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International Financial Management:

International Asset Pricing II


Arie E. Gozluklu
Warwick Business School
Week 8
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 1 / 56
Today
International diversication
International cost of capital
domestic vs. world CAPM
other models
Beyond national borders
alternative investments
Home bias
investors tilt toward local assets
Country Risk
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 2 / 56
Traditional Asset Classes
- Cash/Currency
- Equity
- Bonds
- Real estate
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 3 / 56
Real Investment Returns (local currency)
Source: Prof. Faveros website
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 4 / 56
Investing Abroad
Two risk dimensions of investing abroad= country risk
returns of the international asset in its local currency
variations in the value of the foreign currency relative to investors
currency
Main advantages
broader opportunity set
diversication of risk
dierent economic, political, psychological factors
asynchronous business cycles
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 5 / 56
Investing Abroad
Let S
t
be the current $/ spot rate and S
t+1
the future spot rate
Let r
$
t+1
be the dollar return on a foreign (e.g. British) asset
1 +r
$
t+1
=
1
S
t
[1 +r

t+1
] S
t+1
Dening
S
t+1
S
t
= 1 +s
t+1
, we obtain
r
$
t+1
= r

t+1
+s
t+1
+ [r

t+1
s
t+1
]
The dollar return on a foreign asset depens both on the foreign asset
return and currency return.
The cross-product term is often small and neglible.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 6 / 56
Foreign Investment
Example
At the beginning of year, a US investor buys a share of Geox at e4.68 with
the exchange rate at 1.38$/e. During the year, the investor receives a
dividend of e0.4 per share. At the end of year, the investor sells the share
of Geox at e5.25 with the exchange rate at 1.52$/e. What is the
investors dollar return on this investment? (Hint: use logs)
r
t+1
= ln

