Global Investing

Francis & Ibbotson Chapter 18: Global Investing 11

Slides by:

Pamela L. Hall, Western Washington University

Global InvestingGlobal Investing

Chapter 18


BackgroundBackground

International investing increases each year– Due to high returns available in other countries

– Offers international diversification

Involves all the same risks as domestic investing plus additional risks– Foreign exchange risk

– Sovereign risk

– International liquidity risk

– International information risk


Sovereign RiskSovereign Risk

Sovereign risk involves the possibility that– The foreign country’s government may collapse– Its legal system is inadequate– Its police force can not maintain order– The settlement process may occasionally break down– Other political upheaval may occur

Euromoney magazine ranks countries’ sovereign risk– As of March 2000 Luxembourg ranked as the

country with lowest risk and Afghanistan as the highest


Sovereign RiskSovereign Risk

Multinational investors require a higher rate of return from riskier countries– Large investors may be able to obtain a

guarantee from government officials– Mostly, however, investors refuse to

invest unless they expect a higher return to compensate them for the international risk premium


International Liquidity RiskInternational Liquidity Risk

Emerging financial markets often lack liquidity due to– Modest trading volume—significant intervals

between transactions

– Inexperienced and/or undercapitalized market-makers

– Insufficient legal systems

– Inability to quickly and economically clear security transactions

– Lack of access to international cash flows


Example: The 1999 Russian CrisisExample: The 1999 Russian Crisis

During 1996-1997 Russian stocks earned 143% By 1998 Russia was experiencing

– A decline in oil revenues

– A ballooning budget deficit

– Poor tax collections

In 1999 the ruble was devalued– Inflation zoomed to 56%

– Many businesses were bankrupt

– Government offered tax credit to pay for services

– Corporations used bartering to pay for services



Rubles were used less than IOUs, barter and other payment methods

Companies paid workers with chits to be used in company-owned shops or with product (to be used for barter)

Many Russians kept savings in the form of U.S. dollars



Russian government allowed its biggest oil company, Lukoil, to pay ½ its taxes with IOUs or veksels– Lukoil would later redeem for oil

Government paid for its goods and services with these veksels– Veksel brokers developed

• Bought veksels for rubles and resold to customers– Usually for 50% of face value


International Information RiskInternational Information Risk

More difficult to obtain information on international investments due to:– Language differences– Currency differences– Different weight and measurement systems– Different political systems– Length of time to deliver international mail– Unfamiliar geography– Different financial reporting techniques

Easier for an ‘insider’ to obtain information than an ‘outsider’


Foreign Exchange RiskForeign Exchange Risk

Currency exchange rates fluctuate continuously

Investment in country:

Return from investing in country via currency:

U.S. $ Yen DM Pound Local

United States 12.5 8.5 9.7 14.0 12.5

Japan 13.3 9.3 10.5 14.9 9.3

United Kingdom 13.8 9.7 10.9 15.3 15.3

Germany 12.3 8.3 9.5 13.8 9.5

France 12.3 8.4 9.5 13.9 12.7Most of these investments involve

foreign currency risk.

Contains no foreign

exchange risk—the

investment was made in the country’s

local currency.


Simple International DiversificationSimple International Diversification

A few dozen securities in your portfolio is sufficient for simple diversification– Diversifying across industries within a single country

doesn’t offer additional diversification benefits• Competing firms within a country tend to have high positive

correlation

Even though barriers to entry exist, international market segmentation tends to make international diversification beneficial

Solnik (1974) studied international diversification


Solnik’s Diversification StudySolnik’s Diversification Study

Examined stock returns from 8 countries over 5 years– Used random selection and equal weighting – Only invested using U.S. dollars—thus returns also include

foreign exchange risk

Results indicate– Randomly selecting stocks across countries is superior to

only investing in U.S. stocks– Randomly selecting stocks across countries and across both

countries and industries is superior to diversifying across industries

– Portfolios that are hedged against foreign exchange risk have only slightly less risk than unhedged portfolios


Portfolio Analysis of Two-Country Portfolio Analysis of Two-Country DiversificationDiversification

The lower (or more negative) the correlation coefficient between securities within a portfolio the more diversification benefits– In general, correlations between counties

are fairly low• Correlations between emerging markets are

lower than correlations in developing markets– Some negative correlation occurs between

emerging markets


International Efficient FrontiersInternational Efficient Frontiers

Consider the following international efficient frontiers– Some theoretically optimal portfolios may be unobtainable

due to government-imposed policies

U.S. markets

only

Developed markets

only

Emerging markets only—

dominates developed

markets due to low correlations and some very

high returns during sample

period.

All opportunities


Correlation Coefficient Correlation Coefficient Between Different CountriesBetween Different Countries

Solnik, Boucrelle & Fur (1996) [SBF] analyzed over 30 years of data from 4 countries and conclude– Correlations across countries are not stable over

time– Correlations seem to be tending upward

• World’s financial markets are becoming more integrated

– Standard deviations are also somewhat unstable– When financial markets’ volatility increases,

correlations between countries tends to increase temporarily


Correlation Coefficient Correlation Coefficient Between Different CountriesBetween Different Countries

SBL analyzed returns to a U.S. investor investing in Japan

s fluctuate between positive

and negative values.

Trend is toward an

increasing .


