CH-15 International Portfolio Investment – International Financial Management : Book Guide

CHAPTER 15 INTERNATIONAL PORTFOLIO INVESTMENT ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. What factors are responsible for the recent surge in international portfolio investment (IPI)? Answer: The recent surge in international portfolio investments reflects the globalization of financial markets. Specifically, many countries have liberalized and deregulated their capital and foreign exchange markets in recent years. In addition, commercial and investment banks have facilitated international investments by introducing such products as American Depository Receipts (ADRs) and country funds. Also, recent advancements in computer and telecommunication technologies led to a major reduction in transaction and information costs associated with international investments. In addition, investors might have become more aware of the potential gains from international investments. 2. Security returns are found to be less correlated across countries than within a country. Why can this be? Answer: Security returns are less correlated probably because countries are different from each other in terms of industry structure, resource endowments, macroeconomic policies, and have non-synchronous business cycles. Securities from a same country are subject to the same business cycle and macroeconomic policies, thus causing high correlations among their returns. 3. Explain the concept of the world beta of a security. Answer: The world beta measures the sensitivity of returns to a security to returns to the world market portfolio. It is a measure of the systematic risk of the security in a global setting. Statistically, the world beta can be defined as: Cov(Ri, RM)/Var(RM), where Ri and RM are returns to the i-th security and the world market portfolio, respectively. 4. Explain the concept of the Sharpe performance measure. Answer: The Sharpe performance measure (SHP) is a risk-adjusted performance measure. It is defined as the mean excess return to a portfolio above the risk-free rate divided by the portfolio’s standard deviation. 5. Explain how exchange rate fluctuations affect the return from a foreign market measured in dollar terms. Discuss the empirical evidence on the effect of exchange rate uncertainty on the risk of foreign investment. Answer: It is useful to refer to Equations 15.4 and 15.5 of the text. Exchange rate fluctuations mostly contribute to the risk of foreign investment through its own volatility as well as its covariance with the local market returns. The covariance tends to be positive in most of the cases, implying that exchange rate changes tend to add to exchange risk, rather than offset it. Exchange risk is found to be much more significant in bond investments than in stock investments. 6. Would exchange rate changes always increase the risk of foreign investment? Discuss the condition under which exchange rate changes may actually reduce the risk of foreign investment. Answer: Exchange rate changes need not always increase the risk of foreign investment. When the covariance between exchange rate changes and the local market returns is sufficiently negative to offset the positive variance of exchange rate changes, exchange rate volatility can actually reduce the risk of foreign investment. 7. Evaluate a home country’s multinational corporations as a tool for international diversification. Answer: Despite the fact that MNCs have operations worldwide, their stock prices behave very much like purely domestic firms. This is puzzling yet undeniable. As a result, MNCs are a poor substitute for direct foreign portfolio investments. 8. Discuss the advantages and disadvantages of closed-end country funds (CECFs) relative to the American Depository Receipts (ADRs) as a means of international diversification. Answer: CECFs can be used to diversify into exotic markets that are otherwise difficult to access such as India and Turkey. Being a portfolio, CECFs also provide instant diversification. ADRs do not provide instant diversification; investors should form portfolios themselves. In addition, there are relatively few ADRs from emerging markets. The main disadvantage of CECFs is that their share prices behave somewhat like the host country’s share prices, reducing the potential diversification benefits. 9. Why do you think closed-end country funds often trade at a premium or discount? Answer: CECFs trade at a premium or discount because capital markets of the home and host countries are segmented, preventing cross-border arbitrage. If cross-border arbitrage is possible, CECFs should be trading near their net asset values. 10. Why do investors invest the lion’s share of their funds in domestic securities? Answer: Investors invest heavily in their domestic securities mainly because there are barriers to investing overseas. The barriers may include excessive transaction costs, information costs for foreign securities, legal and institutional restrictions, extra taxes, exchange risk and political risk associated with overseas investments, etc. Investors may also disproportionately invest in domestic securities due to the behavioral bias toward familiarity. 