Chapter 19

Globalization and

International Investing

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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19.1 Global Markets for Equities

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Background• Global market

– US stock exchanges make up approximately 40% of all markets

– Emerging market development

– Market capitalization and GDP

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Stock Market Cap Developed Countries

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Stock Market Cap Emerging Markets

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Per Capita GDP and Market Capitalization as a % of GDP Log Scale, 2003

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Per Capita GDP and Market Capitalization as a % of GDP Log Scale, 2007

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19.2 Risk Factors in International Investing

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Risks in International Investing

• What are the risks involved in investment in foreign securities?– Exchange rate risk– Country specific risk

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Exchange Rate Risk• Variation in return related to changes in

the relative value of the domestic and foreign currency

• Total Return is a function of 1. Investment return &

2. Change in the value of the foreign currency

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Returns with Foreign Exchange

0

1

E

Er(For)][1r(US)1

r(US) = return on the foreign investment in US Dollars

r(FM) = return on the foreign market in local currency

E0 = original exchange rate

E1 = subsequent exchange rate

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Return Example: Dollar Depreciates Relative to the Pound

0

1

E

Er(For)][1r(US)1

If you invest in a British Security and earn 10%, find the return in US Dollars given:

Initial Exchange rate : £ = $2.00

Final Exchange rate: £ = $2.10

Why is your return > 10%?%5.15)US(r$2.00

$2.101.10r(US)1

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Return Example: Dollar Appreciates Relative to the Pound

0

1

E

Er(For)][1r(US)1

If you invest in a British Security and earn 10%, find the return in US Dollars given:

Initial Exchange rate : £ = $2.00

Final Exchange rate: £ = $1.85

%75.1)US(r$2.00

$1.851.10r(US)1

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Figure 19.2 Stock Market Returns in US Dollars and Local Currencies for 2007

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Table 19.3 Rates of Change in the US Dollar Against Major World Currencies, 2003-

2007(monthly data)

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The Carry Trade

• Suppose the yen LIBOR = 0.24% and U.S. $ LIBOR = 3.75%.

• An astute investor may borrow yen at the yen rate, convert the borrowed funds to dollars and invest at $ LIBOR.

• What can go wrong with this strategy?– Default– Yen increases in value by 3.75% - 0.24% =

3.51% or more.

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Covered Interest Arbitrage (1)U.S. interest rates are 6.15% and British interest rates are at 10% when the exchange rate is $2.00 / £. The one year forward exchange rate for the pound is $1.95/£.

• How can you earn a riskless arbitrage profit based on these quotes?1.Borrow $1 at 6.15%: Will owe $1.0615 in one year

2.Convert $1 to pounds: $1 / $2.00/£ = £0.50

3.Invest £0.50 at 10%: Will yield £.50 x 1.10 = £0.55.

4.Sell pound forward at $1.95: £55 x $1.95 = $1.0725

5.Net: $1.0725 - $1.0615 = $0.011 / dollar

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Covered Interest Arbitrage (2)U.S. interest rates are 6.15% and British interest rates are at 10% when the exchange rate is $2.00 / £. The one year forward exchange rate for the pound is $1.90/£.

• How can you earn a riskless arbitrage profit based on these quotes?1.Borrow £1 at 10%: Will owe £1.10 in one year

2.Convert £1 to $ at $2.00/£ = $2

3. Invest $2 at 6.15%: Will yield $2 x 1.0615 =$2.123

4.Buy pound forward at $1.90: Will cost £1.10 x $1.90 = $2.09

5.Net profit = $2.123 - $2.09 = $0.033

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Covered Interest Parity

The spot-futures exchange rate relationship that prevents arbitrage opportunities.

If the interest rates and exchange rates are in this relationship no arbitrage is possible.

0

1

E

F

r(For)1

r(US)1

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Other Risks in International Investing

• Imperfect exchange rate risk hedging – Difficult to hedge out equities with variable

rates of return

• Country Specific Risk– Composition

• Political– Unfavorable regulations or rules changes

» Taxes on withdrawals, expropriation, repatriation restrictions, etc.

