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Introduction
The twentieth century has seen massive cross-
border flows of capital. Cross border equity
investment is a relatively recent phenomenon.
The initial thrust to cross border flows of
equity investment came from the desire on the
part of institutional investors to diversify their
portfolios globally in search of both higher
return and risk reduction.
Financial deregulation and elimination of
exchange controls in a number of developed
countries at the beginning of eighties permitted
large institutional investors to increase their
exposure to foreign equities.

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Introduction
The decade of 1990's witnessed opening up of
equity markets of developing countries like
South Korea, Taiwan, Indonesia and India to
foreign investors albeit with some restrictions
The trend towards global integration of equity
markets is unmistakable though it is
punctuated by intermittent crises and
consequent investor retreat
We investigate the determinants of foreign
equity investment decision and address the
issues related to capital market integration and
valuation of foreign equities
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Overview
A Private Investors Viewpoint
Policy Matters - Private Investors
What Factors Favor Overweighting Foreign
Markets in Portfolios?
What Factors Favor Overweighting Home
Markets in Portfolios?
Is Investment in MNCs a Close Substitute
for International Investment?
Can Investors Create Homemade
International Diversification?
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Overview
A Private Investors Viewpoint

Can Investors Count on International
Diversification Gains in the Future?
Are Emerging Markets Integrated with
World Capital Markets?
Policy Matters - Public Policymakers
Equity Market Trading Arrangements
Diversity in Accounting Principles and
Disclosure Practices
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International Investment Vehicles
Direct Purchase of Foreign Shares
This route is usually reserved for large
institutional investors because of the
additional considerations involved.
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International Investment Vehicles
Depositary Receipts (ADRs, GDRs)
After a bank has taken custody of foreign shares in its
foreign office, ADRs/GDRs can be issued as claims against
the foreign shares.
The issuing bank services the ADRs/GDRs by collecting all
dividends (in the issuing companys home currency), rights
offerings, etc., and distributing the proceeds to investors in
a convertible currency such as USD.
In a sponsored ADR, the foreign firm pays a fee to the
depositary bank to cover the cost of the ADR program,
while in an unsponsored ADR, the issuance of the ADR is
demand driven.
ADRs are directed at US based investors and issued in US
while GDRs are issued outside US and are targeted at
global investors. The main difference is in regulatory
framework, disclosure requirements, accounting standards
etc.
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International Investment Vehicles
Closed-End and Open-End Mutual Funds
Mutual funds that invest in foreign stocks can be
grouped into several categories from a U.S.
perspective:
Global - Investing in U.S. and non-U.S. shares.
International - Investing in non-U.S. shares only.
Regional - Investing in a geographic area.
Country - Investing in a single country.
Specialty - International investments in an
industry group such as telecommunications, or
special themes such as newly privatized firms.
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International Investment Vehicles