11. What are the advantages of investing via international mutual funds? Answer: The advantages of investing via international mutual funds include: (1) save transaction/information costs, (2) circumvent legal/institutional barriers, and (3) benefit from the expertise of professional fund managers. 12. Discuss how the advent of the euro would affect international diversification strategies. Answer: As the euro-zone has the same monetary and exchange-rate policies, the correlations among euro-zone markets are likely to go up. This will reduce diversification benefits. However, to the extent that the adoption of euro strengthens the European economy, investors may benefit from enhanced returns. PROBLEMS 1. Suppose you are a euro-based investor who just sold Microsoft shares that you had bought six months ago. You had invested 10,000 euros to buy Microsoft shares for $120 per share; the exchange rate was $1.15 per euro. You sold the stock for $135 per share and converted the dollar proceeds into euro at the exchange rate of $1.06 per euro. First, determine the profit from this investment in euro terms. Second, compute the rate of return on your investment in euro terms. How much of the return is due to the exchange rate movement? Solution: It is useful first to compute the rate of return in euro terms: r€  r$ + e  1 1  =135−120  1. −        1.15  = 0.125+ 0.085 = 0.210 This indicates that this euro-based investor benefited from an appreciation of dollar against the euro, as well as from an appreciation of the dollar value of Microsoft shares. The profit in euro terms is about €2,100, and the rate of return is about 21.0% in euro terms, of which 8.5% is due to the exchange rate movement. 2. Mr. James K. Silber, an avid international investor, just sold a share of Nestlé, a Swiss firm, for SF5,080. The share was bought for SF4,600 a year ago. The exchange rate is SF1.60 per U.S. dollar now and was SF1.78 per dollar a year ago. Mr. Silber received SF120 as a cash dividend immediately before the share was sold. Compute the rate of return on this investment in terms of U.S. dollars. Solution: Mr. Silber must have paid $2,584.27 (=4,600/1.78) for a share of Néstle a year ago. When the share was liquidated, he must have received $3,250 [=(5,080 + 120)/1.60]. Therefore, the rate of return in dollar terms is: R($) = [(3,250-2,584.27)/2584.27] x 100 = 25.76%. 3. In the above problem, suppose that Mr. Silber sold SF4,600, his principal investment amount, forward at the forward exchange rate of SF1.62 per dollar. How would this affect the dollar rate of return on this Swiss stock investment? In hindsight, should Mr. Silber have sold the Swiss franc amount forward or not? Why or why not? Solution: The dollar profit from selling SF4,600 forward is equal to: Profit ($) = 4,600 (1/1.62 – 1/1.60) = 4,600 (0.6173 – 0.625) = -$35.42. Thus, the total return of investment is: R($) = [(3,250-2,584.27-35.42)/2584.27] x 100 = 24.39%. By ‘hindsight’, Mr. Silber should not have sold the SF amount forward as it reduced the return in dollar terms. But this is only by hindsight. Obviously, hedging decision must be made ex ante. 4. Japan Life Insurance Company invested $10,000,000 in pure-discount U.S. bonds in May 1995 when the exchange rate was 80 yen per dollar. The company liquidated the investment one year later for $10,650,000. The exchange rate turned out to be 110 yen per dollar at the time of liquidation. What rate of return did Japan Life realize on this investment in yen terms? Solution: Japan Life Insurance Company spent ¥800,000,000 to buy $10,000,000 that was invested in U.S. bonds. The liquidation value of this investment is ¥1,171,500,000, which is obtained from multiplying $10,650,000 by ¥110/$. The rate of return in terms of yen is: [(¥1,171,500,000 - ¥800,000,000)/ ¥800,000,000]x100 = 46.44%. 5. At the start of 1996, the annual interest rate was 6 percent in the United States and 2.8 percent in Japan. The exchange rate was 95 yen per dollar at the time. Mr. Jorus, who is the manager of a Bermuda-based hedge fund, thought that the substantial interest advantage associated with investing in the United States relative to investing in Japan was not likely to be offset by the decline of the dollar against the yen. He thus concluded that it might be a good idea to borrow in Japan and invest in the United States. At the start of 1996, in fact, he borrowed ¥1,000 million for one year and invested in the United States. At the end of 1996, the exchange rate became 105 yen per dollar. How much profit did Mr. Jorus make in dollar terms? Solution: Let us first compute the maturity value of U.S. investment: (¥1,000,000,000/95)(1.06) = $11,157,895. The dollar amount necessary to pay off yen loan is: (¥1,000,000,000)(1.028)/105 = $9,790,476. The dollar profit = $11,157,895 - $9,790,476 = $1,367,419. Mr. Jorus was able to realize a large dollar profit because the interest rate was higher in the U.S. than in Japan and the dollar actually appreciated against yen. This is an example of uncovered interest arbitrage. 