417Chapter 03

Chapter 3Chapter 3

SELECTING INVESTMENTS IN A SELECTING INVESTMENTS IN A GLOBAL MARKETGLOBAL MARKET

Chapter 3 QuestionsChapter 3 Questions

•• Why should investors have a global Why should investors have a global perspective regarding their investments?perspective regarding their investments?

•• What has happened to the relative size of What has happened to the relative size of U.S. and foreign stock and bond markets?U.S. and foreign stock and bond markets?

•• How can investors compute returns on How can investors compute returns on investments outside their home country?investments outside their home country?

•• What additional advantage is there to What additional advantage is there to diversifying in international markets beyond diversifying in international markets beyond the benefits of domestic diversification?the benefits of domestic diversification?

Chapter 3 QuestionsChapter 3 Questions

•• What securities are available? What are their What securities are available? What are their cash flow and risk properties?cash flow and risk properties?

•• What are the historical return and risk What are the historical return and risk characteristics of the major investment characteristics of the major investment instruments?instruments?

•• What is the relationship among the returns What is the relationship among the returns for foreign and domestic investment for foreign and domestic investment instruments? What is the implication of these instruments? What is the implication of these relationships for portfolio diversification?relationships for portfolio diversification?

Computing Returns on Computing Returns on Foreign InvestmentsForeign Investments

(1 + HCR) = (1+ FR) ( CER/IER)(1 + HCR) = (1+ FR) ( CER/IER)Where:Where:

HCR is the Home Country ReturnHCR is the Home Country ReturnFR is the Foreign ReturnFR is the Foreign ReturnCER is the Current Exchange RateCER is the Current Exchange RateIER is the Initial Exchange RateIER is the Initial Exchange Rate

The Effect of Changing The Effect of Changing Exchange RatesExchange Rates

•• For U.S. investors, a foreign securityFor U.S. investors, a foreign security’’s return s return in its domestic market is not the in its domestic market is not the ““bottom line.bottom line.””

•• Exchange rates have a major impact on the Exchange rates have a major impact on the equivalent U.S. return on a foreign equivalent U.S. return on a foreign investment.investment.–– This is known as exchange rate riskThis is known as exchange rate risk

•• The key factor is the changing strength of the The key factor is the changing strength of the U.S. dollar U.S. dollar visvis--àà--visvis the foreign currency.the foreign currency.

The Effect of Changing The Effect of Changing Exchange RatesExchange Rates

•• Stronger dollar: Income Stronger dollar: Income from foreign from foreign investments gets investments gets exchanged for fewer exchanged for fewer dollars over time, dollars over time, reducing net return for reducing net return for the U.S. investor.the U.S. investor.

•• Weaker dollar: Income Weaker dollar: Income from foreign from foreign investments gets investments gets exchanged for more exchanged for more dollars over time, dollars over time, increasing net return for increasing net return for the U.S. investor.the U.S. investor.

Why have a global Why have a global perspective?perspective?

•• Broadened horizons. The foreign market for Broadened horizons. The foreign market for stocks and bonds is huge!stocks and bonds is huge!–– U.S. markets comprise less than half of the total U.S. markets comprise less than half of the total

available securitiesavailable securities–– More opportunities broaden the range of riskMore opportunities broaden the range of risk--

return choicesreturn choices•• Returns on nonReturns on non--U.S. securities have often U.S. securities have often

exceeded U.S. securitiesexceeded U.S. securities–– Higher returns on equities are explained by higher Higher returns on equities are explained by higher

growth rates in some countriesgrowth rates in some countries

Why have a global Why have a global perspective?perspective?

•• Diversification with foreign securities Diversification with foreign securities can help reduce portfolio risk.can help reduce portfolio risk.–– Since foreign investments are impacted by Since foreign investments are impacted by

somewhat different forces than domestic somewhat different forces than domestic investments, risks can be reduced.investments, risks can be reduced.

•• ItIt’’s easier than ever before!s easier than ever before!–– Barriers to global investing, both for Barriers to global investing, both for

companies and for individual investors, are companies and for individual investors, are getting smaller.getting smaller.

