Module V

International Portfolio Management

A. International Investment and Capital Markets
B. International Portfolio Diversification
C. Investment Management and Evaluation

Prepared by: BSBA IV-5

INTERNATIONAL INVESTMENT AND CAPITAL MARKETS

International Short-term Financing

Before resorting to external financing, a business firm normally determines whether or not
internal funds are available. A multinational business firm with international subsidiaries can
utilize internal financing by requesting a transfer of surplus funds from one of its subsidiaries.
One source of external financing, is borrowing the Eurocurrency market. To source funds from
the Eurocurrency market, direct loans may be obtained from Euro banks by utilizing credit lines.
Short term financing

This area of financing provides many options for an exporter and in some cases desirable
financing options for an importer. It is important to remember that all options carry risk and the
greater the risk the higher the cost. When evaluating risk, the associated costs must be a factor in
the cost equation. The financing tools that have been presented in other sections merge at this
point into potential financing options.
These options include financing from vendors (suppliers), banks, insurance (making receivables
eligible for financing), standby letters of credit (to provide credit terms from a seller),
commercial letters of credit (under acceptance financing), government programs (pre- and postshipment financing options) and documentary collections (under extended payment terms with an
accepted draft). These options are tied to inventory and accounts receivable which are short- term
in nature and turn over within a six- month period, or in some cases up to one year. Careful
examination of these options is necessary to select the right option for the right price and risk
level.
This module will introduce you to the forms and functions of short-term financing: credit
insurance, government-supported finance, discounting, time-draft letters of credit, and the Export
Working Capital Program.
If you are not familiar with the basic accounting terminology covered in this module (accounts
receivable, debit, credit) you need to review a basic accounting book to familiarize yourself with
the terms.
2 types of Standby Euro credits
* Eurocurrency lines of credit - means that a bank promises to lend funds denominated in a
Eurocurrency up to its credit limit.
* Eurocurrency revolving commitment
* An arrangement whereby a bank agrees to lend Eurocurrency funds for a period of 3 to 5 years
by accepting a series of sequential notes at each maturity.
Another fund that can be obtained is Euro notes. These are the debt instruments that include:

* Note issuance facilities

* Short term notes underwritten by banks or guaranteed by bank standby credit arrangements.
* It offers high liquidity through an active secondary market.
* Euro commercial papers
* Short term debt obligation of a corporation of a bank.
* Normally sold at a discount and occasionally they offer a fixed interest rate.
Foreign currency financing- It creates exposure to foreign exchange risk.
Why do business firms find it attractive (at least sometimes) to borrow in foreign currency?
The first reason is that foreign currency financing introduces exposure to foreign exchange risk if
the business firm does not already have such an exposure. The second reason is that foreign
currency financing may be cheaper. Interest rates on loans in various currencies are different and
in many cases foreign currencies offer lower interest rates rather than the domestic currency.
International short-term investment
It is the activity of placing excess funds or cash balances in the short term instruments available
in international money markets, which are denominated in various currencies. The word placing
here has the same meaning as lending, depositing, and investing.
Basic types of deposit instruments
* Time deposits- imply that the depositor commits the underlying funds for a specified period of
time at a specified interest rate.
* Certificate of deposits (CDs) - compromise a smaller percentage of the total value of these
instruments than time deposits. It also specifies the amount of the deposit, the date of maturity
and the interest rate applicable to the principal.

3 types of CDs
* Tap CDs- which are large-denomination, fixed-term deposits
* Tranche CDs- which are divided into several portions, making them appealing to smaller
investors
* Rollover CDs- which are renewed after maturity at an interest rate reflecting market conditions
The effective financing rate and effective rate of return
The effective rate in foreign currency depends on the foreign nominal interest rate and the
percentage change in the exchange rate. It can be calculated as follows. Suppose that an amount,
K, of foreign currency is borrowed at the time 0 at a nominal rate i. The domestic currency value
of the amount borrowed, Lo, is given by Lo= KSo. Where so is the spot exchange rate prevailing
at the time 0. When the loan mature at the time 1, the domestic currency amount to be repaid, 1,
is given by 1=1 (1+). The effective financing rate, e, is therefore given
by(1+)=(1+). By ignoring the term i S, an approximate formula for the effective
financing rate is e= i + S. This tells us that the effective financing rate is approximately equal to
the foreign nominal interest rate plus the rate of change of the exchange rate.
The effective financing rate can be looked upon from an ex ante perspective (before the fact) or
from an ex post (after the fact). At the time 0, the borrower does not know what the effective
financing rate will be, because it depends on the percentage change in the spot.
Introducing the bid-offer spreads
The equations that are used to calculate the effective financing rate and the effective rate of
return will be different when allowance is made for bid-offer spreads in interest and exchange
rates.
Implications of international parity conditions
We shall now examine a simple yet elegant set of equilibrium (or parity) conditions that should
apply to product prices, interest rates, and spot and forward exchange rates if the markets are not

impeded. These parity conditions provide the foundation for much of the theory and practice of
international finance.
In competitive markets, characterized by numerous buyers and sellers having low-cost access to
information, exchange-adjusted prices of identical tradable goods and financial assets must be
within transactions costs of equality worldwide. This idea, referred to as the law of one price, is
enforced by international arbitrageurs who follow the profit-guaranteeing dictum of "buy low,
sell high" and prevent all but trivial deviations from equality. Similarly, in the absence of market
imperfections, risk-adjusted expected returns on financial assets in different markets should be
equal.
Two international parity conditions have some implications for short-term financing and
investment decisions: covered interest parity (CIP) and uncovered interest parity (UIP).

Covered interest parity (CIP)

To assess the implications of CIP for short-term financing decisions, the process used to derive
an expression for the effective financing rate is modified by assuming that the borrowing firm
wishes to avoid foreign exchange risk. To do this, foreign currency exposure is covered in the
forward market.
Uncovered interest parity (UIP)
If the UIP holds, then the percentage change in the spot exchange rate will be equal to the interest
rate differential.
Introduction to Probability distributions
A probability distribution assigns a probability to each measurable subset of the possible
outcomes of a random experiment, survey, or procedure of statistical inference. Examples are
found in experiments whose sample space is non-numerical, where the distribution would be a
categorical distribution; experiments whose sample space is encoded by discrete random
variables, where the distribution can be specified by a probability mass function; and

experiments with sample spaces encoded by continuous random variables, where the distribution
can be specified by a probability density function. More complex experiments, such as those
involving stochastic processes defined in continuous time, may demand the use of more general
probability measures.
A probability distribution can either be univariate or multivariate. A univariate distribution gives
the probabilities of a single random variable taking on various alternative values; a multivariate
distribution (a joint probability distribution) gives the probabilities of a random vectora set of
two or more random variablestaking on various combinations of values. Important and
commonly encountered univariate probability distributions include the binomial distribution, the
hypergeometric distribution, and the normal distribution. The multivariate normal distribution is
a commonly encountered multivariate distribution.
Terminology
As probability theory is used in quite diverse applications, terminology is not uniform and
sometimes confusing. The following terms are used for non-cumulative probability distribution
functions:
Probability mass, Probability mass function, p.m.f.: for discrete random variables.
Categorical distribution: for discrete random variables with a finite set of values.
Probability density, Probability density function, p.d.f.: most often reserved for continuous
random variables.
The following terms are somewhat ambiguous as they can refer to non-cumulative or cumulative
distributions, depending on authors' preferences:
Probability distribution function: continuous or discrete, non-cumulative or cumulative.
Probability function: even more ambiguous, can mean any of the above or other things.
Finally,

 Probability distribution: sometimes the same as probability distribution function, but usually
refers to the more complete assignment of probabilities to all measurable subsets of outcomes,
not just to specific outcomes or ranges of outcomes.
Basic terms
Mode: for a discrete random variable, the value with highest probability (the location at which
the probability mass function has its peak); for a continuous random variable, the location at
which the probability density function has its peak.
Support: the smallest closed set whose complement has probability zero.
Head: the range of values where the pmf or pdf is relatively high.
Tail: the complement of the head within the support; the large set of values where the pmf or
pdf is relatively low.
Expected value or mean: the weighted average of the possible values, using their probabilities
as their weights; or the continuous analog thereof.
Median: the value such that the set of values less than the median has a probability of one-half.
Variance: the second moment of the pmf or pdf about the mean; an important measure of the
dispersion of the distribution.
Standard deviation: the square root of the variance, and hence another measure of dispersion.
Symmetry: a property of some distributions in which the portion of the distribution to the left of
a specific value is a mirror image of the portion to its right.
Skewness: a measure of the extent to which a pmf or pdf "leans" to one side of its mean.
Several Properties of Probabilities
At this point, many statistical texts would cover the laws and axioms of probability. We will take
a less formal approach by introducing only selected properties of probabilities:

1. The range of possible probabilities. This may seem obvious, but keep in mind that probabilities
can be no less than zero and no more than one. A statement that the probability is 110%, of
course, is ridiculous.
2. Complements. We often speak of the complement of an event. The complement of an event is
its opposite, or event NOT happening. For example, if the event under consideration is being
correct, the complement of the event is being incorrect. If we are denoting an event with the
symbol A, the complement may be denoted as the same symbol with a line overhead (}). The
sum of the probabilities of an event and its complement is always equal to one:
Pr (A) + Pr (}) = 1
Therefore, the probability of the complementary of an event is equal to 1 minus the probability of
the event:
Pr (}) = 1 - Pr (A)
For example, if the probability of being correct is .95, the probability of being incorrect = 1 - .95
= .05. In contrast if the probability of being correct is .99, then the probability of being incorrect
= 1 - .99 = .01.
3. Probability distributions. The usefulness of probability theory comes in understanding
probability distributions (also called probability functions and probability densities or masses).
Probability distributions list or describe probabilities for all possible occurrences of a random
variable. There are two types of probability distributions:
Discrete distributions
Continuous distributions.
4. Discrete probability distributions describes a finite set of possible occurrences, for discrete
count data. For example, the number of successful treatments out of 2 patients is discrete,
because the random variable represent the number of success can be only 0, 1, or 2. The
probability of all possible occurrencesPr (0 successes), Pr (1 success), Pr (2 successes)
constitutes the probability distribution for this discrete random variable.

5. Continuous probability distributions describe an unbroken continuum of possible

occurrences. For example, the probability of a given birth weight can be anything from, say, half
a pound to more than 12 pounds (or something like that). Thus, the random variable of birth
weight is continuous, with an infinite number of possible points between any two values. (Think
in terms of Xenos Paradox.)
There are many families of discrete and continuous probability distributions. We will study only
a couple, starting with the binomial distribution.

Financing and Investment with Currency Portfolio

The role of currency in investment portfolios has not yet been clearly defined. Views range from
considering currency as a byproduct of international investments to seeing it as its own asset
class. The objective of this paper is to promote greater understanding of currencies and to better
define currency trading as an investment strategy.
Our view is that currency strategies can play an important role in both multi-asset and singleasset portfolios. For investors in multiple assets, a potential diversification benefit derives from
currencys low correlations with multi-asset portfolios, and for investors in single assets
particularly, fixed income portfolios currency may serve as both a diversifier and a potential
source of returns. In this paper, we will discuss currencys role in fixed income portfolios, in
addition to where currency and bond strategies historically have shown similarities in terms of
market characteristics and underlying investment theses.
The Currency Market
All investors already have exposure to the currency market, because every investment is
denominated in a currency. For U.S.-based investors, the largest currency exposure will typically
be long the U.S. dollar. However, because U.S. investors usually measure their performance from
a U.S. dollar base, the long U.S. dollar exposure does not contribute to a portfolios absolute
volatility. The currency market is driven primarily by relative inter-country differences in interest
rate, inflation level, capital market flows, monetary policy, international trade and political risk.

Most of these factors are observable and quantifiable. Therefore, currency managers tend to
analyze these factors using a systematic approach and quantitative models in order to understand
currency behavior. Generally, currencies exhibit similar characteristics when their factors are
similar. For example, countries experiencing high inflation will have depreciating currencies, as
the markets perceive that inflation is eroding the value of the currencies. In countries
experiencing significant capital inflow, currencies will be appreciating.
Corporations, commercial banks, equity and bond investors, currency managers, central banks
and tourists are the active participants in global currency trading. Participants can be broadly
classified as:
1. Hedgers Many global corporations systematically convert their foreign currency revenues
into their home currencies, to hedge their future international revenues/profits and international
assets/liabilities. Equity and fixed income investors may hedge the currency exposures embedded
in their international investments. Central banks are also active participants as they hedge to
manage capital and currency flows.
2. Profit seekers Currency managers, global bond managers, hedge fund managers and
commodities trading advisors (CTAs) are active participants, with profit-seeking objectives.
3. Dealers Commercial banks provide liquidity and facilitate trading activities by acting as
intermediaries.
Despite the enormous average daily turnover, a large portion of the currency transactions are not
motivated by profit seeking. The hedging activity related to corporate treasuries and asset
management portfolio flows makes up the majority of the markets trading volume. This group of
investors (asset managers) may be willing to pay a premium to accomplish their hedging
objectives. For this reason, profit-seeking currency managers, whose activities make up only a
relatively small portion of the markets volume, believe there may be persistent inefficiencies that
can potentially be exploited in the currency market.
Currency Indexing

Because of their role as a financial intermediary, global commercial banks have an active role in
currency transactions as market makers providing liquidity and acting as trading partners. They
also provide currency market analysis and suggest trading strategies, and they have a vested
interest in generating trading volume and profits. To serve their profit-seeking clients, the banks
have expanded their services to include investable currency indexes. For the same reasons
investors use equity and bond indexes to passively invest in those markets, profit-seeking
investors can now use indexes to passively invest in currencies.
Currency indexes are constructed systematically to passively invest in baskets of currencies with
similar characteristics. Via these indexes, investors can gain exposure to a diversified currency
portfolio that is periodically rebalanced and regularly recalculated. Similarly to other asset
classes, currency returns can be related to and explained by various risk factors. Among the
currency factors, Carry (interest ratebased), Value (fundamental economics based) and
Momentum (price-based) are the factors index providers most often include in their currency
indexes. Beta based on volatility (currency optionbased) has started to emerge, but has not been
widely followed. A currency index provides benchmark exposure to these systematic strategies.
Currency Factors
Currency indexes attempt to capture the systematic risk premiums (currency beta) potentially
available in currency investing, and to enable investors to distinguish between the risk/return
produced with and without active management insight (alpha and beta). The performance of
these investment factors has been shown to explain currency returns.
Carry Factor
In a Carry strategy, investors buy (long) high-interest-rate currencies and sell (short) low interestrate currencies. Carry currency trades bear the risk of changing interest rates and exchange rates.
For example, if the 1-year interest rate in the U.S. is 0.70% and the 1-year interest rate in
Australia is 3.70%, a U.S. investor can enter into a one-year forward contract by buying AUD
and selling USD. The investor could potentially make money if the USD appreciated less than
3% (3.70% minus 0.70%) against the AUD.

