Opportunities in international investments do not come free of risk or of the cost of spe- cialized analysis. The risk factors that are unique to international investments are exchange rate risk and political risk, discussed in the next two sections.
Exchange Rate Risk
It is best to begin with a simple example.
Example 25.1 Exchange Rate Risk
Consider an investment in risk-free British government bills paying 10% annual interest in British pounds. While these U.K. bills would be the risk-free asset to a British investor, this is not the case for a U.S. investor. Suppose, for example, the current exchange rate is
$2 per pound, and the U.S. investor starts with $20,000. That amount can be exchanged for £10,000 and invested at a riskless 10% rate in the United Kingdom to provide £11,000 in 1 year.
What happens if the dollar–pound exchange rate varies over the year? Say that dur- ing the year, the pound depreciates relative to the dollar, so that by year-end only $1.80 is required to purchase £1. The £11,000 can be exchanged at the year-end exchange rate for only $19,800 ( 5 £11,000 3 $1.80/£), resulting in a loss of $200 relative to the initial $20,000 investment. Despite the positive 10% pound-denominated return, the dollar-denominated return is a negative 1%.
We can generalize from Example 25.1. The $20,000 is exchanged for $20,000/ E 0 pounds, where E 0 denotes the original exchange rate ($2/£). The U.K. investment grows to (20,000/ E 0 )[1 1 r f (UK)] British pounds, where r f (UK) is the risk-free rate in the United Kingdom. The pound proceeds ultimately are converted back to dollars at the subsequent exchange rate E 1 , for total dollar proceeds of 20,000( E 1 / E 0 )[1 1 r f (UK)]. The dollar-denominated return on the investment in British bills, therefore, is
11r(US)5311rf (UK)4E1/E0 (25.1)
We see in Equation 25.1 that the dollar-denominated return for a U.S. investor equals the pound-denominated return times the exchange rate “return.” For a U.S. investor, the investment in British bills is a combination of a safe investment in the United Kingdom and a risky investment in the performance of the pound relative to the dollar. Here, the pound fared poorly, falling from a value of $2.00 to only $1.80. The loss on the pound more than offset the earnings on the British bill.
Figure 25.2 illustrates this point. It presents rates of returns on stock market indexes in several countries for 2009. The colored bars depict returns in local currencies, while
the dark bars depict returns in dollars, adjusted for exchange rate movements.
It’s clear that exchange rate fluctuations over this period had large effects on dollar- denominated returns in several countries.
Pure exchange rate risk is the risk borne by investments in foreign safe
assets. The investor in U.K. bills of Example 25.1 bears the risk of the U.K./U.S. exchange rate only. We can assess the magnitude of exchange rate risk by examining historical rates of change in various exchange rates and their correlations.
Table 25.3 A shows historical exchange rate risk measured from monthly percentage changes in the exchange rates of major currencies over the period 2000–2009. The data show that currency risk can be quite high. The annualized standard deviation of the per- centage changes in the exchange rate ranged from 9.65% (Canadian dollar) to 13.84%
(Australian dollar). The annualized standard deviation of returns on U.S. stocks for the same period was 17.08%. Hence, currency exchange risk alone would amount to between 57% and 81% of the risk on U.S. stocks. Clearly, an active investor who believes that Australian stocks are underpriced, but has no information about any m ispricing of the
9.212.7
0 10 20 30 40 50 60 70 80 90 100
Taiwan Hong Kong Norway Spain Netherlands Australia Canada Denmark France U.K.
Italy Germany New Zealand Ireland Japan Finland
%
Return (in U.S.$) Return (in local currency)
75.780.2 60.260.2
55.6 88.6
40.645.1 38.643.0
37.0 76.8
33.6 57.4
32.837.1 29.133.3
27.7 43.4
24.028.0 22.626.6
21.9 51.7
9.412.9 6.49.3
Figure 25.2 Stock market returns in U.S. dollars and local currencies, 2009
CONCEPT CHECK
1
Using the data in Example 25.1 , calculate the rate of return in dollars to a U.S. investor hold- ing the British bill if the year-end exchange rate is: ( a ) E15 $2.00/£; ( b ) E15 $2.20/£.
