International Financial Management P G Apte


• The twentieth century has seen massive crossborder flows of capital • 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.

• 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

Announced International Equity Issues (USD Billion)
1998 2001Q1 ALL COUNTRIES DEVELOPED COUNTRIES DEVELOPING COUNTRIES China 21.2 1.8 0.9 India 125.9 215.8 111.4 180.0 10.1 22.7 315.9 254.7 44.0 1.1 0.1 0.5 0.2 38.0 34.0 2.5 3.4 0.9 6.9



Korea South 0.8 Malaysia


Foreign Equity Investment in India (US Dollars Million)
199394 199495 199596 199697 199798 199899 1999 00

























Offshore Funds









Foreign Equity Investment - Risk-Return
• Comparing Investments in a Risk-Neutral World
– The expected annual dividend yields in the two investments are δ US and δ IN, the expected annual average rates of capital appreciation are α US and α IN. The (INR/USD) exchange rate is S0, dollars per rupee. After k years, a dollar invested in the US company is expected to accumulate to $(1 + δ US + α US)k – a dollar invested in the Indian shares is expected to accumulate to $(1/S0)(1 + δ IN + α IN)k(Se)k

Foreign Equity Investment - Risk-Return
– The investor would invest in the Indian stock if
( k 1 (1 + δ + α )k e )  (1 + δ US + α US) IN (S )k IN S 0

– and in the US stock if the reverse inequality holds – Let ŝe denotes the expected annual proportionate rate of change of the exchange rate S expressed as USD per INR. Then – [(Se)k/S0] = (1 + ŝe)k

Foreign Equity Investment - Risk-Return
Substitute, simplify, ignore cross products to get that US investor would invest in India if – ŝe > (δ US - δ IN) + (α US - α 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

Foreign Equity Investment - Risk-Return
– Let θ y and θ k be tax rates for ordinary income and capital gains respectively with θ y > θ k – After-tax returns on the US and Indian investments are, respectively (1-θ y)δ US + (1-θ k)α US and (1-θ y)δ IN + (1-θ k)(α IN+ Ŝe) – Latter will θ ) (1- exceed the former if y ˆe > S (1- ) (δ US − δ IN ) + (α US - α IN ) θk

Risk and Return from Foreign Equity Investment
• Risk and gains from international diversification
– Three components of risk viz. variability of the return in local currency, fluctuations in the exchange rate and the association between the two - the covariance risk. – Let RIN denote the return in rupee terms from an Indian equity share


Risk and Return from Foreign Equity Investment
– From a US investor's point of view, the dollar return from this investment, denoted ρUS, is (RIN+ŝe) where ŝe is the expected appreciation of the rupee E(ρUS) = E(RIN) + E(ŝe) = δ IN + α IN + ŝe Var(ρUS) = Var(RIN) + Var(ŝe) + 2Cov(RIN, ŝe) – As long as returns on different risky assets are not perfectly (positively) correlated, risk can be reduced by spreading total wealth across a portfolio of assets

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

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


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


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


The International CAPM
• Consider a portfolio consisting of assets i = 1,2....N • A necessary condition for a portfolio to be efficient is
E(r* - r) i = θ for all i = 1,2... N *, r* ) cov(r p i

• where ri* and rp* denote, respectively return on asset i and the portfolio

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 θ is known as the investor's relative risk aversion and is a measure of his or her attitude towards risk


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 • The above equation when applied to the market portfolio becomes


The International CAPM
E(r* - r) i = θ for all i = 1,2... N *, r* ) cov(r m i

• Where rm* is the return on the market portfolio
* E(r* - r) = θ cov(r*, rm ) i i
* - r) = [θ σ2(r* ) σim E(ri m σ2 m


The International CAPM
∀ σ im denotes the covariance between the returns on asset i and the market portfolio and σ m2 denotes the variance of the return on the market portfolio • The expression [σ im/σ m2] is the familiar "Beta" of the asset i, denoted β i which measures the covariance of asset i with the market portfolio

The International CAPM
• The parameter β i is estimated by means of a regression of realized historical returns on asset i on the realized historical returns on the market portfolio ri* = α i + β i rm* + ui (18.8) • Let the weight of asset i in the market portfolio be xi. Multiply the following equation by xi and sum over i
* E(r* - r) = θ cov(r*, rm ) i i


The International CAPM
• This gives E(rm – r) = θ σ2m
i= N i= N * x E(r* - r) = θ ∑ x cov(r*, rm ) ∑ i i i i=1 i=1 i

• Rewriting θ = [E(rm* - r)/σ m2] • Replace [θ σ m2] by E(rm* - r) and recall the definition of the beta of asset i to get E(ri* - r) = β i E(rm* - r) •

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

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 country’s 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”?

