Essentials of Investments: Chapter 19 - Globalization and International Investing

Essentials of Investments: Chapter 19 - Globalization and International Investing includes Risk Factors in International Investing, Exchange Rate Risk, Hedging Exchange Rate Risk, Political Risk.

INVESTMENTS | BODIE, KANE, MARCUSGlobalization and International

Investing

• The U.S accounts

for only about a third

Canada – make up about 62% of the world stock market.

• The weight of the U.S within this group

of six is 54%.

• Clearly, U.S stocks do not comprise a

fully diversified equity portfolio

• International investing provides greater

diversification opportunities

• It also carries some special risks

Figure 25.1 Per Capita GDP and Market

Capitalization as Percentage of GDP

• A developed stock market enriches the

population.

• Home-country bias:

– Investors frequently overweight

home-country stocks.

– They may even completely ignore

opportunities for international

diversification.

Issues

Foreign Exchange Risk

• Variation in return due to changes in

the exchange rate

• Foreign investments may yield more or

less home currency than expected

• A foreign investment is simultaneously

an investment in an overseas asset and in a foreign currency

Risk Factors in International Investing

Risk Factors in International Investing

1 Return expressed in

local currency

2 Return obtained when

local currency is exchanged for home currency

Two sources of

variation or

risk:

• Suppose the risk-free rate in U.K is 10%

and the current exchange rate is $2/£1.

• A U.S investor with $20,000 can buy

£10,000 and invest them to obtain

£11,000 in one year.

• If the £ depreciates to $1.80, the

investment will yield only $19, 800, a

• The equation shows that the return to

the U.S investor is:

– The pound-denominated return

– Multiplied by

– The exchange rate “return”

Example 25.1 Exchange Rate Risk

1 0

1 r US( ) 1 r UK f ( ) E

E

Figure 25.2 Stock Market Returns in U.S

Dollars and Local Currencies for 2009

Hedging Exchange Rate Risk

• Futures or forward markets are used to

hedge the risk.

• The U.S investor can make a riskless dollar

return either by investing in UK bills and

hedging exchange rate risk or by investing in

riskless U.S assets.

0 0

0 0

F

E

r US F

• In principle, security analysis at the

macroeconomic, industry, and

firm-specific level is similar in all

countries

• In practice, getting good information

about foreign investments can be

more difficult

• PRS Group (Political Risk Services)

assesses political risk by country

Political Risk

Risk Score

Table 25.6 Current Risk Ratings and

Composite Risk Forecasts

Forecasts

Table 25.7 Interpretation

• The table captures country risk through

scenario analysis

• Risk stability is based on the difference in

the rating between the best- and

worst-case scenarios

Component

Foreign Investment Avenues

• Purchase securities directly in the capital

markets of other countries

• American depository receipts (ADR)

• International mutual funds

• International ETFs

• For the overall portfolio, standard deviation

of excess returns is the appropriate

measure of risk

• For an asset to be added to the current

portfolio, beta (covariance with U.S

portfolio) is the appropriate measure of

risk

Figure 25.3 Monthly Std Deviation of Excess

Returns in Developed, Emerging Markets

Stocks, 2000–2009

Figure 25.5 Average Dollar-Denominated

Excess Returns

Asset Pricing Theory

• Figure 25.5 shows a clear advantage to

investing in emerging markets

• Results are consistent with risk ranking by

standard deviation, but not with ranking by

beta

• Beta rankings may fail because of

home-country bias, which dominates

international investing

• Correlations between countries suggest

international diversification is beneficial,

especially for active investors.

• Globalization may have caused higher

cross-country correlations.

• It’s possible to expand the efficient

frontier some.

• It’s possible to reduce the systematic

risk level below the domestic only level.

Benefits from International

Diversification

Diversification

Figure 25.8 Efficient Frontier of Country

Portfolios

Are Benefits Preserved in Bear Markets?

country-specific events.

• What happened in 1987? In 2008?

Figure 25.9 Regional Indexes around the

Crash, October 14–October 26, 1987

Figure 25.10 Beta and SD of Portfolios

Three Rules of Thumb

To passively diversify your portfolio, include

country indexes in order of:

1.Market capitalization (from high to low)

2.Beta against the U.S (from low to high)

3.Country index standard deviation (from

high to low)

international portfolios, 2000–2009

Performance Attribution

• The EAFE index is a commonly used

benchmark for portfolio performance.

• Measure the contribution of:

1.Currency selection

2.Country selection

3.Stock selection

4.Cash/bond selection

Attribution: International