international diversification

Question 1

Develop on asymmetries in volatility of developed versus emerging markets and explain the implications

Answer 1

Developed have lower volatility than emerging, this implies more risk for a portfolio that is geared towards emerging markets more than developed

Question 2

Explain the volatilities asymmetry between bull and bear markets and recession vs expansion

Answer 2

Both pretty much the same: volatility is higher in the bad cases.
- Expected return is a bad term to use from the prof, required return would be better. As asset prices are lower in recessions and bear markets, required return of risky environment is higher.
- Thus, bear and recession times have higher volatility, and higher risk.
- He also doesn’t mention the uncertainty that these times generate compared to expansion and bull, where uncertainty of whether what you buy will either go high up or to zero is much less pronounced

Question 3

Asymmetries in correlations among developed and emerging markets and what it implies

Answer 3

Developed markets are more correlated than emerging markets.
Intuition: most portfolios hold more developed, and thus are less diversified, since developed are correlated and move together. They are thus more risky than what people realize, as a higher proportion in emerging would see correlation of overall asset decrease and diversify risk away, even if emerging have higher volatility.

Question 4

Asymmetries in correlation bull bear, recession vs expansion and implications

Answer 4

To simplify this very unclear statement: both the same just like for volatility:
- recessions and bear show most correlated environments.
Intuition: when people seek lower risk and correlation: they paradoxically tend to all go for the same assets, risk might go down at first glance, but correlation surely goes up if everyone goes for the same type of assets.
- on the opposite side, in good times, there is a lot of choice, so many sectors, types of assets and investment, investments finds itself very spread out and returns are then much less correlated.
- very behavioral explanation

Question 5

Whats direct diversification and difference with indirect

Answer 5

It’s diversifying through the same asset: ex buying stocks from many different countries, whereas indirect is through different asset classes, such as bonds, physical assets, etc.

Question 6

What does the integration of international capital markets worldwide lead to?

Answer 6

• increased synchronization among developed markets
• increased investment potential in emerging markets
  Does it mean any emerging mrkt is good place to invest?
  no–»many underperform developed markets

Question 7

What the most important problem to global equity investors

Answer 7

Defining an efficient aset allocation among three global equity asset classes:
1- domestic market
2- developed markets
3- emerging markets
- the classic approach to this problem is mean-variance efficient allocation based on historical data

Question 8

What the theory behind asset allocation and what really happens in practice

Answer 8

standard portf. optimization:
- requires investors to know expected returns of all assets
- determines optimal portfolio weights through the risk-return tradeoff
In reality, investors
- Focus on small set of assets
- think directly in terms of portfolio weights

Question 9

Is currency risk an obstacle to int. diversification? why or why not?

Answer 9

no
- not highly correlated to market risk
- can be eliminated w/derivatives
- substantially diversified away in international portfolio
- smaller at longer inv horizon
HOWEVER, even if currencies have zero correlations with other assets, they increase the total risk exposure

Question 10

Whats the incorrect an common view on currency hedging?

Answer 10

That it should be seen as a strategy to do after the fact. Once you realize your exposures, hedge them. That is incorrect, it should be integrate hedgind into the investment decisions made

Question 11

home bias?

Answer 11

Investors erroneously overweigh domestic holdings

Question 12

Institutional reasons for home bias

Answer 12

• tax reasons
• perception higher transaction costs
• constraints: limits on cross-border investment

Question 13

Behavioral factors of home bias

Answer 13

• perception of higher domestic returns
• perception of domestic lower volatility
• developed domestic market(more choice)

Question 14

Two methods allow investors to exploit non-perfect positive correlation structure of global
equity market returns

Answer 14

Method 1: purchasing foreign shares directly in foreign markets
method 2: purchasing foreign-listed shares, eg. ADRs in the domestic market

Question 15

What are ADRs

Answer 15

ADR (American Depositary Receipts) is aa certificate issued by a US depositary bank, representing foreign shares held by the bank by a branch or correspondant in the country of issue
- Carries the same currency, political and economic risks as the underlying foreign share

Question 16

Advantages of ADRs

Answer 16

• avoid administrative problems associated with converting currencies to buy the foreign stocks
• shorter settlement period for foreign shares
• received dividends automatically converted in USD at the preferential wholesale exchange rate

