11

Chapter Nineteen

International Securities Markets

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

22

The World Equity MarketThe World Equity Market

World equity markets grew rapidly from 1992 World equity markets grew rapidly from 1992 to 1999 to 1999

Peaked end of 1999Peaked end of 1999 Market capitalization (value) of developed Market capitalization (value) of developed

countries stock markets was $33 trillioncountries stock markets was $33 trillion 3 years later decreased to about $20.9 trillion 3 years later decreased to about $20.9 trillion Lot of money evaporated in 3 years timeLot of money evaporated in 3 years time

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The World Equity MarketThe World Equity Market Markets fluctuate with economic activity Markets fluctuate with economic activity Over time markets recover with the economyOver time markets recover with the economy World markets had a strong recovery in 2003World markets had a strong recovery in 2003 Developed world securities markets continue to Developed world securities markets continue to

expandexpand Major growth also in the “emerging” marketsMajor growth also in the “emerging” markets

• ArgentinaArgentina• BrazilBrazil• ChinaChina• TaiwanTaiwan• MexicoMexico

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55

Diversification BenefitsDiversification Benefits

Invest in foreign markets forInvest in foreign markets for diversificationdiversification Foreign markets do NOT move in harmony Foreign markets do NOT move in harmony

with each other with each other Diversified Diversified portfolio from many countries is portfolio from many countries is

less volatile than domestic portfolio - could less volatile than domestic portfolio - could even have a higher rate of returneven have a higher rate of return

WARNING – It does not always workWARNING – It does not always work In1987 market crashIn1987 market crash

19 of 23 markets declined more than 20%19 of 23 markets declined more than 20%

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Diversification Benefits Diversification Benefits cont.cont.

Low degree of correlation between the Low degree of correlation between the historical returns of different countrieshistorical returns of different countries

Richard Roll: Most significant factor relating Richard Roll: Most significant factor relating to the size of the market decline in each to the size of the market decline in each

country was the beta, country was the beta, ββ,, of that market to of that market to the world market indexthe world market index

No country continually outperforms the No country continually outperforms the others on an annual basisothers on an annual basis

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Degree of DiversificationDegree of Diversification

Measure correlation of stock movementsMeasure correlation of stock movements

Correlation Coefficient:Correlation Coefficient: Measures movement of one series of dataMeasures movement of one series of data

over time to another series of data -over time to another series of data -in this case stock market returnsin this case stock market returns

88

1 nCorrelatiot Coefficien1 CoefficientCoefficient RelationshipRelationship ImplicationImplication

11Perfect Perfect positivepositive

Two variables move Two variables move together up and downtogether up and down

-1-1Perfect Perfect

negativenegativeTwo variables move Two variables move opposite of each otheropposite of each other

00No No

relationshiprelationship

Assets with correlation coefficient of less than 1 reduce amount of risk

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Return Potential in International MarketsReturn Potential in International Markets

International International diversificationdiversification

Less risk exposureLess risk exposure Possible higher returnsPossible higher returns

1.1. Several countries had long-term growth Several countries had long-term growth rates superior to U.S. in terms of real GDP:rates superior to U.S. in terms of real GDP:

• SingaporeSingapore • ChinaChina• NorwayNorway

++

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Return Potential in International MarketsReturn Potential in International Markets

2.2. Many countries are highly competitive in Many countries are highly competitive in automobiles, steel, & consumer electronicsautomobiles, steel, & consumer electronics

Capital formation and Capital formation and potential investment opportunitypotential investment opportunity

Germany Germany JapanJapan FranceFrance CanadaCanada

3.3.Enjoy higher Enjoy higher

individual individual savings rates savings rates

than U.S.than U.S.

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Annualized rates of return of Annualized rates of return of selected indexes over 32-year periodselected indexes over 32-year period

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Current Quotations on Foreign Current Quotations on Foreign Market PerformanceMarket Performance

Track performance of selected world marketsTrack performance of selected world markets

1st index EAFE =Europe, Australia, FarEast1st index EAFE =Europe, Australia, FarEast Quotes are in local currencies & in U.S. $Quotes are in local currencies & in U.S. $ U.S. investors compare returns in U.S. U.S. investors compare returns in U.S.

against an investment in U.S. stock marketagainst an investment in U.S. stock market

Instructions to navigate msci website: on Power Point Instructions to navigate msci website: on Power Point tool bar click tool bar click ViewView, choose , choose Notes PageNotes Page

www.msci.com

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Other Market DifferencesOther Market Differences

CultureCulture Willingness to take riskWillingness to take risk Desire for dividend income versus growth in Desire for dividend income versus growth in

share valueshare value Number & type of companies available to Number & type of companies available to

stockholdersstockholders Bureaucratic differences Bureaucratic differences

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Other Market Differences cont.Other Market Differences cont.

