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Transcript of Chapter 21International Investing.ppt
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Chapter 21
INTERNATIONAL INVESTING
The Global Search
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Prospects for Global Investing
The world is being swept by a second wave of globalisation at the
beginning of the twenty first century. How would investors fare now?We believe that investors would fare better this time because of the
following fundamental geopolitical changes that have taken place in thisworld.
With the apparent demise of communism as a valid economicphilosophy, the threat of nationalisation and governmentexpropriation has decreased considerably.
With the passing of colonialism, tensions among developed
countries and between developed and developing countries havediminished.
Capitalistic philosophy is maturing, leading to a kinder systema system that mitigates some of the destabilising political
tensions that characterised free markets earlier.
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Of course, the world is not perfect and is plagued by a new set
of problems at the beginning of the third millennium. The relative
order imposed by colonial powers has given way to political
instability in many countries. More important, problems like
overpopulation, resurgence of nationalism, and environmental
pollution loom large. Notwithstanding these portents, we are fairly
optimistic about the prospects of global investing.
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Opportunities for Indian Citizens
From early, 2003, Indian citizens have been allowed to invest
abroad. To begin with, investment in mutual funds up to $25,000 in
a calendar year was permitted. Since then, the Reserve Bank of
India has enhanced the limit to $200,000 in a calendar year.
You can now invest in stocks, mutual funds, hedge funds, foreigncurrencies, foreign currency derivatives, insurance policies, and real
estate anywhere in the world. So, the vast array of financial
products in the global markets may be just a click away.
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Benefits of Global Investing
Attractive Opportunities
Diversification Benefits
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Risks in Global Investing
Political Risk
Currency Risk
Custody Risk
Liquidity Risk
Market Volatility
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Return on Foreign Investment
Formally, the rate of return in INR terms from investing in the ith
foreign market is as follows:
Ri,INR
= (1 +Ri) ( 1 + e
i) - 1
= Ri + ei + Riei
where Ri is the foreign currency rate of return in the ith foreign
market and eiis the rate of change in the exchange rate between the
foreign currency and the INR, ei
will be positive (negative) if the
foreign currency appreciates (depreciates) vis--vis the INR.
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Illustration of Return Calculation
To illustrate, suppose an Indian resident just sold shares of IBM he
purchased a year ago and earned a rate of return of 14 percent interms of the US dollar (R
i= 0.14). During the same period the US
dollar depreciated 4 percent against the INR (ei= -.04). The realised
rate of return in INR terms from this investment is:
Ri,INR
= (1 + 0.14) (1 - 0.04)1
= 1.0944 - 1 = .0944 or 9.44 percent
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Risk of Foreign Investment
The risk of foreign investment measured in terms of variance, is:
Var (Ri, INR) = Var (Ri) + Var (ei) + 2Cov (Ri, ei) + Var
where Var (Ri) is the variance of foreign currency rate of return, Var (e
i)
is the variance of the exchange rate change, Cov (Ri, e
i) is the
covariance between the foreign currency rate of return and the
exchange rate change, and Var reflects the contribution of the cross-product term,R
ie
i, to the risk of the foreign investment.
If the exchange rate remains unchanged, implying that ei is zero,
only one term, Var (Ri), remains on the right side of equation. From
this equation, it is clear that exchange rate change contributes to the
risk of foreign investment in three ways:
Its own volatility : Var (ei)
Its covariance with the returns in the foreign market: Cov (Ri,
ei)
Its contribution to the cross-product term: Var
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Empirical Evidence
Empirical evidence suggests the following:
Exchange rate uncertainty contributes more significantly to
the risk associated with foreign bond returns and less
significantly to the risk associated with foreign equity returns.
Exchange rate changes tend to covary positively with
foreign bond returns and, interestingly, negatively with
foreign equity returns.
The cross product term, Var, as expected contributes little
to volatility.
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Equilibrium in International Capital Markets
We can use the capital asset pricing model (CAPM) or the arbitrage
pricing theory (APT) to estimate expected returns in the
international capital market, just as we do for domestic assets.
However, these models have to be adapted to the international
context.
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Growing Importance of Global Factors
In recent years, stock markets across the world seem to have become
more closely aligned. Several factors have contributed to a higher
correlation between changes in stock prices in different countries.
