Chapter 3SELECTING INVESTMENTS IN A GLOBAL MARKET
Chapter 3 Questions• Why should investors have a global perspective regarding their investments?• What has happened to the relative size of U.S. and foreign stock and bond markets?• How can investors compute returns on investments outside their home country?• What additional advantage is there to diversifying in international markets beyond the benefits of domestic diversification?
Chapter 3 Questions• What securities are available? What are their cash flow and risk properties?• What are the historical return and risk characteristics of the major investment instruments?• What is the relationship among the returns for foreign and domestic investment instruments? What is the implication of these relationships for portfolio diversification?
Computing Returns on Foreign Investments (1 + HCR) = (1+ FR) ( CER/IER)Where: HCR is the Home Country Return FR is the Foreign Return CER is the Current Exchange Rate IER is the Initial Exchange Rate
The Effect of Changing Exchange Rates• For U.S. investors, a foreign security’s return in its domestic market is not the “bottom line.”• Exchange rates have a major impact on the equivalent U.S. return on a foreign investment. – This is known as exchange rate risk• The key factor is the changing strength of the U.S. dollar vis-à-vis the foreign currency.
The Effect of Changing Exchange Rates• Stronger dollar: Income from foreign investments gets exchanged for fewer dollars over time, reducing net return for the U.S. investor.• Weaker dollar: Income from foreign investments gets exchanged for more dollars over time, increasing net return for the U.S. investor.
Why have a global perspective?• Broadened horizons. The foreign market for stocks and bonds is huge! – U.S. markets comprise less than half of the total available securities – More opportunities broaden the range of risk- return choices• Returns on non-U.S. securities have often exceeded U.S. securities – Higher returns on equities are explained by higher growth rates in some countries
Why have a global perspective?• Diversification with foreign securities can help reduce portfolio risk. – Since foreign investments are impacted by somewhat different forces than domestic investments, risks can be reduced.• It’s easier than ever before! – Barriers to global investing, both for companies and for individual investors, are getting smaller.
Relative Size of U.S. and Foreign Markets• The overall value of world financial markets has seen explosive growth ($2.4 trillion in 1969 to $70.9 trillion in 2003)• The U.S. share of the overall world financial markets has gone from well over half (65% in 1969) to about half (50% in 2003).• See Exhibits 3.2 and 3.3
Diversification in International MarketsRecall that diversification involves risk reduction. – Correlations range from +1 (perfect positive correlation) to –1 (perfect negative correlation) – By combining securities whose returns are not perfectly positively correlated with each other in a portfolio, the portfolio standard deviation characteristically falls. – The lower the correlation coefficient between investments, the greater the benefit of diversification.
Diversification in International Markets• Correlations between U.S. markets and major foreign markets are relatively low. – In bond markets, the correlations, while positive, are below +.50, on average (See Exhibit 3.6) – In equity markets, the correlations are a bit higher, but still relatively low with an average of about +.55 (See Exhibit 3.7)• The bottom line: there is considerable benefit to international diversification. – Portfolios that are diversified internationally tend to have substantially lower standard deviations.
Diversification in International MarketsSeveral words of caution:• Correlations vary greatly between pairs of counties. – As you might guess, there is a higher correlation between U.S. and Canadian returns than between U.S. and various European returns. – Not all international diversification is created equal!• Correlations are increasing over time. – As global competition and various regulatory barriers have fallen, correlations have increased.
Global Investment Choices• Money market securities• Capital market instruments (Debt)• Equity instruments• Derivatives• Managed investments
Money Market Securities• Typically very liquid, low-risk (and also relatively low return) investments• Mostly sold at a discount from their maturity value• Includes T-bills, which are sold in weekly auctions for various maturities
Capital Market Instruments: Fixed Income Investments• Except for preferred stock, fixed income securities are debts of the issuer.• Promise specified cash flows at pre- determined times. – Legal force behind the agreement varies by type of security and issuer, as does the corresponding risk borne by the investor.
