1. International Finance
Lecture 6

2. World Financial Markets and Institutions
International Banking and Money Market
International Bond Market
International Equity Markets
International Portfolio Investment
Futures and Options on Foreign Exchange
Currency and Interest Rate Swaps

3. International Portfolio Investment
Portfolio theory and _______________ investment
International mutual funds
International diversification through country _____
International diversification through __________
Home ____________

4. Portfolio return
Investment in international securities offer opportunities for ______________ but increases foreign exchange ____________;
For example,
A Canadian portfolio manager buys 10 UK shares at £10 per share, at $2.30/£;
At the end of the period, the shares have risen in value to £110, but the pound falls to $2.10/£:

5. Portfolio return
Three rates of return:

6. Portfolio risk Two sources of uncertainly Stock return volatility
Exchange rate volatility

7. Portfolio risk and return
You are investing into a stock in the emerging market. The stock return is expected to be 30% and the standard deviation of the return is estimated 45%. The foreign currency is expected to depreciate by 10% during the following year, with estimated 20% standard deviation of the currency depreciation. The correlation between stock returns in that country and the exchange rate changes is estimated
What are the expected return and risk of holding this stock, in $?
What is the probability that you will lose money? … earn no more than the current $ riskless rate of 5% on this investment? … probability that you will earn return between 5% and zero ? Assume normal distribution.

8. Portfolio risk and return

9. Portfolio theory and international investment
Returns are not perfectly correlated with exchange rates. Under certain conditions stocks:
Less risky for international investors than for domestic investors.
i.e.
Provide higher returns for international investors than for domestic investors
International investments offer greater investment opportunities compared to domestic investments

10. Markowitz Efficient frontier
Portfolio risk and return
Mean portfolio return ___________
Portfolio variance _____________
Mean-variance efficiency
For any combination of stocks, it is possible to construct a portfolio that will give the __________ return for a given level of risk, or the lowest risk for a given _________ of required return
Capital Allocation with lending/borrowing
If you use a riskless asset in your investments, or if you ___________, it is possible to achieve higher returns compared with the case when you do not use riskless investment / borrowing

11. Markowitz Frontier and CML
Actual spreadsheet. Double-click on graph and go to sheet “Markowitz” to see calculations.

12. International Portfolio Diversification

13. Optimal International Portfolio Selection
Security returns are much less correlated across countries than within a country.
__________, ___________, __________, and even _________ factors affecting security returns tend to ____ across countries, resulting in low correlations among international securities.
The correlation of Canadian stock markets with the returns on the stock markets in other nations varies.
The correlation of the U.S. stock market with the Canadian stock market is 58%.
The correlation of the U.S. stock market with the Japanese stock market is 26%.
A U.S. investor would get ________ diversification from investments in Japan than Canada.

14. CAN$ - Based Equity Correlations

15. Summary Statistics for Monthly Returns for 12 Major Stock Markets
1/ /2001

16. Domestic v. International Diversification

17. Optimal Portfolio Investment
Various ways to optimize, the text suggests the following technique:
______________ portfolio’s Sharpe Ratio subject to the following:
Portfolio _________ = weighted average return
Portfolio ____________ = [ΣiΣjσij]0.5
Constraints:
Sum of ____________ weights xi= 1
Obtain optimal weights for each country’s stock market index and call them OIP weights, OIP – optimal investment portfolio

18. Composition of the OIP for a Canadian Investor
Hong Kong market
3.31%
Italian market
2.62%
Netherlands market
28.53%
Swedish market
23.92%
U.S. market
41.62%
Total
100.00%

19. OIP by Investors’ Domicile (1980-2001)

20. International Mutual Funds:
An investor can easily achieve international diversification by investing in international mutual fund. View HSBC funds
The advantages include
__________ on ____________ and ___________ costs.
Circumvention of legal and institutional ___________ to direct portfolio investments abroad.
Professional _____________ and record ___________.
A country fund invests exclusively in the stocks of a single county. This allows investors to:
Speculate in a _________ foreign market with minimum cost.
Construct their own ___________ international portfolios.
Diversify into ___________ markets that are otherwise practically inaccessible.

21. International Mutual Funds: A Performance Evaluation

22. American Depository Receipts
Foreign stocks often trade on U.S. exchanges as ADRs.
It is a receipt that represents the number of foreign shares that are deposited at a U.S. bank.
The bank serves as a _________ agent for the ADRs
There are many advantages to trading ADRs as opposed to direct investment in the company’s shares:
ADRs are in U.S. dollars, trade on U.S. exchanges and can be bought through any broker.
Dividends are paid in U.S. dollars.
Most underlying stocks are bearer securities, the ADRs are registered.

23. i Shares World Equity Benchmark Shares (WEBS)
Country-specific _________ of stocks designed to replicate the country indexes of 14 countries.
WEBS are subject to U.S. SEC and IRS diversification _______________.
Low ____________, convenient way for investors to hold diversified investments in several different countries.
Re-named into iShares in 2000.

24. The Home Bias in Equity Portfolios
Country
Share in World Market Value
Proportion of Domestic Equities in Portfolio
France
2.6%
64.4%
Germany
3.2%
75.4%
Italy
1.9%
91.0%
Japan
43.7%
86.7%
Spain
1.1%
94.2%
Sweden
0.8%
100.0%
United Kingdom
10.3%
78.5%
United States
36.4%
98.0%
Total

25. Why Home Bias in Portfolio Holdings?
Three explanations come to mind:
Domestic equities may provide a superior _____________ hedge.
Home bias may reflect institutional and legal ___________ on foreign investment.
Extra taxes and transactions/information costs for __________ securities may give rise to home bias.

