1 international financial management p g apte. 2 introduction the twentieth century has seen massive...

1

International Financial Management

P G Apte

2

Introduction• The twentieth century has seen massive cross-border

flows of capital. Cross border equity investment is a relatively recent phenomenon.

• The initial thrust to cross border flows of equity investment came from the desire on the part of institutional investors to diversify their portfolios globally in search of both higher return and risk reduction.

• Financial deregulation and elimination of exchange controls in a number of developed countries at the beginning of eighties permitted large institutional investors to increase their exposure to foreign equities.

3

Introduction• The decade of 1990's witnessed opening up of equity

markets of developing countries like South Korea, Taiwan, Indonesia and India to foreign investors albeit with some restrictions

• The trend towards global integration of equity markets is unmistakable though it is punctuated by intermittent crises and consequent investor retreat

• We investigate the determinants of foreign equity investment decision and address the issues related to capital market integration and valuation of foreign equities

4

ISSUERS FROM 2006 2007 2008 2009Q1

All Countries 371 499 392 57 Developed Countries 225 256 306 43

Developing Countries 124 216 79 9.5 China 52 62.4 15.6 6.4 India 10.3 22.9 12.0 0.0

S.Korea 7.4 5.3 1.2 1.0 Brazil 10.9 38.0 14.9 1.0

ANNOUNCED INTERNATIONAL EQUITY ISSUES (US $ BILLION)

5

World Market Capitalization

0

5

10

15

20

25

30

35

40

1984 1988 1993 1999

U.S. U.K. Japan Other Developed Emerging

US

$ T

rill

ions

$3.4

$9.7$14.1

$36.0

46.2%

8.1%

12.6%

24.6%

8.4%

5.0%18.2%40.2%

7.9%28.7%

4.2%15.2%19.4%

7.1%54.1%

11.6%21.9%21.3%

8.2%37.0%

6

India - Inward Investment (US $ million)

Item 2000-01 2001-02 2002-03 2003-04 2004-05 Direct 4029 6130 5035 4673 5535Investment

Portfolio 2760 2021 979 11377 8909 Investment

GDRs/ADRs 831 477 600 459 613

FIIs ** 1847 1505 377 10918 8280

Offshore 82 39 2 --- 16Funds and others

TOTAL 6789 8151 6014 16050 14444

7

OverviewA Private Investor’s Viewpoint

• Policy Matters - Private Investors– What Factors Favor Overweighting Foreign

Markets in Portfolios?– What Factors Favor Overweighting Home

Markets in Portfolios?– Is Investment in MNCs a Close Substitute

for International Investment?– Can Investors Create “Homemade”

International Diversification?

8

OverviewA Private Investor’s Viewpoint

– Can Investors Count on International Diversification Gains in the Future?

– Are Emerging Markets Integrated with World Capital Markets?

• Policy Matters - Public Policymakers– Equity Market Trading Arrangements– Diversity in Accounting Principles and

Disclosure Practices

9

International Investment Vehicles

Direct Purchase of Foreign Shares– This route is usually reserved for large

institutional investors because of the additional considerations involved.

10

International Investment VehiclesDepositary Receipts (ADRs, GDRs)

– After a bank has taken custody of foreign shares in its foreign office, ADRs/GDRs can be issued as claims against the foreign shares.

– The issuing bank services the ADRs/GDRs by collecting all dividends (in the issuing company’s home currency), rights offerings, etc., and distributing the proceeds to investors in a convertible currency such as USD.

– In a sponsored ADR, the foreign firm pays a fee to the depositary bank to cover the cost of the ADR program, while in an unsponsored ADR, the issuance of the ADR is demand driven.

– ADRs are directed at US based investors and issued in US while GDRs are issued outside US and are targeted at global investors. The main difference is in regulatory framework, disclosure requirements, accounting standards etc.