Capital Market Instruments: Fixed Income InvestmentsMost fixed income instruments specify a number of features including the following: – The maturity date – the date that the obligation is to be fully repaid, according to its provisions. – The coupon – the income that the investor will receive each year. – The par value – the principal value of the obligation; usually the original value and also the amount to be returned to the investor on the maturity date.
Capital Market Instruments: Fixed Income Investments• U.S. Treasury Securities• U.S. Government Agency Securities• Municipal Bonds• Corporate Bonds• Asset-backed Securities
U.S. Treasury Securities• Bills, notes, or bonds - depending on maturity – Bills mature in less than 1 year – Notes mature in 1 - 10 years – Bonds mature in over 10 years• Highly liquid• Very low risk of default, so essentially no credit risk
U.S. Government Agency Securities• Sold by government agencies – Federal National Mortgage Association (FNMA or Fannie Mae) – Federal Home Loan Bank (FHLB) – Government National Mortgage Association (GNMA or Ginnie Mae) – Federal Housing Administration (FHA)• Not direct obligations of the Treasury – Still considered default-free and fairly liquid
Municipal Bonds• Issued by local governments – General obligation bonds (GOs) – Revenue bonds• Exempt from federal income taxes and often state income taxes – Popular instrument for high tax bracket investors.
Corporate Bonds• Debt securities issued by corporations.• Vary by: – Level of claim (security) – Credit quality (rated for default risk) – Term to maturity – Special features
Corporate Bonds: Secured or Unsecured?• Secured bonds feature some sort of collateral to protect the investor. – Mortgage bonds: backed by land and buildings – Collateral trust bonds: backed by financial assets – Equipment trust certificates: backed by specific pieces of equipment• Unsecured bonds or debentures are backed only by the firm’s promise to pay. – Subordinated debentures: lower priority claim – Income bonds: pay only if profits are earned
Corporate Bonds: Special Provisions• The bond contract (the indenture) may include several important provisions that can influence the actual maturity of the bond.• Call provision: allows the issuer to buy back or “call in” the bond prior to maturity at a specified call price – Bonds range from freely callable (can be called any time) to non-callable – Most have deferred calls, which are non-callable for a period of time, then freely callable
Corporate Bonds: Special Provisions• Sinking fund provision: requires the issuer to retire a portion of a bond issue prior to maturity. – Like a call provision, the investor would typically receive a specified call price under a sinking fund provision.• Both call provisions and sinking fund provisions can shorten the actual maturity of a bond.
Bond Ratings• Most bonds are rated for default, or credit risk by one or more rating agency. – Duff and Phelps, Fitch Investors Service, Moody’s, Standard & Poors (S & P)• Ratings from AAA to D, some agencies give slightly different modifiers or letters• Top four ratings (AAA down to BBB): Investment Grade Securities• Below the top four ratings: Speculative Grade Securities (High-yield or junk bonds)
Asset-Backed Securities• GNMA pass-through certificates: pass through the payments made on a pool of mortgages• Collateralized Mortgage Obligations (CMOs): securities that pass through payments made on mortgages, with specific distribution rules that apply to different classes• Other asset-backed securities, such as certificates for automobile receivables (CARs)
International Bond Investing• Eurobond: an international bond that pays cash flows in a currency not native to the country of issue – Eurodollar bonds are denominated in U.S. dollars, but sold outside of the U.S.• Yankee bond: a bond denominated in U.S. dollars, sold in the U.S., but issued by a foreign corporation or government• International domestic bonds: U.S. investor in a foreign bond, subject to exchange rate risk.
