1. 1
Chapter 7
International Investment and
Diversification
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2. 2
Outline
Introduction
Why international diversification makes
theoretical sense
Foreign exchange risk
Investments in emerging markets
Political risk
Other topics related to international
diversification
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3. 3
Introduction
The marketplace of the twenty-first century
is global
• U.S. equities represent only about 51% of the
world’s equity capitalization
• Over the period 1980-2000, the U.S. was the
best-performing market only once
• In September 1999, each of the 66 U.S. pension
funds had more than $1 billion in actively
managed international investment portfolios
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4. 4
Introduction (cont’d)
International investments carry additional
sources of risk
Managers can reduce total portfolio risk via
global investment
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5. 5
Why International Diversification Makes Sense
(Evans and Archer)
Portfolio theory works to the investor’s
benefit even if he selects securities at
random
Ideally, the portfolio manager selects
securities because of their fit with the rest of
the portfolio
• By choosing poorly correlated securities, a
manager can reduce total portfolio risk
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6. 6
Why International Diversification Makes Sense
(Evans and Archer Cont’d)
Total risk contains both systematic and
unsystematic risk
• Evans and Archer show that holding 15 to 20
equity securities substantially reduces the
unsystematic risk
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7. 7
Utility, Risk, and Return
Unsystematic risk reduction is possible with
more than 20 securities
• For a given level of return, any reduction in
risk, no matter how small, is a worthy goal
• A rational invest will reduce risk if given the
opportunity
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8. 8
Variance of
A Linear Combination
As long as assets are less than perfectly
correlated, there will be diversification
benefits
• More pronounced the lower the correlation
• No two shares move in perfect lockstep
– Diversification benefits accrue every time we add a
new position to a portfolio
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9. 9
Relationship of
World Exchanges
For U.S. securities, market risk account for
about 25% of a security’s total risk
For less developed countries, market risk
tends to be higher because:
• Fewer securities make up the market
• The securities are exposed to more extreme
economic and political events
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10. 10
Relationship of
World Exchanges (cont’d)
International capital markets continue to
show independent price behavior
• International diversification offers potential
advantages
• Repeating the Evans and Archer methodology
for international securities should result in a
lower level of systematic risk
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11. 11
Relationship of
World Exchanges (cont’d)
Number of Securities
Portfolio Variance
U.S. Securities: Systematic Risk 27%
International Securities: Systematic Risk 11.7%
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12. 12
Fundamental
Logic of Diversification
Investors are, on average, rational
Rational people do not like unnecessary
risk
By holding one more security, an investor
can reduce portfolio risk without giving
up any expected return
Rational investors, therefore, will hold as
many securities as they can
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13. 13
Fundamental Logic of
Diversification (cont’d)
The most securities investors can hold is
all of them
The collection of all securities makes up
the “world market portfolio”
Rational investors will hold some
proportion of the world market portfolio
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14. 14
Other Considerations
Optimum portfolio size involves a trade-off
between:
• The benefits of additional diversification
• Commissions and capital constraints
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15. 15
Foreign Exchange Risk
Definition
Business example
Investment example
From whence cometh the risk?
Dealing with the risk
The eurobond market
Combining the currency and market decisions
Key issues in foreign exchange risk management
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16. 16
Definition
Foreign exchange risk refers to the
changing relationships among currencies
• Modest changes in exchange rates can result in
significant dollar differences
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17. 17
Business Example
A U.S. importer has agreed to purchase 40 New Zealand
leather vests at a price of NZ$110 each. The vests will take
two months to produce, and payment is due before the
vests are shipped.
The current spot rate of the NZ$ is $0.5855.
What is the price of the vests to the importer if the spot
rate remains unchanged in the next two months? If it is
$0.5500? If it is $0.6200?
