10/15/01deutsche bank: international equity copyright (c) 1997-2001 by marshall, tucker &...

10/15/01 Deutsche Bank: International Equity Copyright (c) 1997-2001 by Marshall, Tucker & Associates, LLC All rights reserved

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Deutsche Bank

Motivating International Equity Investing

Alan L. Tucker, Ph.D.631-331-8024 (tel)631-331-8044 (fax)

[email protected]

Copyright © 1997-2001Marshall, Tucker & Associates, LLC

All rights reserved


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ALAN L. TUCKER, Ph.D.

Alan L. Tucker is Associate Professor of Finance at the Lubin School of Business, Pace University, New York, NY and an Adjunct Professor at the Stern School of Business of New York University, where he teaches graduate courses in derivative instruments. Dr. Tucker is also a principal of Marshall, Tucker & Associates, LLC, a financial engineering and derivatives consulting firm with offices in New York, Chicago, Boston, San Francisco and Philadelphia. Dr. Tucker was the founding editor of the Journal of Financial Engineering, published by the International Association of Financial Engineers (IAFE). He presently serves on the editorial board of Journal of Derivatives and the Global Finance Journal and is a former associate editor of the Journal of Economics and Business. He is a former director of the Southern Finance Association and a former program co-director of the 1996 and 1997 Conferences on Computational Intelligence in Financial Engineering, co-sponsored by the IAFE and the Neural Networks Council of the IEEE.

Dr. Tucker is the author of three books on financial products and markets: Financial Futures, Options & Swaps, International Financial Markets, and Contemporary Portfolio Theory and Risk Management (all published by West Publishing, a unit of International Thompson). He has also published more than fifty articles in academic journals and practitioner-oriented periodicals including the Journal of Finance, the Journal of Financial and Quantitative Analysis, the Review of Economics and Statistics, the Journal of Banking and Finance, and many others.

Dr. Tucker has contributed to the development of the theory of derivative products including futures, options and swaps, and to the theory of international capital markets and trade. He has also contributed to the theory of technology adoption over the life-cycle. The Social Sciences Citation Index shows that his research has been cited in refereed journals on over one hundred occasions.

As a consultant, Dr. Tucker has worked for The United States Treasury Department, the United States Justice Department, Morgan Stanley Dean Witter, Union Bank of Switzerland, LG Securities (Korea), and Chase Manhattan Bank. Dr. Tucker holds the B.A. in economics from LaSalle University (1982), and the MBA (1984) and Ph.D. (1986) in finance from Florida State University. He was born in Philadelphia in 1960, is married (Wendy) and has three children (Emily, 1993, Michael and Matthew, both 1995).


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Topics Covered

Risk Reduction as a Motivating Factor

Methods to Invest Internationally

Political Risk and Exchange Rate Risk

Performance of International Mutual Funds

Web Sites

Case Study

International Equity Investing


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Motivation for International Equity Investing

Clearly the principal motivation for investing in foreign equity is the prospect for an enhanced risk-return profile and therefore increased investor utility. If foreign equities are fairly priced and do not represent redundant investments already available in domestic markets, and absent arbitrage opportunities occasioned by say tax plays, then foreign equity investment should, over the long run, offer an important free lunch - namely reduced risk without lowered expected return, especially when political and exchange rate risks are controlled.



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Illustration #1

To illustrate, consider a standard Value-at-Risk (VaR) application involving the SP500 and DAX. Currently, the annualized vols of these two indices are about 38% and 31% respectively, and their correlation is about 35% (all measured in dollars). Using a trading-day year, the daily vols of the two indices are about 2.40% (SP500) and 1.95% (DAX). Also, the ratio of market capitalization of the two indices is approximately 11:1 (SP500:DAX). Finally, the long-run (1917-2000) returns of the indices (again measured in dollars) are both about 13% per annum (cum-dividend).