P
t+1
+D
t+1
P
t

+ ln

S
t+1
S
t

= ln

5.25 + 0.4
4.68

+ ln

1.52
1.38

= 0.285 (28.5%)
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 7 / 56
Volatility of Foreign Investment
The realized dollar return for a U.S. resident investing in a foreign
market i is given by
r
$
i
= (1 +r
+
i
)(1 +s
$/i
) 1
r
$
i
= r
+
i
+s
$/i
+r
+
i
s
$/i
r
$
i
- r
+
i
+s
$/i
where r
+
i
is the return from a foreign asset and s
$/i
is the dollar
return on foreign currency.
Notice that volatility (square root of variance) is not additive, i.e.
involves covariance terms
var (r
$
i
) = var ([r
+
i
+s
$/i
])
= var (r
+
i
) +var (s
$/i
) + 2cov(r
+
i
, s
$/i
)
= var (r
+
i
) +var (s
$/i
) + 2
r
+
i
,s
$/i
vol (r
+
i
)vol (s
$/i
)
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 8 / 56
Volatility of Currency and Equity Returns
Means Volatilities
Data: Market Currency Dollar Market Currency Dollar
1980-2010 Return Return Return Return Return Return
US 11.52% 0% 11.52% 15.58% 0% 15.58%
Canada 10.72% 0.54% 11.73% 17.00% 6.73% 20.64%
Japan 5.21% 4.10% 9.28% 19.22% 11.76% 22.51%
UK 12.98% -0.65% 12.17% 16.45% 10.50% 18.91%
France 12.56% -0.21% 12.14% 20.12% 11.00% 21.93%
Germany 11.00% 1.21% 11.91% 21.13% 11.21% 23.06%
Italy 14.26% -1.48% 12.51% 24.35% 10.89% 25.59%
Source: Bekaert&Hodrick (2010)
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 9 / 56
Correlation between Equity and Currency Return
If
r
+
i
,s
$/i
= 1, then (a +b)
2
= a
2
+b
2
+ 2 a b implies
var (r
$
i
) = vol (r
$
i
)
2
= [vol (r
+
i
) +vol (s
$/i
)]
2
vol (r
$
i
) = vol (r
+
i
) +vol (s
$/i
)
If
r
+
i
,s
$/i
< 1
vol (r
$
i
) < vol (r
+
i
) +vol (s
$/i
)
Hence, as long as
r
+
i
,s
$/i
< 1, there is room for diversication.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 10 / 56
Correlation between Equity and Currency Return
In fact, the correlation,
r
+
i
,s
$/i
, is in general lower than one.
Country
r
+
i
,s
$/i
Canada 0.42
Japan -0.02
UK -0.09
France -0.10
Germany -0.09
Italy -0.09
Source: Bekaert&Hodrick (2010). Sample Jan. 1980-Aug. 2010.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 11 / 56
Risk and Return of International Investments
Sharpe ratio: measured as the average excess return relative to the
volatility of return
SR =
E(r ) r
f
vol (r )
SR
+
=
E(r
$
) r
f
vol (r
$
)
This ratio summarizes risk-return trade-o of both securities and
portfolios.
One choice criterion: choose portfolios with high Sharpe ratio
Note: focusing on the Sharpe ratio of a single market can be
misleading.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 12 / 56
Sharpe Ratios
Assuming r
f
= 5% = SR =
E(r )r
f
vol (r )
US example:
E(r
US
) = 11.52%, vol (r
US
) = 15.58% =
11.515
15.58
= 0.4178
Country Sharpe ratio
US 0.42
Canada 0.33
Japan 0.19
UK 0.38
Germany 0.30
France 0.33
Italy 0.29
Source: Bekaert&Hodrick (2010). Sample 1980-2010.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 13 / 56
Portfolio Problem
Let r and r
$
be the domestic and foreign (dollar) return, respectively
If you invest w portion of your wealth in foreign asset, then the
expected return of the portfolio
E(r
p
) = (1 w)E(r ) +wE(r
$
)
BUT, the volatility does not aggregate linearly, i.e. volatility of the
portfolio will be
vol (r
p
) = (1 w)
2
var (r ) +w
2
var (r
$
) + 2w(1 w)cov(r , r
$
)
1/2
Recall that covariance is a function of correlation
cov(r , r
$
) =
r ,r
$
vol (r ) vol (r
$
)
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 14 / 56
Equity Return Correlation Matrix
Geographical proximity and trade increase equity return correlations
Source: Bekaert&Hodrick (2010). Sample 1980-2010
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 15 / 56
International Diversication: Risk Reduction (Solnik, 1974)
Adding international assets to a local portfolio reduces portfolio risk.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 16 / 56
International Diversication
What happens to the Sharpe ratio, if we include a foreign equity to an
all-US portfolio?
Let the US and foreign Sharpe ratio be
SR =
E(r ) r
f
vol (r )
, SR
+
=
E(r
$
) r
f
vol (r
$
)
The Sharpe ratio of the portfolio improves if
E(r
$
) r
f
vol (r
$
)
>
r ,r
$

E(r ) r
f
vol (r )
Foreign investment hurdle rate
E(r
$
)
HR
=
r ,r
$

E(r ) r
f
vol (r )
vol (r
$
) +r
f
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 17 / 56
Hurdle Rates for Foreign Investments
Hurdle rate is higher when the domestic Sharpe ratio, return
correlations and foreign return volatility is high.
Country E(r)=10% E(r)=12%
Canada 9.96 11.94
Japan 7.67 8.74
UK 9.01 10.61
France 9.32 11.05
Germany 9.41 11.17
Italy 8.57 9.99
Source: Bekaert&Hodrick (2010). Sample 1980-2010.
The hurdle rate is the lowest possible expected foreign return that must be
earned to improve the Sharpe ratio of a domestic portfolio.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 18 / 56
Investors Utility Function
Utility function represents investors preferences
Mean-variance preferences are commonly assumed
U = E(r
p
)
A
2

2
p
Example
Suppose the expected portfolio return is 7.50%, and the volatility is 6%.
An investor with A=5 has the utility
U = 7.50%
1
2
5 (6%)
2
= 7.50%0.9% = 6.6%
The investor is indierent between investing in the portfolio above
and investing in a completely risk-free portfolio with a return of 6.6%.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 19 / 56
Optimal Portfolio Allocation: One risky asset
An investor can invest in one risk-free and one risky asset
Let r
f
and r
a
be the return of the risk-free and risky asset, respectively
And let w the weight on the risky asset in the portfolio
Then the (expected) return on the portfolio
r
p
= w r
a
+ (1 w) r
f
= r
f
+w (r
a
r
f
)
E(r
p
) = r
f
+w E(r
a
r
f
)
var (r
p
) =
2
p
= w
2

