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The Global Economy and Investment Management

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The Global Economy and Investment Management

  1. 1. zimm_c01.qxd 10/8/02 9:08 AM Page 1 CHAPTER 1 The Global Economy and Investment Management EXECUTIVE SUMMARY Globalization, or more precisely, integration of financial markets implies the convergence of risk premiums between national mar- kets, sectors, and other market segments. In integrated financial markets, risk is priced consistently across national markets and currencies. The most important reason for increased integration is the liberal- ization and deregulation of capital markets, with relaxed invest- ment restrictions, free cross-border capital flows, and significantly lower transaction costs. Globalization affects expected risk premiums through three main channels: the profitability of firms, the structure of the mar- ket portfolio, and the pricing of global risk. Whether markets are integrated or (at least partially) segmented has important implications for the design of asset allocation strategies as well as the cost of capital of firms. This chapter gives a brief overview of the material covered in this book. 1
  2. 2. zimm_c01.qxd 10/8/02 9:08 AM Page 2 2 GLOBAL ASSET ALLOCATION MOTIVATION Financial markets have become increasingly globalized over the past two decades for a number of reasons, including: The globalization of the economies themselves. The broader recognition of the benefits of international diversi- fication. The decreasing role of purchasing power and foreign exchange risk in Western economies. The progress and internationalization of information technology and communication systems. The emergence of global trading systems. The decrease of information and transactions costs for interna- tional trades. The institutionalization of investors such as pension funds, mu- tual funds, and hedge funds, with a broad focus on international investments. The trend toward international investments is a natural conse- quence of the overall globalization of the economies and the interna- tional financial system. However, the question remains: How exactly are portfolio diversification strategies affected by the general trend toward globalization? GLOBALIZATION AND RISK Neglecting transaction costs and capital market imperfections, global portfolio decisions are determined by the risks and expected returns on national markets as well as global sectors. A first observation, well documented in numerous empirical studies, is that country-by- country correlations between global stock and bond market returns have substantially increased over the past decades. Alan Greenspan and Wall Street seem to be the leading indicators for what happens on
  3. 3. zimm_c01.qxd 10/8/02 9:08 AM Page 3 The Global Economy and Investment Management 3 the exchanges across the rest of the world (see Oertmann, 1997, for an interesting empirical study on this subject). This increase in correla- tions has dramatic effects on the risk of globally diversified portfolios. Global systematic risk has increased substantially. This implies that the international diversification benefits reported in the early studies by Grubel (1968), Levy and Sarnat (1970), and Solnik (1974c) have largely disappeared in recent years. From a practical standpoint, what are the investment implications: staying at home, taking a different asset allocation approach (e.g., a sector approach), or investing in nontraditional asset classes such as hedge funds, private equity, com- modities, or emerging markets? GLOBALIZATION AND EXPECTED RETURNS We cannot derive investment implications without taking expected re- turns into account. Asset allocation decisions always reflect a tradeoff between risk and expected returns. Globalization affects expected re- turns through three main channels: the profitability of firms, the struc- ture of the market portfolio, and the pricing of global risk. The first effect is immediately obvious: Globalization is a major force for the competitive power of firms, sectors, and countries; it determines their profitability, growth potential and, finally, expected returns. Second, globalization has a substantial effect on the industrial structure of na- tional economies (or international sectors), and consequently also af- fects the composition of the major stock market indices. Even ignoring the growth of alternative investments and mutual funds, the invest- ment universe has changed substantially over the past decade (e.g., due to numerous initial public offerings, or IPOs, and the associated growth of the information technology and communication sectors). This has had a substantial effect on the composition of the relevant market (or benchmark) portfolio, which in turn affects equilibrium expected returns on individual assets. Third, globalization affects the pricing of market risk (i.e., the unit price of nondiversifiable risk in the economy). The next section discusses this third channel in depth.