6. Suppose we obtain the following data in dollar terms: Stock market Return (mean) Risk (SD) United States 1.26% per month 4.43% United Kingdom 1.23% per month 5.55% The correlation coefficient between the two markets is 0.58. Suppose that you invest equally, i.e., 50% each, in the two markets. Determine the expected return and standard deviation risk of the resulting international portfolio. Solution: The expected return of the equally weighted portfolio is: E(Rp) = (.5)(1.26%) + (.5)(1.23%) = 1.25% The variance of the portfolio is: Var(Rp) = (.5)2(4.43)2 + (.5)2(5.55)2 +2(.5)2(4.43)(5.55)(.58) = 4.91 +7.70 + 7.13 = 19.74 The standard deviation of the portfolio is thus 4.44%. 7. Suppose you are interested in investing in the stock markets of 7 countries--i.e., Australia, Canada, Germany, Japan, Switzerland, the United Kingdom, and the United States--the same 7 countries that appear in Exhibit 15.9. Specifically, you would like to solve for the optimal (tangency) portfolio comprising the above seven stock markets. In solving the optimal portfolio, use the input data (i.e. correlation coefficients, means, and standard deviations) provided in Exhibit 15.4. The risk-free interest rate is assumed to be 0.2% per month and you can take a short position in any stock market. What are the optimal weights for each of the seven stock markets? What is the risk and return of the optimal portfolio? This problem can be solved using MPTSolver.xls spreadsheet. Solution: Sample Period: 1980.1 -2012.12 (in U.S. dollar terms) Correlation Coefficients Stock Market AU CN GM JP SW UK US Mean (%) SD (%) Optimal Weight Australia (AU) 1 0.550 7.18 -0.0557 Canada (CN) 0.69 1 0.549 6.11 -0.2081 Germany (GM) 0.55 0.60 1 0.565 6.87 -0.3597 Japan (JP) 0.39 0.40 0.41 1 0.437 6.59 -0.0344 Switzerland (SW) 0.55 0.58 0.76 0.47 1 0.709 5.42 0.7968 United Kingdom (UK) 0.68 0.69 0.67 0.48 0.69 1 0.550 5.59 -0.1285 United States (US) 0.63 0.77 0.65 0.38 0.65 0.72 1 0.647 4.59 0.9896 The monthly mean return and standard deviation of the optimal portfolio are 0.772% and 4.790%, respectively. Hence, the Sharpe ratio of the optimal portfolio is equal to 0.119 = (0.772- 0.20)/4.790. 8. The HFS Trustees have solicited input from three consultants concerning the risks and rewards of an allocation to international equities. Two of them strongly favor such action, while the third consultant commented as follows: “The risk reduction benefits of international investing have been significantly overstated. Recent studies relating to the cross-country correlation structure of equity returns during different market phases cast serious doubt on the ability of international investing to reduce risk, especially in situations when risk reduction is needed the most.” a. Describe the behavior of cross-country equity return correlations to which the consultants is referring. Explain how that behavior may diminish the ability of international investing to reduce risk in the short run. Assume that the consultant’s assertion is correct. b. Explain why it might still be more efficient on a risk/reward basis to invest internationally rather than only domestically in the long run. The HFS Trustees have decided to invest in non-U.S. equity markets and have hired Jacob Hind, a specialist manager, to implement this decision. He has recommended that an unhedged equities position be taken in Japan, providing the following comments and the table data to support his view: “Appreciation of a foreign currency increases the returns to a U.S. dollar investor. Since appreciation of the Yen from ¥100/$U.S. to ¥98/$U.S. is expected, the Japanese stock position should not be hedged.” Market Rates and Hind’s Expectations U.S. Japan Spot rate (yen per $U.S.) n/a 100 Hind’s 12-month currency forecast (yen per $U.S.) n/a 98 1-year Eurocurrency rate (% per annum) 6.00 0.80 Hind’s 1-year inflation forecast (% per annum) 3.00 0.50 Assume that the investment horizon is one year and that there are no costs associated with currency hedging. c. State and justify whether Hind’s recommendation (not to hedge) should be followed. Show any calculations. Solution: a. Cross-country correlations tend to increase during the turbulent market phase, reducing the benefits from international diversification in the short run. b. Unless the investor has to liquidate investments during the turbulent phase, he/she can ride out the turbulence and realize the benefits from international investments in the long run. c. The interest rate parity implies that the forward exchange rate would be ¥95.09/$: F = [1.06/1.008](1/100) = $0.010516/¥ = ¥95.09/$, which is compared with Hind’s expected future spot rate of ¥98/$. Clearly, the HFS Trustees can receive more dollar amount from selling yen forward than from the unhedged position. Relative to the forward rate, Hind underestimates the yen’s future strength. 