Accounting conventions Accounting conventions Government regulation of marketsGovernment regulation of markets Problem with comparing P/E ratios: Problem with comparing P/E ratios:

Earnings calculated differently according Earnings calculated differently according to local or regional accountingto local or regional accounting

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Currency Fluctuations and Currency Fluctuations and Rates of ReturnRates of Return

Tracking foreign markets requires Tracking foreign markets requires adjustmentsadjustments

Reported returns adjusted for Reported returns adjusted for foreign currency effectsforeign currency effects How important is the foreign currency effect How important is the foreign currency effect

in relation to overall return performance in in relation to overall return performance in foreign currency? foreign currency?

Do foreign exchanges overpower actual Do foreign exchanges overpower actual return on investments in foreign countries?return on investments in foreign countries?

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Currency Fluctuations and Currency Fluctuations and Rates of ReturnRates of Return

Foreign currency effect is about 10 to 20% Foreign currency effect is about 10 to 20% as significant as the actual return as significant as the actual return performance in the foreign currencyperformance in the foreign currency

If dollar is rising/falling rapidly over a short If dollar is rising/falling rapidly over a short period the impact can be much greaterperiod the impact can be much greater

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Currency Fluctuations and Currency Fluctuations and Rates of Return Rates of Return

Investment in Switzerland: 10% return CHF declines by 5% against U.S. $ CHF profits are worth less in $Gain on investment: 110% (Investment with 10% profit) Adjusted value of CHF relative to U.S. $ = 0.95 =1.00 - 0.05 decline in currency 104.5% (= 110 x 0.95) of original investment Actual return in U.S. $ 4.5% instead of 10%

Swiss franc = CHF

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Currency Fluctuations and Currency Fluctuations and Rates of ReturnRates of Return

Examine currency effects in Sweden YTDExamine currency effects in Sweden YTD Return in local currency 4.58% (3Return in local currency 4.58% (3rdrd column) column) Return in U.S. $............. 6.31% (7Return in U.S. $............. 6.31% (7thth column) column) Change in $/SEK made a positive return in Change in $/SEK made a positive return in

kronor become a negative return in U.S. $kronor become a negative return in U.S. $

Swedish currency Krona (pl. Kronor) symbol SEK

See Table 19-8 next 2 slide

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Currency Fluctuations and Currency Fluctuations and Rates of ReturnRates of Return

Computed returns:Computed returns: 104.58% (Investment with 4.58% profit)104.58% (Investment with 4.58% profit) (Adjusted value of the SEK to U.S. $)(Adjusted value of the SEK to U.S. $)

0.896 (1.000 - 0.104 decline in currency)0.896 (1.000 - 0.104 decline in currency) 93.7% (= 104.58 x 0.896) 93.7% (= 104.58 x 0.896) of original of original

investmentinvestment

See Table 19-8 next slide

2020

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Other Obstacles to International Other Obstacles to International InvestmentsInvestments

Political RisksPolitical Risks Tax ProblemsTax Problems Lack of Market EfficiencyLack of Market Efficiency Administrative ProblemsAdministrative Problems Information ProblemsInformation Problems Corruption (not having an Eliot Spitzer!)Corruption (not having an Eliot Spitzer!)

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Political RisksPolitical Risks

Danger of nationalization of foreign firms Danger of nationalization of foreign firms Restriction of capital flows to investorsRestriction of capital flows to investors Violent overthrow of political party in power Violent overthrow of political party in power Not meeting their foreign debt obligations Not meeting their foreign debt obligations Check the political/economic climateCheck the political/economic climate

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Tax ProblemsTax Problems Foreign countries may impose 15 to 30% Foreign countries may impose 15 to 30%

withholding tax against dividends or interest withholding tax against dividends or interest paid to nonresidentspaid to nonresidents

Tax-exempt Tax-exempt U.S. investors can secure U.S. investors can secure exemption or rebate exemption or rebate

Taxable U.S. investors can claim a U.S. tax Taxable U.S. investors can claim a U.S. tax credit for taxes paid in foreign countriescredit for taxes paid in foreign countries