11

International Investment VehiclesClosed-End and Open-End Mutual Funds

– Mutual funds that invest in foreign stocks can be grouped into several categories from a U.S. perspective:Global - Investing in U.S. and non-U.S. shares.International - Investing in non-U.S. shares only.Regional - Investing in a geographic area.Country - Investing in a single country.Specialty - International investments in an

industry group such as telecommunications, or special themes such as newly privatized firms.

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– An open-end fund stands ready to issue and redeem shares at prices reflecting the net-asset-value of the underlying foreign shares.

– A closed-end fund issues a fixed number of shares against an initial capital offering. The shares then trade in a secondary market at prices reflecting a premium or discount relative to the net-asset-value of the underlying foreign shares.

13


World Equity Benchmark Shares (WEBS)– WEBS represent shares in an index fund

that is intended to track the performance of a single country index.

– Like an open-end fund, the size of the WEBS fund can grow without limit, but the shares are traded on an exchange at any time of the day like a closed-end fund.

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Equity Financing in Global Markets

• Since many Indian companies have accessed the global equity market primarily for establishing their image as global companies, the major consideration has been visibility and post-issue considerations related to investor relations, liquidity of the stock (or instruments based on the stock such as depository receipts which are listed and traded on foreign stock exchanges) in the secondary market and regulatory matters pertaining to reporting and disclosure

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• Other relevant considerations are the price at which the issue can be placed, costs of issue and factors related to taxation

• With segmented markets, the price that can be obtained would vary from one market to another

• When the issue size is large, the issuer may consider a simultaneous offering in two or more markets

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Equity Financing in Global Markets• Issue costs are an important consideration

• Shares of many firms are traded indirectly in the form of depository receipts e.g. GDR and ADR .

• After a hesitant start in 1992 following the experience of the first ever GDR issue by an Indian corporate , a fairly large number of Indian companies have raised equity capital in international markets

• In recent years, a major driving force has been the desire of Indian IT companies to make acquisitions in the US. The ADS are used as “acquisition currency” in share swaps. For this purpose the ADRs must be listed and actively traded

17

Equity Financing in the International Markets

Subscribers,Lead Managers etc

Depository

Company

Custodian

GDR Holders Nominee for Euroclear and Cedel

Hold the American GDR and Register it in the Name of DTC

The GDR Mechanism

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• From the point of view of the issuer, GDRs and ADRs represent non-voting stock with a distinct identity which do not figure in its books

• There is no exchange risk for the issuing firm since dividends are paid by the issuer in its home currency. Exchange risk is borne by the investors.

• Apart from imparting global visibility, the device allows the issuer to broaden its capital base by tapping large foreign equity markets

19

GDRs / ADRs

Year No. of Issues

Amount(Rs.Crore)

Amount($ mln)

2004-2005 14 4435.45 915.47

2005-2006 56 15895.91 3280.89

2006-2007 21 4922.50 1016.00

2007-2008 33 30949.26 6387.88

2008-2009 12 893.42 184.40

2009-2010(Till Jul,09)

7 11990.47 2474.81

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Indian ADRs Trading in US

Dr. Reddy's Laboratories Ltd.

HDFC Bank Ltd.

ICICI Bank Ltd.

Infosys Technologies Limited

Mahanagar Telephone Nigam Limited

Rediff.com India Ltd

Satyam Computer Services Limited

Sify Ltd.

