Chapter 8
International Investment and
Diversification
1
All the people like us are We,
And everyone else is They.
And They live over the sea,
While We live over the way.
But – would you believe it? –
They look upon We
As only a sort of They.
- Rudyard Kipling
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
 Remembering
Evans and Archer
 Remembering capital market theory
6
Remembering
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
7
Remembering
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
8
Remembering
Capital Market Theory
 Utility,
risk, and return
 Variance of a linear combination
 Relationship of world exchanges
 Fundamental logic of diversification
 Other considerations
9
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
10
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
11
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
12
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
13
Relationship of
World Exchanges (cont’d)
Portfolio Variance
U.S. Securities: Systematic Risk 27%
International Securities: Systematic Risk 11.7%
Number of Securities
14
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
15
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
16
Other Considerations
 Optimum
portfolio size involves a trade-off
between:
• The benefits of additional diversification
• Commissions and capital constraints
17
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

18
Definition
 Foreign
exchange risk refers to the
changing relationships among currencies
• Modest changes in exchange rates can result in
significant dollar differences
19
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?
20
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
21
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?
22
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%
23
From Whence
Cometh the Risk?
 Role
of interest rates
 Forward rates
 Interest rate parity
 Covered interest arbitrage
 Purchasing power parity
24
Role of Interest Rates
 Real
rate of interest
 Inflation premium
 Risk premium
25
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
26
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
27
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
28
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
29
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
30
Forward Rates (cont’d)
 Forward
rate premium or discount:
Forward rate - Spot rate 12
 100
Spot rate
n
where n  the contract length in months
31
Forward Rates (cont’d)
Example
On June 12, 2002, the British pound had a spot rate of
$1.4728. The 3-month forward rate of the pound was
$1.4645 on that date.
What is the forward premium or discount?
32
Forward Rates (cont’d)
Example (cont’d)
Solution: The forward premium or discount is calculated
as follows:
Forward rate - Spot rate 12
$1.4645  $1.4728 12
 100 
 100
Spot rate
n
$1.4728
3
 2.25%
There is a forward discount of –2.25%.
33
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
34
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.
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:
1 IF
S 
1
1 ID
where S  change in the spot exchange rate
I F  foreign country inflation rate
I D  domestic country inflation rate
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
Dealing With the Risk
 The
concept of exposure
 Dealing with the exposure
41
The Concept of Exposure
 Definition
 Accounting
exposure
 Transaction exposure
 Translation exposure
 Economic exposure
42
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
43
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
44
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”
45
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
46
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
47
Dealing With the Exposure
 Ignore
the exposure
 Reduce or eliminate the exposure
 Hedge the exposure
48
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
49
Reduce or Eliminate
the Exposure
 If
the dollar is expected to appreciate
dramatically, an investor may reduce or
eliminate foreign currency holdings
50
Hedge the Exposure
 Definition
 Hedging
with forward contracts
 Hedging with futures contracts
 Hedging with foreign currency options
51
Definition
 Hedging
involves taking one position in the
market that offsets another position
• Covering foreign exchange risk means hedging
foreign exchange risk
52
Hedging With
Forward Contracts
 A forward
contract is a private, nonnegotiable transaction between a client and
a commercial bank
• No money changes hands until the foreign
currency is delivered, but the rate is determined
now
• The forward rate reflects relative interest rates
and associated risks
53
Hedging With
Futures Contracts

A futures contract is a promise to buy or sell a
specified quantity of a particular good at a
predetermined price by a specified delivery date

On the delivery date, there will be a gain or loss in
the futures market that will offset the gain or loss
experienced when converting the foreign currency
54
Hedging With
Futures Contracts (cont’d)
 To
hedge an investment, sell foreign
currency futures
 To
hedge a liability, buy foreign currency
futures
55
Hedging With
Foreign Currency Options
 There
are two types of foreign currency
options:
• Call options give their owner the right to buy a
set quantity of foreign currency
• Put options give their owner the right to sell a
set quantity of foreign currency
• The price at which you have the right to buy or
sell is the striking (exercise) price
56
Hedging With Foreign
Currency Options (cont’d)
 Currency
option characteristics:
• A call option with an exercise price quoted in
dollars for the purchase of euros is the same as
a put option on dollars with an exercise price
quoted in euros
• Put-call parity for foreign currency options is a
restatement of interest rate parity
57
Hedging With Foreign
Currency Options (cont’d)
 The
disadvantage of hedging with currency
options is that the hedger must pay a
premium to established the hedge
• Options provide more precision than futures
contracts
• Options are more expensive than futures
contracts
58
The Eurobond Market