Relative Size of U.S. and Relative Size of U.S. and Foreign MarketsForeign Markets

•• The overall value of world financial markets The overall value of world financial markets has seen explosive growth ($2.4 trillion in has seen explosive growth ($2.4 trillion in 1969 to $70.9 trillion in 2003)1969 to $70.9 trillion in 2003)

•• The U.S. share of the overall world financial The U.S. share of the overall world financial markets has gone from well over half (65% in markets has gone from well over half (65% in 1969) to about half (50% in 2003).1969) to about half (50% in 2003).

•• See Exhibits 3.2 and 3.3See Exhibits 3.2 and 3.3

Diversification in Diversification in International MarketsInternational Markets

Recall that diversification involves risk Recall that diversification involves risk reduction.reduction.–– Correlations range from +1 (perfect positive Correlations range from +1 (perfect positive

correlation) to correlation) to ––1 (perfect negative correlation)1 (perfect negative correlation)–– By combining securities whose returns are not By combining securities whose returns are not

perfectly positively correlated with each other in a perfectly positively correlated with each other in a portfolio, the portfolio standard deviation portfolio, the portfolio standard deviation characteristically falls.characteristically falls.

–– The lower the correlation coefficient between The lower the correlation coefficient between investments, the greater the benefit of investments, the greater the benefit of diversification.diversification.


•• Correlations between U.S. markets and Correlations between U.S. markets and major foreign markets are relatively low.major foreign markets are relatively low.–– In bond markets, the correlations, while positive, In bond markets, the correlations, while positive,

are below +.50, on average (See Exhibit 3.6)are below +.50, on average (See Exhibit 3.6)–– In equity markets, the correlations are a bit higher, In equity markets, the correlations are a bit higher,

but still relatively low with an average of about but still relatively low with an average of about +.55 (See Exhibit 3.7)+.55 (See Exhibit 3.7)

•• The bottom line: there is considerable benefit The bottom line: there is considerable benefit to international diversification.to international diversification.–– Portfolios that are diversified internationally tend Portfolios that are diversified internationally tend

to have substantially lower standard deviations.to have substantially lower standard deviations.


Several words of caution:Several words of caution:•• Correlations vary greatly between pairs of Correlations vary greatly between pairs of

counties.counties.–– As you might guess, there is a higher correlation As you might guess, there is a higher correlation

between U.S. and Canadian returns than between between U.S. and Canadian returns than between U.S. and various European returns.U.S. and various European returns.

–– Not all international diversification is created Not all international diversification is created equal!equal!

•• Correlations are increasing over time.Correlations are increasing over time.–– As global competition and various regulatory As global competition and various regulatory

barriers have fallen, correlations have increased.barriers have fallen, correlations have increased.

Global Investment ChoicesGlobal Investment Choices

•• Money market securities Money market securities •• Capital market instruments (Debt)Capital market instruments (Debt)•• Equity instrumentsEquity instruments•• DerivativesDerivatives•• Managed investmentsManaged investments

Money Market SecuritiesMoney Market Securities

•• Typically very liquid, lowTypically very liquid, low--risk (and also risk (and also relatively low return) investmentsrelatively low return) investments

•• Mostly sold at a discount from their Mostly sold at a discount from their maturity valuematurity value

•• Includes TIncludes T--bills, which are sold in bills, which are sold in weekly auctions for various maturitiesweekly auctions for various maturities

Capital Market Instruments: Capital Market Instruments: Fixed Income InvestmentsFixed Income Investments

•• Except for preferred stock, fixed income Except for preferred stock, fixed income securities are debts of the issuer.securities are debts of the issuer.

•• Promise specified cash flows at prePromise specified cash flows at pre-- determined times.determined times.–– Legal force behind the agreement varies Legal force behind the agreement varies

by type of security and issuer, as does the by type of security and issuer, as does the corresponding risk borne by the investor.corresponding risk borne by the investor.


