Interest Rate Swaps and Currency Swaps

In international finance, monetary exchanges are a constant event. Interest rate and currency swaps are two forms of exchanging cash flow. Interest rate swaps occur when money is exchanged over a contract that has fixed obligations within the same currency. Currency swaps have the same contractual obligations, however, they occur when money is exchanged across the different currencies.

Consider when it would be best for a company to use both types of financial swaps. With these thoughts in mind, address the following:

Evaluate how businesses and investors use an interest rate swap or a currency swap as a hedging strategy.
In your opinion, when should a business or investor use an interest rate swap and a currency swap? Support your response with this week’s Learning Resources.

By Day 4

Reada brief statement.

Read a selection of your colleagues’ postings.

Interest Rate and Currency Swaps

Chapter Fourteen

CHAPTER 14 covers interest rate and currency swaps, useful tools for hedging long-term interest rate and currency risk.

Chapter Outline

Types of Swaps

Size of the Swap Market

The Swap Bank

Swap Market Quotations

Interest Rate Swaps

Currency Swaps

Variations of Basic Interest Rate and Currency Swaps

Risks of Interest Rate and Currency Swaps

Is the Swap Market Efficient?

14-2

Types of Swaps

In interest rate swap financing, two parties, called counterparties, make a contractual agreement to exchange cash flows at periodic intervals

Two types of interest rate swaps:

Single-currency interest rate swaps (i.e., interest rate swaps) involve swapping interest payments on debt obligations that are denominated in the same currency

In a cross-currency interest rate swap (i.e., currency swap), one counterparty exchanges the debt service obligations of a bond denominated in one currency for the debt service obligations of the other counterparty that are denominated in another currency

14-3

Size of the Swap Market

Market for currency swaps developed first, but the interest rate swap market is larger, where size is measured by notional principal

In 2018, the notational principal was as follows:

Interest rate swaps at $326,690 billion USD

Currency swaps at $24,858 billion USD

The five most common currencies used to denominate interest rate and currency swaps were the following:

U.S. dollar, euro, Japanese yen, the British pound sterling, and the Canadian dollar

14-4

EXHIBIT 14.1
Size of OTC Interest Rate and Currency Swap Markets: Total Notional Principal Outstanding Amounts in Billions of U.S.D.

14-5

The Swap Bank

Swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties

Can be international commercial bank, investment bank, merchant bank, or independent operator

Serves as either a swap broker or swap dealer

As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap

As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay it off, or match it with a counterparty

14-6

Swap Market Quotations

Swap banks will tailor the terms of interest rate and currency swaps to customers’ needs.

They also make a market in “plain vanilla” swaps and provide quotes for these and provide current market quotations applicable to counterparties with Aa or Aaa credit ratings

14-7

Swap Market Quotations (Continued)

It is convention for swap banks to quote interest rate swap rates for a currency against a local standard reference in the same currency and currency swap rates against dollar LIBOR

For example, for a five-year swap with semiannual payments in Swiss francs, suppose the bid-ask swap quotation is 6.60–6.70 percent against six-month LIBOR flat

This means the swap bank will pay semiannual fixed-rate SFr payments at 6.60 percent against receiving six-month SFr (dollar) LIBOR in an interest rate (a currency) swap, or it will receive semiannual fixed-rate SFr payments at 6.70 percent against paying six-month SFr (dollar) LIBOR in an interest rate (a currency) swap

14-8

Basic Interest Rate Swap: Bank A

Consider the following example of a fixed-for-floating rate swap:

Bank A is a AAA-rated international bank located in the United Kingdom. The bank needs $10,000,000 to finance floating-rate Eurodollar term loans to its clients.

It is considering issuing five-year floating-rate notes indexed to LIBOR. Alternatively, the bank could issue five-year fixed-rate Eurodollar bonds at 10 percent.

The FRNs make the most sense for Bank A.

In this manner, the bank avoids the interest rate risk associated with a fixed-rate issue.

Without this hedge, Bank A could end up paying a higher rate than it is receiving on its loans should LIBOR fall substantially.

