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1
Chapter 7
International Investment and
Diversification
www.StudsPlanet.com
2
Outline
Introduction
Why international diversification makes
theoretical sense
Foreign exchange risk
Investments in emer...
3
Introduction
The marketplace of the twenty-first century
is global
• U.S. equities represent only about 51% of the
world...
4
Introduction (cont’d)
International investments carry additional
sources of risk
Managers can reduce total portfolio ris...
5
Why International Diversification Makes Sense
(Evans and Archer)
Portfolio theory works to the investor’s
benefit even i...
6
Why International Diversification Makes Sense
(Evans and Archer Cont’d)
Total risk contains both systematic and
unsystem...
7
Utility, Risk, and Return
Unsystematic risk reduction is possible with
more than 20 securities
• For a given level of re...
8
Variance of
A Linear Combination
As long as assets are less than perfectly
correlated, there will be diversification
ben...
9
Relationship of
World Exchanges
For U.S. securities, market risk account for
about 25% of a security’s total risk
For le...
10
Relationship of
World Exchanges (cont’d)
International capital markets continue to
show independent price behavior
• In...
11
Relationship of
World Exchanges (cont’d)
Number of Securities
Portfolio Variance
U.S. Securities: Systematic Risk 27%
I...
12
Fundamental
Logic of Diversification
Investors are, on average, rational
Rational people do not like unnecessary
risk
B...
13
Fundamental Logic of
Diversification (cont’d)
The most securities investors can hold is
all of them
The collection of a...
14
Other Considerations
Optimum portfolio size involves a trade-off
between:
• The benefits of additional diversification
...
15
Foreign Exchange Risk
Definition
Business example
Investment example
From whence cometh the risk?
Dealing with the risk...
16
Definition
Foreign exchange risk refers to the
changing relationships among currencies
• Modest changes in exchange rat...
17
Business Example
A U.S. importer has agreed to purchase 40 New Zealand
leather vests at a price of NZ$110 each. The ves...
18
Business Example (cont’d)
Solution: If the spot rate does not change, the cost to the importer is:
40 x NZ$110 x $0.585...
19
Investment Example
You just purchased 1,000 of Kangaroo Lager trading on
the Sydney Stock Exchange for AUD1.45 per shar...
20
Investment Example (cont’d)
Solution: The purchase price in U.S. dollars is:
1,000 x AUD1.45 x $0.7735 = $1,121.58
If t...
21
From Whence
Cometh the Risk?
Role of interest rates
Forward rates
Interest rate parity
Covered interest arbitrage
Purch...
22
Real Rate of Interest
The real rate of interest reflects the rate of
return investors demand for giving up the
current ...
23
Inflation Premium
The inflation premium reflects the way the
general price level is changing
Inflation is normally posi...
24
Risk Premium
The risk premium is the component of
interest rates that reflects compensation for
risk to risk-averse inv...
25
Forward Rates
The forward rate is a contractual rate
between a commercial bank and a client for
the future delivery of ...
26
Forward Rates (cont’d)
The forward rate is the best estimate of the
future spot rate
• If the forward rate indicates th...
27
Forward Rates (cont’d)
Forward rate premium or discount:
Forward rate - Spot rate 12
100
Spot rate
where the contract l...
28
Forward Rates (cont’d)
Example
On April 29, 2005, the British pound had a spot rate of
$1.9146. The 3-month forward rat...
29
Forward Rates (cont’d)
Example (cont’d)
Solution: The forward premium or discount is
calculated as follows:
There is a ...
30
Interest Rate Parity
Interest rate parity states that differences in
national interest rates will be reflected in
the c...
31
Interest Rate Parity Formula
domestic
foreign
where
annualized domestic risk-free rate
annualized foreign risk-free rat...
32
Example
Six-month German Treasury Bills yield
2.60% (annualized rate)
Spot exchange rate is $ 0.6051 / DM
Six-month For...
33
Covered Interest Arbitrage
Covered interest arbitrage is possible when
the conditions of interest rate parity are
viola...
34
Example of CIA
Six-month Swiss rate is 1.00 % (annualized rate)
Six-month US Treasury Bills yield 2.00 %
(annualized ra...
35
Example of CIA
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36
Purchasing Power Parity
Purchasing power parity (PPP) refers to
the situation in which the exchange rate
equals the rat...
37
Purchasing Power
Parity (cont’d)
Absolute purchasing power parity follows
from “the law of one price:”
• A basket of go...
38
Purchasing Power
Parity (cont’d)
Relative purchasing power parity states
that differences in countries’ inflation rates...
39
Purchasing Power
Parity (cont’d)
A country with an increase in inflation will
experience a depreciation of its currency...
40
The Concept of Exposure
Definition
Accounting exposure
Transaction exposure
Translation exposure
Economic exposure
www....