Australian dollar, would be advised to hedge the dollar risk exposure when tilting the port- folio toward Australian stocks. Exchange rate risk of the major currencies seems fairly stable over time. For example, a study by Solnik for the period 1971–1998 finds similar standard deviations, ranging from 4.8% (Canadian dollar) to 12.0% (Japanese yen). 4
In the context of international portfolios, exchange rate risk may be partly diversifi- able. This is evident from the relatively low correlation coefficients in Table 25.3B . (This observation will be reinforced when we compare the risk of hedged and unhedged country portfolios in a later section.) Thus, passive investors with well-diversified international portfolios may not need to hedge 100% of their exposure to foreign currencies.
The annualized average change in the value of the U.S. dollar against the major curren- cies over the 10-year period and dollar returns on foreign bills (cash investments) appear in Table 25.3C . The table shows that the value of the U.S. dollar consistently depreciated in this particular period. For example, the average rate of depreciation against the euro over the 10 years was 2.98%. Had an investor been able to forecast these large exchange rate movements, it would have been a source of great profit. The currency market thus provided attractive opportunities for investors with superior information or analytical ability.
The investor in Example 25.1 could have hedged the exchange rate risk using a forward or futures contract on foreign exchange. Recall that a forward or futures contract on for- eign exchange calls for delivery or acceptance of one currency for another at a stipulated
4 B. Solnik, International Investing, 4th ed. (Reading, MA: Addison Wesley, 1999).
A. Standard deviation (annualized)
Country Currency Euro (€) U.K. ( £) Japan ( ¥ ) Australia ($A) Canada ($C)
Standard deviation 10.66 9.84 10.13 13.84 9.65
B. Correlation matrix
Euro (€) U.K. ( £) Japan ( ¥ ) Australia ($A) Canada ($C)
Euro (€) 1.00
U.K. (£) 0.68 1.00
Japan (¥) 0.35 0.14 1.00
Australia ($A) 0.72 0.60 0.19 1.00
Canada ($C) 0.45 0.52 0.10 0.67 1.00
C. Average annual returns from rolling over 1-month LIBOR rates
Country Currency
Return in Local Currency
Gains from Exchange Rate
Movements
Average Annual Return in
U.S. $
Standard Deviation of Average Annual
Return
U.S. U.S. $ 3.15 3.15
Euro € 3.06 22.98 0.08 3.37
U.K. £ 4.47 0.46 4.93 3.11
Japan ¥ 0.25 22.75 22.50 3.20
Australia A$ 5.42 22.22 3.20 4.38
Canada C$ 3.28 22.75 0.53 3.05
Sources: Exchange rates: Datastream; LIBOR rates: www.economagic.com.
Table 25.3
Rates of change in the U.S. d ollar against major world currencies, 2000–2009
exchange rate. Here, the U.S. investor would agree to deliver pounds for dollars at a fixed exchange rate, thereby eliminating the risk involved with conversion of the pound invest- ment back into dollars.
Example 25.2 Hedging Exchange Rate Risk
If the forward exchange rate in Example 25.1 had been F 0 5 $1.93/£ when the investment was made, the U.S. investor could have assured a riskless dollar-denominated return by arranging to deliver the £11,000 at the forward exchange rate of $1.93/£. In this case, the riskless U.S. return would then have been 6.15%:
311rf (UK)4F0 /E05(1.10)1.93/2.0051.0615
You may recall that the hedge underlying Example 25.2 is the same type of hedging strategy at the heart of the spot-futures parity relationship first discussed in Chapter 22. In both instances, futures or forward markets are used to eliminate the risk of holding another asset. The U.S. investor can lock in a riskless dollar-denominated return either by investing in United Kingdom bills and hedging exchange rate risk or by investing in riskless U.S.
assets. Because investments in two riskless strategies must provide equal returns, we con- clude that [1 1 r f (UK)] F 0 / E 0 5 1 1 r f (US), which can be rearranged to
F0
E0511rf (US)
11rf (UK) (25.2)
This relationship is called the interest rate parity relationship or covered interest arbi- trage relationship, which we first encountered in Chapter 23.
