International Financial Management

P G Apte
1
 Introduction
• The twentieth century has seen massive cross-
border flows of capital
• The initial thrust to cross border flows of equity
investment came from the desire on the part of
institutional investors to diversify their portfolios
globally in search of both higher return and risk
reduction. . Financial deregulation and elimination
of exchange controls in a number of developed
countries at the beginning of eighties permitted
large institutional investors to increase their
exposure to foreign equities.

2
 Introduction
• The decade of 1990's witnessed opening up of
equity markets of developing countries like South
Korea, Taiwan, Indonesia and India to foreign
investors albeit with some restrictions
• The trend towards global integration of equity
markets is unmistakable though it is punctuated by
intermittent crises and consequent investor retreat
• We investigate the determinants of foreign equity
investment decision and address the issues related
to capital market integration and valuation of
foreign equities

3
Announced International Equity Issues
(USD Billion)
1998 1999 2000
2001Q1
ALL COUNTRIES 125.9 215.8 315.9 38.0
DEVELOPED COUNTRIES 111.4 180.0 254.7 34.0
DEVELOPING COUNTRIES 10.1 22.7 44.0 2.5
China 1.1 3.4
21.2 1.8
India 0.1 0.9
0.9 -
Korea South 0.5 6.9
0.8 -
4
Malaysia 0.2 -
 Foreign Equity Investment in India (US Dollars Million)

1993- 1994- 1995- 1996- 1997- 1998- 1999

94 95 96 97 98 99 00

TOTAL 3,567 3,824 2,748 3,312 1,828 -61 3,026

GDRs/ADRs 1,520 2,082 683 1,366 645 270 768

FIIs 1,665 1,503 2,009 1,926 979 -390 2,135

Offshore 382 239 56 20 204 59 123

Funds

5
Foreign Equity Investment - Risk-Return
• Comparing Investments in a Risk-Neutral World
– The expected annual dividend yields in the two
investments are δ US and δ IN, the expected annual
average rates of capital appreciation are α US and α IN.
The (INR/USD) exchange rate is S0, dollars per rupee.
After k years, a dollar invested in the US company is
expected to accumulate to
$(1 + δ US + α US)k
– a dollar invested in the Indian shares is expected to
accumulate to
$(1/S0)(1 + δ IN + α IN)k(Se)k

6
Foreign Equity Investment - Risk-Return
– The investor would invest in the Indian stock if

1 (1 + δ + α )k e (1 + + )k
( ) δ α
S IN IN (S )k  US US
0

– and in the US stock if the reverse inequality holds

– Let ŝe denotes the expected annual proportionate
rate of change of the exchange rate S expressed as
USD per INR. Then
– [(Se)k/S0] = (1 + ŝe)k

7
Foreign Equity Investment - Risk-Return
Substitute, simplify, ignore cross products to get that
US investor would invest in India if
– ŝe > (δ US - δ IN) + (α US - α IN)
–Thus even with lower dividend yield and capital
gains, foreign equities can be attractive if the foreign
currency is expected to appreciate strongly
–Presence of differential tax treatment of ordinary
income and capital gains can reinforce the bias in
favor of foreign equities if exchange gains are treated
as capital gains and capital gains are taxed at a lower
rate
8
Foreign Equity Investment - Risk-Return
– Let θ y and θ k be tax rates for ordinary income
and capital gains respectively with θ y > θ k
– After-tax returns on the US and Indian
investments are, respectively
(1-θ y)δ US + (1-θ k)α US and
(1-θ y)δ IN + (1-θ k)(α IN+ Ŝe)
– Latter will
(1 - exceed
θ ) the former if
e> y
Ŝ (1- ) (δ US − δ IN ) + (α US - α IN )
θk

9
Risk and Return from Foreign Equity
Investment
• Risk and gains from international
diversification
– Three components of risk viz. variability of the
return in local currency, fluctuations in the
exchange rate and the association between the
two - the covariance risk.
– Let RIN denote the return in rupee terms from
an Indian equity share

