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Chapter 8

International Investment and


Diversification

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All the people like us are We,
And everyone else is They.
And They live over the sea,
While We live over the way.
But would you believe it?
They look upon We
As only a sort of They.

- Rudyard Kipling
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Outline
Introduction
Why international diversification makes
theoretical sense
Foreign exchange risk
Investments in emerging markets
Political risk
Other topics related to international
diversification
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Introduction
The marketplace of the twenty-first century
is global
U.S. equities represent only about 51% of the
worlds equity capitalization
Over the period 1980-2000, the U.S. was the
best-performing market only once
In September 1999, each of the 66 U.S. pension
funds had more than $1 billion in actively
managed international investment portfolios
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Introduction (contd)
International investments carry additional
sources of risk

Managers can reduce total portfolio risk via


global investment

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Why International
Diversification Makes Sense
Remembering Evans and Archer
Remembering capital market theory

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Remembering
Evans and Archer
Portfolio theory works to the investors
benefit even if he selects securities at
random
Ideally, the portfolio manager selects
securities because of their fit with the rest of
the portfolio
By choosing poorly correlated securities, a
manager can reduce total portfolio risk
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Remembering
Evans and Archer (contd)
Totalrisk contains both systematic and
unsystematic risk
Evans and Archer show that holding 15 to 20
equity securities substantially reduces the
unsystematic risk

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Remembering
Capital Market Theory
Utility,
risk, and return
Variance of a linear combination
Relationship of world exchanges
Fundamental logic of diversification
Other considerations

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Utility, Risk, and Return
Unsystematicrisk reduction is possible with
more than 20 securities
For a given level of return, any reduction in
risk, no matter how small, is a worthy goal

A rational invest will reduce risk if given the


opportunity

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Variance of
A Linear Combination
Aslong as assets are less than perfectly
correlated, there will be diversification
benefits
More pronounced the lower the correlation

No two shares move in perfect lockstep


Diversification benefits accrue every time we add a
new position to a portfolio

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Relationship of
World Exchanges
For
U.S. securities, market risk account for
about 25% of a securitys total risk

Forless developed countries, market risk


tends to be higher because:
Fewer securities make up the market
The securities are exposed to more extreme
economic and political events

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Relationship of
World Exchanges (contd)
International
capital markets continue to
show independent price behavior
International diversification offers potential
advantages

Repeating the Evans and Archer methodology


for international securities should result in a
lower level of systematic risk
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Relationship of
World Exchanges (contd)
Portfolio Variance

U.S. Securities: Systematic Risk 27%

International Securities: Systematic Risk 11.7%

Number of Securities

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Fundamental
Logic of Diversification
Investors are, on average, rational
Rational people do not like unnecessary
risk
By holding one more security, an investor
can reduce portfolio risk without giving up
any expected return
Rational investors, therefore, will hold as
many securities as they can
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Fundamental Logic of
Diversification (contd)
The most securities investors can hold is
all of them

The collection of all securities makes up


the world market portfolio

Rational investors will hold some


proportion of the world market portfolio
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Other Considerations
Optimum portfolio size involves a trade-off
between:
The benefits of additional diversification

Commissions and capital constraints

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Foreign Exchange Risk
Definition
Business example
Investment example
From whence cometh the risk?
Dealing with the risk
The eurobond market
Combining the currency and market decisions
Key issues in foreign exchange risk management
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Definition
Foreignexchange risk refers to the
changing relationships among currencies
Modest changes in exchange rates can result in
significant dollar differences

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Business Example
A U.S. importer has agreed to purchase 40 New Zealand
leather vests at a price of NZ$110 each. The vests will take
two months to produce, and payment is due before the
vests are shipped.

The current spot rate of the NZ$ is $0.5855.