An open-end fund stands ready to issue and
redeem shares at prices reflecting the net-
asset-value of the underlying foreign shares.
A closed-end fund issues a fixed number of
shares against an initial capital offering. The
shares then trade in a secondary market at
prices reflecting a premium or discount
relative to the net-asset-value of the
underlying foreign shares.
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International Investment Vehicles
World Equity Benchmark Shares (WEBS)
WEBS represent shares in an index fund
that is intended to track the performance of
a single country index.
Like an open-end fund, the size of the WEBS
fund can grow without limit, but the shares
are traded on an exchange at any time of the
day like a closed-end fund.
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Equity Financing in Global Markets
Since many Indian companies have accessed
the global equity market primarily for
establishing their image as global companies,
the major consideration has been visibility and
post-issue considerations related to investor
relations, liquidity of the stock (or instruments
based on the stock such as depository receipts
which are listed and traded on foreign stock
exchanges) in the secondary market and
regulatory matters pertaining to reporting and
disclosure
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Equity Financing in Global Markets
Other relevant considerations are the price at
which the issue can be placed, costs of issue and
factors related to taxation
With segmented markets, the price that can be
obtained would vary from one market to
another
When the issue size is large, the issuer may
consider a simultaneous offering in two or
more markets
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Equity Financing in Global Markets
Issue costs are an important consideration
Shares of many firms are traded indirectly in the form
of depository receipts e.g. GDR and ADR .
After a hesitant start in 1992 following the experience
of the first ever GDR issue by an Indian corporate , a
fairly large number of Indian companies have raised
equity capital in international markets
In recent years, a major driving force has been the
desire of Indian IT companies to make acquisitions in
the US. The ADS are used as acquisition currency in
share swaps. For this purpose the ADRs must be listed
and actively traded
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Equity Financing in the International Markets
Subscribers,
Lead Managers etc
Depository
Company
Custodian
GDR Holders
Nominee
for
Euroclear
and Cedel
Hold the American
GDR and Register
it in the Name of
DTC
The GDR Mechanism
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Equity Financing in Global Markets
From the point of view of the issuer, GDRs and
ADRs represent non-voting stock with a
distinct identity which do not figure in its books
There is no exchange risk for the issuing firm
since dividends are paid by the issuer in its
home currency. Exchange risk is borne by the
investors.
Apart from imparting global visibility, the
device allows the issuer to broaden its capital
base by tapping large foreign equity markets
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GDRs / ADRs

Year

No. of
Issues

Amount
(Rs.Crore)

Amount
($ mln)

2004-2005

14

4435.45

915.47

2005-2006

56

15895.91

3280.89

2006-2007

21

4922.50

1016.00

2007-2008

33

30949.26

6387.88

2008-2009

12

893.42

184.40

2009-2010
(Till Jul,09)

7

11990.47

2474.81

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Indian ADRs Trading in US

Dr. Reddy's Laboratories Ltd.

HDFC Bank Ltd.

ICICI Bank Ltd.

Infosys Technologies Limited

Mahanagar Telephone Nigam Limited

Rediff.com India Ltd

Satyam Computer Services Limited

Sify Ltd.

Videsh Sanchar Nigam Limited

Wipro Ltd

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Indian GDRs
Arvind Mills, Ashok Leyland,Bajaj Auto,Ballarpur Ind.,Bombay
Dye,BSES Ltd,Century Textiles,CESC,Core Parent, Crompton
Greaves,DCW,Dr. Reddy's,E. I. Hotels,EID Parry,Finolex Cab, Flex
Industries,G.E. Shipping,G.N.F.C,GAIL,Garden Silk, Grasim
(1st),Grasim (2nd),Guj Ambuja ,Himachal Futuri,Hindalco
(1st),Hindalco (2nd),Hindustan Dev,India Cements, Indian
Alum.,Indian Hotels,Indian Rayon,Indo Gulf,Indo
Rama,ICICI,Infosys,IPCL,ITC,J.K. Corp,Jain Irrig,JCT Ltd.,Kesoram
Ind,L & T (1st),L & T (2nd)Mah & Mah,MTNL,NEPC Micon,Nippon
Denro,Oriental Hotels,Ranbaxy Labs,Raymond
Woolen,Reliance,Reliance (2nd),Reliance
Petroleum,S.A.I.L.,Satyam Infoway,S.I.E.L.,Sanghi Poly,SIV Ind
,SPIC,SBI,Sterlite India,Tata Electric,Telco (1st),Telco (2nd),Tube
Invest,United Phos.,Usha Beltron,Videocon Int.,VSNL,Wockhardt