Eurobonds are debt agreements that are
denominated in a currency other than that of the
country in which they are held
• E.g., a bond denominated in yen sold in the United
Kingdom

A foreign bond is denominated in the local
currency but is issued by a foreigner
• E.g., a bond denominated in yen sold in Japan, issued
by a firm in the United Kingdom
59
The Eurobond Market (cont’d)
 About
75% of eurobonds are denominated
in U.S. dollars
 Firms
issuing dollar-denominated
Eurobonds pay a slightly lower interest rate
than they would pay in the U.S.
60
Combining the Currency and
Market Decisions
 It
is often desirable to cross-hedge a foreign
investment into a different currency
• E.g., a U.S. investor might invest in Japan, use
the forward market to sell yen for British
pounds and convert the pounds back to dollars
• The currency return comes from the forward
market premium or discount and the actual
change in the exchange rate
61
Key Issues in Foreign
Exchange Risk Management

The steps in foreign exchange risk
management:
1) Define and measure foreign exchange
exposure
2) Organize a system that monitors this exposure
and exchange rate changes
3) Assign responsibility for hedging
4) Formulate a strategy for hedging
62
Investments in
Emerging Markets
Overview
 Background
 Adding value
 Reducing risk
 Following the crowd
 Special risks
 Asymmetric correlations
 Market microstructure considerations

63
Overview
 Emerging
market investments:
• Offer substantial potential rewards to the
careful investor in added return and risk
reduction
• Are accompanied by special risks:
– Foreign exchange risk
– High political and economic risk
– Unreliable investment information
– High trading costs
64
Background
 Over
$20 billion is invested globally in
securities issued in underdeveloped
countries
 Pension
funds’ largest emerging market
exposure is in:
• Asia (39.1%)
• Latin America (32.7%)
65
Background (cont’d)
 Dollars
invested in emerging markets has
increased at a compound rate of almost 50%
over the last 10 years
 Private
sector growth in emerging markets
• E.g., Hungary and Poland after 1989
66
Adding Value
 Prices
in developing markets often contain
significant inefficiencies
• Tend to sell for lower price/earnings multiples
than do firms in developed markets
– Emerging market firms have greater expected
growth and are cheaper
67
Reducing Risk
 Low
correlations are attractive as a means
of reducing portfolio variability
• Emerging markets show low correlation with
developed markets
• Emerging markets show low correlation with
each other
68
Following the Crowd
 Some
professional money managers
carefully analyze emerging markets for:
• Profit potential
• Portfolio risk reduction
 Some
professional money managers “follow
the crowd” because they must invest in
emerging markets
69
Special Risks
 Incomplete
accounting information
 Foreign currency risk
 Fraud and scandals
 Weak legal system
70
Incomplete
Accounting Information
 In
some countries, financial statements are
more than 6 months old when they become
available
• The acquisition of reliable investment
information generally requires on-site security
analysts
71
Incomplete Accounting
Information (cont’d)
 Accounting
standards differ substantially
across countries
 Accounting information is frequently
unavailable for an emerging market security
 Some emerging market brokerage firms
focus on the income statement but ignore
the balance sheet
72
Foreign Currency Risk
 Foreign
exchange securities are
denominated in a foreign currency
• Introduces foreign exchange risk for foreign
investors
• E.g., Mexican peso crisis and Asian crisis
 In
emerging markets, traditional hedging
vehicles may be unavailable
73
Fraud and Scandals
 Emerging
markets carry a substantial risk of
fraud
• E.g., accounting misstatements, counterfeit
securities, “bucket” shops
 Redress
available to victims of a scandal in
a developing country may be inadequate
74
Weak Legal System
 Low
confidence in a country’s legal system:
• Leads to increased uncertainty
• Leads to an increased risk premium required by
investors
75
Asymmetric Correlations
 Correlation
between emerging and
developed markets:
• Increases during bear markets
• Is low during bull markets
• The extent of portfolio managers’
diversification depends on whether they are
experiencing an up or a down market
76
Asymmetric
Correlations (cont’d)
 Investment
returns show:
• Homogeneity within emerging markets
– Securities tend to move as a group within a single
emerging market
• Heterogeneity across emerging markets
– Emerging markets show low correlation across
markets
77
Market
Microstructure Considerations
 Liquidity
risk
 Trading costs
 Market pressure
 Marketability risk
 Country risk
78
Liquidity Risk

