Lesson 1.3: Foreign Equity Securities Flashcards
Investing in emerging market stocks is least likely to expose your client to which of the following risks?
A) Political
B) Interest rate
C) Currency
D) Liquidity
Interest rate
Interest rate risk applies primarily to fixed income securities. Stock, unless it specifies preferred stock, are not normally considered to have interest rate risk. However, any foreign investment incurs currency risk and, when dealing with emerging markets, there is a higher degree of liquidity and political risk than with developed economies.
Emerging markets:
Emerging markets are markets in lesser-developed countries. As a result, the political risk tends to be higher than with developed economies. Whether it is emerging or developed, a U.S.-based investor will always face currency risk, and all countries have some degree of country risk. A way to simplify things is to invest in ADRs rather than the foreign stock itself. International equity is a subclass of equities when allocating assets, and the addition of them tends to offer diversification and potentially higher returns because foreign markets are not necessarily correlated to the U.S. ones.
Which of the following statements regarding ADRs are true?
I. The securities are vehicles used to facilitate U.S. trading of foreign securities.
II. Dividends are received in the foreign currency.
III. Holders have foreign currency risk.
IV. The receipts are issued by a foreign branch of a domestic bank.
I & III
ADRs are vehicles that facilitate U.S. trading of foreign securities. They are issued in English in the United States by domestic banks. Dividends are declared in the foreign currency but are payable to holders in U.S. dollars, which means that ADR holders are subject to foreign currency risk.
Most foreign investment entails foreign exchange or currency risk???
Foreign markets entail foreign exchange risk (currency risk). It’s possible that the foreign market value of the investment increases while the value of that currency decreases against the U.S. currency. Most foreign markets are not more efficient than the U.S. market. The U.S. market is among the most highly regulated markets in the world. A 1.0 correlation offers no diversification.
What is a risk faced by investors in foreign stocks that is not found when investing in domestic issues?
Exchange rate risk
An investor who invests in foreign stocks is subject to many of the same risks associated with domestic stock investment, but a unique risk faced by investors in foreign stocks is exchange rate risk, sometimes called currency risk. Someone who invests in foreign stocks has as much invested in the currency of the foreign stock as in the stock itself. Exchange rate risk is not necessarily a bad thing, but it is one more significant factor that investors in foreign stocks must take into account. Credit risk never applies to stock; only debt securities and both domestic and foreign issues are subject to business risk.
A client is considering the purchase of American depositary receipts (ADRs). She is looking to further diversify her portfolio. What is a feature of this type of investment vehicle?
They are subject to exchange rate, or currency, risk.
Even though ADRs are denominated in U.S. dollars, they are subject to exchange rate, or currency, risk. In order to trade in the U.S. markets, information about the foreign company must be available to investors. ADRs representing the best-known companies typically trade on the NYSE or the Nasdaq stock market while lesser companies trade OTC.
An investor may expect to receive dividends from:
ADRs
An American depositary receipt (ADR) represents ownership in a foreign corporation, and dividends declared by the corporation are paid to the ADR owner. The currency conversion is performed by the issuing domestic bank. Options and warrants do not grant the holder the right to receive dividends on the underlying stock; one must own the security itself to be entitled to the dividend.
Concerning international direct investing:
Information is not as readily available on foreign investments as on domestic ones.
In general, foreign investments don’t have the transparency of domestic ones. Rather than directly investing in the foreign security, trading the ADR has the advantage of the full disclosure requirements of the SEC. Investors may earn higher returns in foreign markets, and including foreign securities in an investment portfolio may lower risk through greater diversification. This is because there may be a low correlation with U.S. markets. Although securities markets in most developed economies are mature, that doesn’t mean they can’t grow, and the markets in emerging economies offer great potential growth commensurate with their greater risk.
What are characteristics of American depositary receipts (ADRs)?
A) ADRs are denominated and pay dividends in U.S. dollars, not foreign currencies, thus saving the investor transaction costs with respect to converting currencies.
B) ADR holders may surrender ADRs in exchange for receiving the shares of the non-U.S. company.
C) Because ADRs are traded on the exchanges, they are relatively liquid and marketable investments.
D) ADR is a certificate representing ownership of a foreign security that is on deposit at a U.S. bank.
ADRs are receipts issued by a U.S. bank for shares of a foreign company purchased and held by a foreign branch of the bank. Dividends are declared in the local currency, so exchange rate, or currency, risk is not completely eliminated. They are generally traded on one of the major exchanges ensuring liquidity. They are an alternative to investing directly in foreign companies or foreign mutual funds. If the investor desires the foreign shares, the ADR may be surrendered and the exchange made.
An investor wishing to add some diversification to his portfolio wants to purchase 200 shares of an ADR for a Japanese electronics manufacturer. The ADR is listed on the NYSE. Which of the following risks should be of most concern to this investor?
I. Business
II. Currency
III. Inflation
IV. Liquidity
I & II
Owning stock in any corporation always subjects the holder to business risk—the uncertainty that the entity might fail to meet its economic goals. Whenever one invests internationally, whether directly or through the vehicle of an ADR, one is subject to currency risk, sometimes called exchange rate risk. Inflation risk is of concern to those who purchase fixed-income investments, and any security listed on the NYSE has little or no liquidity risk.
