2. Chapter 3 Questions
• Why should investors have a global
perspective regarding their investments?
• What has happened to the relative size of
U.S. and foreign stock and bond markets?
• How can investors compute returns on
investments outside their home country?
• What additional advantage is there to
diversifying in international markets beyond
the benefits of domestic diversification?
3. Chapter 3 Questions
• What securities are available? What are their
cash flow and risk properties?
• What are the historical return and risk
characteristics of the major investment
instruments?
• What is the relationship among the returns
for foreign and domestic investment
instruments? What is the implication of these
relationships for portfolio diversification?
4. Computing Returns on
Foreign Investments
(1 + HCR) = (1+ FR) ( CER/IER)
Where:
HCR is the Home Country Return
FR is the Foreign Return
CER is the Current Exchange Rate
IER is the Initial Exchange Rate
5. The Effect of Changing
Exchange Rates
• For U.S. investors, a foreign security’s return
in its domestic market is not the “bottom line.”
• Exchange rates have a major impact on the
equivalent U.S. return on a foreign
investment.
– This is known as exchange rate risk
• The key factor is the changing strength of the
U.S. dollar vis-à-vis the foreign currency.
6. The Effect of Changing
Exchange Rates
• Stronger dollar: Income
from foreign
investments gets
exchanged for fewer
dollars over time,
reducing net return for
the U.S. investor.
• Weaker dollar: Income
from foreign
investments gets
exchanged for more
dollars over time,
increasing net return for
the U.S. investor.
7. Why have a global
perspective?
• Broadened horizons. The foreign market for
stocks and bonds is huge!
– U.S. markets comprise less than half of the total
available securities
– More opportunities broaden the range of risk-
return choices
• Returns on non-U.S. securities have often
exceeded U.S. securities
– Higher returns on equities are explained by higher
growth rates in some countries
8. Why have a global
perspective?
• Diversification with foreign securities
can help reduce portfolio risk.
– Since foreign investments are impacted by
somewhat different forces than domestic
investments, risks can be reduced.
• It’s easier than ever before!
– Barriers to global investing, both for
companies and for individual investors, are
getting smaller.
9. Relative Size of U.S. and
Foreign Markets
• The overall value of world financial markets
has seen explosive growth ($2.4 trillion in
1969 to $70.9 trillion in 2003)
• The U.S. share of the overall world financial
markets has gone from well over half (65% in
1969) to about half (50% in 2003).
• See Exhibits 3.2 and 3.3
10. Diversification in
International Markets
Recall that diversification involves risk
reduction.
– Correlations range from +1 (perfect positive
correlation) to –1 (perfect negative correlation)
– By combining securities whose returns are not
perfectly positively correlated with each other in a
portfolio, the portfolio standard deviation
characteristically falls.
– The lower the correlation coefficient between
investments, the greater the benefit of
diversification.
11. Diversification in
International Markets
• Correlations between U.S. markets and
major foreign markets are relatively low.
– In bond markets, the correlations, while positive,
are below +.50, on average (See Exhibit 3.6)
– In equity markets, the correlations are a bit higher,
but still relatively low with an average of about
+.55 (See Exhibit 3.7)
• The bottom line: there is considerable benefit
to international diversification.
– Portfolios that are diversified internationally tend
to have substantially lower standard deviations.
12. Diversification in
International Markets
Several words of caution:
• Correlations vary greatly between pairs of
counties.
– As you might guess, there is a higher correlation
between U.S. and Canadian returns than between
U.S. and various European returns.
– Not all international diversification is created
equal!
• Correlations are increasing over time.
– As global competition and various regulatory
barriers have fallen, correlations have increased.
14. Money Market Securities
• Typically very liquid, low-risk (and also
relatively low return) investments
• Mostly sold at a discount from their
maturity value
• Includes T-bills, which are sold in
weekly auctions for various maturities
15. Capital Market Instruments:
Fixed Income Investments
• Except for preferred stock, fixed income
securities are debts of the issuer.
• Promise specified cash flows at pre-
determined times.
– Legal force behind the agreement varies
by type of security and issuer, as does the
corresponding risk borne by the investor.
16. Capital Market Instruments:
Fixed Income Investments
Most fixed income instruments specify a
number of features including the following:
– The maturity date – the date that the obligation is
to be fully repaid, according to its provisions.
