Chapter 21International Investing.ppt

7/29/2019 Chapter 21International Investing.ppt

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Chapter 21

INTERNATIONAL INVESTING

The Global Search


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Prospects for Global Investing

The world is being swept by a second wave of globalisation at the

beginning of the twenty first century. How would investors fare now?We believe that investors would fare better this time because of the

following fundamental geopolitical changes that have taken place in thisworld.

With the apparent demise of communism as a valid economicphilosophy, the threat of nationalisation and governmentexpropriation has decreased considerably.

With the passing of colonialism, tensions among developed

countries and between developed and developing countries havediminished.

Capitalistic philosophy is maturing, leading to a kinder systema system that mitigates some of the destabilising political

tensions that characterised free markets earlier.


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Of course, the world is not perfect and is plagued by a new set

of problems at the beginning of the third millennium. The relative

order imposed by colonial powers has given way to political

instability in many countries. More important, problems like

overpopulation, resurgence of nationalism, and environmental

pollution loom large. Notwithstanding these portents, we are fairly

optimistic about the prospects of global investing.


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Opportunities for Indian Citizens

From early, 2003, Indian citizens have been allowed to invest

abroad. To begin with, investment in mutual funds up to $25,000 in

a calendar year was permitted. Since then, the Reserve Bank of

India has enhanced the limit to $200,000 in a calendar year.

You can now invest in stocks, mutual funds, hedge funds, foreigncurrencies, foreign currency derivatives, insurance policies, and real

estate anywhere in the world. So, the vast array of financial

products in the global markets may be just a click away.


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Benefits of Global Investing

Attractive Opportunities

Diversification Benefits


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Risks in Global Investing

Political Risk

Currency Risk

Custody Risk

Liquidity Risk

Market Volatility


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Return on Foreign Investment

Formally, the rate of return in INR terms from investing in the ith

foreign market is as follows:

Ri,INR

= (1 +Ri) ( 1 + e

i) - 1

= Ri + ei + Riei

where Ri is the foreign currency rate of return in the ith foreign

market and eiis the rate of change in the exchange rate between the

foreign currency and the INR, ei

will be positive (negative) if the

foreign currency appreciates (depreciates) vis--vis the INR.


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Illustration of Return Calculation

To illustrate, suppose an Indian resident just sold shares of IBM he

purchased a year ago and earned a rate of return of 14 percent interms of the US dollar (R

i= 0.14). During the same period the US

dollar depreciated 4 percent against the INR (ei= -.04). The realised

rate of return in INR terms from this investment is:

Ri,INR

= (1 + 0.14) (1 - 0.04)1

= 1.0944 - 1 = .0944 or 9.44 percent


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Risk of Foreign Investment

The risk of foreign investment measured in terms of variance, is:

Var (Ri, INR) = Var (Ri) + Var (ei) + 2Cov (Ri, ei) + Var

where Var (Ri) is the variance of foreign currency rate of return, Var (e

i)

is the variance of the exchange rate change, Cov (Ri, e

i) is the

covariance between the foreign currency rate of return and the

exchange rate change, and Var reflects the contribution of the cross-product term,R

ie

i, to the risk of the foreign investment.

If the exchange rate remains unchanged, implying that ei is zero,

only one term, Var (Ri), remains on the right side of equation. From

this equation, it is clear that exchange rate change contributes to the

risk of foreign investment in three ways:

Its own volatility : Var (ei)

Its covariance with the returns in the foreign market: Cov (Ri,

ei)

Its contribution to the cross-product term: Var


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Empirical Evidence

Empirical evidence suggests the following:

Exchange rate uncertainty contributes more significantly to

the risk associated with foreign bond returns and less

significantly to the risk associated with foreign equity returns.

Exchange rate changes tend to covary positively with

foreign bond returns and, interestingly, negatively with

foreign equity returns.

The cross product term, Var, as expected contributes little

to volatility.


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Equilibrium in International Capital Markets

We can use the capital asset pricing model (CAPM) or the arbitrage

pricing theory (APT) to estimate expected returns in the

international capital market, just as we do for domestic assets.

However, these models have to be adapted to the international

context.


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Growing Importance of Global Factors

In recent years, stock markets across the world seem to have become

more closely aligned. Several factors have contributed to a higher

correlation between changes in stock prices in different countries.