Videsh Sanchar Nigam Limited

Wipro Ltd

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Indian GDRs

Arvind Mills, Ashok Leyland,Bajaj Auto,Ballarpur Ind.,Bombay

Dye,BSES Ltd,Century Textiles,CESC,Core Parent, Crompton

Greaves,DCW,Dr. Reddy's,E. I. Hotels,EID Parry,Finolex Cab, Flex

Industries,G.E. Shipping,G.N.F.C,GAIL,Garden Silk, Grasim

(1st),Grasim (2nd),Guj Ambuja ,Himachal Futuri,Hindalco

(1st),Hindalco (2nd),Hindustan Dev,India Cements, Indian

Alum.,Indian Hotels,Indian Rayon,Indo Gulf,Indo

Rama,ICICI,Infosys,IPCL,ITC,J.K. Corp,Jain Irrig,JCT Ltd.,Kesoram

Ind,L & T (1st),L & T (2nd)Mah & Mah,MTNL,NEPC Micon,Nippon

Denro,Oriental Hotels,Ranbaxy Labs,Raymond

Woolen,Reliance,Reliance (2nd),Reliance

Petroleum,S.A.I.L.,Satyam Infoway,S.I.E.L.,Sanghi Poly,SIV

Ind ,SPIC,SBI,Sterlite India,Tata Electric,Telco (1st),Telco

(2nd),Tube Invest,United Phos.,Usha Beltron,Videocon

Int.,VSNL,Wockhardt

22


• From the investors' point of view, they achieve portfolio diversification while acquiring an instrument which is denominated in a convertible currency and is traded on developed stock markets

• The investors bear exchange risk and all the other risks borne by an equity holder

• They have all the rights and privileges of ordinary stockholders except the voting rights.

23

GDRs and ADRs

GDRs could be offered to US investors only if very stringent requirements of registration with the SEC are complied with. However, under an exemption granted by Rule 144A of the securities act, securities can be offered to Qualified Institutional Buyers without going through the registration process.

As to ADRs, offereings at various levels are possible with more and more stringent accounting and disclosure requirements as one goes from lower to higher levels. There are four types of ADRs : Unsponsored and Levels I to III

24

American Depository Receipts (ADRs)

Unsponsored Depositary Receipts

These are issued by one or more depositaries in response to market demand, but without a formal agreement with the company. Today, unsponsored Depositary Receipts are considered obsolete.

Sponsored Level I Depositary Receipts

Level I Depositary Receipts are traded in the U.S. OTC market and on some exchanges outside the United States. The company does not have to comply with U.S. GAAP or full SEC disclosure. Essentially, a Sponsored Level I Depositary Receipt program allows companies to enjoy the benefits of a publicly traded security without changing its current reporting process.

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Level II Depositary ReceiptsThese are listed on a US stock exchange but no new capital is raised.

Level III Depositary ReceiptsThese are listed on a US stock exchange and are used to raise new capital.

Companies that wish to either list their securities on an exchange in the U.S. or raise capital use sponsored Level II or III Depositary Receipts respectively.

These types of Depositary Receipts can also be listed on some exchanges outside the United States. Each level requires different SEC registration and reporting, plus adherence to U.S. GAAP.

The companies must also meet the listing requirements of the national exchange (New York Stock Exchange, American Stock Exchange) or NASDAQ, whichever it chooses.

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American Depository Receipts Sponsored Level II And III Depositary Receipts

Companies that wish to either list their securities on an exchange in the U.S. or raise capital use sponsored Level II or III Depositary Receipts respectively.

These types of Depositary Receipts can also be listed on some exchanges outside the United States. Each level requires different SEC registration and reporting, plus adherence to U.S. GAAP.

The companies must also meet the listing requirements of the national exchange (New York Stock Exchange, American Stock Exchange) or NASDAQ, whichever it chooses.

27

American Depository Receipts

Each higher level of Depositary Receipt program generally increases the visibility and attractiveness of the Depositary Receipt.

Level II is used when the company does not wish to raise funds i.e. just acquire listing while level III is used when funds are to be raised. For Level II issue the issuing firm converts some of its existing stock into ADRs.

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Rule 144a Depositary Receipts

These are also used to raise new capital but are privately placed with Qualified Institutional Buyers in the United States. Because of the sophisticated investor base to which these Depositary Receipts are restricted, the US Securities Exchange Commission imposes fewer reporting and registration requirements on the issuer than for a public offering and Rule 144a ADRs can therefore be a quicker and simpler way to access the US market than Level III ADRs.

29


• A major problem and concern with international equity issues used to be that of flowback i.e. the investors will sell the shares back in the home stock market of the issuing firm. Initially GOI had imposed a minimum time limit before which conversion and sale in home market was not permitted. After FIIs were allowed into Indian markets, this was abolished.