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What are the 10-day, 99% VaR’s of a $1MM portfolio invested in the:

SP500 (pure domestic investing)

DAX (international investing)

A market capitalization-weighted portfolio of the SP500 and DAX (global investing)



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.0240 x $1MM x (10)^(0.5) x 2.33 = $176,835

.0195 x $1MM x (10)^(0.5) x 2.33 = $143,678

{[(0.9167)^2 x (.0240)^2] + [(0.0833)^2 x (0.0195)^2] +

2(0.9167)(0.0833)(.35)(.0240)(0.0195)}^(0.50) x $1MM

x (10)^(0.5) x 2.33 = $166,671

Conclusion: Under current market conditions, reallocating 8.33% of invested wealth from the SP500 to the DAX reduces the 10-day, 99% VaR by $10,164 or 5.747%.



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Illustration #2

For the period 1970 through 1997, the annual returns (ex-dividend) and their standard deviations - both in US dollar terms - for the SP500, DAX, and Nikkei were as reported below. Correlation coefficients among the three indices - again in US dollar terms - are also report below.

Index $Return $Vol Correlation Matrix

SP500 12.5% 16.4% SP500 DAX Nikkei

DAX 12.3% 30.0% SP500 1.00 0.29 0.20

Nikkei 13.3% 36.3% DAX 1.00 0.24

Nikkei 1.00

Notes: In home currency terms, the returns (vols) were SP500 12.5% (16.4%), DAX 9.5% (26.1%), and Nikkei 9.3% (29.3%). Vols and correlation coefficients were highly unstable. For example, the correlation among the SP500 and Nikkei ranged from a low of -35% to a high of 60% for the period 1961-1994.



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As measured in February 1998, the market capitalization of all stock markets worldwide was about $38.5 million millions ($38.5 x 10^11). The stock markets of North America accounted for nearly 45% of this total (South America under 2%); the stock markets of Europe, Africa, and the Middle East accounted for about 30% of this total (with most of this attributable to European nations per se); and the Asian-Pacific stock markets accounted for about 24% of this total (with Osaka and Tokyo making up about 18% of the 24%).

So now let us compare the 99%, 10-day VaR of a $1B portfolio invested in the SP500 for the period 1970-1997, to that of a $1B portfolio invested 45% in the SP500, 30% in the DAX, and 25% in the Nikkei 225.



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0.164/[(252)^(0.50)] = 0.01033 = 1.033% (one-day SP500 vol)

0.300/[(252)^(0.50)] = 0.01890 = 1.890% (one-day DAX vol)

0.363/[(252)^(0.50)] = 0.02287 = 2.287% (one-day Nikkei vol)

0.01033 x $1B x (10)^(0.50) x 2.33 = $76.12MM (SP500 VaR)

{(.45)^2 x (.01033)^2 + (.30)^2 x (.01890)^2 + (.25)^2 x (.02287)^2

+ 2(.45)(.30)(.29)(.01033)(.01890) + 2(.45)(.25)(.20)(.01033)(.02287)

+ 2(.30)(.25)(.24)(.01890)(.02287)}^(0.50) x $1B x (10)^(0.50) x 2.33

= $83.34MM (World VaR)

Conclusion: For the period 1970-1997, global investing (without exchange rate risk management) would have actually increased VaR by about 9.5% from the perspective of a US investor.



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Standarddeviationof return

Number of Stocks in Portfolio 10 20 30 40

domestic portfolio only (U.S.)

global portfolio (U.S. + other)



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p

p

Rf

M

m

m

with inclusion of international stocks



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The following table shows the ex post risk reduction benefits of combining a value-weighted world portfolio (excluding US stocks) and the SP500 for the period 1986-2000. The exhibit reports annualized standard deviations under various percentages of foreign investment. The minimum risk was achieved with a 50-60% investment in the US and a 40-50% investment in the value-weighted world portfolio. Total risk was reduced by about 14% from a US perspective.