Increase in cross-border trading

Multiple listing

Spurt in cross-border mergers and acquisitions Internet


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Investing in Developed Markets

You can buy stocks of domestically-oriented companies invarious developed markets as well as stocks of multinational

companies such as Coca Cola, Toyota, and Unilever. A convenient way of investing in major multinational

companies, not headquartered in the US, is to buy their

American Depository Receipts (ADRs).

If you find investing on your own to be dauntingas is the case with

most individual investors your best bet will be to invest through

mutual funds. In this context, the following options seem attractive:

Index funds

Exchange-traded funds like the World Equity BenchmarkSecurities (covering developed markets)

Just as equity investors seeking to diversify globally may buy ADRs,

bond investors wanting to diversify globally may find it convenient tobuy Yankee bonds.


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Investing in Emerging Markets

You can invest in emerging markets through mutual funds or on your

own. For most investors, the mutual fund route is the most sensible route.

While there are hundreds of emerging markets investment funds available,the following appear to be the more attractive options.

Close-ended mutual funds selling at a significant discount

Open-ended index funds like the Vanguard Emerging Markets

Index Fund. Exchange-traded funds like the World Equity Benchmark

Securities (covering emerging markets)

Although the mutual fund route is the generally recommended route for

individual investors, some investors love the excitement and challenge of

investing on their own. If you have such an inclination, you will find the

following tips useful: (a) Invest in countries that have low price-earnings

ratio, low price-to-book value ratio, and high dividend yield. (b) Choose

countries where political risk is diminishing. (c) Trade minimally. (d) Do

not hedge currency risk.


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How to Invest

To invest in equities abroad you need a bank account with a brank

that allows foreign remittances and an account with a domestic

broker who has a tie up with a foreign broker. Alternatively, you

must have an account with a foreign broker. (You can sign up

directly with an online broker abroad). You have to transfer the

investible amount to your brokerage account by filling up Form A2.

Once the money is transferred, you can buy shares online on your

trading screen. Likewise, you can sell shares online and transfer

money electronically to your bank account.


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How to Invest

Another option to invest in foreign securities is to buy a foreign exchange-

traded fund (ETF) listed on an Indian stock exchange. For example, the

Hang Seng BeES, an open-ended index scheme, which tracks the Hang

Seng index on a real-time basis is listed on the National Stock Exchange.

(Hang Seng index, comprising 42 stocks, is the benchmark of Hang Seng

BeES). Through Hang Seng BeES you can buy into China, the largest

manufacturing economy in the world. Hang Seng BeES NAV replicates

Hang Sengs total return index minus expenses on a currency adjustedbasis. The taxation rules that apply to Hang Seng BeES will be the same as

the ones applicable to buying or selling of non-equity mutual funds.


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Tracking Global Markets

Morgan Stanley capital International (MSCI) compilesindices for individual countries, regions, developed markets,emerging markets, and the entire world.

The premier MSCI benchmarks used by investment

managers to measure the performance of global markets areas follows:

The MSCI World Index

The MSCI EAFE (Europe, Australia, Far East) Index

The MSCI Emerging Markets Free Index.


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Summary

The world is being swept by a second wave of globalisationat the beginning of the twenty first century.

Within limits, Indian citizens can invest in various assets

abroad.

Global investing provides two advantage viz., attractive

opportunities and diversification benefits.

There are several risks which exist or become morepronounced in global investing: political risk, currency,

risk, custody risk, liquidity risk, and market volatility.

The rate of return in INR (Indian national rupee) terms

from investing in the ith

foreign market is:R

i,

INR= R

i+ e

i +R

ie

i

The risk of foreign investment measured in terms of

variance is:

Var (Ri,

INR) = Var (R

i) + Var (e

i) + 2Cov (R

i, e

i) +

Var


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With some adaptation, we can use the capital asset pricingmodel (CAPM) or the arbitrage pricing theory (APT) to

estimate expected returns in the International capital market.

In recent years, stock markets across the world have

become more closely aligned.

There is a bewildering range of investment options availableglobally for developed markets as well as emerging markets.

The premier Morgan Stanley Capital International (MSCI)

benchmarks used by investment managers to measure theperformance of global markets are as follows: the MSCI

World Index, the MSCI EAFE (Europe, Australasia, Far

East) Index, and the MSCI Emerging Markets Free index.

Chapter 21International Investing.ppt

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