14-9

Basic Interest Rate Swap: Company B

Consider the following example of a fixed-for-floating rate swap:

Company B is a BBB-rated U.S. company. It needs $10,000,000 to finance a capital expenditure with a five-year economic life.

It can issue five-year fixed-rate bonds at a rate of 11.25 percent in the U.S. bond market. Alternatively, it can issue five-year FRNs at LIBOR plus 0.50%.

The fixed-rate debt makes the most sense for Company B because it locks in a financing cost.

The FRN alternative could prove very unwise should LIBOR increase substantially over the life of the note, and could possibly result in the project being unprofitable.

14-10

Basic Interest Rate Swap

A swap bank familiar can set up a fixed-for-floating interest rate swap that will benefit each counterparty and the swap bank

Assume that the swap bank is quoting five-year U.S. dollar interest rate swaps at 10.375 – 10.50 percent against LIBOR flat

Necessary condition is a positive quality spread differential (QSD)

If a positive QSD exists, it is possible for each counterparty to issue the debt alternative that is least advantageous for it (given its financing needs), then swap interest payments, such that each counterparty ends up with the type of interest payment desired, but at a lower all-in cost than it could arrange on its own

14-11

14-12

EXHIBIT 14.3
Calculation of Quality Spread Differential

A QSD is the difference between the default-risk premium differential on the fixed-rate debt and the default-risk premium differential on the floating-rate debt. Typically, the former is greater than the latter.

14-13

EXHIBIT 14.4
Fixed-for-Floating Interest Rate Swap

Exhibit 14.4 diagrams a possible scenario the swap bank could arrange for the two counterparties.

Basic Currency Swap

Consider the following example:

A U.S. MNC desires to finance a capital expenditure of its German subsidiary. The project has an economic life of five years, and the cost of the project is €40,000,000. At the current exchange rate of $1.30/€1.00, the parent firm could raise $52,000,000 in the U.S. capital market by issuing 5-year bonds at 8%. The parent would then convert the dollars to euros to pay the project cost. The German subsidiary would be expected to earn enough on the project to meet the annual dollar debt service and to repay the principal in five years. The only problem with this situation is that a long-term transaction exposure is created. If the dollar appreciates against the euro over the loan period, it may be difficult for the German subsidiary to earn enough in euros to service the dollar loan.

14-14

Basic Currency Swap (Continued)

An alternative is for the U.S. parent to raise €40,000,000 in the international bond market by issuing euro-denominated Eurobonds.

The U.S. parent might instead issue euro-denominated foreign bonds in the German capital market.

However, if the U.S. MNC is not well known, it will have difficulty borrowing at a favorable interest rate.

Suppose the U.S. parent can borrow €40,000,000 for a term of five years at a fixed rate of 7%. The current normal borrowing rate for a well-known firm of equivalent creditworthiness is 6%

14-15

Basic Currency Swap (Concluded)

Assume a German MNC of equivalent creditworthiness has a mirror-image financing need.

It has a U.S. subsidiary in need of $52,000,000 to finance a capital expenditure with an economic life of five years.

The German parent could raise €40,000,000 in the German bond market at a fixed rate of 6% and convert the funds to dollars to finance the expenditure.

Transaction exposure is created, however, if the euro appreciates substantially against the dollar. In this event, the U.S. subsidiary might have difficulty earning enough in dollars to meet the debt service. The German parent could issue Eurodollar bonds (or alternatively, Yankee bonds in the U.S. capital market), but since it is not well known its borrowing cost would be, say, a fixed rate of 9 percent.

14-16

Basic Currency Swap Solution

A swap bank could arrange a currency swap that would solve the double problem of each MNC, that is, be confronted with long-term transaction exposure or borrow at a disadvantageous rate.

The swap bank would instruct each parent firm to raise funds in its national capital market where it is well known and has a comparative advantage

14-17

In order not to complicate this example any more than is necessary, it is assumed that the bid and ask swap rates charged by the swap bank are the same; that is, there is no bid-ask spread. This assumption is relaxed in a later example.