Proportion Invested in World Index Total Risk

0.00 0.1821

0.20 0.1668

0.40 0.1581

0.50 0.1573

0.60 0.1586

0.80 0.1687

1.00 0.1856



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Methods to Invest Internationally

– Buying Multinational Corporations (a poor substitute)

– Global and International Mutual Funds including Country Funds

– American Depository Receipts

– Global Depository Receipts

– World Equity Benchmark Shares (WEBS)/iShares MSCI

– Direct Purchase of Foreign Stocks• In the Domestic Market (Cross Listings/Ordinaries)

• In the Foreign Market

– Equity Derivatives



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Example: Creating a Synthetic Country Fund

A

B

A: Investor Funds C D

B: $LIBOR

C: $LIBOR

D: TR Nikkei 225

EurodollarsSynthetic Country

Fund

Equity SwapDealer



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Example: Efficient Nation Rotating AB A:

TR on DAX

TR on DAXTR on FTSE-100

IMFEquity Swap

Desk



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Example: Vanguard’s Europe Fund

Founded 1990

Originally a No-Load

Now 1% Front and Back Loads

Operating Expenses 33 bps p.a.

Tracks the Morgan Stanley Capital International European Free Index (MSCIEFI)

39% UK, 15% German, 13% French, 7% Swiss, 7% Netherlands,

5% Spain, and Italy, 9% spread over Belgium, Sweden,

Denmark, Austria and Norway

No Currency Risk Management



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Ten ADRs with Highest Trading Volume

1. BP-Amoco, UK, NYSE

2. B.A.T. Industries, UK, Amex

3. Hanson Trust, UK, NYSE

4. Glaxo Wellcome, UK, NYSE

5. Reuters Holding, UK, NASDAQ

6. Vodafone, UK, NYSE

7. Telefonos de Mexico (Telmex), Mexico, NASDAQ

8. De Beers Consolidated, South Africa, NASDAQ

9. Volvo, Sweden, NASDAQ

10. LM Ericsson, Sweden, NASDAQ



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Global Depository Receipts

Like ADRs but not denominated in US dollars.

www.bankofny.com/adr: Good information on ADRs, GDRs, and EDRs (European Depository Receipts)

www.jpmorgan.com: Follow links to information on 500 ADRs.



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iShares/WEBS

iShares MSCI (Morgan Stanley Capital International), which are offered by Barclay’s Global Investors (BGI), now track 17 non-US stock market indexes. The Vanguard Group now offers index funds based on various combinations of iShares MSCI. iShares MSCI were originally called WEBS. [BGI is a large institutional money manager owned by Barclay’s Bank in London, and was the first to launch an exchange-traded fund (ETF) in Canada in 1999 (originally called an iUnit, it was indexed to the Toronto Stock Exchange Index of 60 stocks.]



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Disadvantages of Investing Internationally

• political (sovereign) risk (can sometimes insure)• exchange rate risk (can hedge)• transaction costs• liquidity constraints• settlement and delivery risks• limited information

– disclosure rules differ– language barriers– supervisory functions limited– cost of collecting and analyzing information



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Country Risk Indices Corruption Indices

United States 97 Russia 93

United Kingdom 94 India 89

. .

. .

. .

Iran 8 United States 7Sources: Euromoney Magazine, Bank of America World Information Services,

Business Enviroment Risk Intelligence (BERI) S.A., Control Risks Information Services (CRIS), Economist Intelligence Unit (EIU), Institutional Investor (II), S&P, Political Risk Services of ICRG, Coplin-O’Leary, and Moody’s.



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Euromoney’s March 2001 Sovereign Risk Ratings

Country Rank Total Score

Luxembourg 1 98.83

Switzerland 2 97.06

Norway 3 94.88

United States 4 94.04

. . .

. . .

. . .

Iraq 178 6.90

North Korea 179 3.65

Afghanistan 180 1.84



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An example of country risk is the U.S. freezing of all Iraqi assets since the Gulf War in 1991.

The Overseas Private Investment Corporation (OPIC) was formed in 1991 and is a quasi-federal agency that provides insurance against some risks occasioned by foreign investment.



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Currency Risk in International Investing

RD = [(1 + RF) × (1 + RER)] – 1

RD = total return in dollars

RF = total return measured in the foreign currency

RER = percentage change in the value of the foreign currency relative to the USD

Note that if one ignores the small cross-product term RF x RER, then the return (in domestic currency terms) of a foreign stock holding is equivalent to the return of a two-asset portfolio with one asset being the foreign stock measured in the foreign currency and the second asset being the relevant exchange rate.



