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Lectures 12 and 13 International Asset Portfolios

Lectures 12 and 13 International Asset Portfolios. Galina A Schwartz Department of Finance University of Michigan Business School. Plan of Lectures 12 & 13. Levich, Chapters 14 and 15 Bond portfolio Risks: hedge or not to hedge? Equity portfolio major types of equity portfolios

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Lectures 12 and 13 International Asset Portfolios

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  1. Lectures 12 and 13International Asset Portfolios Galina A Schwartz Department of Finance University of Michigan Business School Finance 614: Lecture notes

  2. Plan of Lectures 12 & 13 • Levich, Chapters 14 and 15 • Bond portfolio Risks: hedge or not to hedge? • Equity portfolio • major types of equity portfolios • cross-country differences • Home country bias [over-investment in domestic assets] common for both types of international portfolios Finance 614: Lecture notes

  3. Bond Portfolio I • Two components of associated risk: [for un-hedged foreign bond] • 1. Variability in foreign bond prices [country interest rate risk] • 2. Variability in foreign exchange rate [central bank risk] • and the covariance between them [Levich, p. 495] • + exposure to changes in credit risk, exchange controls & the risk of default • Empirics [Facts] • International bond returns are weakly correlated • Three heavily concentrated markets: US, EU countries, Japan Finance 614: Lecture notes

  4. Bond portfolio II • Terms [Jargon]: • Non-hedged portfolios under-perform • Passively hedged portfolios • Passively hedged portfolios under-perform • Actively hedged portfolios [tactical or overlay] • Brady Bonds (1989) [to resolve emerging market debt issues] http://www.bradynet.com Finance 614: Lecture notes

  5. Bond Portfolio III: Brady bonds • Why Brady bond mechanism was possible? [collateralization of the debt was the key] • Emerging market defaults were the reality • The market value of the outstanding debt was  • Overall this market was small ( ~ 150 billion $) Finance 614: Lecture notes

  6. Brady Mechanism & Russian crisis of 1998 • Why Brady mechanism was not used with Russia? 1. Debt collateralization is essential for Brady mechanism It was hardly an option in Russia 2. Volume of Russian debt – high (~ 150 billion $) 3. Russian government capacity to service its debt? questionable… Finance 614: Lecture notes

  7. Equity portfolio I • Associated risks [similar to bond portfolios] Levich, p. 539 [compare to p. 495] • Institutional aspects • Market size • market concentration • trading volume • Transaction taxes • Transaction costs • clearing procedures (& costs) • settlement procedures (& costs) Finance 614: Lecture notes

  8. Equity portfolio II • Main types of Funds • Close-End and Open-End Funds • Country Baskets (CBs) • World Equity Benchmark Shares (WEBS) • Regional Funds • Industry Funds • Why do we observe the variety of Fund’s types? Finance 614: Lecture notes

  9. Equity portfolio III • Pricing, Levich, pp. 544-549 • Generalized capital asset pricing model (CAPM) Somewhat unrealistic assumptions: (no transaction costs & taxes, returns are in nominal terms existence of a risk-free asset investor utility depends only on expected return and risk) • Arbitrage pricing theory (APT) (a set of `factors` drives equity returns) Importance of financial variables as factors Finance 614: Lecture notes

  10. Home country biasPossible explanations • Barriers to international investment • Regulatory and tax reasons [& uncertainty] • High share of non-tradables in consumption • Substitution of investment in foreign assets by investment in multinational corporations (MNC) • Informational imperfections • Endogenous exchange rate risk [Risk increases in the volume of foreign exchange market, see midterm 2.2. & 2.3 ] Finance 614: Lecture notes

  11. To hedge or not to hedge? • Different incentives of bond & equity holders w.r.t. hedging foreign exchange risk exposure [Levich, p. 588, box 16. 1] • Bond holders – hedge • Equity holders – do not hedge Finance 614: Lecture notes

  12. Bonds and Equity international portfolios Common issues • Exposure to exchange rate risk • Exposure to country risk • Cross country regulatory & tax differences • Robust home country bias Finance 614: Lecture notes

  13. Summary of Lectures 12 & 13, I • Bonds and Equity international portfolio • Current trends • Increased correlation of returns in mature markets • Increased market volatility & • its correlation with high correlation of returns  Lower gains from diversification into mature markets Finance 614: Lecture notes

  14. Summary of Lectures 12 & 13, II • Bonds and Equity international portfolio • Current trends (continued) • Low correlation of returns in mature & emerging markets  diversification into emerging markets is profitable difficulty: ratings are not reliable. To diversify profitably one have to acquire information Finance 614: Lecture notes

  15. Next week (Lectures 14 and 15) • Importance of Financial Institutions • Summary of what we have learned • Final Exam will be distributed on Monday 12/11/2000 – due 12/20/2000 (or 12/22/2000?) Finance 614: Lecture notes

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