14-18

EXHIBIT 14.5
Interest Savings from Comparative Advantage

14-19

EXHIBIT 14.6
$/€ Currency Swap

There is a combined total of 2 percent that can be saved or earned through the currency swap, 1 percent on the dollar notional amount, and 1 percent on the equivalent euro notional value.

There is a cost savings for each counterparty because of their relative comparative advantage in their respective national capital markets.

Variations of Basic Interest Rate and Currency Swaps

Several variants of the basic interest rate and currency swaps are listed below:

Fixed-for-floating interest rate swap

Zero-coupon-for-floating rate swap

Floating-for-floating interest rate swap

Amortizing currency swaps

14-20

Risks of Interest Rate and Currency Swaps

Major risks faced by a swap dealer:

Interest-rate risk refers to the risk of interest rates changing unfavorably before the swap bank can lay off on an opposing counterparty the other side of an interest rate swap entered into with a counterparty

Basis risk refers to a situation in which the floating rates of the two counterparties are not pegged to the same index

Exchange-rate risk refers to the risk the swap bank faces from fluctuating exchange rates during the time it takes for the bank to lay off a swap it undertakes with one counterparty with an opposing counterparty

14-21

Risks of Interest Rate and Currency Swaps (Continued)

Major risks faced by a swap dealer:

Credit risk refers to the probability that a counterparty, or even the swap bank, will default

Mismatch risk refers to the difficulty of finding an exact opposite match for a swap the bank has agreed to take

Sovereign risk refers to the probability that a country will impose exchange restrictions on a currency involved in a swap

14-22

Is the Swap Market Efficient?

Two primary reasons for a counterparty to use a currency swap:

Obtain debt financing in the swapped currency at an interest cost reduction (brought about through comparative advantages each counterparty has in its national capital market)

Benefit of hedging long-run exchange rate exposure

Two primary reasons for swapping interest rates:

Better match maturities of assets and liabilities

Obtain a cost savings (via a positive quality spread differential)

14-23

If the positive QSD is one of the primary reasons for the existence of interest rate swaps, one would expect arbitrage to eliminate it over time and that the growth of the swap market would decrease. Quite the contrary has happened. Thus, the arbitrage argument does not seem to have much merit.

Is the Swap Market Efficient? (Continued)

One must rely on an argument of market completeness for the existence and growth of interest rate swaps

All types of debt instruments are not regularly available for all borrowers

Interest rate swap market assists in tailoring financing to the type desired by a particular borrower

Both counterparties can benefit (as well as the swap dealer) through financing that is more suitable for their asset maturity structures

14-24

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Futures and Options on Foreign Exchange

Chapter 7

Chapter Outline

Futures Contracts: Some Preliminaries

Currency Futures Markets

Basic Currency Futures Relationships

Options Contracts: Some Preliminaries

Currency Options Markets

Currency Futures Options

Basic Option-Pricing Relationships at Expiration

American Option-Pricing Relationships

European Option-Pricing Relationships

Binomial Option-Pricing Model

European Option-Pricing Model

Empirical Tests of Currency Options

Summary

7-2

BIG chapter

Futures Contracts: Preliminaries

Both forward and futures contracts are derivative or contingent claim securities because their values are derived from or contingent upon the value of the underlying security

Forward contract

Tailor-made for a client by their international bank

Futures contract

Standardized features (e.g., contract size, maturity date, delivery months)

Exchange traded

7-3

Futures Contracts: Preliminaries (Continued)

An initial performance bond (formerly called margin) must be deposited into a collateral account to establish a futures position

Generally equal to 2% of contract value

Cash or T-bills may be used to meet requirement

Major difference between forward contract and futures contract is the way the underlying asset is priced for future purchase or sale

Forward contract states a price for the future transaction, but futures contract is settled-up, or marked-to-market, daily at the settlement price

7-4

The settlement price is a price representative of futures transaction prices at the close of daily trading on the exchange. It is determined by a settlement committee for the commodity, and it may be somewhat arbitrary if trading volume for the contract has been light for the day.