9. Rebecca Taylor, an international equity portfolio manager, recognizes that optimal country allocation strategy combined with an optimal currency strategy should produce optimal portfolio performance. To develop her strategy, Taylor produced the table below, which provides expected return data for the three countries and three currencies in which she may invest. The table contains the information she needs to make market strategy (country allocation) decisions and currency strategy (currency allocation) decisions. Expected Returns for a U.S.-Based Investor Country Local Currency Exchange Rate Local Currency Equity Returns Returns Eurodeposit Returns Japan 7.0% 1.0% 5.0% United Kingdom 10.5 -3.0 11.0 United States 8.4 0.0 7.5 a. Prepare a ranking of the three countries in terms of expected equity-market return premiums. Show your calculations. b. Prepare a ranking of the three countries in terms of expected currency return premiums from the perspective of a U.S. investor. Show your calculations. c. Explain one advantage a portfolio manager obtains, in formulating a global investment strategy, by calculating both expected market premiums and expected currency premiums. Solution: a. United Kingdom = first; United States = second; Japan = third. b. Japan = first; United States = second; United Kingdom = third. c. Computing expected currency premium helps the portfolio manager to decide whether to hedge currency risk. 10. The Glover Scholastic Aid Foundation has received a €20 million global government bond portfolio from a Greek donor. This bond portfolio will be held in euros and managed separately from Glover’s existing U.S. dollar-denominated assets. Although the bond portfolio is currently unhedged, the portfolio manager, Raine Sofia, is investigating various alternatives to hedge the currency risk of the portfolio. The bond portfolio’s current allocation and the relevant country performance data are given in Exhibits 1 and 2. Historical correlations for the currencies being considered by Sofia are given in Exhibit 3. Sofia expects that future returns and correlations will be approximately equal to those given in Exhibits 2 and 3. Exhibit 1. Glover Scholastic Aid Foundation Current Allocation Global Government Bond Portfolio Country Allocation (%) Maturity (years) Greece 25 5 A 40 5 B 10 10 C 10 5 D 15 10 Exhibit 2. Country Performance Data (in local currency) Country Cash Return (%) 5-year Excess Bond Return (%) 10-year Excess Bond Return (%) Unhedged Currency Return (%) Liquidity of 90-day Currency Forward Contracts Greece 2.0 1.5 2.0 --- Good A 1.0 2.0 3.0 – 4.0 Good B 4.0 0.5 1.0 2.0 Fair C 3.0 1.0 2.0 – 2.0 Fair D 2.6 1.4 2.4 – 3.0 Good Exhibit 3. Historical Currency Correl ation Table (199 8-2003, weekly observations) € Currency (Greece) A B C D € (Greece) 1.00 –0.77 0.45 –0.57 0.77 A --- 1.00 –0.61 0.56 –0.70 B --- --- 1.00 –0.79 0.88 C --- --- --- 1.00 –0.59 D --- --- --- --- 1.00 a. Calculate the expected total annual return (euro-based) of the current bond portfolio if Sofia decides to leave the currency risk unhedged. Show your calculations. b. Explain, with respect to currency exposure and forward rates, the circumstance in which Sofia should use a currency forward contract to hedge the current bond portfolio’s exposure to a given currency. c. Determine which one of the currencies being considered by Sofia would be the best proxy hedge for Country B bonds. Justify your response with two reasons. Sofia has been disappointed with the low returns on the current bond portfolio relative to the benchmark—a diversified global bond index—and is exploring general strategies to generate excess returns on the portfolio. She has already researched two such strategies: duration management and investing in markets outside the benchmark index. d. Identify three general strategies (other than duration management and investing in markets outside the benchmark index) that Sofia could use to generate excess returns on the current bond portfolio. Give, for each of the three strategies, a potential benefit specific to the current bond portfolio. Solution: a. The unhedged expected annual portfolio return in euros is calculated as follows: WG × (rG + eH,G) + WA × (rA + eH,A) + WB × (rB + eH,B) + WC × (rC + eH,C) + WD × (rD + eH,D) = 0.25 × (2% + 1.5%) + 0.4 × (1% + 2% – 4%) + 0.1 × (4% + 1% + 2%) + 0.1 × (3% + 1% – 2%) + 0.15 × (2.6% + 2.4% – 3%) = 0.875% – 0.4% + 0.7% + 0.2% + 0.3% = 1.675% = 1.68% b. If Sofia expects the unhedged percentage return from exposure to a currency to be less than the forward discount or premium, she should use a forward contract to hedge exposure to that currency. The circumstance can also be expressed as: eH,i < cH – ci where: unhedged expected currency return for country i = eH,i forward premium or discount = cH – ci c. Country D currency would provide the best proxy hedge for Country B bonds for any of the following reasons: • The liquidity of 90-day currency forward contracts for country D is good. • The relevant currencies − Country B and Country D (hedge) − are historically more highly correlated (0.88) and therefore Country D provides a more accurate proxy hedge. • Sofia could capitalize on a negative view of Country D currency relative to Country B currency by establishing a short position in Country D currency. d. 1. Bond Market Selection: Because there are bonds from only five countries in the current portfolio, better risk-adjusted returns could be realized by diversifying into government bonds from other countries in the index that have low correlations with existing bonds. 