1. 12/04/2000 Finance 614: Lecture notes1 Lectures 12 and 13 International Asset Portfolios Galina A Schwartz Department of Finance University of Michigan Business School

2. 12/04/2000 Finance 614: Lecture notes2 Plan of Lectures 12 & 13  Levich, Chapters 14 and 15  Bond portfolio Risks: hedge or not to hedge?  Equity portfolio  major types of equity portfolios  cross-country differences  Home country bias [over-investment in domestic assets] common for both types of international portfolios

3. 12/04/2000 Finance 614: Lecture notes3 Bond Portfolio I  Two components of associated risk: [for un-hedged foreign bond]  1. Variability in foreign bond prices [country interest rate risk]  2. Variability in foreign exchange rate [central bank risk]  and the covariance between them [Levich, p. 495]  + exposure to changes in credit risk, exchange controls & the risk of default  Empirics [Facts]  International bond returns are weakly correlated  Three heavily concentrated markets: US, EU countries, Japan

4. 12/04/2000 Finance 614: Lecture notes4 Bond portfolio II  Terms [Jargon]:  Non-hedged portfolios under-perform  Passively hedged portfolios  Passively hedged portfolios under-perform  Actively hedged portfolios [tactical or overlay]  Brady Bonds (1989) [to resolve emerging market debt issues] http://www.bradynet.com

5. 12/04/2000 Finance 614: Lecture notes5 Bond Portfolio III: Brady bonds  Why Brady bond mechanism was possible? [collateralization of the debt was the key]  Emerging market defaults were the reality  The market value of the outstanding debt was   Overall this market was small ( ~ 150 billion $)

6. 12/04/2000 Finance 614: Lecture notes6 Brady Mechanism & Russian crisis of 1998  Why Brady mechanism was not used with Russia? 1. Debt collateralization is essential for Brady mechanism It was hardly an option in Russia 2. Volume of Russian debt – high (~ 150 billion $) 3. Russian government capacity to service its debt? questionable…

7. 12/04/2000 Finance 614: Lecture notes7 Equity portfolio I  Associated risks [similar to bond portfolios] Levich, p. 539 [compare to p. 495]  Institutional aspects  Market size  market concentration  trading volume  Transaction taxes  Transaction costs  clearing procedures (& costs)  settlement procedures (& costs)

8. 12/04/2000 Finance 614: Lecture notes8 Equity portfolio II  Main types of Funds  Close-End and Open-End Funds  Country Baskets (CBs)  World Equity Benchmark Shares (WEBS)  Regional Funds  Industry Funds  Why do we observe the variety of Fund’s types?

9. 12/04/2000 Finance 614: Lecture notes9 Equity portfolio III  Pricing, Levich, pp. 544-549  Generalized capital asset pricing model (CAPM) Somewhat unrealistic assumptions: (no transaction costs & taxes, returns are in nominal terms existence of a risk-free asset investor utility depends only on expected return and risk)  Arbitrage pricing theory (APT) (a set of `factors` drives equity returns) Importance of financial variables as factors

10. 12/04/2000 Finance 614: Lecture notes10 Home country bias Possible explanations  Barriers to international investment  Regulatory and tax reasons [& uncertainty]  High share of non-tradables in consumption  Substitution of investment in foreign assets by investment in multinational corporations (MNC)  Informational imperfections  Endogenous exchange rate risk [Risk increases in the volume of foreign exchange market, see midterm 2.2. & 2.3 ]

11. 12/04/2000 Finance 614: Lecture notes11 To hedge or not to hedge?  Different incentives of bond & equity holders w.r.t. hedging foreign exchange risk exposure [Levich, p. 588, box 16. 1]  Bond holders – hedge  Equity holders – do not hedge

12. 12/04/2000 Finance 614: Lecture notes12 Bonds and Equity international portfolios Common issues  Exposure to exchange rate risk  Exposure to country risk  Cross country regulatory & tax differences  Robust home country bias

13. 12/04/2000 Finance 614: Lecture notes13 Summary of Lectures 12 & 13, I  Bonds and Equity international portfolio  Current trends  Increased correlation of returns in mature markets  Increased market volatility &  its correlation with high correlation of returns  Lower gains from diversification into mature markets

14. 12/04/2000 Finance 614: Lecture notes14 Summary of Lectures 12 & 13, II  Bonds and Equity international portfolio  Current trends (continued)  Low correlation of returns in mature & emerging markets  diversification into emerging markets is profitable difficulty: ratings are not reliable. To diversify profitably one have to acquire information

15. 12/04/2000 Finance 614: Lecture notes15 Next week (Lectures 14 and 15)  Importance of Financial Institutions  Summary of what we have learned  Final Exam will be distributed on Monday 12/11/2000 – due 12/20/2000 (or 12/22/2000?)