19 Globalization and International Investing Bodie, Kane, and Marcus Essentials of Investments, 9th Edition

19.1 Global Markets for Equities Background Global market U.S. stock exchanges make up roughly 40% of all markets Emerging market development Market capitalization and GDP

Market Capitalization Market Capitalization as % of GDP Table 19.1 Market Capitalization of Stock Exchanges, Developed Countries Market Capitalization GDP GDP per Capita Market Capitalization as % of GDP Billions of U.S. Dollars Percent of World Annual Growth (%) 2000 2011 2000-2011 2010 WORLD 27,473 38,200 100% 2.8 63,124 9,228 68 US 12,900 13,917 47.0 36.4 0.6 14,587 47,199 98 JAPAN 3,140 3,289 11.4 8.6 0.4 5,459 42,831 69 UK 2,566 2,794 9.3 7.3 0.7 2,249 36,144 133 CANADA 615 1,581 2.2 4.1 8.2 1,577 46,236 114 FRANCE 1,278 1,455 4.7 3.8 1.1 2,560 39,460 70 HONG KONG 564 1,369 2.1 3.6 7.7 225 31,758 701 GERMANY 1,061 1,177 3.9 3.1 0.9 3,281 40,152 43 SWITZERLAND 783 1,062 2.9 2.6 528 67,464 224 AUSTRALIA 349 1,039 1.3 2.7 9.5 925 42,131 132 KOREA 123 763 2.0 16.4 1,015 20,757 86 SPAIN 331 546 1.2 1.4 4.2 1,407 30,542 44 ITALY 716 460 -3.6 2,051 33,917 28 SWEDEN 274 440 1.0 4.0 459 48,936 118 NETHERLANDS 680 376 2.5 -4.8 779 46,915 60 MEXICO 112 372 10.5 1,035 9,123 39 NORWAY 52 238 0.2 13.5 413 84,538 61 CHILE 229 14.7 213 12,431 136 BELGIUM 159 216 469 43,144 54 DENMARK 99 176 0.5 4.9 310 55,891 67 TURKEY 50 164 10.4 734 10,094 34 FINLAND 280 139 -5.7 239 44,512 ISRAEL 46 119 0.3 8.3 217 28,504 80 POLAND 27 0.1 12.5 12,293 AUSTRIA 85 9.8 379 45,209 33 IRELAND 82 65 -1.9 211 47,170 30 PORTUGAL 64 59 -0.6 21,505 35 CZECH REP. 12 0.0 192 18,245 23 NEW ZEALAND 20 5.0 31,067 LUXEMBURG 1.7 53 105,438 79 GREECE 72 29 -7.1 301 26,600 21 HUNGARY 19 129 12,852 22 SLOVENIA 2 6 11.2 47 22,851 18

Table 19.2 Market Capitalization of Stock Exchanges, Emerging Markets GDP GDP per Capita Market Capitalization as % of GDP Billions of U.S. Dollars Percent of World Growth (%) 2000 2011 2000-2011 2010 BRAZIL 180 1,056 0.7 2.8 15.9 2,088 10,710 66 INDIA 107 868 0.4 2.3 19.0 1,727 1,475 69 RUSSIA 19 694 0.1 1.8 34.9 1,480 10,440 58 CHINA 13 499 0.0 1.3 35.2 5,927 4,428 11 TAIWAN 177 455 0.6 1.2 8.2 430 18,300 134 SINGAPORE 136 428 0.5 1.1 10.1 209 41,122 241 SOUTH AFRICA 104 405 12.0 364 7,275 MALAYSIA 83 330 0.3 0.9 12.1 238 8,373 135 INDONESIA 21 301 0.8 24.8 707 2,946 41 THAILAND 23 219 20.7 319 4,608 70 COLOMBIA 4 191 37.3 288 6,225 PHILIPPINES 20 141 17.6 200 2,140 67 PERU 5 77 0.2 25.9 157 5,401 64 ARGENTINA 24 36 3.6 369 9,124 15 PAKISTAN 26 15.2 1,019 17 SRI LANKA 1 14 27.5 50 2,375 31 ROMANIA 36.9 162 7,538 9 VENEZUELA 6 -0.2 392 13,590 3 CYPRUS -9.7 28,779 28 BULGARIA 2 29.6 48 6,325