2. Sector/Credit/Security Selection: The current portfolio is invested exclusively in government bonds. Other sectors such as corporate bonds, asset-backed securities, and mortgage-backed securities could provide further diversification and potentially enhance portfolio risk-adjusted return. 3. Currency Selection: Active currency management can be used to produce superior risk-adjusted returns. One could either hedge the entire portfolio from currency risk or implement expectations about specific currencies by fully hedging, partially hedging, or not hedging. MINI CASE: SOLVING FOR THE OPTIMAL INTERNATIONAL PORTFOLIO Suppose you are a financial advisor and your client, who is currently investing only in the U.S. stock market, is considering diversifying into the U.K. stock market. At the moment, there are neither particular barriers nor restrictions on investing in the U.K. stock market. Your client would like to know what kind of benefits can be expected from doing so. Using the data provided in the above problem (i.e., problem 12), solve the following problems: (a) Graphically illustrate various combinations of portfolio risk and return that can be generated by investing in the U.S. and U.K. stock markets with different proportions. Two extreme proportions are (I) investing 100% in the U.S. with no position in the U.K. market, and (ii) investing 100% in the U.K. market with no position in the U.S. market. (b) Solve for the ‘optimal’ international portfolio comprised of the U.S. and U.K. markets. Assume that the monthly risk-free interest rate is 0.5% and that investors can take a short (negative) position in either market. (c) What is the extra return that U.S. investors can expect to capture at the ‘U.S.-equivalent’ risk level? Also trace out the efficient set. [The Appendix 11.B provides an example.] Suggested Solution to the Optimal International Portfolio: Let U.S. be market 1 and U.K. be market 2. The parameter values are: R¯1 = 1.26%, R¯2 = 1.23%, 1 = 4.43%, 2 = 5.55%, Rf = 0.5%. Accordingly, 12 = 12 ρ12 = (4.43)(5.55)(0.58) = 14.26, 12 = 19.62, 22 = 30.80. (a) E(Rp) = 1.26w1 + 1.23w2 The variance of the portfolio is: Var(Rp) = 19.62w12 + 30.80w22 + 2(14.26)w1w2 Some possible portfolios are: w1 w2 E(Rp) Var(Rp) 1.00 0.00 1.26 19.62 0.75 0.25 1.25 18.31 0.50 0.50 1.245 19.74 0.25 0.75 1.238 23.90 0.00 1.00 1.23 30.80 (b) The optimal weights are w1 = 0.79 and w2 = 0.21. (c) R¯I = Rf + US Here,  = Slope of efficient set = (R¯OIP - Rf )/ OIP R¯OIP = (0.79)(1.26) + (0.21)(1.23) = 1.26% OIP2 = (0.79)2(19.62) + (0.21)2(30.8) + 2(0.79)(0.21)(14.26) = 18.55 OIP = 4.28% Therefore, R¯I = 0.5 + [(1.26 - 0.5)/4.28](4.43) = 1.29% Extra return = 1.29 - 1.26 = 0.03% International Portfolio Investment Chapter 15 Chapter Outline • International Correlation Structure and Risk Diversification • Optimal International Portfolio Selection • Effects of Changes in the Exchange Rate • International Bond Investment • International Mutual Funds: A Performance Evaluation • International Diversification through Country Funds • International Diversification with ADRs • International Diversification with ETFs • International Diversification with Hedge Funds • Why Home Bias in Portfolio Holdings? • International Diversification with Small-Cap Stocks U.S. Investment in Foreign Equities International Correlation Structure and Risk Diversification • Security returns are much less correlated across countries than within a country. – This is true because economic, political, institutional, and even psychological factors affecting security returns tend to vary across countries, resulting in low correlations among international securities. – Business cycles are often high asynchronous across countries. Domestic vs. International Diversification When fully diversified, an international portfolio can be less than half as risky as a purely U.S. portfolio. A fully diversified international portfolio is only 12 percent as risky as holding a single security. 0.44 Swiss stocks 0.27 U.S. stocks 0.12 International stocks Number 1 10 20 30 40 50 of Stocks Summary Statistics of the Monthly Returns for 12 Major Stock Markets: 1980.1 – 2012.12 (All Statistics in U.S. Dollars) Correlation Coefficients Mean SD Stock Market AU CN FR GM HK IT JP NL SD SW UK (%) (%) βa SHPb (Rank) Australia (AU)  measures the sensitivity of the 0.550 7.18 1.09 0.074 (9) Canada (CN) 0.69 market to the world market. 