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 • 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”.


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

The International CAPM
– In a multi-currency portfolio the following parameters are relevant • Expected excess return on a portfolio, measured in some numeraire currency ΣxiE(ri* - r) where xi is the share of asset i, ri* is its return measured in the numeraire currency and r is the risk-free rate in the numeraire currency • Variance of portfolio returns σ p2 = cov(Σxiri*,rp*) = Σ xicov(ri*,rp*) which in turn depends upon (1) Pairwise covarinces of individual market returns (2) Pairwise covariances between exchange rates

The International CAPM
Covariance between stock market returns and changes in the exchange rate between the numeraire currency and other currencies cov(Σxiri*, ŝi) where ŝi 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 ŝi do not enter portfolio choice because the portfolio weights xi 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

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 EUR/USD exchange rate.: • A US T-bill : rGE = rUS – Ŝ where rUS is the return in USD terms. Thus correlation between rGE and Ŝ is -1. • • What about a US stock? What about a German stock?

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? What about a German firm? EUR depreciation might help if strong US market presence. Costs might increase. Net impact again ambiguous.


The International CAPM
• Incorporating exchange rate risk: A two-country model (r*)iGE = α i + γ i Ŝ + ui where (r*)iGE denotes the EUR return on an asset i, the coefficient γ i will equal cov[(r*)iGE , Ŝ]/var(Ŝ) which is a measure of asset i's covariation with the changes in exchange rate US T-bill: γ negative US stocks : γ positive? German stocks : γ negative?

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*)iGE - r] = θ cov[(r*)iGE,(r*)W] + δ cov[(r*)iGE,Ŝ] – The parameters θ and δ 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).


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 θ and δ – Consider the world market portfolio E[(r*)W - rGE] = θ cov[(r*)W,(r*)W] + δ cov[(r*)W, Ŝ] = θ var[(r*)W] + δ cov[(r*)W, Ŝ] – Consider a foreign i.e. US T-bill E[rUS - Ŝ - rGE] = - θ cov[Ŝ, (r*)W] + δ cov(Ŝ,Ŝ) = - θ cov[Ŝ,(r*)W] + δ var(Ŝ) These two equations can be used to estimate θ and δ.

The International CAPM
– Resulting two-country CAPM is E[(r*)iGE - rGE] = β i [(r*)W - rGE] + γ i E[rUS - Ŝ - rGE] Assets' beta and gamma have to be jointly estimated from a multiple regression with historical data (r*)iGE = α i + β i(r*)W + γ i Ŝ+ ui


The International CAPM
– Extension to a multi-country CAPM – E[(r*)iH - rH] = β iE[(r*)W - rH] + γ i1E[Ŝ1+rF1-rH] + γ i2E[Ŝ2+rF2-rH]....+ γ iKE[ŜK+rFK-rH] – Here rH denotes riskfree rate in investor's currency, rF1..rFK are riskfree rates in foreign currencies 1... ŜK are the changes in exchange rates of these currencies measured as units of home currency per unit of foreign currency .K and Ŝ1 ..


The International CAPM
– The parameters β i, γ i1 ... γ iK have to be obtained from a multiple regression with historical data (r*)iH = α i + β i(r*)W + γ i1 Ŝ1 + ...+ γ iK ŜK + ui • 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

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 - rH], E[Ŝ1+rF1-rH]...E[ŜK+rFK-rH]

Equity Financing in Global Markets
• Since many companies have accessed the global equity market primarily for establishing their image as global companies, to 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


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


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

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


Some Indian ADR/GDR Issues Company Industry Date of Issue Size ($m) Arvind Mills Textiles Feb-1994 125 Ashok Leyland Auto Mar-1995 138 Century Textiles Diversified Sep-1994 100 Crompton Electrical Jul- 1996 50 Dr. Reddy’s Pharma Jul-1994 48 GE Shipping Shipping Feb-1994 100 Indian Hotels Hotels Apr-1995 86 Indo Gulf Fertilizers Jan-1994 100 ICICI Finance Sep-1999 315 Infosys IT Mar-1999 70 L&T Diversified Mar-1996 135 Mah&Mah Auto Nov-1993 75 Reliance Diversified May-1992 150 Satyam Infoway IT Oct-1999 75 VSNL Telecom Mar-1997 527 Wipro IT Sep-2000

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.


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


• American Depository Receipts • • 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.

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.


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.


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. • The chart below shows the GDR mechanism


Equity Financing in the International Markets
Subscribers, Lead Managers etc Company



Nominee for Euroclear and Cedel

Hold the American GDR and Register it in the Name of DTC

GDR Holders


18.5 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 nonresident firms to tap equity markets in US and Europe