Some emerging markets’ investors are mostly
foreign
• Increases political risk
• Sets the stage for a market collapse if everyone pulls
out at once

Some emerging markets lack depth
• The bid/ask spread tends to be wide with few standing
order to buy and to sell
79
Trading Costs
 Foreign
market trading costs are more than
1% higher than domestic trading costs
• E.g., bid/ask spread is an average of 95 basis
points for Barings’ Securities emerging market
index
• This indicates an investment must appreciate
more to show a given net return
80
Market Pressure
 An
order to buy or sell a large number of
shares might cause a substantial
supply/demand imbalance
• Causes the price to move adversely from the
investor’s perspective
• Indicates that emerging market investments
should be viewed as long-term investments
rather than a source of trading profits
81
Marketability Risk
 An
investor may be unable to close out a
position at a reasonable price
82
Country Risk
risk refers to a country’s ability
and willingness to meet its foreign
exchange obligations
 Country
• Especially important in emerging markets
 Country
risk has two components:
• Political risk
• Economic risk
83
Political Risk
 Introduction
 Factors
contributing to political risk
 Macro risk versus micro risk
 Dealing with political risk
84
Introduction
 Political
risk is a measure of a country’s
willingness to honor its foreign obligations
• A function of:
– The stability of the governments and its leadership
– Attitudes of labor unions
– The country’s ideological background
– The country’s past history with foreign investors
85
Introduction (cont’d)
 Real
(direct) investment is an investment
over which the investor retains control
• E.g., a plant in a foreign country
 Portfolio
investment refers to foreign
investment via the securities market
• E.g., buying a number of shares of a foreign
company
86
Introduction (cont’d)
 Extreme
forms of country risk for portfolio
investment:
•
•
•
•
Government takeover of a company
Political unrest leading to work stoppages
Physical damage to facilities
Forced renegotiation of contracts
87
Introduction (cont’d)
 Modest
forms of country risk for portfolio
investment:
• A requirement that a minimum percentage of
supervisory positions be held by locals
• Changes in operating rules
• Restrictions on repatriation of capital
88
Factors Contributing
to Political Risk
 “Buy
local” attitude
 Public attitude
 Government attitude
89
“Buy Local” Attitude
 Buy
local campaigns seek to make foreign
consumers buy local goods instead of goods
produced by a foreign firm or its
subsidiaries
 Contributes
to political risk
90
Public Attitude

In emerging markets, people may see no
opportunity to improve their standard of living
• Foreign subsidiaries may contribute to this attitude with
luxury items

The gap between the public’s aspirations and its
expectations contributes to political risk
91
Government Attitude
 Unstable
governments can lead to foreign
investors being a volatile political issue
• Foreign investors can be blamed for local
problems
• Foreign governments can suspend a firm’s
ability to send funds back to its home country
92
Macro Risk Versus Micro Risk

Macro risk refers to government actions that
affect all foreign firms in a particular industry
 Micro
risk refers to politically motivated changes
in the business environment directed to selected
fields of business activity or to foreign enterprises
with specific characteristics
93
Dealing With Political Risk
 Seek
a foreign investment guarantee from
the Overseas Private Investment
Corporation
• Provides coverage against:
– Loss due to expropriation
– Nonconvertibility of profits
– War or civil disorder
94
Dealing With
Political Risk (cont’d)
 Avoid
engaging in behavior that stirs up
trouble with the host people or government:
• Constructing flamboyant office buildings
• Giving the impression of natural resource
exploitation
95
Economic Risk
 Economic
risk is a measure of a country’s
ability to pay
• Assess economic risk by:
– Using coverage ratios
– Assessing the country’s capital base
96
Other Topics
 Multinational
corporations
 American depository receipts
 International mutual funds
97
Multinational Corporations
 Investing
in a multinational corporation
may provide a ready-made means of getting
the risk-reduction benefits of international
diversification
• Research is unclear whether MNCs are better
investments than purely domestic firms
98
American Depository Receipts

American depository receipts (ADRs) are receipts
representing shares of stock that are held on the
ADR holder’s behalf in a bank in the country of
origin
• An alternative to purchasing shares in a foreign
company directly on the foreign exchange

By 2000, 1,534 ADRS from dozens of countries
traded in the U.S.
99
International Mutual Funds
 Mutual
funds permit diversification to an
extent that would not otherwise be possible
• Some mutual funds invest only in securities
issued outside the U.S.
• Buying an international mutual fund is a good
way to achieve international diversification
100