10
Risk and Return from Foreign Equity
Investment
– From a US investor's point of view, the dollar return
from this investment, denoted ρUS, is (RIN+ŝe) where ŝe
is the expected appreciation of the rupee
E(ρUS) = E(RIN) + E(ŝe) = δ IN + α IN + ŝe

Var(ρUS) = Var(RIN) + Var(ŝe) + 2Cov(RIN, ŝe)

– As long as returns on different risky assets are not
perfectly (positively) correlated, risk can be reduced by
spreading total wealth across a portfolio of assets

11
Risk and Return from Foreign Equity
Investment
– Since countries differ in their economic and
industrial structures and since business cycles
in different parts of the world are not
synchronous, one would expect further risk
reduction to be possible through diversification
beyond national boundaries
– For a given expected return, an internationally
(optimally) diversified portfolio should afford
smaller risk than a purely national optimal
portfolio

12
Risk and Return from Foreign Equity
Investment
– Prima facie equity investment in emerging
markets appears to present substantial
opportunities for risk reduction from the point
of view of investors in the developed countries
– Total risk of an internationally diversified
portfolio can once again be broken down into
three components
• Exchange Rate Risk
• Local Returns Risk
• Local Returns-Exchange Rates Covariance Risk

13
Risk and Return from Foreign Equity
Investment
– General agreement that international
diversification does pay in terms of risk
reduction. Some ambiguity remains. One
additional source of risk viz. exchange rate.
– Availability of products to hedge exchange rate
risk further reinforces this conclusion
– However, it is not clear whether exchange risk
hedging would reduce expected returns at the
same time as it reduces risk

14
 The International Capital Asset
Pricing Model
• CAPM links the expected (excess) returns on a
risky asset to its risk in an efficient portfolio
• The expected excess return on a risky asset or a
portfolio of assets is its expected return over and
above the risk-free return
• A portfolio is said to be efficient if among all
possible portfolios with the same excess return it
has the lowest variance

15
 The International CAPM
• Consider a portfolio consisting of assets i =
1,2....N
• A necessary condition for a portfolio to be
efficient is
E(r* - r)
i = θ for all i = 1,2... N
* *
cov(r , rp )
i

• where ri* and rp* denote, respectively return on

asset i and the portfolio

16
 The International CAPM
• The numerator is the contribution of asset i
to the portfolio's excess return while the
denominator is the contribution of asset i to
the portfolio's variance or risk
• The parameter θ is known as the investor's
relative risk aversion and is a measure of
his or her attitude towards risk

17
 The International CAPM
• “Two fund theorem" says that in
equilibrium all investors will hold some
combination of the risk-free asset and the
so-called "tangency portfolio"
• One of the crucial ingredients in the CAPM
is the notion of Market Portfolio
• The above equation when applied to the
market portfolio becomes

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 The International CAPM
E(r* - r)
i = θ for all i = 1,2... N
* *
cov(r , rm )
i
• Where rm* is the return on the market
portfolio
E(r* - r) = θ cov(r*, rm
*)
i i

* * σ
E(ri - r) = [θ σ (rm ) im
2
σ2m

19
 The International CAPM
∀ σ im denotes the covariance between the
returns on asset i and the market portfolio
and σ m2 denotes the variance of the return
on the market portfolio
• The expression [σ im/σ m2] is the familiar
"Beta" of the asset i, denoted β i which
measures the covariance of asset i with the
market portfolio

20
 The International CAPM
• The parameter β i is estimated by means of a
regression of realized historical returns on
asset i on the realized historical returns on
the market portfolio
ri* = α i + β i rm* + ui (18.8)
• Let the weight of asset i in the market
portfolio be xi. Multiply the following
equation by xi and sum over i
E(r* - r) = θ cov(r*, rm
*)
i i

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 The International CAPM
i= N * i= N
∑ ix E(r - r) = θ ∑ x cov(r*, rm
* )
i=1 i i=1 i i
• This gives
E(rm – r) = θ σ2m
• Rewriting
θ = [E(rm* - r)/σ m2]
• Replace [θ σ m2] by E(rm* - r) and recall the
definition of the beta of asset i to get
• E(ri* - r) = β i E(rm* - r)
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 The International CAPM

