St = P₀^A(1+π^A)^T

       -------------

       P₀^B(1+π^B)^T

Percentage change in the exchange rate

(Little x)

π^A - π^B

------------

1+π^B

If π^B is small, then x = π^A - π^B

S₁ = ______

if PPP holds

S₀* (1+π^DC)

      ------

      (1+ π^FC)

PPP

Short vs Long Term

Monetary Shocks

PPP doesnt hold in short run but it can still hold in long run

Monetary Shocks have immediate effects on exchange rate but slow effects on economy

therefore Capital markets adjust faster than commodity markets

(1+i) = (1+r)(1+π)

~ i = r + π

1+i^A    =    1+π^A

 ------       ------  

   1+i^B    =    1+π^B    

~ i^A- i^B = π^{A -} π^B 

(1+i^A) = S_t+1/S_t(1+i^B)

It is an unhedged investment

No guarantee that

return on foreign investment = domestic IR on investment of identical risk

Spot $/DM: .58

Forward $/DM: .5913

Spot 1 yr later $/DM: .59

Investor 1: Purchase 1 yr US Bond with 5% Interest

Investor 2: Exchange $ for DM and buy a 1 yr GER bond with 3% interest     

Which investor is better off? (UIP)

(1 + i^A) = .59/.58*(1+.03)

= 1.048

Investor 1 is better off

Forward Rate

&

Forward Premium

F = E(S_t+1)

If condition is violated, arbitrage opportunity

Forward premium = (F_t - S_t)

(1+i^A) = F_t/S_t(1+i^B)

CIP = relation between return on hedged investment in foreign currency in terms of domestic currency

Guarantees return on foreign investment = domestic interest rate of identical risk

Spot $/DM: .58

Forward $/DM: .5913

Spot 1 yr later $/DM: .59

Investor 1: Purchase 1 yr US Bond with 5% Interest

Investor 2: Exchange $ for DM and buy a 1 yr GER bond with 3% interest and takes short position in DM forward contract

Which investor is better off? (CIP)

Second investor

When Does International Diversification

Matter

Stock Markets are volatile

Stock markets across countries are not positively correlated

Volatilities:

Developed vs Emerging Markets

Bull vs Bear

Volatility of returns in developing markets is higher than in developed markets

Volatility in bear markets is higher than in bull markets

Correlations

Developed vs Emerging

Bull vs Bear

Recession vs Expansion

Correlations among developed markets are > among developing markets

Correlations in bear markets are > in bull markets

Correlations in recession periods are > in expansion periods

Not Major because:

Market & Currency risk are not highly correlated

Currency risk can be elimnated by a position in a derivative contract

Currency risk in the global portfolio is substantially diversified away

Currency risk is smaller at loner investment horizons

Investment Strategy

Country Selection

Time-Period

Must first define the efficient allocation among:

Domestic market

Developing Markets

Emerging Markets

Then take the mean-varience based on historical data

Increase in correlations

It is based on histroical performances

Doesn't take into account:

Familiarity, Political Risk, Market Efficiency, Regulations, Transaction Costs, Taxes, and

Currency Risk

Investors can exploit less than perfect positive correlations by

Purchasing foreigh shares directly in foreign market

Purchasing foreign listed shares in the domestic market (ADR)

Cost of trading foreign shares

Higher in emerging markets but are generally declining over time

International Portfolio Mgmt

Passive vs Active

Passive - no or infrequent re-balancing

Active - frequent re-balancing

Transaction costs can make passive portfolios APPEAR more preferable to active ones

Not true anymore due to technology

ADR

American Depository Receipts

A certificate issued by a US depositary bank, representing foreign shares held by trhe bank, usually by a branch or correspondent in the country of issue

Carries same currency, political and economic risks as the underlying foreign share

Avoid administrative problems of converting US dollars to purchase foreign stock

Shorter settlement period

Recieve dividends that are converted automatically to US dollar at the preferential wholesale exchange rate

Limited number of companies have ADRs

Tend to be large companies in home country and thus do not offer full international diversification benefit

Execution costs maybe higher on US than on location markets

Closed-end fund whose assets consist of primarily of stocks of the country for which the fund is named

Offers access to a local market and benefit form international diversification

Subject to local gov't aapproval: way to overcome foreign investment restrictions

Special open-end funds that trade on a stock market but are shares of a portfolio not individual company

Benefit of international diversification

Liquidity at a low cost

Designed to be tax efficient

Monitor economic, social and political variables

-Real growth, monetary policy, fiscal policy

In the long run, real economic growth is major influence on national stock market