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Equity Financing in Global Markets
From the investors' point of view, they achieve
portfolio diversification while acquiring an
instrument which is denominated in a
convertible currency and is traded on
developed stock markets
The investors bear exchange risk and all the
other risks borne by an equity holder
They have all the rights and privileges of
ordinary stockholders except the voting rights.
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GDRs and ADRs
GDRs could be offered to US investors only if very
stringent requirements of registration with the SEC
are complied with. However, under an exemption
granted by Rule 144A of the securities act, securities
can be offered to Qualified Institutional Buyers
without going through the registration process.
As to ADRs, offereings at various levels are possible
with more and more stringent accounting and
disclosure requirements as one goes from lower to
higher levels. There are four types of ADRs :
Unsponsored and Levels I to III
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- American Depository Receipts (ADRs)
- Unsponsored Depositary Receipts
These are issued by one or more depositaries in response to
market demand, but without a formal agreement with the
company. Today, unsponsored Depositary Receipts are
considered obsolete.
- Sponsored Level I Depositary Receipts
Level I Depositary Receipts are traded in the U.S. OTC
market and on some exchanges outside the United States. The
company does not have to comply with U.S. GAAP or full
SEC disclosure. Essentially, a Sponsored Level I Depositary
Receipt program allows companies to enjoy the benefits of a
publicly traded security without changing its current
reporting process.

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Level II Depositary Receipts
These are listed on a US stock exchange but no new capital is raised.
Level III Depositary Receipts
These are listed on a US stock exchange and are used to raise new
capital.

Companies that wish to either list their securities on an exchange in the U.S. or
raise capital use sponsored Level II or III Depositary Receipts respectively.

These types of Depositary Receipts can also be listed on some exchanges
outside the United States. Each level requires different SEC registration and
reporting, plus adherence to U.S. GAAP.
The companies must also meet the listing requirements of the national
exchange (New York Stock Exchange, American Stock Exchange) or
NASDAQ, whichever it chooses.



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American Depository Receipts
- Sponsored Level II And III Depositary Receipts
Companies that wish to either list their securities on an
exchange in the U.S. or raise capital use sponsored Level II or
III Depositary Receipts respectively.
These types of Depositary Receipts can also be listed on some
exchanges outside the United States. Each level requires
different SEC registration and reporting, plus adherence to
U.S. GAAP.
The companies must also meet the listing requirements of the
national exchange (New York Stock Exchange, American
Stock Exchange) or NASDAQ, whichever it chooses.

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American Depository Receipts
Each higher level of Depositary Receipt program generally
increases the visibility and attractiveness of the Depositary
Receipt.
Level II is used when the company does not wish to raise
funds i.e. just acquire listing while level III is used when
funds are to be raised. For Level II issue the issuing firm
converts some of its existing stock into ADRs.

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Rule 144a Depositary Receipts
These are also used to raise new capital but
are privately placed with Qualified Institutional
Buyers in the United States. Because of the
sophisticated investor base to which these
Depositary Receipts are restricted, the US
Securities Exchange Commission imposes
fewer reporting and registration requirements
on the issuer than for a public offering and
Rule 144a ADRs can therefore be a quicker
and simpler way to access the US market than
Level III ADRs.

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The Capital Asset Pricing Model (CAPM)
The formula
The CAPM shows how the minimum required return on a quoted security depends on its risk.
The required return of a rational risk-averse well-diversified investor can be found by returning to our original argument:























So the formula becomes:
Required return = R
f
+ (R
m
- R
f
)
where:
R
f
= risk-free rate
R
m
= average return on the market
(R
m
- R
f
) = equity risk premium (sometimes referred to as average market risk premium)
= systematic risk of the investment compared to market and therefore amount of the premium needed.


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Equity Financing in Global Markets
A major problem and concern with
international equity issues used to be that of
flowback i.e. the investors will sell the
shares back in the home stock market of the
issuing firm. Initially GOI had imposed a
minimum time limit before which
conversion and sale in home market was not
permitted. After FIIs were allowed into
Indian markets, this was abolished.