The popularity of Carry trades appears to contradict the uncovered interest rate parity (UIP)
theory, which states that high-interest-rate currencies are expected to depreciate relative to lowinterest-rate currencies. Yet academics and investment practitioners have shown that currencies in
countries with high interest rates tend to appreciate relative to currencies in countries with low
interest rates. This anomaly constitutes the term forward rate bias, with the implication that
investors can make systematic profits by selling (taking a short position) the low-yielding
currency and buying (taking a long position) the high-yielding currency. In effect, the Carry
factor equates to having exposures to short-term bonds, which are very much influenced by
changes in short-term interest rates, which are themselves influenced by central banks monetary
policies. Those policies may also significantly impact the asset risk premium and cross-border
capital flows. In periods of relatively low volatility, Carry strategies can generate relatively stable
returns.
However, Carry strategies are vulnerable during periods of increased market uncertainty and in
risk-off market environments as investors flee to safe-haven instruments. Thus, it is possible for
suddenly distressed market environments to induce sudden reversals in the Carry strategys
performance. This issue is amplified in emerging market countries, where the Carry strategy has
been a staple. Active managers can potentially outperform via Carry strategies if they possess
superior ability to understand market volatility and risk sentiments and to anticipate central bank
policies.
Value Factor
A Value strategy will purchase (long) currencies that are undervalued relative to their fair value
and sell (short) currencies that are overvalued. Value strategies tend to have a long investment
horizon, because the speed of reversion of exchange rates to long-term equilibrium levels, as
estimated by fair value models, can be slow.
It is generally accepted that the Value strategy is based on the law of one price concept, which
states that in the absence of transaction costs, identical goods will have the same effective price
in different markets, regardless of the currencies in which that price is stated. One of the oldest
and most popular measures of currency fair value is purchasing power parity (PPP), a theory
concerning the long-term equilibrium exchange rates based on the relative price levels of two

countries. In its simplest form, a countrys PPP is simply a price relationship that shows the ratio
of the prices, in national currencies, of the same goods and services in different countries. PPP
theory also says that price differences between countries should converge over time by exchange
rate movements or by different speeds of inflation that draw undervalued and overvalued
currencies back to their fair value.
Another popular measure of relative value is based on the balance of payments (BoP) model,
which consists of current account (trade balance of goods and services, income and current
transfers), capital account (capital transfers, remittance, and acquisition/disposal of nonproduced, non-financial assets), and financial account (direct investment, portfolio investment
and reserve account). There are various factors that potentially impact BoP; among them are
changes in the exchange rate, a government's fiscal deficit, business competition, excess
domestic consumption and asset price inflation. A BoP surplus occurs when the current account
surplus is higher than the outflows in the capital accounts, resulting in increased reserve assets. In
BoP terms, a countrys currency appreciates when its BoP is positive (BoP surplus) and
depreciates when its BoP is negative. BoP is a transaction-based approach, and thus it differs
from the price-based approach in PPP. However, the two approaches similarly seek to assess
currency valuation on the basis of countries relative fundamental economics.
Active managers can outperform in this strategy by developing superior valuation models that
incorporate supplementary or proprietary blends of factors. Also, instead of making a naive
investment in a currency that is over-/undervalued, based on current relative rankings, active
managers may have opportunities to outperform by timing their trades so that they pursue
opportunities only when they are most attractive. That a currency is the most undervalued
relative to other currencies doesnt mean it cant become even more undervalued. Active
managers can outperform with trades made closer to an inflection point.
Trend Factor
The basic assumption in a Trend strategy is that the expected distribution of next periods return
is not necessarily independent of historical returns. In other words, information extracted from
time series of historical returns may help to predict the expected distribution of next periods
return. This momentum effect is believed to explain some of the movements in the currency

market, as well as in equity, bond and commodity markets. Due to their focus on price, Trend
strategies rely more on technical analyses than on the fundamental economics of countries.
Trend strategy involves buying currencies that have experienced high historical returns in like
market conditions and selling currencies that have had low or negative historical returns in like
market conditions. A simple implementation of a Trend strategy is to buy when the currency level
is above a simple arithmetic moving average, and to sell when it is below. The relationship
between economic theory and empirical evidence to explain the Trend factor is not well defined.
Clear patterns in currency movements may be signs of a countrys economic growth (or
contraction) and thus of potential benefit to practitioners of the Trend strategy. Trend strategy
tends to perform best when markets evidence a persistent trend and worst when markets are
choppy in tight and range-bound conditions. Active managers can outperform in this strategy
by more accurately detecting when a trend is about to start or end, and by not being fooled by
false signals. Managers need to consider effective responses to changes in market volatility and
to be able to time entry/exit points well, as information diffusion becomes more efficient. Many
active currency investors tend to de-emphasize the momentum effect in markets that are
relatively less liquid.
Currency as a Portfolio Diversifier
Unlike global fixed income investors, U.S. fixed income investors have been generally
underexposed to foreign currencies. The abundance of USD-denominated investment vehicles,
including Yankee bonds1 has not moved most U.S. investors to seek exposures to foreign
currencydenominated opportunities. We believe investors who exclude global currencies from
their portfolios may be missing out on potential diversification benefits.
Investors may find that currency indexes historical returns, and the low correlations between
currency and mainstream asset classes suggest an attractive strategy for consideration. Clearly,
currency strategy analysis is much simpler at the single-asset level than at the multi-asset level.
We believe investors who want to add currency strategies to their portfolios should consider
porting them atop their existing index (beta). The unfunded nature of currency strategies (either
passive or active) facilitates their implementation as overlay exposures through the use of
derivatives.

Active Currency Strategy

Fixed income investors may find currency strategies attractive due to currencys low correlations
with interest rate and credit risk, particularly when the strategy is implemented by adding
currency strategies with a beta overlay. Passive or systematic strategies provide a convenient,
low-cost exposure to currency factors, as ample currency liquidity helps to minimize transaction
costs and management fees.
However, dedicated active currency management is also a reasonable alternative. As previously
suggested, significant presence of nonprofit-seeking oriented participants in the currency markets
may make for persistent inefficiencies that profit-seeking investors can exploit.
Centralization versus Decentralization of Cash Management
Central cash management refers to the practice of dealing with all financial transactions from a
single location, rather than leaving financial transactions in the hands of individual locations. For
example, your company might choose to run all financial transactions from the main office in
Seattle, rather than allowing satellite offices across the country to handle finances individually.
While central cash management provides some advantages, such as improved financial oversight,
it creates disadvantages as well.
ADVANTAGES
Netting
Consolidating the value of two or more transactions, payments or positions in order to create a
single value. Netting entails offsetting the value of multiple positions, and can be used to
determine which party is owed remuneration in a multiparty agreement.
Netting is a general concept that has a number of more specific uses. In a case in which a
company is filing for bankruptcy, parties that do business with the defaulting company will offset
any money owed to the defaulting company with any money owed by the defaulting company.
The remainder represents the total amount owed to the defaulting company or money owed by it,
and can be used in bankruptcy proceedings.

Companies can also use netting to simplify third-party invoices, ultimately reducing multiple
invoices into a single one. For example, several divisions in a large transport corporation
purchase paper supplies from a single supplier, but the paper supplier also uses the same
transport company to ship its products to others. By netting how much each party owes the other,
a single invoice can be created for the company that has the outstanding bill. This technique can
also be used when transferring funds between subsidiaries.
Netting is also used in trading. An investor can offset a position in one security or currency with
another position either in the same security or another one. The goal in netting is to offset gains
in one position with losses in another.
Exposure Management What is Exposure Management?
It is the risk of fluctuating value of a currency over time. If the time and size of cash inflows in
one currency does not match the time and size of cash outflows in the same currency, we face
exchange rate risk. It impacts dollar value of foreign currency cash inflows and foreign currency
cash outflows. If we have foreign currency cash inflows, we face risk of foreign currency
depreciating against domestic currency. If we have foreign currency cash outflows, we face risk
of foreign currency appreciating against domestic currency.
Three (3) Types of Exchange rate Exposure
Transaction Exposure - arises from the possibility of incurring future exchange gains/losses on
transactions already entered into and denominated in a foreign currency.
Translation Exposure - the exposure of the multi-national companys consolidated financial
statements to exchange rate fluctuations
Economic Exposure - the extent to which the economic value of a company can decline because
of exchange rate changes.
Cash Pooling (Reduces cash requirements)
A cash management technique employed by companies holding funds at financial institutions.
Cash pooling allows companies to combine their credit and debit positions in various accounts

into one account, and includes techniques like notional cash pooling and cash concentration.
Notional cash pooling has the company combine the balances of several accounts in order to
limit low balance or transaction fees. Cash concentration or zero balancing has the company
physically combining various accounts into one single account.
DISADVANTAGES
Software Incompatibility during Expansions
Although software companies have taken steps to improve the complications that arise when
different programs try to talk to each other, interoperability problems still plague businesses. This
issue often proves especially problematic during mergers. If your company acquires another
business that runs different accounting or bookkeeping software, implementing centralized cash
management at the business often means a complete overhaul of the other businesss financial IT
infrastructure. Such overhauls require time, labor and costs.

Increased Impact of Software Glitches

Assuming that nothing goes wrong with your cash management system, employees should
receive their pay like clockwork. Few computer systems and software packages remain problemfree over their lifetime. Software updates and even faulty firmware can crash programs, eat data
and freeze systems. In addition, user error in managing or manipulating the cash management
software or even the data can delay payments to every employee and all your vendors.
Distributed and paper-based cash management also suffers from user error problems, but it limits
the problem to a smaller group or single facility, rather than your entire organization.
Adjustments for Multiple Time Zones
Central cash management creates the potential for timing problems if your business works in
multiple time zones or internationally. Assuming your business pays all employees on the same
date your system must account for when banks stop processing transactions across all the
relevant time zones, and accommodate the payment times for employees working across the

international dateline. Rather than sending one mass payment, as you would if all employees
lived locally, your business must manage multiple mass payments across a span of hours.
Other Considerations
Many small businesses use central cash management by default because the business has only a
single location. If you decide to expand but not to implement central cash management at the
time, you can position your business for a future change by installing identical software at all
your locations. That eliminates the interoperability problem before it starts and means you can
import data at will from any of your business locations. Maintaining a distributed cash
management system complicates the work of your financial officers, since they must collect and
assess financial information from all the sources to determine the financial standing of your
business.
International bank loan financing
International Bank Loans are classified into two categories:
1. Foreign Loans are raised by borrowers who are foreign to the country where the loan is raised.
2. Euro loans and foreign loans are distinguished as follows. While Euro loans are financed
wholly out of Eurocurrency funds, irrespective of whether the user is a resident or non-residents
of the country in question, foreign loans are domestic currency credits extended to non-residents
borrower.
Syndicated Loans are so large in size that it becomes necessary to form a syndicate or a group of
lending banks to finance the loans. The advantage of syndication is that it enables bank to spread
the risk of very large loans among themselves.
The interest paid on syndicate loans is usually computed by adding a spread to the London
Interbank Offer Rate (LIBOR) or another reference rate such as the US prime rate or the
Singapore Interbank Offer Rate (SIBOR) of banks; the following factors determine the spread.
1. Whether the market is a borrower or a lender market. Spreads are likely to be higher in a
lender market, which is characterized by a shortage of liquidity.