41
Definition
Exposure is a measure of the extent to
which a person faces foreign exchange risk
In general, there are two ...
42
Accounting Exposure
Accounting exposure is:
• Of concern to MNCs that have subsidiaries in a
number of foreign countrie...
43
Transaction Exposure
FASB Statement No. 8 addresses
transaction exposure:
• “A transaction involving purchase or sale o...
44
Translation Exposure
Translation exposure results from the
holding of foreign assets and liabilities that
are denominat...
45
Economic Exposure
Economic exposure measures the risk that
the value of a security will decline due to an
unexpected ch...
46
Dealing With the Exposure
Ignore the exposure
Reduce or eliminate the exposure
Hedge the exposure
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47
Ignore the Exposure
Ignoring the exposure may be appropriate
for an investor if:
• Foreign exchange movements are expec...
48
Reduce or Eliminate
the Exposure
If the dollar is expected to appreciate
dramatically, an investor may reduce or
elimin...
49
Hedge the Exposure
Definition
Hedging with forward contracts
Hedging with futures contracts
Hedging with foreign curren...
50
Definition
Hedging involves taking one position in the
market that offsets another position
• Covering foreign exchange...
51
Hedging With
Forward Contracts
A forward contract is a private, non-
negotiable transaction between a client and
a comm...
52
Hedging With
Futures Contracts
A futures contract is a promise to buy or sell a
specified quantity of a particular good...
53
Hedging With
Futures Contracts (cont’d)
To hedge an investment, sell foreign
currency futures
To hedge a liability, buy...
54
Hedging With
Foreign Currency Options
There are two types of foreign currency
options:
• Call options give their owner ...
55
Hedging With Foreign
Currency Options (cont’d)
Currency option characteristics:
• A call option with an exercise price ...
56
Hedging With Foreign
Currency Options (cont’d)
The disadvantage of hedging with currency
options is that the hedger mus...
57
The Eurobond Market
Eurobonds are debt agreements that are
denominated in a currency other than that of the
country in ...
58
The Eurobond Market (cont’d)
About 75% of eurobonds are denominated
in U.S. dollars
Firms issuing dollar-denominated
Eu...
59
Combining the Currency and
Market Decisions
It is often desirable to cross-hedge a foreign
investment into a different ...
60
How to do it
Select the market with the highest risk-premium,
not the highest absolute return.
Why?
Because due to non-...
61
Which Currency to Cross-Hedge ?
What is relevant is the total rate of return, after
including the return in the selecte...
62
The return to maximize is the sum of
Chosen Market Equity Return (where we
chose to invest)
Forward market premium/disc...
63
Example
A US investor chooses to invest in German stocks
and then cross-hedges with the Japanese Yen:
Forecasted German...
64
The riskless (Eurobond) rate differential comes
from the fact that we have:
This means that the expected percentage cha...
65
Investments in
Emerging Markets
Overview
Background
Adding value
Reducing risk
Following the crowd
Special risks
Asymme...
66
Overview
Emerging market investments:
• Offer substantial potential rewards to the
careful investor in added return and...
67
Background
Over $20 billion is invested globally in
securities issued in underdeveloped
countries
Pension funds’ larges...
68
Background (cont’d)
Dollars invested in emerging markets has
increased at a compound rate of almost 50%
over the last 1...
69
Adding Value
Prices in developing markets often contain
significant inefficiencies
• Tend to sell for lower price/earni...
70
Reducing Risk
Low correlations are attractive as a means
of reducing portfolio variability
• Emerging markets show low ...
71
Following the Crowd
Some professional money managers
carefully analyze emerging markets for:
• Profit potential
• Portf...
72
Special Risks
Incomplete accounting information
Foreign currency risk
Fraud and scandals
Weak legal system
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73
Incomplete
Accounting Information
In some countries, financial statements are
more than 6 months old when they become
a...
74
Incomplete Accounting
Information (cont’d)
Accounting standards differ substantially
across countries
Accounting inform...
75
Foreign Currency Risk
Foreign exchange securities are
denominated in a foreign currency
• Introduces foreign exchange r...
76
Fraud and Scandals
Emerging markets carry a substantial risk of
fraud
• E.g., accounting misstatements, counterfeit
sec...
77
Weak Legal System
Low confidence in a country’s legal system:
• Leads to increased uncertainty
• Leads to an increased ...
78
Asymmetric Correlations
Correlation between emerging and
developed markets:
• Increases during bear markets
• Is low du...
79
Asymmetric
Correlations (cont’d)
Investment returns show:
• Homogeneity within emerging markets
– Securities tend to mo...
80
Market
Microstructure Considerations
Liquidity risk
Trading costs
Market pressure
Marketability risk
Country risk
www.S...