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Foreign Equity Investment
Risk-Return
Comparing Investments in a Risk-Neutral
World
The expected annual dividend yields in the two
investments are o
US
and o
IN
, the expected annual
average rates of capital appreciation are o
US
and
o
IN
. The (INR/USD) exchange rate is S
0
, dollars per
rupee. After k years, a dollar invested in the US
company is expected to accumulate to
$(1 + o
US
+ o
US
)
k

a dollar invested in the Indian shares is expected to
accumulate to
$(1/S
0
)(1 + o
IN
+ o
IN
)
k
(S
e
)
k

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Foreign Equity Investment - Risk-Return
The investor would invest in the Indian stock if



and in the US stock if the reverse inequality holds
Let
e
denotes the expected annual proportionate
rate of change of the exchange rate S expressed as
USD per INR. Then
[(S
e
)
k
/S
0
] = (1 +
e
)
k

)

US
+

US
+ (1
k

)
S
e
(
k
)

IN
+

IN
+ (1
k
)
S
0
1
(
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Foreign Equity Investment - Risk-Return
Substitute, simplify, ignore cross products to get
that US investor would invest in India if

e
> (o
US
- o
IN
) + (o
US
- o
IN
)
Thus even with lower dividend yield and
capital gains, foreign equities can be attractive if
the foreign currency is expected to appreciate
strongly
Presence of differential tax treatment of
ordinary income and capital gains can reinforce
the bias in favor of foreign equities if exchange
gains are treated as capital gains and capital
gains are taxed at a lower rate


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Foreign Equity Investment - Risk-Return

Let u
y
and u
k
be tax rates for ordinary income
and capital gains respectively with u
y
> u
k

After-tax returns on the US and Indian
investments are, respectively
(1-u
y
)o
US
+ (1-u
k
)o
US
and
(1-u
y
)o
IN
+ (1-u
k
)(o
IN
+
e
)
Latter will exceed the former if

)

IN
-

US
( + )

IN
US
(
)
k
- (1
)
y
- (1
>
S

e

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Risk and Return
in International Equity Markets
Calculating the Unhedged Returns on Foreign
Equity in home currency Terms
Let E
t
be the initial purchase price of the foreign
equity in foreign currency (FC) terms.
Let S
t
be the spot exchange rate, in FC/HC terms,
on the purchase date.
Then E
t
S
t
is the HC purchase price of the foreign
equity.
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Decomposition of the Total Variance of US Dollar Returns on Individual Foreign
Stock Markets
________________________________________________________
Country % Contribution to Total Variance from
______________________________________
Exchange Rate Local Return Covariance
Variance Variance
_________________________________________________________________
Canada 4.26 84.91 10.83
France 29.66 61.79 8.55
Germany 38.92 41.51 19.57
Japan 31.85 47.65 20.50
Switzerland 55.17 30.01 14.81
U.K. 32.35 51.23 16.52
__________________________________________________________________

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Volatility of Returns on Selected Developing Country Stock Markets
__________________________________________________________________________
Developing Countries Annual Standard Deviation (%)

Argentina 108
Brazil 74
Chile 29
HongKong 31
India 31
Indonesia 39
Korea 29
Mexico 56
Singapore 33
Taiwan 63
Thailand 31

Developed Countries
Japan 22
U.K. 19
U.S. 17
___________________________________________________________

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Risk and Return
in International Equity Markets
Stock
Market
Returns
Stock Market Prices +
Spot FX +
(A)
Stock Market Prices |
Spot FX +
(D)
Stock Market Prices |
Spot FX |
(B)
Stock Market Prices +
Spot FX |
(C)
Negative
Positive
Negative Positive
Currency Market Returns
Combinations of Currency Market and Stock Market Returns
36
Risk and Return from Foreign Equity
Investment
Since countries differ in their economic and
industrial structures and since business
cycles in different parts of the world are not
synchronous, one would expect further risk
reduction to be possible through
diversification beyond national boundaries
For a given expected return, an
internationally (optimally) diversified
portfolio should afford smaller risk than a
purely national optimal portfolio
37
Risk and Return from Foreign Equity
Investment
Prima facie equity investment in emerging
markets appears to present substantial
opportunities for risk reduction from the point of
view of investors in the developed countries
Total risk of an internationally diversified
portfolio can once again be broken down into
three components
Exchange Rate Risk
Local Returns Risk
Local Returns-Exchange Rates Covariance
Risk
38
Risk and Return from Foreign Equity
Investment
General agreement that international
diversification does pay in terms of risk
reduction. Some ambiguity remains. One
additional source of risk viz. exchange rate.
Availability of products to hedge exchange
rate risk further reinforces this conclusion
However, it is not clear whether exchange
risk hedging would reduce expected returns
at the same time as it reduces risk
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The International Capital Asset
Pricing Model
CAPM links the expected (excess) returns on a
risky asset to its risk in an efficient portfolio
The expected excess return on a risky asset or a
portfolio of assets is its expected return over
and above the risk-free return
A portfolio is said to be efficient if among all
possible portfolios with the same excess return
it has the lowest variance
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The International CAPM
Consider a portfolio consisting of assets i = 1,
2....N
A necessary condition for a portfolio to be
efficient is