-Business Cycle and Long-term sustainable growth

Industry Analysis

4 Elements

Demand analysis

Value Creation

Industry Life Cycle

Competition

Learning/Experience curve

Economies of scale

Economies of scope

Network Externalities

Pioneer Stage

Rapid Accelerating Growth Stage

Mature Growth Stage

Stabilization Growth

Deceleration of Growth

Competition Structure

Competition Advantage

Competition Strategy

N Firm concentration ratio: Combined market shares of X largest firms in industry

Herfindahl Index: Sqaured Markets shares of firms in industry

Factor Conditions

Demand conditions

Related Supplier and Support Industries

Strategy Structure and Rivalry

Set of actions that a firm takes to optimize future competitive position

Porter's classification: Cost Leadership vs Differentiation

Participants along value change compete but also cooperate to produce mutually beneficial results

Caution: Participants may be good in a good economy and staunch in a bad economy

Market Competition

Value Chain Competition

Government Participation

Cash Flow Covariance

Should be carried out in the context of the country and the global industry

Global industry factors tend now to dominate country factors

Ratio Analysis

-DuPont model

Discounted Cash Flow Models

-Gordon Dividen Discount

Analysts try to find mispriced securities

Value

Growth

Size

- Low P/E

Strategy usually purchases defensive, cyclical, or out-of-favor industry

- Contrarian

Strategy focuses on stock with low valuations relative to book value

-Yield

Strategy focuses on above average earnings or dividend yields that are expected to maintain dividend payouts

-Consistent Growth

Strategy focuses on high quality firms with continually growing earnings primarily in consumer-oriented industries

-Earnings Momentum

Strategy tends to purchase stocks with the anticipation of earnings acceleration

-Focuses on price component

-Do not care about current earnings

-Assumes P/E ratio is below its natural level

-Assets/CF are unpriced and market will realize soon

-Multiple will return to market levels

Overreaction to bad news

Focuses on EPS and its economic determinants

Looks for companies expected to have rapid EPS growth

Assumes constant P/E ratio

Earnings will grow more than market consensus expects

Earnings have momentum

Value

- Investor misreads the 'cheapness' of the stock

-Market did not overreact to the bad news

Growth

- Future earnings growth does not occur

-P/E ratio declines for some unexpected reason

Does not have a particular preference for value or growth and tends to hold portfolios that closely resemble broad market averages

Substyles: Value or Growth Bias

Substyles: Market-Normal

-Large Cap stocks are efficiently priced

Lots of analysts

Lots of institutional money eager of good information

-Mid and Small Cap stocks are inefficiently priced

Few Analysts

Difficult to estimate their earnings

Little is known about these stocks

Research can uncover mispricing

Market risk (beta) is all that matters

All firm-sepcific risk can be fully diversified

Different investing styles would not produce differential returns

Style investing should not work

• Returns are significantly different from market
• Actual styles portfolio returns and style index returns must differ from each other
• Actual style portfolios and style indexes must have different factor exposures between themselves and the overall market

Used to develop a passive value or growth strategy

Is appropriate for investors who have:

Low risk tolerace

Short Time Horizon

Multiple parties to whom they need to explain performance results

-Factors

• Size is measured by market capitalization

• Growth/Value is forcasted on one year earnings

-Method

• Size: Rank orders on market cap
• Growth/Value: Rank orders on Price/Book

-Problems

• Firm might be growth in one time period and value in another

Styles exist globally

Problems with using style investing

- Notions of style are less well know

-Managers do not see themselves in terms of style

-Multi-national portfolios are difficult to classify in terms of style

Value vs Growth Styles

Growth stocks outperform value stocks for a time and then the opposite occures

Overtime, value stocks have higher returns than growth

Variation in returns among mutual funds are attrituable to differences in style

• Indexes are constructed differently
• A portion of national equity index behavior is influenced by exchange rate changes
• Different countries have different industrial structures

Proportion of the given industry representation in a country's economy

Important for explaining cross-sectional differences in volatility and the correlation structure of country index returns

Separate country-specific shock from the industry shock

R = Alpha + omega + theta + error

omega = pure industry i effect

therta = pure country j effect

error = firm specific fluctuation

Country and industry effects are estimated from:

Rk = alpha + omega₁*D_k1 + ... + omega₁D_kI + theta₁*C_k1 + ... + theta*C_kj + error

