Post on 31-Dec-2015
Lecture 13 1
International Portfolio Investment
I. The Rationale for International Portfolio Investment
II. Avenues for International Investment
Lecture 13 2
International Portfolio Investment cont’d
I. The Rationale for International Portfolio Investment
** Internationally diversified portfolio less risky than purely domestic portfolio
Reason: Securities are less correlated across countries than within a country
Preliminaries: Measuring Risk and Return
Single Securities:• Expected Return
• Variance of Returns (Standard Deviation of Returns)
• Covariance of Returns
• Correlation between Returns
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Lecture 13 3
International Portfolio Investment cont’d
Portfolio Risk and Returns:
* Risk-averse investors hold well-diversified portfolio (not single securities)
• Expected Return of a Portfolio
• Variance (and standard deviation)
- Example - Two-asset case
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Lecture 13 4
International Portfolio Investment cont’d
Aside: The Variance, Covariances and Expected returns are based on the future.
Computing variances, covariances and returns based on historical data:
• Average (historical) return as proxy for Expected Return
• Historical Variance as proxy for (expected) Variance
• Historical Covariance as proxy for (expected) Covariance
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Lecture 13 5
International Portfolio Investment cont’d
Principles of Diversification:
• Generally, Riskiness of Portfolio (p) falls, as # securities increases
• The degree of risk reduction depends on the degree of correlation among security returns
• Example: Three Cases– Case 1: Perfect Negative Correlation ( = -1)
» Risk can be eliminated
– Case 2: Perfect Positive Correlation ( = 1)
» No benefit from diversification
– Case 3: Imperfect Correlation ( -1 < < 1)
» Diversification reduces risk
• The less correlated component securities, the less risky the portfolio
• Distinction between firm-specific and systematic risks
• Importance of covariance (reflection of systematic risk)
Lecture 13 6
International Portfolio Investment cont’d
Lecture 13 7
International Portfolio Investment cont’d
Correlation Structure of International Assets
• Returns display much lower correlations across countries than within a country– Risk reduction higher through international diversification
• The dynamic behavior of Correlations across countries– Correlation changes over time and varies across countries
– Does it increase over time?
– Evidence that correlation increases during volatile periods
– Impact on the potential diversification benefit
• Currency Risk and the Diversification Benefit– International investing involves risk of currency fluctuation
– Is the additional currency risk large enough to eliminate the diversification benefit?
• Market and currency risks not additive
• currency risk can be hedged
• currency risk lower in longer investment horizon
Lecture 13 8
International Portfolio Investment cont’d
Lecture 13 9
International Portfolio Investment cont’d
Lecture 13 10
International Portfolio Investment cont’d
Lecture 13 11
International Portfolio Investment cont’d
Another Look at the Case for International Investment:
• International Investment Expands the set of Profitable Investment Opportunities– improves the return-risk trade-off
– may reflect higher growth of economies, currency gains etc.
• Optimal International Portfolios and Measuring the gains from international investment
– The Efficient Frontier: Domestic vs International
– Sharpe Ratio: Excess return of a portfolio above the risk free asset per unit of portfolio risk
– Optimal international portfolios vary across countries (see Exhibit 11-13)
– Gain from international investment positive (see Exhibit 11-13)
Lecture 13 12
International Portfolio Investment cont’d
Lecture 13 13
International Portfolio Investment cont’d
II. Avenues for International Investment
Direct Purchase of Foreign Shares– High Transaction costs involved
• foreign exchange conversion, account custody, settlement, dividend collection etc.
– Information Problems - poor accounting and financial disclosure– Illiquid markets - difficult to divest– Not feasible for small investors
Cross-Listed Companies
American Depository Receipts (ADR) and (Global Depository Receipts (GDR)):
– Negotiable certificates issued by a U.S bank in U.S. to represent the underlying shares of stock, held in trust at a foreign custodian bank.