Most fixed income instruments specify a Most fixed income instruments specify a number of features including the following:number of features including the following:–– The maturity date The maturity date –– the date that the obligation is the date that the obligation is

to be fully repaid, according to its provisions.to be fully repaid, according to its provisions.–– The coupon The coupon –– the income that the investor will the income that the investor will

receive each year.receive each year.–– The par value The par value –– the principal value of the the principal value of the

obligation; usually the original value and also the obligation; usually the original value and also the amount to be returned to the investor on the amount to be returned to the investor on the maturity date.maturity date.


•• U.S. Treasury SecuritiesU.S. Treasury Securities•• U.S. Government Agency SecuritiesU.S. Government Agency Securities•• Municipal BondsMunicipal Bonds•• Corporate BondsCorporate Bonds•• AssetAsset--backed Securitiesbacked Securities

U.S. Treasury SecuritiesU.S. Treasury Securities

•• Bills, notes, or bonds Bills, notes, or bonds -- depending on depending on maturitymaturity–– Bills mature in less than 1 yearBills mature in less than 1 year–– Notes mature in 1 Notes mature in 1 -- 10 years10 years–– Bonds mature in over 10 yearsBonds mature in over 10 years

•• Highly liquidHighly liquid•• Very low risk of default, so essentially Very low risk of default, so essentially

no credit riskno credit risk

U.S. Government Agency U.S. Government Agency SecuritiesSecurities

•• Sold by government agenciesSold by government agencies–– Federal National Mortgage Association (FNMA or Federal National Mortgage Association (FNMA or

Fannie Mae)Fannie Mae)–– Federal Home Loan Bank (FHLB)Federal Home Loan Bank (FHLB)–– Government National Mortgage Association Government National Mortgage Association

(GNMA or Ginnie Mae)(GNMA or Ginnie Mae)–– Federal Housing Administration (FHA)Federal Housing Administration (FHA)

•• Not direct obligations of the TreasuryNot direct obligations of the Treasury–– Still considered defaultStill considered default--free and fairly liquidfree and fairly liquid

Municipal BondsMunicipal Bonds

•• Issued by local governmentsIssued by local governments–– General obligation bonds (General obligation bonds (GOsGOs))–– Revenue bondsRevenue bonds

•• Exempt from federal income taxes and Exempt from federal income taxes and often state income taxesoften state income taxes–– Popular instrument for high tax bracket Popular instrument for high tax bracket

investors.investors.

Corporate BondsCorporate Bonds

•• Debt securities issued by corporations.Debt securities issued by corporations.•• Vary by:Vary by:

–– Level of claim (security)Level of claim (security)–– Credit quality (rated for default risk)Credit quality (rated for default risk)–– Term to maturityTerm to maturity–– Special featuresSpecial features

Corporate Bonds: Secured or Corporate Bonds: Secured or Unsecured?Unsecured?

•• Secured bonds feature some sort of collateral Secured bonds feature some sort of collateral to protect the investor.to protect the investor.–– Mortgage bonds: backed by land and buildingsMortgage bonds: backed by land and buildings–– Collateral trust bonds: backed by financial assetsCollateral trust bonds: backed by financial assets–– Equipment trust certificates: backed by specific Equipment trust certificates: backed by specific

pieces of equipmentpieces of equipment•• Unsecured bonds or debentures are backed Unsecured bonds or debentures are backed

only by the firmonly by the firm’’s promise to pay.s promise to pay.–– Subordinated debentures: lower priority claimSubordinated debentures: lower priority claim–– Income bonds: pay only if profits are earnedIncome bonds: pay only if profits are earned

Corporate Bonds: Special Corporate Bonds: Special ProvisionsProvisions

•• The bond contract (the indenture) may The bond contract (the indenture) may include several important provisions that can include several important provisions that can influence the actual maturity of the bond.influence the actual maturity of the bond.