81
Liquidity Risk
Some emerging markets’ investors are mostly
foreign
• Increases political risk
• Sets the stage for a ma...
82
Trading Costs
Foreign market trading costs are more than
1% higher than domestic trading costs
• E.g., bid/ask spread i...
83
Market Pressure
An order to buy or sell a large number of
shares might cause a substantial
supply/demand imbalance
• Ca...
84
Marketability Risk
An investor may be unable to close out a
position at a reasonable price
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85
Country Risk
Country risk refers to a country’s ability
and willingness to meet its foreign
exchange obligations
• Espe...
86
Political Risk
Introduction
Factors contributing to political risk
Macro risk versus micro risk
Dealing with political ...
87
Introduction
Political risk is a measure of a country’s
willingness to honor its foreign obligations
• A function of:
–...
88
Introduction (cont’d)
Real (direct) investment is an investment
over which the investor retains control
• E.g., a plant...
89
Introduction (cont’d)
Extreme forms of country risk for portfolio
investment:
• Government takeover of a company
• Poli...
90
Introduction (cont’d)
Modest forms of country risk for portfolio
investment:
• A requirement that a minimum percentage ...
91
Factors Contributing
to Political Risk
“Buy local” attitude
Public attitude
Government attitude
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92
“Buy Local” Attitude
Buy local campaigns seek to make foreign
consumers buy local goods instead of goods
produced by a ...
93
Public Attitude
In emerging markets, people may see no
opportunity to improve their standard of living
• Foreign subsid...
94
Government Attitude
Unstable governments can lead to foreign
investors being a volatile political issue
• Foreign inves...
95
Macro Risk Versus Micro Risk
Macro risk refers to government actions that
affect all foreign firms in a particular indu...
96
Dealing With Political Risk
Seek a foreign investment guarantee from
the Overseas Private Investment
Corporation
• Prov...
97
Dealing With
Political Risk (cont’d)
Avoid engaging in behavior that stirs up
trouble with the host people or governmen...
98
Economic Risk
Economic risk is a measure of a country’s
ability to pay
• Assess economic risk by:
– Using coverage rati...
99
Other Topics
Multinational corporations
American depository receipts
International mutual funds
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100
Multinational Corporations
Investing in a multinational corporation
may provide a ready-made means of getting
the risk...
101
American Depository Receipts
American depository receipts (ADRs) are receipts
representing shares of stock that are he...
102
International Mutual Funds
Mutual funds permit diversification to an
extent that would not otherwise be possible
• Som...
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Transcript of "Internationl investment"

  1. 1. 1 Chapter 7 International Investment and Diversification www.StudsPlanet.com
  2. 2. 2 Outline Introduction Why international diversification makes theoretical sense Foreign exchange risk Investments in emerging markets Political risk Other topics related to international diversification www.StudsPlanet.com
  3. 3. 3 Introduction The marketplace of the twenty-first century is global • U.S. equities represent only about 51% of the world’s equity capitalization • Over the period 1980-2000, the U.S. was the best-performing market only once • In September 1999, each of the 66 U.S. pension funds had more than $1 billion in actively managed international investment portfolios www.StudsPlanet.com
  4. 4. 4 Introduction (cont’d) International investments carry additional sources of risk Managers can reduce total portfolio risk via global investment www.StudsPlanet.com
  5. 5. 5 Why International Diversification Makes Sense (Evans and Archer) Portfolio theory works to the investor’s benefit even if he selects securities at random Ideally, the portfolio manager selects securities because of their fit with the rest of the portfolio • By choosing poorly correlated securities, a manager can reduce total portfolio risk www.StudsPlanet.com
  6. 6. 6 Why International Diversification Makes Sense (Evans and Archer Cont’d) Total risk contains both systematic and unsystematic risk • Evans and Archer show that holding 15 to 20 equity securities substantially reduces the unsystematic risk www.StudsPlanet.com
  7. 7. 7 Utility, Risk, and Return Unsystematic risk reduction is possible with more than 20 securities • For a given level of return, any reduction in risk, no matter how small, is a worthy goal • A rational invest will reduce risk if given the opportunity www.StudsPlanet.com
  8. 8. 8 Variance of A Linear Combination As long as assets are less than perfectly correlated, there will be diversification benefits • More pronounced the lower the correlation • No two shares move in perfect lockstep – Diversification benefits accrue every time we add a new position to a portfolio www.StudsPlanet.com
  9. 9. 9 Relationship of World Exchanges For U.S. securities, market risk account for about 25% of a security’s total risk For less developed countries, market risk tends to be higher because: • Fewer securities make up the market • The securities are exposed to more extreme economic and political events www.StudsPlanet.com