2. The credit worthiness of the borrower, as lower spreads is charged to high quality borrowers.
3. The maturity of the loan, as higher spreads is charged on long term maturity.
4. The fees charged, in addition to interest payments, the borrower is expected to pay
management fees, participation fees, commitment fees and charges.
International Bond Financing
A bond is a fixed-income security. It offers fixed contractual payments in the form of periodic
coupon interest payments (paid annually or semi-annually) and or a par value or a face value that
is paid on the maturity of the bond. These payments are contractual in the sense that they are
fixed irrespective of what happens in the market throughout the life of the bond.
Eurobonds and Foreign Bonds
International bonds can be Eurobonds and foreign bonds. A gain, the distinction depends on
whether the borrower is a domestic or a foreign resident and whether the issue is denominated in
a domestic or a foreign currency. A Eurobond issue is underwritten by an international syndicate
of banks and other financial institutions and placed in countries other than the country in which
the currency is denominated. A foreign bond, which is underwritten by a syndicate consisting of
members from a single country, is sold primarily within that country and is denominated in its
currency.
In the early 1960s the volume for foreign bonds dwarfed that of Eurobonds, but this trend has
been reversed. Foreign bonds have nicknames: foreign bonds sold in the United States are
Yankee bonds, in Japan they are Samurai bonds and in the United Kingdom they are bulldogs. In
April 1992, the Australian governments allowed the foreign parties to raised funds in the
Australian domestic capital market, which came to be known as Matilda Bond Market.
The Eurobond markets which is an extension of an offshore or external financial markets, has
emerged because of some of the same factors that have led to the emergence of the Eurocurrency
market or the market for short term Euro currency funds. These includes: (i) absence of

regulatory interference (ii) less stringent disclosure requirements, and (iii) favorable tax status, as
interest income is not subject to income and withholding tax.

Types of International Bonds

Straight fixed rate bonds
The most common type of bond is a straight bond. Interest payments are a fixed percentage
determined by the coupon rate of the face value of the bond. On maturity, the bondholder
receives the face value and the last interest payments.
Floating rate notes
The holder of this receives variable s mi-annual coupon payments. The variable coupon rate is
determined by adding a margin to a variable reference rate such as LIBOR.
Convertible Bonds
This is bonds which are equity-related bonds. They resemble straight bonds, with the added
feature that they are convertible into equity prior to maturity at a specified price per share.
Bonds with equity warrants
Bonds with equity warrants are another type of equity related bonds. They give the holder the
extra privilege of having the right to buy the shares of same company issuing the bonds.
Zero coupon bonds
The holder of Zero coupon bonds does not receives coupon payments prior to the maturity date.
Upon maturity, the holder receives the whole face value of the bond, which are initially
purchased at a discount.

Multicurrency bonds
The holder of this receives payments in more than one currency. One variant is dual currency
bond, which has different currency denominations for coupon payments and face value
payments.
Global bonds
It was introduced by the World Bank in 1989. It comes in very large issues, which are placed
simultaneously in the worlds major capital markets.
Novel bonds
Represent financial innovation in the bond market. Examples are reverse floaters (on which the
coupon rate falls as market interest rates rise), asset-backed bonds (which are backed by a
specific group of assets), catastrophe bonds (whose payments depend upon the materialization of
a certain event) and indexed bonds (whose payments are tied to the general price level or the
price of a particular commodity).
International Equity Financing
The process of raising capital through the sale of shares in an enterprise. Equity financing
essentially refers to the sale of an ownership interest to raise funds for business purposes. Equity
financing spans a wide range of activities in scale and scope, from a few thousand dollars raised
by an entrepreneur from friends and family, to giant initial public offerings (IPOs) running into
the billions by household names such as Google and Facebook. While the term is generally
associated with financings by public companies listed on an exchange, it includes financings by
private companies as well. Equity financing is distinct from debt financing, which refers to funds
borrowed by a business.
METHODS OF EQUITY FINANCING
There are two primary methods that small businesses use to obtain equity financing: the private
placement of stock with investors or venture capital firms; and public stock offerings.
Private placement is simpler and more common for young companies or startup firms. Although

the private placement of stock still involves compliance with several federal and state securities
laws, it does not require formal registration with Securities and Exchange Commission. The main
requirements for private placement of stock are that the company cannot advertise the offering
and must make the transaction directly with the purchaser.
In contrast, public stock offerings entail a lengthy and expensive registration process. In fact, the
costs associated with a public stock offering can account for more than 20 percent of the amount
of capital raised. As a result, public stock offerings are generally a better option for mature
companies than for startup firms. Public stock offerings may offer advantages in terms of
maintaining control of a small business, however, by spreading ownership over a diverse group
of investors rather than concentrating it in the hands of a venture capital firm.
OTHER SOURCES OF LONG-TERM FINANCING
Long term financing is a form of financing that is provided for a period of more than a year.
Long term financing services are provided to those business entities that face a shortage of
capital.
Sources of Long Term Financing: The various sources are as follows 1. Shares: These are issued to the general public. The holders of shares are the owners of the
business. These may be of two types:
o Equity shares and
o Preference shares.
2. Debentures: These are also issued to the general public. The holders of debentures are the
creditors of the company.
3. Public Deposits: General public also likes to deposit their savings with a popular and well
established company which can pay interest periodically and pay-back the deposit when due.
4. Retained Earnings: The Company may not distribute the whole of its profits among its
shareholders. It may retain a part of the profits and utilize it as capital.

5. Term Loans from Banks: Many industrial development banks, cooperative banks and
commercial banks grant medium term loans for a period of 3-5 years.
6. Loan from Financial Institutions: There are many specialized financial institutions established
by the Central and State governments which give long term loans at reasonable rates of interest.
Bond investment
What Are Bonds?
A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money
to a government, municipality, corporation, federal agency or other entity known as an issuer.* In
return for that money, the issuer provides you with a bond in which it promises to pay a specified
rate of interest during the life of the bond and to repay the face value of the bond (the principal)
when it matures, or comes due.
Among the types of bonds available for investment are: U.S. government securities, municipal
bonds, corporate bonds, mortgage- and asset-backed securities, federal agency securities and
foreign government bonds. The characteristics of several different types of U.S. bonds are
described in the Bond Basics Glossary at the end of this section. Market practices described here
apply to the U.S. bond market, and may differ from those in other countries.
Bonds can be also called bills, notes, debt securities, or debt obligations. To simplify matters, we
will refer to all of these as "bonds."
Why Invest in Bonds?
Many personal financial advisors recommend that investors maintain a diversified investment
portfolio consisting of bonds, stocks and cash in varying percentages, depending upon individual
circumstances and objectives. Whatever your investment goals, your investment advisor can help
explain the investment options available, taking into account your income needs and tolerance
for risk.
Typically, bonds pay interest semiannually, which means they can provide a predictable income
stream. Many people invest in bonds for that expected interest income and also to preserve their

capital investment. Understanding the role bonds play in a diversified investment portfolio is
especially important for retirement planning. During the past decade, the traditional definedbenefit retirement plans (pensions) have increasingly been replaced by defined contribution
programs such as 401(k) plans or IRAs. Because these plans offer greater individual freedom in
selecting from a range of investment options, investors must be increasingly self-reliant in
securing their retirement.
Whatever the purposesaving for your childrens college education or a new home, increasing
retirement income or any of a number of other financial goalsinvesting in bonds may help you
achieve your objectives.
Assessing Risk
All investments carry some degree of risk, which is linked to the return that investment will
provide. A good rule of thumb is the higher the risk, the higher the return. Conversely, safer
investments offer lower returns. There are a number of key variables that comprise the risk
profile of a bond: its price, interest rate, yield, maturity, redemption features, default history,
credit ratings and tax status. Together, these factors help determine the value of your bond
investment and whether it is an appropriate investment for you.
Price
The price you pay for a bond is based on a whole host of variables, including interest rates,
supply and demand, liquidity, credit quality, maturity and tax status. Newly issued bonds
normally sell at or close to par (100 percent of the face, or principal, value). Bonds traded in the
secondary market, however, fluctuate in price in response to changing interest rates, credit
quality, general economic conditions, and supply and demand. When the price of a bond
increases above its face value, it is said to be selling at a premium. When a bond sells below face
value, it is said to be selling at a discount.
Interest Rate
Bonds pay interest that can be fixed, floating or payable at maturity. Most debt securities carry an
interest rate that stays fixed until maturity and is a percentage of the face (principal) amount.

Fixed rate bonds carry any interest rate that is established when the bonds are issued (expressed
as a percentage of the face amount) with semiannual interest payments. For example, a $1,000
bond with an eight percent interest rate will pay investors $80 a year, in payments of $40 every
six months. This $40 payment is called a coupon payment. When the bond matures, investors
receive the full face amount of the bond, $1,000.
Some issuers, however, prefer to issue floating rate bonds, the rate of which is reset periodically
in line with interest rates on Treasury bills, the London Interbank Offered Rate (LIBOR), or some
other benchmark interest-rate index.
The third type of bond does not make periodic interest payments. Instead, the investor receives
one payment at maturity that is equal to the purchase price (principal) plus the total interest
earned, compounded at the original interest rate. Known as zero coupon bonds, they are sold at a
substantial discount from their face amount. For example, a bond with a face amount of $20,000
maturing in 20 years might be purchased for about $5,050. At the end of the 20 years, the
investor will receive $20,000. The difference between $20,000 and $5,050 represents the interest,
based on an annual interest rate of seven percent, compounded semiannually, until the bond
matures. Such future value calculations vary somewhat depending on the specific terms of the
bond. Since all the accrued interest and principal are payable only at the bond's maturity, the
prices of this type of bond tend to fluctuate more than those of coupon bonds. If the bond is
taxable, the interest is taxed as it accrues, even though it is not paid to the investor before
maturity or redemption.
Maturity
A bonds maturity refers to the specific future date on which the investors principal will be
repaid. Generally, bond terms range from one year to 30 years. Term ranges are often categorized
as follows:
Short-term: maturities of up to 5 years
Medium-term: maturities of 5 - 12 years
Long-term: maturities greater than 12 years

The choice of term will depend on when an investor wants the initially invested principal repaid
and on risk tolerance. Short-term bonds, which generally offer lower returns, are considered
comparatively stable and safe because the principal will be repaid sooner. Conversely, long-term
bonds provide greater overall returns to compensate investors for greater pricing fluctuations and
other market risks.
Redemption Features
While the maturity date indicates how long a bond will be outstanding, many bonds are
structured in such a way so that an issuer or investor can substantially change that maturity date.
Call Provision
Bonds may have a redemption or call provision that allows or requires the issuer to redeem
the bonds at a specified price and date before maturity. For example, bonds are often called when
interest rates have dropped significantly from the time the bond was issued. Before you buy a
bond, always ask if there is a call provision and, if there is, be sure to consider the yield to call as
well as the yield to maturity. (These terms are discussed below and are defined in the glossary).
Since a call provision offers protection to the issuer, callable bonds usually offer a higher annual
return than comparable non-callable bonds to compensate the investor for the risk that the
investor might have to reinvest the proceeds of a called bond at a lower interest rate.

Put Provision
A bond may have a put provision, which gives an investor the option to sell the bond to an issuer
at a specified price and date prior to maturity. Typically, investors exercise a put provision when
they need cash or when interest rates have risen so that they may then reinvest the proceeds at a
higher interest rate. Since a put provision offers protection to the investor, bonds with such
features usually offer a lower annual return than comparable bonds without a put to compensate
the issuer.

Conversion
Some corporate bonds, known as convertible bonds, contain an option to convert the bond into
common stock instead of receiving a cash payment. Convertible bonds contain provisions on
how and when the option to convert can be exercised. Convertibles offer a lower coupon rate
because they have the stability of a bond while offering the potential upside of a stock.
Principal Payments and Average Life
Certain bonds are priced and traded on the basis of their average life rather than their stated
maturity. In purchasing mortgage-backed securities, for example, it is important to consider that
homeowners often prepay mortgages when interest rates decline, which may result in an earlier
than expected return of principal, reducing the average life of the investment. If mortgage rates
rise, the reverse may be true: homeowners will be slow to prepay and investors may find their
principal committed longer than expected.
Yield
A bond's yield is the return earned on the bond, based on the price paid and the interest payment
received. Usually, yield is quoted in basis points, or bps. One basis point is equal to one onehundredth of a percentage point or 0.01%. For example, 8.00% = 800 bps (8.00% / 0/01% = 800
bps).
There are two types of bond yields: current yield and yield to maturity (or yield to call).
Current yield is the annual return on the dollar amount paid for the bond and is derived by
dividing the bonds interest payment by its purchase price. If you bought a $1,000 bond at par
and the annual interest payment is $80, the current yield is 800 bps or 8% ($80 / $1,000). If you
bought the same bond for $900 and the annual interest payment is $80, the current yield is 889
bps or 8.89% ($80 / $900). Current yield does not take into account the fact that, if you held the
bond to maturity, you would receive $1,000 even though you only paid $900.
Yield to maturity is the total return you will receive by holding the bond until it matures. This
figure is common to all bonds and enables you to compare bonds with different maturities and

coupons. Yield to maturity equals all the interest you receive from the time you purchase the
bond until maturity, including interest earned plus any gain or loss of principal. Yield to call is
the total return you will receive by holding the bond until it is called or paid off before the
maturity date at the issuer's discretion. In many cases, an issuer will pay investors a premium
for the right to call the bonds prior to maturity. Yield to call is calculated the same way as yield to
maturity, but assumes that a bond will be called and that the investor will receive the face value
of the bond plus any premium on the call date. You should ask your investment advisor for the
yield to maturity and the yield to call on any bond you are considering purchasing.
The Link between Price and Yield
From the time a bond is originally issued until the day it matures or is called, its price in the
marketplace will fluctuate depending on the particular terms of that bond as well as general
market conditions, including prevailing interest rates, the bond's credit and other factors. Because
of these fluctuations, the value of bonds will likely be higher or lower than its original face value
if you sell it before it matures. In general, when interest rates fall, prices of outstanding bonds
with higher rates rise. The inverse also holds true: when interest rates rise, prices of outstanding
bonds with lower rates fall to bring the yield of those bonds into line with higher-interest bearing
new issues. Take, for example, a $1,000 bond issued at eight percent. If during the term of that
bond interest rates rise to nine percent, it is expected that the price of the bond will fall to about
$888, so that its yield to maturity will be in line with the market yield of nine percent ($80 / $888
= 9.00%)
When interest rates fall, prices of outstanding bonds rise until the yield of older bonds match the
lower interest rate on new issues. In this case, if interest rates fall to seven percent during the
term of the bond, the bond price will rise to about $1,142 to match the market yield of seven
percent ($80 / $1,142 = 7.00%).
Credit Quality
The array of credit quality choices available in the bond market ranges from the highest credit
quality Treasury bonds, which are backed by the full faith and credit of the U.S. government, to
bonds that are below investment-grade and considered speculative, such as bond issues by a start-

