1. GATE April 15, 2002 Economic, Financial and Political Risk in Portfolio and Direct Investment Campbell R. Harvey Duke University, Durham, NC National Bureau of Economic Research, Cambridge, MA www.duke.edu/~charvey

2. 2 Why invest internationally? World growth life cycle Importance of country risk Understanding diversification Should all countries be investment targets? International Risk/Harvey Plan

3. 3 International Risk/Harvey International Investment Rationale Standard reasons: –Performance (but non-U.S. hasn’t done well) –Diversification (misunderstood)

4. 4 When U.S. down, other markets likely down Hence, correlation higher (less beneficial) when U.S. market is down Critical to distinguish long-run and short- run International Risk/Harvey International Investment Rationale

5. 5 10 Worst Months - U.S. Equity Returns From January 1995- Oct 87 Aug 98 Aug 90 Sept 86 Nov 87 Jan 90 Aug 97 Jul 86 Sept 90 Jun 91 Return

6. 6 International Risk/Harvey International Investment Rationale 1990 has 3 of 10 worst months Performance in full year of 1990 Return

7. 7 International Risk/Harvey Understanding Growth Emerging economies-> high growth prospects Emerging economies much like start-up companies Do not want to exclude these opportunities Finance plays an important role (Bekaert, Harvey and Lundblad “Does Liberalization Spur Growth” 2002 Working paper)

8. 8 International Risk/Harvey Understanding Growth Finance and growth Bekaert, Harvey and Lundblad “Does Liberalization Spur Growth” 2002 Working paper)

9. 9 International Risk/Harvey Understanding Growth Finance and growth Data: 4 samples determined by data availability Sample I: 95 countries Sample II: 75 countries [macroeconomic and demographic data]

10. 10 International Risk/Harvey Understanding Growth Finance and growth Data: Sample III: 50 countries Sample IV: 28 countries [add financial development indicators]

11. 11 International Risk/Harvey Understanding Growth Real GDP growth

12. 12 International Risk/Harvey Understanding Growth

13. 13 International Risk/Harvey Understanding Growth

14. 14 International Risk/Harvey Understanding Growth

15. 15 International Risk/Harvey Understanding Growth

16. 16 International Risk/Harvey Understanding Growth

17. 17 International Risk/Harvey Understanding Growth

18. 18 International Risk/Harvey Understanding Growth

19. 19 International Risk/Harvey Understanding Growth

20. 20 International Risk/Harvey Understanding Growth

21. 21 International Risk/Harvey Understanding Growth

22. 22 International Risk/Harvey Understanding Growth

23. 23 International Risk/Harvey Understanding Growth

24. 24 International Risk/Harvey Understanding Growth

25. 25 Lower risk implies Lower hurdle rates for investment Increased investment Increased growth International Risk/Harvey Country Risk

26. 26 Country Risk Ratings Erb, Harvey and Viskanta (1995, 1996, 1999) Explore risk surrogates: –Political Risk, –Economic Risk, –Financial Risk and –Country Credit Ratings International Risk/Harvey Country Risk

27. 27 International Risk/Harvey Country Risk Sources Political Risk Services’ International Country Risk Guide Institutional Investor’s Country Credit Rating Euromoney’s Country Credit Rating Moody’s S&P

28. 28 International Risk/Harvey Country Risk Political risk. International Country Risk Guide

29. 29 International Risk/Harvey Country Risk Financial risk. International Country Risk Guide

30. 30 International Risk/Harvey Country Risk Economic risk. International Country Risk Guide

31. 31 International Risk/Harvey Country Risk International Country Risk Guide Risk Categories

32. 32 International Risk/Harvey Country Risk Ratings are correlated:

33. 33 International Risk/Harvey Country Risk Ratings are correlated:

34. 34 International Risk/Harvey Country Risk Ratings are correlated:

35. 35 International Risk/Harvey Country Risk Ratings are correlated:

36. 36 International Risk/Harvey Country Risk ICRG ratings predict changes in II ratings:

37. 37 International Risk/Harvey Country Risk Ratings predict inflation:

38. 38 International Risk/Harvey Country Risk Ratings correlated with wealth:

39. 39 International Risk/Harvey Country Risk Fit is as good as it gets - lower rating (higher risk) commands higher expected returns. Even in among US firms, our best model gets about 30% explanatory power.