  10. 10. 10 Relationship of World Exchanges (cont’d) International capital markets continue to show independent price behavior • International diversification offers potential advantages • Repeating the Evans and Archer methodology for international securities should result in a lower level of systematic risk www.StudsPlanet.com
  11. 11. 11 Relationship of World Exchanges (cont’d) Number of Securities Portfolio Variance U.S. Securities: Systematic Risk 27% International Securities: Systematic Risk 11.7% www.StudsPlanet.com
  12. 12. 12 Fundamental Logic of Diversification Investors are, on average, rational Rational people do not like unnecessary risk By holding one more security, an investor can reduce portfolio risk without giving up any expected return Rational investors, therefore, will hold as many securities as they can www.StudsPlanet.com
  13. 13. 13 Fundamental Logic of Diversification (cont’d) The most securities investors can hold is all of them The collection of all securities makes up the “world market portfolio” Rational investors will hold some proportion of the world market portfolio www.StudsPlanet.com
  14. 14. 14 Other Considerations Optimum portfolio size involves a trade-off between: • The benefits of additional diversification • Commissions and capital constraints www.StudsPlanet.com
  15. 15. 15 Foreign Exchange Risk Definition Business example Investment example From whence cometh the risk? Dealing with the risk The eurobond market Combining the currency and market decisions Key issues in foreign exchange risk management www.StudsPlanet.com
  16. 16. 16 Definition Foreign exchange risk refers to the changing relationships among currencies • Modest changes in exchange rates can result in significant dollar differences www.StudsPlanet.com
  17. 17. 17 Business Example A U.S. importer has agreed to purchase 40 New Zealand leather vests at a price of NZ$110 each. The vests will take two months to produce, and payment is due before the vests are shipped. The current spot rate of the NZ$ is $0.5855. What is the price of the vests to the importer if the spot rate remains unchanged in the next two months? If it is $0.5500? If it is $0.6200? www.StudsPlanet.com
  18. 18. 18 Business Example (cont’d) Solution: If the spot rate does not change, the cost to the importer is: 40 x NZ$110 x $0.5855 = $2,576.20 If the spot rate is $0.5500: 40 x NZ$110 x $0.5500 = $2,420.00 If the spot rate is $0.6200: 40 x NZ$110 x $0.6200 = $2,728.00 www.StudsPlanet.com
  19. 19. 19 Investment Example You just purchased 1,000 of Kangaroo Lager trading on the Sydney Stock Exchange for AUD1.45 per share. The exchange rate for the Australian dollar at the time of purchase was $0.7735. What is the U.S. dollar purchase price? If Kangaroo Lager stock rises to AUD1.95 per share and if the Australian dollar depreciates to $0.7000, what is your holding period return if you sell the shares? www.StudsPlanet.com
  20. 20. 20 Investment Example (cont’d) Solution: The purchase price in U.S. dollars is: 1,000 x AUD1.45 x $0.7735 = $1,121.58 If the Australian dollar depreciates and you sell the shares, you will receive: 1,000 x AUD1.95 x $0.7000 = $1,365.00 The holding period return is: ($1,365.00 - $1,121.58)/$1,121.58 = 21.7% www.StudsPlanet.com
  21. 21. 21 From Whence Cometh the Risk? Role of interest rates Forward rates Interest rate parity Covered interest arbitrage Purchasing power parity www.StudsPlanet.com
  22. 22. 22 Real Rate of Interest The real rate of interest reflects the rate of return investors demand for giving up the current use of funds In a world of no risk and no inflation, the real rate indicates people’s willingness to postpone spending their money www.StudsPlanet.com
  23. 23. 23 Inflation Premium The inflation premium reflects the way the general price level is changing Inflation is normally positive • The inflation premium measures how rapidly the money standard is losing its purchasing power www.StudsPlanet.com
  24. 24. 24 Risk Premium The risk premium is the component of interest rates that reflects compensation for risk to risk-averse investors The risk premium is a function of how much risk a security carries • E.g., common stock vs. T-bills www.StudsPlanet.com
  25. 25. 25 Forward Rates The forward rate is a contractual rate between a commercial bank and a client for the future delivery of a specified quantity of foreign currency • Typically quoted on the basis of 1, 2, 3, 6, and 12 months www.StudsPlanet.com
  26. 26. 26 Forward Rates (cont’d) The forward rate is the best estimate of the future spot rate • If the forward rate indicates the dollar will strengthen, importers should delay payment • If the forward rate indicates the dollar will weaken, importers should lock in a rate now www.StudsPlanet.com
  27. 27. 27 Forward Rates (cont’d) Forward rate premium or discount: Forward rate - Spot rate 12 100 Spot rate where the contract length in months n n × × = www.StudsPlanet.com
  28. 28. 28 Forward Rates (cont’d) Example On April 29, 2005, the British pound had a spot rate of $1.9146. The 3-month forward rate of the pound was $1.9041 on that date. What is the forward premium or discount? www.StudsPlanet.com