30

Foreign Equity Investment

Risk-Return • Comparing Investments in a Risk-Neutral

World– The expected annual dividend yields in the two

investments are US and IN, the expected annual average rates of capital appreciation are US and IN. The (INR/USD) exchange rate is S0, dollars per rupee. After k years, a dollar invested in the US company is expected to accumulate to

$(1 + US + US)k

– a dollar invested in the Indian shares is expected to accumulate to

$(1/S0)(1 + IN + IN)k(Se)k

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Foreign Equity Investment - Risk-Return

– The investor would invest in the Indian stock if

– and in the US stock if the reverse inequality holds

– Let ŝe denotes the expected annual proportionate

rate of change of the exchange rate S expressed as

USD per INR. Then

– [(Se)k/S0] = (1 + ŝe)k

)αUS

+ δUS

+ (1 k )Se( k) α

IN + δ

IN +(1 k

)S

0

1(

32


Substitute, simplify, ignore cross products to get that US investor would invest in India if

– ŝe > (US - IN) + (US - IN)

–Thus even with lower dividend yield and capital gains, foreign equities can be attractive if the foreign currency is expected to appreciate strongly –Presence of differential tax treatment of ordinary income and capital gains can reinforce the bias in favor of foreign equities if exchange gains are treated as capital gains and capital gains are taxed at a lower rate

33


– Let y and k be tax rates for ordinary income

and capital gains respectively with y > k

– After-tax returns on the US and Indian

investments are, respectively

(1-y)US + (1-k)US and

(1-y)IN + (1-k)(IN+ Ŝe)

– Latter will exceed the former if )α

IN-α

US( + )δ

INUSδ()θk-(1)θy-(1

> Se

34

Risk and Returnin International Equity Markets

Calculating the Unhedged Returns on Foreign Equity in home currency Terms

Let Et be the initial purchase price of the foreign equity in foreign currency (FC) terms.

Let St be the spot exchange rate, in FC/HC terms, on the purchase date.

Then EtSt is the HC purchase price of the foreign equity.

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Let Et+1 be the FC value of the stock after one period.

111

~~ tttt DEE

where

1

1

~

t

t

t

D

E = the initial equity price

= the price change over the period

= dividends

Then is the value of the equity after one period in HC terms.

11

~~ tt SE

~

Risk and Return in International Equity Markets

36


The continuous rate of return on the equity measured in HC and on an unhedged basis is:

FCHC

t

t

t

t

tt

ttU SE

S

S

E

E

SE

SER ,FC

1111$,

~~)

~ln()

~ln()

~~ln(

~

Note that the unhedged HC return on the foreign equity has two pieces: the return on the equity shares in FC terms (EFC), &

the return on the foreign currency used to buy the shares (SHC,FC).

~

~

37


The variance of the returns reflects the variance of each term and the covariance between the returns on the foreign equity and the returns on spot foreign exchange:

Note that the covariance of equity returns and currency returns can be either positive or negative.

Thus from a foreign investor’s viewpoint the risk has three components: local market risk, exchange rate risk, covariance risk – what’s the correlation between local market performance and local currency exchange rate against investor’s home currency.

)~

;~

(Cov2)~

()~

()~

( FCHC,FCFCHC,2

FC2

$,2 SESER U

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Decomposition of the Total Variance of US Dollar Returns on Individual Foreign Stock Markets

________________________________________________________

Country % Contribution to Total Variance from

______________________________________

Exchange Rate Local Return Covariance

Variance Variance

_________________________________________________________________

Canada 4.26 84.91 10.83

France 29.66 61.79 8.55

Germany 38.92 41.51 19.57

Japan 31.85 47.65 20.50

Switzerland 55.17 30.01 14.81

U.K. 32.35 51.23 16.52

__________________________________________________________________

39

Volatility of Returns on Selected Developing Country Stock Markets

__________________________________________________________________________

Developing Countries Annual Standard Deviation (%)

Argentina 108 Brazil 74 Chile 29 HongKong 31 India 31 Indonesia 39 Korea 29 Mexico 56 Singapore 33 Taiwan 63 Thailand 31