This is the famous equilibrium Capital

Asset Pricing Model for a single country
• The excess return on any risky asset i
equals the excess return on the benchmark
portfolio multiplied by the asset's beta
which in turn measures the co-variation of
the (return on) asset i with the (return on)
the benchmark portfolio

23
 The International CAPM
• Extending One Country CAPM
– If resident investors hold exclusively assets
issued by resident firms and foreign investors
are not allowed to hold domestic assets then
that country’s capital market is fully
segmented from the global capital market
– Capital markets of most countries are certainly
not fully segmented
– Are global capital markets fully integrated?
– What is the relevant “market portfolio”?
24
 The International CAPM
– Where there are no restrictions whatsoever on investors
in a country holding foreign assets and foreign
investors investing in domestic assets, that global
capital markets are fully integrated at least in a legal
sense. There could be informational asymmetries
– Consider the portfolio consisting of all the stocks
issued by all the firms in such an integrated world
• CAPM requires the further assumption that all
investors must have identical expectations
regarding the performance of any risky asset.
Otherwise they would not agree on the composition
of the “tangency portfolio”.

25
 The International CAPM
• For any risky asset investors would compute the
real return measured in their own currencies
• If PPP does not hold, would investors from different
countries agree on the real return from a given risky
asset?
• If not, the ICAPM must take account of exchange
rate risk in addition to the covariance risk with the
world market benchmark portfolio
• Investors in a given country would choose their
portfolios in the light of their estimates of expected
returns, variances of returns and covariances
measured in their reference currency, their home
currency

26
 The International CAPM
– In a multi-currency portfolio the following parameters
are relevant
• Expected excess return on a portfolio, measured in
some numeraire currency ΣxiE(ri* - r) where xi is the
share of asset i, ri* is its return measured in the
numeraire currency and r is the risk-free rate in the
numeraire currency
• Variance of portfolio returns σ p2 = cov(Σxiri*,rp*) = Σ
xicov(ri*,rp*) which in turn depends upon
(1) Pairwise covarinces of individual market returns
(2) Pairwise covariances between exchange rates
27
 The International CAPM
(3) Covariance between stock market returns and
changes in the exchange rate between the numeraire
currency and other currencies cov(Σxiri*, ŝi) where ŝi is
the proportionate change in the spot rate of currency i
with respect to the numeraire currency
• The remaining parameters viz. expected values and
variances of ŝi do not enter portfolio choice because the
portfolio weights xi are not affected by them
• The total variance of portfolio returns can be attributed
to return variances, exchange rate varinces and
covarinces between returns and exchange rate changers.
Contributions of each vary according to currency
composition and whose point of view is adopted

28
 International CAPM
A Two Country CAPM: Ignore inflation
Consider a German investor computing returns on
various assets in terms of his home currency EUR.
Denote by S the EUR/USD exchange rate.:
• A US T-bill : rGE = rUS – Ŝ where rUS is the return in
USD terms. Thus correlation between rGE and Ŝ is
-1.
• What about a US stock?
• What about a German stock?
29
An appreciation of the dollar against the Euro will increase euro
return for a given dollar return.
However, will it help or hurt the valuation of the US firm?
A US exporter firm – export sales might decline due to
appreciation. But interest and labour costs might also decline. Net
impact? On balance correlation between S and return on US
stocks measured in EUR positive?
What about a German firm? EUR depreciation might help if
strong US market presence. Costs might increase. Net impact
again ambiguous.

30
 The International CAPM
• Incorporating exchange rate risk: A two-country
model
(r*)iGE = α i + γ i Ŝ + ui
where (r*)iGE denotes the EUR return on an asset
i, the coefficient γ i will equal
cov[(r*)iGE , Ŝ]/var(Ŝ)
which is a measure of asset i's covariation with
the changes in exchange rate
US T-bill: γ negative US stocks : γ positive?
German stocks : γ negative?

31
 The International CAPM
• A Two Country CAPM
– Extending the one-country CAPM, the equilibrium
expected excess return on asset i measured in EUR is
given by

– E[(r*)iGE - r] = θ cov[(r*)iGE,(r*)W] + δ cov[(r*)iGE,Ŝ]

– The parameters θ and δ are prices of world market and

exchange rate covariance risks, and (r*)W is the return
on the world market portfolio measured in EUR and r is
the risk-free rate in EUR (e.g. German T-bills).