  29. 29. 29 Forward Rates (cont’d) Example (cont’d) Solution: The forward premium or discount is calculated as follows: There is a forward discount of –2.19%. %19.2 100 3 12 9146.1$ 9146.1$9041.1$ 100 12 rateSpot rateSpot-rateForward −= ×× − =×× n www.StudsPlanet.com
  30. 30. 30 Interest Rate Parity Interest rate parity states that differences in national interest rates will be reflected in the currency forward market • Two securities of similar risk and maturity will show a difference in their interest rates equal to the forward premium or discount, but with the opposite sign www.StudsPlanet.com
  31. 31. 31 Interest Rate Parity Formula domestic foreign where annualized domestic risk-free rate annualized foreign risk-free rate F=Forward (contract) rate [value of foreign currency expressed in units of domestic currency] S=Spot exchange R R = = rate [value of foreign currency expressed in units of domestic currency] domestic foreign 365F S R R S n −   = +  ÷   www.StudsPlanet.com
  32. 32. 32 Example Six-month German Treasury Bills yield 2.60% (annualized rate) Spot exchange rate is $ 0.6051 / DM Six-month Forward rate is $ 0.6095 / DM RUS=2.60+100(0.6095-0.6051)(12/6)/0.6051 RUS=4.05 % www.StudsPlanet.com
  33. 33. 33 Covered Interest Arbitrage Covered interest arbitrage is possible when the conditions of interest rate parity are violated • If the foreign interest rate is too high, convert dollars to the foreign currency and invest in the foreign country • If the U.S. interest rate is too high, borrow the foreign currency and invest in the U.S. www.StudsPlanet.com
  34. 34. 34 Example of CIA Six-month Swiss rate is 1.00 % (annualized rate) Six-month US Treasury Bills yield 2.00 % (annualized rate) Spot exchange rate is $ 0.8542 / CHF Six-month Forward rate is $ 0.8610 / CHF What arbitrage strategy can you implement ? www.StudsPlanet.com
  35. 35. 35 Example of CIA www.StudsPlanet.com
  36. 36. 36 Purchasing Power Parity Purchasing power parity (PPP) refers to the situation in which the exchange rate equals the ratio of domestic and foreign price levels • A relative change in the prevailing inflation rate in one country will be reflected as an equal but opposite change in the value of its currency www.StudsPlanet.com
  37. 37. 37 Purchasing Power Parity (cont’d) Absolute purchasing power parity follows from “the law of one price:” • A basket of goods in one country should cost the same in another country after conversion to a common currency • Not very accurate due to: – Transportation costs – Trade barriers – Cultural differences www.StudsPlanet.com
  38. 38. 38 Purchasing Power Parity (cont’d) Relative purchasing power parity states that differences in countries’ inflation rates determine exchange rates: 1 1 1 where change in the spot exchange rate foreign country inflation rate domestic country inflation rate D F F D IS S I S I I +∆ = − + ∆ = = = www.StudsPlanet.com
  39. 39. 39 Purchasing Power Parity (cont’d) A country with an increase in inflation will experience a depreciation of its currency because: • Exports decline • Imports increase • There is less demand for goods from that country www.StudsPlanet.com
  40. 40. 40 The Concept of Exposure Definition Accounting exposure Transaction exposure Translation exposure Economic exposure www.StudsPlanet.com
  41. 41. 41 Definition Exposure is a measure of the extent to which a person faces foreign exchange risk In general, there are two types of exposure: accounting and economic • Economic exposure is more important www.StudsPlanet.com
  42. 42. 42 Accounting Exposure Accounting exposure is: • Of concern to MNCs that have subsidiaries in a number of foreign countries • Important to people who hold foreign securities and must prepare dollar-based financial reports U.S. firms must prepare consolidated financial statements in U.S. dollars www.StudsPlanet.com
  43. 43. 43 Transaction Exposure FASB Statement No. 8 addresses transaction exposure: • “A transaction involving purchase or sale of goods or services with the price states in foreign currency is incomplete until the amount in dollars necessary to liquidate a related payable or receivable is determined” www.StudsPlanet.com
  44. 44. 44 Translation Exposure Translation exposure results from the holding of foreign assets and liabilities that are denominated in foreign currencies • E.g., foreign real estate and mortgage holdings must be translated to U.S. dollars before they are incorporated into a U.S. balance sheet www.StudsPlanet.com
  45. 45. 45 Economic Exposure Economic exposure measures the risk that the value of a security will decline due to an unexpected change in relative foreign exchange rates Security analysts should include expected changes in exchange rates in forecasted cash flows www.StudsPlanet.com
  46. 46. 46 Dealing With the Exposure Ignore the exposure Reduce or eliminate the exposure Hedge the exposure www.StudsPlanet.com
  47. 47. 47 Ignore the Exposure Ignoring the exposure may be appropriate for an investor if: • Foreign exchange movements are expected to be modest • The dollar mount of the exposure is small relative to the cost of inconvenience of hedging • The U.S. dollar is expected to depreciate relative to the foreign currency www.StudsPlanet.com
