1

I nternational I nvestment and

Diversification
2
Outline
Introduction
Why international diversification makes
theoretical sense
Foreign exchange risk
Investments in emerging markets
Political risk
Other topics related to international
diversification
3
Introduction
The marketplace of the twenty-first century
is global
U.S. equities represent only about 51% of the
worlds equity capitalization
Over the period 1980-2000, the U.S. was the
best-performing market only once
In September 1999, each of the 66 U.S. pension
funds had more than $1 billion in actively
managed international investment portfolios
4
Introduction (contd)
International investments carry additional
sources of risk

Managers can reduce total portfolio risk via
global investment
5
Why International Diversification Makes Sense
(Evans and Archer)
Portfolio theory works to the investors
benefit even if he selects securities at
random
Ideally, the portfolio manager selects
securities because of their fit with the rest of
the portfolio
By choosing poorly correlated securities, a
manager can reduce total portfolio risk
6
Why International Diversification Makes Sense
(Evans and Archer Contd)
Total risk contains both systematic and
unsystematic risk
Evans and Archer show that holding 15 to 20
equity securities substantially reduces the
unsystematic risk
7
Utility, Risk, and Return
Unsystematic risk reduction is possible with
more than 20 securities
For a given level of return, any reduction in
risk, no matter how small, is a worthy goal

A rational invest will reduce risk if given the
opportunity
8
Variance of
A Linear Combination
As long as assets are less than perfectly
correlated, there will be diversification
benefits
More pronounced the lower the correlation

No two shares move in perfect lockstep
Diversification benefits accrue every time we add a
new position to a portfolio
9
Relationship of
World Exchanges
For U.S. securities, market risk account for
about 25% of a securitys total risk

For less developed countries, market risk
tends to be higher because:
Fewer securities make up the market
The securities are exposed to more extreme
economic and political events
10
Relationship of
World Exchanges (contd)
International capital markets continue to
show independent price behavior
International diversification offers potential
advantages

Repeating the Evans and Archer methodology
for international securities should result in a
lower level of systematic risk
11
Relationship of
World Exchanges (contd)
Number of Securities
Portfolio Variance
U.S. Securities: Systematic Risk 27%
International Securities: Systematic Risk 11.7%
12
Fundamental
Logic of Diversification
Investors are, on average, rational
Rational people do not like unnecessary
risk
By holding one more security, an investor
can reduce portfolio risk without giving up
any expected return
Rational investors, therefore, will hold as
many securities as they can
13
Fundamental Logic of
Diversification (contd)
The most securities investors can hold is
all of them

The collection of all securities makes up
the world market portfolio

Rational investors will hold some
proportion of the world market portfolio
14
Other Considerations
Optimum portfolio size involves a trade-off
between:
The benefits of additional diversification

Commissions and capital constraints
15
Foreign Exchange Risk
Definition
Business example
Investment example
From whence cometh the risk?
Dealing with the risk
The eurobond market
Combining the currency and market decisions
Key issues in foreign exchange risk management
16
Definition
Foreign exchange risk refers to the
changing relationships among currencies
Modest changes in exchange rates can result in
significant dollar differences
17
Business Example
A U.S. importer has agreed to purchase 40 New Zealand
leather vests at a price of NZ$110 each. The vests will take
two months to produce, and payment is due before the
vests are shipped.

The current spot rate of the NZ$ is $0.5855.

What is the price of the vests to the importer if the spot
rate remains unchanged in the next two months? If it is
$0.5500? If it is $0.6200?






18
Business Example (contd)
Solution: If the spot rate does not change, the cost to the importer is:

40 x NZ$110 x $0.5855 = $2,576.20

If the spot rate is $0.5500:

40 x NZ$110 x $0.5500 = $2,420.00

If the spot rate is $0.6200:

40 x NZ$110 x $0.6200 = $2,728.00






19
Investment Example
You just purchased 1,000 of Kangaroo Lager trading on
the Sydney Stock Exchange for AUD1.45 per share. The
exchange rate for the Australian dollar at the time of
purchase was $0.7735.

What is the U.S. dollar purchase price? If Kangaroo
Lager stock rises to AUD1.95 per share and if the
Australian dollar depreciates to $0.7000, what is your
holding period return if you sell the shares?