D_ki = 1 if firm k belonds to industry i

C_kj =1 if firm k belonds to country j

Result = time series of industry and country effects

Economic Problem of

Time series regression of industry and country effects

Number of identified industry groups differs widely across countries

Many firms may belong to more than one industry

Multinational firms belong to more than one country

Estimation Problem of

Time series regression of industry and country effects

Each firm belongs to both one industry and one country

= Multicollinearity problem

Solution: Measure industry and country effects relative to the common factor (e.g.) World equally weighted index

Interpretation of

Time series regression of industry and country effects

Each omega_i = excess return over the world equally-weighted index on a portfolio that invests only in industry i

Each theta_j = excess return over the world equally-weighted index on a portfolio that invests only in country j

Stocks from same domestic market but different industries are closer substitutes than stocks from the same industry but in different countries

Benefits of international diversification are from geographical diversification and not industrial diversification

Two Stage Portfolio Selection

+

Assumption

Stage one: Allocate portfolio to several countries

Stage two: Use industry analysis to select most attractive stocks

Assumption: International returns are driven by country factors

If goods are not internationally traded, country factors explain a larger proportion of variation in their returns

If goods are internationally traded, industry factors explain a larger proportion of variation in their returns

- Worldwide growth in demand for goods in a particular industry will benefit all firms within the industry

-Due to competition, if one major firm is highly successful, it will be at expense of other firms in the same industry

1. Regress Global industry return on the world index return
2. Regress residuals on country index returns
3. Residual v is pure global industry shock

1. Regress Country industry return on the world index return
2. Regress residuals on global index returns
3. Residual v is pure country shock

Does not provide any substantial value in the U.S.

True sector rotation is a valid approach to investing only when country-specific effects are eliminated

Only glbal diversification is possible to eliminate country risk

Higher Expected Return

Higher local risks

Positive correlation with developed markets

Volatility

- Much larger than that of developed markets

-Investment risk in emerging economies often comes from the possibility of a crisis

-Factors to consider: Political, Social, Existing infrastructure, Corruption, Banking Sector

Correlations: Tend to increase in periods of crises and emerging markets are subject to large periodic crises

Currency Risk: Tend to exhibit a positive correlation with value of their currencies

Emerging markets grow at a higher rate than developed nations

Emerging markets have become more efficient

BUT, they tend to be segmented and mispricing is evident

Asset prices are assumed to be efficient

Any new information is reflected in prices

Any typical investor could consider an asset price to reflect its true fundamental value

Integration: Efficent because prices do not violate the law of one price

Segmentation: Inefficent because prices violate the law of one price

Impediments to Capital Mobility

• Not integrated but segmented because of various impediments to capital mobility
• e.g. Psychological barriers, legal restrictions, transaction costs, discriminatory taxation, politial risks, foreign currency risks
• Reduce international capital flows and lead to segmented markets. More apparent in emerging markets
• Flow of foreign investment has grown over time
• Conclusion: International markets are not fully segmented but need to look at international asset pricing

Risk-averse

Expected Return and risk for all assets is assumed correct

Investors care about nominal returns

Risk free IR exist with unlimited borrowing and lending

No Transactions costs or taxes

CAPM, investors determine their demands for each asset by a mean-variance optimization

Domestic CAPM states that investors hold: Risk free asset and market portfolio made up from assets traded in proportion to their market cap.

Optimal Investment Strategy for any investor is a combination of two portfolios (Market and Risk-free)

E(R) = Rf + B(Rm - Rf)

Similar to domestic CAPM, but World market portfolio replaces the domestic market portfolio

Not reasonable since, investors throughout the world do not have identical consumption baskets

Real prices of goods are not identical in every country

Assumption:

• Nationals of a country care about returns and risks in their home currency
• CAPM holds
• All investors determine their demand for each asset by a mean-variance optimization using domestic currency as base currency

SRP defined as E(R^DOM) - r_DC

SRP = E(s) - (R_DC - R_FC)

Expected Return on Foreign investment

Unhedged  vs Hedged

Hedged

E(R^DOM) = E(R^FC) + E(s)

E(s) = E(S₁ - S₀)/S₀

Unhedged

E(R^DOM) = E(R^FC) + (F₀ - S₀)/S₀

• Market and currency risk factors are unstable over time
• Market imperfections are much more sever at the international level
• Definition of a world market portfolio is extremely complicated
• World is not perfectly integrated

If:

• Access to both capital markets by residents of both countries is unrestricted
• To assets which belong to these two countries have the same risk and same expected return

• High correlation between two markets indicates a high degree of their integration but neither implies the other
• Higher if Market Cap to GDP is high
• Higher if exports and imports to GDP is high