Preferred Stock• Classified as a fixed income security since yearly dividends are stipulated.• Preferred dividends are not legally binding, so preferred stock is technically not a debt.• Since corporations are loathe to miss a dividend, they are binding in practical terms.• Much of the outstanding preferred stock is held by other corporations. – 80% of dividends received by one corporation from another are excluded from taxable income
Equities• Returns are not contractual.• Instead, returns vary according to performance, and can be much better or much worse than fixed income investments.• Equity represents an ownership interest. – The owner gets as much or as little as is left over after all fixed and higher priority claims have been met.• Most common equity investment: Common Stock
Common Stock• Represents the ownership of a corporation• Relatively risky investment compared to fixed income securities• Investment considerations include choice of business group or sector and at industries within those broad groups – Business groups: Industrial firms, Utilities, Transportation firms, Financial Institutions
Foreign Equity InvestmentsSeveral means of obtaining an equity interest in foreign investments:• Through American Depository Receipts (ADRs)• Through direct investment in foreign shares listed on a U.S. or foreign stock exchange• Through indirect investment in international or global mutual funds
American Depository Receipts• Easiest way to acquire foreign shares• Certificates issued by a U.S. bank – Represent indirect ownership of shares of a foreign firm on deposit in a bank in the firm’s home country• Buy and sell in U.S. dollars• Dividends in U.S. dollars• May represent multiple shares• Very popular, about 2,000 ADR programs available in 2003
Direct Investment in Foreign Shares• The most difficult approach, especially when purchasing stock in the foreign country (in the foreign currency) and transferring back to the investor’s home country.• A growing number of foreign firms do list their stock directly on the NYSE.
International and Global Mutual Funds• Global funds: invest in both U.S. and foreign stocks• International funds: invest mostly outside the U.S.• Funds can specialize – Diversification across many countries – Concentrate in a segment of the world – Concentrate in a specific country – Concentrate in types of markets
Derivative SecuritiesThere are many types of derivative investments, including financial derivative securities whose payoffs are tied to various financial assets.• Options – Puts and calls• Futures contracts
Option ContractsPuts and calls• Give the owner the right to sell (put) or buy (call) a company’s stock within a specified period of time at a specified price (called the strike price).
Futures Contracts• Standardized contracts to make or take delivery of some financial (or other) asset in exchange a specified payment at a future date.• Payment not due until the future date, but margin (a good faith deposit) is required.• Futures contracts are often used to manage risk, especially the risk of changing interest rates.
Managed InvestmentsInvestment companies sell shares in themselves and use the proceeds to invest in other investment instruments.• Closed-end investment companies: offer a fixed number of shares.• Open-end investment companies (Mutual funds): offer fluctuating number of shares based on purchases/sales of fund shares. – Stock funds, Bond funds, Money market funds, Mixed funds
Managed Investments• Hedge Funds: typically act as a partnership where one partner manages funds for all other partners according to some investment strategy.• Venture capital pools: Similar to hedge funds, these partnerships obtain an equity interest in promising start-up or privately held firms.• Real Estate Investment Trusts (REITs): provides investors with an indirect means of investing in real estate.
Historic Return and Risk Characteristics• Historic investment results have been studied extensively.• We can see the historic risk/return relationship by examining rates of return for major classes of assets in the United States: 1. Large-company common stocks 2. Small-capitalization common stocks 3. Long-term U.S. government bonds 4. Long-term corporate bonds 5. Intermediate-term U.S. Treasury bills 6. U.S. Treasury bills
Summarizing the Historic Data• Examining recent history (1980-2003) confirms the relationship between risk and return. – The higher returning classes of investments (common stock, especially small-cap firms) have experienced higher average returns as well as greater volatility.• Adjusting for inflation, thereby creating real returns, shows a small positive real interest rate for even the lowest risk investment
Summarizing the Historic DataThe historical data also allows for the calculation of average premiums earned – Equity risk premium = Common Stock return minus T-bill return = 8.57% – Small-stock premium = Small stock return minus Large stock return = -0.58% – Horizon premium = Long-term T-bond return minus T-bill return = 4.93% – Default premium = Long-term Corporate bond return minus Int.-term T-bond return = 1.44%
World Portfolio PerformanceExamination of historical returns largely confirm expectations.• Riskier assets also have had higher average returns.• Coefficients of variation range widely, with the combined World Stock Index having a low CV, showing benefits of global diversification.• Correlations between asset returns vary by global regions, also showing the potential, but variant advantages to global diversification.