up company or a company in danger of bankruptcy. Since a bond may not reach maturity for
years to come, credit quality is an important consideration when evaluating investment in a bond.
When a bond is issued, the issuer is usually responsible for providing details as to its financial
soundness and creditworthiness.
This information can be found in a document known as an offering document, official statement
or prospectus, which is the document that explains the bond's terms, features and risks that
investors should know about before investing. This document is usually provided by your
investment advisor and helps an investor evaluate whether the bond issuer will be able to make
its regularly scheduled interest payments for the term of the bond. While no single source of
information should be relied on exclusively, rating agencies, securities firms and bank research
staff monitor corporate, government and other issuers' financial conditions and their ability to
make interest and principal payments when due. Your investment advisor, or sometimes the
issuer of the bond, can supply you with current research.
Credit Ratings
In the United States, major rating agencies include Moodys Investors Service, Standard &
Poors Corporation and Fitch Ratings. Each of the agencies assigns its ratings based on analysis
of the issuers financial condition and management, economic and debt characteristics, and the
specific revenue sources securing the bond. The highest ratings are AAA (S&P and Fitch
Ratings) and Aaa (Moodys). Bonds rated in the BBB/Baa category or higher are considered
investment-grade; bonds with lower ratings are considered high yield, or speculative. IN the
United States, major rating agencies include Moodys Investors Service, Standard & Poors
Corporation and Fitch Ratings. Each of the agencies assigns its ratings based on analysis of the
issuers financial condition and management, economic and debt characteristics, and the specific
revenue sources securing the bond. The highest ratings are AAA (S&P and Fitch Ratings) and
Aaa (Moodys). Bonds rated in the BBB/Baa category or higher are considered investment-grade;
bonds with lower ratings are considered high yield, or speculative.
Tax Status

Some bonds offer special tax advantages. For example, interest from U.S. Treasury bonds is not
subject to state or local income tax. Many municipal bonds are triple tax-free; that is, for
investors who live in the same state as the issuer, the interest received from the bond may be
exempt from federal, state and/or local income tax. However, in certain cases, the interest
received may be subject to the individual federal alternative minimum income tax or may have to
be taken into account in calculating the taxable portion of social security benefits. Furthermore, a
portion of the interest on certain tax-exempt obligations earned by certain corporations may be
included in the calculation of adjusted current earnings for purposes of the corporate federal
alternative minimum tax, and interest income may also be subject to (i) a federal branch profits
tax imposed on certain foreign corporations doing business in the United States or (ii) a federal
tax imposed on excess net passive income of certain S corporations. The choice between taxable
and tax-exempt bond income depends on ones income tax bracket as well as the difference
between what can be earned from taxable versus tax-exempt bonds at the time of and through the
entire period of the investment.
You may access a yield calculator on this web site and your investment advisor can help you
compare the various tax alternatives. For example, the decision about whether to invest in a
taxable bond or a tax-exempt bond can also depend on whether you will be holding the bonds in
an account that is already tax-preferred or tax-deferred, such as a pension account, 401(k) or
IRA.
Equity investments
In accounting and finance, equity is the residual value or interest of the most junior class of
investors in assets, after all liabilities are paid; if liability exceeds assets, negative equity exists.
In an accounting context, shareholders' equity (or stockholders' equity, shareholders' funds,
shareholders' capital or similar terms) represents the remaining interest in the assets of a
company, spread among individual shareholders of common or preferred stock; a negative
shareholders' equity is often referred to as a positive shareholders' deficit.
At the very start of a business, owners put some funding into the business to finance operations.
This creates a liability on the business in the shape of capital as the business is a separate entity
from its owners. Businesses can be considered, for accounting purposes, sums of liabilities and

assets; this is the accounting equation. After liabilities have been accounted for, the positive
remainder is deemed the owners' interest in the business.
This definition is helpful in understanding the liquidation process in case of bankruptcy. At first,
all the secured creditors are paid against proceeds from assets. Afterwards, a series of creditors,
ranked in priority sequence, have the next claim/right on the residual proceeds. Ownership equity
is the last or residual claim against assets, paid only after all other creditors are paid. In such
cases where even creditors could not get enough money to pay their bills, nothing is left over to
reimburse owners' equity. Thus owners' equity is reduced to zero. Ownership equity is also
known as risk capital or liable capital.
APPROACHES OF INTERNATIONAL BUSINESS
International business approaches are similar to the stages of internationalization or
globalization. There appears to be an evolutionary pattern of internationalization that determines
the executive state of mind. This state of mind pertains to the orientations of the executives
towards foreign people, ideas, and resources, both at home and abroad. This attitude not only
differentiates between the executives of international and domestic firms, but also differentiates
among executives of Multi-National Companies.
The evolutionary process of multinational firms can be categorized into four stages. The four
stages are ethnocentric, polycentric, regiocentric and geocentric. These stages represent
managerial mentality of international business.
Ethnocentric Approach The domestic company normally formulate their strategies, their
product design and their operations towards the national markets, customers and competitors.
But, the excessive production more than the demand for the product, either due to competition or
due to changes in customer preferences push the company to excessive production to foreign
countries. The domestic company continues the exports to the foreign countries and views the
foreign market as an extension to the domestic markets just like a new region. The executives at
the head office of the company make the decisions relating to exports and the marketing
personnel of the domestic company monitor the export operations with the help of an export
department. The company exports the same product designed for domestic markets to foreign

countries under this approach. Thus, maintenance of domestic approach towards international
business is called ethnocentric approach.
Polycentric Approach The domestic companies which are exporting to foreign countries using
the ethnocentric approach find at the later stage that the foreign markets need an altogether
different approach.
Then, the company establishes a foreign subsidiary company and decentralizes all the operations
and delegates decision-making and policy making authority to its executives. In fact, the
company appoints executives and personnel including a chief executive who reports directly to
the Managing Director of the company. Company appoints the key personnel from the home
country and all other vacancies are filled by the people of the host country.
The executives of the subsidiary formulate the policies and strategies, design the product based
on the host countrys environments and the preferences of the local customers. Thus, the
polycentric approach mostly focuses on the conditions of the host country in policy formulation,
strategy and implementation and operations.
Regiocentric Approach The Company after operating successfully in a foreign country, thinks
of exporting to the neighboring countries of the host country. At this, the foreign subsidiary
considers the regional environment for formulating policies and strategies. However, it markets
more or less the same product designed under polycentric approach in other countries of the
region, but with different market strategies.
Geocentric Approach Under this approach, the entire world is just a single country for the
company. They select the employees from the entire globe and operate with a number of
subsidiaries. The head quarter coordinates the activities of subsidiaries. Each subsidiary functions
like an independent and autonomous company in formulating policies, strategies, product design,
human resource policies, operations etc.
THEORIES OF FOREIGN DIRECT INVESTMENT
Foreign Direct Investment (FDI) acquired an important role in the international economy after
the Second World War. Theoretical studies on FDI have led to a better understanding of the

economic mechanism and the behavior of economic agents, both at micro and macro level
allowing the opening of new areas of study in economic theory. To understand foreign direct
investment must first understand the basic motivations that cause a firm to invest abroad rather
than export or outsource production to national firms. The purpose of this study is to identify the
main trends in FDI theory and highlight how these theories were developed, the motivations that
led to the need for new approaches to enrich economic theory of FDI. Although several
researchers have tried to explain the phenomenon of FDI, we cannot say there is a generally
accepted theory, every new evidence adding some new elements and criticism to the previous
ones.
1. Product Life-Cycle Theory
International product life-cycle theory (first introduced in Chapter 2) provides a theoretical
explanation for both trade and FDI. The theory, developed by Raymond Vernon, explains why
U.S. manufacturers shift from exporting to FDI. The manufacturers initially gain a monopolistic
export advantage from product innovations developed for the U.S. market. In the new product
stage, production continues to be concentrated in the United States even though production costs
in some foreign countries may be lower. When the product becomes standardized in its growth
product stage, the U.S. manufacturer has an incentive to invest abroad to exploit lower
manufacturing costs and to prevent the loss of the export market to local producers. The U.S.
manufacturers first investment will be made in another industrial country where export sales are
large enough to support economies of scale in local production. In the mature product stage, cost
competition among all producers, including imitating foreign firms, intensifies. At this stage, the
U.S. manufacturer may also shift production from the country of the initial FDI to a lower-cost
country, sustaining the old subsidiary with new products.
Vernons theory is more relevant to manufacturers initial entries into foreign markets than to
MNEs that have FDI already in place. Many MNEs are able to develop new products abroad for
subsequent sale in the United States, thus standing the product life-cycle model on its head. For
example, Procter & Gamble employed more than 8,000 scientists and researchers in 2000 in 18
technical centers in nine countries. Many new products in the health care and beauty care
segments were developed in these offshore research centers and subsequently marketed in the
United States and other foreign countries. MNEs can also transfer new products from the United

States directly to their existing foreign subsidiaries, thereby skipping the export stage. Otis
Elevator, a wholly owned subsidiary of United Technologies Corp., offers its products in more
than 200 countries and maintains major manufacturing facilities in Europe, Asia, and the
Americas. Despite being headquartered in the United States, 80% of Otiss 2005 revenues of $9.6
billion were generated elsewhere. Most of Otiss new elevators, escalators, moving walkways,
and shuttle systems were first developed in the United States and then transferred to and
manufactured by its foreign subsidiaries in the target overseas markets, although the company
increasingly engages in development work abroad.
2. Monopolistic Advantage Theory
The monopolistic advantage theory suggests that the MNE possesses monopolistic advantages,
enabling it to operate subsidiaries abroad more profitably than local competing firms can.
Monopolistic advantage is the benefit accrued to a firm that maintains a monopolistic power in
the market. Such advantages are specific to the investing firm rather than to the location of its
production. Stephen H. Hymer found that FDI takes place because powerful MNEs choose
industries or markets in which they have greater competitive advantages, such as technological
knowledge not available to other firms operating in a given country. These competitive
advantages are also referred to as firm-specific or ownership-specific advantages.
According to this theory, monopolistic advantages come from two sources: superior knowledge
and economies of scale. The term knowledge includes production technologies, managerial skills,
industrial organization, and knowledge of product. Although the MNE could possibly exploit its
already developed superior knowledge through licensing to foreign markets, many types of
knowledge cannot be directly sold. This is because it is impossible to package technological
knowledge in a license, as is true for managerial expertise, industrial organization, knowledge of
markets, and such. Even when the knowledge can be embodied in a license, the local producer
may be unwilling to pay its full value because of uncertainties about its utilization. Given these
reasons, the MNE realizes that it can obtain a higher return by producing directly through a
subsidiary than by selling the license. Besides superior knowledge, another determinant of FDI is
the opportunity to achieve economies of scale. Economies of scale occur through either
horizontal or vertical FDI. An increase in production through horizontal investment permits a
reduction in unit cost of services such as financing, marketing, and technological research.

Because each overseas plant produces the same product in its entirety, horizontal investment may
also have the advantage of allowing the firm to even out the effects of business cycles in various
markets by rearranging sales destinations across nations. Through vertical investment in which
each affiliate produces those parts of the final product for which local production costs are lower,
the MNE may benefit from local advantages in production costs while achieving maximum
economies of scale in the production of single components. Such an international integration of
production would be much more difficult through trade because of the need for close
coordination of different producers and production phases.
3. Internalization Theory
Internalization theory holds that the available external market fails to provide an efficient
environment in which the firm can profit by using its technology or production resources.
Therefore, the firm tends to produce an internal market via investment in multiple countries and
thus creates the needed market to achieve its objective. A typical MNE consists of a group of
geographically dispersed and goal-disparate organizations that include its headquarters and
different national subsidiaries. These MNEs achieve their objectives not only through exploiting
their proprietary knowledge but also through internalizing operations and management.
Internalization is the activity in which an MNE internalizes its globally dispersed foreign
operations through a unified governance structure and common ownership. Internalization
theorists argue that internalization creates contracting through a unified, integrated intrafirm
governance structure. It takes place either because there is no market for the intermediate
products needed by MNEs (e.g., Falk, a global power transmission manufacturer, must use
intermediate goods such as couplings and backstops produced by its Brazilian subsidiary owing
to the unavailability from any outside source) or because the external market for such products is
inefficient (e.g., IBMs speech-recognition technology is transacted internally among different
units because the external market has not been developed enough to properly value and protect
such expertise). The costs of transactions conducted at arms length in an external market (i.e., a
fair price in an open market) may be higher than transactions within an intraorganizational
market. The incentives to internalize activities are to avoid disadvantages in external mechanisms
of resource allocation or to benefit from an internally integrated and intraorganizational network.