What is the price of the vests to the importer if the spot


rate remains unchanged in the next two months? If it is
$0.5500? If it is $0.6200?
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Business Example (contd)
Solution: If the spot rate does not change, the cost to the importer is:

40 x NZ$110 x $0.5855 = $2,576.20

If the spot rate is $0.5500:

40 x NZ$110 x $0.5500 = $2,420.00

If the spot rate is $0.6200:

40 x NZ$110 x $0.6200 = $2,728.00


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Investment Example
You just purchased 1,000 of Kangaroo Lager trading on
the Sydney Stock Exchange for AUD1.45 per share. The
exchange rate for the Australian dollar at the time of
purchase was $0.7735.

What is the U.S. dollar purchase price? If Kangaroo


Lager stock rises to AUD1.95 per share and if the
Australian dollar depreciates to $0.7000, what is your
holding period return if you sell the shares?

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Investment Example (contd)
Solution: The purchase price in U.S. dollars is:

1,000 x AUD1.45 x $0.7735 = $1,121.58

If the Australian dollar depreciates and you sell the shares, you will
receive:

1,000 x AUD1.95 x $0.7000 = $1,365.00

The holding period return is:

($1,365.00 - $1,121.58)/$1,121.58 = 21.7%

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From Whence
Cometh the Risk?
Role of interest rates
Forward rates
Interest rate parity
Covered interest arbitrage
Purchasing power parity

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Role of Interest Rates
Real rate of interest
Inflation premium
Risk premium

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Real Rate of Interest
The real rate of interest reflects the rate of
return investors demand for giving up the
current use of funds

In a world of no risk and no inflation, the


real rate indicates peoples willingness to
postpone spending their money

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Inflation Premium
The inflation premium reflects the way the
general price level is changing

Inflation is normally positive


The inflation premium measures how rapidly
the money standard is losing its purchasing
power

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Risk Premium
The risk premium is the component of
interest rates that reflects compensation for
risk to risk-averse investors

The
risk premium is a function of how
much risk a security carries
E.g., common stock vs. T-bills

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Forward Rates
The forward rate is a contractual rate
between a commercial bank and a client for
the future delivery of a specified quantity of
foreign currency
Typically quoted on the basis of 1, 2, 3, 6, and
12 months

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Forward Rates (contd)
The forward rate is the best estimate of the
future spot rate
If the forward rate indicates the dollar will
strengthen, importers should delay payment

If the forward rate indicates the dollar will


weaken, importers should lock in a rate now

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Forward Rates (contd)
Forward rate premium or discount:

Forward rate - Spot rate 12


100
Spot rate n

where n the contract length in months

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Forward Rates (contd)
Example

On June 12, 2002, the British pound had a spot rate of


$1.4728. The 3-month forward rate of the pound was
$1.4645 on that date.

What is the forward premium or discount?

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Forward Rates (contd)
Example (contd)

Solution: The forward premium or discount is calculated


as follows:
Forward rate - Spot rate 12 $1.4645 $1.4728 12
100 100
Spot rate n $1.4728 3
2.25%

There is a forward discount of 2.25%.


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Interest Rate Parity
Interest rate parity states that differences in
national interest rates will be reflected in the
currency forward market
Two securities of similar risk and maturity will
show a difference in their interest rates equal to
the forward premium or discount, but with the
opposite sign

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Covered Interest Arbitrage
Covered interest arbitrage is possible when
the conditions of interest rate parity are
violated
If the foreign interest rate is too high, convert
dollars to the foreign currency and invest in the
foreign country

If the U.S. interest rate is too high, borrow the


foreign currency and invest in the U.S.
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Example of CIA

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Purchasing Power Parity
Purchasing power parity (PPP) refers to
the situation in which the exchange rate
equals the ratio of domestic and foreign
price levels
A relative change in the prevailing inflation rate
in one country will be reflected as an equal but
opposite change in the value of its currency

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Purchasing Power
Parity (contd)
Absolutepurchasing power parity follows
from the law of one price:
A basket of goods in one country should cost
the same in another country after conversion to
a common currency
Not very accurate due to:
Transportation costs
Trade barriers
Cultural differences