Figure 19.1A Per Capita DGP and Market Capitalization as Percent of GDP, Log Scale 2000

Figure 19.1B Per Capita GDP and Market Capitalization as Percent of GDP, Log Scale 2010

19.2 Risk Factors in International Investing Risks in Foreign Security Investment Exchange rate risk Uncertainty in asset returns due to movements in exchange rates between U.S. dollar and foreign currency Country-specific risk Political risk: Possibility of expropriation of assets, changes in tax policy, restrictions on exchange of foreign currency for domestic, etc. Imperfect exchange rate risk hedging Hard to hedge equities with variable rates of return

19.2 Risk Factors in International Investing  

19.2 Risk Factors in International Investing Dollar Depreciation Relative to Pound If you invest in a British security and earn 10%, find the return in U.S. dollars given Initial exchange rate: £ = $2 Final exchange rate: £ = $2.10

19.2 Risk Factors in International Investing Dollar Appreciation Relative to Pound If you invest in a British security and earn 10%, find the return in U.S. dollars given Initial exchange rate: £ = $2 Final exchange rate: £ = $1.85

Figure 19.2 Stock Returns, U.S. Dollars and Local Currencies, 2010

Table 19. 3 Rates of Change, U. S Table 19.3 Rates of Change, U.S. Dollar versus World Currencies, 2002-2011   Euro (€) U.K. (£) Switzerland (SF) Japan (¥) Australia (A$) Canada (C$) A. Standard deviation (annualized %) 11.04 9.32 11.94 9.13 13.87 10.04 B. Correlation matrix 0.63 1 0.83 0.51 0.27 0.08 0.42 0.75 0.6 0.61 0.05 0.49 0.37 -0.02 0.72 C. Average annual returns from rolling over one-month LIBOR rates (%) Return in Expected Actual Surprise Local Gain from Actual Return Component SD of Annual Country Currency in U.S. dollars of Return Return U.S. $ 2.18 Euro € 2.38 -0.20 4.38 6.77 4.58 U.K. £ 3.51 -1.32 1.09 4.60 2.41 SF 0.90 1.28 6.46 7.36 5.17 Japan ¥ 0.24 1.94 5.75 5.99 3.81 Australia A$ 5.25 -3.07 7.94 13.19 11.01 Canada C$ 2.50 -0.31 5.01 7.51 5.32

19.2 Risk Factors in International Investing Carry Trade Suppose yen LIBOR = .24%, USD LIBOR = 3.75% An astute investor may borrow yen at the yen rate, convert the borrowed funds to dollars, and invest at dollar LIBOR What can go wrong with this strategy? Default Yen increases in value by  3.75% − .24% = 3.51% or more

19.2 Risk Factors in International Investing Covered Interest Arbitrage U.S. interest rates 6.15%, British rates 10%, exchange rate $2/£; 1-year forward exchange rate for pound is $1.95/£ How can you earn a riskless arbitrage profit based on these quotes? Borrow $1 at 6.15%: will owe $1.0615 in 1 year Convert $1 to pounds: $1/($2/£) = £.50 Invest £.50 at 10%: Will yield £.50 x 1.10 = £.55 Sell pound forward at $1.95: £55 x $1.95 = $1.0725 Net: $1.0725 − $1.0615 = $.011/dollar

19.2 Risk Factors in International Investing Covered Interest Parity The spot-futures exchange rate relationship that prevents arbitrage opportunities If the interest rates and exchange rates are in this relationship, no arbitrage is possible

