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Globalization and International Investing. 19. Bodie, Kane, and Marcus Essentials of Investments, 9 th Edition. 19.1 Global Markets for Equities. Background Global market U.S. stock exchanges make up roughly 40% of all markets Emerging market development Market capitalization and GDP.
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Globalization and International Investing 19 Bodie, Kane, and Marcus Essentials of Investments, 9th Edition
19.1 Global Markets for Equities • Background • Global market • U.S. stock exchanges make up roughly 40% of all markets • Emerging market development • Market capitalization and GDP
Table 19.1 Market Capitalization of Stock Exchanges, Developed Countries
Table 19.2 Market Capitalization of Stock Exchanges, Emerging Markets
Figure 19.1A Per Capita DGP and Market Capitalization as Percent of GDP, Log Scale 2000
Figure 19.1B Per Capita GDP and Market Capitalization as Percent of GDP, Log Scale 2010
19.2 Risk Factors in International Investing • Risks in Foreign Security Investment • Exchange rate risk • Uncertainty in asset returns due to movements in exchange rates between U.S. dollar and foreign currency • Country-specific risk • Political risk: Possibility of expropriation of assets, changes in tax policy, restrictions on exchange of foreign currency for domestic, etc. • Imperfect exchange rate risk hedging • Hard to hedge equities with variable rates of return
19.2 Risk Factors in International Investing • Dollar Depreciation Relative to Pound • If you invest in a British security and earn 10%, find the return in U.S. dollars given • Initial exchange rate: £ = $2 • Final exchange rate: £ = $2.10
19.2 Risk Factors in International Investing • Dollar Appreciation Relative to Pound • If you invest in a British security and earn 10%, find the return in U.S. dollars given • Initial exchange rate: £ = $2 • Final exchange rate: £ = $1.85
Figure 19.2 Stock Returns, U.S. Dollars and Local Currencies, 2010
Table 19.3 Rates of Change, U.S. Dollar versus World Currencies, 2002-2011
19.2 Risk Factors in International Investing • Carry Trade • Suppose yen LIBOR = .24%, USD LIBOR = 3.75% • An astute investor may borrow yen at the yen rate, convert the borrowed funds to dollars, and invest at dollar LIBOR • What can go wrong with this strategy? • Default • Yen increases in value by 3.75% − .24% = 3.51% or more
19.2 Risk Factors in International Investing • Covered Interest Arbitrage • U.S. interest rates 6.15%, British rates 10%, exchange rate $2/£; 1-year forward exchange rate for pound is $1.95/£ • How can you earn a riskless arbitrage profit based on these quotes? • Borrow $1 at 6.15%: will owe $1.0615 in 1 year • Convert $1 to pounds: $1/($2/£) = £.50 • Invest £.50 at 10%: Will yield £.50 x 1.10 = £.55 • Sell pound forward at $1.95: £55 x $1.95 = $1.0725 • Net: $1.0725 − $1.0615 = $.011/dollar
19.2 Risk Factors in International Investing • Covered Interest Parity • The spot-futures exchange rate relationship that prevents arbitrage opportunities • If the interest rates and exchange rates are in this relationship, no arbitrage is possible
Table 19.6 Current Risk Ratings and Composite Risk Forecasts
19.3 International Investing Risk, Return, and Benefits from Diversification • International Investment Choices • Direct stock purchases • Difficult for individual investors due to currency and tax issues • Mutual funds • Open end • World versus international funds • Higher expenses • Closed end • Country or regional funds • WEBS
Figure 19.3 Monthly Standard Deviation of Excess Returns, Developed and Emerging Markets, 2002-2011
Figure 19.4 Beta against U.S. Market of Developed and Emerging Markets, 2002-2011
Figure 19.5 Average Excess Dollar-Denominated Returns, Developed and Emerging Markets, 2002-2011
Figure 19.6 Information Ratios, Developed and Emerging Markets versus U.S. Dollar-Denominated Returns, 2002-11
Figure 19.7 Standard Deviation of Excess Returns, Dollar-Denominated and Local Currencies, 2002-2011
Figure 19.8 Market Beta against U.S. Using Dollar-Denominated and Local-Currency Excess Returns, 2002-11
Figure 19.9 Average Dollar-Denominated and Local-Currency Excess Returns, 2002-2011
19.3 International Investing: Risk, Return, and Benefits from Diversification • Diversification Benefits • Evidence shows international diversification is beneficial • Possible to expand the efficient frontier above domestic-only frontier • Possible to reduce the systematic risk level below the domestic-only level
Figure 19.10 Information Ratios against U.S. Computed from Dollar-Denominated and Local Currency Returns, 2002-2011
Table 19.10 Correlation of Foreign Investments with U.S. Returns over Time
Figure 19.12 Ex-Post Efficient Frontier of Country Portfolios
Figure 19.13A Efficient Frontier of Country Portfolios (World Expected Excess Return = .3% per Month)
Figure 19.13B Efficient Frontier of Country Portfolios (World Expected Excess Return = .6% per Month)
Figure 19.14A Regional Indexes around the Crash, 10/14/87-10/26/87
19.14B Beta and of Portfolios against Deviation of Monthly Return, 9/08-12/08
19.3 International Investing: Risk, Return, and Benefits from Diversification • Conclusions • Passive investment in all countries would not have lowered risk during recent crisis • Hedging currencies has little effect; U.S. stock market crash appears to be systemic factor that cannot be diversified away from in crisis • Correlations are increasing due to globalization; nevertheless, we still expect modest international diversification benefits in normal markets
19.3 International Investing: Risk, Return, and Benefits from Diversification • Active Management • First level • Security selection and asset allocation within each market to identify country portfolio superior to country index • Second level • Optimize allocations across country portfolios to maximize diversification
19.5 International Investing and Performance Attribution • The “Bogey” or Benchmark • EAFE index (non-U.S. stocks) • Currency Selection • Contribution to performance due to currency movements • Country Selection • Contribution to performance due to choosing better-performing countries
19.5 International Investing and Performance Attribution • Stock Selection • Measured as weighted average of equity returns in excess of equity index in each country • Cash/Bond Selection • Excess return due to weighting bonds and bills differently from benchmark weights