2
, where var (r
a
) =
2
Since the volatility of the portfolio is
p
= w, we can write
E(r
p
) = r
f
+

p

E(r
a
r
f
)
Hence we derived the risk-return trade-o in a single risky asset case
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 20 / 56
Optimal Portfolio Allocation: Capital Allocation Line(CAL)
x-axis: portfolio volatility, y-axis: portfolio expected return
Intercept: the return on the risk-free asset (r
f
= 6%)
Slope: the Sharpe ratio of the risky asset
E(r
a
r
f
)

= 0.4917
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 21 / 56
Investors problem
The investor has to decide how much to invest in a risky asset to
maximize her utility function
Notice that the optimal portfolio depends on investors preferences
max
w
U = max
w
[E(r
p
)
1
2
A
2
p
]
Substitute portfolio mean and volatility using previous derivation
(CAL)
max
w
[r
f
+w E(r
a
r
f
)
1
2
Aw
2

2
]
Denoting the optimal portfolio weight w
opt
, = FOC wrt to w
E(r
a
) r
f
Aw
opt

2
= 0
w
opt
=
E(r
a
) r
f
A
2
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 22 / 56
The Optimal Portfolio
At point K, w < 1, at point L w > 1(more than 100% invested in
risky asset)
Note: A
L
(less risk averse)< A
K
(more risk averse)
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 23 / 56
The Optimal Portfolio: Multiple Assets
Harry Markowitz (Nobel prize 1990) provides the solution:
Minimum variance : min
w
1
,....w
N

[
N

i =1
w
2
i

2
i
+
N

i =1
N

j ,=i
w
i
w
j
cov(r
i
, r
j
)]
s.t
N

i =1
w
i
= 1 = feasible portfolio
N

i =1
w
i
E(r
i
) = r = target return
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 24 / 56
Modern Portfolio Theory (MPT)
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 25 / 56
Mean-Variance Ecient Portfolio
We can add as many assets as we want and construct the ecient
frontier
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 26 / 56
Mean-Variance Ecient Portfolio
If we add a risk-free asset, the intersection where CAL is tangent to
the mean-variance frontier denes the mean-variance-ecient
portfolio.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 27 / 56
Capital Asset Pricing Model (CAPM)
The most popular model underlying cost of capital calculations
Assumptions:
single period investment horizon
small investors as price takers
costless and homogenous information
homogenous expectations,i.e. same expected returns, volatility and
covariance estimations
rational investors with mean-variance preferences
Predictions:
all investors hold the same portfolio of risky assets- market
portfolio= index fund industry
market portfolio contains all securities
market risk premium is the average risk premium of all investors
risk premium of a single security is determined by its covariance with
market portfolio
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 28 / 56
CAPM Derivation
An investor adds an asset to a portfolio if
SR
new
> SR
p
where is the return correlation between portfolio and the new asset
Add an asset until
SR
new
= SR
p
E(r
new
) r
f

new
=
E(r
p
) r
f

p
Since =
cov (r
new
,r
p
)

new

p
, for any asset i
E(r
i
) r
f
=
cov(r
i
, r
p
)

2
p
| {z }
[E(r
p
) r
f
]
E(r
i
) r
f
=
i
[E(r
p
) r
f
]
Extra return (compensation) for the systematic risk measured by
i
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 29 / 56
CAPM in Equilibrium
All the investors hold the market portfolio
E(r
i
) = r
f
+
i
[E(r
m
) r
f
]

i
=
cov(r
i
, r
m
)

2
m
Market portfolio is the mean-variance-ecient portfolio.
Market portfolio is measured as an aggregate index, e.g. S&P 500, a
value-weighted index in NYSE, LSE, TSE
CAPM in its original form assumes no international diversication.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 30 / 56
Multi-Factor Models
Ross (1976), Sharpe(1982) propose multi-factor formulation
E(r
i
) = r
f
+
N

j =1

i ,j
E(F
j ,t
)
F
j ,t
represent dierent systematic risk factors and
i ,j
factor loading of
security i to factor j
Examples: Fama-French three factor model (market, size, book to
market), momentum factor...
CAPM is a single factor model.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 31 / 56
Domestic vs. World CAPM
Can we apply CAPM in an international setting?
We can replace US market portfolio with the world market portfolio
E(r
i
) r
f
=
i ,w
[E(r
w
) r
f
]