Table 19.4 Composite Risk Ratings for 01/2011, 02/2010 Rank in January 2011 Country Composite Risk Rating January 2011 Composite Risk Rating February 2012 January 2011 versus February 2010 Rank in February 2010   Very low risk 1 Norway 90.5 90.00 0.50 11 Germany 83.5 83.50 0.00 5 13 Canada 82.8 82.75 6 16 Qatar 82.0 81.25 0.75 19 Japan 81.0 80.00 1.00 17 Low risk 31 United Kingdom 77.3 73.75 3.50 39 32 United States 77.0 77.25 -0.25 26 China, Peoples' Rep. 75.0 76.25 -1.25 30 44 Brazil 74.5 72.75 1.75 46 68 Spain 70.0 71.00 -1.00 58 Moderate risk 78 Indonesia 68.5 67.25 1.25 81 86 India 67.3 70.50 -3.25 62 104 Egypt 64.5 66.50 -2.00 84 111 Turkey 63.3 63.50 100 High risk 124 Venezuela 59.5 53.75 5.75 133 127 Iraq 58.5 59.25 -0.75 119 129 Pakistan 57.3 57.00 0.25 125 Very high risk 138 Haiti 48.5 49.75 137 140 Somalia 41.5 36.75 4.75

Table 19.5 Variables Used in PRS’s Political Risk Score

Table 19.6 Current Risk Ratings and Composite Risk Forecasts   Composite Ratings Current Ratings Year Ago Current Political Risk Financial Economic Country February 2010 January 2011 Norway 90.00 90.50 88.5 46.5 46.0 Canada 82.75 86.5 40.0 39.0 Japan 80.00 81.00 78.5 44.0 39.5 United States 77.25 77.00 81.5 37.0 35.5 China, Peoples' Rep. 76.25 75.00 62.5 48.0 India 70.50 67.25 58.5 43.5 32.5 Turkey 63.50 63.25 57.0 34.5 35.0

Table 19.7 Risk Forecasts Composite Risk Forecasts   Current One Year Ahead Five Years Ahead Country Rating January 2011 Worst Case Best Case Risk Stability Norway 90.5 88.3 93.3 5.0 83.3 92.8 9.5 Canada 82.8 78.3 84.3 6.0 75.3 86.5 11.3 Japan 81.0 77.0 7.3 72.5 87.5 15.0 United States 73.3 80.3 7.0 69.5 83.0 13.5 China, Peoples' Rep. 75.0 70.8 79.0 8.3 61.3 82.0 20.8 India 67.3 64.0 72.3 57.5 19.5 Turkey 63.3 57.8 67.5 9.8 53.8 71.5 17.8 Political Risk Forecasts   Current One Year Ahead Five Years Ahead Country Rating 01/11 Worst Case Best Case Risk Stability Norway 88.5 88.0 92.0 4.0 86.0 89.5 3.5 Canada 86.5 83.0 5.5 81.5 8.0 Japan 78.5 75.5 84.0 8.5 72.0 16.0 United States 77.5 85.5 76.0 87.0 11.0 China, Peoples' Rep. 62.5 58.5 68.5 10.0 55.0 73.0 18.0 India 64.0 9.0 53.5 71.0 17.5 Turkey 57.0 52.5 63.5 51.5 69.0

Table 19.8 Political Risk Points by Component, 1/2011

International Investment Choices 19.3 International Investing Risk, Return, and Benefits from Diversification International Investment Choices Direct stock purchases Difficult for individual investors due to currency and tax issues Mutual funds Open end World versus international funds Higher expenses Closed end Country or regional funds WEBS

Figure 19.3 Monthly Standard Deviation of Excess Returns, Developed and Emerging Markets, 2002-2011 Rank Legend Rank Developed Emerging 1 U.S. Malaysia 2 Japan Morocco 3 Switzerland Jordan 4 U.K. Chile 5 Israel Mexico 6 New Zealand Philippines 7 Canada Taiwan 8 Hong Kong Czech Republic 9 Denmark South Africa 10 Singapore China 11 Portugal Thailand 12 Australia Colombia 13 France Korea 14 Netherlands India 15 Italy Peru 16 Belgium Indonesia 17 Spain Pakistan 18 Ireland Poland 19 Germany Egypt 20 Sweden Russia 21 Austria Hungary 22 Finland Brazil 23 Norway Sri Lanka 24 Greece Argentina 25 Turkey