0.549 6.11 1.04 0.087 (6) France (FR) 0.56 0.59 0.551 6.73 1.13 0.079 (8) Germany (GM) 0.55 0.60 0.79 Clearly the Japanese market is 0.565 6.87 1.14 0.080 (7) Hong Kong (HK) 0.55 0.52 0.38 0.42 more sensitive to the world 0.664 9.04 1.03 0.071 (10) Italy (IT) 0.46 0.53 0.67 0.64 0.37 market than is the U.S. 0.450 7.57 1.07 0.057 (12) Japan (JP) 0.39 0.40 0.45 0.41 0.30 0.40 0.437 6.59 0.99 0.064 (11) Netherlands (NL) 0.61 0.67 0.79 0.81 0.49 0.62 0.47 0.635 5.97 1.08 0.103 (4) Sweden (SD) 0.60 0.62 0.65 0.70 0.45 0.59 0.43 0.70 1.008 7.51 1.23 0.132 (3) Switzerland (SW) 0.55 0.58 0.71 0.76 0.40 0.52 0.47 0.76 0.63 0.709 5.42 0.89 0.133 (2) United Kingdom 0.68 0.69 0.71 0.67 0.53 0.58 0.48 0.78 0.65 0.69 0.550 5.59 1.01 0.095 (5) United States (US) 0.63 0.77 0.65 0.65 0.48 0.51 0.38 0.73 0.67 0.65 0.72 0.647 4.59 0.88 0.137 (1) The Average Return Correlation among 10 Major International Stock Markets Over Time, 1981 – 2012 Australia, Canada, France, Germany, Hong Kong, Italy, Japan, Netherlands, the UK and the U.S. Optimal International Portfolio Selection • The correlation of the U.S. stock market with the returns on the stock markets in other nations varies. • The correlation of the U.S. stock market with the Canadian stock market is 77%. • The correlation of the U.S. stock market with the Japanese stock market is 38%. • A U.S. investor would get more diversification from investments in Japan than Canada. Selection of the Optimal International Portfolio Gains from International Diversification by Investor’s Domicile (Monthly Returns: 1980 – 2012) Investor's Domicile Mean (%) Domestic Portfolio SD (%) SHP Mean (%) Optimal International Portfolio SD (%) SHP Gains from International Investment ΔSHP (Δ%)a ΔR(%)b (%p.a.)c Australia (AU) 0.56 5.43 0.068 0.83 4.78 0.133 0.065 (95) (0.35) (4.23) Canada (CN) 0.51 4.98 0.086 0.73 4.39 0.147 0.061 (71) (0.30) (3.65) France (FR) 0.61 6.00 0.100 0.83 4.95 0.168 0.067 (67) (0.40) (4.85) Germany (GM) 0.53 6.18 0.085 0.77 5.10 0.149 0.064 (76) (0.40) (4.78) Hong Kong (HK) 0.78 8.71 0.087 0.85 4.81 0.173 0.086 (98) (0.75) (8.95) Italy (IT) 0.60 6.93 0.086 0.93 4.95 0.187 0.100 (116) (0.69) (8.33) Japan (JP) 0.17 5.72 0.028 0.63 6.65 0.093 0.066 (236) (0.38) (4.51) Netherlands (NL) 0.60 5.57 0.108 0.77 5.08 0.150 0.043 (39) (0.24) (2.84) Sweden (SD) 1.13 6.90 0.148 0.91 4.69 0.173 0.025 (17) (0.17) (2.05) Switzerland (SW) 0.57 4.89 0.120 0.76 5.03 0.153 0.033 (28) (0.16) (1.94) United Kingdom (UK) 0.63 4.85 0.122 0.86 5.14 0.159 0.038 (31) (0.18) (2.19) United States (US) 0.65 4.59 0.137 0.75 4.86 0.151 0.014 (10) (0.06) (0.78) Composition of the Optimal International Portfolio by Investors’ Domicile (Holding Period: 1980 – 2012) From the perspective of Investors Domiciled in Stock Market AU CN FR GM HK IT JP NL SD SW UK US LCa Australia (AU) 0.0650 0.0099 Canada (CN) France (FR) Germany (GM) Hong Kong (HK) 0.0020 0.0307 0.0171 Italy (IT) Japan (JP) 0.0015 0.0043 0.0054 0.0104 0.0053 Netherlands (NL) Sweden (SD) 0.4372 0.2962 0.2596 0.3210 0.1950 0.2558 0.6409 0.3121 0.3220 0.3319 0.3073 0.2431 0.5378 Switzerland (SW) 0.2688 0.2365 0.6338 0.6233 0.3239 0.5654 0.3591 0.6245 0.5323 0.6681 0.4541 0.2797 United Kingdom (UK) 0.0770 0.0748 United States (US) 0.2290 0.4638 0.1022 0.0558 0.4450 0.1684 0.0635 0.1404 0.1616 0.4772 0.3604 Total 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 Risk-free rate (%)b 0.1958 0.0817 0.0050 0.0050 0.0192 0.0050 0.0075 0.0050 0.1032 -0.0129 0.0408 0.0179 0.0179 Composition of the Optimal International Portfolio for U.S.-Based Investor (Holding Period: 1980 – 2012) Stock Market US LCa Australia (AU) 0.0099 Hong Kong (HK) 0.0171 Sweden (SD) 0.2431 0.5378 Switzerland (SW) 0.2797 United Kingdom (UK) 0.0748 United States (US) 0.4772 0.3604 Total 1.0000 1.0000 Risk-free rate (%)b 0.0179 0.0179 a LC column provides the composition of the optimal international portfolio without considering exchange rate changes. b The risk-free rate denotes the risk-free interest rate faced by investors domiciled in the corresponding country in December 2012. It is proxied by the one-month Treasury bill rate. Gains from International Diversification OIP ODP Mean Return 0.75% 0.65% Standard Deviation 4.86% 4.59% • For a U.S. investor, OIP has more return and more risk. The Sharpe measure is 10 percent higher, suggesting that an equivalent-risk OIP would have more return per unit of risk than a domestic portfolio.Effects of Changes in the Exchange Rate • The realized dollar return for a U.S. resident investing in a foreign market will depend not only on the return in the foreign market but also on the change in the exchange rate between the U.S. dollar and the foreign currency. Effects of Changes in the Exchange Rate • The realized dollar return for a U.S. resident investing in a foreign market is given by Ri$ = (1 + Ri)(1 + ei) – 1 = Ri + ei + Riei Where Ri is the local currency return in the ith market ei is the rate of change in the exchange rate between the local currency and the dollar Effects of Changes in the Exchange Rate • For example, if a U.S. resident just sold shares in a British firm that had a 15% return (in pounds) during a period when the pound depreciated 5%, his dollar return is 9.25%: Ri$ = (1 + .15)(1 – 0.05) – 1 = 0.925 = .15 + –.05 + .15×(–.05) = 0.925 Effects of Changes in the Exchange Rate • The risk for a U.S. resident investing in a foreign market will depend not only on the risk in the foreign market but also on the risk in the exchange rate between the U.S. dollar and the foreign currency. Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + Var The Var term represents the contribution of the cross-product term, Riei, to the risk of foreign investment. Effects of Changes in the Exchange Rate Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + Var • This equation demonstrates that exchange rate fluctuations contribute to the risk of foreign investment through three channels: – Its own volatility, Var(ei). – Its covariance with the local market returns Cov(Ri,ei). – The contribution of the cross-product term, Var. International Bond Investment • There is substantial exchange rate risk in foreign bond investment. This suggests that investors may be able to increase their gains if they can control this risk, for example with currency forward contracts or swaps. • The advent of the euro is likely to alter the riskreturn characteristics of the euro-zone bond markets, enhancing the importance of non-euro currency bonds. Decomposition of the Variance of International Security Returns in USD (Monthly Data: 1990.1 – 2012.12) Summary Statistics of the Monthly Returns to Bonds and the Composition of the Optimal International Bond Portfolio (in U.S.D 1990.1 – 2012.12) Optimal Correlation Coefficient International Portfolioa Mean SD Bond Market AU CN GM JP SW UK (%) (%) SHP (Weights) Australia (AU) 0.40% monthly return = 4.80% APR 0.40 3.77 0.10 0.1439 Canada (CN) 0.68 0.30 2.82 0.10 0.3629 Germany (GM) 0.50 0.42 0.27 3.40 0.07 -0.6597 Japan (JP) 0.27 0.19 0.45 0.45 3.63 0.12 0.3456 Switzerland (SW) 0.42 0.32 0.82 0.50 0.44 3.61 0.12 0.6329 United Kingdom (UK) 0.46 0.48 0.71 0.33 0.60 0.27 3.23 0.08 0.0731 United States (US) 0.35 0.36 0.49 0.36 0.36 0.41 0.16 2.17 0.07 0.1014 Optimal International Portfolio : 0.46 2.64 0.17 International Mutual Funds: A Performance Evaluation • A U.S. investor can easily achieve international diversification by investing in a U.S.-based international mutual fund. • The advantages include: – Savings on transaction and information costs. – Circumvention of legal and institutional barriers to direct portfolio investments abroad. – Professional management and record keeping. International Mutual Funds: A Performance Evaluation As sample of U.S.-based international mutual funds has outperformed the S&P 500 during the period 1977-1986, but with a higher standard deviation. US Mean Annual Standard Return Deviation US R2 U.S. Based International Mutual Funds 18.96% 5.78% 0.69 0.39 S&P 500 14.04% 4.25% 1.00 1.00 U.S. MNC Index 16.08% 4.38 0.98 0.90 International Mutual Funds: A Performance Evaluation U.S. stock market movements account for less than 40% of the fluctuations of international mutual funds, but over 90% of the movements in U.S. MNC shares. This means that the shares of U.S. MNCs behave like those of domestic firms, without providing effective international diversification. Mean Annual Standard Return Deviation US R2 U.S. Based International Mutual Funds 18.96% 5.78% 0.69 0.39 S&P 500 14.04% 4.25% 1.00 1.00 U.S. MNC Index 16.08% 4.38 0.98 0.90 International Diversification Through Country Funds • Recently, country funds have emerged as one of the most popular means of international investment. • A country fund invests exclusively in the stocks of a single county. This allows investors to: – Speculate in a single foreign market with minimum cost. – Construct their own personal international portfolios. – Diversify into emerging markets that are otherwise practically inaccessible. International Diversification Through American Depository Receipts • Foreign stocks often trade on U.S. exchanges as ADRs. • An ADR is a receipt that represents the number of foreign shares that are deposited at a U.S. bank. • The bank serves as a transfer agent for the ADRs. American Depository Receipts • There are many advantages to trading ADRs as opposed to direct investment in the company’s shares: – ADRs are denominated in U.S. dollars, trade on U.S. exchanges, and can be bought through any broker. – Dividends are paid in U.S. dollars. – Most underlying stocks are bearer securities and the ADRs are registered. • Adding ADRs to domestic portfolios has a substantial risk reduction benefit. World Equity Benchmark Shares • In April 1996, the American Stock Exchange (AMEX) introduced a class of securities called World Equity Benchmark Shares (WEBS), designed and managed by Barclays Global Investors. • In essence, WEBS are exchange-traded funds (ETFs) that are designed to closely track foreign stock market indexes. • Currently, there are 23 WEBS tracking the Morgan Stanley Capital International (MSCI) indexes for the following individual countries: Australia, Austria, Belgium, Brazil, Canada, Chile, China, France, Germany, Hong Kong, Italy, Japan, Korea, Malaysia, Mexico, the Netherlands, Singapore, South Africa, Spain, Sweden, Switzerland, Taiwan, and the United Kingdom. International Diversification with Exchange Traded Funds • Using exchange traded funds (ETFs) like WEBS and spiders, investors can trade a whole stock market index as if it were a single stock. • Being open-end funds, WEBS trade at prices that are very close to their net asset values. In addition to single country index funds, investors can achieve global diversification instantaneously just by holding shares of the S&P Global 100 Index Fund that is also trading on the AMEX with other WEBS. International Diversification with Hedge Funds • Hedge funds which represent privately pooled investment funds have experienced phenomenal growth in recent years. • This growth has been mainly driven by the desire of institutional investors (such as pension plans, endowments, and private foundations) to achieve positive or absolute returns, regardless of whether markets are rising or falling. International Diversification with Hedge Funds • Unlike traditional mutual funds that generally depend on “buy and hold” investment strategies, hedge funds may adopt flexible, dynamic trading strategies, often aggressively using leverages, short positions, and derivative contracts, in order to achieve their investment objectives. • These funds may invest in a wide spectrum of securities, such as currencies, domestic and foreign bonds and stocks, commodities, real estate, and so forth. • Many hedge funds aim to realize positive returns, regardless of market conditions. International Diversification with Hedge Funds • Hedge funds tend to have relatively low correlations with various stock market benchmarks and thus offer diversification. • In addition, hedge funds allow investors to access foreign markets that are not easily accessible. – For example, JPMorgan provides access to the Jayhawk China Fund, a hedge fund investing in Chinese stocks not readily available in U.S. markets. • Also, hedge funds may allow investors to benefit from certain global macroeconomic events. In fact, many hedge funds are classified as “global/macro” funds. – Examples of global/macro funds include such well-known names as George Soros’ Quantum Fund, Julian Robertson’s Jaguar Fund, and Louis Bacon’s Moore Global Fund. International Diversification with Hedge Funds • Legally, hedge funds are private investment partnerships. As such, these funds generally do not register as an investment company under the Investment Company Act and are not subject to any reporting or disclosure requirements. – As a result, many hedge funds operate under rather opaque environments. • While investors may benefit from hedge funds, they need to be aware of the associated risk as well. – Hedge funds may make wrong bets based on the incorrect prediction of future events and wrong models. – The failure of Long Term Capital Management provides an example of the risk associated with hedge fund investing. International Diversification with Hedge Funds • Hedge fund advisors typically receive a management fee, often 1-2 percent of the fund asset value, as compensation plus a performance fee that can be 20-25 percent of capital appreciation. • Investors may not be allowed to liquidate their investments during a certain lock-up period. • In the United States, only institutional investors and wealthy individuals are allowed to invest in hedge funds. • In many European countries, however, retail investors are also allowed to invest in these funds. Home Bias in Portfolio Holdings • As previously documented, investors can potentially benefit a great deal from international diversification. • The actual portfolios that investors hold, however, are quite different from those predicted by the theory of international portfolio investment. • Home bias refers to the extent to which portfolio investments are concentrated in domestic equities. Home Bias in Equity Portfolios Country Share in World Market Value Proportion of Domestic Equities in Portfolio Australia 1.70 78.91 Brazil 0.71 100.00 Canada 2.67 28.67 Germany 3.21 29.35 Japan 9.29 98.50 Sweden 1.00 48.56 United Kingdom 7.64 42.95 United States 44.86 86.88 Why Home Bias in Portfolio Holdings? • Three explanations come to mind: – Domestic equities may provide a superior inflation hedge. – Home bias may reflect institutional and legal restrictions on foreign investment. – Extra taxes and transactions/information costs for foreign securities may give rise to home bias. Why Home Bias in Portfolio Holdings? • A recent study of the brokerage records of tens of thousands of U.S. individual investors shows that wealthier, more experienced, sophisticated investors are more likely to invest in foreign securities. • Another study shows that when a country is remote and has an uncommon language, foreign investors tend to stay away. International Diversification with Small- Cap Stocks • Current research suggests that investors can clearly enhance the gains from international investment by augmenting their portfolios with foreign, small-cap stocks. • In response, investment companies have introduced many small-cap-oriented international mutual funds. Solution Manual for International Financial Management Cheol S. Eun, Bruce G. Resnick 9780077861605