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1. Growth and development of foreign
financial markets
2. Advances in telecommunications
3. Mergers of firms and security exchanges
1. Ignoring foreign markets can substantially
reduce the investment choices for U.S.
2. The rates of return on non-U.S. securities
often have substantially exceeded those for
U.S.-only securities
3. The low correlation between U.S. stock
markets and many foreign markets can
help to substantially reduce portfolio risk

1. The share of the U.S. in world stock and
bond markets has dropped from about 65
percent of the total in 1969 to about 51
percent in 2003
2. The growing importance of foreign
securities in world capital markets is likely
to continue

elative Size of
U.S. Financial Markets

‡ Overall value of the total investable capital

market has increased from $2.3 Trillion in
1969 to $70.9 Trillion in 2003 and the U.S.
portion has declined to less than half.
‡ This trend is likely to continue

ates of return available on non-U.S.

securities often exceed U.S. Securities due
to higher growth rates in foreign countries,
especially the emerging markets
*iversification with foreign securities can
help reduce portfolio risk because foreign
markets have low correlation with U.S. capital

1. Macroeconomic differences cause the
correlation of bond returns between the
United States and foreign countries to
2. The correlation of returns between a single
pair of countries changes over time
because the factors influencing the
correlation change over time

‡ *iversified portfolios reduce variability of
returns over time
‡ Correlation coefficients measure
diversification contribution
‡ Compare correlation of return among U.S.
bonds and stocks with returns on foreign
bonds and stocks

‡ Low positive correlation
‡ Opportunities for U.S. investors to reduce
‡ Correlation changes over time
‡ Adding non-correlated foreign bonds to a
portfolio of U.S. bonds increases the rate of
return and reduces the risk of the portfolio

‡ Low positive correlation

‡ Opportunities to reduce risk of stock

portfolio by including foreign stocks

Summary on Global Investing
elatively high rates of return
combined with low correlation
coefficients indicate that adding
foreign stocks and bonds to a U.S.
portfolio will reduce risk and may
increase its average return
‡ Fixed-income investments
± bonds and preferred stocks
‡ Equity investments
‡ Special equity instruments
± warrants and options
‡ Futures contracts
‡ Investment companies
eal assets
‡ Contractual payment schedule
ecourse varies by instrument
‡ Bonds
± investors are lenders
± expect interest payment and return of
‡ Preferred stocks
± dividends require board of directors
‡ Fixed earnings
‡ Convenient
‡ Liquid
‡ Low risk
‡ Low rates
‡ Certificates of *eposit (C*s)
- instruments that require minimum deposits
for specified terms, and pay higher rates of
interest than savings accounts. Penalty
imposed for early withdrawal
‡ Compete against Treasury bills (T-bills)
‡ Minimum $10,000
‡ Minimum maturity of six months
edeemable only at bank of issue
‡ Penalty if withdrawn before maturity
  ! c 
‡ Fixed income obligations that trade in
secondary market
‡ U.S. Treasury securities
‡ U.S. Government agency securities
‡ Municipal bonds
‡ Corporate bonds
‡ Bills, notes, or bonds - depending on
± Bills mature in less than 1 year
± Notes mature in 1 - 10 years
± Bonds mature in over 10 years
‡ Highly liquid
‡ Backed by the full faith and credit of the
U.S. Government
‡ 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
!  " 
‡ Issued by state and local governments
usually to finance infrastructural projects.
‡ Exempt from taxation by the federal
government and by the state that issued the
bond, provided the investor is a resident of
that state
‡ Two types:
± General obligation bonds (GOs)
evenue bonds
‡ Issued by a corporation
‡ Fixed income
‡ Credit quality measured by ratings
‡ Maturity
‡ Features
± Indenture
± Call provision
± Sinking fund
‡ Senior secured bonds
± most senior bonds in capital structure and have
the lowest risk of default
‡ Mortgage bonds
± secured by liens on specific assets
‡ Collateral trust bonds
± secured by financial assets
‡ Equipment trust certificates
± secured by transportation equipment
‡ *ebentures
± Unsecured promises to pay interest and
± In case of default, debenture owner can force
bankruptcy and claim any unpledged assets to
pay off the bonds
‡ Subordinated bonds
± Unsecured like debentures, but holders of these
bonds may claim assets after senior secured and
debenture holders claims have been satisfied
‡ Income bonds
± Interest payment contingent upon earning
sufficient income
‡ Convertible bonds
± Offer the upside potential of common
stock and the downside protection of a
± Usually have lower interest rates
‡ Warrants
± Allows bondholder to purchase the firm¶s
common stock at a fixed price for a given time
± Interest rates usually lower on bonds with
warrants attached
‡ Zero coupon bond
± Offered at a deep discount from the face value
± No interest during the life of the bond, only the
principal payment at maturity
‡ Hybrid security
‡ Fixed dividends
‡ *ividend obligations are not legally
binding, but must be voted on by the board
of directors to be paid
‡ Most preferred stock is cumulative
‡ Credit implications of missing dividends
‡ Corporations may exclude 80% of dividend
income from taxable income
c   " c
Investors should be aware that there is a very
substantial fixed income market outside the
United States that offers additional opportunity
for diversification
c   " c
‡ Bond identification characteristics
± Country of origin
± Location of primary trading market
± Home country of the major buyers
± Currency of the security denomination
‡ Eurobond
± An international bond denominated in a
currency not native to the country where it is
c   " c
‡ Yankee bonds
± Sold in the United States and denominated is
U.S. dollars, but issued by foreign corporations
or governments
± Eliminates exchange risk to U.S. investors
‡ International domestic bonds
± Sold by issuer within its own country in that
country¶s currency
#$ c
eturns are not contractual and
may be better or worse than on
a bond
#$ c
Common Stock
epresents ownership of a firm
± Investor¶s return tied to performance of
the company and may result in loss or
   " " 
‡ Industrial: manufacturers of automobiles,
machinery, chemicals, beverages
‡ Utilities: electrical power companies, gas
suppliers, water industry
‡ Transportation: airlines, truck lines,
‡ Financial: banks, savings and loans, credit
&$    #$ 
1. Purchase of American *epository
2. Purchase of American shares
3. *irect purchase of foreign shares listed on a
U.S. or foreign stock exchange
4. Purchase of international mutual funds
&  ( 

