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International Investments

Bruno Solnik
H.E.C. SCHOOL of MANAGEMENT

Dennis McLeavey
ASSOCIATION for INVESTMENT MANAGEMENT and RESEARCH

PEARSON
Addison
Wesley

Boston San Francisco New York

London Toronto Sydney Tokyo Singapore Madrid
Mexico City Munich Paris Cape Town Hong Kong Montreal
Contents

Chapter 1 Foreign Exchange 1

Learning Outcomes 1
Foreign Exchange Quotations 3
Basic Principles and the Forex Quotation Convention 3
More on Quotation Conventions 4
Bid-Ask (Offer) Quotes and Spreads 5
Arbitrage 7
Cross-Rate Calculations with Bid-Ask Spreads 7
Bilateral Arbitrage 10
Triangular Arbitrage 12
Forward Quotes 14
Interest Rate Parity: The Forward Discount and the Interest Rate Differential 16
Summary 21
Problems 23
Solutions 25

Chapter 2 Foreign Exchange Parity Relations 31

Learning Outcomes 31
Foreign Exchange Fundamentals 33
Supply and Demand for Foreign Exchange 33
Balance of Payments 34
Current Account Deficits and Financial Account Surpluses 35
Factors That Cause a Nation's Currency to Appreciate or Depreciate 38
Government Policies: Monetary and Fiscal 40
Exchange Rate Regimes 42
International Parity Relations 44
Some Definitions 44
Interest Rate Parity 45
Purchasing Power Parity: The Exchange Rate and the Inflation Differential 46
International Fisher Relation: The Interest Rate and Expected Inflation Rate Differentials 48
Uncovered Interest Rate Parity 50
Foreign Exchange Expectations: The Forward Premium (Discount) and the Expected
Exchange Rate Movement 52
Combining the Relations 53
International Parity Relations and Global Asset Management 55

XII
 Contents xiii

Exchange Rate Determination 56

Purchasing Power Parity Revisited 56
Fundamental Value Based on Absolute PPP 59
Fundamental Value Based on Relative PPP 59
The Balance ofPayments Approach 62
The Asset Market Approach 70
Summary 77
Problems 79
Solutions 83
Bibliography 89

Chapter 3 Foreign Exchange Determination

and Forecasting 91
Learning Outcomes 91
International Monetary Arrangements 92
A Historical Perspective 92
The Empirical Evidence 100
Interest Rate Parity 100
International Fisher Relation 100
Purchasing Power Parity 101
Foreign Exchange Expectations 105
Practical Implications 106
Exchange Rate Forecasting 107
Is the Market Efficient and Rational ? 108
The Econometric Approach 111
Technical Analysis 112
Central Bank Intervention 114
The Use and Performance ofForecasts 115
Summary 119
Problems 119
Solutions 122
Bibliography 127

Chapter 3 Appendix: Statistical Supplements on

Forecasting and Asset Returns 130
Some Notations 130
Traditional Statistical Models with Constant Moments 131
Traditional Statistical Models with Time-Varying Moments 132
Nontraditional Models 134
Data Mining, Data Snooping, and Model Mining 136
 i

xiv Contents

Chapter 4 International Asset Pricing 139

Learning Outcomes 139
International Market Efficiency 140
Asset-Pricing Theory 143
The Domestic Capital Asset-Pricing Model 143
Asset Returns and Exchange Rate Movements 146
The Domestic CAPM Extended to the International Context 147
International CAPM 150
Market Imperfections and Segmentation 157
Practical Implications 158
A Global Approach to Equilibrium Pricing 158
Estimating Currency Exposures 161
Tests of the ICAPM 169
Summary 171
Problems 173
Solutions 177
Bibliography 181