Developed Countries Japan 22 U.K. 19 U.S. 17 ___________________________________________________________

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StockMarketReturns

Stock Market Prices Spot FX (A)

Stock Market Prices Spot FX (D)

Stock Market Prices Spot FX (B)

Stock Market Prices Spot FX (C)

Negative

Positive

Negative Positive

Currency Market Returns

Combinations of Currency Market and Stock Market Returns

41

Risk and Return from Foreign Equity Investment

– Since countries differ in their economic and industrial structures and since business cycles in different parts of the world are not synchronous, one would expect further risk reduction to be possible through diversification beyond national boundaries

– For a given expected return, an internationally (optimally) diversified portfolio should afford smaller risk than a purely national optimal portfolio

42


– Prima facie equity investment in emerging markets appears to present substantial opportunities for risk reduction from the point of view of investors in the developed countries

– Total risk of an internationally diversified portfolio can once again be broken down into three components • Exchange Rate Risk • Local Returns Risk • Local Returns-Exchange Rates Covariance

Risk

43


– General agreement that international diversification does pay in terms of risk reduction. Some ambiguity remains. One additional source of risk viz. exchange rate.

– Availability of products to hedge exchange rate risk further reinforces this conclusion

– However, it is not clear whether exchange risk hedging would reduce expected returns at the same time as it reduces risk

44

The International Capital Asset Pricing Model

• CAPM links the expected (excess) returns on a risky asset to its risk in an efficient portfolio

• The expected excess return on a risky asset or a portfolio of assets is its expected return over and above the risk-free return

• A portfolio is said to be efficient if among all possible portfolios with the same excess return it has the lowest variance

45

The International CAPM

• Consider a portfolio consisting of assets i = 1, 2....N

• A necessary condition for a portfolio to be efficient

is

• where ri* and rp

* denote, respectively return on

asset i and the portfolio

N1,2... = i allfor θ = )*

pr ,*i

rcov(

r) - *i

rE(

46


• The numerator is the contribution of asset i to the portfolio's excess return while the denominator is the contribution of asset i to the portfolio's variance or risk

• The parameter is known as the investor's relative risk aversion and is a measure of his or her attitude towards risk

47

The International CAPM• “Two fund theorem" says that in equilibrium all

investors will hold some combination of the risk-free asset and the so-called "tangency portfolio"

• One of the crucial ingredients in the CAPM is the notion of Market Portfolio

• Now let rp be the market portfolio. Denote the return on market portfolio by rm

• For the market portfolio to be efficient we must have

N1,2... = i allfor θ =

)*mr ,

*i

cov(r

r) - *i

E(r

48


This can be written as follows

)*mr ,

*i

rcov( θ = r) - *i

rE(

2mσimσ

mσ2 θ = r) - ri*E(

(1)

(2)

When (2) is applied to the market portfolio

E(rm* - r) = 2

m (3)

49


Rewriting

= [E(rm* - r)/m

2]

• Replace [ m2] by E(rm

* - r) and recall the definition of the beta of asset i to get

• E(ri* - r) = i E(rm

* - r)• This is the one country CAPM• The only source of systematic risk is the

market risk.

50


im denotes the covariance between the

returns on asset i and the market portfolio and m

2 denotes the variance of the return on the

market portfolio

• The expression [im/m2] is the familiar

"Beta" of the asset i, denoted i which

measures the covariance of asset i with the market portfolio

51


• The parameter i is estimated by means of a

regression of realized historical returns on asset i on the realized historical returns on the market portfolio

ri* = i + i rm

* + ui

OLS estimator of i = Cov (ri*, rm

*)/Var (rm*)

52


This is the famous equilibrium Capital Asset Pricing Model for a single country

• The excess return on any risky asset i equals the excess return on the benchmark portfolio multiplied by the asset's beta which in turn measures the co-variation of the (return on) asset i with the (return on) the benchmark portfolio

53

When to use the one-country CAPM?