where r
i
*
and r
p
*
denote, respectively return on
asset i and the portfolio
N 1,2... = i all for =
)
*
p
r ,
*
i
r cov(
r) -
*
i
r E(
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The International CAPM
The numerator is the contribution of
asset i to the portfolio's excess return
while the denominator is the contribution
of asset i to the portfolio's variance or
risk
The parameter u is known as the
investor's relative risk aversion and is a
measure of his or her attitude towards
risk
42
The International CAPM
Two fund theorem" says that in equilibrium all
investors will hold some combination of the risk-free
asset and the so-called "tangency portfolio"
One of the crucial ingredients in the CAPM is the
notion of Market Portfolio
Now let r
p
be the market portfolio. Denote the return
on market portfolio by r
m

For the market portfolio to be efficient we must have


N 1,2... = i all for =
)
*
m
r ,
*
i
cov(r
r) -
*
i
E(r
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The International CAPM
This can be written as follows

)
*
m
r ,
*
i
r cov( = r) -
*
i
r E(
2
m

im

2
= r) -
ri
*
E(
(1)
(2)
When (2) is applied to the market portfolio
E(r
m
*
- r) = u o
2
m
(3)
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The International CAPM
Rewriting
u = [E(r
m
*
- r)/o
m
2
]
Replace [u o
m
2
] by E(r
m
*
- r) and recall the
definition of the beta of asset i to get
E(r
i
*
- r) = |
i
E(r
m
*
- r)
This is the one country CAPM
The only source of systematic risk is the
market risk.
45
The International CAPM
o
im
denotes the covariance between the
returns on asset i and the market portfolio
and o
m
2
denotes the variance of the return
on the market portfolio
The expression [o
im
/o
m
2
] is the familiar
"Beta" of the asset i, denoted |
i
which
measures the covariance of asset i with the
market portfolio
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The International CAPM
The parameter |
i
is estimated by means of a
regression of realized historical returns on asset
i on the realized historical returns on the
market portfolio
r
i
*
= o
i
+ |
i
r
m
*
+ u
i


OLS estimator of |
i
= Cov (r
i
*
, r
m
*
)/Var (r
m
*
)
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The International CAPM
This is the famous equilibrium Capital
Asset Pricing Model for a single country
The excess return on any risky asset i equals
the excess return on the benchmark
portfolio multiplied by the asset's beta
which in turn measures the co-variation of
the (return on) asset i with the (return on)
the benchmark portfolio
48
When to use the one-country CAPM?
When national markets are completely segmented.
Market portfolio of assets held by investors in a
country is same as portfolio of assets issued by
corporations in that country
Only locals hold local assets & locals hold only
local assets
Not true in most countries.
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The International CAPM
Extending One Country CAPM
If resident investors hold exclusively assets
issued by resident firms and foreign
investors are not allowed to hold domestic
assets then that countrys capital market is
fully segmented from the global capital
market
Capital markets of most countries are
certainly not fully segmented
Are global capital markets fully integrated?
What is the relevant market portfolio?
50
The International CAPM
Where there are no restrictions whatsoever on
investors in a country holding foreign assets and
foreign investors investing in domestic assets, that
global capital markets are fully integrated at least in
a legal sense. There could be informational
asymmetries
Consider the portfolio consisting of all the stocks
issued by all the firms in such an integrated world
the world market portfolio
CAPM requires the further assumption that all
investors must have identical expectations
regarding the performance of any risky asset.
Otherwise they would not agree on the
composition of the tangency portfolio.

