Chapter 19 – Globalization and International Investing
CHAPTER NINETEEN
GLOBALIZATION AND INTERNATIONAL INVESTING
CHAPTER OVERVIEW
This chapter notes that the United States offers a relatively small portion of the entire assets
available for investment purposes. In addition, the benefits of increased diversification as a result
of international investing are presented. International indexes are available for passive investing
purposes. Although exchange rate risk is present in international investing, exchange rate futures
allow a much of this risk to be hedged. This edition has a plethora of updated results concerning
the efficacy of passive international diversification. The results indicate that the benefits of
internationally diversifying are declining and are now rather modest. Moreover, the recent
financial crisis show once more that correlations increase in a market panic and it is very difficult
if not impossible to diversify away from U.S. market crash.
LEARNING OBJECTIVES
After studying this chapter, the student should understand the potential and real advantages of
international diversification, and be able to devise hedge strategies to offset currency risk involved
in international investing. The student should have a basic idea of how to decompose investment
returns into contributing factors such as country, currency, and stock selections.
CHAPTER OUTLINE
1. Global Markets for Equities
PPT 19-2 through PPT 19-6
This section presents some background and focuses on growth in international investing and
begins exploring the tie between market capitalization and growth. The growth of international
2. Risk Factors in International Investing
PPT 19-7 through PPT 19-20
One of the key elements of risk that is presented in the chapter is foreign exchange risk. It is not
possible to completely hedge for foreign exchange risk for equities because the returns that an
investor gets in foreign markets are not completely predictable. The emphasis on the material in
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Chapter 19 – Globalization and International Investing
A simple example illustrates this point:
The return is better because while the investor held the British investment, the pound increased in
forecast. In other words active managers should consider exchange rate risk.
Figure 19.2 displays information on how actual security returns for US investors have been
impacted by foreign exchange rates. Exchange rate movements have material affects on dollar
returns in some countries. The Carry Trade
The carry trade was very popular for a few years when Japan kept interest rates lower than U.S
unlikely that investors will invest in very risky assets for this type transaction however. The main
risk is that the yen increases in value by 3.75% – 0.24% = 3.51% or more. Even individual
investors in Japan were exploiting this risky arbitrage opportunity and many were hurt when the
yen rose during the financial crisis as for a time investors believed the yen was safer than the
dollar. The weakening of Japan’s economy in 2009 brought the yen back down. The 3.51% is an
The covered interest parity formula presents the no arbitrage condition required to eliminate
covered interest arbitrage:
Covered interest parity formula
transaction makes the process more transparent. This strategy works because the currency %
change is ($1.95 – $2.00) / $2.00 = -2.5% (pound depreciation) is not enough to offset the higher
British interest rate. In doing so one gains 10% – 6.15% = 3.85% on the interest rates and one
loses on 2.5% on the currency depreciation. It is riskless if steps 3 and 4 can be done
simultaneously. This is a violation of covered interest parity and it should not persist. Borrowing
countries from 0 (most risky) to 100 (least risky) are provided. Variables that are used in the
political risk scores are shown. Current ratings and the breakdown of political, financial and
economic risk scores are presented.
3. International Investing: Risk, Return, and Benefits from Diversification
PPT 19-21 through PPT 19-39
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Chapter 19 – Globalization and International Investing
Funds labeled “World” usually include U.S. investments; those labeled “International” exclude
U.S. investments. WEBS are low cost tradable investment alternatives that track performance in
an index in a country or region.
Several important questions concerning international investments are addressed in the text. The
central questions asked are;
standard deviation. The figure reveals imperfect correlations between standard deviation and beta.
The evidence of lower betas indicates that there may be diversification benefits from including
international investments into a U.S. portfolio. Are average returns higher in emerging markets?
Figure 19.5 indicates that Emerging markets generally have higher excess returns. Since some
had returns below the risk free rate we can reaffirm that risky returns may fall short of
Hedging currency risk can materially affect returns, particularly if a currency is over or
undervalued against many other currencies. The choice to hedge or not now becomes one of the
decision variables for an active manager but a well diversified passive portfolio may not need to
hedge.
Are there significant benefits to international diversification?
19.10, Hedged & Unhedged Correlations, indicate that international diversification benefits will be
19.13 and 19.14A contain the efficient frontier for two different levels of expected excess returns
consistent with historical results. Changing the expected excess return by varying the expected
excess return makes the slope of the CML larger because a higher excess return simply shifts the
curve upward. This graph also indicates only modest benefits from international diversification
from including developed markets.
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several studies as well. If this is so then diversification fails just when you need it most. This was
certainly true for the hedge fund Long Term Capital Management.
Conclusions:
A passive investment in all countries would not have lowered risk at all during the recent
crisis. This isn’t particularly surprising. We have always known that you could not
Hedging currencies has little effect either.
A U.S. stock market crash appears to be a systemic factor that cannot be diversified away
from in a crisis. (See the first bullet in this list.)
Correlations are on the increase due to globalization; nevertheless we still expect modest
international diversification benefits in normal markets.
Second level:
Optimize allocations across country portfolios to maximize diversification.
4. International Investing and Performance Attribution
PPT 19-40 through PPT 19-41
When assessing the performance of managers of international investment portfolios variations in
performance attribution discussed in Chapter 18 can be used:
An Excel model that allows a student to construct an efficient frontier for international
investments is available. It demonstrates the potential benefits of diversification.
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