Portfolio Theory and International Securities Markets

1. Portfolio Theory and International Securities Markets Short Review of Portfolio Theory Diversification and Globalization

2. The World Equity Market • World equity markets grew rapidly from 1992 to 2006 • Market capitalization (value) of developed countries stock markets was $33 trillion at year end 1999. By year end 2002 it was $20.9 trillion • By 2005 the developed markets had recovered and their market capitalization reached $36.5 trillion

3. The World Equity Market • Markets fluctuate with economic activity • Over time markets recover with the economy • World markets had a strong recovery in 2003 and continued into 2007. • Developed world securities markets continue to expand • Major growth also in the “emerging” markets • Argentina - Brazil - China – Taiwan -- Mexico

4. Emerging Markets Share2002 and 2005 • 2002 2005 • Mideast and Africa 18% > 31% • South Asia 12% > 14% • East Asia 48% < 29% • Eastern/Central Europe 7% > 11% • Latin America 15% = 15%

5. Diversification Benefits • Invest in foreign markets fordiversification • Foreign markets do NOT move in harmony with each other • Diversified portfolio from many countries is less volatile than domestic portfolio - could even have a higher rate of return As the world markets become more global, returns between countries may become more harmonized.

6. Diversification Benefits cont. • Correlation between the historical returns of different countries is less than 1.0 • Richard Roll: Most significant factor relating to the size of the market decline in each country was the beta, β, of that market to the world market index • No country continually outperforms the others on an annual basis

9. Developing an Efficient Portfolio Consider large number of portfolios based on • Expected value • Standard deviation • Correlations between the individual securities • A portfolio of 14 to 16 stocks is fully diversified • Portfolio theory was developed by Professor Harry Markowitz (1950s). Won the Nobel prize in 1990 for this work

11. Efficient Frontier Line • 4 points out of 8 possibilities lie on the frontier • ACFH delineates the efficient set of portfolios • It is efficient because portfolios on this line dominate all other attainable portfolios ACFH line: efficient frontier because portfolios on it provide best risk-return trade-off

13. Risk Reduction with International Securities

14. Capital Asset Pricing Model (CAPM) • Professor Sharpe advanced efficient portfoliosto capital asset pricing model • Assets value based on risk characteristics • CAPM takes off where efficient frontier stops • Introduce • New investment outlet • Risk-free asset (RF)

15. Risk-free (RF) Asset • Has no risk of default • Standard deviation of zero (-0-) • Lowest/safest return • U.S. Treasury bill • U.S. Treasury bond Zero risk CAPM combines risk-free asset & efficient frontier

16. Capital Market Line (CML) • RFMZ line capital market line (CML) • Formula for the capital market line See next slide Kp = Expected value of the portfolio σM = Market standard deviation RF = Risk-free rate KM = Market rate of return σP= Portfolio standard deviation

18. Return on an Individual Security Ki = Stock return, dependent variable, Y-axis ai (alpha) = Line intersects vertical axis bi (beta) = Slope of the line KM = Market return, independent variable, X-axis ei = Random error term ai + biKM : Straight line ei = Deviations, nonrecurring movements

19. Beta Beta is a measure of Risk relative to a market index. In the U.S. it is usually measured over 60 months against the broad Standard and Poor’s 500 Index.

20. Beginning Domestic Portfolio

21. Beginning Foreign Portfolio

22. 50% Domestic & 50% Foreign

23. The Best of Both Worlds

24. Correlation Coefficients Between Foreign Markets and U.S. Markets in $ Rates of Return

25. Correlations of Total Return between U.S. Markets and Emerging Markets in U.S. Dollars 2000-2005

26. Return Potential in International Markets + Less risk exposure Possible higher returns International diversification Several countries had long-term growth rates superior to U.S. in terms of real GDP: • Norway • Singapore • China

27. Returns in Developed Markets In U.S. $

28. 5 Yr. Returns in Emerging Marketsin U.S. $ 2000-2005

29. Return Potential in International Markets • Many countries are highly competitive in • automobiles, steel, & consumer electronics • Germany • Japan • France • Canada Enjoy higher individual savings rates than U.S. 3. Capital formation and potential investment opportunity