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18. 18
Business Example (cont’d)
Solution: If the spot rate does not change, the cost to the importer is:
40 x NZ$110 x $0.5855 = $2,576.20
If the spot rate is $0.5500:
40 x NZ$110 x $0.5500 = $2,420.00
If the spot rate is $0.6200:
40 x NZ$110 x $0.6200 = $2,728.00
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19. 19
Investment Example
You just purchased 1,000 of Kangaroo Lager trading on
the Sydney Stock Exchange for AUD1.45 per share. The
exchange rate for the Australian dollar at the time of
purchase was $0.7735.
What is the U.S. dollar purchase price? If Kangaroo
Lager stock rises to AUD1.95 per share and if the
Australian dollar depreciates to $0.7000, what is your
holding period return if you sell the shares?
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20. 20
Investment Example (cont’d)
Solution: The purchase price in U.S. dollars is:
1,000 x AUD1.45 x $0.7735 = $1,121.58
If the Australian dollar depreciates and you sell the shares, you will
receive:
1,000 x AUD1.95 x $0.7000 = $1,365.00
The holding period return is:
($1,365.00 - $1,121.58)/$1,121.58 = 21.7%
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21. 21
From Whence
Cometh the Risk?
Role of interest rates
Forward rates
Interest rate parity
Covered interest arbitrage
Purchasing power parity
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22. 22
Real Rate of Interest
The real rate of interest reflects the rate of
return investors demand for giving up the
current use of funds
In a world of no risk and no inflation, the
real rate indicates people’s willingness to
postpone spending their money
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23. 23
Inflation Premium
The inflation premium reflects the way the
general price level is changing
Inflation is normally positive
• The inflation premium measures how rapidly
the money standard is losing its purchasing
power
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24. 24
Risk Premium
The risk premium is the component of
interest rates that reflects compensation for
risk to risk-averse investors
The risk premium is a function of how
much risk a security carries
• E.g., common stock vs. T-bills
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25. 25
Forward Rates
The forward rate is a contractual rate
between a commercial bank and a client for
the future delivery of a specified quantity of
foreign currency
• Typically quoted on the basis of 1, 2, 3, 6, and
12 months
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26. 26
Forward Rates (cont’d)
The forward rate is the best estimate of the
future spot rate
• If the forward rate indicates the dollar will
strengthen, importers should delay payment
• If the forward rate indicates the dollar will
weaken, importers should lock in a rate now
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27. 27
Forward Rates (cont’d)
Forward rate premium or discount:
Forward rate - Spot rate 12
100
Spot rate
where the contract length in months
n
n
× ×
=
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28. 28
Forward Rates (cont’d)
Example
On April 29, 2005, the British pound had a spot rate of
$1.9146. The 3-month forward rate of the pound was
$1.9041 on that date.
What is the forward premium or discount?
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29. 29
Forward Rates (cont’d)
Example (cont’d)
Solution: The forward premium or discount is
calculated as follows:
There is a forward discount of –2.19%.
%19.2
100
3
12
9146.1$
9146.1$9041.1$
100
12
rateSpot
rateSpot-rateForward
−=
××
−
=××
n
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30. 30
Interest Rate Parity
Interest rate parity states that differences in
national interest rates will be reflected in
the currency forward market
• Two securities of similar risk and maturity will
show a difference in their interest rates equal to
the forward premium or discount, but with the
opposite sign
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31. 31
Interest Rate Parity Formula
domestic
foreign
where
annualized domestic risk-free rate
annualized foreign risk-free rate
F=Forward (contract) rate [value of foreign currency expressed in units of domestic currency]
S=Spot exchange
R
R
=
=
rate [value of foreign currency expressed in units of domestic currency]
domestic foreign
365F S
R R
S n
−  
= +  ÷
 
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32. 32
Example
Six-month German Treasury Bills yield
2.60% (annualized rate)
Spot exchange rate is $ 0.6051 / DM
Six-month Forward rate is $ 0.6095 / DM
RUS=2.60+100(0.6095-0.6051)(12/6)/0.6051
RUS=4.05 %
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33. 33
Covered Interest Arbitrage
Covered interest arbitrage is possible when
the conditions of interest rate parity are
violated
• If the foreign interest rate is too high, convert
dollars to the foreign currency and invest in the
foreign country
• If the U.S. interest rate is too high, borrow the
foreign currency and invest in the U.S.