Inconvenience rather than loss of fundsInconvenience rather than loss of funds

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Lack of Market EfficiencyLack of Market Efficiency

U.S. capital markets the most liquid & U.S. capital markets the most liquid & efficient in the worldefficient in the world

Investors accustomed to trading on NYSE will Investors accustomed to trading on NYSE will find it difficult to adjust to foreign marketsfind it difficult to adjust to foreign markets

Larger spread between bid (sell) & ask (buy) Larger spread between bid (sell) & ask (buy) priceprice

Difficulty executing large transaction Difficulty executing large transaction Higher commission rates Higher commission rates

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Administrative ProblemsAdministrative Problems Adjusting to various local systemsAdjusting to various local systems

For example, For example, Hong Kong, Swiss, & Mexican stock markets Hong Kong, Swiss, & Mexican stock markets

settle account one day after the transaction settle account one day after the transaction London: two-week settlement London: two-week settlement Different administrative procedures add extra Different administrative procedures add extra

difficulty in executing tradesdifficulty in executing trades Avoid these difficulties by going through Avoid these difficulties by going through

mutual funds and other investment outletsmutual funds and other investment outlets

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Information ProblemsInformation Problems U.S. securities markets are the best at U.S. securities markets are the best at

providing investment informationproviding investment information S.E.C. has rigorous requirements for full S.E.C. has rigorous requirements for full

disclosure informationdisclosure information FASB continually providing pronouncements FASB continually providing pronouncements

on GAAP for financial reportingon GAAP for financial reporting Publicly traded companies required to Publicly traded companies required to

provide stockholders with fully audited provide stockholders with fully audited annual reportsannual reports

Evaluative reports/ratings by Moody’s, Evaluative reports/ratings by Moody’s, Standard & Poor’s, Value Line, & other firmsStandard & Poor’s, Value Line, & other firms

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Information ProblemsInformation Problems

Extensive economic data provided by Extensive economic data provided by governmental sources e.g.governmental sources e.g.• Department of CommerceDepartment of Commerce

• Federal Reserve SystemFederal Reserve System International firms in less sophisticated International firms in less sophisticated

foreign markets do not provide sufficient dataforeign markets do not provide sufficient data Language problems for the analystLanguage problems for the analyst

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Methods of Participating in Methods of Participating in Foreign InvestmentsForeign Investments

International investment International investment Investing in firms in foreign marketsInvesting in firms in foreign markets Purchasing foreign shares trading in U.S.Purchasing foreign shares trading in U.S. Mutual funds investing overseasMutual funds investing overseas Closed-end funds with global orientationClosed-end funds with global orientation Buying shares of multinational corporationsBuying shares of multinational corporations

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Methods of Participating in Methods of Participating in Foreign InvestmentsForeign Investments

Direct InvestmentsDirect Investments Indirect InvestmentsIndirect Investments

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Direct InvestmentsDirect Investments

Directly purchase shares of firm in foreign market Directly purchase shares of firm in foreign market Use foreign broker/overseas branch of U.S. brokerUse foreign broker/overseas branch of U.S. broker

Difficulties and administrative problems: Difficulties and administrative problems: Information-gathering problemsInformation-gathering problems Tax problemsTax problems Stock-delivery problemsStock-delivery problems Capital-transfer problemsCapital-transfer problems Communication difficulties in executing ordersCommunication difficulties in executing orders Sophisticated money manager follow this approachSophisticated money manager follow this approach

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Direct InvestmentsDirect Investments

Purchase shares of foreign firms that trade in Purchase shares of foreign firms that trade in U.S. stock markets (NYSE)U.S. stock markets (NYSE)

Purchase Purchase ADRsADRs

ADRs represent ownership interest ADRs represent ownership interest in a foreign company’s common stockin a foreign company’s common stock

Go to: Go to: 1. International1. International 2. Non-U.S. Listed Company Directory2. Non-U.S. Listed Company Directory

www.nyse.com

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Direct Investments - Direct Investments - Hyperlinks to some companies that Hyperlinks to some companies that

have ADRshave ADRs

www.alcan.com

www.honda.com

www.sony.com

www.britishairways.com

www.nortelnetworks.com

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Indirect InvestmentsIndirect Investments

