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Global Investing

Global Investing. Chapter 18. Background. International investing increases each year Due to high returns available in other countries Offers international diversification Involves all the same risks as domestic investing plus additional risks Foreign exchange risk Sovereign risk

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Global Investing

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  1. Global Investing Chapter 18 Chapter 18: Global Investing

  2. Background • International investing increases each year • Due to high returns available in other countries • Offers international diversification • Involves all the same risks as domestic investing plus additional risks • Foreign exchange risk • Sovereign risk • International liquidity risk • International information risk Chapter 18: Global Investing

  3. Sovereign Risk • Sovereign risk involves the possibility that • The foreign country’s government may collapse • Its legal system is inadequate • Its police force can not maintain order • The settlement process may occasionally break down • Other political upheaval may occur • Euromoney magazine ranks countries’ sovereign risk • As of March 2000 Luxembourg ranked as the country with lowest risk and Afghanistan as the highest Chapter 18: Global Investing

  4. Sovereign Risk • Multinational investors require a higher rate of return from riskier countries • Large investors may be able to obtain a guarantee from government officials • Mostly, however, investors refuse to invest unless they expect a higher return to compensate them for the international risk premium Chapter 18: Global Investing

  5. International Liquidity Risk • Emerging financial markets often lack liquidity due to • Modest trading volume—significant intervals between transactions • Inexperienced and/or undercapitalized market-makers • Insufficient legal systems • Inability to quickly and economically clear security transactions • Lack of access to international cash flows Chapter 18: Global Investing

  6. Example: The 1999 Russian Crisis • During 1996-1997 Russian stocks earned 143% • By 1998 Russia was experiencing • A decline in oil revenues • A ballooning budget deficit • Poor tax collections • In 1999 the ruble was devalued • Inflation zoomed to 56% • Many businesses were bankrupt • Government offered tax credit to pay for services • Corporations used bartering to pay for services Chapter 18: Global Investing

  7. Example: The 1999 Russian Crisis • Rubles were used less than IOUs, barter and other payment methods • Companies paid workers with chits to be used in company-owned shops or with product (to be used for barter) • Many Russians kept savings in the form of U.S. dollars Chapter 18: Global Investing

  8. Example: The 1999 Russian Crisis • Russian government allowed its biggest oil company, Lukoil, to pay ½ its taxes with IOUs or veksels • Lukoil would later redeem for oil • Government paid for its goods and services with these veksels • Veksel brokers developed • Bought veksels for rubles and resold to customers • Usually for 50% of face value Chapter 18: Global Investing

  9. International Information Risk • More difficult to obtain information on international investments due to: • Language differences • Currency differences • Different weight and measurement systems • Different political systems • Length of time to deliver international mail • Unfamiliar geography • Different financial reporting techniques • Easier for an ‘insider’ to obtain information than an ‘outsider’ Chapter 18: Global Investing

  10. Most of these investments involve foreign currency risk. Foreign Exchange Risk • Currency exchange rates fluctuate continuously Contains no foreign exchange risk—the investment was made in the country’s local currency. Chapter 18: Global Investing

  11. Simple International Diversification • A few dozen securities in your portfolio is sufficient for simple diversification • Diversifying across industries within a single country doesn’t offer additional diversification benefits • Competing firms within a country tend to have high positive correlation • Even though barriers to entry exist, international market segmentation tends to make international diversification beneficial • Solnik (1974) studied international diversification Chapter 18: Global Investing

  12. Solnik’s Diversification Study • Examined stock returns from 8 countries over 5 years • Used random selection and equal weighting • Only invested using U.S. dollars—thus returns also include foreign exchange risk • Results indicate • Randomly selecting stocks across countries is superior to only investing in U.S. stocks • Randomly selecting stocks across countries and across both countries and industries is superior to diversifying across industries • Portfolios that are hedged against foreign exchange risk have only slightly less risk than unhedged portfolios Chapter 18: Global Investing

  13. Portfolio Analysis of Two-Country Diversification • The lower (or more negative) the correlation coefficient between securities within a portfolio the more diversification benefits • In general, correlations between counties are fairly low • Correlations between emerging markets are lower than correlations in developing markets • Some negative correlation occurs between emerging markets Chapter 18: Global Investing

  14. International Efficient Frontiers • Consider the following international efficient frontiers • Some theoretically optimal portfolios may be unobtainable due to government-imposed policies Emerging markets only—dominates developed markets due to low correlations and some very high returns during sample period. All opportunities U.S. markets only Developed markets only Chapter 18: Global Investing

  15. Correlation Coefficient Between Different Countries • Solnik, Boucrelle & Fur (1996) [SBF] analyzed over 30 years of data from 4 countries and conclude • Correlations across countries are not stable over time • Correlations seem to be tending upward • World’s financial markets are becoming more integrated • Standard deviations are also somewhat unstable • When financial markets’ volatility increases, correlations between countries tends to increase temporarily Chapter 18: Global Investing

  16. Correlation Coefficient Between Different Countries • SBL analyzed returns to a U.S. investor investing in Japan Trend is toward an increasing . s fluctuate between positive and negative values. Chapter 18: Global Investing