20
Investment Example (contd)
Solution: The purchase price in U.S. dollars is:

1,000 x AUD1.45 x $0.7735 = $1,121.58

If the Australian dollar depreciates and you sell the shares, you will
receive:

1,000 x AUD1.95 x $0.7000 = $1,365.00

The holding period return is:

($1,365.00 - $1,121.58)/$1,121.58 = 21.7%






21
From Whence
Cometh the Risk?
Role of interest rates
Forward rates
Interest rate parity
Covered interest arbitrage
Purchasing power parity
22
Real Rate of Interest
The real rate of interest reflects the rate of
return investors demand for giving up the
current use of funds

In a world of no risk and no inflation, the
real rate indicates peoples willingness to
postpone spending their money
23
Inflation Premium
The inflation premium reflects the way the
general price level is changing

Inflation is normally positive
The inflation premium measures how rapidly
the money standard is losing its purchasing
power
24
Risk Premium
The risk premium is the component of
interest rates that reflects compensation for
risk to risk-averse investors

The risk premium is a function of how
much risk a security carries
E.g., common stock vs. T-bills
25
Forward Rates
The forward rate is a contractual rate
between a commercial bank and a client for
the future delivery of a specified quantity of
foreign currency
Typically quoted on the basis of 1, 2, 3, 6, and
12 months
26
Forward Rates (contd)
The forward rate is the best estimate of the
future spot rate
If the forward rate indicates the dollar will
strengthen, importers should delay payment

If the forward rate indicates the dollar will
weaken, importers should lock in a rate now
27
Forward Rates (contd)
Forward rate premium or discount:

Forward rate - Spot rate 12
100
Spot rate
where the contract length in months
n
n

=
28
Forward Rates (contd)
Example

On April 29, 2005, the British pound had a spot rate of
$1.9146. The 3-month forward rate of the pound was
$1.9041 on that date.

What is the forward premium or discount?




29
Forward Rates (contd)
Example (contd)

Solution: The forward premium or discount is
calculated as follows:




There is a forward discount of 2.19%.






% 19 . 2
100
3
12
9146 . 1 $
9146 . 1 $ 9041 . 1 $
100
12
rate Spot
rate Spot - rate Forward
=

=
n
30
Interest Rate Parity
I nterest rate parity states that differences in
national interest rates will be reflected in the
currency forward market
Two securities of similar risk and maturity will
show a difference in their interest rates equal to
the forward premium or discount, but with the
opposite sign
31
Interest Rate Parity Formula
domestic
foreign
where
annualized domestic risk-free rate
annualized foreign risk-free rate
F=Forward (contract) rate [value of foreign currency expressed in units of domestic currency]
S=Spot exchange
R
R
=
=
rate [value of foreign currency expressed in units of domestic currency]
domestic foreign
365 F S
R R
S n

| |
= +
|
\ .
32
Example
Six-month German Treasury Bills yield 2.60%
(annualized rate)
Spot exchange rate is $ 0.6051 / DM
Six-month Forward rate is $ 0.6095 / DM

R
US
=2.60+100(0.6095-0.6051)(12/6)/0.6051
R
US
=4.05 %


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Covered Interest Arbitrage
Covered interest arbitrage is possible when
the conditions of interest rate parity are
violated
If the foreign interest rate is too high, convert
dollars to the foreign currency and invest in the
foreign country

If the U.S. interest rate is too high, borrow the
foreign currency and invest in the U.S.
34
Example of CIA
Six-month Swiss rate is 1.00 % (annualized rate)
Six-month US Treasury Bills yield 2.00 %
(annualized rate)
Spot exchange rate is $ 0.8542 / CHF
Six-month Forward rate is $ 0.8610 / CHF

What arbitrage strategy can you implement ?

35
Example of CIA
36
Purchasing Power Parity
Purchasing power parity (PPP) refers to
the situation in which the exchange rate
equals the ratio of domestic and foreign
price levels
A relative change in the prevailing inflation rate
in one country will be reflected as an equal but
opposite change in the value of its currency
37
Purchasing Power
Parity (contd)
Absolute purchasing power parity follows
from the law of one price:
A basket of goods in one country should cost
the same in another country after conversion to
a common currency
Not very accurate due to:
Transportation costs
Trade barriers
Cultural differences
38
Purchasing Power
Parity (contd)
Relative purchasing power parity states
that differences in countries inflation rates
determine exchange rates:

1
1
1
where change in the spot exchange rate
foreign country inflation rate
domestic country inflation rate
D
F
F
D
I S
S I
S
I
I
+ A
=
+
A =
=
=
39
Purchasing Power
Parity (contd)
A country with an increase in inflation will
experience a depreciation of its currency
because:
Exports decline
Imports increase
There is less demand for goods from that
country
40
The Concept of Exposure
Definition
Accounting exposure
Transaction exposure
Translation exposure
Economic exposure
41
Definition
Exposure is a measure of the extent to
which a person faces foreign exchange risk