30. Annualized rates of return of world indexes over 32-yr. period 1969-2001

31. Current Quotations on Foreign Market Performance • Track performance of selected world markets • 1st index EAFE =Europe, Australia, FarEast • Quotes are in local currencies & in U.S. $ • U.S. investors compare returns in U.S. against an investment in U.S. stock market www.msci.com Instructions to navigate msci website: on Power Point tool bar click View, choose Notes Page

32. Other Market Differences • Culture • Willingness to take risk • Desire for dividend income versus growth in share value • Number & type of companies available to stockholders • Bureaucratic differences

33. Other Market Differences cont. • Accounting conventions • Government regulation of markets • Problem with comparing P/E ratios: Earnings calculated differently according to local or regional accounting

34. Currency Fluctuations and Rates of Return • Tracking foreign markets requires adjustments • Reported returns adjusted for foreign currency effects • How important is the foreign currency effect in relation to overall return performance in foreign currency? • Do foreign exchanges overpower actual return on investments in foreign countries?

35. Currency Fluctuations and Rates of Return • Foreign currency effect is about 10 to 20% as significant as the actual return performance in the foreign currency • If dollar is rising/falling rapidly over a short period the impact can be much greater

36. Currency Fluctuations and Rates of Return • Investment in Switzerland: 10% return • CHF declines by 5% against U.S. $ • CHF profits are worth less in $ Gain on investment: • 110% (Investment with 10% profit) • Adjusted value of CHF relative to U.S. $ • = 0.95 =1.00 - 0.05 decline in currency • 104.5% (= 110 x 0.95) of original investment • Actual return in U.S. $ 4.5% insteadof 10% Swiss franc = CHF

37. Currency Fluctuations and Rates of Return • Examine currency effects in Sweden YTD • Return in local currency 4.58% (3rd column) • Return in U.S. $............. 6.31% (7th column) • Change in $/SEK made a positive return in kronor become a negative return in U.S. $ See Table 19-8 next 2 slide Swedish currency Krona (pl. Kronor) symbol SEK

38. Currency Fluctuations and Rates of Return Computed returns: • 104.58% (Investment with 4.58% profit) • (Adjusted value of the SEK to U.S. $) 0.896 (1.000 - 0.104 decline in currency) • 93.7% (= 104.58 x 0.896) of original investment See Table 19-8 next slide

40. Other Obstacles to International Investments • Political Risks • Tax Problems • Lack of Market Efficiency • Administrative Problems • Information Problems • Corruption

41. Political Risks • Danger of nationalization of foreign firms • Restriction of capital flows to investors • Violent overthrow of political party in power • Not meeting their foreign debt obligations • Check the political/economic climate

42. Tax Problems • Foreign countries may impose 15 to 30% withholding tax against dividends or interest paid to nonresidents • Tax-exempt U.S. investors can secure exemption or rebate • Taxable U.S. investors can claim a U.S. tax credit for taxes paid in foreign countries • Inconvenience rather than loss of funds

43. Lack of Market Efficiency • U.S. capital markets the most liquid & efficient in the world • Investors accustomed to trading on NYSE will find it difficult to adjust to foreign markets • Larger spread between bid (sell) & ask (buy) price • Difficulty executing large transaction • Higher commission rates

44. Elkins/McSherry Global Universe of Transaction Costs Developed Markets 4 factors: price, commission, fees, mkt impact

45. Market Capitalization of Developed WorldMarkets (Year end 2005) in billions of U.S.

46. Market Capitalization of The Largest EmergingMarkets (year end 2005) in billions of U.S.

47. Market Capitalization of the Three Largest U.S. Companies in billions U.S.$

48. Automobile Industry Capitalization in Billions of U.S.$

49. Oil Industry Capitalization in Billions of U.S.$

50. Administrative Problems • Adjusting to various local systems For example, • Hong Kong, Swiss, & Mexican stock markets settle accounts one day after the transaction • London: two-week settlement • Different administrative procedures add extra difficulty in executing trades • Avoid these difficulties by going through mutual funds and other investment outlets