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Chapter 22

Chapter 22. International Investing. Chapter Summary. Objective: To show the importance of world markets and the benefits of international diversification. International investments Risk issues in international investing Measurement of international investing Integration of Markets.

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Chapter 22

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  1. Chapter 22 International Investing

  2. Chapter Summary • Objective: To show the importance of world markets and the benefits of international diversification. • International investments • Risk issues in international investing • Measurement of international investing • Integration of Markets

  3. Background • Global market • US Market represents about 50% of all markets • Canadian market, although the sixth-largest one, represents only 2.5% • Improved access & technology • New instruments • Emphasis for our investigation • Risk assessment • Diversification

  4. Issues • What are the risks involved in investment in foreign securities? • How do you measure benchmark returns on foreign investments? • Are there benefits to diversification in foreign securities?

  5. Diversification Benefits • Evidence shows international diversification is beneficial • It is possible to expand the efficient frontier above domestic-only frontier • Possible to reduce the systematic risk level below the domestic-only level

  6. Int’l Return Domestic * * * * * * * * Risk Efficient Frontier with International Diversification

  7. Risk Domestic International Securities Systematic Risk Level with International Diversification

  8. International Investment Choices • Direct stock purchases (institutional investors) • American Depository Receipts (ADRs) • International mutual funds • Open-end funds • Closed-end funds

  9. Summary Reminder • Objective: To show the importance of world markets and the benefits of international diversification. • International investments • Risk issues in international investing • Measurement of international investing • Integration of Markets

  10. Risks in International Investing Political Risks • Expropriation of assets • Restrictions on foreign exchange • Political instability

  11. Risks in International Investing Foreign Exchange Risk • Variation in return related to changes in the relative value of the domestic and foreign currency • Total return = investment return & return on foreign exchange • It is not possible to completely hedge a foreign investment

  12. Returns with FX • Return in Canada is a function of two factors 1. Return in the foreign market 2. Return on the foreign exchange

  13. Returns with FX (1 + rCAN) = (1 + rFM) (1 + rFX) rCAN = return on the foreign investment in Canadian Dollars rFM = return on the foreign market in local currency rFX = return on the foreign exchange

  14. Return Example: Dollar Appreciates Initial Investment : $20,000 Initial Exchange: $2.00/ Pound Sterling Final Exchange:$1.80/ Pound Sterling Return in British Security: 10% Return in Canadian Dollars (1 + rCAN) = (1.10) (.90) = .99 rCAN = -1%

  15. Return Example: Dollar Depreciates Initial Investment : $20,000 Initial Exchange: $2.00/ Pound Sterling Final Exchange: $2.10/ Pound Sterling Return in British Security: 10% Return in Canadian Dollars (1 + rCAN) = (1.10) (1.05) = 1.155 rCAN = 15.5%

  16. Hedging Foreign Exchange Risk • Canadian firm wants to protect against a decline in profit that would result from a decline in the UK pound • Estimated profit loss of $200,000 if the pound declines by $.10 • Short or sell pounds for future delivery to avoid the exposure

  17. Hedge Ratio in pounds $200,000 per $.10 change in the pound/dollar exchange rate $.10 profit per pound delivered per $.10 in exchange rate = 2,000,000 pounds to be delivered Hedge Ratio for Foreign Exchange Example Hedge Ratio in contacts Each contract is for 62,500 pounds or $6,250 per a $.10 change $200,000 / $6,250 = 32 contracts

  18. Summary Reminder • Objective: To show the importance of world markets and the benefits of international diversification. • International investing • Risk issues in international investing • Measurement of international investing • Integration of Markets

  19. Measuring Benchmark Returns • Indexes • EAFE Index • Issues in measuring performance • Weighting • Cross-Holdings • Other possibilities • Country and Region Funds

  20. Performance Attribution with International Investment Extension to consider additional factors • Currency selection • Country selection • Stock selection • Cash and bond selection

  21. Security Analysis with International Investments • Accounting rules and conventions complicate security analysis • Depreciation • Reserves • Consolidation • Taxes • P/E ratios

  22. Summary Reminder • Objective: To show the importance of world markets and the benefits of international diversification. • International investing • Risk issues in international investing • Measurement of international investing • Integration of Markets

  23. Integration of Security Markets • Integration - two markets respond to common factors (risk-return) • Segmentation – two markets respond to different factors • Canadian and U.S. markets are largely integrated (not entirely) • International markets are increasingly integrated – still segmented

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