In general, there are two types of exposure:
accounting and economic
Economic exposure is more important
42
Accounting Exposure
Accounting exposure is:
Of concern to MNCs that have subsidiaries in a
number of foreign countries
Important to people who hold foreign securities
and must prepare dollar-based financial reports

U.S. firms must prepare consolidated
financial statements in U.S. dollars
43
Transaction Exposure
FASB Statement No. 8 addresses
transaction exposure:
A transaction involving purchase or sale of
goods or services with the price states in
foreign currency is incomplete until the amount
in dollars necessary to liquidate a related
payable or receivable is determined
44
Translation Exposure
Translation exposure results from the
holding of foreign assets and liabilities that
are denominated in foreign currencies
E.g., foreign real estate and mortgage holdings
must be translated to U.S. dollars before they
are incorporated into a U.S. balance sheet
45
Economic Exposure
Economic exposure measures the risk that
the value of a security will decline due to an
unexpected change in relative foreign
exchange rates

Security analysts should include expected
changes in exchange rates in forecasted
cash flows
46
Dealing With the Exposure
Ignore the exposure
Reduce or eliminate the exposure
Hedge the exposure
47
Ignore the Exposure
Ignoring the exposure may be appropriate
for an investor if:
Foreign exchange movements are expected to
be modest
The dollar mount of the exposure is small
relative to the cost of inconvenience of hedging
The U.S. dollar is expected to depreciate
relative to the foreign currency
48
Reduce or Eliminate
the Exposure
If the dollar is expected to appreciate
dramatically, an investor may reduce or
eliminate foreign currency holdings
49
Hedge the Exposure
Definition
Hedging with forward contracts
Hedging with futures contracts
Hedging with foreign currency options
50
Definition
Hedging involves taking one position in the
market that offsets another position
Covering foreign exchange risk means hedging
foreign exchange risk
51
Hedging With
Forward Contracts
A forward contract is a private, non-
negotiable transaction between a client and
a commercial bank
No money changes hands until the foreign
currency is delivered, but the rate is determined
now

The forward rate reflects relative interest rates
and associated risks
52
Hedging With
Futures Contracts
A futures contract is a promise to buy or sell a
specified quantity of a particular good at a
predetermined price by a specified delivery date

On the delivery date, there will be a gain or loss in
the futures market that will offset the gain or loss
experienced when converting the foreign currency

53
Hedging With
Futures Contracts (contd)
To hedge an investment, sell foreign
currency futures

To hedge a liability, buy foreign currency
futures

54
Hedging With
Foreign Currency Options
There are two types of foreign currency
options:
Call options give their owner the right to buy a
set quantity of foreign currency
Put options give their owner the right to sell a
set quantity of foreign currency
The price at which you have the right to buy or
sell is the strike (exercise) price
55
Hedging With Foreign
Currency Options (contd)
Currency option characteristics:
A call option with an exercise price quoted in
dollars for the purchase of euros is the same as
a put option on dollars with an exercise price
quoted in euros

Put-call parity for foreign currency options is a
restatement of interest rate parity
56
Hedging With Foreign
Currency Options (contd)
The disadvantage of hedging with currency
options is that the hedger must pay a
premium to established the hedge
Options provide more precision than futures
contracts

Options are more expensive than futures
contracts
57
The Eurobond Market
Eurobonds are debt agreements that are
denominated in a currency other than that of the
country in which they are held
E.g., a bond denominated in yen sold in the United
Kingdom

A foreign bond is denominated in the local
currency but is issued by a foreigner
E.g., a bond denominated in yen sold in Japan, issued
by a firm in the United Kingdom
58
The Eurobond Market (contd)
About 75% of eurobonds are denominated
in U.S. dollars

Firms issuing dollar-denominated
Eurobonds pay a slightly lower interest rate
than they would pay in the U.S.
59
Combining the Currency and
Market Decisions
It is often desirable to cross-hedge a foreign
investment into a different currency
E.g., a U.S. investor might invest in Japan, use
the forward market to sell yen for British
pounds and convert the pounds back to dollars

The currency return comes from the forward
market premium or discount and the actual
change in the exchange rate
60
How to do it
Select the market with the highest risk-premium,
not the highest absolute return.
Why?
Because due to non-arbitrage, investing in riskless
securities of various countries will yield the same
returns once the proceeds are translated back into
the domestic currency (either always true if use
forward contracts or true on average if use
currency spot market to repatriate the funds).
Thus what matters (what differentiates markets) is
the return expected ABOVE the risk-free rate.
61
Which Currency to Cross-Hedge ?
What is relevant is the total rate of return, after
including the return in the selected local market
(foreign equity), the cost/benefit of holding the
currency, and the expected return on that currency.

