Chapter 24 Managing an International Investment Portfolio

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 24-1

Chapter 24Chapter 24Managing an Managing an International Investment PortfolioInternational Investment Portfolio

24.1 Vehicles for Overcoming Capital Flow Barriers

24.2 Asset Allocation Policy and Managerial Style

24.3 Cross-Border Financial Statement Analysis

24.4 The Shifting Sands of Portfolio Analysis

24.5 Portfolio Hedging Strategies

24.6 Summary


Vehicles for overcoming capital flow barriersVehicles for overcoming capital flow barriers

Domestic-based MNCs Individual foreign securities

– Direct purchase in the foreign market

– Direct purchase in the domestic market

• Foreign shares (e.g. American shares in the U.S.)

• Depository receipts (e.g. ADRs in the U.S.)

– Mutual funds specializing in foreign securities

• Closed-end and open-end mutual funds

• Closed-end country funds

Hedge funds - private investment partnerships

Other international investment vehicles• Equity-linked Eurobonds

• Stock index futures, options, and swaps


Closed-end country fundsClosed-end country funds

Closed-end country funds invest in a single country’s stocks

CECFs trading on the NYSE include Brazil Germany Italy India

Korea Mexico Malaysia South Africa

Spain Switzerland Taiwan Thailand

United Kingdom

The CECFs of restricted markets can trade at substantial premiums or discounts to net asset value.

» classic portfolio maximization

» investor sentiment


Hedge fundsHedge funds

Hedge funds are private investment partnerships» a general manager and fewer than 100 limited partners

» unregulated (as long as each partner passes SEC accreditation)

Hedge fund strategies include– arbitrage

– emerging markets

– market-neutral

– opportunistic

– short-selling

– small-cap

– special situations

– value

– yield-curve arbitrage


Portfolio management stylesPortfolio management styles

Asset allocation policy– target weights on asset classes

Investment philosophy

» Passive fund management– often benchmarked to an index

» Active fund management– active asset allocation

– active security selection


Cross-border financial statement analysisCross-border financial statement analysis

Accounting systems influence statement analysis

» Legalistic accounting systems

– Emphasis is on the legal entity

– Used in “code law” countries such as France and Germany

– Accounting rules consist of “thou shalts”

» Nonlegalistic accounting systems

– Emphasis is on the economic entity

– Used in “common law” countries such as the United Kingdom and the United States

– Accounting rules consist of a list of “thou shalt nots”


Cross-border financial statement analysisCross-border financial statement analysis

Differences in financial accounting measure are particularly prominent in accounting for

» Goodwill

» Discretionary reserves

» Pension liabilities

» Inflation accounting


Responses to the need for financial information

» Do nothing

» Prepare convenience translations

» Restate selected items

» Prepare financial statements using another country’s accounting principles

There are notable international differences in financial disclosure requirements

Cross-border financial statement analysis:Cross-border financial statement analysis:International financial disclosureInternational financial disclosure


Portfolio analysisPortfolio analysis

Inputs to portfolio analysis

» E[RP] = i Xi E[Ri]

» Var(RP) = i Xi2 i

2 + i j Xi Xjij

ij

The shifting sands of portfolio analysis

» Time-varying expected returns

» Time-varying risk premiums

» Time-varying volatilities

» Time-varying correlations


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

Canada

U.K.Germany

Japan


National markets during the international National markets during the international stock market crash of October 1987stock market crash of October 1987

0

20

40

60

80

100

120

9/30

/87

10/1

/87

10/2

/87

10/5

/87

10/6

/87

10/7

/87

10/8

/87

10/9

/87

10/1

2/87

10/1

3/87

10/1

4/87

10/1

5/87

10/1

6/87

10/1

9/87

10/2

0/87

10/2

1/87

10/2

2/87

10/2

3/87

10/2

6/87

10/2

7/87

10/2

8/87

10/2

9/87

10/3

0/87

Japan

U.K.

U.S.


Are Cross-Country Correlations Constant?Are Cross-Country Correlations Constant?

Longin & Solnik estimated national stock market correlations during periods of high and low market volatility assuming constant correlations i,us between index i and the U.S. market.*

* Francois Longin and Bruno Solnik, “Is the Correlation in International

Equity Returns Constant?” Journal of International Money and Finance,

No. 1, 1995.



National stock market returns were modeled with autoregressive variances:

i,t2 = ai + bi i,t-1

2 + ci si,t-12

where

i,t-12 = conditional variance from previous period

si,t-12 = square of return during previous period

ai, bi, and ci are constants for stock market index i

Conditional covariance is i,us:t = i,usi,tus,t

given conditional variances i,t2 and us,t

2



Correlation with U.S. market

Calm Volatile Unconditional

Country periods periods correlation

Canada 0.729 0.753 0.723

France 0.331 0.525 0.407

Germany 0.327 0.461 0.353

Japan 0.265 0.366 0.297

Switzerland 0.458 0.650 0.508

U.K. 0.468 0.525 0.469


The benefits of currency risk hedgingThe benefits of currency risk hedging

8%

10%

12%

14%

16%

18%

20%

22%

24%

4% 6% 8% 10% 12% 14% 16% 18% 20%

Standard deviation of annual return

Mean annual return

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

Hedgedforeignstocks

U.S.bonds

Foreign bonds

U.S.stocks

Foreignstocks

Hedged foreign bonds

Hedged stocksand bonds Internationally diversified

stocks and bonds

U.S. stocksand bonds

Documents

Chapter 24 Managing an International Investment Portfolio