  4. 4. zimm_c01.qxd 10/8/02 9:08 AM Page 4 4 GLOBAL ASSET ALLOCATION GLOBALIZATION AND THE MARKET PRICE OF RISK In the development of the financial sector, new products (e.g., funds), markets, and financial instruments (e.g., derivatives) that have been introduced to transfer economic and financial risks could potentially affect the size of the risk premiums demanded by in- vestors. In addition, the emergence of institutional investors—acting under different constraints than private investors—has probably changed the aggregate risk tolerance of the market and, therefore, the magnitude and the temporal behavior of market risk premiums. But most important, the liberalization and deregulation of capital markets with relaxed investment restrictions, free cross-border capital flows, and significantly lower transaction costs has led to an increased integration of markets. In integrated markets, risk is priced consis- tently across national markets and currencies. Whether markets are integrated or (at least partially) segmented has important implications for asset allocation strategies. In integrated markets, there should be less room for tactical asset allocation strategies than in segmented markets—investors diversify their portfolios to reach their desired level of expected return. If markets are (partially) segmented, investors use active return bets to improve portfolio performance by over- weighting markets where they perceive attractive risk-return tradeoffs. However, to determine whether markets are integrated or seg- mented requires a joint test of integration and market equilibrium. In- tegration is conceptually related to the consistency of expected returns across markets or sectors, but expected returns must be de- rived from an underlying asset pricing model. The results of empirical tests for integration are notoriously hard to interpret because one cannot distinguish which of the two underlying hypotheses fails. TACTICAL ASSET ALLOCATION AND ESTIMATION RISK Portfolio optimization tools and simulation techniques are widely used to investigate the impact of alternative market assumptions and
  5. 5. zimm_c01.qxd 10/8/02 9:08 AM Page 5 The Global Economy and Investment Management 5 parameter specifications on the optimal asset allocation. If investors would fully agree on estimated returns, volatilities, and correlations of the relevant asset classes, they would passively hold the market portfolio. But most investors have individual views and opinions about markets and sectors, and thus over- and underweight selected asset categories relative to the market. In the aggregate, however, these categories must add up to the market portfolio. Thus, as in- vestors, we must ask: How can we incorporate the level and confi- dence of our individual estimates and forecasts to portfolio strategies consistent with capital market equilibrium? ABOUT THIS BOOK Chapter 2 contains an overview of international asset allocation and asset pricing models, including a discussion on currency hedging. It grew out of a series of lecture notes used by Peter Oertmann and Heinz Zimmermann in their international finance classes. Chapters 3 and 4 cover the observation that stock market volatility and corre- lation are substantially different in up and down markets. The two chapters contain detailed analyses of this empirical observation and discuss the implications for diversification strategies and risk man- agement. Chapter 5 describes an empirical methodology that is useful in im- plementing global asset allocation strategies. It empirically explores common economic determinants of returns (volatility drivers) as well as expected returns (value drivers) across international stock and bond markets. The empirical results lead to the conclusion that multi- ple sources of global economic risk affect both the variability of re- turns and the valuation on international stock and bond markets. To control the variance and measure the performance of an internation- ally diversified portfolio including both stock and bond positions, a framework with multiple global risk factors is preferable to the single- factor model specified in the international Capital Asset Pricing Model (CAPM).
  6. 6. zimm_c01.qxd 10/8/02 9:08 AM Page 6 6 GLOBAL ASSET ALLOCATION Chapter 6 presents an econometric test on the integration of stock markets. As mentioned, whether markets are integrated is important not only for tactical asset allocation strategies but also for corporations in optimizing their financial structure. The same methodology can be used to test whether new investment opportu- nities expand the risk-return menu from existing investments in an economically meaningful sense. Chapter 7 investigates whether emerging stock markets can be seen as integrated parts of the de- veloped worldwide stock markets. Chapter 8 addresses whether global sector diversification strate- gies produce risk-return patterns different from asset allocation rules defined in terms of national markets. This question is important not only for portfolio managers, but also for financial analysts. In Chapter 9, strategies exploiting a specific investment style-value and growth characteristics of stocks are analyzed in a global asset pricing framework by implementing active style rotation strategies. Finally, Chapter 10 shows how the approach originally developed in the Black-Litterman (1992) model can improve global asset allo- cation decisions. The approach combines a passive (market equilib- rium) approach with an investor’s subjective view of markets, based on his or her confidence in the forecasts. This is a useful methodol- ogy because it allows investors to take an intermediate view about the informational efficiency of markets.

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