International Investing (Part II).doc


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International Investing (Part II).doc

  1. 1. FIN 476 Greg MacKinnon Sobey School of Business Saint Mary's University International Investing (Part II) As discussed previously, when someone makes an investment in a foreign stock (or stock market), they are really making an investment in two things; the stock itself and the foreign currency in which it is held. Because of this, there are two components to the return and risk of a foreign investment. Say the return on a foreign stock is R, in foreign currency terms (or “local currency” terms). Let %∆e be the percentage change in the value of the foreign currency. Assume that an investor is concerned with the return on the stock in dollar terms. Let the return in dollar terms be R$. Then, as seen before: R$ = (1+R)(1+%∆e)-1 Example: If the S&P 500 goes from 1000 to 1100 over a one year period and over the same period the $US goes from 1.5 $Can/$US to 1.6$Can/$US, then the return on the S&P 500 to a US investor is 10%, but the return on an investment to a Canadian investor in $Can terms can be calculated as: %∆e = (1.6 − 1.5) = 6.7% 1.5 R $ Can = (1.1)(1.067) − 1 = 17.37% Of course, because both the return on the stock and the return on the currency enter the calculation for return, they will both also affect the calculation for risk. Intuitively, there is an extra source of risk for international investments because the investor has to worry about changes in the exchange rate as well as changes in the value of the stock itself. Variance of returns is a standard measure of risk. From the equation above, an investor worried about the dollar returns on a foreign investment would measure risk by Var[R$]. R $ = (1 + R )(1 + %∆e) − 1 = R + %∆e + R (%∆e) ≈ R + %∆e where the last near equality holds since the cross product will tend to be very small. Looking at variance of R$: Var[ R $ ] = Var[ R + %∆e] = Var[ R ] + Var[ %∆e] + 2Cov[ R ,%∆e]
  2. 2. FIN 476 Greg MacKinnon Sobey School of Business Saint Mary's University So, the risk of an international investment depends on three things: the risk of the investment itself (in local currency), the risk of the exchange rate, and the covariance (or correlation) of the change sin the exchange rate and the changes in the stock. While the overall risk to an investor in a foreign stock market will depend on the relative sizes of the three components in the equation above, generally speaking Var[R$] will usually be higher than Var[R] (the only way it could be smaller is if the covariance term was negative and large enough to offset the exchange rate risk, which does not generally occur in the real world). This means that an investment will be more risky for a foreign investor than it would be for a local investor. Generally speaking, the variance of exchange rate term and the covariance term will be relatively more important for international bond investments than for international stock investments (although they are important for both). This is because bonds tend to be less risky than stocks, so the volatility induced by exchange rate changes is often a bigger source of risk than the bonds themselves. For international bond investors, knowledge of exchange rate risk and consideration of ways to control it are paramount. Ways to Invest Internationally There are a number of ways for investors to engage in international investing. Many of these ways are open to all investors, whether large institutions or small retail investors. In many ways, over the last 20 years international investing has become as easy as domestic investing because of the products available. Some of the methods of foreign equity investment are: 1. Invest Directly in Foreign Stocks 2. International Mutual Funds 3. Country Funds 4. American Depository Receipts (ADR’s) 5. World Equity Benchmark Securities (WEBS) 6. Invest in Domestic Firms with International Exposure 1. Invest Directly in Foreign Stocks One way to invest in foreign stocks is to simply buy them directly. Unfortunately, this can be very difficult for small, retail investors. Most brokers do not offer access to foreign stock exchanges (the exception in Canada being access to US markets which is easy and generally no more expensive than buying Canadian stocks). Further, even if a small, individual investor had the ability to purchase foreign stocks directly, there are large information costs involved. It can be very difficult to gather timely information about foreign companies for most people. The effort required to gather the information needed to make informed investment choices may not be worth it for a small investment. Large, institutional investors however can have access to brokers in many countries giving then the ability to directly purchase stocks around the world. Further, because of the size of their investments it is worthwhile to them to personnel (and make use of foreign brokers) to gather information about the stocks in which they invest.