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Purchasing Power
Parity (contd)
Relative purchasing power parity states
that differences in countries inflation rates
determine exchange rates:
1 IF
S 1
1 ID
where S change in the spot exchange rate
I F foreign country inflation rate
I D domestic country inflation rate
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Purchasing Power
Parity (contd)
A countrywith an increase in inflation will
experience a depreciation of its currency
because:
Exports decline
Imports increase
There is less demand for goods from that
country

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Dealing With the Risk
The concept of exposure
Dealing with the exposure

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The Concept of Exposure
Definition
Accounting exposure
Transaction exposure
Translation exposure
Economic exposure

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Definition
Exposure is a measure of the extent to
which a person faces foreign exchange risk

Ingeneral, there are two types of exposure:


accounting and economic
Economic exposure is more important

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Accounting Exposure
Accounting exposure is:
Of concern to MNCs that have subsidiaries in a
number of foreign countries
Important to people who hold foreign securities
and must prepare dollar-based financial reports

U.S.firms must prepare consolidated


financial statements in U.S. dollars
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Transaction Exposure
FASB Statement No. 8 addresses
transaction exposure:
A transaction involving purchase or sale of
goods or services with the price states in
foreign currency is incomplete until the amount
in dollars necessary to liquidate a related
payable or receivable is determined

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Translation Exposure
Translation exposure results from the
holding of foreign assets and liabilities that
are denominated in foreign currencies
E.g., foreign real estate and mortgage holdings
must be translated to U.S. dollars before they
are incorporated into a U.S. balance sheet

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Economic Exposure
Economic exposure measures the risk that
the value of a security will decline due to an
unexpected change in relative foreign
exchange rates

Security analysts should include expected


changes in exchange rates in forecasted
cash flows
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Dealing With the Exposure
Ignorethe exposure
Reduce or eliminate the exposure
Hedge the exposure

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Ignore the Exposure
Ignoring the exposure may be appropriate
for an investor if:
Foreign exchange movements are expected to
be modest
The dollar mount of the exposure is small
relative to the cost of inconvenience of hedging
The U.S. dollar is expected to depreciate
relative to the foreign currency
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Reduce or Eliminate
the Exposure
If the dollar is expected to appreciate
dramatically, an investor may reduce or
eliminate foreign currency holdings

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Hedge the Exposure
Definition
Hedging with forward contracts
Hedging with futures contracts
Hedging with foreign currency options

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Definition
Hedging involves taking one position in the
market that offsets another position
Covering foreign exchange risk means hedging
foreign exchange risk

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Hedging With
Forward Contracts
A forward contract is a private, non-
negotiable transaction between a client and
a commercial bank
No money changes hands until the foreign
currency is delivered, but the rate is determined
now

The forward rate reflects relative interest rates


and associated risks
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Hedging With
Futures Contracts
A futures contract is a promise to buy or sell a
specified quantity of a particular good at a
predetermined price by a specified delivery date

On the delivery date, there will be a gain or loss in


the futures market that will offset the gain or loss
experienced when converting the foreign currency

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Hedging With
Futures Contracts (contd)
Tohedge an investment, sell foreign
currency futures

Tohedge a liability, buy foreign currency


futures

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Hedging With
Foreign Currency Options
Thereare two types of foreign currency
options:
Call options give their owner the right to buy a
set quantity of foreign currency
Put options give their owner the right to sell a
set quantity of foreign currency
The price at which you have the right to buy or
sell is the striking (exercise) price
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Hedging With Foreign
Currency Options (contd)
Currency option characteristics:
A call option with an exercise price quoted in
dollars for the purchase of euros is the same as
a put option on dollars with an exercise price
quoted in euros

Put-call parity for foreign currency options is a


restatement of interest rate parity
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Hedging With Foreign
Currency Options (contd)
Thedisadvantage of hedging with currency
options is that the hedger must pay a
premium to established the hedge
Options provide more precision than futures
contracts

Options are more expensive than futures


contracts
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The Eurobond Market
Eurobonds are debt agreements that are
denominated in a currency other than that of the
country in which they are held
E.g., a bond denominated in yen sold in the United
Kingdom

A foreign bond is denominated in the local


currency but is issued by a foreigner
E.g., a bond denominated in yen sold in Japan, issued
by a firm in the United Kingdom
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The Eurobond Market (contd)
About 75% of eurobonds are denominated
in U.S. dollars

Firms issuing dollar-denominated


Eurobonds pay a slightly lower interest rate
than they would pay in the U.S.