  48. 48. 48 Reduce or Eliminate the Exposure If the dollar is expected to appreciate dramatically, an investor may reduce or eliminate foreign currency holdings www.StudsPlanet.com
  49. 49. 49 Hedge the Exposure Definition Hedging with forward contracts Hedging with futures contracts Hedging with foreign currency options www.StudsPlanet.com
  50. 50. 50 Definition Hedging involves taking one position in the market that offsets another position • Covering foreign exchange risk means hedging foreign exchange risk www.StudsPlanet.com
  51. 51. 51 Hedging With Forward Contracts A forward contract is a private, non- negotiable transaction between a client and a commercial bank • No money changes hands until the foreign currency is delivered, but the rate is determined now • The forward rate reflects relative interest rates and associated risks www.StudsPlanet.com
  52. 52. 52 Hedging With Futures Contracts A futures contract is a promise to buy or sell a specified quantity of a particular good at a predetermined price by a specified delivery date On the delivery date, there will be a gain or loss in the futures market that will offset the gain or loss experienced when converting the foreign currency www.StudsPlanet.com
  53. 53. 53 Hedging With Futures Contracts (cont’d) To hedge an investment, sell foreign currency futures To hedge a liability, buy foreign currency futures www.StudsPlanet.com
  54. 54. 54 Hedging With Foreign Currency Options There are two types of foreign currency options: • Call options give their owner the right to buy a set quantity of foreign currency • Put options give their owner the right to sell a set quantity of foreign currency • The price at which you have the right to buy or sell is the strike (exercise) price www.StudsPlanet.com
  55. 55. 55 Hedging With Foreign Currency Options (cont’d) Currency option characteristics: • A call option with an exercise price quoted in dollars for the purchase of euros is the same as a put option on dollars with an exercise price quoted in euros • Put-call parity for foreign currency options is a restatement of interest rate parity www.StudsPlanet.com
  56. 56. 56 Hedging With Foreign Currency Options (cont’d) The disadvantage of hedging with currency options is that the hedger must pay a premium to established the hedge • Options provide more precision than futures contracts • Options are more expensive than futures contracts www.StudsPlanet.com
  57. 57. 57 The Eurobond Market Eurobonds are debt agreements that are denominated in a currency other than that of the country in which they are held • E.g., a bond denominated in yen sold in the United Kingdom A foreign bond is denominated in the local currency but is issued by a foreigner • E.g., a bond denominated in yen sold in Japan, issued by a firm in the United Kingdom www.StudsPlanet.com
  58. 58. 58 The Eurobond Market (cont’d) About 75% of eurobonds are denominated in U.S. dollars Firms issuing dollar-denominated Eurobonds pay a slightly lower interest rate than they would pay in the U.S. www.StudsPlanet.com
  59. 59. 59 Combining the Currency and Market Decisions It is often desirable to cross-hedge a foreign investment into a different currency • E.g., a U.S. investor might invest in Japan, use the forward market to sell yen for British pounds and convert the pounds back to dollars • The currency return comes from the forward market premium or discount and the actual change in the exchange rate www.StudsPlanet.com
  60. 60. 60 How to do it Select the market with the highest risk-premium, not the highest absolute return. Why? Because due to non-arbitrage, investing in riskless securities of various countries will yield the same returns once the proceeds are translated back into the domestic currency (either always true if use forward contracts or true on average if use currency spot market to repatriate the funds). Thus what matters (what differentiates markets) is the return expected ABOVE the risk-free rate. www.StudsPlanet.com
  61. 61. 61 Which Currency to Cross-Hedge ? What is relevant is the total rate of return, after including the return in the selected local market (foreign equity), the cost/benefit of holding the currency, and the expected return on that currency. So instead of “mechanically” hedging the local currency with the US Dollar (domestic), we should look for a third currency for cross-hedging purposes so as to maximize the total expected return. www.StudsPlanet.com
  62. 62. 62 The return to maximize is the sum of Chosen Market Equity Return (where we chose to invest) Forward market premium/discount (riskless rate in country selected for cross-hedging minus riskless rate in country where we chose to invest). Expected return in currency of country where we chose to invest. www.StudsPlanet.com
  63. 63. 63 Example A US investor chooses to invest in German stocks and then cross-hedges with the Japanese Yen: Forecasted German equity returns: 10 % Forecasted change in Japanese Yen: 2.5 % Japanese riskless rate (Eurobond rate): 2 % German riskless rate (Eurobond rate): 4.5 % Forecasted total return: 10% + (2% - 4.5%) + 2.5% Total (Expected) Return = 10% www.StudsPlanet.com