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34. 34
Example of CIA
Six-month Swiss rate is 1.00 % (annualized rate)
Six-month US Treasury Bills yield 2.00 %
(annualized rate)
Spot exchange rate is $ 0.8542 / CHF
Six-month Forward rate is $ 0.8610 / CHF
What arbitrage strategy can you implement ?
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35. 35
Example of CIA
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36. 36
Purchasing Power Parity
Purchasing power parity (PPP) refers to
the situation in which the exchange rate
equals the ratio of domestic and foreign
price levels
• A relative change in the prevailing inflation rate
in one country will be reflected as an equal but
opposite change in the value of its currency
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37. 37
Purchasing Power
Parity (cont’d)
Absolute purchasing power parity follows
from “the law of one price:”
• A basket of goods in one country should cost
the same in another country after conversion to
a common currency
• Not very accurate due to:
– Transportation costs
– Trade barriers
– Cultural differences
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38. 38
Purchasing Power
Parity (cont’d)
Relative purchasing power parity states
that differences in countries’ inflation rates
determine exchange rates:
1
1
1
where change in the spot exchange rate
foreign country inflation rate
domestic country inflation rate
D
F
F
D
IS
S I
S
I
I
+∆
= −
+
∆ =
=
=
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39. 39
Purchasing Power
Parity (cont’d)
A country with an increase in inflation will
experience a depreciation of its currency
because:
• Exports decline
• Imports increase
• There is less demand for goods from that
country
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40. 40
The Concept of Exposure
Definition
Accounting exposure
Transaction exposure
Translation exposure
Economic exposure
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41. 41
Definition
Exposure is a measure of the extent to
which a person faces foreign exchange risk
In general, there are two types of exposure:
accounting and economic
• Economic exposure is more important
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42. 42
Accounting Exposure
Accounting exposure is:
• Of concern to MNCs that have subsidiaries in a
number of foreign countries
• Important to people who hold foreign securities
and must prepare dollar-based financial reports
U.S. firms must prepare consolidated
financial statements in U.S. dollars
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43. 43
Transaction Exposure
FASB Statement No. 8 addresses
transaction exposure:
• “A transaction involving purchase or sale of
goods or services with the price states in
foreign currency is incomplete until the amount
in dollars necessary to liquidate a related
payable or receivable is determined”
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44. 44
Translation Exposure
Translation exposure results from the
holding of foreign assets and liabilities that
are denominated in foreign currencies
• E.g., foreign real estate and mortgage holdings
must be translated to U.S. dollars before they
are incorporated into a U.S. balance sheet
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45. 45
Economic Exposure
Economic exposure measures the risk that
the value of a security will decline due to an
unexpected change in relative foreign
exchange rates
Security analysts should include expected
changes in exchange rates in forecasted
cash flows
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46. 46
Dealing With the Exposure
Ignore the exposure
Reduce or eliminate the exposure
Hedge the exposure
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47. 47
Ignore the Exposure
Ignoring the exposure may be appropriate
for an investor if:
• Foreign exchange movements are expected to
be modest
• The dollar mount of the exposure is small
relative to the cost of inconvenience of hedging
• The U.S. dollar is expected to depreciate
relative to the foreign currency
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48. 48
Reduce or Eliminate
the Exposure
If the dollar is expected to appreciate
dramatically, an investor may reduce or
eliminate foreign currency holdings
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49. 49
Hedge the Exposure
Definition
Hedging with forward contracts
Hedging with futures contracts
Hedging with foreign currency options
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50. 50
Definition
Hedging involves taking one position in the
market that offsets another position
• Covering foreign exchange risk means hedging
foreign exchange risk
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51. 51
Hedging With
Forward Contracts
A forward contract is a private, non-
negotiable transaction between a client and
a commercial bank
• No money changes hands until the foreign
currency is delivered, but the rate is determined
now
• The forward rate reflects relative interest rates
and associated risks