•• Call provision: allows the issuer to buy back Call provision: allows the issuer to buy back or or ““call incall in”” the bond prior to maturity at a the bond prior to maturity at a specified call pricespecified call price–– Bonds range from freely callable (can be called Bonds range from freely callable (can be called

any time) to nonany time) to non--callablecallable–– Most have deferred calls, which are nonMost have deferred calls, which are non--callable callable

for a period of time, then freely callablefor a period of time, then freely callable

Corporate Bonds: Special Corporate Bonds: Special ProvisionsProvisions

•• Sinking fund provision: requires the Sinking fund provision: requires the issuer to retire a portion of a bond issue issuer to retire a portion of a bond issue prior to maturity.prior to maturity.–– Like a call provision, the investor would Like a call provision, the investor would

typically receive a specified call price typically receive a specified call price under a sinking fund provision.under a sinking fund provision.

•• Both call provisions and sinking fund Both call provisions and sinking fund provisions can shorten the actual provisions can shorten the actual maturity of a bond.maturity of a bond.

Bond RatingsBond Ratings

•• Most bonds are rated for default, or credit risk Most bonds are rated for default, or credit risk by one or more rating agency.by one or more rating agency.–– Duff and Phelps, Fitch Investors Service, Duff and Phelps, Fitch Investors Service,

MoodyMoody’’ss, Standard & , Standard & Poors Poors (S & P)(S & P)•• Ratings from AAA to D, some agencies give Ratings from AAA to D, some agencies give

slightly different modifiers or lettersslightly different modifiers or letters•• Top four ratings (AAA down to BBB): Top four ratings (AAA down to BBB):

Investment Grade SecuritiesInvestment Grade Securities•• Below the top four ratings: Speculative Grade Below the top four ratings: Speculative Grade

Securities (HighSecurities (High--yield or junk bonds)yield or junk bonds)

AssetAsset--Backed SecuritiesBacked Securities

•• GNMA passGNMA pass--through certificates: pass through certificates: pass through the payments made on a pool of through the payments made on a pool of mortgagesmortgages

•• Collateralized Mortgage Obligations (Collateralized Mortgage Obligations (CMOsCMOs): ): securities that pass through payments made securities that pass through payments made on mortgages, with specific distribution rules on mortgages, with specific distribution rules that apply to different classes that apply to different classes

•• Other assetOther asset--backed securities, such as backed securities, such as certificates for automobile receivables certificates for automobile receivables ((CARsCARs))

International Bond InvestingInternational Bond Investing

•• Eurobond: an international bond that pays Eurobond: an international bond that pays cash flows in a currency not native to the cash flows in a currency not native to the country of issuecountry of issue–– Eurodollar bonds are denominated in U.S. dollars, Eurodollar bonds are denominated in U.S. dollars,

but sold outside of the U.S.but sold outside of the U.S.•• Yankee bond: a bond denominated in U.S. Yankee bond: a bond denominated in U.S.

dollars, sold in the U.S., but issued by a dollars, sold in the U.S., but issued by a foreign corporation or governmentforeign corporation or government

•• International domestic bonds: U.S. investor in International domestic bonds: U.S. investor in a foreign bond, subject to exchange rate risk.a foreign bond, subject to exchange rate risk.

Preferred StockPreferred Stock

•• Classified as a fixed income security since Classified as a fixed income security since yearly dividends are stipulated.yearly dividends are stipulated.

•• Preferred dividends are not legally binding, Preferred dividends are not legally binding, so preferred stock is technically not a debt.so preferred stock is technically not a debt.

•• Since corporations are loathe to miss a Since corporations are loathe to miss a dividend, they are binding in practical terms.dividend, they are binding in practical terms.

•• Much of the outstanding preferred stock is Much of the outstanding preferred stock is held by other corporations.held by other corporations.–– 80% of dividends received by one corporation 80% of dividends received by one corporation

from another are excluded from taxable income from another are excluded from taxable income

EquitiesEquities

•• Returns are not contractual.Returns are not contractual.•• Instead, returns vary according to Instead, returns vary according to

performance, and can be much better or performance, and can be much better or much worse than fixed income investments.much worse than fixed income investments.