  64. 64. 64 The riskless (Eurobond) rate differential comes from the fact that we have: This means that the expected percentage change in the DM value (expressed in Yen) is the riskless rate differential. When using forward contracts, we get the forward rate instead of the spot rate due to the fact that we need to wait for that future date before transforming the DM into Japanese Yen. Therefore the amount in DM that gets converted to Yen in the end is subject to a change in value since the forward rate F is different than the spot rate S. future date / / / / Japan Germany / / [ ]Yen DM Yen DM Yen DM Yen DM Yen DM Yen DM F S E S S r r S S − − = = − www.StudsPlanet.com
  65. 65. 65 Investments in Emerging Markets Overview Background Adding value Reducing risk Following the crowd Special risks Asymmetric correlations Market microstructure considerations www.StudsPlanet.com
  66. 66. 66 Overview Emerging market investments: • Offer substantial potential rewards to the careful investor in added return and risk reduction • Are accompanied by special risks: – Foreign exchange risk – High political and economic risk – Unreliable investment information – High trading costs www.StudsPlanet.com
  67. 67. 67 Background Over $20 billion is invested globally in securities issued in underdeveloped countries Pension funds’ largest emerging market exposure is in: • Asia (39.1%) • Latin America (32.7%) www.StudsPlanet.com
  68. 68. 68 Background (cont’d) Dollars invested in emerging markets has increased at a compound rate of almost 50% over the last 10 years Private sector growth in emerging markets • E.g., Hungary and Poland after 1989 www.StudsPlanet.com
  69. 69. 69 Adding Value Prices in developing markets often contain significant inefficiencies • Tend to sell for lower price/earnings multiples than do firms in developed markets – Emerging market firms have greater expected growth and are cheaper www.StudsPlanet.com
  70. 70. 70 Reducing Risk Low correlations are attractive as a means of reducing portfolio variability • Emerging markets show low correlation with developed markets • Emerging markets show low correlation with each other www.StudsPlanet.com
  71. 71. 71 Following the Crowd Some professional money managers carefully analyze emerging markets for: • Profit potential • Portfolio risk reduction Some professional money managers “follow the crowd” because they must invest in emerging markets www.StudsPlanet.com
  72. 72. 72 Special Risks Incomplete accounting information Foreign currency risk Fraud and scandals Weak legal system www.StudsPlanet.com
  73. 73. 73 Incomplete Accounting Information In some countries, financial statements are more than 6 months old when they become available • The acquisition of reliable investment information generally requires on-site security analysts www.StudsPlanet.com
  74. 74. 74 Incomplete Accounting Information (cont’d) Accounting standards differ substantially across countries Accounting information is frequently unavailable for an emerging market security Some emerging market brokerage firms focus on the income statement but ignore the balance sheet www.StudsPlanet.com
  75. 75. 75 Foreign Currency Risk Foreign exchange securities are denominated in a foreign currency • Introduces foreign exchange risk for foreign investors • E.g., Mexican peso crisis and Asian crisis In emerging markets, traditional hedging vehicles may be unavailable www.StudsPlanet.com
  76. 76. 76 Fraud and Scandals Emerging markets carry a substantial risk of fraud • E.g., accounting misstatements, counterfeit securities, “bucket” shops Redress available to victims of a scandal in a developing country may be inadequate www.StudsPlanet.com
  77. 77. 77 Weak Legal System Low confidence in a country’s legal system: • Leads to increased uncertainty • Leads to an increased risk premium required by investors www.StudsPlanet.com
  78. 78. 78 Asymmetric Correlations Correlation between emerging and developed markets: • Increases during bear markets • Is low during bull markets • The extent of portfolio managers’ diversification depends on whether they are experiencing an up or a down market www.StudsPlanet.com
  79. 79. 79 Asymmetric Correlations (cont’d) Investment returns show: • Homogeneity within emerging markets – Securities tend to move as a group within a single emerging market • Heterogeneity across emerging markets – Emerging markets show low correlation across markets www.StudsPlanet.com
  80. 80. 80 Market Microstructure Considerations Liquidity risk Trading costs Market pressure Marketability risk Country risk www.StudsPlanet.com
  81. 81. 81 Liquidity Risk Some emerging markets’ investors are mostly foreign • Increases political risk • Sets the stage for a market collapse if everyone pulls out at once Some emerging markets lack depth • The bid/ask spread tends to be wide with few standing order to buy and to sell www.StudsPlanet.com
  82. 82. 82 Trading Costs Foreign market trading costs are more than 1% higher than domestic trading costs • E.g., bid/ask spread is an average of 95 basis points for Barings’ Securities emerging market index • This indicates an investment must appreciate more to show a given net return www.StudsPlanet.com