Question 17

Diversification with ADRs

Answer 17

US investors can effectively reduce the risk of
their portfolios by investing in ADRs rather than
directly in foreign countries.
The gains from direct diversification beyond the
“home-made” diversification have diminished
over time.
-INDIRECT DIVERSIFICATON

Question 18

Advantages of stock index futures

Answer 18

• low transaction cost alternative to int. divers.
• allow foreign investors to avoid restrictions on cap movements
• allow efficient country allocation shifts between countries that have different equity settlement periods

Question 19

Disadv of stock index futures

Answer 19

• not available for the majority of countries
• short-lived contracts, transactions costs can be multiple times a year
• replication of a country index may be expensive for horizons of several years

Question 20

What is a closed-end fund?

Answer 20

Investment tool for buying stocks in a country
- shares are listed on some national market and traded at a price determined by market demand and supply
- closed-end fund never liquidated and the number of fund shares remains the same
-price can differ than that of assets in portfolio

Question 21

pricing of a closed end fund

Answer 21

The price of the closed-end country fund is the
sum of the net asset value and the premium:
FV = NAV + PR
The premium is usually positive if a country has
substantial restrictions on direct foreign
investment.
The premium is the amount that investors are
willing to pay to circumvent these restrictions

Question 22

Why are closed end funds traded at discount

Answer 22

Four pieces of the puzzle
Closed-end funds start out at a premium of
about 10%.
Closed-end funds move into a 10% average
discount within 120 days from the beginning of
trading.
Discounts widely fluctuate over time.
Discount diminishes at the termination of
closed-end funds through liquidation or open
ending.

Question 23

Agency costs’ implications

Answer 23

Can create a discount for a closed end fund is future management is expected to be bad
- but they cannot explain wide cost fluctuations

Question 24

Why do investors buy closed-end funds initially at a premium if they will be selling at the end at a discount?

Answer 24

Argument 1: restricted stock hypothesis
- closed-end funds hold large amounts of stock, the market value of which is lower than its unrestricted counterpart, thus the NAV is overvalued
- problem, often the proportion of this stock is smaller than 1%
- Badlyexplained by prof, IN short, the NAV of assets of portfolio is higher than what they are really worth when they are in the closed end fund, as their being in the fund makes them less liquid.

Argument 2: Block discount hypothesis
Closed-end funds hold sizable blocks of individual securities. Thus, the price of their realization will be lower than that of respective marginal securities.
Problem: Often funds realize large abnormal returns.
once again very badly explained: closed end buy large blocks, when they sell such large blocks, not so much market transaction as negotiated transaction, so lower sale price than what asset is often worth. but in reality, they actually have high returns, which challenges the theory

Question 25

tax explanation of discount of closed end fund

Answer 25

The NAV of the closed-end fund does not reflect the capital gains tax that the fund must pay if it sells its assets. Thus, the liquidation value of fund’s assets is lower than the reported value.
Problems:
Tax liabilities can account for a discount of no more than 6%.
On open ending, closed-end fund prices move up to the NAV, not vice versa.

Question 26

Investor sentiment first slide

Answer 26

Fact 1:
Institutions hold more than 25% (50%) of shares in
the smallest (largest) firms traded on NYSE.
Fact 2:
Institutions hold less than 10% of shares in closedend funds (Weiss, 1999).
Thus:
Closed-end fund discount should reflect the
differential sentiment of individual investors.

Question 27

investor sentiment second slide

Answer 27

Implications:
Closed-end fund discount occurs because holding a fund is riskier than holding its portfolio directly.
Fund starts operating when noise traders are
excessively optimistic about particular fund(s).
Discounts on closed-end funds fluctuate with
changing investor sentiment.
Changes in investor sentiment should affect both closed-end funds and small stocks.

Question 28

Describe ETFs

Answer 28

• represent basket of stocks
• traded freely on an exchange
• typically track an index
• not actively managed
• trade close to the NAV thanks to market specialists and institutions
• have usually lower expense ratios than CEFs

Question 29

conclusions

Answer 29

• direct diversification=largest gains
• currency overlay is useful alt to hedging
• currency risk man should be done simultaneously with equity selection
• realtive benefits of direct vs indirect diversification varies across countries