Internalization theory also specifies that the common governance of activities in different
locations (e.g., Rubbermaids subsidiary in China uses materials supplied by its sister subsidiary
in Thailand and then ships products to the United States, Europe, and Japan) is likely to result in
transaction gains. In many industries, MNEs are no longer able to compete as a collection of
nationally independent subsidiaries; rather, competition is based in part on the ability to link or
integrate subsidiary activities across geographic locations. To summarize, internalization
advantages include the following:
1. To avoid search and negotiating costs
2. To avoid costs of moral hazard (moral hazard refers to hidden detrimental action by external
partners such as suppliers, buyers, and joint venture partners)
3. To avoid costs of violated contracts and ensuing litigation
4. To capture economies of interdependent activities
5. To avoid government intervention (e.g., quotas, tariffs, price controls)
6. To control supplies and conditions of sale of inputs (including technology)
7. To control market outlets
8. To better apply cross-subsidization, predatory pricing, and transfer pricing
Through internalization, global competitive advantages are developed by forming international
economies of scale and scope and by triggering organizational learning across national markets.
Operational flexibility can leverage the degree of integration. The allocation and dispersal of
resources (both tangible and intangible) serve as a primary device for maintaining operational
flexibility in global business activities. Essentially, by directing resource flows, an MNE may
shift its activities in response to changes in tax structures, labor rates, exchange rates,
governmental policy, competitor moves, or other uncertainties. Thus, resource flows are a
necessary condition for achieving either location-specific or competitive advantages in global
business. Resource flow requires internalization within an MNE network because it involves
interdependence among subsidiaries. Internalization, in turn, requires centralized decision-

making responsibility and authority. Nevertheless, control should be segmented by product line
and distributed among different subsidiaries, depending on particular capabilities and
environmental conditions.
4. The Eclectic Paradigm
The eclectic paradigm offers a general framework for explaining international production. This
paradigm includes three variables: ownership-specific (O), location-specific (L), and
internalization (I), all identified in earlier theories of trade and FDI. The paradigm is also called
the OLI framework. It stands at the intersection of a macroeconomic theory of international trade
(L) and a microeconomic theory of the firm (O and I). It is an exercise in resource allocation and
organizational economics. The key assertion is that all three factors (OLI) are important in
determining the extent and pattern of FDI.
Ownership-specific variables include tangible assets such as natural endowments, manpower, and
capital but also intangible assets such as technology and information, managerial, marketing, and
entrepreneurial skills, and organizational systems.
Location-specific (or country-specific) variables refer to factor endowments introduced in the
preceding chapter as well as market structure, government legislation and policies, and the
political, legal, and cultural environments in which FDI is undertaken. Finally, internalization
refers to the firms inherent flexibility and capacity to produce and market through its own
internal subsidiaries. It is the inability of the market to produce a satisfactory deal between
potential buyers and sellers of intermediate products that explains why MNEs often choose
internalization over the market route for exploiting differences in comparative advantages
between countries. The eclectic paradigm distinguishes between structural and transactional
market failure. Structural market failure is an external condition that gives rise to monopoly
advantages as a result of entry barriers erected or increased by incumbent firms or governments.
Structural market failure thus discriminates between firms in terms of their ability to gain and
sustain control over property rights or to govern geographically dispersed valued-added
activities. Transactional market failure is the failure of intermediate product markets to transact
goods and services at a lower cost than that incurred via internalization. Overall, the eclectic
paradigm provides a more comprehensive view explaining FDI than do the product life-cycle

theory, the monopolistic advantage theory, or the internalization theory. It combines and
integrates country specific, ownership-specific, and internalization factors in articulating the
logic and benefits of international production. Although todays international business
environment and MNE behavior are markedly different from what they were two decades ago,
when the theory first emerged, the OLI advantages are still vital to explaining why FDI takes
place and where MNEs superior returns come from. The eclectic paradigm, like other theories of
FDI, has some limitations, however. First, it does not adequately address how an MNEs
ownership specific advantages such as distinctive resources and capabilities should be deployed
and exploited in international production. Possessing these resources is indeed important, but it
will not yield high returns for the MNE unless they are efficiently deployed, allocated, and
utilized in foreign production and operations. Second, the paradigm does not explicitly delineate
the ongoing, evolving process of international production. FDI itself is a dynamic process in
which resource commitment, production scale, and investment approaches are changing over
time. The product life-cycle theory also falls short on explaining the dynamics of the FDI
process. Third, the conventional wisdom seems inadequate in illuminating how geographically
dispersed international production should be appropriately coordinated and integrated. The
internalization perspective addresses how an MNE could circumvent or exploit market failure for
intermediate products and services but does not discuss how a firm could integrate a multitude of
sophisticated international production and balance global integration with local adaptation.

INTERNATIONAL PORTFOLIO DIVERSIFICATION

Investment of one's portfolio in securities that are traded in various countries. This is done to
reduce risk, often political risk. For example, if one countrys government announces a larger
than normal budget deficit, or the central bank raises interest rates, this may affect security prices
in one country, but not necessarily in other countries that did not take equivalent steps. Likewise,
if a whole industry fails in one country but thrives in another, investing in the same industry in
both countries hedges one's risk. Some analysts argue that international diversification is less
effective in an era of globalization, but other analysts dispute that. An allocation of investments
in a portfolio of international securities in order to achieve broader equity exposure to many
foreign markets while spreading the risks associated with investing in any one foreign market. In
practice, diversification does not just smooth returns, it can increase them. Between 2000 and
2013 a global portfolio has outperformed the S&P 500 by a little over 2% a year on average. This
may in part be due to the contribution of emerging markets, which due to their favorable
demographic trends and relatively low valuations can contribute higher growth to a portfolio.
Across the Western world, people are having less children than previously, this means that the
proportion of working age population is declining and the elderly increasing. This isnt good for
growth since the elderly tend to be less economically productive. Fortunately, in emerging
markets, birth rates and working age populations remain high. That wont be true forever, but its
true for now. In addition, emerging markets and indeed Europe appear cheap on long term
metrics such as CAPE.
Critics of international diversification observe that it does not protect investors against short-term
market crashes because markets become more correlated during downturns. Although true, this
observation misses the big picture. Over longer horizons, underlying economic growth matters
more than short-lived panics with respect to returns, and international diversification does an
excellent job of protecting investors.
What is a Portfolio?
A collection of investments all owned by the same individual or organization. These investments
often include stocks, which are investments in individual businesses; bonds, which are

investments in debt that are designed to earn interest; and mutual funds, which are essentially
pools of money from many investors that are invested by professionals or according to indices.
What is diversification?
A portfolio strategy designed to reduce exposure to risk by combining a variety of investments,
such as stocks, bonds, and real estate, which are unlikely to all move in the same direction. The
goal of diversification is to reduce the risk in a portfolio. Volatility is limited by the fact that not
all asset classes or industries or individual companies move up and down in value at the same
time or at the same rate. Diversification reduces both the upside and downside potential and
allows for more consistent performance under a wide range of economic conditions.
Advantages of international portfolio diversification
1. Using Portfolio Diversification to Reduce Investment Risks
The goal of diversification is to reduce the risk involved in building a portfolio. Volatility is
limited by the fact that not all asset classes or industries or individual companies move up and
down in value at the same time or at the same rate. While this limits the rate of growth as well, it
reduces the likelihood of substantial losses and allows for more consistent performance under a
wide range of economic conditions.
Devising an asset allocation plan is the first step toward diversifying a portfolio. Dividing funds
between different asset classes provides some protection against loss when one type of
investment is underperforming. Because the values of different investments often move in
opposite directions, investing in a range of securities reduces the risk that all assets will be
decreasing in value at the same time. The process of diversification, however, does not end with
asset allocation.
Within asset classes, it is important to purchase securities from a variety of industries, so that
poor performance in one area will not send an entire portfolio reeling. Certain industries perform
better under certain economic conditions, but a diverse portfolio should continue to build overall
value under almost any conditions. Diversification should then continue even within industries
by purchasing securities from a mix of companies that serve different roles within the industry. A

single stock in a high-flying industry may still fail, but a group of ten diverse stocks within that
industry will have lower volatility than just one would.
Learning enough about the many industries and companies that make up a diverse portfolio is no
easy task. A great deal of research is required to make good decisions. For investors who wish to
learn about a few specific areas to pick individual investments, mutual funds can fill in the gaps.
Professionals design mutual funds to have a great deal of diversification built in. Even mutual
funds that focus on a particular part of a particular industry will usually provide the chance to
invest in a broad cross-section of that sector . Index funds provide another option for
diversification by giving investors the opportunity to invest in all of the stocks that appear in a
certain index. While these funds vary widely in terms of the stocks they cover, they all provide
the opportunity to tie the returns on invested funds to the performance of a large number of
individual stocks. These funds differ from the actively managed funds discussed above in that the
contents of the funds are determined independently by whoever maintains the index instead of
relying on a fund manager who has the power to make decisions about where to invest the
money.
2. Spreading risk: Correlations between national asset markets
Because of risk aversion, investors demand higher expected returns for taking on investments
with greater risk. It is a well-established proposition in portfolio theory that whenever there is
imperfect co-relation between different assets returns, risk is reduced by maintaining only a
portion of wealth in any individual asset. More generally, by selecting a portfolio according to
expected returns, variances of returns, and co-relations between returns, an investor can achieve
minimum risk for a given expected portfolio return, or maximum expected portfolio return for a
given risk. Furthermore, ceteris paribus, the lower are the co-relations between returns on
different assets, the greater are the benefits of portfolio diversification. Because of different
industrial structure in different countries, and because different economies do not trace out
exactly the same business cycle, there are reasons for smaller co-relations of expected returns
between investments in numerous different countries than between investments within any one
country. This means that foreign investments offer diversification benefits that cannot be enjoyed
by investing only at home, and for example, that a US investor might include British stocks in a

portfolio even if they offer lower expected returns than US stocks; the benefit of risk reduction
might more than compensate for lower expected returns.
3. Country-specific volatility versus industrial structure
Two possible explanations for the generally low correlations between different countries stock
markets are:
i) That the countries economies evolve differently over time with different business cycles.
ii) That the countries have different industries in their stock market indexes.
In the latter case, the low correlations between overall stock market indexes could occur despite
firms in a given industry, but in different countries, having highly correlated stock values; high
correlations within industries might be swamped by low correlations between industries.
4. Increased size of the gain from stock diversification
An indication of the size of the gain from including foreign stocks in a portfolio has been
provided by the research of Bruno Solnik.3 Solnik computed the risk of randomly selected
portfolios of n securities for different values of n in terms of the volatility of these portfolios. For
example, a large number of portfolios of two randomly selected companies were formed, and
their return and volatility calculated. Then, portfolios of three randomly selected companies were
formed, with average returns and volatilities calculated, and so on. As expected, it was found that
volatility declines as more stocks are included. Moreover, Solnik discovered that an international
portfolio of stocks has about half as much risk as a portfolio of same size containing only US
stocks.
5. Reduced risk from exchange rates
While there are gains from international diversification because of the independence between
foreign and domestic stock returns, there is a possibility of added risk from unanticipated
changes in exchange rates when foreign stocks are held. It is important to confirm whether this
completely nullifies the benefits from international diversification from the presence of some
independence between stock market returns in different countries. The answer is no. One reason

is that it is possible to diversify internationally without adding exchange rate exposure- by

hedging in the forward market, by borrowing in the foreign currencies, or by using futures or
currency options. The hedges would have to be based on the exposure in each currency, as given
by regression coefficients. A second reason why international portfolio diversification is
beneficial despite exchange-rate variability is that, even without hedging, the variance of dollar
return on an internationally diversified portfolio of stocks remains lower than the variance of the
expected dollar return investing in the domestic stock market. This has been shown by Bruno
Solnik, who compared the variance of returns on portfolios of US stocks with the variance of
returns on internationally diversified portfolios, both when not hedging exchange- rate exposure
and when hedging in the forward market.
6. Gain in International Capital Asset Pricing
The central international financial question concerning the pricing of assets, and hence their
expected rates of return, is whether they are determined in an integrated international capital
market or in local segmented markets. If assets are priced in an internationally integrated capital
market, expected yields on assets will be in accordance with the risks of the assets when they are
held in an efficient, internationally diversified portfolio, such as the world market portfolio. This
means that while in such a situation it is better to diversify internationally than not to. On the
other hand, if assets are priced in segmented capital markets, their returns will be in accordance
with the systematic risk of their domestic market. This means that if an investor happens to have
an ability to circumvent whatever it is that causes markets to be segmented, this investor will be
able to enjoy special benefits from international diversification. It is consequently important for
us to consider whether assets are priced in internationally integrated or in segmented capital
markets. However, before doing this it is useful to review the theory of asset pricing is a
domestic context, because if we do not understand the issues in the simpler domestic context, we
cannot understand the international dimensions of asset pricing.
7. Gain from International Portfolio Diversification In Case of Bonds
The empirical importance of international portfolio diversification of bonds is addressed in figure

The figure shows two efficiency frontiers, one for optimally internationally diversified portfolio
of stocks only, and other for stocks plus bonds. The frontier when bonds are included in the
portfolio shows reduced risk for given returns. The reduction in risk does not, of course, occur at
high rates of return because to achieve such returns it is necessary to hold only stocks. The lower
expected returns the advantage of including bond is substantial, with, for example, a volatility.