Investments in international securities include: Investments in international securities include:

a)a) Purchasing shares of multinational corporationsPurchasing shares of multinational corporations

b)b) Mutual funds or closed-end investment funds Mutual funds or closed-end investment funds specializing in worldwide investmentsspecializing in worldwide investments

c)c) Investing in exchange traded funds (ETF) Investing in exchange traded funds (ETF)

d)d) Use a private firm specializing in foreign Use a private firm specializing in foreign investment portfolio managementinvestment portfolio management

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(a)- Purchasing Shares of (a)- Purchasing Shares of Multinational CorporationsMultinational Corporations

Firms with operations in several countriesFirms with operations in several countries Opportunity for international diversificationOpportunity for international diversification

• Major oil companiesMajor oil companies

• Large banking firms Large banking firms

• Large mainframe computer manufacturersLarge mainframe computer manufacturers

E.g. ExxonMobil 69.4% overseas salesE.g. ExxonMobil 69.4% overseas sales

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(b)- Mutual Funds and Closed-(b)- Mutual Funds and Closed-End Investment CompaniesEnd Investment Companies

Mutual funds offerMutual funds offer• Diversification Diversification

• Professional management Professional management Invest in closed-end investment Invest in closed-end investment

companies specializing in international companies specializing in international equity investmentsequity investments

May trade at premium/discount from NAV May trade at premium/discount from NAV Example - Japan FundExample - Japan Fund

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(c)- Exchange Traded Funds (ETFs)

Use ETFs to invest in international marketsUse ETFs to invest in international markets Biggest market the American Stock Exchange Biggest market the American Stock Exchange

Lists over 40 international funds Lists over 40 international funds ETF: basket of securities that track an indexETF: basket of securities that track an index Trades like an individual stock with all dayTrades like an individual stock with all day

• Trading Trading • Price trackingPrice tracking

www.amex.com

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Exchange Traded Funds (ETFs)

ETF mimics a major index, e.g.ETF mimics a major index, e.g.• Financial Times 100 for United KingdomFinancial Times 100 for United Kingdom• DAX for GermanyDAX for Germany

ETF can track ETF can track • A broad stock indexA broad stock index• Bond indexBond index• Industry indexIndustry index• Sector indexSector index

Lower costs Lower costs Better tax efficiency than mutual fundsBetter tax efficiency than mutual funds Ability to diversify using these fundsAbility to diversify using these funds

www.amex.com

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(d)- Specialists in International Securities

Large investors may engage services of firms with Large investors may engage services of firms with specialized expertise in foreign equities specialized expertise in foreign equities

BanksBanks Investment counselorsInvestment counselors

• Morgan Guaranty Trust Company Morgan Guaranty Trust Company • State Street Bank and Trust CompanyState Street Bank and Trust Company• Batterymarch Financial ManagementBatterymarch Financial Management• Fidelity Trust Company of New YorkFidelity Trust Company of New York

Minimum investment well in excess of $100,000 Minimum investment well in excess of $100,000 Cater to large institutional investorsCater to large institutional investors

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WebsiteWebsite CommentsComments

www.adr.comwww.adr.com

Provides screening &research Provides screening &research services for American services for American depository receiptsdepository receipts

www.amex.comwww.amex.com Exchange Traded FundsExchange Traded Funds

www.global-investor.comwww.global-investor.comProvides international news & Provides international news & information on foreign information on foreign marketsmarkets

cbs.marketwatch.comcbs.marketwatch.com Provides news on global Provides news on global marketsmarkets

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WebsiteWebsite CommentsComments

www.economist.comwww.economist.comGlobal magazine Global magazine providing news on providing news on markets and economicsmarkets and economics

www.wsj.comwww.wsj.comProvides information on Provides information on global markets and global markets and economicseconomics

www.oecd.orgwww.oecd.orgProvides international Provides international economic information and economic information and links to related siteslinks to related sites

www.www.rubiconrubicon.com.comProvides currency rates Provides currency rates and conversionsand conversions

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SummarySummary Diversify by investing in international

securities Different foreign markets influenced by

varying & contradictory factors Effective risk reduction

Example:Sharp & unexpected increase in energy pricesnegative impact on oil importers may beoffset by positive impact on oil exporters

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SummarySummary

Investments in selected foreign equity markets Investments in selected foreign equity markets may provide may provide

Excellent return opportunitiesExcellent return opportunities Many countries GDP growth rate is like U.S.Many countries GDP growth rate is like U.S. Greater savings rates Greater savings rates Higher capital formationHigher capital formation Consider currency fluctuationsConsider currency fluctuations RiskRisk