Unfortunately, such perfect exchange rate hedging usually is not so easy. In our exam- ple, we knew exactly how many pounds to sell in the forward or futures market because the pound-denominated return in the United Kingdom was riskless. If the U.K. investment had not been in bills, but instead had been in risky U.K. equity, we would have known neither the ultimate value in pounds of our U.K. investment nor how many pounds to sell forward.
The hedging opportunity offered by foreign exchange forward contracts would thus be imperfect.
To summarize, the generalization of Equation 25.1 for unhedged investments is that 11r (US)5311r(foreign)4E1 /E0 (25.3) where r (foreign) is the possibly risky return earned in the currency of the foreign invest- ment. You can set up a perfect hedge only in the special case that r (foreign) is itself a known number. In that case, you
know you must sell in the forward or futures market an amount of foreign currency equal to [1 1 r (foreign)] for each unit of that currency you pur- chase today.
Political Risk
In principle, security analysis at the macroeconomic, industry, and firm-specific level is similar in all countries. Such analysis aims to provide estimates of expected returns and risk of individual assets and portfolios. However, to achieve the same quality of in formation
CONCEPT CHECK
2
How many pounds would the investor in Example 25.2 need to sell forward to hedge exchange rate risk if:
( a ) r (UK) 5 20%; and ( b ) r (UK) 5 30%?
about assets in a foreign country is by nature more difficult and hence more expensive.
Moreover, the risk of coming by false or misleading information is greater.
Consider two investors: an American wishing to invest in Indonesian stocks and an Indonesian wishing to invest in U.S. stocks. While each would have to consider macro- economic analysis of the foreign country, the task would be much more difficult for the American investor. The reason is not that investment in Indonesia is necessarily riskier than investment in the U.S. You can easily find many U.S. stocks that are, in the final analysis, riskier than a number of Indonesian stocks. The difference lies in the fact that U.S. financial markets are more transparent than those of Indonesia.
In the past, when international investing was novel, the added risk was referred to as political risk and its assessment was an art. As cross-border investment has increased and more resources have been utilized, the quality of related analysis has improved. A lead- ing organization in the field (which is quite competitive) is the PRS Group (Political Risk Services) and the presentation here follows the PRS methodology. 5
PRS’s country risk analysis results in a country composite risk rating on a scale of 0 (most risky) to 100 (least risky). Countries are then ranked by the composite risk measure and divided into five categories: very low risk (100–80), low risk (79.9–70), moderate risk (69.9–60), high risk (59.9–50), and very high risk (less than 50). To illustrate, Table 25.4 shows the placement of countries in the July 2008 issue of the PRS International Country Risk Guide. It is not surprising to find Norway at the top of the very-low-risk list, and small
5 You can find more information on the Web site: www.prsgroup.com. We are grateful to the PRS Group for sup- plying us data and guidance.
Rank in
July 2008 Country
Composite Risk Rating July 2008
July 2008 versus August 2007
Rank in August 2007 Very low risk
1 Norway 91.8 20.5 1
11 Canada 85.0 1.25 17
22 Japan 81.8 22 17
Low risk
35 United Kingdom 78.8 22 29
36 China 78.5 20.75 35
46 United States 76.5 2.75 57
70 Argentina 71.5 23 52
Moderate risk
82 Indonesia 69.0 20.5 83
94 India 67.3 23 79
114 Turkey 63.5 21.5 108
High risk
128 Lebanon 58.5 0.25 129
135 Iraq 53.0 4.25 137
Very high risk
140 Somalia 39.3 20.5 140
Source: International Country Risk Guide, July 2008, Table 1.
Table 25.4
Composite risk ratings for July 2008 versus August 2007
emerging markets at the bottom, with Somalia (ranked 140) closing the list. What may be surprising is the fairly mediocre ranking of the U.S. (ranked 46), comparable to China (36) and the U.K. (35), all three appearing in the low-risk category.
The composite risk rating is a weighted average of three measures: political risk, finan- cial risk, and economic risk. Political risk is measured on a scale of 100–0, while financial and economic risk are measured on a scale of 50–0. The three measures are added and divided by two to obtain the composite rating. The variables used by PRS to determine the composite risk rating from the three measures are shown in Table 25.5 .
