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Describe some of the barriers to international portfolio diversification.

Solution:

Barriers to International Diversification: - The following are the barriers to


international diversification-

(i) Segmented Markets.


(ii) Lack of Liquidity
(iii) Exchange Rate Controls
(iv) Underdeveloped Capital Market
(v) Exchange Rate Risk
(vi) Lack of information
(a) Data is not easily accessible
(b) Data is not easily comparable

Segmented markets: -

Market segmentation is a concept in economics and marketing. A market


segment is a sub-set of a market made up of people or organizations with one or
more characteristics that cause them to demand similar product and/or services
based on qualities of those products such as price or function. A true market
segment meets all of the following criteria: it is distinct from other segments
(different segments have different needs), it is homogeneous within the segment
(exhibits common needs); it responds similarly to a market stimulus, and it can
be reached by a market intervention. The term is also used when consumers with
identical product and/or service needs are divided up into groups so they can be
charged different amounts. These can broadly be viewed as 'positive' and
'negative' applications of the same idea, splitting up the market into smaller
groups.

Examples:
 Age

 Gender

 Price

 Interests

While there may be theoretically 'ideal' market segments, in reality every


organization engaged in a market will develop different ways of imagining market
segments, and create Product differentiation strategies to exploit these
segments. The market segmentation and corresponding product differentiation
strategy can give a firm a temporary commercial advantage.

Market segmenting is dividing the market into groups of individual markets with
similar wants or needs that a company divides the market into distinct groups
who have distinct needs, wants, behavior or who might want different products &
services. Broadly, markets can be divided according to a number of general
criteria, such as by industry or public versus private although industrial market
segmentation is quite different from consumer market segmentation, both have
similar objectives. All of these methods of segmentation are merely proxies for
true segments, which don't always fit into convenient demographic boundaries.

Consumer-based market segmentation can be performed on a product


specific basis, to provide a close match between specific products and
individuals. However, a number of generic market segment systems also exist,
e.g. the system provides a broad segmentation of the population of the United
States based on the statistical analysis of household and geodemographic data.

The process of segmentation is distinct from positioning (designing an


appropriate marketing mix for each segment). The overall intent is to identify
groups of similar customers and potential customers; to prioritize the groups to
address; to understand their behavior; and to respond with appropriate
marketing strategies that satisfy the different preferences of each chosen
segment. Revenues are thus improved.
Improved segmentation can lead to significantly improved marketing
effectiveness. Distinct segments can have different industry structures and thus
have higher or lower attractiveness. With the right segmentation, the right lists
can be purchased, advertising results can be improved and customer satisfaction
can be increased leading to better reputation.

Lack of liquidity:-

One of the oldest ideas in the study of entrepreneurship is that entrepreneurs


may be unable to establish a venture at an efficient scale due to liquidity-
constraints arising from capital market imperfections. This idea can be traced
back to Adam Smith, who in the Wealth of Nations stated that entrepreneurs:
"have all the knowledge, in short, that is necessary for a great merchant, which
nothing hinders him from becoming but the want of sufficient capital."

Business people and venture capitalists, on the other hand, caution that excess
liquidity can facilitate overspending or adversely affect the entrepreneur’s
motivation to perform. The idea that more liquidity can have a negative effect on
performance can be traced back to Plato, who in the Republic wrote that ”wealth
is the parent of luxury and indolence.

“Lack of liquidity in the market and absence of buyers and sellers have led
foreign funds to enter off-market block deals, mainly in first tier stocks,” says an
equity dealer at a larger brokerage house. He said that the launch of a leverage
product could help generate volumes and enable price discovery, which were
essential to attract offshore investor to the ready board. Several analysts
contend that the fast increasing off-market transactions carried an inherent risk
as those were not guaranteed by the KSE, like the normal trade on the ready
market.
Major foreign institutions and funds, which are around a dozen in number operate
through financially strong brokerages that are backed by reputed parties.
Analysts admit that ‘block deals’ though a major support to stabilize the market
that is in a bad bearish mood, was also a ‘double-edged’ sword. They observe
that in a situation where ‘crisis of confidence’ was created, the foreigner could
disappear as quickly as he had appeared, ditching the stocks in ‘block deals’ at
throw-away prices.