Disadvantages:International Portfolio Diversification

* Missed Windfalls
If your holdings are widely diversified, you are as unlikely to make a huge profit from a single
sector as to suffer a huge loss. If 5 percent of your holdings suddenly spike, you will make far
less profit than if 100 percent have your holdings were in that asset. In hindsight, many investors
have regretted diversification after a small percentage of their holdings made a large profit.
However, it is very difficult to predict where and when this will happen to an asset class or
market sector. The more tightly your investments are focused, the higher risk you are taking,
which can lead to large losses or to large gains.
* Increased Exposure

When your holdings are widely diversified, you will suffer some amount of loss whenever some
part of your portfolio dips in value. If the market as a whole is declining, it is very likely that
your holdings will do the same. When you diversify your investments, you protect yourself from
excessive financial exposure, but at the cost of missing out on potentially major profits.
* Currency exchange risk
* Less convenient to invest than U.S. stocks
* More expensive to invest
* Riskier than investing in U.S
INTERNATIONAL PORTFOLIO INVESTMENT
PORTFOLIO THEORY
* Assumptions
> Nominal returns are normally distributed.
> Investors want higher return and less risk in their functional currency.
* Return and Risk:
Let Xi = proportion of wealth devoted to asset i, such that Xi = 1.
> Expected return on a portfolio is simply a weighted average of the expected returns on the
securities in the portfolio, i.e.,

E[R p ] X i E[R i ]
i

> Portfolio variance:

Var [ R p ] p2 X i X j ij
i

where ij = iji
> Portfolio variance depends on the correlation between assets. The correlation does not impact
the expected return on a portfolio.
* Key results of portfolio theory
> The extent to which risk is reduced by portfolio diversification depends on correlation of assets
in the portfolio.
High correlations yield few diversification benefits.
Low correlations yield lots of diversification benefits.
> With a single security, portfolio variance equals the variance of that single security. As the
number of assets increases, portfolio variance becomes more dependent on the covariances and
less dependent on variances.
In the limit as N, portfolio variance depends only on covariance.
> The risk of an asset when held in a large portfolio depends on its return covariance with other
securities in the portfolio and not on its return variance.
* Diversification and Correlation Coefficient
> Risk is reduced by portfolio diversification when a portfolio is extended to include new
investments whose returns are imperfectly correlated with the original portfolio.
> How does one measure the relative independence of asset returns?
Correlation coefficient between returns of assets A and B is the covariance scaled by the standard
deviations of returns of the two assets, i.e., rAB = sAB/sAsB.
-1 rAB +1

> The less the correlation between two assets, the greater the potential for risk reduction through
portfolio diversification.

Exhibit 13.1

Mean annual return

20%

J
= -1

= +0.325

= +1

A
10%

0%
0%

10%

20%

30%

40%

Standard deviation of annual return

Portfolio Diversification
INTERNATIONAL PORTFOLIO DIVERSIFICATION
* A globally diversified stock/bond portfolio offers higher expected return at lower portfolio risk
than a purely domestic portfolio.

Exhibit 13.2

Expected return

Rf

Standard deviation of return

> Higher expected return Developing economies are much more likely to experience aboveaverage economic growth. This leads to higher expected returns in emerging markets.
> Lower portfolio risk National economies do not move in unison, and stock and bond returns
vary widely across national markets. Diversifying across international markets can greatly reduce
portfolio risk because of the relatively low correlation between national debt and equity market
indices.
* Can we achieve the same diversification benefits by selecting only a few issues in the domestic
market?

Exhibit 13.3

Portfolio risk relative to

the risk of a single asset
(P/i)

U.S. diversification only

International diversification

1.0
0.5

10
15
20
Number of stocks in portfolio

25

Domestic versus International Diversification

* The benefits of international diversification are the greatest for residents of those countries with
the least diversified economies.
* The degree of independence of a stock market is linked to the independence of a nations
economy and government policies.
Constraints and regulations imposed by national governments, technological specialization,
independent fiscal and monetary policies, and cultural and sociological differences all contribute
to the degree of a capital markets independence.
Conversely, when there are close economic and government policies, like among the members of
the European Union, one observes more commonality in capital market behavior.

* Correlation between national markets tend to increase when market volatility increases.

RETURN AND RISK ON FOREIGN INVESTMENT

* Notations:
St = Spot exchange rate, in $/FC
Ptf = Price of foreign asset in foreign currency units
Ptd = Price of foreign asset in domestic currency ($) units
Rtf = Return on foreign asset in foreign currency units
Rtd = Return on foreign asset in domestic currency units
* What is the price of the foreign equity in domestic currency?

Domestic currency return on foreign asset:

Rtd = (Ptd / Pt-1d) 1
= (Ptf St / Pt-1f St-1) 1
= (Ptf / Pt-1f) (St / St-1) 1
= (1 + Rtf) (1 + std/f) 1
= Rtf + std/f + Rtf std/f
Hence, domestic currency return on foreign assets has three parts:

return in the local currency,

change in the spot exchange rate,

an interaction term.
Example 1: The Mexican stock market goes up by 30% in pesos, but the peso falls 20% against
$. What is the $ return on the Mexican market?

Example 2: Pohang Steel of South Korea falls 20% in local terms. The Japanese yen falls 20%
against the Korean won. What is the yen return on an investment in Pohang Steel?

Expected return on foreign asset and variance:

E[Rd] = E[Rf] + E[sd/f] + E[Rf sd/f]
Var[Rd]

= Var[Rf] + Var[sd/f] + Var[Rf sd/f] + 2Cov[Rf , sd/f]

+ 2Cov[Rf , Rf sd/f] + 2Cov[sd/f , Rf sd/f]

= Var[Rf] + Var[sd/f] + Var[Rf sd/f] + 2Cov[Rf , sd/f]
+ 2(Rf)2Cov[1, sd/f] + 2(sd/f)2Cov[1, Rf]
= Var[Rf] + Var[sd/f] + Var[Rf sd/f] + 2Cov[Rf , sd/f]

Variance of return on foreign stocks

Exhibit 13.4
Variance of Returns on Foreign Stocks

interaction
=

Var(Rf)
Var(Rf)

Canada
0.122
France
0.041

+ Var(s$/f) + terms
+

0.052

0.826
1.000

0.216

0.825
1.000

The dominant risk in the equity markets is return volatility in national markets.

Equity values in foreign currency have a low correlation with the value of the currency itself.

Variance of return on foreign bonds

Exhibit 13.5
Variance of Returns on Foreign Bonds

interaction
Var(Rf)
+ Var(s$/f)
terms
= Var(Rf)
Canada
0.215
France
0.065

0.184

0.601
1.000

0.823

0.242
1.000

Foreign bonds have two sources of risk:

Interest rate variability in foreign currency

Exchange rate variability

The relative split between Var[Rf] and Var[sd/f] depends on the relative volatility of interest
rates and exchange rates.

Smaller and less diversified countries typically have even more volatile returns in the local
currency.
In addition, volatile currencies lead to additional volatility on foreign assets.

Currency risk

Currency risk is smaller than the risk of the corresponding stock market.

Market risks and currency risks are not additive.

The exchange risk of an investment may be hedged.

The contribution of currency risk should be measured for the total portfolio rather than for
individual markets or securities.
Components of variance of the rate of return

1. variance of the rate of return in foreign currency terms

2. variance of the percentage change in the exchange rate
3. covariance of the two component
Dealing with the currency factor in international portfolios
Believing that international portfolio managers do not have sufficient expertise in foreign
exchange, some institutional investors have turned to specialized overlay managers to manage
the currency risk of the portfolio separately.
Currency overlay is a financial trading strategy or method conducted by specialist firms who
manage the currency exposures of large clients, typically institutions such as pension funds,
endowments and corporate entities. Typically the institution will have a pre-existing exposure to
foreign currencies, and will be seeking to:

limit the risk from adverse movements in exchange-rates, i.e. hedge; and

attempt to profit from tactical foreign-exchange views, i.e. speculate.

The currency overlay manager will conduct foreign-exchange hedging on their behalf, selectively
placing and removing hedges to achieve the objectives of the client.
Many types of currency overlay accounts are more focused on the speculative aspect, i.e.
profiting from currency movements. These so-called 'pure alpha mandates' are set up to allow the
manager as much scope as possible to take speculative positions. As such, they are similar in
nature to foreign-exchange hedge funds in terms of objective and trading style. Currency overlay
is a relatively new area of finance; the first intuitional overlay mandate was awarded only in

1983 when the UK water Authorities Superannuation Fund awarded a contract to Record
Currency Management.
Currency hedging
Individuals and institutions who own equities, government bonds, cash, or other assets
denominated in foreign currencies are exposed to fluctuations in the foreign exchange market.
This is an unrewarded risk: the volatility in valuation of an international portfolio is generally
increased by adding currency exposure, yet there is no risk premium earned for that added
volatility in the long term. Thus investors with international portfolios often hedge their currency
risk, normally using forward currency contracts, currency swaps, currency futures contracts, or
currency options.
Passive currency overlay
Currency hedging can be done passively or actively. The stream of returns from passive currency
overlay is negatively correlated with international equities, has an expected return of zero, and
does not employ any capital. The overlay manager uses forward contracts to match the portfolios
currency exposures in such a way as to insure against exchange rate fluctuations. A decision list
for a passive overlay manager would include

Original maturity of forward contracts

Frequency of cash flows

Currencies to be hedged

Benchmark or actual asset weights to be hedged?

Denominator of contribution from hedging

Frequency of asset valuation

Frequency of rebalancing

Rebalancing buffer

Delay in rebalancing

Instantaneous absolute hedge ratio limitation?

Valuation rates
The decisions will be informed by, among other things,

1.

The hedged portfolio

2.

The benchmark

3.

The investors cash flow preferences

Active currency overlay
Active currency overlay requires management style decisions on the part of the manager, based
on the types of model and model input that the manager chooses to employ. The most common
categories in active currency overlay are as follows:

Fundamental

Technical

Dynamic

Option-based
Fundamental managers believe they can exploit price inefficiencies using models and
processes in which economic and financial data are used as the exogenous variables, including
balance of payments, capital flows, price levels, monetary conditions, etc.
Technical managers tend to ignore completely external economic variables, and argue that price
and price history provide the most effective mechanism for exploiting inefficiencies. A typical
approach would be to model price history to determine successful trading rules.
Dynamic managers are a group that aims to create an asymmetric returnrunning profits and
cutting losseswith forwards or option technology.
Option-based managers exploit systematic differences between implied and actual future
volatility.
Currency for return
The foreign exchange market exhibits systematic inefficiencies, owing mostly to its unique status
among financial markets: only a small proportion of currency market participants are seeking
profit in that market. Instead, most participants transact in the foreign exchange markets for other
purposestrade or investment, for instance.
Because the market is dominated by highly constrained participants like industrial and
commercial companies, fund managers, portfolio investors, and central banks, there still exist
arbitrage opportunities that are not fully exploited. These include cyclical behaviour, trending,
disparities in implied and actual volatility, and the forward rate bias.

The outsourcing of currency risk management to a specialist firm, known as the overlay manager.
This is used in international investment portfolios to separate the management of currency risk

from the asset allocation and security selection decisions of the investor's money managers. The
overlay manager's hedging is "overlaid" on the portfolios created by the other money managers,
whose activities continue unaffected.
OBJECTIVE OF CURRENCY OVERLAY
to separate foreign exchange risk from the investment portfolio
allowing investors to focus on the merit of the underlying investment without worrying about
exchange rate fluctuations.
APPROACHES USED IN CURRENCY OVERLAY
1. joint, full-blown optimization of the underlying securities and currencies
the manager has the expertise in many securities and can construct a portfolio to account to
correlations between security prices and exchange rates.
2. partial optimization of the currencies, given a predetermined position in the portfolio
currencies are managed separately, but the manager still control the total portfolio risk.
3. separate optimization of the currencies
currencies are managed completely independently of the portfolio, such that performance with
respect to the currency is measured against a separate benchmark.
Currency overlay managers follow 4 styles
1. fundamental discretionary
2. technical quantitative
3. fundamental quantitative
4. technical discretionary

INTERNATIONAL CAPITAL ASSET PRICING MODEL

The conventional or domestic Capital Asset Pricing Model (CAPM) postulates that the expected
return on asset or a portfolio is positively related to its systematic risk.
CAPITAL ASSET PRICING MODEL - CAPM
A model that describes the relationship between risk and expected return and that is used in the
pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value
of money and risk. The time value of money is represented by the risk-free (rf) rate in the
formula and compensates the investors for placing money in any investment over a period of
time. The other half of the formula represents risk and calculates the amount of compensation the
investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that
compares the returns of the asset to the market over a period of time and to the market premium
(Rm-rf).
The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free
security plus a risk premium. If this expected return does not meet or beat the required return,
then the investment should not be undertaken. The security market line plots the results of the
CAPM for all different risks (betas).
Using the CAPM model and the following assumptions, we can compute the expected return of a
stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2
and the expected market return over the period is 10%, the stock is expected to return 17% (3%
+2(10%-3%)).