Differences between Futures and Forward Contract

7-5

Currency Futures Markets

Trading in currency futures began at the Chicago Mercantile Exchange (CME) on May 16, 1972

2 million contracts traded in 1978

230 million contracts traded in 2018

CME Group formed in 2007, through a merger between the CME and Chicago Board of Trade (CBOT)

In 2008, CME Group acquired the New York Mercantile Exchange (NYMEX)

7-6

Currency Futures Markets (Continued)

Most CME currency futures trade in a March, June, September, and December expiration cycle out six quarters into the future, with the delivery date being the third Wednesday of the expiration month

Last day of trading for most contracts is the second business day prior to the delivery date

Trading takes place Sunday through Friday on the GLOBEX trading system from 5:00 PM to 4:00 PM Chicago time the next day

Currency futures trading takes place on other exchanges, in addition to the CME

7-7

Basic Currency Futures Relationships

Information provided on quotes for CME futures contracts includes the following:

Opening price, high and low quotes for the trading day, settlement price, and open interest

Open interest is the total number of short or long contracts outstanding for the particular delivery month

Futures are prices very similarly to forward contracts

Recall from chapter 6, the IRP model states the forward price for delivery at time T is:

7-8

We will use the same equation to define the futures price.

Option Contracts: Some Preliminaries

An option is a contract giving the owner the right, but now the obligation, to buy or sell a given quantity of an asset at a specified price at some time in future

Option to buy is a call, and option to sell is a put

Buying or selling the underlying asset via the option is know as “exercising” the option

Stated price paid or received is known as the exercise or striking price

Buyer of an option is often referred to as the long, and the seller of an option is referred to as the writer (or the short)

European option can be exercised only at maturity or expiration date of contract, but American option can be exercised any time during contract

7-9

Four main positions are as follows: call writer, call buyer, put writer, and put buyer

Currency Option Markets

Prior to 1982, all currency option contracts were OTC options written by international banks, investment banks, and brokerage houses

OTC options are tailor-made and generally for large amounts (i.e., at least $1m of currency serving as underlying assets)

OTC options are typically European style, and they are often written for U.S. dollars, with the euro, British pound, Japanese yen, Canadian dollar, and Swiss franc serving as the underlying currency

In December 1982, Philadelphia Stock Exchange (PHLX) began trading options on foreign currency

In 2008, PHLX was acquired by NASDAQ OMX Group

7-10

The volume of OTC currency options trading is much larger than that of organized-exchange option trading.

Currency Futures Options

CME Group trades European style options on several of the currency futures contracts it offers

With these, the underlying asset is a futures contract on the foreign currency instead of the physical currency

One futures contract underlies one options contract

Most CME futures options trade with expirations in the March, June, September, December expiration cycle of the underlying futures contract and three serial noncycle months

Options expire on the second business day prior to the third Wednesday of the options contract month

Trading takes place Sunday through Friday on the GLOBEX system from 5:00 PM to 4:00 PM Chicago time the next day

7-11

Options on currency futures behave very similarly to options on the physical currency since the futures price converges to the spot price as the futures contract nears maturity.

Basic Option-Pricing Relationships at Expiration

At expiration, a European option and an American option (which has not been previously exercised), both with the same exercise price, will have the same terminal value

For call options the time T expiration value per unit of foreign currency is stated as the following:

7-12

Equation definitions

CaT denotes the value of the American call at expiration

CeT is the value of the European call at expiration

E is the exercise price per unit of foreign currency

ST is the expiration date spot price

Max is an abbreviation for denoting the maximum of the arguments within the brackets

Basic Option-Pricing Relationships at Expiration (Continued)

Call (put) option with ST > E (E > ST) expires in-the-money

It will be exercised because the buyer will make money

If ST = E, the option expires at-the-money

It will not be exercised because no money will be made by doing so

If ST < E (E < ST), the call (put) option expires out-of-the-money

It will not be exercised because the buyer would lose money by doing so and is under no obligation to exercise the option

7-13

American Option-Pricing Relationships

American options will satisfy the following basic pricing relationships at time t prior to expiration:

The above equations state that the American call and put premiums at time t will be at least as large as the immediate exercise value, or the intrinsic value, of the call or put option

