International Portfolio Investment

1. International Portfolio Investment • I. The Rationale for International Portfolio Investment • II. Avenues for International Investment

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

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

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

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)

6. International Portfolio Investment cont’d

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

8. International Portfolio Investment cont’d

9. International Portfolio Investment cont’d

10. International Portfolio Investment cont’d

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)

12. International Portfolio Investment cont’d

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)

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

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

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

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.

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 funds • Reference: http://www.websontheweb.com/

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

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

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.