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52. 52
Hedging With
Futures Contracts
A futures contract is a promise to buy or sell a
specified quantity of a particular good at a
predetermined price by a specified delivery date
On the delivery date, there will be a gain or loss in
the futures market that will offset the gain or loss
experienced when converting the foreign currency
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53. 53
Hedging With
Futures Contracts (cont’d)
To hedge an investment, sell foreign
currency futures
To hedge a liability, buy foreign currency
futures
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54. 54
Hedging With
Foreign Currency Options
There are two types of foreign currency
options:
• Call options give their owner the right to buy a
set quantity of foreign currency
• Put options give their owner the right to sell a
set quantity of foreign currency
• The price at which you have the right to buy or
sell is the strike (exercise) price
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55. 55
Hedging With Foreign
Currency Options (cont’d)
Currency option characteristics:
• A call option with an exercise price quoted in
dollars for the purchase of euros is the same as
a put option on dollars with an exercise price
quoted in euros
• Put-call parity for foreign currency options is a
restatement of interest rate parity
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56. 56
Hedging With Foreign
Currency Options (cont’d)
The disadvantage of hedging with currency
options is that the hedger must pay a
premium to established the hedge
• Options provide more precision than futures
contracts
• Options are more expensive than futures
contracts
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57. 57
The Eurobond Market
Eurobonds are debt agreements that are
denominated in a currency other than that of the
country in which they are held
• E.g., a bond denominated in yen sold in the United
Kingdom
A foreign bond is denominated in the local
currency but is issued by a foreigner
• E.g., a bond denominated in yen sold in Japan, issued
by a firm in the United Kingdom
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58. 58
The Eurobond Market (cont’d)
About 75% of eurobonds are denominated
in U.S. dollars
Firms issuing dollar-denominated
Eurobonds pay a slightly lower interest rate
than they would pay in the U.S.
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59. 59
Combining the Currency and
Market Decisions
It is often desirable to cross-hedge a foreign
investment into a different currency
• E.g., a U.S. investor might invest in Japan, use
the forward market to sell yen for British
pounds and convert the pounds back to dollars
• The currency return comes from the forward
market premium or discount and the actual
change in the exchange rate
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60. 60
How to do it
Select the market with the highest risk-premium,
not the highest absolute return.
Why?
Because due to non-arbitrage, investing in riskless
securities of various countries will yield the same
returns once the proceeds are translated back into
the domestic currency (either always true if use
forward contracts or true on average if use
currency spot market to repatriate the funds).
Thus what matters (what differentiates markets) is
the return expected ABOVE the risk-free rate.
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61. 61
Which Currency to Cross-Hedge ?
What is relevant is the total rate of return, after
including the return in the selected local market
(foreign equity), the cost/benefit of holding the
currency, and the expected return on that currency.
So instead of “mechanically” hedging the local
currency with the US Dollar (domestic), we
should look for a third currency for cross-hedging
purposes so as to maximize the total expected
return.
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62. 62
The return to maximize is the sum of
Chosen Market Equity Return (where we
chose to invest)
Forward market premium/discount (riskless
rate in country selected for cross-hedging
minus riskless rate in country where we
chose to invest).
Expected return in currency of country
where we chose to invest.
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63. 63
Example
A US investor chooses to invest in German stocks
and then cross-hedges with the Japanese Yen:
Forecasted German equity returns: 10 %
Forecasted change in Japanese Yen: 2.5 %
Japanese riskless rate (Eurobond rate): 2 %
German riskless rate (Eurobond rate): 4.5 %
Forecasted total return: 10% + (2% - 4.5%) + 2.5%
Total (Expected) Return = 10%
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64. 64
The riskless (Eurobond) rate differential comes
from the fact that we have:
This means that the expected percentage change in
the DM value (expressed in Yen) is the riskless
rate differential. When using forward contracts,
we get the forward rate instead of the spot rate due
to the fact that we need to wait for that future date
before transforming the DM into Japanese Yen.