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Combining the Currency and
Market Decisions
Itis often desirable to cross-hedge a foreign
investment into a different currency
E.g., a U.S. investor might invest in Japan, use
the forward market to sell yen for British
pounds and convert the pounds back to dollars

The currency return comes from the forward


market premium or discount and the actual
change in the exchange rate
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Key Issues in Foreign
Exchange Risk Management
The steps in foreign exchange risk
management:
1) Define and measure foreign exchange
exposure
2) Organize a system that monitors this exposure
and exchange rate changes
3) Assign responsibility for hedging
4) Formulate a strategy for hedging
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Investments in
Emerging Markets
Overview
Background
Adding value
Reducing risk
Following the crowd
Special risks
Asymmetric correlations
Market microstructure considerations
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Overview
Emerging market investments:
Offer substantial potential rewards to the
careful investor in added return and risk
reduction
Are accompanied by special risks:
Foreign exchange risk
High political and economic risk
Unreliable investment information
High trading costs

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Background
Over$20 billion is invested globally in
securities issued in underdeveloped
countries

Pensionfunds largest emerging market


exposure is in:
Asia (39.1%)
Latin America (32.7%)
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Background (contd)
Dollars invested in emerging markets has
increased at a compound rate of almost 50%
over the last 10 years

Private sector growth in emerging markets


E.g., Hungary and Poland after 1989

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Adding Value
Prices in developing markets often contain
significant inefficiencies
Tend to sell for lower price/earnings multiples
than do firms in developed markets
Emerging market firms have greater expected
growth and are cheaper

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Reducing Risk
Low correlations are attractive as a means
of reducing portfolio variability
Emerging markets show low correlation with
developed markets

Emerging markets show low correlation with


each other

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Following the Crowd
Some professional money managers
carefully analyze emerging markets for:
Profit potential
Portfolio risk reduction

Some professional money managers follow


the crowd because they must invest in
emerging markets
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Special Risks
Incomplete accounting information
Foreign currency risk
Fraud and scandals
Weak legal system

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Incomplete
Accounting Information
Insome countries, financial statements are
more than 6 months old when they become
available
The acquisition of reliable investment
information generally requires on-site security
analysts

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Incomplete Accounting
Information (contd)
Accounting standards differ substantially
across countries
Accounting information is frequently
unavailable for an emerging market security
Some emerging market brokerage firms
focus on the income statement but ignore
the balance sheet

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Foreign Currency Risk
Foreignexchange securities are
denominated in a foreign currency
Introduces foreign exchange risk for foreign
investors
E.g., Mexican peso crisis and Asian crisis

Inemerging markets, traditional hedging


vehicles may be unavailable
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Fraud and Scandals
Emerging markets carry a substantial risk of
fraud
E.g., accounting misstatements, counterfeit
securities, bucket shops

Redressavailable to victims of a scandal in


a developing country may be inadequate

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Weak Legal System
Low confidence in a countrys legal system:
Leads to increased uncertainty

Leads to an increased risk premium required by


investors

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Asymmetric Correlations
Correlationbetween emerging and
developed markets:
Increases during bear markets

Is low during bull markets

The extent of portfolio managers


diversification depends on whether they are
experiencing an up or a down market
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Asymmetric
Correlations (contd)
Investment returns show:
Homogeneity within emerging markets
Securities tend to move as a group within a single
emerging market

Heterogeneity across emerging markets


Emerging markets show low correlation across
markets

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Market
Microstructure Considerations
Liquidityrisk
Trading costs
Market pressure
Marketability risk
Country risk

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Liquidity Risk
Some emerging markets investors are mostly
foreign
Increases political risk
Sets the stage for a market collapse if everyone pulls
out at once

