Understanding Foreign Exchange Risk and Portfolio Diversification in Global Investing Environments

1. Lecture 11 Return and Risk

2. Taking a Global Perspective • When investors buy or sell securities in othe countries, they also take exchange rate risk or currency risk • Fluctuation in currency value can be either a source of loss or profit • If the foregin currency strengthens, your returns will increase or vice versa

3. An Example • Suppose you purchased 100 shares of IBM at NYSE for $300 each. The dollar-rupee parity was 60 rupees a dollar at the that time. So your total investment in rupees was 100x$300 = $30000 x 60 =Rs.1800,000 • At the end of the year, IBM share price was $310, giving you $10 profit per share, your profit is = 100 x 10 = $1000x60 = Rs.60000 • But the dollar-rupee parity had jumped to 78 rupee a dollar, now your total investment is =100x310 = $31000 x 78 = Rs.2418000 • And your profit is 2,418,000-180,0000 = Rs.618,000 • Or in percentage = 618,000/1800,000 = .339 or 33.9%

4. Equation for calculating returns from foregin stocks • = [(P1/Po)x(C1/Co)] – 1 • [(310/300)x(78/60)] – 1 • [(1.03) x (1.3)] – 1 • 1.339 – 1 • 0.339 or 33.9% • P1 = Ending share price • Po = Beginning share price • C1 = Ending value of demestic currency • Co = Beginning value of domestic currency

5. Risk • Any investment involves some degree of uncertainty about future returns • Risk arises out of variability in returns • If an asset has no variability in returns, the assets is considered to be risk free like one year T-bills

6. Sources of Risk • A. Interest rate risk = variability in returns of securities resulting from changes in interest rates • Securities prices move inversely with interest rates [why]?

7. Interest rates and returns • 1. Increase in interest rates increases the required rate of return •  RRR=  Rf+Risk premium which reduces the prices of the securities (intrinsic value) • 2. It increases cost of borrowing and hence cost capital • 3. It reduces money supply which lower demand for securities and resultantly prices fall-

8. Sources of Risk • Market risk : variability in returns due to fluctuations in aggregate market • Recession, wars etc • Inflation risk • when purchasing power declines. • Inflation also leads to hike in interest rates because lenders demand more to compensate themselves for loss in purchasing power • Business risk = the risk of doing business in a particular industry. Like OGDC has a unique risk of falling oil prices

9. Sources of Risk • Financial risk = It is associated with the use of debt financing by companies. The larger the financial leverage, the larger will be the variability in returns • Liquidity Risk = Whether a particular security can be sold quickly and without price concession in the secondary market. • Exchange risk = for international investors, a source of risk come from exchange rate fluctuation

10. Sources of Risk • Country Risk = For international investors, economic and political stability, law and order situation are important consideration in the investment decision

11. Measuring Risk • The most commonly used measure of risk for securities is standard deviation • SD measure the total risk of a security or a portfolio • It measure deviations of each observation from the arithmetic mean

12. Standard Deviation

13. Interpretation • The 5.89 SD means that the security return can fluctuate between +/-5.89 from the mean value of 16% • More specifically, the return can fluctuate between 16 - 5.89 = 10.11 or 16 + 5.89 = 21.89 • Your return could fall to as low as 10.11% or could rise to 21.89 %

14. Realized Returns and risk from Investing