26. Example
You are a French investor holding a portfolio of US bonds. Over the month, the value of your portfolio increases from $1 million to $1.05 million. The exchange rate moves from EUR/USD to 1.02 EUR/USD. (i) what is your rate of return in dollars? (ii) what is your rate of return in Euros? Is the difference exactly equal to the percentage movement in the exchange rates, and why?

27. Example
Consider a Canadian pension fund with the following characteristics:
% invested
Total $
Return
Std. Dev. of
Dollar Return
Correlation
with Canadian
Stock Index
Canadian equity
90%
10%
15%
0.99
Foreign Equity
11%
20%
-0.10
Is the risk-return of the foreign portfolio attractive?

28. Taxes
Types of taxation
Tax environments
Tax planning

29. Example
On June 1, 2005 you bought a 182-day T-bill at a price of of its maturity value. Your average tax rate is 26.5% and you marginal tax rate of 33.0%. What is your after-tax EAR on the T-bill?

30. Example
What is the after-tax real rate of return on this t-bill for a person whose marginal tax rate is 48%? Inflation rate is 3%.
Assume that interest rates do not change during the year and there is opportunity for re-investment at the same rate.

31. Types of Taxation Income Tax Withholding Tax Value-Added Tax
Other taxes

32. Income Tax
An income tax is a tax on __________ and ___________ __________.
Many countries in the world obtain a significant portion of their tax _________ from income taxes.
An income tax is a _________ tax, that is one that is paid directly by the taxpayer upon whom it is levied.

33. Corporate Income Tax Rates in Selected Countries

34. Withholding Tax
Withholding taxes are withheld from the payments a corporation __________ to the taxpayer.
The taxes are levied on __________ income earned by an individual or corporation of one country within the tax jurisdiction of another country.
Passive income includes dividends and interest income, income from royalties, patents, or copyrights.
A withholding tax is an ____________ tax.

35. Value-Added Tax
A value-added tax (_______) is an indirect national tax levied on the value added in production of a good or service.
In many European and Latin American countries the VAT has become a major source of taxation on private citizens.
Many ________________ prefer a VAT to an income tax because the incentive effects of the two taxes differ sharply.

36. Value-Added Tax
An income tax has the incentive effect of discouraging _________.
A VAT has the incentive effect of discouraging ___________ (thereby encouraging saving).
VAT’s are easier to administer as well. While taxpayers have an incentive to hide their income, producers have an incentive to make sure that their upstream suppliers in the production process declare the value added (and pay the tax!).

37. Value-Added Tax Calculation
Value-Added Tax Calculation
Production Stage
Selling Price
Value Added
Incremental VAT 1
€100 2
€300
€200 3
€380
€80
Total VAT
In this example, the tax rate is 15 percent. Suppose that stage one is the sale of raw materials to the manufacturer; stage two is the sale of finished goods to a retailer; stage three is the sale of inventory from the retailer to the consumer.

38. Other Types of Taxation
A __________ tax is a tax levied not on income but on the wealth of a taxpayer. __________ taxes are an example.
A poll tax is a tax on your _____________. It is so called because it was collected from those who wished to vote.

39. The National Tax Environments
Worldwide Taxation
Tax national residents of the country on their worldwide income no matter in which country it was __________;
Creates the _____________ for double taxation.
Territorial Taxation
Territorial taxation tax residents based upon __________ the taxable event occurred.
Foreign Tax ___________

40. Foreign Tax Credits
Allows taxpayers to recover somewhat from _________ taxation.
Direct foreign tax credits are computed for direct taxes ______ on active foreign-source income of a foreign branch of a MNC or on withholding taxes ________ from passive income.
Indirect foreign tax credits are for income taxes ______________ by the subsidiary.

41. Organizational Structures for Reducing Tax Liabilities
Branch & Subsidiary Income
Payments to and from Foreign Affiliates
Tax Havens

42. Branch & Subsidiary Income
An overseas affiliate of a MNC can be organized as a _______ or a ____________.
A foreign branch is not an independently incorporated firm separate from the parent.
Branch income passes ____________ through to the parent’s income statements.
A foreign subsidiary is an affiliate organization of the MNC that is independently incorporated.
Income may not be _________ in domestic country until it is ______________, under certain circumstances.

43. Foreign Corporations US tax law _______________ foreign corporation
______ < ownership stake < ________
Active and passive income taxed only when remitted to parent in the _________________
Controlled foreign corporation
_________ < ownership stake
Active and income taxed only when __________ to parent, passive income taxed when ________ even if not remitted to parent

44. Transfer pricing
Having foreign affiliates offers transfer price tax arbitrage strategies.
The transfer price is the accounting value assigned to a good or service as it is transferred from one affiliate to another.
If one country has ______ taxes, don’t recognize income there—have those affiliates pay _________ transfer prices. If one country has _________ taxes, recognize income there—have those affiliates pay ________ transfer prices.

45. Tax Havens
Tax havens are countries with ______ corporate income tax rates and ______ withholding tax rates on _________ income.
Tax havens were once useful as ___________ for a MNC to establish a shell company.

46. Continue with Lecture 7 if time permits