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 The International CAPM
– Two benchmark portfolios : (1) The world market
portfolio and (2) The foreign riskless asset
– To operationalise the two country CAPM we must
estimate θ and δ
– Consider the world market portfolio
E[(r*)W - rGE] = θ cov[(r*)W,(r*)W] + δ cov[(r*)W, Ŝ]
= θ var[(r*)W] + δ cov[(r*)W, Ŝ]
– Consider a foreign i.e. US T-bill
E[rUS - Ŝ - rGE] = - θ cov[Ŝ, (r*)W] + δ cov(Ŝ,Ŝ)
= - θ cov[Ŝ,(r*)W] + δ var(Ŝ)
These two equations can be used to estimate θ and δ.

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 The International CAPM
– Resulting two-country CAPM is

E[(r*)iGE - rGE] = β i [(r*)W - rGE] + γ i E[rUS - Ŝ - rGE]

Assets' beta and gamma have to be jointly estimated

from a multiple regression with historical data

(r*)iGE = α i + β i(r*)W + γ i Ŝ+ ui

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 The International CAPM
– Extension to a multi-country CAPM
– E[(r*)iH - rH] = β iE[(r*)W - rH] + γ i1E[Ŝ1+rF1-rH]
+ γ i2E[Ŝ2+rF2-rH]....+ γ iKE[ŜK+rFK-rH]

– Here rH denotes riskfree rate in investor's currency,

rF1..rFK are riskfree rates in foreign currencies 1... ŜK are
the changes in exchange rates of these currencies
measured as units of home currency per unit of foreign
currency .K and Ŝ1 ..

35
 The International CAPM
– The parameters β i, γ i1 ... γ iK have to be obtained
from a multiple regression with historical data
(r*)iH = α i + β i(r*)W + γ i1 Ŝ1 + ...+ γ iK ŜK + ui
• Global Capital Markets: Segmented or Integrated
– Is the underlying assumption of no constraints
on cross-border capital flows valid?
– Even if legal barriers are eliminated
informational barriers may remain; withholding
taxes may also lead to segmentation

36
 The International CAPM
– The evidence from empirical testing of the ICAPM
– tests lead to the conclusion that international capital
markets are not fully integrated
– Volatility clustering has been observed in almost all
national stock markets
– There are volatility spillovers between stock markets
and between the forex and the stock market.
• Estimation of Risk Premia
– To use the ICAPM for asset pricing we need to estimate
the beta and gammas for the asset and the risk premia
E[(r*)W - rH], E[Ŝ1+rF1-rH]...E[ŜK+rFK-rH]

37
 Equity Financing in Global Markets
• Since many companies have accessed the global
equity market primarily for establishing their
image as global companies, to the major
consideration has been visibility and post-issue
considerations related to investor relations,
liquidity of the stock (or instruments based on the
stock such as depository receipts which are listed
and traded on foreign stock exchanges) in the
secondary market and regulatory matters
pertaining to reporting and disclosure

38
 Equity Financing in Global Markets
• Other relevant considerations are the price at
which the issue can be placed, costs of issue and
factors related to taxation
• With segmented markets, the price that can be
obtained would vary from one market to another
• When the issue size is large, the issuer may
consider a simultaneous offering in two or more
markets

39
 Equity Financing in Global Markets
• Issue costs are an important consideration
• Shares of many firms are traded indirectly in the form
of depository receipts e.g. GDR and ADR .
• After a hesitant start in 1992 following the experience
of the first ever GDR issue by an Indian corporate , a
fairly large number of Indian companies have raised
equity capital in international markets
• In recent years, a major driving force has been the
desire of Indian IT companies to make acquisitions in
the US. The ADS are used as “acquisition currency” in
share swaps. For this purpose the ADRs must be listed
and actively traded

