lecture 131 international portfolio investment i.the rationale for international portfolio...

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.