Therefore the amount in DM that gets converted to
Yen in the end is subject to a change in value
since the forward rate F is different than the spot
rate S.
future date
/ / / /
Japan Germany
/ /
[ ]Yen DM Yen DM Yen DM Yen DM
Yen DM Yen DM
F S E S S
r r
S S
− −
= = −
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65. 65
Investments in
Emerging Markets
Overview
Background
Adding value
Reducing risk
Following the crowd
Special risks
Asymmetric correlations
Market microstructure considerations
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66. 66
Overview
Emerging market investments:
• Offer substantial potential rewards to the
careful investor in added return and risk
reduction
• Are accompanied by special risks:
– Foreign exchange risk
– High political and economic risk
– Unreliable investment information
– High trading costs
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67. 67
Background
Over $20 billion is invested globally in
securities issued in underdeveloped
countries
Pension funds’ largest emerging market
exposure is in:
• Asia (39.1%)
• Latin America (32.7%)
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68. 68
Background (cont’d)
Dollars invested in emerging markets has
increased at a compound rate of almost 50%
over the last 10 years
Private sector growth in emerging markets
• E.g., Hungary and Poland after 1989
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69. 69
Adding Value
Prices in developing markets often contain
significant inefficiencies
• Tend to sell for lower price/earnings multiples
than do firms in developed markets
– Emerging market firms have greater expected
growth and are cheaper
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70. 70
Reducing Risk
Low correlations are attractive as a means
of reducing portfolio variability
• Emerging markets show low correlation with
developed markets
• Emerging markets show low correlation with
each other
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71. 71
Following the Crowd
Some professional money managers
carefully analyze emerging markets for:
• Profit potential
• Portfolio risk reduction
Some professional money managers “follow
the crowd” because they must invest in
emerging markets
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72. 72
Special Risks
Incomplete accounting information
Foreign currency risk
Fraud and scandals
Weak legal system
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73. 73
Incomplete
Accounting Information
In some countries, financial statements are
more than 6 months old when they become
available
• The acquisition of reliable investment
information generally requires on-site security
analysts
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74. 74
Incomplete Accounting
Information (cont’d)
Accounting standards differ substantially
across countries
Accounting information is frequently
unavailable for an emerging market security
Some emerging market brokerage firms
focus on the income statement but ignore
the balance sheet
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75. 75
Foreign Currency Risk
Foreign exchange securities are
denominated in a foreign currency
• Introduces foreign exchange risk for foreign
investors
• E.g., Mexican peso crisis and Asian crisis
In emerging markets, traditional hedging
vehicles may be unavailable
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76. 76
Fraud and Scandals
Emerging markets carry a substantial risk of
fraud
• E.g., accounting misstatements, counterfeit
securities, “bucket” shops
Redress available to victims of a scandal in
a developing country may be inadequate
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77. 77
Weak Legal System
Low confidence in a country’s legal system:
• Leads to increased uncertainty
• Leads to an increased risk premium required by
investors
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78. 78
Asymmetric Correlations
Correlation between emerging and
developed markets:
• Increases during bear markets
• Is low during bull markets
• The extent of portfolio managers’
diversification depends on whether they are
experiencing an up or a down market
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79. 79
Asymmetric
Correlations (cont’d)
Investment returns show:
• Homogeneity within emerging markets
– Securities tend to move as a group within a single
emerging market
• Heterogeneity across emerging markets
– Emerging markets show low correlation across
markets
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80. 80
Market
Microstructure Considerations
Liquidity risk
Trading costs
Market pressure
Marketability risk
Country risk
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81. 81
Liquidity Risk
Some emerging markets’ investors are mostly
foreign
• Increases political risk
• Sets the stage for a market collapse if everyone pulls
out at once
Some emerging markets lack depth
• The bid/ask spread tends to be wide with few standing
order to buy and to sell
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82. 82
Trading Costs
Foreign market trading costs are more than
1% higher than domestic trading costs
• E.g., bid/ask spread is an average of 95 basis
points for Barings’ Securities emerging market
index
• This indicates an investment must appreciate
more to show a given net return
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83. 83
Market Pressure
An order to buy or sell a large number of
shares might cause a substantial
supply/demand imbalance