Longer-term American option will have a market price at least as large as the short-term option

7-14

American Option-Pricing Relationships (Continued)

Call (put) option with ST > E (E > ST) is trading in-the-money

If ST ≅ E, the option is trading in-the-money

If ST < E (E < ST), the call (put) option is trading out-of-the-money

Difference between the option premium and the option’s intrinsic value is nonnegative and is sometimes referred to as the option’s time value

7-15

Market Value, Time Value, and Intrinsic Value of an American Call Option

7-16

European Option-Pricing Relationships

Pricing boundaries for European put and call premiums are more complex

Consider two portfolios:

Portfolio A involves purchasing a European call option and lending (or investing) an amount equal to the present value of the exercise price, E, at the U.S. interest rate, i$, which we assume corresponds to the length of the investment period

Cost of this investment is as follows: Ce + E / (1 + i$)

If ST ≤ E, call owner will let call option expire worthless

If ST > E, call owner will exercise the call, and exercise value will be ST – E > 0

Portfolio B consists of lending the present value of one unit of foreign currency, f, at the foreign interest rate, if, which we assume corresponds to the length of the investment period

Cost of this investment is St /(1 + if)

7-17

Equation for a European Call Option Lower Boundary

7-18

European Option-Pricing Relationships (Continued)

In a rational marketplace, portfolio A will be priced to sell for at least as much as portfolio B, implying the following:

Similarly, it can be shown the lower boundary pricing relationship for a European put is:

7-19

European Option-Pricing Relationships (Concluded)

Based on the two equations from the preceding slide, it can be determined that, when all else remains the same, the call premium, Ce (put premium, Pe) will increase:

The larger (smaller) is the exchange rate, St

The smaller (larger) is the exercise price, E

The smaller (larger) is the foreign interest rate, if

The larger (smaller) is the dollar interest rate, i$

The larger (smaller) i$ is relative to if

7-20

European Call and Put Prices on Spot Foreign Exchange

Equations 7.6 and 7.7 (see slide 19) may be restated as the following:

7-21

European Option-Pricing Valuation: Example 7.5

7-22

Binomial Option-Pricing Model

Binomial option-pricing model provides an exact pricing formula for a European call or put

In this case, binomial model assumes that at the end of the option period, the underlying foreign exchange has either appreciated one step upward or depreciated one step downward from its initial value

Objective is to value the PHLX 112 Sep EUR European call

Option is quoted at a premium of 3.78 cents

Current spot price of the EUR in American terms is S0 = 113.14 cents

Estimate of the option’s volatility is σ = 6.18 percent

Last day of trading in the call option is in 179 days on 9/20/19

At the end of the option period, the EUR will have appreciated to SuT = S0 ⋅ u or depreciated to SdT = S0 ⋅ d

7-23

PHLX World Currency Options Quotations

7-24

Binomial Option-Pricing Model (Continued)

Binomial option-pricing model relies on the risk-neutral probabilities of the underlying asset increasing and decreasing in value

Risk-neutral probability of the EUR appreciating is:

q = (FT − S0 ⋅ d) / S0(u − d)

Use September EUR futures price on 3/25/19 as estimate of FT($/EUR) = $1.1487

Therefore, q = (114.87 – 108.35) / (118.14 – 108.35) = 0.666

Binomial call option premium is determined by:

C0 = [qCuT + (1 − q)CdT] / (1 + i$)

= [.666(6.14) +.334(0)] / (1.0133 )

= 4.04 cents per EUR

7-25

FT is the forward (or futures) price that spans the option period.

Schematic of Binomial Option-Pricing Example

7-26

FT is the forward (or futures) price that spans the option period.