•• Equity represents an ownership interest.Equity represents an ownership interest.–– The owner gets as much or as little as is left over The owner gets as much or as little as is left over

after all fixed and higher priority claims have been after all fixed and higher priority claims have been met.met.

•• Most common equity investment: Common Most common equity investment: Common StockStock

Common StockCommon Stock

•• Represents the ownership of a corporationRepresents the ownership of a corporation•• Relatively risky investment compared to fixed Relatively risky investment compared to fixed

income securitiesincome securities•• Investment considerations include choice of Investment considerations include choice of

business group or sector and at industries business group or sector and at industries within those broad groupswithin those broad groups–– Business groups: Industrial firms, Utilities, Business groups: Industrial firms, Utilities,

Transportation firms, Financial InstitutionsTransportation firms, Financial Institutions

Foreign Equity Investments Foreign Equity Investments

Several means of obtaining an equity interest in Several means of obtaining an equity interest in foreign investments:foreign investments:

•• Through American Depository Receipts Through American Depository Receipts ((ADRsADRs))

•• Through direct investment in foreign shares Through direct investment in foreign shares listed on a U.S. or foreign stock exchangelisted on a U.S. or foreign stock exchange

•• Through indirect investment in international Through indirect investment in international or global mutual fundsor global mutual funds

American Depository ReceiptsAmerican Depository Receipts

•• Easiest way to acquire foreign sharesEasiest way to acquire foreign shares•• Certificates issued by a U.S. bankCertificates issued by a U.S. bank

–– Represent indirect ownership of shares of a Represent indirect ownership of shares of a foreign firm on deposit in a bank in the firmforeign firm on deposit in a bank in the firm’’s s home countryhome country

•• Buy and sell in U.S. dollarsBuy and sell in U.S. dollars•• Dividends in U.S. dollarsDividends in U.S. dollars•• May represent multiple sharesMay represent multiple shares•• Very popular, about 2,000 ADR programs Very popular, about 2,000 ADR programs

available in 2003available in 2003

Direct Investment in Foreign Direct Investment in Foreign SharesShares

•• The most difficult approach, especially The most difficult approach, especially when purchasing stock in the foreign when purchasing stock in the foreign country (in the foreign currency) and country (in the foreign currency) and transferring back to the investortransferring back to the investor’’s home s home country.country.

•• A growing number of foreign firms do A growing number of foreign firms do list their stock directly on the NYSE.list their stock directly on the NYSE.

International and Global International and Global Mutual FundsMutual Funds

•• Global funds: invest in both U.S. and foreign Global funds: invest in both U.S. and foreign stocksstocks

•• International funds: invest mostly outside the International funds: invest mostly outside the U.S.U.S.

•• Funds can specializeFunds can specialize–– Diversification across many countriesDiversification across many countries–– Concentrate in a segment of the worldConcentrate in a segment of the world–– Concentrate in a specific countryConcentrate in a specific country–– Concentrate in types of marketsConcentrate in types of markets

Derivative SecuritiesDerivative Securities

There are many types of derivative There are many types of derivative investments, including financial investments, including financial derivative securities whose payoffs are derivative securities whose payoffs are tied to various financial assets.tied to various financial assets.

•• OptionsOptions–– Puts and callsPuts and calls

•• Futures contractsFutures contracts

Option ContractsOption Contracts

Puts and callsPuts and calls•• Give the owner the right to sell (put) or Give the owner the right to sell (put) or

buy (call) a companybuy (call) a company’’s stock within a s stock within a specified period of time at a specified specified period of time at a specified price (called the strike price).price (called the strike price).

Futures ContractsFutures Contracts

•• Standardized contracts to make or take Standardized contracts to make or take delivery of some financial (or other) asset in delivery of some financial (or other) asset in exchange a specified payment at a future exchange a specified payment at a future date.date.

•• Payment not due until the future date, but Payment not due until the future date, but margin (a good faith deposit) is required.margin (a good faith deposit) is required.

•• Futures contracts are often used to manage Futures contracts are often used to manage risk, especially the risk of changing interest risk, especially the risk of changing interest rates.rates.

