Essentials of Investments: Chapter 19 - Globalization and International Investing includes Risk Factors in International Investing, Exchange Rate Risk, Hedging Exchange Rate Risk, Political Risk.
CHAPTER 19 Globalization and International Investing INVESTMENTS | BODIE, KANE, MARCUS McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc All rights reserved 25-2 Background • Of the six largest • The U.S accounts countries – U.S., for only about a third Japan, U.K., France, of world stock Hong Kong and market Canada – make up capitalization about 62% of the • Emerging markets world stock market make up about 16% • The weight of the of the world stock U.S within this group market of six is 54% INVESTMENTS | BODIE, KANE, MARCUS 25-3 Background • Clearly, U.S stocks not comprise a fully diversified equity portfolio • International investing provides greater diversification opportunities • It also carries some special risks INVESTMENTS | BODIE, KANE, MARCUS 25-4 Figure 25.1 Per Capita GDP and Market Capitalization as Percentage of GDP INVESTMENTS | BODIE, KANE, MARCUS 25-5 Issues • A developed stock market enriches the population • Home-country bias: – Investors frequently overweight homecountry stocks – They may even completely ignore opportunities for international diversification INVESTMENTS | BODIE, KANE, MARCUS 25-6 Risk Factors in International Investing Foreign Exchange Risk • Variation in return due to changes in the exchange rate • Foreign investments may yield more or less home currency than expected • A foreign investment is simultaneously an investment in an overseas asset and in a foreign currency INVESTMENTS | BODIE, KANE, MARCUS 25-7 Risk Factors in International Investing Two sources of Return expressed in variation or local currency risk: Return obtained when local currency is exchanged for home currency INVESTMENTS | BODIE, KANE, MARCUS 25-8 Example 25.1 Exchange Rate Risk • Suppose the risk-free rate in U.K is 10% and the current exchange rate is $2/£1 • A U.S investor with $20,000 can buy £10,000 and invest them to obtain £11,000 in one year • If the £ depreciates to $1.80, the investment will yield only $19, 800, a $200 loss • The investment was not risk free to a U.S investor! INVESTMENTS | BODIE, KANE, MARCUS 25-9 Example 25.1 Exchange Rate Risk • The equation shows that the return to the U.S investor is: – The pound-denominated return – Multiplied by – The exchange rate “return” E1 r (US ) 1 rf (UK ) E0 INVESTMENTS | BODIE, KANE, MARCUS 25-10 Figure 25.2 Stock Market Returns in U.S Dollars and Local Currencies for 2009 INVESTMENTS | BODIE, KANE, MARCUS 25-19 Are Investments in Emerging Markets Riskier? • For the overall portfolio, standard deviation of excess returns is the appropriate measure of risk • For an asset to be added to the current portfolio, beta (covariance with U.S portfolio) is the appropriate measure of risk INVESTMENTS | BODIE, KANE, MARCUS 25-20 Figure 25.3 Monthly Std Deviation of Excess Returns in Developed, Emerging Markets INVESTMENTS | BODIE, KANE, MARCUS 25-21 Figure 25.4 Index Dollar Return Beta on U.S Stocks, 2000–2009 INVESTMENTS | BODIE, KANE, MARCUS 25-22 Figure 25.5 Average Dollar-Denominated Excess Returns INVESTMENTS | BODIE, KANE, MARCUS 25-23 Average Country-Index Returns and Capital Asset Pricing Theory • Figure 25.5 shows a clear advantage to investing in emerging markets • Results are consistent with risk ranking by standard deviation, but not with ranking by beta • Beta rankings may fail because of homecountry bias, which dominates international investing INVESTMENTS | BODIE, KANE, MARCUS 25-24 Benefits from International Diversification • Correlations between countries suggest international diversification is beneficial, especially for active investors • Globalization may have caused higher cross-country correlations • It’s possible to expand the efficient frontier some • It’s possible to reduce the systematic risk level below the domestic only level INVESTMENTS | BODIE, KANE, MARCUS 25-25 Figure 25.6 International Diversification INVESTMENTS | BODIE, KANE, MARCUS 25-26 Figure 25.8 Efficient Frontier of Country Portfolios INVESTMENTS | BODIE, KANE, MARCUS 25-27 Are Benefits Preserved in Bear Markets? • Correlations between countries may increase in a crisis • Roll’s model suggests a common factor underlying the movement of stocks around the world • Prediction: Diversification only protects against country-specific events • What happened in 1987? In 2008? INVESTMENTS | BODIE, KANE, MARCUS 25-28 Figure 25.9 Regional Indexes around the Crash, October 14–October 26, 1987 INVESTMENTS | BODIE, KANE, MARCUS 25-29 Figure 25.10 Beta and SD of Portfolios INVESTMENTS | BODIE, KANE, MARCUS 25-30 Three Rules of Thumb To passively diversify your portfolio, include country indexes in order of: 1.Market capitalization (from high to low) 2.Beta against the U.S (from low to high) 3.Country index standard deviation (from high to low) INVESTMENTS | BODIE, KANE, MARCUS 25-31 Figure 25.11 Risks and rewards of international portfolios, 2000–2009 INVESTMENTS | BODIE, KANE, MARCUS 25-32 Performance Attribution • The EAFE index is a commonly used benchmark for portfolio performance • Measure the contribution of: 1.Currency selection 2.Country selection 3.Stock selection 4.Cash/bond selection INVESTMENTS | BODIE, KANE, MARCUS 25-33 Table 25.15 Example of Performance Attribution: International INVESTMENTS | BODIE, KANE, MARCUS ... Crash, October 14–October 26, 198 7 INVESTMENTS | BODIE, KANE, MARCUS 2 5-2 9 Figure 25.10 Beta and SD of Portfolios INVESTMENTS | BODIE, KANE, MARCUS 2 5-3 0 Three Rules of Thumb To passively diversify... simultaneously an investment in an overseas asset and in a foreign currency INVESTMENTS | BODIE, KANE, MARCUS 2 5-7 Risk Factors in International Investing Two sources of Return expressed in variation or local... directly in the capital markets of other countries • American depository receipts (ADR) • International mutual funds • International ETFs INVESTMENTS | BODIE, KANE, MARCUS 25 -1 9 Are Investments in Emerging