan
20.14 BP
21.39 BP
United Kingdom (sells)
United Kingdom (buys)
France
Canada
25.78 BP
73.77 BP
25.77 BP
32.51 BP
Germany
Hong Kong
23.20 BP
41.71 BP
Spain
28.37 BP
Switzerland
Italy
30.38 BP
30.65 BP
30
Market Capitalization of Developed World
Markets (Year end 2005) in billions of U.S. $
United States
$16,997
Japan
$4,736
London
$3,058
France
$1,710
Canada
$1,480
Germany
$1,221
Hong Kong
$1,006
Spain
$960
Switzerland
$938
Italy
$798
31
Market Capitalization of The Largest Emerging
Markets (year end 2005) in billions of U.S. $
China
$780
S. Korea
$718
Saudi Arabia
$646
South Africa
$565
India
$553
Russia
$548
Taiwan
$485
Brazil
$474
32
Market Capitalization of the Three
Largest U.S. Companies in billions U.S. $
Exxon
$446
General Electric
$361
Microsoft
$280
$1,087
33
Administrative Problems
Adjusting to various local systems
For example,
 Hong Kong, Swiss, & Mexican stock markets
settle accounts one day after the transaction
 London: two-week settlement
 Different administrative procedures add extra
difficulty in executing trades
 Avoid these difficulties by going through
mutual funds and other investment outlets

34
Information Problems





U.S. securities markets are the best at
providing investment information
S.E.C. has rigorous requirements for full
disclosure information
FASB continually providing pronouncements
on GAAP for financial reporting
Publicly traded companies required to
provide stockholders with fully audited
annual reports
Evaluative reports/ratings by Moody’s,
Standard & Poor’s, Value Line, & other firms
35
Information Problems

Extensive economic data provided by
governmental sources e.g.
• Department of Commerce
• Federal Reserve System


International firms in less sophisticated
foreign markets do not provide sufficient data
Language problems for the analyst
36
Methods of Participating in
Foreign Investments
International investment
 Investing in firms in foreign markets
 Purchasing foreign shares trading in U.S.
 Mutual funds investing overseas
 Closed-end funds with global orientation
 Buying shares of multinational corporations
37
Methods of Participating in
Foreign Investments
Direct Investments
 Indirect Investments

38
Direct Investments
Directly purchase shares of firm in foreign market
 Use foreign broker/overseas branch of U.S. broker
Difficulties and administrative problems:
 Information-gathering problems
 Tax problems
 Stock-delivery problems
 Capital-transfer problems
 Communication difficulties in executing orders
 Sophisticated money manager follow this approach

39
Direct Investments


Purchase shares of foreign firms that trade in
U.S. stock markets (NYSE)
Purchase ADRs
ADRs represent ownership interest
in a foreign company’s common stock
www.nyse.com
Go to:
1. International
2. Non-U.S. Listed Company Directory
40
Direct Investments Hyperlinks to some companies that
have ADRs
www.alcan.com
www.britishairways.com
www.honda.com
www.nortelnetworks.com
www.sony.com
41
Indirect Investments
Investments in international securities include:
a) Purchasing shares of multinational corporations
b) Mutual funds or closed-end investment funds
specializing in worldwide investments
c) Investing in exchange traded funds (ETF)
d) Use a private firm specializing in foreign
investment portfolio management
42
(a)- Purchasing Shares of
Multinational Corporations


Firms with operations in several countries
Opportunity for international diversification
•
•
•
•
Major oil companies e.g. Exxon, BP, Shell
Large banking firms e.g. Barclays, HSBC
Pharmaceuticals e.g. Glaxo, Novartis
Consumer Products e.g. Sony, Coca Cola
43
(b)- Mutual Funds and ClosedEnd Investment Companies

Mutual funds offer
• Diversification
• Professional management

Invest in closed-end investment
companies specializing in international
equity investments
May trade at premium/discount from NAV
44
(c)- Exchange Traded Funds (ETFs)


Use ETFs to invest in international markets
Biggest market the American Stock Exchange
www.amex.com



Lists over 40 international funds
ETF: basket of securities that track an index
Trades like an individual stock with all day
• Trading
• Price tracking
45
Exchange Traded Funds (ETFs)

ETF mimics a major index, e.g.
• Financial Times 100 for United Kingdom
• DAX for Germany

ETF can track
•
•
•
•



A broad stock index
Bond index
Industry index
Sector index
www.amex.com
Lower costs
Better tax efficiency than mutual funds
Ability to diversify using these funds
46
(d)- Specialists in International Securities
Large investors may engage services of firms with
specialized expertise in foreign equities
 Banks
 Investment counselors
•
•
•
•


Morgan Guaranty Trust Company
State Street Bank and Trust Company
Batterymarch Financial Management
Fidelity Trust Company of New York
Minimum investment well in excess of $100,000
Cater to large institutional investors
47
Website
www.adr.com
www.amex.com
Comments
Provides screening &research
services for American
depository receipts
Exchange Traded Funds
Provides international news &
www.global-investor.com information on foreign
markets
Provides news on global
cbs.marketwatch.com markets
48
Website
www.economist.com
www.wsj.com
www.oecd.org
www.rubicon.com
Comments
Global magazine
providing news on
markets and economics
Provides information on
global markets and
economics
Provides international
economic information and
links to related sites
Provides currency rates
and conversions
49
Summary



Diversify by investing in international
securities
Different foreign markets influenced by
varying & contradictory factors
Effective risk reduction
Example:
Sharp & unexpected increase in energy prices
negative impact on oil importers may be
offset by positive impact on oil exporters
50
Summary
Investments in selected foreign equity markets
may provide
 Excellent return opportunities
 Many countries GDP growth rate is like U.S.
 Greater savings rates
 Higher capital formation
 Consider currency fluctuations
 Risk
51