Such episodes were witnessed on the imposition of sanctions following the


nuclear blast in 1998 and lately on the removal of the ‘floor’ at the market,
imposed for 105 days through Sept-Dec 2008.

That danger lurks in foreigners’ control of bigger share of the ‘free-float’. And so,
theoretically, if the offshore funds were to dump large blocks of heavy-weight
stocks, it would sink all of the market. But many market participants argue that
foreign investors would act like a panic-prone herd only in case of ‘extra-ordinary
events’.

Exchange rate controls: -

Exchange controls are various forms of controls imposed by a government on the


purchase/sale of foreign currencies by residents or on the purchase/sale of local
currency by nonresidents.

Common foreign exchange controls include:

 Banning the use of foreign currency within the country

 Banning locals from possessing foreign currency

 Restricting currency exchange to government-approved exchangers

 Fixed exchange rates

 Restrictions on the amount of currency that may be imported or exported


Countries with foreign exchange controls are also known as "Article 14
countries," after the provision in the International Monetary Fund agreement
allowing exchange controls for transitional economies. Such controls used to be
common in most countries, particularly poorer ones, until the 1990s when free
trade and globalization started a trend towards economic liberalization. Today,
countries which still impose exchange controls are the exception rather than the
rule.

The exchange rate is what is used to convert one monetary unit to another.
Because of the many different currencies in circulation, having an exchange rate
among them is necessary. However, each country fixes its own exchange rate
value, and sometimes some countries fix their exchange rate value above the
market rate of their currency. In addition, they may also impose restrictions on
exchange rate transactions. The most commonly employed exchange rate
restriction is that individuals be required to obtain prior approval from the
government before engaging in transactions involving foreign currency. Yet,
when countries set high exchange rate controls, they can negatively impact both
their countries and other countries. In fact, they usually do.

First of all, at the high exchange rate, the country's goods will be extremely
expensive to foreigners so because of the expensive price, it will sell fewer goods
overseas, meaning that its exports will drop. Foreigners will purchase the goods
elsewhere for a cheaper price so the country with the high exchange rate will
have fewer exports and, consequently, less income flowing into the country. As a
result of this, the low level of exports, it will become much more difficult for the
country's domestic residents and citizens to produce the foreign currency needed
to purchase imports. Therefore, exports and imports will both suffer, affecting not
only the one country's economy but other countries' economies too.
Moreover, not only do exchange rate controls affect exports and imports, they
reduce trade and lead to black market currency exchanges. By stunting free
trade, it reduces the ability of countries to specialize in those goods that they can
produce at the lowest opportunity cost and then trade to other countries. This, in
turn, causes goods to become less affordable due to the inflated prices. And all of
this will lead to black market exchanges. In fact, a large black market premium is
a prime indicator that a country's exchange rate policy is set too high.

Underdeveloped capital markets:-

The growth and liberalization of financial markets in industrial countries over the
past three decades provides developing countries unprecedented access to
international capital markets, and exposes them to sometimes dramatic and
sudden swings in capital flows. The 1990s witnessed a number of economic crises
in developing countries that were accompanied by (if not precipitated by)
outflows of international capital. This recent experience with capital flow
reversals can, at least in part, explain the desire by developing countries to
decrease their dependence on international capital by accumulating foreign
reserves.

While financial markets in industrial countries have deepened and broadened,


financial markets in many developing countries remain incomplete. This paper
focuses on the implications for developing countries of underdeveloped capital
markets.

The analysis considers the role of financial market underdevelopment in


motivating reserve accumulation by developing countries, while also allowing for
the more traditional mercantilist and precautionary motives. In theory there can
be a strict distinction between the precautionary motive, which seeks to smooth
consumption fluctuations, and the underdeveloped financial markets motive,
which seeks to offset a tightening of a financial constraint. However, in practice,
these two motivations for reserve accumulation may be difficult to disentangle. In
particular, the desire to smooth inter temporal consumption is likely to be
influenced by financial market constraints.