• Causes the price to move adversely from the
investor’s perspective
• Indicates that emerging market investments
should be viewed as long-term investments
rather than a source of trading profits
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84. 84
Marketability Risk
An investor may be unable to close out a
position at a reasonable price
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85. 85
Country Risk
Country risk refers to a country’s ability
and willingness to meet its foreign
exchange obligations
• Especially important in emerging markets
Country risk has two components:
• Political risk
• Economic risk
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86. 86
Political Risk
Introduction
Factors contributing to political risk
Macro risk versus micro risk
Dealing with political risk
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87. 87
Introduction
Political risk is a measure of a country’s
willingness to honor its foreign obligations
• A function of:
– The stability of the governments and its leadership
– Attitudes of labor unions
– The country’s ideological background
– The country’s past history with foreign investors
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88. 88
Introduction (cont’d)
Real (direct) investment is an investment
over which the investor retains control
• E.g., a plant in a foreign country
Portfolio investment refers to foreign
investment via the securities market
• E.g., buying a number of shares of a foreign
company
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89. 89
Introduction (cont’d)
Extreme forms of country risk for portfolio
investment:
• Government takeover of a company
• Political unrest leading to work stoppages
• Physical damage to facilities
• Forced renegotiation of contracts
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90. 90
Introduction (cont’d)
Modest forms of country risk for portfolio
investment:
• A requirement that a minimum percentage of
supervisory positions be held by locals
• Changes in operating rules
• Restrictions on repatriation of capital
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91. 91
Factors Contributing
to Political Risk
“Buy local” attitude
Public attitude
Government attitude
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92. 92
“Buy Local” Attitude
Buy local campaigns seek to make foreign
consumers buy local goods instead of goods
produced by a foreign firm or its
subsidiaries
Contributes to political risk
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93. 93
Public Attitude
In emerging markets, people may see no
opportunity to improve their standard of living
• Foreign subsidiaries may contribute to this attitude with
luxury items
The gap between the public’s aspirations and its
expectations contributes to political risk
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94. 94
Government Attitude
Unstable governments can lead to foreign
investors being a volatile political issue
• Foreign investors can be blamed for local
problems
• Foreign governments can suspend a firm’s
ability to send funds back to its home country
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95. 95
Macro Risk Versus Micro Risk
Macro risk refers to government actions that
affect all foreign firms in a particular industry
Micro risk refers to politically motivated changes
in the business environment directed to selected
fields of business activity or to foreign enterprises
with specific characteristics
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96. 96
Dealing With Political Risk
Seek a foreign investment guarantee from
the Overseas Private Investment
Corporation
• Provides coverage against:
– Loss due to expropriation
– Nonconvertibility of profits
– War or civil disorder
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97. 97
Dealing With
Political Risk (cont’d)
Avoid engaging in behavior that stirs up
trouble with the host people or government:
• Constructing flamboyant office buildings
• Giving the impression of natural resource
exploitation
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98. 98
Economic Risk
Economic risk is a measure of a country’s
ability to pay
• Assess economic risk by:
– Using coverage ratios
– Assessing the country’s capital base
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99. 99
Other Topics
Multinational corporations
American depository receipts
International mutual funds
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100. 100
Multinational Corporations
Investing in a multinational corporation
may provide a ready-made means of getting
the risk-reduction benefits of international
diversification
• Research is unclear whether MNCs are better
investments than purely domestic firms
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American Depository Receipts
American depository receipts (ADRs) are receipts
representing shares of stock that are held on the
ADR holder’s behalf in a bank in the country of
origin
• An alternative to purchasing shares in a foreign
company directly on the foreign exchange
By 2000, 1,534 ADRS from dozens of countries
traded in the U.S.
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International Mutual Funds
Mutual funds permit diversification to an
extent that would not otherwise be possible
• Some mutual funds invest only in securities
issued outside the U.S.
• Buying an international mutual fund is a good
way to achieve international diversification
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