When national markets are completely segmented.

Market portfolio of assets held by investors in a country is same as portfolio of assets issued by corporations in that country

Only locals hold local assets & locals hold only local assets

Not true in most countries.

54


• Extending One Country CAPM– If resident investors hold exclusively assets

issued by resident firms and foreign investors are not allowed to hold domestic assets then that country’s capital market is fully segmented from the global capital market

– Capital markets of most countries are certainly not fully segmented

– Are global capital markets fully integrated?– What is the relevant “market portfolio”?

55


– Where there are no restrictions whatsoever on investors in a country holding foreign assets and foreign investors investing in domestic assets, that global capital markets are fully integrated at least in a legal sense. There could be informational asymmetries

– Consider the portfolio consisting of all the stocks issued by all the firms in such an integrated world – “the world market portfolio”

• CAPM requires the further assumption that all investors must have identical expectations regarding the performance of any risky asset. Otherwise they would not agree on the composition of the “tangency portfolio”.

56

The International CAPM• For any risky asset investors would compute the

real return measured in their own currencies• If PPP does not hold, would investors from

different countries agree on the real return from a given risky asset?

• If not, the ICAPM must take account of exchange rate risk in addition to the covariance risk with the world market benchmark portfolio

• Investors in a given country would choose their portfolios in the light of their estimates of expected returns, variances of returns and covariances measured in their reference currency, their home currency

57

The International CAPM– In a multi-currency portfolio the following parameters are relevant

• Expected excess return on a portfolio, measured in some

numeraire currency xiE(ri* - r) where xi is the share of asset i,

ri* is its return measured in the numeraire currency and r is the

risk-free rate in the numeraire currency

• Variance of portfolio returns p2 = cov(xiri

*,rp*) = xicov(ri

*,rp*)

which in turn depends upon

(1) Pair-wise co-variances of individual market returns

(2) Pair-wise co-variances between exchange rates

58

The International CAPM(3) Covariance between stock market returns and changes in the exchange rate between the numeraire currency and other currencies cov(xiri

*, ŝi) where ŝi is the proportionate change in the spot rate of currency i with respect to the numeraire currency

• The remaining parameters viz. expected values and variances of ŝi do not enter portfolio choice because the portfolio weights xi are not affected by them

• The total variance of portfolio returns can be attributed to return variances, exchange rate varinces and covarinces between returns and exchange rate changers. Contributions of each vary according to currency composition and whose point of view is adopted

59

International CAPM

A Two Country CAPM: Ignore inflation

Consider a German investor computing returns on various assets in terms of his home currency EUR. Denote by S the USD/EUR exchange rate.:

(1)A US T-bill : rGE = rUS + Ŝ where rUS is the return in USD terms. Thus correlation between rGE and Ŝ is +1.

(2) What about a US stock?

(3) What about a German stock?

60

An appreciation of the dollar against the Euro will increase euro return for a given dollar return.

However, will it help or hurt the valuation of the US firm?

A US exporter firm – export sales might decline due to appreciation. But interest and labour costs might also decline. Net impact? On balance correlation between S and return on US stocks measured in EUR positive or negative?

What about a German firm? EUR depreciation might help if strong US market presence. Costs might increase. Net impact again ambiguous.

Many empirical studies using firm-level data from do not show up an exchange rate factor in stock returns after the market factor is included.

61

The International CAPM• Incorporating exchange rate risk: A two-country model

ri = i + i Ŝ + ui

where ri denotes the EUR return on an asset i, the

coefficient i will equal

cov[ri , Ŝ]/var(Ŝ)

which is a measure of asset i's covariation with the changes in exchange rate

US T-bill: positive; US stocks : negative?

German stocks : positive?

62


• A Two Country CAPM– Extending the one-country CAPM, the equilibrium

expected excess return on asset i measured in EUR is given by

– E[ri - r] = cov[ri ,rW] + cov[ri ,Ŝ]

– The parameters and are prices of world market and exchange rate covariance risks, and rW is the return on the world market portfolio measured in EUR and r is the risk-free rate in EUR (e.g. German T-bills).