‡ Easiest way to directly acquire foreign shares
‡ Certificates of ownership issued by a U.S. bank
that represents indirect ownership of a certain
number of shares of a specific foreign firm on
deposit in a U.S. bank in the firm¶s home country
‡ Buy and sell in U.S. dollars
‡ *ividends in U.S. dollars
‡ May represent multiple shares
‡ Listed on U.S. exchanges
‡ Very popular
‡ Issued in the United States by transfer
agent on behalf of a foreign firm
‡ Higher expenses
‡ Limited availability
‡ *irect investment in foreign equity markets-
difficult and complicated due to
administrative, information, taxation, and
market efficiency problems
‡ Purchase foreign stocks listed on a U.S.
exchange ± limited choice
‡ Global funds - invest in both U.S. and
foreign stocks
‡ International funds - invest mostly outside
the U.S.
‡ Funds can specialize
± *iversification across many countries
± Concentrate in a segment of the world
± Concentrate in a specific country
± Concentrate in types of markets
‡ Exchange-traded funds or ETFs are a recent
innovation in the world of index products
 #$ c 
‡ Equity-derivative securities have a claim on
common stock of a firm
‡ Options are rights to buy or sell at a stated
price for a period of time
‡ Warrants are options to buy from the
‡ Puts are options to sell to an investor
‡ Calls are options to buy from a stockholder
‡ Exchange of a particular asset at a specified
delivery date for a stated price paid at the
time of delivery
‡ *eposit (10% margin) is made by buyer at
contract to protect the seller
‡ Commodities trading is largely in futures
‡ Current price depends on expectations
ecent development of contracts on financial
instruments such as T-bills, Treasury bonds,
and Eurobonds
‡ Traded mostly on Chicago Mercantile
Exchange (CME) and Chicago Board of Trade
‡ Allow investors and portfolio managers to
protect against volatile interest rates
‡ Currency futures allow protection against
changes in exchange rates
ather than buy individual securities
directly from the issuer they can be acquired
indirectly through shares in an investment
‡ Investment companies sell shares in itself
and uses proceeds to buy securities
‡ Investors own part of the portfolio of
‡ Money market funds
± Acquire high-quality, short-term investments
± Yields are higher than normal bank C*s
± Typical minimum investment is $1,000
± No sales commission charges
± Withdrawal is by check with no penalty
± Investments usually are not insured
‡ Bond funds
± Invest in long-term government,
corporate, or municipal bonds
± Bond funds vary in bond quality selected
for investment
± Expected returns vary with risk of bonds
‡ Common stock funds
± Many different funds with varying stated
investment objectives
‡ Aggressive growth, income, precious metals,
international stocks
± Offer diversification to smaller investors
± Sector funds concentrate in an industry
± International funds invest outside the United
± Global funds invest in the U.S. and other
‡ Balanced funds
± Invest in a combination of stocks and
bonds depending on their stated
‡ Index Funds
± These are mutual funds created to equal
the performance of a market index like
the S&P 500
‡ Exchange-Traded Funds (ETFs)
± These are depository receipts for a portfolio of
securities deposited at a financial institution in
a unit trust that issues a certificate of ownership
for the portfolio of stocks
± The stocks in a portfolio are those in an index
like the S&P 500 and dozens of country or
industry indexes
± ETFs can be bought and sold continuously on
an exchange like common stock