Chapter 5 Equity: Markets and Instruments 185

Learning Outcomes 185
Market Differences: A Historical Perspective 186
Historical Differences in Market Organization 187
Historical Differences in Trading Procedures 188
Automation on the Major Stock Exchanges 189
Some Statistics 195
Market Size 195
Liquidity 197
Concentration 198
Some Practical Aspects 199
Tax Aspects 199
Stock Market Indexes 202
Information 205
Execution Costs 206
Components ofExecution Costs 206
Estimation and Uses ofExecution Costs 208
Some Approaches to Reducing Execution Costs 211
Investing in Foreign Shares Listed at Home 214
Global Shares and American Depositary Receipts 214
Closed-End Country Funds 211
Open-End Funds 221
Exchange Traded Funds 222
 Contents xv

Summary 225
Problems 226
Solutions 230
Bibliography 234

Chapter 6 Equity: Concepts and Techniques 237

Learning Outcomes 237
Approaching International Analysis 238
The Information Problem 240
A Vision of the World 241
Differences in National Accounting Standards 242
Historical Setting 243
International Harmonization of Accounting Practices 244
Differences in Global Standards 247
The Effects of Accounting Principles on Earnings and Stock Prices 254
The Information Content of International Differences in GAAP 255
Global Industry Analysis 256
Country Analysis 256
Industry Analysis: Return Expectation Elements 262
Industry Analysis: Risk Elements 268
Global Industry Analysis in Practice: An Example 273
Equity Analysis 277
Global Risk Factors in Security Returns 292
Risk-Factor Model: Industry and Country Factors 292
Other Risk Factors: Styles 293
Other Risk Factors: Macroeconomic 294
Practical Use of Factor Models 296
Summary 296
Problems 297
Solutions 302
Bibliography 309

Chapter 7 Global Bond Investing 311

Learning Outcomes 311
The Global Bond Market 312
The Various Segments 312
World Market Size 314
Bond Indexes 315
The Eurobond Market 316
Emerging Markets and Brady Bonds 320
xvi Contents

Major Differences Among Bond Markets 323

Types of Instruments 323
Quotations, Day Count, and Frequency of Coupons 324
Legal and Fiscal Aspects 326
A Refresher on Bond Valuation 327
Zero-Coupon Bonds 328
Bond with Coupons 330
Duration and Interest Rate Sensitivity 332
Credit Spreads 334
Multicurrency Approach 335
International Yield Curve Comparisons 335
The Return and Risk on Foreign Bond Investments 338
Currency-Hedging Strategies 339
International Portfolio Strategies 340
Floating-Rate Notes and Structured Notes 344
Floating-Rate Notes (FRNs) 345
BullFRN 351
BearFRN 352
Dual-Currency Bonds 353
Currency-Option Bonds 356
Summary 359
Problems 361
Solutions 365
Bibliography 370

Chapter 8 Alternative Investments 371

Learning Outcomes 371
Investment Companies 373
Valuing Investment Company Shares 373
Fund Management Fees 3 74
Investment Strategies 374
Exchange Traded Funds 377
Real Estate 386
Forms of Real Estate Investment 387
Valuation Approaches 388
Real Estate in a Portfolio Context 396
* Private Equity: Venture Capital 398
Stages of Venture Capital Investing 400
Investment Characteristics 401
Types of Liquidation/Divestment 403
Valuation and Performance Measurement 404
Hedge Funds and Absolute Return Strategies 406
 Contents xvii

Definition 409
Classification 410
Funds ofFunds 414
Leverage and Unique Risks of Hedge Funds 416
The Case for Hedge Funds 417
Caveats 421
Closely Held Companies and Inactively Traded Securities 424
Legal Environment 424
Valuation Alternatives 424
Bases for Discounts/Premiums 425
Distressed Securities/Bankruptcies 425
Commodity Markets and Commodity Derivatives 426
Commodity Futures 428
Motivation and Investment Vehicles 428
Active Investment 429
The Example of Gold 430
Commodity-Linked Securities 432
Summary 433
Problems 436
Solutions 441
Bibliography 447

