Chapter 22 Managing an International Investment Portfolio

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 3e

22-1

Chapter 22Chapter 22Managing an InternationalManaging an International

Investment PortfolioInvestment Portfolio

22.1 Vehicles for Overcoming Capital Flow Barriers

22.2 Share Prices in International Markets

22.3 Asset Allocation Policy and Investment Style

22.4 Cross-Border Financial Statement Analysis

22.5 The Shifting Sands of Portfolio Analysis

22.6 Portfolio Hedging Strategies

22.7 Summary


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Overcoming capital flow barriersOvercoming capital flow barriers

Domestic-based MNCs

- AdvantageDomestically-based MNCs are familiar and accessible to domestic investors

- DisadvantageMNC share prices move more closely with the domestic stock market than with international markets


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Domestic-based MNCs Individual foreign securities

- Direct purchase in the foreign market

- Direct purchase in the domestic market

- Foreign shares (American shares in the US)

- Depository receipts (ADRs in the US)


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Domestic-based MNCs Individual foreign securities Mutual funds of foreign assets

- Mutual funds (open-end or closed-end)

- Many mutual funds are exchange-listed

- Closed-end country funds (CECFs)

- CECFs trading on the NYSE include Brazil, Germany, Italy, India, Korea, Mexico, Malaysia, S. Africa, Spain, Switzerland, Taiwan, Thailand, UK


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Domestic-based MNCs Individual foreign securities Mutual funds of foreign assets Hedge funds

- Private investment partnerships

- In the U.S., hedge funds have a general manager, fewer than 100 limited partners, and are not regulated by the SEC


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Hedge fund strategiesHedge fund strategies

A wide variety…- Emerging markets- Market-neutral- Opportunistic- Short-selling- Small-cap- Special situations- Value- Arbitrage

e.g., yield-curve arbitrage


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Domestic-based MNCs Individual foreign securities Mutual funds of foreign assets Hedge funds Other international investment

vehicles- Equity-linked bonds- Index futures, options or swaps


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Share prices in restricted marketsShare prices in restricted markets

Governments allow restricted access to their financial markets through- Closed-end country funds (CECFs)

(mutual funds invested in a single country)

- Unrestricted shares sold internationally(only domestic investors can hold restricted shares)

CECFs and unrestricted shares can trade at substantial premiums to net asset value (NAV)


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International asset pricing with investment restrictions- A classic portfolio maximization

argument

- Assumes rational investors maximizing the mean-variance efficiency of their portfolios

Explanations for share pricesExplanations for share pricesin segmented marketsin segmented markets


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Explanations for share prices in Explanations for share prices in segmented marketssegmented markets

International asset pricing with investment restrictions

Investor sentiment- Individual investors trade on their

(possibly irrational) sentiment regarding future returns and risks

- Premiums are large when foreign investor demand is high


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Portfolio investment stylesPortfolio investment styles

Asset allocation policy- A fund’s target weights on various

asset classes

Investment philosophy

- Passive fund management- Benchmarked to an index

- Active fund management- Active asset allocation- Active security selection


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The market timer’s penaltyThe market timer’s penalty

8%

10%

12%

14%

16%

10% 20% 30% 40%

Market timer’s penalty for random switches between Hong Kong and U.S. stocks

US

HK

Buy-and-hold investor

Naive market timer


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Financial accounting measurement Financial accounting measurement

Cross-country financial statement analysis is difficult because of national differences in the measurement of accounting income

- Differences show up in the construction of nearly every financial account

- National accounting differences can result in huge differences in reported income


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There are also cross-border differences in financial disclosure requirements

Alternatives for providing financial information to investors in another country- Do nothing- Prepare convenience translations- Using different accounting principles, such

as IAS standards, in preparing the firm’s financial statements

Financial accounting disclosureFinancial accounting disclosure


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Inputs to portfolio analysis

E[rP] = i Xi E[ri]

P2 = i j Xi Xj ij

The shifting sands of portfolio analysis- Time-varying expected returns & risk premia

- Time-varying volatilities

- Time-varying correlations

Portfolio analysisPortfolio analysis


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Time-varying volatility, 1970-Time-varying volatility, 1970-20022002

-30%

-10%

10%

30%

50%

1

-30%

-10%

10%

30%

50%

1

-30%

-10%

10%

30%

50%

1

-30%

-10%

10%

30%

50%

1

Canada Japan

United Kingdom United States


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60-month rolling correlations60-month rolling correlationswith the U.S. stock marketwith the U.S. stock market

0.0

0.2

0.4

0.6

0.8

1.0

Dec-75 Dec-80 Dec-85 Dec-90 Dec-95 Dec-00

CanadaU.K.Japan


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Returns during the crash of 1987Returns during the crash of 1987

0

20

40

60

80

100

1209/

30/1

987

10/1

/198

7

10/2

/198

7

10/5

/198

7

10/6

/198

7

10/7

/198

7

10/8

/198

7

10/9

/198

7

10/1

2/19

87

10/1

3/19

87

10/1

4/19

87

10/1

5/19

87

10/1

6/19

87

10/1

9/19

87

10/

20/1

987

10/2

1/19

87

10/2

2/19

87

10/2

3/19

87

10/2

6/19

87

10/2

7/19

87

10/

28/1

987

10/2

9/19

87

10/3

0/19

87

JapanU.K.U.S.


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When it rains, it pours…When it rains, it pours…

FactObserved correlations are higher during market downturns than conventional models predict

ConsequenceInternational diversification may fail to yield its promised gains just when they are most needed


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Stock market correlationsStock market correlationsin bear, calm, and bull marketsin bear, calm, and bull markets

USA + World-ex-USA

-0.2

0.0

0.2

0.4

0.6

0.8

-7% -5% -3% -1% 1% 3% 5% 7%

UK + World-ex-UK

-0.2

0.0

0.2

0.4

0.6

0.8

-7% -5% -3% -1% 1% 3% 5% 7%

Japan + World-ex-Japan

-0.2

0.0

0.2

0.4

0.6

0.8

-7% -5% -3% -1% 1% 3% 5% 7%

Australia + World-ex-Australia

-0.2

0.0

0.2

0.4

0.6

0.8

-7% -5% -3% -1% 1% 3% 5% 7%


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Std dev ofannual return

Mean annual returnHedgedforeignstocks

U.S. bonds

Foreign bonds

U.S. stocks

Foreignstocks

Hedgedforeign bonds

Hedged stocksand bonds

Internationally diversifiedstocks and bonds

U.S. stocksand bonds

10%

14%

18%

22%

4% 8% 12% 16% 20%

Adapted from “Asset Allocation with Hedged and Unhedged Foreign Stocks and Bonds” by Philippe Jorion, Journal of Portfolio Management, Summer 1989, p 49-54.

The benefits of currency risk hedgingThe benefits of currency risk hedging

Documents

Chapter 22 Managing an International Investment Portfolio