Lecture 3 - International Diversification Flashcards
What does MSCI do?
Investment research firm that provides indicies, portfolio risk and performance analytics
3 Types of Markets
1) Developed
2) Emerging
3) Frontier
North American Developed Markets
Canada & USA
European Developed Markets
UK, Italy, Germany, France, Spain
Middle Eastern Developed Markets
Israel
APAC Developed Markets
Australia, Japan, Hong Kong, Singapore
Emerging Countries Classification
- Undergoing industrialization
- Transitioning into a modern economy with higher standard of living
- Economies growing faster than developed countries
- Higher political risk
True or False: Emerging countries do not have a greater risk than developed countries (booms and busts)
False
Frontier Market Classification
- Less advanced capital markets
- More established than least developed countries but still less established than emerging markets
- Offer above average returns and low correlations
- Political and economic risk
Another term for frontier markets
Pre-emerging markets or the next wave
Frontier market countries
Croatia, Serbia, Morocco, Kenya
Home Country Bias
Investors underweight foreign equities and primarily hold equities from their home country
Reasons for Home Country Bias
- Investor reflects their consumption patterns
- Lack of financial knowledge
- Used to be difficult to invest internationally
How to invest internationally
- Purchase multinational corporations
- ADRs
- ETFs
ADRs
American Depository Receipts
What are ADRs
Certificate issued by the US bank that represents a share in foreign stock (1:1 or 1:5)
Where do ADRs trade?
American stock exchanges
Issue with international investing
Country risk rating hardly change
Major Risks of International Investing
1) FX Risk
2) Political Risk
3) Economic Risk
4) Sovereign/Financial Risk
FX Risk
Foreign investments may yield more or less home currency than expected
rcan
return on foreign investment in CAD
rFM
return on the foreign market in local currency
E1
FX Rate at the end of the period
E0
FX Rate at the beginning of the period
Foreign Exchange Return Formula
(1 + rcan) = (1 + rFM)(E1/E0)
How to hedge foreign currency exposure
1) Futures Contracts
2) Forward Contracts
Political Risk
Risk that an investment’s returns could suffer as a result of political changes on instability in a country
Economic Risk
Country’s ability to pay back its debts
Sovereign/Financial Risk
Foreign central bank will alter its fx contracts or risk of imminent default on its bonds
What factors does PRS Group use to rank countries?
1) Political Risk
2) Financial Risk
3) Economic Risk
Integration
When assets in foreign markets have same risk/return as domestic markets
Segmentation
When assets in foreign markets have different risk/return characteristics
Factors Causing Segmentation
1) Legal barriers
2) Indirect barriers
How to passively diversify your portfolio
Include Country Indexes in order of:
1) Market cap (high to low)
2) Beta against Canada (low to high)
3) Country index standard deviation (high to low)
How to actively diversify your portfolio
1) Asset Allocation
2) Security Selection
Can U.S. companies with global diversification give you international diversification?
U.S. companies with global operations do offer some international exposure, but not as much as directly investing in foreign stocks.
- U.S. multinationals are still heavily influenced by the U.S. market, so their performance is tied to how the U.S. economy does.
- It’s difficult to know exactly how much of a multinational’s business comes from abroad, making it unclear how much international exposure you really get.
- U.S. companies tend to follow U.S. market trends more closely than foreign stocks, so investing in foreign markets gives better diversification.
Suppose a U.S. investor wishes to invest in a British firm currently selling for £40 per share. The investor has $10,000 to invest, and the current exchange rate is $2/£.
How many shares can the investor purchase?
$10,000/2 = 5000 Euros
5000 Euros / 40 Euros = 125 Shares
Fill in the table below for rates of return after 1 year in each of the nine scenarios (three possible prices per share in pounds times three possible exchange rates).
Price Per Share (£) Return (%) $1.80/£ $2.00/£ $2.20/£
£35
40
45
1 + r(US) = [(1 + r(UK)] x (E1/E0)
Price Per Share (£) Return (%) $1.80/£ $2.00/£ $2.20/£
£35 -12.5% -21.25% -12.5% -3.75%
40 0.0 -10.00 0.0 10.00
45 12.5 1.25 12.5 23.75
You are a U.S. investor who purchased British securities for £2,000 one year ago when the British pound cost U.S.$1.50. What is your total return (based on U.S. dollars) if the value of the securities is now £2,400 and the pound is worth $1.75? No dividends or interest were paid during this
period.
(1 + rUSD) = (1 + rFM) (E1/E0)
rFM = 2400/2000 -1 = 20%
E1 = 1.75; E0 = 1.50
(1 + rUSD) = (1.20) x (1.75/1.50)
(1 + rUSD) = 1.40 rUSD = 1.40 -1 = .40 = 40%
The correlation coefficient between the returns on a broad index of U.S. stocks and the returns on indexes of the stocks of other industrialized countries is mostly ________ , and the correlation coefficient between the returns on various diversified portfolios of U.S. stocks is mostly
________ .
less than .8; greater than .8.
An investor in the common stock of companies in a foreign country may wish to hedge against the ________ of the investor’s home currency and can do so by ________ the foreign currency in
the forward market.
appreciation; selling.
True or False:
“For an investor holding only developed market equities, the existence of stable emerging market currencies is one of several preconditions necessary for that investor to realize strong
emerging market performance.”
False
True or False:
“Local currency depreciation against the dollar has been a frequent occurrence for U.S. investors in emerging markets. U.S. investors have consistently seen large percentages of their
returns erased by currency depreciation. This is true even for long-term investors.”
True
True or False:
“Historically, the addition of emerging market stocks to a U.S. equity portfolio such as the S&P 500 index has reduced volatility; volatility has also been reduced when emerging market stocks are combined with an international portfolio such as the MSCI EAFE
index.”
True
True or False:
“Although correlations among emerging markets can change over the short term, such correlations show evidence of stability over the long term. Thus, an emerging markets portfolio that
lies on the efficient frontier in one period tends to remain close to the frontier in subsequent
periods.”
False