  3. 3. FIN 476 Greg MacKinnon Sobey School of Business Saint Mary's University Because if the difficulties for individuals in investing in foreign st6ocks directly, the next method of investing in foreign equities is very popular; international mutual funds. 2. International Mutual Funds Th essence of a mutual fund is that it sells units to the -public, pools together then money of many investors, and uses that money to invest in a portfolio of securities. In the case of international ,mutual funds, the money is invested in a portfolio of international securities. Some funds are global, investing around the world, while some specialize in certain regions (e.g. Asia, Europe, Japan, US, et cetera). They may also be categorized by whether they invest in bonds, stocks or both. For small investors, mutual funds are easy to invest in, with a large number of mutual fund companies around, most of which offer various types of international funds. In the case of open end mutual funds (the most common), units in the fund are purchased directly from the mutual fund company. Every new sale is a sale of newly issued units. When redeemed by investors. the units are redeemed by the mutual fund company and those units canceled. 3. Country Funds Closed end mutual funds are different from the more common open end funds in that the fund company issues a set number of units. If an investor wishes to purchase units in the fund, they must purchase then from another investor who already owns them. When selling units, the units must be sold to another investor at the market price. The mutual fund company does not issue or redeem units (other than the initial issuance to start). Closed end funds trade on a stock exchange. There are a number of closed end funds in Canada, but they are far more common in the US. The easy access to US markets for Canadian investors allows Canadians access to a wide selection of closed end funds (although they would be priced in $US). A common type of closed end fund is a country fund. This is a closed end fund which specializes in a particular country. That is, the fund invests in a portfolio of stocks from a particular country. For instance, in the US there are approximately 30 different country funds trading, based on countries such as Thailand, South Africa, Germany, India, Malaysia et cetera. Country funds therefore allow investors access to portfolios of stocks from specific countries. They are especially appealing for investments in developing countries stock markets, which can be difficult to access otherwise. As for all closed end funds, the price for a unit of a country fund is determined on the stock market on which it trades (usually the American Stock Exchange). The price of the fund depends on supply and demand. Because of this, the price of a unit is often not equal to the underlying value of the securities it holds in its portfolio (the net asset value). This is much different than for an open end fund which the fund company will sell or redeem at the net asset value at any time. Depending on circumstances, an investor might have to pay more or less than the net asset value of a country fund in order to purchase units. While the value of a country fund should depend largely on the value of its stock holdings in the foreign country, its price may depart from this value. A study by Bodurtha, Kim and Lee1 shows that investor sentiment in the US affects the price of country funds. In other words, country fund prices may go up and down (above and below their underlying net asset value) partly based upon the optimism or pessimism of 1 “Closed-end Country Funds and U.S. Market Sentiment”, Review of Financial Studies, 1995
  4. 4. FIN 476 Greg MacKinnon Sobey School of Business Saint Mary's University US investors (who are the ones trading the country funds) about the stock market. Hence, prices of country funds may reflect not only the performance of stocks in the foreign country, but also be affected by domestic influences. It is possible that this may affect the ability of country funds to provide full international diversification. 4. American Depository Receipts (ADR’s) Many non-US firms list their shares on US stock exchanges. Foreign shares listed on a US exchange are listed in the form of an ADR. An exception is shares of Canadian firms which can list their shares directly on a US exchange. ADR’s trade on a US exchange in exactly the same way as a regular share (other than representing a foreign firm). The only difference is technical. An investor who buys an ADR is actually buying a share in a trust account which holds share sin the foreign firm, rather than actually buying the shares directly. Hence, ADR’s represent a way for investors to purchase share sin foreign firms with no more difficulty or expanse than purchasing US stock. Unfortunately, it is only large, verity well established foreign companies that generally list on the major US exchanges. This limits the possibilities for investors, although there are almost 200 ADR’s available. 5. World Equity Benchmark Securities (WEBS) WEBS are a form of exchange traded fund developed by Morgan Stanley Capital International. An exchange traded fund is an open end mutual fund which trades on a stock exchange. Hence, it combines elements of both open end and closed end funds. It trades on a stock exchange, giving the same buying and selling convenience as a closed end fund. However, the fund company (MSCI in this case) stands by ready to redeem units at their underlying bet asset value if requested. This means that exchange traded funds trade at (or very near) their net asset value at all times (like an open end fund). WEBS are exchange traded funds which are linked to various stock indices around the world. There are currently 127 WEBS traded (on the American Stock Exchange), representing stock indices from: Australia, Austria, Belgium, Canada, France, German, Hong Kong, Italy, Japan, Malaysia, Mexico, the Netherlands, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. Buying units in, for instance, the Spain WEB, gives investors a share of a portfolio comprised of the stocks in a broadly based Spanish stock index. 6. Invest in Domestic Firms with International Exposure One way to gain exposure to international markets is to invest in domestic stocks, but pick firms which have significant business operations in other countries. For instance, investing in a firm which is itself internationally diversified may provide international diversification to an investor. Alternatively, investing in domestic firms which do a lot of business with a particular country may give investors exposure to that country. Evidence on whether this type of international investing is effective is mixed. It would appear that doing this in Canada does not provide the same benefits as actual international investing (probably due to the relatively small range of companies in Canada from which to choose). Doing so in the US (with a much broader range of stocks from which to choose) seems to provide some of the benefits of international diversification, although various studies differ in their findings.