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The International CAPM
For any risky asset investors would compute the
real return measured in their own currencies
If PPP does not hold, would investors from
different countries agree on the real return from
a given risky asset?
If not, the ICAPM must take account of exchange
rate risk in addition to the covariance risk with
the world market benchmark portfolio
Investors in a given country would choose their
portfolios in the light of their estimates of
expected returns, variances of returns and
covariances measured in their reference
currency, their home currency
52
The International CAPM
In a multi-currency portfolio the following parameters are
relevant
Expected excess return on a portfolio, measured in
some numeraire currency Ex
i
E(r
i
*
- r) where x
i
is the
share of asset i, r
i
*
is its return measured in the
numeraire currency and r is the risk-free rate in the
numeraire currency
Variance of portfolio returns o
p
2
= cov(Ex
i
r
i
*
,r
p
*
) =
Ex
i
cov(r
i
*
,r
p
*
) which in turn depends upon
(1) Pair-wise co-variances of individual market returns
(2) Pair-wise co-variances between exchange rates

53
The International CAPM
(3) Covariance between stock market returns
and changes in the exchange rate between the
numeraire currency and other currencies
cov(Ex
i
r
i
*
,
i
) where
i
is the proportionate change
in the spot rate of currency i with respect to the
numeraire currency
The remaining parameters viz. expected values
and variances of
i
do not enter portfolio choice
because the portfolio weights x
i
are not affected
by them
The total variance of portfolio returns can be
attributed to return variances, exchange rate
varinces and covarinces between returns and
exchange rate changers. Contributions of each
vary according to currency composition and
whose point of view is adopted
54
International CAPM
A Two Country CAPM: Ignore inflation
Consider a German investor computing returns on
various assets in terms of his home currency
EUR. Denote by S the USD/EUR exchange rate.:
(1) A US T-bill : r
GE
= r
US
+ where r
US
is the return
in USD terms. Thus correlation between r
GE
and
is +1.
(2) What about a US stock?
(3) What about a German stock?
55
An appreciation of the dollar against the Euro will increase
euro return for a given dollar return.
However, will it help or hurt the valuation of the US firm?
A US exporter firm export sales might decline due to
appreciation. But interest and labour costs might also decline.
Net impact? On balance correlation between S and return on
US stocks measured in EUR positive or negative?
What about a German firm? EUR depreciation might help if
strong US market presence. Costs might increase. Net impact
again ambiguous.
Many empirical studies using firm-level data from do not
show up an exchange rate factor in stock returns after the
market factor is included.
56
The International CAPM
Incorporating exchange rate risk: A two-country model
r
i
= o
i
+
i
+ u
i

where r
i
denotes the EUR return on an asset i, the
coefficient
i
will equal
cov[r
i
, ]/var()
which is a measure of asset i's covariation with the
changes in exchange rate
US T-bill: positive; US stocks : negative?
German stocks : positive?
57
The International CAPM
A Two Country CAPM
Extending the one-country CAPM, the equilibrium
expected excess return on asset i measured in EUR
is given by

E[r
i
- r] = u cov[r
i
,r
W
] + o cov[r
i
,]

The parameters u and o are prices of world market
and exchange rate covariance risks, and r
W
is the
return on the world market portfolio measured in
EUR and r is the risk-free rate in EUR (e.g. German
T-bills).
58
The International CAPM
Two benchmark portfolios : (1) The world market
portfolio and (2) The foreign riskless asset
To operationalise the two country CAPM we must
estimate u and o