Chapter 9 The Case for International Diversification 451

Learning Outcomes 451
The Traditional Case for International Diversification 454
Risk Reduction Through Attractive Correlations 454
Portfolio Return Performance 464
Currency Risk Not a Barrier to International Investment 4 71
The Case Against International Diversification 472
Increase in Correlations 4 73
Past Performance Is a Good Indicator of Future Performance 4 76
Barriers to International Investments 477
The Case for International Diversification Revisited 481
Pitfalls in Estimating Correlation During Volatile Periods 481
Expanded Investment Universe and Performance Opportunities 483
Global Investing Rather Than International Diversification 483
The Case for Emerging Markets 486
The Basic Case 486
Volatility, Correlations, and Currency Risk 488
Portfolio Return Performance 489
Investability ofEmerging Markets 490
Segmentation versus Integration Issue 491
xviii Contents

Summary 491
Problems 493
Solutions 496
Bibliography 505

Chapter 10 Derivatives 507

Learning Outcomes 507
Forward and Futures 508
The Principles of a Forward and a Futures Contract 508
The Different Instruments 511
Forward and Futures Valuation 517
Use ofForward and Futures 522
Swaps 528
The Principles of a Swap 528
The Different Instruments 529
Swaps Valuation 533
Use of Swaps 537
Options 542
Introduction to Options 542
The Different Instruments 543
Option Valuation 546
Use of Options 549
Summary 555
Problems 556
Solutions 562
Bibliography 570

Chapter 11 Currency Risk Management 571

Learning Outcomes 571
Hedging with Futures or Forward Currency Contracts 573
The Basic Approach: Hedging the Principal 5 73
Minimum-Variance Hedge Ratio 576
Optimal Hedge Ratio 580
Hedging Strategies 582
Hedging Multiple Currencies 582
Insuring and Hedging with Options 584
Insuring with Options 584
Dynamic Hedging with Options 587
Hedging Strategies 589
Other Methods for Managing Currency Exposure 590
Currency Overlay 592
Summary 595
 Contents xix

Problems 597
Solutions 602
Bibliography 613

Chapter 12 Global Performance Evaluation 615

Learning Outcomes 615
The Basics 616
Principles and Objectives 616
Calculating a Rate of Return 619
Performance Attribution in Global Performance Evaluation 626
The Mathematics of Multicurrency Returns 627
Total Return Decomposition 629
Performance Attribution 631
An Example of Output 634
More on Currency Management 636
From Quarterly to Multi-Year Performance 637
Performance Appraisal in Global Performance Evaluation 637
Risk 638
Risk-Adjusted Performance 639
Risk Allocation and Budgeting 642
Some Potential Biases in Return and Risk 644
Implementation 645
More on Global Benchmarks 646
Global Investment Performance Standards and Other Performance Presentation
Standards 648
Summary 650
Problems 651
Solutions 659
Bibliography 674

Chapter 13 Structuring the Global

Investment Process 677
Learning Outcomes 677
A Tour of the Global Investment Industry 679
Investors 679
Investment Managers 684
Brokers 685
Consultants and Advisers 686
Custodians 687
Global Investment Philosophies 688
The Passive Approach 688
The Active Approach 689
xx Contents

Balanced or Specialized 691

Industry or Country Approach 692
Top-Down or Bottom-Up 692
Style Management 693
Currency 694
Quantitative or Subjective 695
The Investment Policy Statement 695
Capital Market Expectations 698
Defining Asset Classes 698
Long-Term Capital Market Expectations: Historical Returns 699
Long-Term Capital Market Expectations: Forward-Looking Returns 701
Short-Term Capital Market Expectations 705
Global Asset Allocation: From Strategic to Tactical 706
Strategic Asset Allocation 706
Tactical Asset Allocation 711
Global Asset Allocation: Structuring and Quantifying the Process 712
Research and Market Analysis 713
Asset Allocation Optimization 715
Portfolio Construction 717
Performance and Risk Control 718
Summary 719
J o h n Bouderi: Case Study A 720
Leigh Brennan: Solution A 730
John Bouderi: Case Study B 731
Leigh Brennan: Solution B 735
Bibliography 736

Glossary 738
Index 751