Table 25.6 shows the three risk measures for five of the countries in Table 25.4 , in order of the July 2008 ranking of the composite risk ratings. The table shows that by politi- cal risk, the United States ranked second among these five countries. But in the finan- cial risk measure, the U.S. ranked last among the five. The surprisingly poor performance of the U.S. in this dimension was probably due to its exceedingly large government and balance-of-trade deficits, which put considerable pressure on its exchange rate. Exchange
Political Risk Variables Financial Risk Variables Economic Risk Variables Government stability Foreign debt (% of GDP) GDP per capita
Socioeconomic conditions Foreign debt service (% of GDP) Real annual GDP growth Investment profile Current account (% of exports) Annual inflation rate Internal conflicts Net liquidity in months of imports Budget balance (% of GDP) External conflicts Exchange rate stability Current account balance (% GDP) Corruption
Military in politics Religious tensions Law and order Ethnic tensions
Democratic accountability Bureaucracy quality Table 25.5
Variables used in PRS’s political risk score
Composite Ratings Current Ratings
Country August 2007 July 2008
Political Risk July 2008
Financial Risk July 2008
Economic Risk July 2008
Canada 83.75 85 86 42 42
Japan 83.75 81.75 77.5 46 40
China 80.5 78.5 67.5 48 41.5
United States 73.5 76.5 81 32 40
India 71 67.25 60.5 43.5 30.5
Table 25.6
Current risk ratings and composite risk forecasts Source: International Country Risk Guide, July 2008, Table 2B.
A. Composite risk forecasts
One Year Ahead Five Years Ahead
Country
Current Rating July 2008
Worst Case
Best Case
Risk Stability
Worst Case
Best Case
Risk Stability
Canada 85.0 80.8 87.8 7.0 78.0 90.8 12.8
Japan 81.8 78.3 85.0 6.8 75.5 89.0 13.5
China 78.5 72.3 80.3 8.0 63.3 83.3 20.0
United States 76.5 74.8 82.0 7.3 71.0 84.3 13.3
India 67.3 63.8 71.3 7.5 61.8 76.3 14.5
B. Political Risk Forecasts
One Year Ahead Five Years Ahead
Country
Current Rating July 2008
Worst Case
Best Case
Risk Stability
Worst Case
Best Case
Risk Stability
Canada 86.0 83.5 88.5 5.0 83.0 92.5 9.5
Japan 77.5 75.0 83.0 8.0 74.0 89.0 15.0
China 67.5 63.5 70.5 7.0 60.5 77.0 16.5
United States 81.0 79.0 87.0 8.0 77.0 87.5 10.5
India 60.5 59.0 65.5 6.5 61.0 72.5 11.5
Table 25.7
Composite and political risk forecasts
Sources: A:International Country Risk Guide, July 2008, Table 2C; B:International Country Risk Guide, July 2008, Table 3C.
rate stability, foreign trade imbalance, and foreign indebtedness all enter PRS’s computa- tion of financial risk. The financial crisis that began in August of 2008 was a striking vin- dication of PRS’s judgment; our initial surprise at the rank of the U.S. arose from a failure to carefully consider the underpinnings of their methodology.
Country risk is captured in greater depth by scenario analysis for the composite mea- sure and each of its components. Table 25.7 (A and B) shows 1- and 5-year worst-case and best-case scenarios for the composite ratings and for the political risk measure. Risk stabil- ity is based on the difference in the rating between the best- and worst-case scenarios and is quite large in most cases. The worst-case scenario can move a country to a higher risk category. For example, Table 25.7 B shows that in the worst-case five-year scenario, India was particularly vulnerable to deterioration in the political environment.
Finally, Table 25.8 shows ratings of political risk by each of its 12 components.
Corruption (variable F) in Japan is rated worse than in the U.S. but better than in China and India. In democratic accountability (variable K), China ranked worst, and the United States, Canada, and India best, while China ranked best in government stability (variable A).
Each monthly issue of the International Country Risk Guide of the PRS Group includes great detail and holds some 250 pages. Other organizations compete in supplying such evaluations. The result is that today’s investor can become well equipped to properly assess the risk involved in international investing.