Fundamental Reasons for Low Inter-Country Fundamental Reasons for Low Inter-Country

Different countries have different– Political systems

• Capitalism vs. socialism

– Currencies– Foreign exchange regulations

• Fixed vs. floating exchange rates

– Trade restrictions • Import/export limitations

– Political alliances Different countries may be at different stages in their business

cycles– War vs. peace– Inflation, monetary/fiscal policies

Due to above issues, different countries’ security markets are not highly positively correlated


Do Multinational Corporations Provide Do Multinational Corporations Provide International Diversification?International Diversification?

The largest corporations in the world are multinational corporations (MNCs)– Will investing in MNCs offer a quick (and easy)

method for diversifying internationally?• No! The variability in a MNC’s stock returns are

largely determined by variations in the domestic stock market

– Between 69-93% of the variability is explained by domestic stock market index

» However, as the MNC’s sales outside its domestic country increase, the correlation with its domestic stock market tends to decrease


American Depository Receipts (ADRs)American Depository Receipts (ADRs)

Several fairly easy methods for obtaining international diversification include:– American Depository Receipts

• Evidence of ownership in a foreign corporation

– Created by J.P. Morgan in 1927

• Removes foreign exchange complications from international investing

– Bank collects dividends in foreign currency and converts to U.S. dollars

Some high volume ADRs include:

•BP-Amoco

•Volvo

•Nestle S.A.

•Toyota

•Nokia


Problems with ADRsProblems with ADRs

Some ADRs are highly liquid– If issued by well known international corporations– Sponsored by the issuer

• Pay the ADR fees

– Listed on an organized U.S. stock exchange

If the stock issuer does not sponsor the ADR– Investors must pay the ADR fees– May not provided financial statements in English– If trade OTC may not be very liquid

Some corporations purposely have their ADRs trade OTC– Avoids costly disclosure requirements and stringent U.S.

accounting conventions


Problems with ADRsProblems with ADRs

Corporate control can be an issue– Some depository banks are allowed to vote on

behalf of ADR shareholders

Price volatility may be high in the ADR issuer’s domestic country

Foreign income is typically subject to more complicated tax regulations

May be more difficult to follow foreign news Still subject to exchange rate risk

– Risk is hidden since the investor does not have to deal with it directly


Global Depository ReceiptsGlobal Depository Receipts

Patterned after ADRs except most are not denominated in U.S. dollars

Can be issued in any country and denominated in any currency

First issued in 1993 GDRs and ADRs represent only a small portion

of publicly traded foreign corporations– Thus, an investor might consider investing in

international mutual funds• None of these methods eliminates foreign exchange risk


International Investment CompaniesInternational Investment Companies

Some mutual funds specialize in international investments– Global funds—invest in both foreign and domestic

securities– International funds or foreign funds—invest primarily in

foreign securities• Regional foreign funds—invest only in foreign securities

from specific regions (Price New Asia Fund)• International style funds—invest in unique categories of

foreign securities (Fidelity Emerging Markets Fund)• Foreign index funds (Vanguard International Equity Index

Fund for Europe)

– Country funds—confine investments to securities in a single country (Korea Fund)


International Index FundsInternational Index Funds

iShares MSCI—shares in a mutual fund indexed to a stock market in a single foreign country– 17 different iShares MSCI mutual funds exist

• Each converts U.S. dollar investment into foreign currency, buys the stocks making up the country’s MSCI index, managers the fund, collect cash dividends and converts them to U.S. dollars, etc.

» Allows investors the ability to diversify internationally without dealing with foreign exchange transactions and stock-picking in a foreign market


Homemade International DiversificationHomemade International Diversification

Erunza, Hogan & Hung (1999) [EHH] analyzed how much international diversification a U.S. investor could achieve without leaving U.S. markets– Compared results to 7 developed markets

and 9 emerging markets– Conclude that U.S. investors are able to

achieve significant diversification• Able to mimic all developed markets and all

but 2 of the emerging markets


International Security Market LineInternational Security Market Line

If international financial markets are fully integrated, an asset’s international beta can be calculated as: i i

iworld's market portfolio

with world's market portfoliocorrelation SD

SDβ

Can use the MSCI world market index as a surrogate for the world market portfolio

Could calculate country betas If all individual security betas in each separate country were

averaged

Problem—all the world’s financial markets are not fully integrated Even the U.S. and Canadian markets are not fully integrated


International Arbitrage Pricing TheoryInternational Arbitrage Pricing Theory

Home bias occurs due to barriers to entry– Thus, international risk premiums exist for

each country

APT model can easily be extended to include international risk factors– Home bias can be included– Country-to-country PPP violations can be

included


The Bottom LineThe Bottom Line

International investors face additional risks compared to domestic investors– Country (or sovereign) risk– Liquidity risk

• Especially in emerging markets

– Foreign exchange risk– Lack of information

Buying shares in iShares MSCI or international mutual funds allows investors to passively diversify internationally

ADRs, GDRs and international mutual funds allow investors to invest internationally without dealing with foreign exchange transactions


The Bottom LineThe Bottom Line

If the world’s financial markets were fully integrated, the international SML would be be the same as the domestic SML– However, investors demand international risk premiums

International diversification offers advantages that outweigh the costs– Offers the dominant Markowitz efficient frontier

Caveats– Correlations between countries are unstable through time

– Correlations are likely to rise as world markets become more fully integrated

– Correlations increase as financial markets become more volatile

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