Figure 19.4 Beta against U.S. Market of Developed and Emerging Markets, 2002-2011 Rank Legend Rank Developed Emerging 1 Japan Pakistan 2 Switzerland Jordan 3 Israel Morocco 4 New Zealand Sri Lanka 5 Hong Kong Malaysia 6 U.K. Philippines 7 U.S. Egypt 8 Portugal Chile 9 Singapore Colombia 10 Denmark Thailand 11 Canada Argentina 12 Australia Czech Republic 13 Italy Peru 14 Belgium China 15 Spain Taiwan 16 France South Africa 17 Ireland Indonesia 18 Netherlands India 19 Austria Mexico 20 Greece Russia 21 Finland Korea 22 Sweden Hungary 23 Germany Poland 24 Norway Brazil 25 Turkey

Figure 19.5 Average Excess Dollar-Denominated Returns, Developed and Emerging Markets, 2002-2011 Rank Legend Rank Developed Emerging 1 Greece Taiwan 2 Ireland Jordan 3 Finland Malaysia 4 U.S. Morocco 5 Italy Poland 6 Japan Hungary 7 Belgium Philippines 8 Portugal Mexico 9 France Argentina 10 U.K. Korea 11 Netherlands China 12 Israel Chile 13 Germany Russia 14 Switzerland India 15 Hong Kong South Africa 16 Spain Turkey 17 Austria Sri Lanka 18 Sweden Pakistan 19 New Zealand Thailand 20 Denmark Czech Republic 21 Canada Brazil 22 Singapore Egypt 23 Australia Peru 24 Norway Indonesia 25 Colombia

Figure 19.6 Information Ratios, Developed and Emerging Markets versus U.S. Dollar-Denominated Returns, 2002-11 Rank Legend Rank Developed Emerging 1 Ireland Taiwan 2 Greece Jordan 3 Finland Argentina 4 Italy Hungary 5 Belgium Turkey 6 Japan Poland 7 Portugal Russia 8 France Sri Lanka 9 Netherlands Philippines 10 U.K. India 11 Germany Korea 12 Israel China 13 Austria Pakistan 14 Spain Morocco 15 Hong Kong Egypt 16 Switzerland Malaysia 17 Sweden Brazil 18 New Zealand South Africa 19 Singapore Chile 20 Norway Thailand 21 Denmark Mexico 22 Canada Peru 23 Australia Czech Republic 24 Indonesia 25 Colombia

Figure 19.7 Standard Deviation of Excess Returns, Dollar-Denominated and Local Currencies, 2002-2011 Rank Legend Rank Country Rank Country 1 U.S. 27 Czech Republic 2 Japan 28 South Africa 3 Switzerland 29 Sweden 4 Malaysia 30 China 5 U.K. 31 Thailand 6 Morocco 32 Colombia 7 Israel 33 Korea 8 New Zealand 34 Austria 9 Jordan 35 Finland 10 Canada 36 Norway 11 Hong Kong 37 India 12 Denmark 38 Peru 13 Chile 39 Indonesia 14 Singapore 40 Pakistan 15 Portugal 41 Greece 16 Australia 42 Poland 17 France 43 Egypt 18 Netherlands 44 Russia 19 Mexico 45 Hungary 20 Italy 46 Brazil 21 Philippines 47 Sri Lanka 22 Taiwan 48 Argentina 23 Belgium 49 Turkey 24 Spain 25 Ireland 26 Germany

Figure 19. 8 Market Beta against U. S Figure 19.8 Market Beta against U.S. Using Dollar-Denominated and Local-Currency Excess Returns, 2002-11 Rank Legend Rank Country Rank Country 1 Pakistan 27 Indonesia 2 Jordan 28 Australia 3 Morocco 29 India 4 Sri Lanka 30 Mexico 5 Japan 31 Italy 6 Malaysia 32 Belgium 7 Philippines 33 Spain 8 Switzerland 34 France 9 Israel 35 Ireland 10 Egypt 36 Netherlands 11 New Zealand 37 Russia 12 Chile 38 Korea 13 Hong Kong 39 Austria 14 U.K. 40 Greece 15 Colombia 41 Finland 16 Thailand 42 Sweden 17 Argentina 43 Germany 18 Portugal 44 Norway 19 Czech Republic 45 Hungary 20 Peru 46 Poland 21 Singapore 47 Brazil 22 China 48 Turkey 23 Denmark 24 Canada 25 Taiwan 26 South Africa