Official foreign exchange reserve holdings by developing countries greatly


exceed those of industrial countries (in the case of China, in absolute terms, and
in most other cases relative to the sizes of their economies). This is yet another
example of the capital flows paradox described by Lucas (1990). Capital should
flow to where its return is highest, which ought to be where capital is scare. If
instead capital flows from the capital-poor developing world to the capital-rich
industrialized world, the explanation is likely to be found in distortions not
entertained in standard models.

Lack of information: -

Knowledge is power. This is well known fact and knowledge comes from
information. Information can be derived from the collection of data. But in most
of the cases where portfolio diversification is not taking place, there is lack of
information, i.e. either data is not easily accessible or not available. In such case
this becomes a barrier for the diversification of portfolio.

Common Language: -

Another obstacle that impedes investment in foreign securities is the absence of


a common language that supplies desired information about potential customers,
suppliers or partners from foreign lands. Further, adequate and comparable
information on securities is not readily available resulting in significant increase
in the perceived riskiness of foreign securities, giving investors an added reason
to invest funds at home. It is even possible that some investors may not be fully
aware of the potential gains from international investments. Possibility of
inaccuracy and inadequate transparency in financial and accounting statements
in companies of foreign countries is galore because of cross-cultural differences,
substantial differences in national accounting disclosure practices and unrealistic
conventions in developing countries. All these inhibit investors to put their money
in foreign securities.

Exchange rate risk: -

Exchange rate risk is simply the risk to which investors are exposed because
changes in exchange rates may have an effect on investments that they have
made. The most obvious exchange rate risks are those that result from buying
foreign currency denominated investments. The commonest of these are
shares listed in another country or foreign currency bonds.

Investors in companies that have operations in another country, or that export,


are also exposed to exchange rate risk. A company with operations abroad will
find the value in domestic currency of its overseas profits changes with
exchange rates.

Similarly an exporter is likely to find that an appreciation in its domestic


currency will mean that either sales fall (because its prices rise in terms of its
customers currency) or that its gross margin shrinks, or both. A depreciation of
its domestic currency would have the opposite effect.

However the two risks can often hedge each other. Suppose an investor in the
US buys shares in a British company. There will be a risk that the value of the
investment in dollar terms may decline if the pound falls against the dollar.

Example: -

Now suppose that a British company makes a substantial proportion of its sales
in the US and most of the rest of its sales are dollar denominated exports. This
situation is not uncommon in sectors like pharmaceuticals or IT, or any which
sell into truly global product markets.
In these circumstances a fall in the value of sterling is likely to reduce the value
of the shares of the British company in dollar terms, for a given share price in
sterling terms. However if the pound depreciates, the share price is likely to
rise as the value in pounds of its dollar denominated sales rises.

The end result is that the two types of exchange rate risk neatly hedge each
other.

This type of offsetting of risks can also be important when dealing with
investments in emerging markets (especially small emerging markets) that
often combine a volatile currency with high dependence on imports and
exports. Small economies tend to be particularly open to the global economy
because an economy that lacks technology must import many things or do
without, and because an economy that produces a small range of goods or
service in quantities that far exceed domestic demand (at reasonable prices),
must depend on exporting them.

Measuring and managing exchange rate risk exposure is important for reducing
a firm’s vulnerabilities from major exchange rate movements, which could
adversely affect profit margins and the value of assets.

Exchange rate risk management is an integral part of every firm’s decisions


about foreign currency exposure. Currency risk hedging strategies entail
eliminating or reducing this risk, and require understanding of both the ways
that the exchange rate risk could affect the operations of economic agents and
techniques to deal with the consequent risk implications. Selecting the
appropriate hedging strategy is often a daunting task due to the complexities
involved in measuring accurately current risk exposure and deciding on the
appropriate degree of risk exposure that ought to be covered. The need for
currency risk management started to arise after the breakdown of the Bretton
Woods system and the end of the US dollar peg to gold in 1973.