• Current research tends to support conclusion that assets are priced in an integrated global financial market
• Evidence justifies using ICAPM as anchor to structuring global portfolios
• In emerging smaller markets, evidence points that constraints are still serious

A contract whereby two parties agree to a periodic exchange of CFs

On each swap payment date, the two CFs are netted and a payment is made by the part owing the money

OTC and there is no secondary sap market

Currency

Interest Rate

Currency & Interest Rate

Return and Risk

Reducing financing costs

Manage exposure to currency and IR Risks

Method 1 (Bonds): V_swap = B_D - S₀B_F

Method 2 (Forwards):

1. Calculate Forward rates using zero rates
2. Calculate swap CFs in FC assuming forward will be realized
3. Discount Swap CFs using zero rates to obtain swap value

Primarily used to protect a portfolio against currency risks

Objective: Minimize exposure to exchange rate movement

Formula on Sheet

Objective: Search for minimum variability in the value of the hedged portfolio

Investors would set hedge ratio so as to minimize the variance of the return on the hedged portfolio

h* = 1 + cover(R,S)/o_s²

First part = translation risk hedge

Comes from translating value of asset from FC to DC

Second part = economic risk hedge

Comes from FI reacting to exchange rate movement

Optimal Hedge Ratio

Minimum Variance is not always optimal in risk-return framework

Basis risk can also affect quality of currency hedging

- movement in basis could correlate with movement in spot exchange rate

Short-term contracts

Roll over Short term hedges

Long Term Contracts

Roll over short-term contracts

Match contract maturity to expected period of hedge

Use long term hedges

Used for closely linked currencies

Reduces total volatility of portfolio

Complete FC hedge can be achieved by heding investments in each FC

Performance Measurement

Returns are calculated over a measurement period for overall portfolio and verious segments

Performance Attribution

Total portfolio performance is attributed

Performance Appraisal

Judgement is formulated on Investment manager's skill

Captures return on average invested capital

Measures net enrichment of the client

Aka IRR or average return

Performance per dollar invested

Calculated independently of CF to or from portfolio

Obtained by chainlinking rate of return between CF date

MWR

Useful for measuring return f invested capital

Gives assesment of client's net enrichment

TWR

Preferred method for measuring and comparing the performance of money managers

Useful for performance evaluation

Global portfolio can be invested in many different local markets and currencies

Breakdown portfolio into various segments according to type of asset and currency

Security Selection

Asset Allocation

- Market Allocation

- Currency Allocation

Other

- Market Timing

- Industry

- Styles

Portfolio Weights

Rate of Return in $

Capital gain in local currency

Currency Contribution

Market Index

Security Selection

Attribution Decomposition

Benchmark return +

Market allocation contribution +

Currency allocation contribution +

Security selection contribution

Portfolio Return

Investor decides asset allocation accross various asset classes based on E(r) and risk

Actively managed portfolio is constructed for each asset class and a benchmark assigned

Absolute: Standard Deviation

Relative: Tracking Error/Active risk

Sharpe

Treynor Ratio

Jensen's Alpha

Infrequently traded assets

Option-like investment strategies

Survivor bias: risk and return

View of world regardign security price behavior

Strengths in terms of research and mgmt

Cost Aspects

Location and domestic/globa marketing strategy

Reproduce market index of securities

Assumes market portfolio is efficient

Uses:

Full replication

Stratified sampling

Optimization sampling

Synthetic replication

Benchmark is often imposted and it will clearly guide structure of portfolio

Top-Down: Allocates assets across asset classes then selects individual securities to satisfy allocation

Bottom-Up: Manager studies the fundamentals of many individual stocks and then selects the best securities

IPS is the cornerstone of the portfolio mgmt process

Includes:

Client Description and Purpose

Return and risk Objectives

Constraints

Asset Allocation Considerations

Schedule for review and monitoring

Define Asset Classes

Formulating long-term expectations used in strategic asset allocation

Formulating short-term expectations used in tactical asset allocation

Short: Tactical devations from the strategic asset allocation

Long: Historical returns + Forward-looking returns

Conducting asset allocation optimization using long-term capital  market expectations

Three important issues:

Scope of the benchmark

Set of weights chosen

Attitude toward currency risk

Deciding which asset classes are currently attractively or unattractively priced

Making short-term departures from the long-term policy by buyin more off attractive markets and reducing unattractive markets

Foreign Yield

Capital Gain/Loss

Currency Gain/Loss

Interest Rate risk

Currency Risk

Expectede return on forign bond = domestic risk free rate + risk premium

Risk Premium = Spread of Foregn bond yield + % capital gain/loss + expected % currency movement