  83. 83. 83 Market Pressure An order to buy or sell a large number of shares might cause a substantial supply/demand imbalance • Causes the price to move adversely from the investor’s perspective • Indicates that emerging market investments should be viewed as long-term investments rather than a source of trading profits www.StudsPlanet.com
  84. 84. 84 Marketability Risk An investor may be unable to close out a position at a reasonable price www.StudsPlanet.com
  85. 85. 85 Country Risk Country risk refers to a country’s ability and willingness to meet its foreign exchange obligations • Especially important in emerging markets Country risk has two components: • Political risk • Economic risk www.StudsPlanet.com
  86. 86. 86 Political Risk Introduction Factors contributing to political risk Macro risk versus micro risk Dealing with political risk www.StudsPlanet.com
  87. 87. 87 Introduction Political risk is a measure of a country’s willingness to honor its foreign obligations • A function of: – The stability of the governments and its leadership – Attitudes of labor unions – The country’s ideological background – The country’s past history with foreign investors www.StudsPlanet.com
  88. 88. 88 Introduction (cont’d) Real (direct) investment is an investment over which the investor retains control • E.g., a plant in a foreign country Portfolio investment refers to foreign investment via the securities market • E.g., buying a number of shares of a foreign company www.StudsPlanet.com
  89. 89. 89 Introduction (cont’d) Extreme forms of country risk for portfolio investment: • Government takeover of a company • Political unrest leading to work stoppages • Physical damage to facilities • Forced renegotiation of contracts www.StudsPlanet.com
  90. 90. 90 Introduction (cont’d) Modest forms of country risk for portfolio investment: • A requirement that a minimum percentage of supervisory positions be held by locals • Changes in operating rules • Restrictions on repatriation of capital www.StudsPlanet.com
  91. 91. 91 Factors Contributing to Political Risk “Buy local” attitude Public attitude Government attitude www.StudsPlanet.com
  92. 92. 92 “Buy Local” Attitude Buy local campaigns seek to make foreign consumers buy local goods instead of goods produced by a foreign firm or its subsidiaries Contributes to political risk www.StudsPlanet.com
  93. 93. 93 Public Attitude In emerging markets, people may see no opportunity to improve their standard of living • Foreign subsidiaries may contribute to this attitude with luxury items The gap between the public’s aspirations and its expectations contributes to political risk www.StudsPlanet.com
  94. 94. 94 Government Attitude Unstable governments can lead to foreign investors being a volatile political issue • Foreign investors can be blamed for local problems • Foreign governments can suspend a firm’s ability to send funds back to its home country www.StudsPlanet.com
  95. 95. 95 Macro Risk Versus Micro Risk Macro risk refers to government actions that affect all foreign firms in a particular industry Micro risk refers to politically motivated changes in the business environment directed to selected fields of business activity or to foreign enterprises with specific characteristics www.StudsPlanet.com
  96. 96. 96 Dealing With Political Risk Seek a foreign investment guarantee from the Overseas Private Investment Corporation • Provides coverage against: – Loss due to expropriation – Nonconvertibility of profits – War or civil disorder www.StudsPlanet.com
  97. 97. 97 Dealing With Political Risk (cont’d) Avoid engaging in behavior that stirs up trouble with the host people or government: • Constructing flamboyant office buildings • Giving the impression of natural resource exploitation www.StudsPlanet.com
  98. 98. 98 Economic Risk Economic risk is a measure of a country’s ability to pay • Assess economic risk by: – Using coverage ratios – Assessing the country’s capital base www.StudsPlanet.com
  99. 99. 99 Other Topics Multinational corporations American depository receipts International mutual funds www.StudsPlanet.com
  100. 100. 100 Multinational Corporations Investing in a multinational corporation may provide a ready-made means of getting the risk-reduction benefits of international diversification • Research is unclear whether MNCs are better investments than purely domestic firms www.StudsPlanet.com
  101. 101. 101 American Depository Receipts American depository receipts (ADRs) are receipts representing shares of stock that are held on the ADR holder’s behalf in a bank in the country of origin • An alternative to purchasing shares in a foreign company directly on the foreign exchange By 2000, 1,534 ADRS from dozens of countries traded in the U.S. www.StudsPlanet.com
  102. 102. 102 International Mutual Funds Mutual funds permit diversification to an extent that would not otherwise be possible • Some mutual funds invest only in securities issued outside the U.S. • Buying an international mutual fund is a good way to achieve international diversification www.StudsPlanet.com
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