The total risk from the variability of the rate of return on a security or portfolio consist of :
a. Systematic risk / market risk
portion of total variability associated with movements of the market as a whole.
Cannot be eliminated by diversification

In finance and economics, systematic risk (in economics often called aggregate
risk or undiversifiable risk) is vulnerability to events which affect aggregate outcomes such as

broad market returns, total economy-wide resource holdings, or aggregate income. In many
contexts, events like earthquakes and major weather catastrophes pose aggregate risksthey
affect not only the distribution but also the total amount of resources. If every possible outcome
of a stochastic economic process is characterized by the same aggregate result (but potentially
different distributional outcomes), then the process has no aggregate risk.
Systematic or aggregate risk arises from market structure or dynamics which produce shocks or
uncertainty faced by all agents in the market; such shocks could arise from government policy,
international economic forces, or acts of nature. In contrast, specific risk (sometimes called
residual risk or idiosyncratic risk) is risk to which only specific agents or industries are
vulnerable (and are uncorrelated with broad market returns). Due to the idiosyncratic nature of
unsystematic risk, it can be reduced or eliminated through diversification; but since all market
actors are vulnerable to systematic risk, it cannot be limited through diversification (but it may be
insurable). As a result, assets whose expected returns are negatively correlated with broader
market returns command higher prices than assets not possessing this property.
In some cases, aggregate risk exists due to institutional or other constraints on market
completeness. For countries or regions lacking access to broad hedging markets, events like
earthquakes and adverse weather shocks can also act as costly aggregate risks. Robert Shiller has
found that, despite the globalization progress of recent decades, country-level aggregate income
risks are still significant and could potentially be reduced through the creation of better global
hedging markets (thereby potentially becoming idiosyncratic, rather than aggregate, risks).
Specifically, Shiller advocated for the creation of macro futures markets. The benefits of such a
mechanism would depend on the degree to which macro conditions are correlated across
countries.
Systematic risk plays an important role in portfolio allocation. Risk which cannot be eliminated
through diversification commands returns in excess of the risk-free rate (while idiosyncratic risk
does not command such returns since it can be diversified). Over the long run, a well-diversified
portfolio provides returns which correspond with its exposure to systematic risk; investors face a
trade-off between returns and systematic risk. Therefore, an investor's desired returns correspond
with their desired exposure to systematic risk and corresponding asset selection. Investors can
only reduce a portfolio's exposure to systematic risk by sacrificing returns.

An important concept for evaluating an asset's exposure to systematic risk is Beta. Since Beta
indicates the degree to which an asset's expected return is correlated with broader market
outcomes, it is simply an indicator of an asset's vulnerability to systematic risk. Hence,
the capital asset pricing model (CAPM) directly ties an asset's equilibrium price to its exposure
to systematic risk.

The risk inherent to the entire market or an entire market segment. Systematic risk, also known
as undiversifiable risk, volatility or market risk, affects the overall market, not just a
particular stock or industry. This type of risk is both unpredictable and impossible to completely
avoid. It cannot be mitigated through diversification, only through hedging or by using the right
asset allocation strategy.

b. Unsystematic / residual risk

Can be diversified away
Company- or industry-specific hazard that is inherent in each investment. Unsystematic risk, also
known as nonsystematic risk, "specific risk," "diversifiable risk" or "residual risk," can be
reduced through diversification. By owning stocks in different companies and in different
industries, as well as by owning other types of securities such as Treasuries and municipal
securities, investors will be less affected by an event or decision that has a strong impact on one
company, industry or investment type. Examples of unsystematic risk include a new competitor,
a regulatory change, a management change and a product recall.

For example, the risk that airline industry employees will go on strike, and airline stock prices
will suffer as a result, is considered to be unsystematic risk. This risk primarily affects the airline
industry, airline companies and the companies with whom the airlines do business. It does not
affect the entire market system, so it is an unsystematic or nonsystematic risk.

An investor who owned nothing but airline stocks would face a high level of unsystematic risk.
By diversifying his or her portfolio with unrelated holdings, such as health-care stocks and retail
stocks, the investor would face less unsystematic risk. However, even a portfolio of welldiversified assets cannot escape all risk. It will still be exposed to systematic risk, which is the
uncertainty that faces the market as a whole. Even staying out of the market completely will not
take an investors risk down to zero, because he or she would still face risks such as losing
money from inflation and not having enough assets to retire.

Investors may be aware of some potential sources of unsystematic risk, but it is impossible to be
aware of all of them or to know whether or when they might occur. An investor in health-care
stocks may be aware that a major shift in government regulations could affect the profitability of
the companies they are invested in, but they cannot know when new regulations will go into
effect, how the regulations might change over time or how companies will respond.

Unsystematic risk, also known as "specific risk," "diversifiable risk" or "residual risk," is the type
of uncertainty that comes with the company or industry you invest in. Unsystematic risk can be
reduced through diversification. For example, news that is specific to a small number of stocks,
such as a sudden strike by the employees of a company you have shares in, is considered to be
unsystematic risk. Systematic risk, also known as "market risk" or "un-diversifiable risk", is the
uncertainty inherent to the entire market or entire market segment. Also referred to as volatility,
systematic risk consists of the day-to-day fluctuations in a stock's price. Volatility is a measure of
risk because it refers to the behavior, or "temperament," of your investment rather than the reason
for this behavior. Because market movement is the reason why people can make money from
stocks, volatility is essential for returns, and the more unstable the investment the more chance
there is that it will experience a dramatic change in either direction. Interest rates, recession and
wars all represent sources of systematic risk because they affect the entire market and cannot be

avoided through diversification. Systematic risk can be mitigated only by being hedged.
Systematic risk underlies all other investment risks. If there is inflation, you can invest in
securities in inflation-resistant economic sectors. If interest rates are high, you can sell your
utility stocks and move into newly issued bonds. However, if the entire economy underperforms,
then the best you can do is attempted to find investments that will weather the storm better than
the broader market. Popular examples are defensive industry stocks, for example,
or bearishoptions strategies. Beta is a measure of the volatility, or systematic risk, of a security or
a portfolio in comparison to the market as a whole. In other words, beta gives a sense of a stock's
market risk compared to the greater market. Beta is also used to compare a stock's market risk to
that of other stocks. Investment analysts use the Greek letter '' to represent beta. Beta is used in
the capital asset pricing model(CAPM), as we described in the previous section. Beta is
calculated using regression analysis, and you can think of beta as the tendency of a security's
returns to respond to swings in the market. A beta of 1 indicates that the security's price will
move with the market. A beta of less than 1 means that the security will be less volatile than the
market. A beta of greater than 1 indicates that the security's price will be more volatile than the
market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market.
Many utility stocks have a beta of less than 1. Conversely, most high-techNasdaq-based stocks
have a beta greater than 1, offering the possibility of a higher rate of return, but also posing more
risk.

Beta helps us to understand the concepts of passive and active risk. The graph below

shows a time series of returns (each data point labeled "+") for a particular portfolio R(p) versus
the market return R(m). The returns are cash-adjusted, so the point at which the x and y axes
intersect is the cash-equivalent return. Drawing a line of best fit through the data points allows us
to quantify the passive, or beta, risk and the active risk, which we refer to as alpha.
Securities market line (SML)
Diagrammatic representation of the relation between expected returnand systematic risk.
Line on a chart derived from the Markowitz Portfolio Theory.
Graphical representation of the Capital Asset Pricing Model and it plots levels of risk against the
expected return of the entire market at a given point in time.

Going by values of beta, SML shows that the relationship between risk and return is
linear for individual securities (i.e. increased risk = increased return).

Essentially it shows what return you need to earn on an investment in order for it to be
worth taking, and this increases with the riskiness of the investment.

Overvalued security is characterized by expected return-risk that places it below security

market line.
The SML Approach

Use the following information to compute our cost of equity

Risk-free rate, Rf
Market risk premium, E(RM) Rf
Systematic risk of asset,

RE R f E ( E ( RM ) R f )

Risk free premium

is used to induce risk-averse investors to buy risky security

Systematic risk - risk inherent to the entire market or an entire market segment.
Also known as undiversifiable risk, volatility or market risk
Affects the overall market, not just a particular stock or industry, due to change in
economy, tax reform, etc
Both unpredictable and impossible to completely avoid. It cannot be mitigated through
diversification, only through hedging or by using the right asset allocation strategy.

Unsystematic Risk
Company- or industry-specific hazard that is inherent in each investment
Independent of economic, political other factors that affect securities in systematic
manner
Also known as nonsystematic risk, "specific risk," "diversifiable risk" or "residual
risk," can be reduced through diversification.
By owning stocks in different companies and in different industries, as well as by owning
other types of securities such as Treasuries and municipal securities, investors will be
less affected by an event or decision that has a strong impact on one company,
industry or investment type.

Examples of unsystematic risk include a new competitor, a regulatory change, a

management change and a product recall.

Possible for a security with great total risk to have lower systematic risk than security
with moderate amount of total risk
Mining company discovering gold & silver deposits is almost chance event. Security
returns bears little relation to market overall

Return from a large manufacturing company or large retailer is closely tied to overall
economy; such have moderate unsystematic risk so that total risk maybe less than mining
company. Their systematic risk can be approximately that of market as whole.
Example: SML

Suppose your company has an equity beta of .58 and the current risk-free rate is 6.1%. If
the expected market risk premium is 8.6%, what is your cost of equity capital?
RE = 6.1 + .58(8.6) = 11.1%

Since we came up with similar numbers using both the dividend growth model and the
SML approach, we should feel pretty good about our estimates.
Imagine you are screening a selection of stocks to determine where best to invest your hard
earned bonus. You know that the risk free rate in Philippine Treasuries is currently 2%, and the
S&P500 is returning approximately 5%. You have narrowed it down to Company A which has a
beta of 0.6 and a return (including dividend) of 4% per annum and Company B which has a beta
of 1.8 and a return of 7%.

The required return to invest in Company A is 2% + ( 0.6 x [5% - 2%] ) = 3.8%

The required return for Company B is 2% + ( 1.8 x [5% - 2%]) which is 7.4%.

In this scenario, you would be best placed to invest in Company A (all other things being
equal) because the return you would earn on Company B is not enough to compensate you for the
risk you are taking.

Extremely effective tool when looking at portfolio composition and stock choices but
should be treated with caution for several reasons:

Return over the risk free rate is not the only thing to look at when making an investment
choice
All of these numbers except for the risk-free rate are based on historic

Despite these limitations, SML is useful when determining your own risk curve.
Disadvantages:

Have to estimate the expected market risk premium, which does vary over time
Have to estimate beta, which also varies over time
We are relying on the past to predict the future, which is not always reliable.
A security with =0 has a rate of return that is equal to risk free interest rate.
A security with <1 has an expected return higher than the risk free rate but lower than the
expected return on the market portfolio.
A security with a systematic risk that is equal to that for the market (=1) has an expected rate of
return on the market portfolio.
If the security is more risky than the market portfolio (>1) , it will offer an expected rate of
return that is higher than what is offered by the market portfolio.
INTERNATIONAL CAPITAL ASSET PRICING MODEL (ICAPM)
Relation between expected return and systematic risk when assets are priced in internationally
integrated financial markets.
A financial model that extends the concept of the capital asset pricing model (CAPM) to
international investments. The standard CAPM pricing model is used to help determine the return
investors require for a given level of risk. When looking at investments in an international
setting, the international version of the CAPM model is used to incorporate foreign exchange
risks (typically with the addition of a foreign currency risk premium) when dealing with several
currencies.
CAPM is a method for calculating anticipated investment risks and returns. The model was
developed by economist and Nobel Memorial Prize winner William Sharpe. It says that the return
on an investment should equal its cost of capital and that the only way to earn a higher return is

by taking on more risk. Investors can use CAPM to evaluate the attractiveness of potential
investments. There are several different versions of CAPM, of which international CAPM is just
one.
MARKET SEGMENTATION
A marketing term referring to the aggregating of prospective buyers into groups (segments) that
have common needs and will respond similarly to a marketing action. Market segmentation
enables companies to target different categories of consumers who perceive the full value of
certain products and services differently from one another. Generally three criteria can be used to
identify different market segments:
1) Homogeneity (common needs within segment)2) Distinction (unique from other groups)3)
Reaction (similar response to market)
For example, an athletic footwear company might have market segments for basketball players
and long-distance runners. As distinct groups, basketball players and long-distance runners will
respond to very different advertisements.
Reason for market segmentation
1. Legal barriers to foreign investments
2. Difficulty of finding and interpreting information about foreign securities
3. Foreign exchange risk
4. Purchasing power risk
5. Political risk
6. Country risk
7. Transaction costs
8. Taxation
9. Domestic regulation

INVESTMENT MANAGEMENT AND EVALUATION

Investment
It is putting money into an asset with the expectation of capital appreciation, dividends, and/or
interest earnings. This may or may not be backed by research and analysis. Most or all forms of
investment involve some form of risk, such as investment in equities, property, and even fixed
interest securities which are subject, among other things, to inflation risk. It is indispensable for
project investors to identify and manage the risks related to the investment.
Investment management
Investment management has two general definitions, one relating to advisory services and the
other relating to corporate finance.
In the first instance, a financial advisor or financial services company provides investment
management by coordinating and overseeing a client's financial portfolio e.g., investments,
budgets, accounts, insurance and taxes.
In corporate finance, investment management is the process of ensuring that a company's
tangible and intangible assets are maintained, accounted for, and put to their highest and best use.
It is the professional asset management of various securities (shares, bonds and other securities)
and other assets(e.g., real estate) in order to meet specified investment goals for the benefit of the
investors. Investors may be institutions (insurance companies, pension funds, corporations,
charities, educational establishments etc.) or private investors (both directly via investment
contracts and more commonly via collective investment schemes e.g. mutual funds or exchangetraded funds).

