Chapter 19: Overseas Markets Flashcards
3 Main reasons to hold foreign assets
- Match liabilities in the foreign currency
- To increase expected returns
- Reduce risk by increasing the level of diversification
How would foreign assets increase expected returns
- strengthening currencies
- higher risk or fast-growing economies
- undervalued markets
FUNDAMENTAL Drawbacks of Overseas Markets
- Mismatch of domestic liabilities
- Tax (withholding tax and possible double taxation)
- Volatility of the currency (currency risk)
PRACTICAL drawbacks of overseas investment
- need an overseas CUSTODIAN
- poorly REGULATED markets
- additional ADMINISTRATION
- possible lack of MARKETABILITY and liquidity
- LANGUAGE problems
- lack of good quality INFORMATION
- restrictions on ownership of certain shares by FOREIGN investors
- cost of obtaining EXPERTISE
- possible TIME delays
- problems REPATRIATING funds
- different ACCOUNTING methods/standards
- POLITICAL instability & risks (asset confiscation)
CRAM LIFE TRAP
Indirect overseas investments include investments in:
- MULTINATIONAL companies based in the home market
- domestic companies with a substantial EXPORT trade
- DERIVATIVES based on overseas assets.
- Companies with INTERNATIONAL SUBSIDIARIES
- (ITCs) COLLECTIVE INVESTMENT SCHEMES specialising in overseas investment
Special characteristics of emerging markets
Can be very volatile (gives the investor chance of making very big gains/losses).
- Can be affected by enormous flows of money generated by changes in investor sentiment.
- Economies and markets of many smaller markets are less interdependent than those of major economic powers, resulting in good diversification.
Factors to consider before investing in emerging markets
- Current market VALUATION
- range of companies available.
- extent of additional DIVERSITY generated.
- Possibility of high ECONOMIC GROWTH rate
- degree of POLITICAL stability
- RESTRICTIONS on foreign investment.
- market REGULATION
- STABILITY AND STRENGTH of the currency
- EXPERTISE in the markets
- availability and quality of INFORMATION.
- COMMUNICATION problems
- level of marketability
- extra EXPENSES
Matching liabilities in the foreign currency
For funds with domestic liabilities, the reasons for overseas investment depend on the effect that such investments have on the expected risk/return of the whole portfolio.
Why may returns on overseas investments be higher than returns on domestic investments?
Returns on overseas investment can be higher than domestic returns either because they are fair compensation for the higher risk involved, or if inefficiencies in the global market allow fund managers to find individual countries whose markets are undervalued.
Diversification w.r.t. overseas investment
- Investing in a number of different countries or economies with a low degree of correlation helps to reduce risk.
- achieved by investing in industries that are not available for investment in the home market
- gives a larger number of companies from which to construct a diversified portfolio.
Withholding tax
tax deducted at source from dividends or other income paid to non-residents of a country.
Double taxation agreement
Done between the domestic tax authorities and the particular overseas country, allowing for domestic tax to be reduced/eliminated because of the overseas tax already paid.
2 reasons for increased expertise requirements
- there are extra variables to analyse (eg overseas economies and currencies)
- more work is required to overcome the problems with information.
Expenses related to overseas investment
- Increased expertise
- Necessary to appoint overseas custodian to deal with settlement
- Need to recruit additional staff & set up accounting for foreign currencies/repatriation of funds.
Advantages of investing in multinational companies based in the home market
- EASY to deal in the the familiar home market
- better/increased ACCESS
- companies will have EXPERTISE and tend to conduct their business in the most profitable areas overseas, including areas where direct investment may be difficult.
- more MARKETABLE
Disadvantages of investing in multinational companies based in the home market
- such a company’s earnings might be DILUTED by domestic earnings
- investor will have no CHOICES in where the company transacts its business.
Emerging market
Stock markets in developing countries such as China, Mexico, Singapore etc.
They offer high expected returns due to rapid industrialisation.
Very risky markets.
The actual term, “emerging markets”
May refer to
- markets in countries classified by the World Bank as low or middle income
- markets with a stock market capitalisation of less than 2% of the total world market capitalisation.
Attractions of investments in emerging markets
- Rapid economic growth
- Better diversification
- Inefficient markets: buy cheaply
- Perceived to be risky: buy cheaply
Inefficient markets: buy cheaply
Pricing of the currencies and the stock markets of developing economies is less efficient than that of the world’s largest markets.
Means that there may be significant anomalies from time to time, giving investors the opportunity to buy cheaply (or make expensive mistakes).
Stock market regulation in emerging economies
Emerging markets are newer & smaller, more doubts about the efficiency of the processes for regulating the markets.
Foreign investors may lose out due to:
- insider trading by local investors
- fraud