So instead of mechanically hedging the local
currency with the US Dollar (domestic), we
should look for a third currency for cross-hedging
purposes so as to maximize the total expected
return.

62
The return to maximize is the sum of
Chosen Market Equity Return (where we
chose to invest)
Forward market premium/discount (riskless
rate in country selected for cross-hedging
minus riskless rate in country where we
chose to invest).
Expected return in currency of country
where we chose to invest.
63
Example
A US investor chooses to invest in German stocks
and then cross-hedges with the Japanese Yen:

Forecasted German equity returns: 10 %
Forecasted change in Japanese Yen: 2.5 %
Japanese riskless rate (Eurobond rate): 2 %
German riskless rate (Eurobond rate): 4.5 %

Forecasted total return: 10% + (2% - 4.5%) + 2.5%
Total (Expected) Return = 10%

64
The riskless (Eurobond) rate differential comes
from the fact that we have:


This means that the expected percentage change in
the DM value (expressed in Yen) is the riskless
rate differential. When using forward contracts,
we get the forward rate instead of the spot rate due
to the fact that we need to wait for that future date
before transforming the DM into Japanese Yen.
Therefore the amount in DM that gets converted to
Yen in the end is subject to a change in value since
the forward rate F is different than the spot rate S.
future date
/ / / /
Japan Germany
/ /
[ ]
Yen DM Yen DM Yen DM Yen DM
Yen DM Yen DM
F S E S S
r r
S S

= =
65
Investments in
Emerging Markets
Overview
Background
Adding value
Reducing risk
Following the crowd
Special risks
Asymmetric correlations
Market microstructure considerations
66
Overview
Emerging market investments:
Offer substantial potential rewards to the
careful investor in added return and risk
reduction
Are accompanied by special risks:
Foreign exchange risk
High political and economic risk
Unreliable investment information
High trading costs
67
Background
Over $20 billion is invested globally in
securities issued in underdeveloped
countries

Pension funds largest emerging market
exposure is in:
Asia (39.1%)
Latin America (32.7%)
68
Background (contd)
Dollars invested in emerging markets has
increased at a compound rate of almost 50%
over the last 10 years

Private sector growth in emerging markets
E.g., Hungary and Poland after 1989
69
Adding Value
Prices in developing markets often contain
significant inefficiencies
Tend to sell for lower price/earnings multiples
than do firms in developed markets
Emerging market firms have greater expected
growth and are cheaper
70
Reducing Risk
Low correlations are attractive as a means
of reducing portfolio variability
Emerging markets show low correlation with
developed markets

Emerging markets show low correlation with
each other
71
Following the Crowd
Some professional money managers
carefully analyze emerging markets for:
Profit potential
Portfolio risk reduction

Some professional money managers follow
the crowd because they must invest in
emerging markets
72
Special Risks
Incomplete accounting information
Foreign currency risk
Fraud and scandals
Weak legal system
73
Incomplete
Accounting Information
In some countries, financial statements are
more than 6 months old when they become
available
The acquisition of reliable investment
information generally requires on-site security
analysts
74
Incomplete Accounting
Information (contd)
Accounting standards differ substantially
across countries
Accounting information is frequently
unavailable for an emerging market security
Some emerging market brokerage firms
focus on the income statement but ignore
the balance sheet

75
Foreign Currency Risk
Foreign exchange securities are
denominated in a foreign currency
Introduces foreign exchange risk for foreign
investors
E.g., Mexican peso crisis and Asian crisis

In emerging markets, traditional hedging
vehicles may be unavailable
76
Fraud and Scandals
Emerging markets carry a substantial risk of
fraud
E.g., accounting misstatements, counterfeit
securities, bucket shops

Redress available to victims of a scandal in
a developing country may be inadequate
77
Weak Legal System
Low confidence in a countrys legal system:
Leads to increased uncertainty

Leads to an increased risk premium required by
investors
78
Asymmetric Correlations
Correlation between emerging and
developed markets:
Increases during bear markets

Is low during bull markets

The extent of portfolio managers
diversification depends on whether they are
experiencing an up or a down market
79
Asymmetric
Correlations (contd)
Investment returns show:
Homogeneity within emerging markets
Securities tend to move as a group within a single
emerging market