  17. Fundamental Reasons for Low Inter-Country  • Different countries have different • Political systems • Capitalism vs. socialism • Currencies • Foreign exchange regulations • Fixed vs. floating exchange rates • Trade restrictions • Import/export limitations • Political alliances • Different countries may be at different stages in their business cycles • War vs. peace • Inflation, monetary/fiscal policies • Due to above issues, different countries’ security markets are not highly positively correlated Chapter 18: Global Investing

  18. Do Multinational Corporations Provide International Diversification? • The largest corporations in the world are multinational corporations (MNCs) • Will investing in MNCs offer a quick (and easy) method for diversifying internationally? • No! The variability in a MNC’s stock returns are largely determined by variations in the domestic stock market • Between 69-93% of the variability is explained by domestic stock market index • However, as the MNC’s sales outside its domestic country increase, the correlation with its domestic stock market tends to decrease Chapter 18: Global Investing

  19. American Depository Receipts (ADRs) • Several fairly easy methods for obtaining international diversification include: • American Depository Receipts • Evidence of ownership in a foreign corporation • Created by J.P. Morgan in 1927 • Removes foreign exchange complications from international investing • Bank collects dividends in foreign currency and converts to U.S. dollars • Some high volume ADRs include: • BP-Amoco • Volvo • Nestle S.A. • Toyota • Nokia Chapter 18: Global Investing

  20. Problems with ADRs • Some ADRs are highly liquid • If issued by well known international corporations • Sponsored by the issuer • Pay the ADR fees • Listed on an organized U.S. stock exchange • If the stock issuer does not sponsor the ADR • Investors must pay the ADR fees • May not provided financial statements in English • If trade OTC may not be very liquid • Some corporations purposely have their ADRs trade OTC • Avoids costly disclosure requirements and stringent U.S. accounting conventions Chapter 18: Global Investing

  21. Problems with ADRs • Corporate control can be an issue • Some depository banks are allowed to vote on behalf of ADR shareholders • Price volatility may be high in the ADR issuer’s domestic country • Foreign income is typically subject to more complicated tax regulations • May be more difficult to follow foreign news • Still subject to exchange rate risk • Risk is hidden since the investor does not have to deal with it directly Chapter 18: Global Investing

  22. Global Depository Receipts • Patterned after ADRs except most are not denominated in U.S. dollars • Can be issued in any country and denominated in any currency • First issued in 1993 • GDRs and ADRs represent only a small portion of publicly traded foreign corporations • Thus, an investor might consider investing in international mutual funds • None of these methods eliminates foreign exchange risk Chapter 18: Global Investing

  23. International Investment Companies • Some mutual funds specialize in international investments • Global funds—invest in both foreign and domestic securities • International funds or foreign funds—invest primarily in foreign securities • Regional foreign funds—invest only in foreign securities from specific regions (Price New Asia Fund) • International style funds—invest in unique categories of foreign securities (Fidelity Emerging Markets Fund) • Foreign index funds (Vanguard International Equity Index Fund for Europe) • Country funds—confine investments to securities in a single country (Korea Fund) Chapter 18: Global Investing

  24. International Index Funds • iShares MSCI—shares in a mutual fund indexed to a stock market in a single foreign country • 17 different iShares MSCI mutual funds exist • Each converts U.S. dollar investment into foreign currency, buys the stocks making up the country’s MSCI index, managers the fund, collect cash dividends and converts them to U.S. dollars, etc. • Allows investors the ability to diversify internationally without dealing with foreign exchange transactions and stock-picking in a foreign market Chapter 18: Global Investing

  25. Homemade International Diversification • Erunza, Hogan & Hung (1999) [EHH] analyzed how much international diversification a U.S. investor could achieve without leaving U.S. markets • Compared results to 7 developed markets and 9 emerging markets • Conclude that U.S. investors are able to achieve significant diversification • Able to mimic all developed markets and all but 2 of the emerging markets Chapter 18: Global Investing

  26. International Security Market Line • If international financial markets are fully integrated, an asset’s international beta can be calculated as: • Can use the MSCI world market index as a surrogate for the world market portfolio • Could calculate country betas • If all individual security betas in each separate country were averaged • Problem—all the world’s financial markets are not fully integrated • Even the U.S. and Canadian markets are not fully integrated Chapter 18: Global Investing

  27. International Arbitrage Pricing Theory • Home bias occurs due to barriers to entry • Thus, international risk premiums exist for each country • APT model can easily be extended to include international risk factors • Home bias can be included • Country-to-country PPP violations can be included Chapter 18: Global Investing

  28. The Bottom Line • International investors face additional risks compared to domestic investors • Country (or sovereign) risk • Liquidity risk • Especially in emerging markets • Foreign exchange risk • Lack of information • Buying shares in iShares MSCI or international mutual funds allows investors to passively diversify internationally • ADRs, GDRs and international mutual funds allow investors to invest internationally without dealing with foreign exchange transactions Chapter 18: Global Investing

  29. The Bottom Line • If the world’s financial markets were fully integrated, the international SML would be be the same as the domestic SML • However, investors demand international risk premiums • International diversification offers advantages that outweigh the costs • Offers the dominant Markowitz efficient frontier • Caveats • Correlations between countries are unstable through time • Correlations are likely to rise as world markets become more fully integrated • Correlations increase as financial markets become more volatile Chapter 18: Global Investing

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