Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
1
All the people like us are We,
And everyone else is They.
And They live over the sea,
While We live over the way.
But would you believe it?
They look upon We
As only a sort of They.
- Rudyard Kipling
2
Outline
Introduction
Why international diversification makes
theoretical sense
Foreign exchange risk
Investments in emerging markets
Political risk
Other topics related to international
diversification
3
Introduction
The marketplace of the twenty-first century
is global
U.S. equities represent only about 51% of the
worlds 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
4
Introduction (contd)
International investments carry additional
sources of risk
5
Why International
Diversification Makes Sense
Remembering Evans and Archer
Remembering capital market theory
6
Remembering
Evans and Archer
Portfolio theory works to the investors
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
7
Remembering
Evans and Archer (contd)
Totalrisk contains both systematic and
unsystematic risk
Evans and Archer show that holding 15 to 20
equity securities substantially reduces the
unsystematic risk
8
Remembering
Capital Market Theory
Utility,
risk, and return
Variance of a linear combination
Relationship of world exchanges
Fundamental logic of diversification
Other considerations
9
Utility, Risk, and Return
Unsystematicrisk 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
10
Variance of
A Linear Combination
Aslong as assets are less than perfectly
correlated, there will be diversification
benefits
More pronounced the lower the correlation
11
Relationship of
World Exchanges
For
U.S. securities, market risk account for
about 25% of a securitys total risk
12
Relationship of
World Exchanges (contd)
International
capital markets continue to
show independent price behavior
International diversification offers potential
advantages
Number of Securities
14
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
15
Fundamental Logic of
Diversification (contd)
The most securities investors can hold is
all of them
17
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
18
Definition
Foreignexchange risk refers to the
changing relationships among currencies
Modest changes in exchange rates can result in
significant dollar differences
19
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.
22
Investment Example (contd)
Solution: The purchase price in U.S. dollars is:
If the Australian dollar depreciates and you sell the shares, you will
receive:
23
From Whence
Cometh the Risk?
Role of interest rates
Forward rates
Interest rate parity
Covered interest arbitrage
Purchasing power parity
24
Role of Interest Rates
Real rate of interest
Inflation premium
Risk premium
25
Real Rate of Interest
The real rate of interest reflects the rate of
return investors demand for giving up the
current use of funds
26
Inflation Premium
The inflation premium reflects the way the
general price level is changing
27
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
28
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
29
Forward Rates (contd)
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
30
Forward Rates (contd)
Forward rate premium or discount:
31
Forward Rates (contd)
Example
32
Forward Rates (contd)
Example (contd)
34
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
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
37
Purchasing Power
Parity (contd)
Absolutepurchasing 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
38
Purchasing Power
Parity (contd)
Relative purchasing power parity states
that differences in countries inflation rates
determine exchange rates:
1 IF
S 1
1 ID
where S change in the spot exchange rate
I F foreign country inflation rate
I D domestic country inflation rate
39
Purchasing Power
Parity (contd)
A countrywith 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
40
Dealing With the Risk
The concept of exposure
Dealing with the exposure
41
The Concept of Exposure
Definition
Accounting exposure
Transaction exposure
Translation exposure
Economic exposure
42
Definition
Exposure is a measure of the extent to
which a person faces foreign exchange risk
43
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
45
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
46
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
48
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
49
Reduce or Eliminate
the Exposure
If the dollar is expected to appreciate
dramatically, an investor may reduce or
eliminate foreign currency holdings
50
Hedge the Exposure
Definition
Hedging with forward contracts
Hedging with futures contracts
Hedging with foreign currency options
51
Definition
Hedging involves taking one position in the
market that offsets another position
Covering foreign exchange risk means hedging
foreign exchange risk
52
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
54
Hedging With
Futures Contracts (contd)
Tohedge an investment, sell foreign
currency futures
55
Hedging With
Foreign Currency Options
Thereare 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 striking (exercise) price
56
Hedging With Foreign
Currency Options (contd)
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
60
Combining the Currency and
Market Decisions
Itis 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
64
Background
Over$20 billion is invested globally in
securities issued in underdeveloped
countries
66
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
67
Reducing Risk
Low correlations are attractive as a means
of reducing portfolio variability
Emerging markets show low correlation with
developed markets
68
Following the Crowd
Some professional money managers
carefully analyze emerging markets for:
Profit potential
Portfolio risk reduction
70
Incomplete
Accounting Information
Insome 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
71
Incomplete Accounting
Information (contd)
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
72
Foreign Currency Risk
Foreignexchange securities are
denominated in a foreign currency
Introduces foreign exchange risk for foreign
investors
E.g., Mexican peso crisis and Asian crisis
74
Weak Legal System
Low confidence in a countrys legal system:
Leads to increased uncertainty
75
Asymmetric Correlations
Correlationbetween emerging and
developed markets:
Increases during bear markets
77
Market
Microstructure Considerations
Liquidityrisk
Trading costs
Market pressure
Marketability risk
Country risk
78
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
82
Country Risk
Country risk refers to a countrys ability
and willingness to meet its foreign
exchange obligations
Especially important in emerging markets
83
Political Risk
Introduction
Factorscontributing to political risk
Macro risk versus micro risk
Dealing with political risk
84
Introduction
Politicalrisk is a measure of a countrys
willingness to honor its foreign obligations
A function of:
The stability of the governments and its leadership
Attitudes of labor unions
The countrys ideological background
The countrys past history with foreign investors
85
Introduction (contd)
Real (direct) investment is an investment
over which the investor retains control
E.g., a plant in a foreign country
87
Introduction (contd)
Modestforms 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
88
Factors Contributing
to Political Risk
Buy local attitude
Public attitude
Government attitude
89
Buy Local Attitude
Buylocal campaigns seek to make foreign
consumers buy local goods instead of goods
produced by a foreign firm or its
subsidiaries
90
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
91
Government Attitude
Unstable governments can lead to foreign
investors being a volatile political issue
Foreign investors can be blamed for local
problems
92
Macro Risk Versus Micro Risk
Macro risk refers to government actions that
affect all foreign firms in a particular industry
93
Dealing With Political Risk
Seeka foreign investment guarantee from
the Overseas Private Investment
Corporation
Provides coverage against:
Loss due to expropriation
Nonconvertibility of profits
94
Dealing With
Political Risk (contd)
Avoid engaging in behavior that stirs up
trouble with the host people or government:
Constructing flamboyant office buildings
95
Economic Risk
Economic risk is a measure of a countrys
ability to pay
Assess economic risk by:
Using coverage ratios
96
Other Topics
Multinational corporations
American depository receipts
International mutual funds
97
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
98
American Depository Receipts
American depository receipts (ADRs) are receipts
representing shares of stock that are held on the
ADR holders behalf in a bank in the country of
origin
An alternative to purchasing shares in a foreign
company directly on the foreign exchange
100