Heterogeneity across emerging markets
Emerging markets show low correlation across
markets
80
Market
Microstructure Considerations
Liquidity risk
Trading costs
Market pressure
Marketability risk
Country risk
81
Liquidity Risk
Some emerging markets investors are mostly
foreign
Increases political risk
Sets the stage for a market collapse if everyone pulls
out at once

Some emerging markets lack depth
The bid/ask spread tends to be wide with few standing
order to buy and to sell
82
Trading Costs
Foreign market trading costs are more than
1% higher than domestic trading costs
E.g., bid/ask spread is an average of 95 basis
points for Barings Securities emerging market
index

This indicates an investment must appreciate
more to show a given net return
83
Market Pressure
An order to buy or sell a large number of
shares might cause a substantial
supply/demand imbalance
Causes the price to move adversely from the
investors perspective

Indicates that emerging market investments
should be viewed as long-term investments
rather than a source of trading profits
84
Marketability Risk
An investor may be unable to close out a
position at a reasonable price

85
Country Risk
Country risk refers to a countrys ability
and willingness to meet its foreign
exchange obligations
Especially important in emerging markets

Country risk has two components:
Political risk
Economic risk
86
Political Risk
Introduction
Factors contributing to political risk
Macro risk versus micro risk
Dealing with political risk

87
Introduction
Political risk is a measure of a countrys
willingness to honor its foreign obligations
A function of:
The stability of the governments and its leadership
Attitudes of labor unions
The countrys ideological background
The countrys past history with foreign investors
88
Introduction (contd)
Real (direct) investment is an investment
over which the investor retains control
E.g., a plant in a foreign country

Portfolio investment refers to foreign
investment via the securities market
E.g., buying a number of shares of a foreign
company
89
Introduction (contd)
Extreme forms of country risk for portfolio
investment:
Government takeover of a company
Political unrest leading to work stoppages
Physical damage to facilities
Forced renegotiation of contracts
90
Introduction (contd)
Modest forms of country risk for portfolio
investment:
A requirement that a minimum percentage of
supervisory positions be held by locals
Changes in operating rules
Restrictions on repatriation of capital
91
Factors Contributing
to Political Risk
Buy local attitude
Public attitude
Government attitude

92
Buy Local Attitude
Buy local campaigns seek to make foreign
consumers buy local goods instead of goods
produced by a foreign firm or its
subsidiaries

Contributes to political risk
93
Public Attitude
In emerging markets, people may see no
opportunity to improve their standard of living
Foreign subsidiaries may contribute to this attitude with
luxury items

The gap between the publics aspirations and its
expectations contributes to political risk
94
Government Attitude
Unstable governments can lead to foreign
investors being a volatile political issue
Foreign investors can be blamed for local
problems

Foreign governments can suspend a firms
ability to send funds back to its home country
95
Macro Risk Versus Micro Risk
Macro risk refers to government actions that
affect all foreign firms in a particular industry

Micro risk refers to politically motivated changes
in the business environment directed to selected
fields of business activity or to foreign enterprises
with specific characteristics
96
Dealing With Political Risk
Seek a foreign investment guarantee from
the Overseas Private Investment
Corporation
Provides coverage against:
Loss due to expropriation

Nonconvertibility of profits

War or civil disorder
97
Dealing With
Political Risk (contd)
Avoid engaging in behavior that stirs up
trouble with the host people or government:
Constructing flamboyant office buildings

Giving the impression of natural resource
exploitation
98
Economic Risk
Economic risk is a measure of a countrys
ability to pay
Assess economic risk by:
Using coverage ratios

Assessing the countrys capital base
99
Other Topics
Multinational corporations
American depository receipts
International mutual funds
100
Multinational Corporations
Investing in a multinational corporation
may provide a ready-made means of getting
the risk-reduction benefits of international
diversification
Research is unclear whether MNCs are better
investments than purely domestic firms
101
American Depository Receipts
American depository receipts (ADRs) are receipts
representing shares of stock that are held on the
ADR holders behalf in a bank in the country of
origin
An alternative to purchasing shares in a foreign
company directly on the foreign exchange

By 2000, 1,534 ADRS from dozens of countries
traded in the U.S.
102
International Mutual Funds
Mutual funds permit diversification to an
extent that would not otherwise be possible
Some mutual funds invest only in securities
issued outside the U.S.

Buying an international mutual fund is a good
way to achieve international diversification