Chapter 19 Globalization and International Investing Copyright © 2010 by The McGraw-Hill...
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Transcript of Chapter 19 Globalization and International Investing Copyright © 2010 by The McGraw-Hill...
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Chapter 19 Globalization and International Investing Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin Slide 2 19-2 19.1 Global Markets for Equities Slide 3 19-3 Background Global market US stock exchanges make up approximately 40% of all markets Emerging market development Market capitalization and GDP Slide 4 19-4 Stock Market Cap Developed Countries Slide 5 19-5 Stock Market Cap Emerging Markets Slide 6 19-6 Per Capita GDP and Market Capitalization as a % of GDP Log Scale, 2003 Slide 7 19-7 Per Capita GDP and Market Capitalization as a % of GDP Log Scale, 2007 Slide 8 19-8 19.2 Risk Factors in International Investing Slide 9 19-9 Risks in International Investing What are the risks involved in investment in foreign securities? Exchange rate risk Country specific risk Slide 10 19-10 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 Slide 11 19-11 Returns with Foreign Exchange r(US) = return on the foreign investment in US Dollars r(FM) = return on the foreign market in local currency E 0 = original exchange rate E 1 = subsequent exchange rate Slide 12 19-12 Return Example: Dollar Depreciates Relative to the Pound 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%? Slide 13 19-13 Return Example: Dollar Appreciates Relative to the Pound 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 Slide 14 19-14 Figure 19.2 Stock Market Returns in US Dollars and Local Currencies for 2007 Slide 15 19-15 Table 19.3 Rates of Change in the US Dollar Against Major World Currencies, 2003- 2007(monthly data) Slide 16 19-16 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. Slide 17 19-17 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 Slide 18 19-18 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 = $0.033 Slide 19 19-19 Covered Interest Parity The spot-futures exchange rate relationship that prevents arbitrage opportunities. If the interest rates and exchange rates are in this relationship no arbitrage is possible. Slide 20 19-20 Other Risks in International Investing Imperfect exchange rate risk hedging Difficult to hedge out equities with variable rates of return Country Specific Risk Composition Political Unfavorable regulations or rules changes Taxes on withdrawals, expropriation, repatriation restrictions, etc. Slide 21 19-21 Other Risks in International Investing Country Specific Risk Composition Macro Financial Risk Ability to pay its debts, domestic and foreign Economic Growth rate, stability and vulnerabilities Data availability problems can be severe Composite Ratings Political Risk Services (PRS) publishes the International Country Risk Guide and rates countries from 0 (most risky) to 100 (least risky) Slide 22 19-22 Variables Used in the PRSs Political Risk Scores Slide 23 19-23 Composite Ratings for July 2008 vs August 2007 Slide 24 19-24 Current Risk Ratings and Composite Forecasts Slide 25 19-25 Political Risk by Component July 2008 Slide 26 19-26 19.3 International Investing: Risk, Return, and Benefits From Diversification Slide 27 19-27 International Investment Choices Direct Stock Purchases Difficult for individual investors due to currency and tax issues. Mutual Funds Open End World versus international funds Higher expenses Closed End Country or regional funds WEBS Slide 28 19-28 Questions on Assessing Performance in US Dollars in Foreign Markets Are emerging markets riskier? Slide 29 19-29 Annualized Standard Deviation of Investments Across the Globe ($ returns) Slide 30 19-30 Figure 19.4 Betas of country returns in $ Slide 31 19-31 Questions on Assessing Performance in US Dollars in Foreign Markets Are average returns higher in emerging markets? Slide 32 19-32 Figure 19.5 Average $ excess returns 1999-2008 Slide 33 19-33 X-Section Country Monthly Return Stats Slide 34 19-34 Questions on Assessing Performance in US Dollars in Foreign Markets Is exchange rate risk important in international portfolios? Slide 35 19-35 Standard Deviation of Investments Across the Globe in US Dollars versus Local Currency Slide 36 19-36 Beta in $US versus Local Currency Slide 37 19-37 Correlation of Returns in $US and Local Currencies 1999 - 2008 Slide 38 19-38 Avg. monthly returns in $ and local currency 1999-2008 Slide 39 19-39 Questions on Assessing Performance in US Dollars in Foreign Markets Are there diversification benefits to international investing? Slide 40 19-40 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 Slide 41 19-41 International Diversification. Portfolio Diversification as a Percentage of the Average Standard Deviation of a One-Stock Portfolio Slide 42 19-42 Hedged & Unhedged Correlations Slide 43 19-43 Ex Post Efficient Frontier of Country Portfolios 1999-2003 Slide 44 19-44 Figure 19.12a Efficient Frontier of Country Portfolios (world expected excess return =.3% per month) Slide 45 19-45 Figure 19.12b Efficient Frontier of Country Portfolios (world expected excess return =.6% per month) Slide 46 19-46 Are diversification benefits preserved in bear markets? Slide 47 19-47 Figure 19.13A Regional Indexes Around the Crash, October 14 26, 1987 Slide 48 19-48 Figure 19.13B Beta and of portfolios against deviation of month return from Sep-Dec 2008 from avg. 1999-2008 Slide 49 19-49 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. Slide 50 19-50 19.4 How to Go about International Diversification and the Benefit We Can Expect Choosing a Practical Internationally Diversified Portfolio Slide 51 19-51 of various portfolios Slide 52 19-52 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. Slide 53 19-53 Monthly Returns & Performance for Index Portfolios 1999-2008 Slide 54 19-54 19.5 International Investing And Performance Attribution Slide 55 19-55 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 Slide 56 19-56 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.