– The coupon – the income that the investor will
receive each year.
– The par value – the principal value of the
obligation; usually the original value and also the
amount to be returned to the investor on the
maturity date.
17. Capital Market Instruments:
Fixed Income Investments
• U.S. Treasury Securities
• U.S. Government Agency Securities
• Municipal Bonds
• Corporate Bonds
• Asset-backed Securities
18. U.S. Treasury Securities
• Bills, notes, or bonds - depending on
maturity
– Bills mature in less than 1 year
– Notes mature in 1 - 10 years
– Bonds mature in over 10 years
• Highly liquid
• Very low risk of default, so essentially
no credit risk
19. U.S. Government Agency
Securities
• Sold by government agencies
– Federal National Mortgage Association (FNMA or
Fannie Mae)
– Federal Home Loan Bank (FHLB)
– Government National Mortgage Association
(GNMA or Ginnie Mae)
– Federal Housing Administration (FHA)
• Not direct obligations of the Treasury
– Still considered default-free and fairly liquid
20. Municipal Bonds
• Issued by local governments
– General obligation bonds (GOs)
– Revenue bonds
• Exempt from federal income taxes and
often state income taxes
– Popular instrument for high tax bracket
investors.
21. Corporate Bonds
• Debt securities issued by corporations.
• Vary by:
– Level of claim (security)
– Credit quality (rated for default risk)
– Term to maturity
– Special features
22. Corporate Bonds: Secured or
Unsecured?
• Secured bonds feature some sort of collateral
to protect the investor.
– Mortgage bonds: backed by land and buildings
– Collateral trust bonds: backed by financial assets
– Equipment trust certificates: backed by specific
pieces of equipment
• Unsecured bonds or debentures are backed
only by the firm’s promise to pay.
– Subordinated debentures: lower priority claim
– Income bonds: pay only if profits are earned
23. Corporate Bonds: Special
Provisions
• The bond contract (the indenture) may
include several important provisions that can
influence the actual maturity of the bond.
• Call provision: allows the issuer to buy back
or “call in” the bond prior to maturity at a
specified call price
– Bonds range from freely callable (can be called
any time) to non-callable
– Most have deferred calls, which are non-callable
for a period of time, then freely callable
24. Corporate Bonds: Special
Provisions
• Sinking fund provision: requires the
issuer to retire a portion of a bond issue
prior to maturity.
– Like a call provision, the investor would
typically receive a specified call price
under a sinking fund provision.
• Both call provisions and sinking fund
provisions can shorten the actual
maturity of a bond.
25. Bond Ratings
• Most bonds are rated for default, or credit risk
by one or more rating agency.
– Duff and Phelps, Fitch Investors Service,
Moody’s, Standard & Poors (S & P)
• Ratings from AAA to D, some agencies give
slightly different modifiers or letters
• Top four ratings (AAA down to BBB):
Investment Grade Securities
• Below the top four ratings: Speculative Grade
Securities (High-yield or junk bonds)
26. Asset-Backed Securities
• GNMA pass-through certificates: pass
through the payments made on a pool of
mortgages
• Collateralized Mortgage Obligations (CMOs):
securities that pass through payments made
on mortgages, with specific distribution rules
that apply to different classes
• Other asset-backed securities, such as
certificates for automobile receivables
(CARs)
27. International Bond Investing
• Eurobond: an international bond that pays
cash flows in a currency not native to the
country of issue
– Eurodollar bonds are denominated in U.S. dollars,
but sold outside of the U.S.
• Yankee bond: a bond denominated in U.S.
dollars, sold in the U.S., but issued by a
foreign corporation or government
• International domestic bonds: U.S. investor in
a foreign bond, subject to exchange rate risk.
28. Preferred Stock
• Classified as a fixed income security since
yearly dividends are stipulated.
• Preferred dividends are not legally binding,
so preferred stock is technically not a debt.
• Since corporations are loathe to miss a
dividend, they are binding in practical terms.
• Much of the outstanding preferred stock is
held by other corporations.
– 80% of dividends received by one corporation
from another are excluded from taxable income
29. Equities
• Returns are not contractual.
• Instead, returns vary according to
performance, and can be much better or
much worse than fixed income investments.
• Equity represents an ownership interest.
– The owner gets as much or as little as is left over
after all fixed and higher priority claims have been
met.