Figure 19.9 Average Dollar-Denominated and Local-Currency Excess Returns, 2002-2011 Rank Legend Rank Country Rank Country 1 Greece 27 Morocco 2 Ireland 28 Poland 3 Finland 29 Hungary 4 U.S. 30 Philippines 5 Italy 31 Mexico 6 Japan 32 Argentina 7 Belgium 33 Korea 8 Portugal 34 Norway 9 France 35 China 10 U.K. 36 Chile 11 Netherlands 37 Russia 12 Taiwan 38 India 13 Israel 39 South Africa 14 Germany 40 Turkey 15 Jordan 41 Sri Lanka 16 Switzerland 42 Pakistan 17 Hong Kong 43 Thailand 18 Spain 44 Czech Republic 19 Austria 45 Brazil 20 Sweden 46 Egypt 21 New Zealand 47 Peru 22 Denmark 48 Indonesia 23 Canada 49 Colombia 24 Singapore 25 Malaysia 26 Australia

Diversification Benefits 19.3 International Investing: Risk, Return, and Benefits from Diversification Diversification Benefits Evidence shows international diversification is beneficial Possible to expand the efficient frontier above domestic-only frontier Possible to reduce the systematic risk level below the domestic-only level

Figure 19. 10 Information Ratios against U. S Figure 19.10 Information Ratios against U.S. Computed from Dollar-Denominated and Local Currency Returns, 2002-2011 Rank Legend Rank Country Rank Country 1 Ireland 27 Philippines 2 Greece 28 Singapore 3 Finland 29 India 4 Italy 30 Korea 5 Belgium 31 China 6 Japan 32 Pakistan 7 Portugal 33 Norway 8 France 34 Denmark 9 Netherlands 35 Morocco 10 Taiwan 36 Canada 11 U.K. 37 Egypt 12 Germany 38 Malaysia 13 Israel 39 Brazil 14 Austria 40 South Africa 15 Jordan 41 Australia 16 Spain 42 Chile 17 Argentina 43 Thailand 18 Hungary 44 Mexico 19 Hong Kong 45 Peru 20 Turkey 46 Czech Republic 21 Poland 47 Indonesia 22 Switzerland 48 Colombia 23 Russia 24 Sweden 25 Sri Lanka 26 New Zealand

Figure 19.11 International Diversification

Table 19. 10 Correlation of Foreign Investments with U. S Table 19.10 Correlation of Foreign Investments with U.S. Returns over Time

Figure 19.12 Ex-Post Efficient Frontier of Country Portfolios

Figure 19.13A Efficient Frontier of Country Portfolios (World Expected Excess Return = .3% per Month)

Figure 19.13B Efficient Frontier of Country Portfolios (World Expected Excess Return = .6% per Month)

Figure 19.14A Regional Indexes around the Crash, 10/14/87-10/26/87

19.14B Beta and  of Portfolios against Deviation of Monthly Return, 9/08-12/08

19.3 International Investing: Risk, Return, and Benefits from Diversification Conclusions Passive investment in all countries would not have lowered risk during recent crisis Hedging currencies has little effect; U.S. stock market crash appears to be systemic factor that cannot be diversified away from in crisis Correlations are increasing due to globalization; nevertheless, we still expect modest international diversification benefits in normal markets

19.3 International Investing: Risk, Return, and Benefits from Diversification Active Management First level Security selection and asset allocation within each market to identify country portfolio superior to country index Second level Optimize allocations across country portfolios to maximize diversification

19.5 International Investing and Performance Attribution The “Bogey” or Benchmark EAFE index (non-U.S. stocks) Currency Selection Contribution to performance due to currency movements Country Selection Contribution to performance due to choosing better-performing countries

19.5 International Investing and Performance Attribution Stock Selection Measured as weighted average of equity returns in excess of equity index in each country Cash/Bond Selection Excess return due to weighting bonds and bills differently from benchmark weights