Managed InvestmentsManaged Investments

Investment companies sell shares in Investment companies sell shares in themselves and use the proceeds to invest in themselves and use the proceeds to invest in other investment instruments.other investment instruments.

•• ClosedClosed--end investment companies: offer a end investment companies: offer a fixed number of shares.fixed number of shares.

•• OpenOpen--end investment companies (Mutual end investment companies (Mutual funds): offer fluctuating number of shares funds): offer fluctuating number of shares based on purchases/sales of fund shares.based on purchases/sales of fund shares.–– Stock funds, Bond funds, Money market funds, Stock funds, Bond funds, Money market funds,

Mixed fundsMixed funds

Managed InvestmentsManaged Investments

•• Hedge Funds: typically act as a partnership Hedge Funds: typically act as a partnership where one partner manages funds for all where one partner manages funds for all other partners according to some investment other partners according to some investment strategy.strategy.

•• Venture capital pools: Similar to hedge funds, Venture capital pools: Similar to hedge funds, these partnerships obtain an equity interest in these partnerships obtain an equity interest in promising startpromising start--up or privately held firms.up or privately held firms.

•• Real Estate Investment Trusts (Real Estate Investment Trusts (REITsREITs): ): provides investors with an indirect means of provides investors with an indirect means of investing in real estate.investing in real estate.

Historic Return and Risk Historic Return and Risk CharacteristicsCharacteristics

•• Historic investment results have been studied Historic investment results have been studied extensively.extensively.

•• We can see the historic risk/return relationship by We can see the historic risk/return relationship by examining rates of return for major classes of assets examining rates of return for major classes of assets in the United States:in the United States:1. Large1. Large--company common stockscompany common stocks2. Small2. Small--capitalization common stockscapitalization common stocks3. Long3. Long--term U.S. government bondsterm U.S. government bonds4. Long4. Long--term corporate bondsterm corporate bonds5. Intermediate5. Intermediate--term U.S. Treasury billsterm U.S. Treasury bills6. U.S. Treasury bills6. U.S. Treasury bills

Summarizing the Historic Summarizing the Historic DataData

•• Examining recent history (1980Examining recent history (1980--2003) 2003) confirms the relationship between risk and confirms the relationship between risk and return.return.–– The higher returning classes of investments The higher returning classes of investments

(common stock, especially small(common stock, especially small--cap firms) have cap firms) have experienced higher average returns as well as experienced higher average returns as well as greater volatility.greater volatility.

•• Adjusting for inflation, thereby creating real Adjusting for inflation, thereby creating real returns, shows a small positive real interest returns, shows a small positive real interest rate for even the lowest risk investmentrate for even the lowest risk investment

Summarizing the Historic Summarizing the Historic DataData

The historical data also allows for the The historical data also allows for the calculation of average premiums earnedcalculation of average premiums earned–– Equity risk premium = Common Stock return Equity risk premium = Common Stock return

minus Tminus T--bill return = 8.57%bill return = 8.57%–– SmallSmall--stock premium = Small stock return minus stock premium = Small stock return minus

Large stock return = Large stock return = --0.58%0.58%–– Horizon premium = LongHorizon premium = Long--term Tterm T--bond return bond return

minus Tminus T--bill return = 4.93%bill return = 4.93%–– Default premium = LongDefault premium = Long--term Corporate bond term Corporate bond

return minus Int.return minus Int.--term Tterm T--bond return = 1.44%bond return = 1.44%

World Portfolio PerformanceWorld Portfolio Performance

Examination of historical returns largely confirm Examination of historical returns largely confirm expectations.expectations.

•• Riskier assets also have had higher average Riskier assets also have had higher average returns.returns.

•• Coefficients of variation range widely, with Coefficients of variation range widely, with the combined World Stock Index having a low the combined World Stock Index having a low CV, showing benefits of global diversification.CV, showing benefits of global diversification.

•• Correlations between asset returns vary by Correlations between asset returns vary by global regions, also showing the potential, global regions, also showing the potential, but variant advantages to global but variant advantages to global diversification.diversification.