Consider the world market portfolio
E[r
W
- r] = u cov[r
W
,r
W
] + o cov[r
W
, ]
= u var[r
W
] + o cov[r
W
, ]

Consider a foreign i.e. US T-bill
E[r
*
+ - r] = u cov[, r
W
] + o cov(,)
= u cov[ , r
W
] + o var()
r
*
: Risk-free rate in the other currency (e.g.USD)
These two equations can be used to estimate u and o.
59
E(r
W
r) = u var(r
W
) + o cov(r
W
, )
E(r
*
+ r) = u cov (, r
W
] + o var()

var (r
W
) cov (r
W
, ) u

cov (, r
W
) var() o

= E(r
W
r)

E(r
*
+ r)
60
var(r
W
) cov (r
W
, ) -1 E(r
W
r)

cov (, r
W
) var() E(r
*
+ r)

= u

o
The two sources of risk: World Market & Exchange Rate
The asset now has two betas correlation with world
market and with the exchange rate.

61
The International CAPM
Resulting two-country CAPM is
E(r
i
r) = |
i
(r
W
r) +
i
E(r
*
+ r)
Assets' beta and gamma have to be jointly
estimated from a multiple regression with
historical data
r
i
= o
i
+ |
i

r
W
+
i
+ u
i

62
The OLS estimates are
|
i
var(r
w
) cov(r
w
, ) -1 cov(r
i
, r
w
)
=

i
cov(r
w
, ) var() cov(r
i
, )

Recall that
E(r
i
r) = [cov (r
i
, r
w
) cov (r
i
, )] u
o

63
Substitute for [ u o ]

var(r
W
) cov (r
W
, ) -1 E(r
W
r)

cov (, r
W
) var() E(r
*
+ r)

= u

o

64

E(r
i
r) = cov (r
i
, r
w
) ' var(r
W
) cov (r
W
, ) -1 E(r
W
r)
cov (r
i
, )
cov (, r
W
) var() E(r
*
+ r)

Which leads to
E(r
i
r) = [ |
i

i
] E(r
W
r)
E(r
*
+ r)

This is the two-country CAPM

65
The International CAPM
Extension to a multi-country CAPM
E[(r
*
)
iH
- r
H
] = |
i
E[(r
*
)
W
- r
H
] +
i1
E[
1
+r
F1
-r
H
]
+
i2
E[
2
+r
F2
-r
H
]....+
iK
E[
K
+r
FK
-r
H
]

Here r
H
denotes riskfree rate in investor's currency,
r
F1
..r
FK
are riskfree rates in foreign currencies 1...

K
are the changes in exchange rates of these
currencies measured as units of home currency per
unit of foreign currency .K and
1
..
66
The International CAPM
The parameters |
i
,
i1
...
iK
have to be obtained
from a multiple regression with historical data
(r
*
)
iH
= o
i
+ |
i
(r
*
)
W
+
i1

1
+ ...+
iK

K
+ u
i


Global Capital Markets: Segmented or Integrated
Is the underlying assumption of no constraints on
cross-border capital flows valid?
Even if legal barriers are eliminated informational
barriers may remain; withholding taxes may also
lead to segmentation
67
The International CAPM
The evidence from empirical testing of the ICAPM
tests lead to the conclusion that international capital
markets are not fully integrated
Volatility clustering has been observed in almost all
national stock markets
There are volatility spillovers between stock
markets and between the forex and the stock
market.
Estimation of Risk Premia
To use the ICAPM for asset pricing we need to
estimate the beta and gammas for the asset and the
risk premia E[(r
*
)
W
- r
H
], E[
1
+r
F1
-r
H
]...
E[
K
+r
FK
-r
H
]
68
Summary
Economics of cross-border equity investment
using the standard capital asset pricing model
as the frame of reference
How to extend the standard capital asset
pricing model to a multi-country context
Segmentation versus integration of global
capital markets
Depository receipts mechanism used by non-
resident firms to tap equity markets in US and
Europe