i ,w
as a country risk measure (Harvey, 1991)
Returns are measured in a common currency, e.g. USD
How to measure r
f
in an international context?
Shortcoming: Systematic risk measure is to low to explain
dierences in average returns
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 32 / 56
Domestic vs. World Portfolio
World market proxied by MSCI world index
24 developed and 21 emerging market country indices
Benchmark: S&P 500 (US market index)
Source: Bloomberg
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 33 / 56
International CAPM
A model that allow for currency risk premium
E(r
i
) r
f
=
i ,w
[E(r
w
) r
f
] +
K

k=1

i ,k
E(s
k,t+1
fp
k,t
)
s
k,t+1
rate of foreign exchange appreciation, fp
k,t
forward premium on
currency k
E(s
t+1
fp
t
) = E(
S
t+1
F
t
S
t
)
First term represents world market risk
Second term captures exchange rate risk

j ,k
measures the exposures of rm is returns to exchange rate risks
The return of an exporting (importing) rm with many unhedged
currency foreign receivables (payables) will increase (decrease), if these
currencies appreciate.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 34 / 56
Integrated vs. Segmented Markets
Markets are integrated, if assets with identical risk prole require the
same expected return regardless of the country of origin.
Government intervention (taxes, restrictions) may result in segmented
markets.
Assets in segmented markets have low correlation with world market
returns
Standard CAPM model is more useful than world CAPM in
segmented markets.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 35 / 56
The Mixture Model (Bekaert and Harvey, 1995)
If a country is segmented from the rest of the world
E
t
(r
m
i
) = r
f
+
i ,w
[E(r
w
) r
f
] + (1 )
i ,m
[E(r
m
) r
f
]
r
m
i
return of a security i from country m.
measures the degree of integration.
If = 1, then markets are perfectly integrated= world CAPM
If = 0, then markets are perfectly segmented= standard CAPM
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 36 / 56
The Goldman Model (Sovereign Spread)
Previous models applied to emerging markets yield very low (close to
zero) or negative
/
s.
Misleading conclusion: Cost of capital from emerging markets equal
to risk free rate.
Investment banks consider an additional factor
E(r
i
) r
f
=
i ,w
[E(r
w
) r
f
] +SS
m
SS
m
sovereign spread, i.e. the dierence between the country ms dollar
denominated bond yield and US treasury bond yield.
Shortcomings: SS
m
is not available for each country, all securities
have the same exposure to SS
m
and conceptually premium attached
to equity should be dierent than the premium attached to debt.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 37 / 56
The Damodaran Model
Damodaran (1999) proposes a partial solution to the conceptual
problem faced by Goldman model, i.e. using bond spreads to price
equity
E(r
i
) r
f
=
i ,w
[E(r
w
) r
f
] +