40
 Equity Financing in Global Markets
• From the point of view of the issuer, GDRs and
ADRs represent non-voting stock with a distinct
identity which do not figure in its books
• There is no exchange risk for the issuing firm
since dividends are paid by the issuer in its home
currency. Exchange risk is borne by the investors.
• Apart from imparting global visibility, the device
allows the issuer to broaden its capital base by
tapping large foreign equity markets

41
 Some Indian ADR/GDR Issues
Company Industry Date of Issue Size ($m)
Arvind Mills Textiles Feb-1994
125 Ashok Leyland Auto Mar-1995
138 Century Textiles Diversified Sep-1994
100 Crompton Electrical Jul- 1996
50 Dr. Reddy’s Pharma Jul-1994 48
GE Shipping Shipping Feb-1994 100
Indian Hotels Hotels Apr-1995 86
Indo Gulf Fertilizers Jan-1994 100
ICICI Finance Sep-1999 315
Infosys IT Mar-1999 70
L&T Diversified Mar-1996 135
Mah&Mah Auto Nov-1993 75
Reliance Diversified May-1992 150
Satyam Infoway IT Oct-1999 75
VSNL Telecom Mar-1997 527
Wipro IT Sep-2000

42
 Equity Financing in Global Markets
• From the investors' point of view, they achieve
portfolio diversification while acquiring an
instrument which is denominated in a convertible
currency and is traded on developed stock markets
• The investors bear exchange risk and all the other
risks borne by an equity holder
• They have all the rights and privileges of ordinary
stockholders except the voting rights.

43
 GDRs could be offered to US investors only if very
stringent requirements of registration with the SEC are
complied with. However, under an exemption granted by
Rule 144A of the securities act, securities can be offered
to Qualified Institutional Buyers without going through
the registration process.
As to ADRs, offereings at various levels are possible
with more and more stringent accounting and disclosure
requirements as one goes from lower to higher levels.
There are four types of ADRs : Unsponsored and Levels
I to III

44
• American Depository Receipts
• • Unsponsored Depositary Receipts
These are issued by one or more depositaries in response to
market demand, but without a formal agreement with the
company. Today, unsponsored Depositary Receipts are
considered obsolete.
• Sponsored Level I Depositary Receipts
Level I Depositary Receipts are traded in the U.S. OTC market
and on some exchanges outside the United States. The company
does not have to comply with U.S. GAAP or full SEC disclosure.
Essentially, a Sponsored Level I Depositary Receipt program
allows companies to enjoy the benefits of a publicly traded
security without changing its current reporting process.

45
 American Depository Receipts
• Sponsored Level II And III Depositary Receipts
Companies that wish to either list their securities on an exchange
in the U.S. or raise capital use sponsored Level II or III
Depositary Receipts respectively.
These types of Depositary Receipts can also be listed on some
exchanges outside the United States. Each level requires different
SEC registration and reporting, plus adherence to U.S. GAAP.
The companies must also meet the listing requirements of the
national exchange (New York Stock Exchange, American Stock
Exchange) or NASDAQ, whichever it chooses.

46
American Depository Receipts
Each higher level of Depositary Receipt program generally
increases the visibility and attractiveness of the Depositary
Receipt.
Level II is used when the company does not wish to raise
funds i.e. just acquire listing while level III is used when funds
are to be raised. For Level II issue the issuing firm converts
some of its existing stock into ADRs.

47
 Equity Financing in Global Markets
• A major problem and concern with international
equity issues used to be that of flowback i.e. the
investors will sell the shares back in the home
stock market of the issuing firm. Initially GOI had
imposed a minimum time limit before which
conversion and sale in home market was not
permitted. After FIIs were allowed into Indian
markets, this was abolished.
• The chart below shows the GDR mechanism

48
Equity Financing in the International Markets

Subscribers,
Company
Lead Managers etc

Depository Custodian

GDR Holders
Nominee Hold the American
for GDR and Register
Euroclear
and Cedel it in the Name of

DTC

49
 18.5 Summary
• Economics of cross-border equity investment
using the standard capital asset pricing model as
the frame of reference
• How to extend the standard capital asset pricing
model to a multi-country context
• Segmentation versus integration of global capital
markets
• Depository receipts mechanism used by non-
resident firms to tap equity markets in US and
Europe
50