• Most common equity investment: Common
Stock
30. Common Stock
• Represents the ownership of a corporation
• Relatively risky investment compared to fixed
income securities
• Investment considerations include choice of
business group or sector and at industries
within those broad groups
– Business groups: Industrial firms, Utilities,
Transportation firms, Financial Institutions
31. Foreign Equity Investments
Several means of obtaining an equity interest in
foreign investments:
• Through American Depository Receipts
(ADRs)
• Through direct investment in foreign shares
listed on a U.S. or foreign stock exchange
• Through indirect investment in international
or global mutual funds
32. American Depository Receipts
• Easiest way to acquire foreign shares
• Certificates issued by a U.S. bank
– Represent indirect ownership of shares of a
foreign firm on deposit in a bank in the firm’s
home country
• Buy and sell in U.S. dollars
• Dividends in U.S. dollars
• May represent multiple shares
• Very popular, about 2,000 ADR programs
available in 2003
33. Direct Investment in Foreign
Shares
• The most difficult approach, especially
when purchasing stock in the foreign
country (in the foreign currency) and
transferring back to the investor’s home
country.
• A growing number of foreign firms do
list their stock directly on the NYSE.
34. International and Global
Mutual Funds
• Global funds: invest in both U.S. and foreign
stocks
• International funds: invest mostly outside the
U.S.
• Funds can specialize
– Diversification across many countries
– Concentrate in a segment of the world
– Concentrate in a specific country
– Concentrate in types of markets
35. Derivative Securities
There are many types of derivative
investments, including financial
derivative securities whose payoffs are
tied to various financial assets.
• Options
– Puts and calls
• Futures contracts
36. Option Contracts
Puts and calls
• Give the owner the right to sell (put) or
buy (call) a company’s stock within a
specified period of time at a specified
price (called the strike price).
37. Futures Contracts
• Standardized contracts to make or take
delivery of some financial (or other) asset in
exchange a specified payment at a future
date.
• Payment not due until the future date, but
margin (a good faith deposit) is required.
• Futures contracts are often used to manage
risk, especially the risk of changing interest
rates.
38. Managed Investments
Investment companies sell shares in
themselves and use the proceeds to invest in
other investment instruments.
• Closed-end investment companies: offer a
fixed number of shares.
• Open-end investment companies (Mutual
funds): offer fluctuating number of shares
based on purchases/sales of fund shares.
– Stock funds, Bond funds, Money market funds,
Mixed funds
39. Managed Investments
• Hedge Funds: typically act as a partnership
where one partner manages funds for all
other partners according to some investment
strategy.
• Venture capital pools: Similar to hedge funds,
these partnerships obtain an equity interest in
promising start-up or privately held firms.
• Real Estate Investment Trusts (REITs):
provides investors with an indirect means of
investing in real estate.
40. Historic Return and Risk
Characteristics
• Historic investment results have been studied
extensively.
• We can see the historic risk/return relationship by
examining rates of return for major classes of assets
in the United States:
1. Large-company common stocks
2. Small-capitalization common stocks
3. Long-term U.S. government bonds
4. Long-term corporate bonds
5. Intermediate-term U.S. Treasury bills
6. U.S. Treasury bills
41. Summarizing the Historic
Data
• Examining recent history (1980-2003)
confirms the relationship between risk and
return.
– The higher returning classes of investments
(common stock, especially small-cap firms) have
experienced higher average returns as well as
greater volatility.
• Adjusting for inflation, thereby creating real
returns, shows a small positive real interest
rate for even the lowest risk investment
42. Summarizing the Historic
Data
The historical data also allows for the
calculation of average premiums earned
– Equity risk premium = Common Stock return
minus T-bill return = 8.57%
– Small-stock premium = Small stock return minus
Large stock return = -0.58%
– Horizon premium = Long-term T-bond return
minus T-bill return = 4.93%
– Default premium = Long-term Corporate bond
return minus Int.-term T-bond return = 1.44%
43. World Portfolio Performance
Examination of historical returns largely confirm
expectations.
• Riskier assets also have had higher average
returns.
• Coefficients of variation range widely, with
the combined World Stock Index having a low
CV, showing benefits of global diversification.
• Correlations between asset returns vary by
global regions, also showing the potential,
but variant advantages to global
diversification.