Some emerging markets lack depth


The bid/ask spread tends to be wide with few standing
order to buy and to sell
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Trading Costs
Foreign
market trading costs are more than
1% higher than domestic trading costs
E.g., bid/ask spread is an average of 95 basis
points for Barings Securities emerging market
index

This indicates an investment must appreciate


more to show a given net return
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Market Pressure
Anorder to buy or sell a large number of
shares might cause a substantial
supply/demand imbalance
Causes the price to move adversely from the
investors perspective

Indicates that emerging market investments


should be viewed as long-term investments
rather than a source of trading profits
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Marketability Risk
Aninvestor may be unable to close out a
position at a reasonable price

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Country Risk
Country risk refers to a countrys ability
and willingness to meet its foreign
exchange obligations
Especially important in emerging markets

Country risk has two components:


Political risk
Economic risk

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Political Risk
Introduction
Factorscontributing to political risk
Macro risk versus micro risk
Dealing with political risk

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Introduction
Politicalrisk is a measure of a countrys
willingness to honor its foreign obligations
A function of:
The stability of the governments and its leadership
Attitudes of labor unions
The countrys ideological background
The countrys past history with foreign investors

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Introduction (contd)
Real (direct) investment is an investment
over which the investor retains control
E.g., a plant in a foreign country

Portfolioinvestment refers to foreign


investment via the securities market
E.g., buying a number of shares of a foreign
company
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Introduction (contd)
Extremeforms of country risk for portfolio
investment:
Government takeover of a company
Political unrest leading to work stoppages
Physical damage to facilities
Forced renegotiation of contracts

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Introduction (contd)
Modestforms of country risk for portfolio
investment:
A requirement that a minimum percentage of
supervisory positions be held by locals
Changes in operating rules
Restrictions on repatriation of capital

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Factors Contributing
to Political Risk
Buy local attitude
Public attitude
Government attitude

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Buy Local Attitude
Buylocal campaigns seek to make foreign
consumers buy local goods instead of goods
produced by a foreign firm or its
subsidiaries

Contributes to political risk

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Public Attitude
In emerging markets, people may see no
opportunity to improve their standard of living
Foreign subsidiaries may contribute to this attitude with
luxury items

The gap between the publics aspirations and its


expectations contributes to political risk

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Government Attitude
Unstable governments can lead to foreign
investors being a volatile political issue
Foreign investors can be blamed for local
problems

Foreign governments can suspend a firms


ability to send funds back to its home country

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Macro Risk Versus Micro Risk
Macro risk refers to government actions that
affect all foreign firms in a particular industry

Micro risk refers to politically motivated changes


in the business environment directed to selected
fields of business activity or to foreign enterprises
with specific characteristics

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Dealing With Political Risk
Seeka foreign investment guarantee from
the Overseas Private Investment
Corporation
Provides coverage against:
Loss due to expropriation

Nonconvertibility of profits

War or civil disorder

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Dealing With
Political Risk (contd)
Avoid engaging in behavior that stirs up
trouble with the host people or government:
Constructing flamboyant office buildings

Giving the impression of natural resource


exploitation

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Economic Risk
Economic risk is a measure of a countrys
ability to pay
Assess economic risk by:
Using coverage ratios

Assessing the countrys capital base

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Other Topics
Multinational corporations
American depository receipts
International mutual funds

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Multinational Corporations
Investing in a multinational corporation
may provide a ready-made means of getting
the risk-reduction benefits of international
diversification
Research is unclear whether MNCs are better
investments than purely domestic firms

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American Depository Receipts
American depository receipts (ADRs) are receipts
representing shares of stock that are held on the
ADR holders behalf in a bank in the country of
origin
An alternative to purchasing shares in a foreign
company directly on the foreign exchange

By 2000, 1,534 ADRS from dozens of countries


traded in the U.S.
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International Mutual Funds
Mutual funds permit diversification to an
extent that would not otherwise be possible
Some mutual funds invest only in securities
issued outside the U.S.

Buying an international mutual fund is a good


way to achieve international diversification

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