Increase in cross-border trading
Multiple listing
Spurt in cross-border mergers and acquisitions Internet
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Investing in Developed Markets
You can buy stocks of domestically-oriented companies invarious developed markets as well as stocks of multinational
companies such as Coca Cola, Toyota, and Unilever. A convenient way of investing in major multinational
companies, not headquartered in the US, is to buy their
American Depository Receipts (ADRs).
If you find investing on your own to be dauntingas is the case with
most individual investors your best bet will be to invest through
mutual funds. In this context, the following options seem attractive:
Index funds
Exchange-traded funds like the World Equity BenchmarkSecurities (covering developed markets)
Just as equity investors seeking to diversify globally may buy ADRs,
bond investors wanting to diversify globally may find it convenient tobuy Yankee bonds.
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Investing in Emerging Markets
You can invest in emerging markets through mutual funds or on your
own. For most investors, the mutual fund route is the most sensible route.
While there are hundreds of emerging markets investment funds available,the following appear to be the more attractive options.
Close-ended mutual funds selling at a significant discount
Open-ended index funds like the Vanguard Emerging Markets
Index Fund. Exchange-traded funds like the World Equity Benchmark
Securities (covering emerging markets)
Although the mutual fund route is the generally recommended route for
individual investors, some investors love the excitement and challenge of
investing on their own. If you have such an inclination, you will find the
following tips useful: (a) Invest in countries that have low price-earnings
ratio, low price-to-book value ratio, and high dividend yield. (b) Choose
countries where political risk is diminishing. (c) Trade minimally. (d) Do
not hedge currency risk.
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How to Invest
To invest in equities abroad you need a bank account with a brank
that allows foreign remittances and an account with a domestic
broker who has a tie up with a foreign broker. Alternatively, you
must have an account with a foreign broker. (You can sign up
directly with an online broker abroad). You have to transfer the
investible amount to your brokerage account by filling up Form A2.
Once the money is transferred, you can buy shares online on your
trading screen. Likewise, you can sell shares online and transfer
money electronically to your bank account.
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How to Invest
Another option to invest in foreign securities is to buy a foreign exchange-
traded fund (ETF) listed on an Indian stock exchange. For example, the
Hang Seng BeES, an open-ended index scheme, which tracks the Hang
Seng index on a real-time basis is listed on the National Stock Exchange.
(Hang Seng index, comprising 42 stocks, is the benchmark of Hang Seng
BeES). Through Hang Seng BeES you can buy into China, the largest
manufacturing economy in the world. Hang Seng BeES NAV replicates
Hang Sengs total return index minus expenses on a currency adjustedbasis. The taxation rules that apply to Hang Seng BeES will be the same as
the ones applicable to buying or selling of non-equity mutual funds.
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Tracking Global Markets
Morgan Stanley capital International (MSCI) compilesindices for individual countries, regions, developed markets,emerging markets, and the entire world.
The premier MSCI benchmarks used by investment
managers to measure the performance of global markets areas follows:
The MSCI World Index
The MSCI EAFE (Europe, Australia, Far East) Index
The MSCI Emerging Markets Free Index.
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Summary
The world is being swept by a second wave of globalisationat the beginning of the twenty first century.
Within limits, Indian citizens can invest in various assets
abroad.
Global investing provides two advantage viz., attractive
opportunities and diversification benefits.
There are several risks which exist or become morepronounced in global investing: political risk, currency,
risk, custody risk, liquidity risk, and market volatility.
The rate of return in INR (Indian national rupee) terms
from investing in the ith
foreign market is:R
i,
INR= R
i+ e
i +R
ie
i
The risk of foreign investment measured in terms of
variance is:
Var (Ri,
INR) = Var (R
i) + Var (e
i) + 2Cov (R
i, e
i) +
Var
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With some adaptation, we can use the capital asset pricingmodel (CAPM) or the arbitrage pricing theory (APT) to
estimate expected returns in the International capital market.
In recent years, stock markets across the world have
become more closely aligned.
There is a bewildering range of investment options availableglobally for developed markets as well as emerging markets.
The premier Morgan Stanley Capital International (MSCI)
benchmarks used by investment managers to measure theperformance of global markets are as follows: the MSCI
World Index, the MSCI EAFE (Europe, Australasia, Far
East) Index, and the MSCI Emerging Markets Free index.