63

The International CAPM– Two benchmark portfolios : (1) The world market portfolio and (2)

The foreign riskless asset– To operationalise the two country CAPM we must estimate and – – Consider the world market portfolio

E[rW - r] = cov[rW ,rW] + cov[rW , Ŝ]

= var[rW] + cov[rW , Ŝ]

– Consider a foreign i.e. US T-bill

E[r* + Ŝ - r] = cov[Ŝ, rW] + cov(Ŝ,Ŝ)

= cov[Ŝ , rW] + var(Ŝ)r*: Risk-free rate in the other currency (e.g.USD)These two equations can be used to estimate and .

64

E(rW – r) = var(rW) + cov(rW, Ŝ)

E(r* + Ŝ – r) = cov (Ŝ, rW] + var(Ŝ)

var (rW) cov (rW, Ŝ)

cov (Ŝ, rW) var(Ŝ)

= E(rW – r)

E(r* + Ŝ – r)

65

var(rW) cov (rW, Ŝ) -1 E(rW – r)

cov (Ŝ, rW) var(Ŝ) E(r* + Ŝ – r)

=

The two sources of risk: World Market & Exchange Rate

The asset now has two “betas” – correlation with world market and with the exchange rate.

66


– Resulting two-country CAPM is

– E(ri – r) = i (rW – r) + i E(r* + Ŝ – r)

Assets' beta and gamma have to be jointly

estimated from a multiple regression with

historical data

ri = i + i rW + i Ŝ + ui

67

The OLS estimates are

i var(rw) cov(rw, Ŝ) -1 cov(ri, rw)

=

i cov(rw, Ŝ) var(Ŝ) cov(ri, Ŝ)

Recall that

E(ri – r) = [cov (ri, rw) cov (ri, Ŝ)]

68

Substitute for [ ]

var(rW) cov (rW, Ŝ) -1 E(rW – r)


=

69

E(ri – r) = cov (ri, rw) var(rW) cov (rW, Ŝ) -1 E(rW – r)

cov (ri, Ŝ)


Which leads to

E(ri – r) = [ i i ] E(rW – r)

E(r* + Ŝ – r)

This is the two-country CAPM

70


– Extension to a multi-country CAPM

– E[(r*)iH - rH] = iE[(r*)W - rH] + i1E[Ŝ1+rF1-rH]

+ i2E[Ŝ2+rF2-rH]....+ iKE[ŜK+rFK-rH]

– Here rH denotes riskfree rate in investor's currency,

rF1..rFK are riskfree rates in foreign currencies 1... ŜK

are the changes in exchange rates of these currencies measured as units of home currency per unit of foreign currency .K and Ŝ1 ..

71


– The parameters i, i1 ... iK have to be obtained from a multiple regression with historical data

(r*)iH = i + i(r*)W + i1 Ŝ1 + ...+ iK ŜK + ui

• Global Capital Markets: Segmented or Integrated

– Is the underlying assumption of no constraints on cross-border capital flows valid?

– Even if legal barriers are eliminated informational barriers may remain; withholding taxes may also lead to segmentation

72

The International CAPM– The evidence from empirical testing of the ICAPM – tests lead to the conclusion that international capital

markets are not fully integrated – Volatility clustering has been observed in almost all

national stock markets– There are volatility spillovers between stock markets

and between the forex and the stock market.

• Estimation of Risk Premia– To use the ICAPM for asset pricing we need to

estimate the beta and gammas for the asset and the risk premia E[(r*)W - rH], E[Ŝ1+rF1-rH]...

E[ŜK+rFK-rH]

73

Summary

• Economics of cross-border equity investment using the standard capital asset pricing model as the frame of reference

• How to extend the standard capital asset pricing model to a multi-country context

• Segmentation versus integration of global capital markets

• Depository receipts mechanism used by non-resident firms to tap equity markets in US and Europe

1 international financial management p g apte. 2 introduction the twentieth century has seen massive...

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