Investment evaluation
The process begins with the financial plan where your personal and financial goals are
established. This process helps to identify your investment objectives, investment time horizons
and comfort level for investment risk/return trade-offs.
Then review your current portfolio to determine if it is likely to provide you with the best
probability of achieving your financial goals. A significant part of this process involves analyzing
how your assets are currently allocated across the various asset classes and help answer the
question How diversified is my portfolio?
With this information, it can help you to develop an investment policy statement which clearly
reflects how your money should be allocated. It will also make specific recommendations about
what changes you need to make in your portfolio.
Portfolio Management
With the thousands of available stocks, bonds, and related financial instruments on the market
today, no one individual or company is likely to best understand what combination is best to
own in any specific client's portfolio. It is believed that the use of mutual funds is the most
efficient means to access professional investment management for many, if not most, investors.
A mutual fund is a collection of stocks, bonds, or other securities that are managed by a
professional investment company. Each fund will have stated investment objectives which
guides the investment decisions of the management company. The funds are classified into asset
classes based on their investment style and performance characteristics. This provides a
reasonable means to evaluate their performance relative to all their peers or like funds.
Factors in Investment Management

Asset allocation
The different asset class definitions are widely debated, but four common divisions
are stocks, bonds, real estate and commodities. The exercise of allocating funds among these
assets (and among individual securities within each asset class) is what investment management
firms are paid for. Asset classes exhibit different market dynamics, and different interaction
effects; thus, the allocation of money among asset classes will have a significant effect on the
performance of the fund. Some research suggests that allocation among asset classes has more
predictive power than the choice of individual holdings in determining portfolio return. Arguably,

the skill of a successful investment manager resides in constructing the asset allocation, and
separately the individual holdings, so as to outperform certain benchmarks (e.g., the peer group
of competing funds, bond and stock indices).

Long-term returns
It is important to look at the evidence on the long-term returns to different assets, and to holding
period returns (the returns that accrue on average over different lengths of investment). For
example, over very long holding periods (e.g. 10+ years) in most countries, equities have
generated higher returns than bonds, and bonds have generated higher returns than cash.
According to financial theory, this is because equities are riskier (more volatile) than bonds
which are they more risky than cash.

Diversification
Against the background of the asset allocation, fund managers consider the degree
of diversification that makes sense for a given client (given its risk preferences) and construct a
list of planned holdings accordingly. The list will indicate what percentage of the fund should be
invested in each particular stock or bond. The theory of portfolio diversification was originated
Investment Styles
There are a range of different styles of fund management that the institution can implement. For
example, growth, value, growth at a reasonable price (GARP), market neutral, small
capitalization, indexed, etc. Each of these approaches has its distinctive features, adherents and,
in any particular financial environment, distinctive risk characteristics. For example, there is
evidence that growth styles (buying rapidly growing earnings) are especially effective when the
companies able to generate such growth are scarce; conversely, when such growth is plentiful,
then there is evidence that value styles tend to outperform the indices particularly successfully.
Performance Measurement
Fund performance is often thought to be the acid test of fund management, and in the
institutional context, accurate measurement is a necessity. For that purpose, institutions measure
the performance of each fund (and usually for internal purposes components of each fund) under
their management, and performance is also measured by external firms that specialize in
performance measurement. The leading performance measurement firms (e.g. Frank Russell in

the USA or BI-SAM in Europe) compile aggregate industry data, e.g., showing how funds in
general performed against given indices and peer groups over various time periods.
Generally speaking, it is probably appropriate for an investment firm to persuade its clients to
assess performance over longer periods (e.g., 3 to 5 years) to smooth out very short term
fluctuations in performance and the influence of the business cycle. This can be difficult however
and, industry wide, there is a serious preoccupation with short-term numbers and the effect on the
relationship with clients (and resultant business risks for the institutions).
An enduring problem is whether to measure before-tax or after-tax performance. After-tax
measurement represents the benefit to the investor, but investors' tax positions may vary. Beforetax measurement can be misleading, especially in regimens that tax realized capital gains (and
not unrealized). It is thus possible that successful active managers (measured before tax) may
produce miserable after-tax results. One possible solution is to report the after-tax position of
some standard taxpayer.
Risk-adjusted Performance Measurement
Performance measurement should not be reduced to the evaluation of fund returns alone, but
must also integrate other fund elements that would be of interest to investors, such as the measure
of risk taken. Several other aspects are also part of performance measurement: evaluating if
managers have succeeded in reaching their objective, i.e. if their return was sufficiently high to
reward the risks taken; how they compare to their peers; and finally whether the portfolio
management results were due to luck or the managers skill. The need to answer all these
questions has led to the development of more sophisticated performance measures, many of
which originate in modern portfolio theory. Modern portfolio theory established the quantitative
link that exists between portfolio risk and return. The Capital Asset Pricing Model (CAPM)
developed by Sharpe (1964) highlighted the notion of rewarding risk and produced the first
performance indicators, be they risk-adjusted ratios (Sharpe ratio, information ratio) or
differential returns compared to benchmarks (alphas). The Sharpe ratio is the simplest and best
known performance measure. It measures the return of a portfolio in excess of the risk-free rate,
compared to the total risk of the portfolio. This measure is said to be absolute, as it does not refer
to any benchmark, avoiding drawbacks related to a poor choice of benchmark. Meanwhile, it
does not allow the separation of the performance of the market in which the portfolio is invested
from that of the manager. The information ratio is a more general form of the Sharpe ratio in

which the risk-free asset is replaced by a benchmark portfolio. This measure is relative, as it
evaluates portfolio performance in reference to a benchmark, making the result strongly
dependent on this benchmark choice.
Portfolio alpha is obtained by measuring the difference between the return of the portfolio and
that of a benchmark portfolio. This measure appears to be the only reliable performance measure
to evaluate active management. In fact, we have to distinguish between normal returns, provided
by the fair reward for portfolio exposure to different risks, and obtained through passive
management, from abnormal performance (or outperformance) due to the managers skill (or
luck), whether through market timing, stock picking, or good fortune. The first component is
related to allocation and style investment choices, which may not be under the sole control of the
manager, and depends on the economic context, while the second component is an evaluation of
the success of the managers decisions. Only the latter, measured by alpha, allows the evaluation
of the managers true performance (but then, only if you assume that any outperformance is due
to skill and not luck).
Portfolio return may be evaluated using factor models. The first model, proposed by Jensen
(1968), relies on the CAPM and explains portfolio returns with the market index as the only
factor. It quickly becomes clear, however, that one factor is not enough to explain the returns
very well and that other factors have to be considered. Multi-factor models were developed as an
alternative to the CAPM, allowing a better description of portfolio risks and a more accurate
evaluation of a portfolio's performance. For example, Fama and French (1993) have highlighted
two important factors that characterize a company's risk in addition to market risk. These factors
are the book-to-market ratio and the company's size as measured by its market capitalization.
Fama and French therefore proposed three-factor model to describe portfolio normal returns
(FamaFrench three-factor model). Carhart (1997) proposed to add momentum as a fourth factor
to allow the short-term persistence of returns to be taken into account. Also of interest for
performance measurement is Sharpes (1992) style analysis model, in which factors are style
indices. This model allows a custom benchmark for each portfolio to be developed, using the
linear combination of style indices that best replicate portfolio style allocation, and leads to an
accurate evaluation of portfolio alpha.
Education or Certification
Increasingly, international business schools are incorporating the subject into their course
outlines and some have formulated the title of 'Investment Management' or 'Asset Management'

conferred as specialist bachelor's degrees (e.g. Cass Business School, London). Due to global
cross-recognition agreements with the 2 major accrediting agencies AACSB and ACBSP which
accredit over 560 of the best business school programs, the Certification of MFP Master
Financial Planner Professional from the American Academy of Financial Management is
available to AACSB and ACBSP business school graduates with finance or financial servicesrelated concentrations. For people with aspirations to become an investment manager, further
education may be needed beyond a bachelors in business, finance, or economics. Designations,
such as the CIM in Canada, are required for practitioners in the investment management industry.
A graduate degree or an investment qualification such as the Chartered Financial
Analyst designation (CFA) may help in having a career in investment management.
There is no evidence that any particular qualification enhances the most desirable characteristic
of an investment manager, that is the ability to select investments that result in an above average
(risk weighted) long-term performance. The industry has a tradition of seeking out, employing
and generously rewarding such people without reference to any formal qualificationsModule V
Questions:
1. It is the value or interest in assets after all liabilities are paid.
(Equity)
2. It is known as the Risk Capital.
(Ownership Equity)
3. It has the ability to convert assets into cash quickly.
(Liquidity)
4. It pertains to the orientations of the executives towards foreign people, ideas, and resources,
both at home and abroad.
(Approach of international business)
5. Under this approach, the entire world is just a single country for the company.
(Geocentric approach)
6. Provides a theoretical explanation for both trade and FDI.
(International product life-cycle theory)
7-10. Enumerate the four stages under evolutionary process of multinational firms.
(ethnocentric, polycentric, regiocentric and geocentric)
11. Collection of investments all owned by the same individual or organization.
(Portfolio)

12. Reduce the risk in a portfolio.

(Diversification)
13-15. Components of variance of the rate of return
(-variance of the rate of return in foreign currency terms
-variance of the percentage change in the exchange rate
-covariance of the two component)
16. Risk is smaller than the risk of the corresponding stock market.
(Currency risk)
17-20 Currency overlay managers follow 4 styles
(-fundamental discretionary
-technical quantitative
-fundamental quantitative
-technical discretionary)
21. What is Investment?
(It is putting money into an asset with the expectation of capital appreciation, dividends, and/or
interest earnings.)
22. What is Investment management?
(In corporate finance, investment management is the process of ensuring that a company's
tangible and intangible assets are maintained, accounted for, and put to their highest and best
use.)
23. ______ is where you financial goals are established.
(Financial plan)
24. ______ is a collection of stocks, bonds, or other securities that are managed by a professional
investment company.
(Mutual fund)
25. Factors in Investment Management (3 items)
(Asset allocation, Long-term returns and Diversification)
26. ______ is often thought to be the acid test of fund management, and in the institutional
context, accurate measurement is a necessity.
(Fund performance)

27. What is CAPM?

(Capital Asset Pricing Model)
28. What is the simplest and best known performance measure?
(Sharpe ratio)
29. _______ is obtained by measuring the difference between the return of the portfolio and that
of a benchmark portfolio.
(Portfolio alpha)
30. ______ may be evaluated using factor models.
(Portfolio return)

Identification
____________1 . Deals with the various financial activities of international corporations
or multinational

companies.

____________2 . The purchase or acquisition of a controlling interest in a foreign

business by means other than the outright purchase of shares.
____________3 . Is a controlling ownership in a business enterprise in one country by
an entity based in another country.
____________4 . Is meant to compensate creditors for the risk of default by the
borrower.
____________5 . Is a direct tax in the sense that it is paid directly by the taxpayer on
whom it is levied.
____________6 . Aims at eliminating this kind of double taxation by conslderfng both the
company and its shareholders, and this can be done in two different ways.
____________7 . Is a field that helps smooth the process of moving money between
countries.
____________8 . Is the planning process used to determine whether an organization's
long term investments are worth the funding of cash through the firm's
capitalization structure.
____________9 . Is defined as the discount rate that gives a net present value (NPV) of
zero.

____________10 .

Expresses the NPV as an annualized cashflow by dividing it

by'the present value of the annuity factor.

II. Matching Type
1.

Managing the corporation's working capital position to sustain ongoing business

operations.
2.

Is implemented by the company for managing the inventory in order to

continue the production without any interruption.

3. Arises when a firm duplicates its home country-based activities at the same
value chain stage in a host country through FDI.
4. Takes place when a firm through FDI moves upstream or downstream in different
value chains i.e., when firms perform value-adding activities stage by stage in a
vertical fashion in a host country.
5. When a firm conducts business in another country, it faces several
disadvantages as it competes with local firms.
6. Is levied on the passive income earned by a firm within the tax jurisdiction of
another country.
7.

Is value added tax (VAT).

8. Offer a variety of benefits, such as low or zero taxes on certain classes of

income.
9. Come from unanticipated changes in relative economic conditions.
10. Analysis that has become important since the 19705 as option pricing models
have gotten more sophisticated.
a) Inventory Management

f) Industrial Organization Hypothesis

b) Working capital Management

g) Tax Haven

c) Vertical FOI

h) Indirect Tax

d) Horizontal FDI

i) Real Option

e) Withholding Tax

j) Long Run Exposure

k) III. Enumeration
l) 1-5 Activities of International Corporation
m) 6-9 Methods that the foreign direct investors may acquire voting power of an
enterprise
n) 10-11 Two Approaches to taxing corporate income
o) 12-17 Types of Taxation
p) 18-20 Foreign Currency Exposures
Q) ANSWER KEY
r) Identification
s) 1. International Corporate

y) 7. International Cash

Finance

Management

t) 2. Direct Investment

z) 8. Capital Budgeting or

u) 3. Foreign Direct Investment

Investment Appraisal

v) 4. Risk Premium

aa)9. Internal Rate of Return

w) 5. Corporate Income Tax

ab)

x) 6. Integrated Approach
ac)

10. Equivalent Annuity

Method

II. Matching Type

1. B

6. E

2. A

7. H

3. D

8. G

4. C

9. J

5. F

10.I

11.

III. Enumeration

12.

1-5 Activities of International Corporation

13.1. Working capital management

14.2. Inventory management
15.3. Cash management
16.4. Short term financing
17.5. Debtors management
18.

6-10 Methods that the foreign direct investors may acquire voting

power of an enterprise
19.6. by incorporating a wholly owned subsidiary or company anywhere
20.7. by acquiring shares in an associated enterprise
21.8. through a merger or an acquisition of an unrelated enterprise
22.9.
23.

Participating in an equity joint venture with another investor or enterprise

10-11 Two Approaches to taxing corporate income

24.10. Classical Approach

25.11. Integrated Approach
26.

12-17 Types of Taxation

27.12. Withholding tax

28.14. Import Duties
29.15. Taxation of Foreign Exchange Gains
30.16. Double taxation
31.17. Tax haven
32.

18-20 Foreign Currency Exposures

33.18. Short run exposure

34.19. Long run exposure
35.20. Translation exposure
36.

37.
38.
39.
40.
41.
42.

43.
44.
45.

46.
47.
48.
49.
50.