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Other Risks in International Investing

• Country – Specific Risk– Composition

• Macro Financial Risk– Ability to pay its debts, domestic and foreign

• Economic– Growth rate, stability and vulnerabilities

• Data availability problems can be severe

– Composite Ratings• Political Risk Services (PRS) publishes the

International Country Risk Guide and rates countries from 0 (most risky) to 100 (least risky)

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Variables Used in the PRSs Political Risk Scores

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Composite Ratings for July 2008 vs August 2007

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Current Risk Ratings and Composite Forecasts

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Political Risk by Component July 2008

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19.3 International Investing: Risk, Return, and Benefits

From Diversification

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International Investment Choices

• Direct Stock Purchases– Difficult for individual investors due to currency

and tax issues.

• Mutual Funds– Open End

• World versus international funds• Higher expenses

– Closed End• Country or regional funds

– WEBS

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Questions on Assessing Performance in US Dollars in

Foreign Markets

• Are emerging markets riskier?

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Annualized Standard Deviation of Investments Across the Globe ($ returns)

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Figure 19.4 Betas of country returns in $

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Questions on Assessing Performance in US Dollars in

Foreign Markets

• Are average returns higher in emerging markets?

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Figure 19.5 Average $ excess returns 1999-2008

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X-Section Country Monthly Return Stats

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Questions on Assessing Performance in US Dollars in

Foreign Markets

• Is exchange rate risk important in international portfolios?

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Standard Deviation of Investments Across the Globe in US Dollars versus Local

Currency

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Beta in $US versus Local Currency

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Correlation of Returns in $US and Local Currencies 1999 - 2008

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Avg. monthly returns in $ and local currency 1999-2008

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Questions on Assessing Performance in US Dollars in

Foreign Markets

• Are there diversification benefits to international investing?

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Diversification Benefits• Evidence shows international

diversification is beneficial

• Possible to expand the efficient frontier above domestic only frontier

• Possible to reduce the systematic risk level below the domestic only level

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International Diversification. Portfolio Diversification as a Percentage of the Average

Standard Deviation of a One-Stock Portfolio

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Hedged & Unhedged Correlations

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Ex Post Efficient Frontier of Country Portfolios 1999-2003

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Figure 19.12a Efficient Frontier of Country Portfolios (world expected excess return =

.3% per month)

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Figure 19.12b Efficient Frontier of Country Portfolios (world expected excess return =

.6% per month)

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Are diversification benefits preserved in bear markets?

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Figure 19.13A Regional Indexes Around the Crash, October 14 – 26, 1987

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Figure 19.13B Beta and of portfolios against deviation of month return from Sep-Dec 2008

from avg. 1999-2008

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Conclusions• A passive investment in all countries would not

have lowered risk at all during the recent crisis.• Hedging currencies has little effect either. A U.S.

stock market crash appears to be a systemic factor that cannot be diversified away from in a crisis.

• Correlations are on the increase due to globalization, nevertheless we still expect modest international diversification benefits in normal markets.

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19.4 How to Go about International

Diversification and the Benefit We Can Expect

Choosing a Practical Internationally Diversified Portfolio

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of various portfolios

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Active Management

• First level:– Security selection and asset allocation within

each market to identify a country portfolio superior to country index.

• Second level– Optimize allocations across country portfolios

to maximize diversification.

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Monthly Returns & Performance for Index Portfolios 1999-2008

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19.5 International Investing And Performance

Attribution

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Performance Attribution• The “Bogey” or benchmark

– EAFE index (non-U.S. stocks)

• Currency Selection– Contribution to performance due to currency

movements

• Country Selection– Contribution to performance due to choosing better

performing countries

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Performance Attribution

• Stock Selection– This ability is measured as the weighted

average of equity returns in excess of the equity index in each country.

• Cash / Bond Selection– Excess return due to weighting bonds and

bills differently from benchmark weights.