 # c[ 
‡ Investment fund that invests in a variety of
real estate properties
‡ Construction and development trusts
provide builders with construction
‡ Mortgage trusts provide long-term
financing for properties
‡ Equity trusts own various income-
producing properties
 # c
‡ Purchase of a home
± Average cost of a single-family house exceeds
± Financing by mortgage requires down payment
± Homeowner hopes to sell the house for cost
plus a gain
 # c
‡ Purchase of raw land
± Intention of selling in future for a profit
± Ownership provides a negative cash flow due to
mortgage payments, taxes, and property
isk from selling for an uncertain price and low
 # c
‡ Land *evelopment
± Buy raw land
± *ivide into individual lots
± Build houses or a shopping mall on it
equires capital, time, and expertise
eturns from successful development can be
 # c
ental Property
± Acquire apartment buildings or houses with
low down payments
± *erive enough income from the rents to pay the
expenses of the structure, including the
mortgage payments, and generate a good return
ental property provides a cash flow and an
opportunity to profit from the sale of the
%'$  c
‡ Some investments don¶t trade on securities
‡ Lack of liquidity keeps many investors
‡ Auction sales create wide fluctuations in
‡ Without markets, dealers incur high
transaction costs
‡ *ealers buy at estate sales, refurbish, and
sell at a profit
‡ Serious collectors may enjoy good returns
‡ Individuals buying a few pieces to decorate
a home may have difficulty overcoming
transaction costs to ever enjoy a profit
‡ Investment requires substantial knowledge
of art and the art world
‡ Acquisition of work from a well-known
artist requires large capital commitments
and patience
‡ High transaction costs
‡ Uncertainty and illiquidity
‡ Enjoyed by many as hobby and as an
‡ Market is more fragmented than stock
market, but more liquid than art and
antiques markets
‡ Price lists are published weekly and
‡ Grading specifications aid sales
‡ Wide spread between bid and ask prices

‡ Can be illiquid
‡ Grading determines value, but is subjective
‡ Investment-grade gems require substantial
‡ No positive cash flow until sold
‡ Costs of insurance, storage, and appraisal
&  c
eilly and Wright (2004) examined the
performance of various investment alternatives
from the United States, Canada, Europe, Japan,
and the emerging markets for the period 1980-

‡ Asset
eturns and Total
± The expected relationship between annual rates
of return and total risk (standard deviation) of
these securities was confirmed

eturn and Systematic
± The systematic risk measure (beta) did a better
job of explaining the returns during the period
than did the total risk measure
± The beta risk measure that used the Brinson
index as a market proxy was somewhat better
than the beta that used the S&P 500 Index

‡ Correlations between Asset
± U.S. equities have a reasonably high correlation
with Canadian and U.K. stocks but low
correlation with emerging market stocks and
Japanese stocks
± U.S. equities show almost zero correlation with
world government bonds, except U.S. bonds
&   &$ 
‡ Market data is limited
esults vary widely, and change over time,
making generalization impossible, but
showing a reasonably consistent
relationship between risk and return
‡ Correlation coefficients vary widely,
allowing for great diversification potential
‡ Liquidity is still a concern

eturns are difficult to derive due to lack of
consistent data
esidential shows lower risk and return
than commercial real estate
‡ *uring some short time periods
EITs have
shown higher returns than stock with lower
risk measures
‡ Long term returns for real estate are lower
than stocks, and have lower risk

‡ Negative correlation between residential
and farm real estate and stocks

‡ Low positive correlation between

commercial real estate and stocks

‡ Potential for diversification

&   /
Covariance and Correlation
‡ absolute measure of the
extent to which two sets
of numbers move together
over time
  î  î
I e de ine (i - i ) as i à
and ( - ) as à
, then

‡ relative measure of a
given relationship