Chapter 22 Bodie Kane Marcus Perrakis Ryan INVESTMENTS

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Chapter Summary w Objective: To show the importance of world markets and the benefits of international diversification. n n Slide 22 -2 International investments Risk issues in international investing Measurement of international investing Integration of Markets Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Background w Global market n n US Market represents about 50% of all markets Canadian market, although the sixth-largest one, represents only 2. 5% Improved access & technology New instruments w Emphasis for our investigation n n Slide 22 -3 Risk assessment Diversification Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Issues w What are the risks involved in investment in foreign securities? w How do you measure benchmark returns on foreign investments? w Are there benefits to diversification in foreign securities? Slide 22 -4 Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Diversification Benefits w Evidence shows international diversification is beneficial w It is possible to expand the efficient frontier above domestic-only frontier w Possible to reduce the systematic risk level below the domestic-only level Slide 22 -5 Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Efficient Frontier with International Diversification Return Int’l ** * * Domestic * Risk Slide 22 -6 Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Systematic Risk Level with International Diversification Risk Domestic International Securities Slide 22 -7 Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition International Investment Choices w Direct stock purchases (institutional investors) w American Depository Receipts (ADRs) w International mutual funds n n Slide 22 -8 Open-end funds Closed-end funds Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Summary Reminder w Objective: To show the importance of world markets and the benefits of international diversification. n n Slide 22 -9 International investments Risk issues in international investing Measurement of international investing Integration of Markets Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Risks in International Investing Political Risks w Expropriation of assets w Restrictions on foreign exchange w Political instability Slide 22 -10 Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Risks in International Investing Foreign Exchange Risk w Variation in return related to changes in the relative value of the domestic and foreign currency w Total return = investment return & return on foreign exchange w It is not possible to completely hedge a foreign investment Slide 22 -11 Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Returns with FX w Return in Canada is a function of two factors 1. Return in the foreign market 2. Return on the foreign exchange Slide 22 -12 Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Returns with FX (1 + r. CAN) = (1 + r. FM) (1 + r. FX) r. CAN = return on the foreign investment in Canadian Dollars r. FM = return on the foreign market in local currency r. FX = return on the foreign exchange Slide 22 -13 Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Return Example: Dollar Appreciates Initial Investment : $20, 000 Initial Exchange: $2. 00/ Pound Sterling Final Exchange: $1. 80/ Pound Sterling Return in British Security: 10% Return in Canadian Dollars (1 + r. CAN) = (1. 10) (. 90) =. 99 r. CAN = -1% Slide 22 -14 Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Return Example: Dollar Depreciates Initial Investment : $20, 000 Initial Exchange: $2. 00/ Pound Sterling Final Exchange: $2. 10/ Pound Sterling Return in British Security: 10% Return in Canadian Dollars (1 + r. CAN) = (1. 10) (1. 05) = 1. 155 r. CAN = 15. 5% Slide 22 -15 Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Hedging Foreign Exchange Risk w Canadian firm wants to protect against a decline in profit that would result from a decline in the UK pound w Estimated profit loss of $200, 000 if the pound declines by $. 10 w Short or sell pounds for future delivery to avoid the exposure Slide 22 -16 Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Hedge Ratio for Foreign Exchange Example Hedge Ratio in pounds $200, 000 per $. 10 change in the pound/dollar exchange rate $. 10 profit per pound delivered per $. 10 in exchange rate = 2, 000 pounds to be delivered Hedge Ratio in contacts Each contract is for 62, 500 pounds or $6, 250 per a $. 10 change $200, 000 / $6, 250 = 32 contracts Slide 22 -17 Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Summary Reminder w Objective: To show the importance of world markets and the benefits of international diversification. n n Slide 22 -18 International investing Risk issues in international investing Measurement of international investing Integration of Markets Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Measuring Benchmark Returns w Indexes w EAFE Index w Issues in measuring performance n n Weighting Cross-Holdings w Other possibilities n Slide 22 -19 Country and Region Funds Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Performance Attribution with International Investment Extension to consider additional factors w Currency selection w Country selection w Stock selection w Cash and bond selection Slide 22 -20 Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Security Analysis with International Investments w Accounting rules and conventions complicate security analysis w Depreciation w Reserves w Consolidation w Taxes w P/E ratios Slide 22 -21 Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Summary Reminder w Objective: To show the importance of world markets and the benefits of international diversification. n n Slide 22 -22 International investing Risk issues in international investing Measurement of international investing Integration of Markets Copyright © Mc. Graw-Hill Ryerson Limited, 2003

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Integration of Security Markets w Integration - two markets respond to common factors (risk-return) w Segmentation – two markets respond to different factors w Canadian and U. S. markets are largely integrated (not entirely) w International markets are increasingly integrated – still segmented Slide 22 -23 Copyright © Mc. Graw-Hill Ryerson Limited, 2003