40. 40 International Risk/Harvey Country Risk Easy to use:

41. 41 International Risk/Harvey Country Risk Also predicts volatility:

42. 42 International Risk/Harvey Country Risk And correlation.

43. 43 International Risk/Harvey Country Risk Asian Crisis.

44. 44 International Risk/Harvey Country Risk Value of US$100

45. 45 S&P 500 September 2001 September 11 International Risk/Harvey Country Risk

46. 46 September 2001 S&P 500 2001 International Risk/Harvey Country Risk

47. 47 September 2001 S&P 500 1980-2002 International Risk/Harvey Country Risk

48. 48 September International Risk/Harvey Country Risk

49. 49 International Risk/Harvey Understanding Diversification Size of Trade Sector

50. 50 International Risk/Harvey Understanding Diversification Size of Trade Sector

51. 51 International Risk/Harvey Understanding Diversification Diversification much misunderstood Diversification really means protection when the U.S. economy is bad But that is not how it is measured Correlation tells us average movement of these markets in both good and bad times

52. 52 International Risk/Harvey Understanding Diversification Correlations of World Returns and Developed Markets

53. 53 International Risk/Harvey Understanding Diversification Correlations of World Equity Returns and Emerging Markets

54. 54 International Risk/Harvey Understanding Diversification World economic linkages World economy is critically linked to health of the U.S. economy

55. 55 International Risk/Harvey Understanding Diversification Average Monthly Returns in %

56. 56 International Risk/Harvey Understanding Diversification Average Monthly Standard Deviation of Returns in %

57. 57 International Risk/Harvey Understanding Diversification Correlation of Returns with World

58. 58 International Risk/Harvey Should All Countries Be Investment Targets? CalPERS Limited Exposure Countries Source: Updated version of Erb, Harvey and Viskanta (1995) [Rating of 100 is best]

59. 59 International Risk/Harvey Should All Countries Be Investment Targets? CalPERS Prohibited Countries Source: Updated version of Erb, Harvey and Viskanta (1995) [Rating of 100 is best]

60. 60 Should you invest in all countries? No –Given the risk of some countries, it is unlikely they can meet their target returns –May be excessively costly to transact –Human rights issue of investing in certain countries –May give up some return performance in the long-run by following this strategy and add tracking error International Risk/Harvey Should All Countries Be Investment Targets?

61. 61 Selection criteria Economic –Tactical criteria International Risk/Harvey Should All Countries Be Investment Targets?

62. 62 Selection criteria Political –Catastrophe risk –Rule of law, for example, insider trading regulations (foreign portfolio investors at distinct disadvantage) –Human rights factors International Risk/Harvey Should All Countries Be Investment Targets?

63. 63 Selection criteria Financial –Liberalization of capital markets –Credibility of liberalizations –Reliability of institutions International Risk/Harvey Should All Countries Be Investment Targets?

64. 64 International Risk/Harvey Should All Countries Be Investment Targets? CalPERS Limited Exposure Countries Source: Bhattacharya & Daouk (1999) [IT=Insider Trading]

65. 65 International Risk/Harvey Should All Countries Be Investment Targets? CalPERS Prohibited Countries Source: Bhattacharya & Daouk (1999) [IT=Insider Trading]

66. 66 International Risk/Harvey Conclusions Reward and risk in finance maps into growth and business cycle volatility Portfolio and direct investment contingent on risk profile Finance and economics not the whole story - the strength of institutions/infrastructure critical to long-term prospects

67. 67 International Risk/Harvey Appendix 10 Worst Months - U.S. Equity Returns January 1970-October 1999 Oct 87 Aug 98 Sept 74 Nov 73 Aug 90 Aug 74 Mar 80 Apr 70 Oct 78 Sept 86 Return

68. 68 International Risk/Harvey Appendix 10 Worst Months - U.S. Equity Returns January 1970- Oct 87 Aug 98 Sept 74 Nov 73 Aug 90 Aug 74 Mar 80 Apr 70 Oct 78 Sept 86 Nov 78 Return