1. Asset Management Lecture 16

2. Outline for today International Diversification Emphasis for our investigation Risk assessment Diversification 3rd Case The question set will be posted On April 22, Wednesday. The report is due on May 1, Friday.

3. Market Capitalization of Stock Exchanges in Developed Countries

4. Global Equity Market 2008

5. Table 25.2 Market Capitalization of Stock Exchanges in Emerging Markets

6. What are the risks involved in investment in foreign securities? How do you measure benchmark returns on foreign investments? Are there benefits to diversification in foreign securities? Issues

7. Example: British T-bill pays 10% per year The exchange rate is $2 per pound The U.S. investor invests $20,000 What is the payoff in one year’s time? If the exchange rate does not change £10,000*1.1=£11,000=$22,000 If the pound depreciate to $1.8 by the end of the year £10,000*1.1=£11,000=$19,800 Foreign Exchange Risk

8. 1. Return in the foreign market 2. Return on the foreign exchange In our example, when E 0 =$2/£, E 1 =$1.8/£ 1+r(US)=1.1*1.8/2=0.99 r(US)=-1% Returns with Foreign Exchange

9. Stock Market Returns in U.S. Dollars and Local Currencies for 2005

10. Rates of Change in the U.S. Dollar Against World Currencies, 2001 – 2005 Partly diversifiable exchange rate risk

11. Hedging Exchange Rate Risk The use of futures or forward contracts In our example: The U.S. investor can lock in a riskless dollar-denominated return either by investing in UK bills and hedging exchange rate risk or by investing riskless U.S. assets

12. Hedging Exchange Rate Risk Interest rate parity, covered interest arbitrage E.g. The forward exchange rate F 0 =$1.93/£ (1+0.1)*1.93/2=1.0615 The hedge would only be perfect if foreign return is risk-free

13. Political Risk Services Group Ratings Rank countries with respect to political risk financial risk economic risk Country Specific Risk

14. Composite Risk Rating for country risk Popular support, legislative strength Unemployment, consumer confidence, poverty Payment delays, contract viability Civil war, terrorism Judicial system, law enforcement

15. Political Risk Points by Component

16. Composite Risk Rating for country risk

17. Table 25.6 Current Risk Ratings and Composite Risk Forecasts

18. Benefits of international diversification expand the efficient frontier reduce the systematic risk level International Diversification

19. Risk and Return Across the Globe, Investment in emerging markets are riskier But the systematic risk to a U.S. investor is not necessarily higher. Higher average returns also?

20. Correlation for Asset Returns: Unhedged and Hedged Currencies Diversification possibilities? Limited benefit of global diversification?

21. Diversification by Market Capitalization: National Markets versus Regional Funds

22. Home bias Preference for domestic securities Consumption in domestic currencies Information asymmetry Other explanations?

23. International Performance Attribution Extension to consider additional factors Currency selection Country selection Stock selection Cash and bond selection