m,e

m,b
SS
m

m,e
abd
m,b
country ms equity and bond market volatility, respectively.
Proposed model adjusts for the relative equity bond market volatility.
Shortcomings: SS
m
is not available for each country and all
securities have the same exposure to SS
m
.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 38 / 56
Cost of Capital Summary
Cost of capital models in general, CAPM in particular, are widely used
for capital budgeting.
There is disagreement how to measure international cost of capital.
CAPM assumptions do not hold for emerging markets.
The degree of segmentation is crucial for model selection.
Consider dierent models, rather than a single model.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 39 / 56
Alternative ways of International Diversication
Depositary receipt (DR)
Mutual funds
Exchange Traded Funds (ETF)
Hedge funds
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 40 / 56
(American) Depository Receipts (ADR)
Foreign stocks often trade on U.S. exchanges as ADRs
It is a receipt that represents the number of foreign shares that are
deposited at a U.S. bank.
The bank serves as a transfer agent for the ADRs
Advantages
ADRs are denominated in U.S. dollars, trade on U.S. exchanges and
can be bought through any broker.
dividends are paid in U.S. dollars.
adding ADRs to domestic portfolios has a substantial risk reduction
benet.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 41 / 56
International Mutual Funds
A local (US) investor can achieve international diversication by
investing in a U.S.-based international mutual fund.
Advantages
savings on transaction and information costs.
circumvention of legal and institutional barriers to direct portfolio
investments abroad.
professional management and record keeping.
Disadvantages
less control over the portfolio choice
potential hidden fees
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 42 / 56
Exchange Traded Funds
An exchange-traded fund (ETF) is an investment fund that holds
assets such as stocks, commodities, or bonds.
It is traded on stock exchanges close to its net asset value.
ETFs usually track an index such as MSCI country indeces (passive
strategy).
Spiders are ETFs on S&P 500 index.
Investors can trade a whole stock market index as if it were a single
stock.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 43 / 56
Diversication Through Country Funds
A country fund invests exclusively in the stocks of a single country.
It allows an investor
speculate in a single foreign market with minimum cost
diversify into emerging markets that are otherwise practically
inaccessible
It creates exposure to country specic risks
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 44 / 56
Hedge Funds
Unlike traditional mutual funds, hedge funds usually follow dynamic
trading strategies, often aggressively using leverages, short positions,
and derivative contracts, in order to achieve their investment
objectives.
These funds may invest in a wide spectrum of securities, such as
currencies, domestic and foreign bonds and stocks, commodities, real
estate...
Advantages
HFs tend to have relatively low correlations with various stock market
benchmarks and thus oer diversication
HFs allow investors to access foreign markets that are not easily
accessible (Jayhawk China Fund)
Risks
HFs are not subject to any reporting or disclosure requirements, hence
operate under rather opaque environments.
HFs may make wrong bets based on the incorrect prediction of future
events (LTCM)
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 45 / 56
Home Bias
Investors are generally not very well internationally diversied.
Most of the portfolios have strong home bias, i.e disproportionately
large share of domestic assets.
Only the Netherlands has a bias less than 50% (Bekaert and wang,
2010)
Bias is larger for emerging markets where international diversication
is more benecial due to higher return volatilities.
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 46 / 56
Home Bias Evidence (Bekaert and Wang, 2010)
Raw home bias= home market share - world market benchmark
Normalized home bias=
raw home bias
1world market benchmark
Country Raw Home Bias Normalized Home Bias
Netherlands 0.457 0.468
UK 0.626 0.689
US 0.386 0.727
France 0.724 0.757
Spain 0.838 0.852
Korea 0.976 0.985
Thailand 0.989 0.991
Indonesia 0.997 0.998
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 47 / 56
Country Risk
Why is it important?
investment returns
rms foreign currency cash ows
potential risk of contagion
Country-specic risk
political risk
nancial risk
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 48 / 56
Political Risk
Actions of host government
taxes, local subsidies
rule of law
blockage of fund transfers
curreny inconvertibility
Bureaucracy
hidden cost
Corruption
bribes, nepotism
War
threat of war
I do not know with what weapons World War III will be fought, but World
War IV will be fought with sticks and stones. Albert Einstein
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 49 / 56
Corruption (Perceptions) Index
Perceived level of public sector corruption
Source: Transparency International
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 50 / 56
War Frequency
Militarized disputes increase over time
number of states from 47 in 1870 to 187 in 2001
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 51 / 56
Financial Risk
Indicators of economic growth
monetary policy
recessions, interest rates, ination
scal policy
BOP, government budget policy
labor markets
unemployment, job creation
Financial indicators
yield spreads
credit default spreads (CDS)
TED spread
credit rating agencies (S&P, Moodys, Fitch)
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 52 / 56
Assessing Country Risk
Inspection visits
traveling to a country and meeting with government ocials, rm
executives, locals
Delphi technique
collecting various independent opinions, averaging and measuring the
dispersion of those opinions
Quantitative analysis
regressions using historical data to assess the sensitivity to various risk
factors
Checklist approach
weighting all political and nancial factors
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 53 / 56
Key Concepts
International diversication
International Cost of Capital
Standard vs. World CAPM
Home bias
Country Risk
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 54 / 56
Final Quote
You ought to be able to explain why youre making the investment youre
making.
And if it cant stand applying pencil to paper, youd better think it
through some more.
And if you cant write an intelligent answer to that question, dont do it.
Warren Buett
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 55 / 56
Readings
Eun, Resnick and Sabherwal (Ch. 11)
Campbell R. Harvey (2005). 12 Ways to Calculate the International
Cost of Capital
Arie E. Gozluklu (WBS) BSc Accounting and Finance Week 8 56 / 56

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