– Sold, registered, and transferred in U.S. in same way as any shares
– Prices of the share and the ADR consistent with each other (ADR exchangeable with the shares)
Lecture 13 14
International Portfolio Investment cont’d
– Advantages to investor include
• convenience
– avoid costs and difficulties of trading abroad
– avoid currency conversions
• conformity with the stringent U.S. reporting requirements
– Drawbacks include
• less liquidity (and high bid-ask spread)
• Limited number of Emerging Market ADRs
• ADRs traded in OTC - with less stringent reporting requirements
Mutual Funds
Open-End vs Closed-End Funds
Diversified vs Regional vs Country Funds
Lecture 13 15
International Portfolio Investment cont’d
Closed-End Country Funds (CECF)
- an investment vehicle for buying stocks of a particular market
(e.g. Korean Fund - an actively managed portfolio consisting of stocks of Korean companies)
- fixed number of shares, non-redeemable to the fund
- shares listed and traded in national market (price determined by demand and supply)
- fund’s market price may differ from its Net Asset Value (NAV)
FV = NAV + Premium/discount
• NAV - value of underlying securities held in the portfolio
• Premium/discount - excess of fund price over its net asset value
Lecture 13 16
International Portfolio Investment cont’d
Advantages of Closed-End Country funds include:
- Provide a simple way for accessing local markets
- overcomes trading difficulties
- Overcome foreign investment restrictions
- in countries where
- The closed-end status provides the funds more control on the timing of purchases and sale of securities
- particularly important for emerging markets
Disadvantage of CECF include
- fund price not NAV and the uncertainty of premium
Lecture 13 17
International Portfolio Investment cont’d
Open End Mutual Funds
-shares redeemable from the fund
-fund value equals NAV
Advantages (to shareholders):
- no premium to pay on shares
Disadvantage:
- risk that fund should liquidate its NAV if investors redeem shares
=> problematic in illiquid emerging markets
- managers impose high bid-ask spread, and limit redemption
Available only in liquid markets.
Lecture 13 18
International Portfolio Investment cont’d
World Equity Benchmark Securities (WEBS)
- an index portfolio designed to track country indices (MSCI indices)
- covers mostly developed country markets (currently includes Hong Kong, Malaysia, Singapore, Mexico)
- listed and traded on AMEX
WEBS vs other funds:
- Like closed-end funds, traded and listed on exchange
- unlike closed-end funds, no premium or discount• WEBS can be redeemed in kind (i.e they are open-end funds), which eliminates
potential premium/discount
– if WEBS trade at discount, investor can claim constituent shares, sell in open market and earn profit
– The arbitrage mechanism prevents occurrence of premium/discount– Like index funds, WEBS invest passively
• Expense ratio lower than closed-end fundsReference: http://www.websontheweb.com/
Lecture 13 19
International Portfolio Investment cont’d
Stocks of Multinational Firms– MNCs have internationally diversified operations
– An investor may reap the diversification benefit through holding securities of MNCs
– Depends on nature and extent of international involvement
• whether MNCs returns move more closely with domestic or foreign markets
• Returns of U.S. MNCs closely related to US stock market than foreign markets
– poor diversification vehicles (Jacquillat and Solnik(1978)
• Provide better diversification benefits in
– economically less diversified countries or
– countries with controls on cross-border portfolio investment
Lecture 13 20
International Portfolio Investment cont’d
Foreign Stock Index Futures and Other Derivatives– Future contracts on country stock indices (e.g. Hong Kong, South Africa
– Cost-effective way for short-term investment horizons
– marking to market
– margin requirements, 5-10% of contract value
– Advantages include:
• High liquidity
– provide market exposure through single purchase
– faster tactical asset allocation (market timing) decisions (compared to cash markets)
– lower settlement (delivery failure etc) risks (because, transactions settled by cash)
• Low cost
– transaction costs cheaper than in cash markets (e.g. U.S.)
– particularly significant for emerging markets where transaction costs of cash markets are much higher
Lecture 13 21
International Portfolio Investment cont’d
– no custody costs
– no withholding taxes
• help avoid foreign ownership restrictions
– Shortcomings include
• costly for long-term investment– maintenance costs
• limited number of emerging markets stock future indexes
– Other derivatives include: index options, stock index swaps etc.