Investments & Securities Chapter 19 Homework Risk Factors Are Mentioned And The Composite

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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

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

markets has been dramatic. Domestic opportunities account for less than 50 percent of

2. Risk Factors in International Investing

Chapter 19 – Globalization and International Investing

PPT 19-7 through PPT 19-21

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

the international area is on risk assessment and diversification opportunities. Returns from

foreign investment are a product of two factors. First, the return is a function of returns on the

foreign investment. Second, the return is a function of the exchange rate(s) at which cash flows

are converted. The two elements can be combined with the following formula:

A simple example illustrates this point:

The return is better because while the investor held the British investment, the pound increased

in value 5%. A similar example is provided that illustrates the effects of an appreciating dollar.

Table 19.3 indicates that standard deviations of the dollar versus other countries indicate that

currency risk is quite high. Exchange rate risk is roughly the same magnitude as the standard

r(For)][1r(US)1 +=+

Chapter 19 – Globalization and International Investing

The Carry Trade

The carry trade was very popular for a few years when Japan kept interest rates lower than U.S

and European interest rates and also engaged in currency interventions to keep the yen from

appreciating.

For example, suppose the yen LIBOR = 0.24% and U.S. $ LIBOR = 3.75%. An astute investor

may borrow yen at the yen rate, convert the borrowed funds to dollars and invest at $ LIBOR.

What can go wrong with this strategy? Two things, first, default on the dollar investment. It is

Chapter 19 – Globalization and International Investing

In addition to foreign exchange, other elements of risk are identified. The second major risk

factor is country specific risk. Risk factors are mentioned and the composite ratings from the

Political Risk Services (PRS) which publishes the International Country Risk Guide and rates

3. International Investing: Risk, Return, and Benefits from Diversification

PPT 19-22 through PPT 19-40

Chapter 19 – Globalization and International Investing

An expanding variety of investment vehicles are possible for international investing. While it is

possible to invest directly in foreign markets, given the complexity of risk assessment, taxes and

trading costs associated with direct investment, investors often choose to invest internationally

through investment companies. There are many choices available. Closed-end funds are

• Are emerging markets riskier?

Figure 19.3 contains the annualized standard deviation of investments across the globe ($

returns). According to the standard deviation investments in emerging markets are generally

riskier than in developed countries. Figure 19.4 contains betas of country returns. If we are

• 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

• Is foreign exchange important in international portfolios?

Hedging currency risk can materially affect returns, particularly if a currency is over or

• Are there significant benefits to international diversification?

Chapter 19 – Globalization and International Investing

Traditionally there have been thought that international diversification reduced risk to a large

degree. More recent findings reveal smaller benefits. It may be possible to expand the efficient

frontier when adding international investments to the portfolio and this is demonstrated in the

PPT. Diversification into foreign markets may afford opportunities to lower the level of

systematic risk when compared to a portfolio that is made up of only domestic stocks. Table

• Are diversification benefits preserved in bear markets?

There is an old saying that in a crash, “All correlations go to 1.” This saying is backed up by

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

diversify away from global systemic risk. Some economists had thought that the BRICs

Active Management

Active international management has two levels

First level:

• Security selection and asset allocation within each market are used to identify a country

portfolio superior to a country index.

Second level:

4. International Investing and Performance Attribution

Chapter 19 – Globalization and International Investing

PPT 19-41 through PPT 19-42

When assessing the performance of managers of international investment portfolios variations in

performance attribution discussed in Chapter 18 can be used:

The “Bogey” or benchmark portfolio typically used is the EAFE index (non-U.S. stocks). The

EAFE is the European, Australian, Far East Index.

• Currency Selection

Contribution to performance due to currency movements

• Country Selection

Contribution to performance due to choosing better performing countries

Excel Applications

An Excel model that allows a student to construct an efficient frontier for international

investments is available. It demonstrates the potential benefits of diversification.