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That is, ignoring the cross product term gives

RD = [(1 + RF)(1 + RER)] - 1

= 1 + RF + RER + RF(RER) - 1

= RF + RER

This would imply that the volatility of the return in domestic dollars would be equivalent to the volatility of the return of a two asset portfolio with the first asset being the foreign stock measured in the foreign currency and the second being the relevant exchange rate. Because the correlation between RF and RER is less than +1 (indeed it is often negative during worldwide equity market downturns), then it should be clear that the volatility of RD is less than the sum of the vols of RF and RER.



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Well known examples of rapid and extreme exchange rate movements include:

Mexico devaluing the peso by 90% against the USD in 1972

Several Asian currencies devalued by 20% or more during the 1997 “Asian flu crisis”

The Russian ruble crashing after Russia tripled interest rates from 50% to 150% in August 1998

Brazil devaluing the real by 67% at year-end 1998



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Example: In the first half of 1991, MFS Worldwide Governments Trust, a load mutual fund specializing in government bonds issued principally in the US, Canada and Europe, had a net realized loss on investments of $756.540. The fund’s realized loss on currency translations was $715,045 (95% of the total loss).

Of course, exchange rate risk can be hedged in a variety of ways using a variety of derivatives including currency forward and futures contracts, currency options, and currency swaps.



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Studies of International Mutual Fund Performance

Essayyad and Wu (Quarterly Journal of Business and Economics, 1988). 18 IMFs, 1977-1984. 15 of 18 higher return than SP500. 16 of 18 lower coefficient of variation. Correlation with SP500 24%.

Rao and Aggarwal (Akron Business and Economic Review, 1987) and Eun, Kolodny and Resnick (Journal of Portfolio Management, 1991) report similar findings.

Cumby and Glen (Journal of Finance, 1990). 15 IMFs, 1982-1988. No evidence that managers outperformed the Morgan Stanley World Index. Therefore the out-performance of IMFs over the SP500 due to diversification and not superior management.



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What to Look for in National Economies

Rising levels of education Technology transfer

Competitive labor costs Currency stability

Increasing political stability Declining political risk

Infrastructure investments Declining corruption

Declining inflation rates Trend toward privatization

High savings rate Deregulating financial markets

Liberal trade policies Young work-age cohort

Example: Ireland (see www.ise.ie)



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Great Web Sites

www.duke.edu/~charvey: Information about exchange rates and political risk.

www.riskcenter.com: Daily news features about various risks worldwide.

www.aonpoliticalrisk.com: Information about insuring against international investing risks.

www.wisi.com: English-language stock quotes, financial histories, and investment reports on stocks and bonds issued

by thousands of foreign companies

www.latinstocks.com: Name says it all.



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More Web Sites

See attached listing.



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Classic Readings

On Country Risk

Agmon (Journal of Business 1972)

On Forming International Portfolios

Arnott and Henrikkson (Financial Analyst Journal, 1989)

Madura (Journal of Business Research, 1985)

Solnik and Noetzlin (Journal of Portfolio Management, 1982)

On Exchange Rate Risk from International Investing

Chamberlain et al (Journal of Economics and Business, 1990)

Eun and Resnick (Journal of Finance, 1988)



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On Correlation Among International Equity Markets

Eun and Resnick (Journal of Finance, 1984)

Hilliard (Journal of Finance, 1979)

Maldonado and Saunders (Financial Management, 1981)

On IMF Performance

Cumby and Glen (Journal of Finance, 1990)

Textbooks

Solnik, International Investments, Addison-Wesley.

Tapley, International Portfolio Management, Euromoney.

Tucker et al, International Financial Markets, West.

Francis & Ibbotson, Investments: A Global Perspective, Prentice Hall



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Case Study

The attached case study details a sophisticated trading strategy involving the use of ADRs that many US firms employed throughout the 1990s.

See “Trafficking in Foreign Tax Credits: A Case Study of Compaq Computer Corporation”.

EIS Industries used a similar strategy and a recent Appeals Court ruling overturned a lower ruling against EIS. Depending on the outcome of the appeal of the Compaq case, the matter could go to the US Supreme Court.


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