European Option-Pricing Formula

When the number of subperiods into which the option period is subdivided goes to infinity, the European call and put pricing formulas presented (below) are obtained

Exact European call and put pricing formulas:

Invoking IRP allows us to restate these as follows:

7-27

Interest rates if and i$ are assumed to be annualized and constant over the term-to-maturity T of the option contract, which is expressed as a fraction of a year

Empirical Tests of Currency Options

Shastri and Tandon (1985)

Discover many violations of the boundary relationships (discussed in this chapter), but conclude that nonsimultaneous data could account for most violations

Shastri and Tandon (1986)

Conclude the European option-pricing model works well in pricing American currency options

Barone-Adesi and Whaley (1987)

Find the European option-pricing model works well for pricing American currency options that are at or out-of-the-money, but does not do well in pricing in-the-money calls and pits

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International Portfolio Investment

Chapter 15

CHAPTER 15 covers international portfolio investment. It documents that the potential benefits from international diversification are available to all national investors.

Chapter Outline

International Correlation Structure and Risk Diversification

Optimal International Portfolio Selection

Effects of Changes in the Exchange Rate

International Bond Investment

International Diversification at Home

Why Home Bias in Portfolio Holdings?

15-2

Introduction

Rapid growth in international portfolio investments in recent years reflects the globalization of financial markets

In this chapter, we focus on the following issues:

Why investors diversify their portfolios internationally

How much investors can gain from international diversification

Effects of fluctuating exchange rates on international portfolio investments

How investors can diversify internationally at home

Possible reasons for “home bias” in actual portfolio holdings

15-3

EXHIBIT 15.1
U.S. Investment in Foreign Equities

15-4

The dollar value invested in international equities (ADRs and local shares) by U.S. investors has grown from a rather negligible level in the early 1980s to $200 billion in 1990 and $7,900 billion at the end of 2018.

aHoldings of foreign issues, including American Depository Receipts (ADRs), by U.S. residents.

Source: The Federal Reserve Board, The Financial Accounts of the United States.

International Correlation Structure and Risk Diversification

Investors can reduce portfolio risk by holding securities that are less than perfectly correlated

International diversification has a special dimension regarding portfolio risk diversification

Security returns are substantially less correlated across countries than within a country

This is true because economic, political, institutional, and even psychological factors affecting security returns tend to vary a great deal across countries

Business cycles are often high asynchronous across countries

15-5

EXHIBIT 15.2
Correlations among International Stock Returns

15-6

The average intracountry correlation is 0.653 for Germany, 0.416 for Japan, 0.698 for the United Kingdom, and 0.439 for the United States. In contrast, the average intercountry correlation of the United States is 0.170 with Germany, 0.137 with Japan, and 0.279 with the United Kingdom. The average correlation of the United Kingdom, on the other hand, is 0.299 with Germany and 0.209 with Japan.

Clearly, stock returns tend to be much less correlated between countries than within a country. As seen in the exhibit, international diversification can sharply reduce risk.

International Correlation Structure and Risk Diversification (Continued)

Solnik (1974) study shows that as a portfolio holds more and more stocks, the risk of the portfolio steadily declines, and eventually converges to the systematic (or nondiversifiable) risk

Systematic risk refers to the risk that remains even after investors fully diversify their portfolio holdings

Results of this study (shown on graphs in the next slide) provide striking evidence supporting international, as opposed to purely domestic, diversification

15-7

EXHIBIT 15.3
Risk Reduction: Domestic versus International Diversification

15-8

This exhibit shows that while a fully diversified U.S. portfolio is about 27 percent as risky as a typical individual stock, a fully diversified international portfolio is only about 12 percent as risky as a typical individual stock.

Additionally, a fully diversified Swiss portfolio is about 44 percent as risky as a typical individual stock. However, this Swiss portfolio is more than three times as risky as a well-diversified international portfolio.

Cautionary Notes about International Correlation

A number of studies found that correlations between international stock markets, especially developed markets, have increased

These correlations are computed at the aggregate stock market level, not the individual stock level; securities are still less correlated across countries than within a country

Empirical studies found that international stock markets tend to move more closely together when the market volatility is higher

Unless investors liquidate their portfolio holdings during the turbulent period, they can still benefit from international risk diversification

15-9

EXHIBIT 15.5
Average Return Correlation, 1980-2018

15-10

Exhibit 15.5 plots the average return correlation among 12 major international stock markets over time.

As can be seen in the exhibit, the average correlation among returns of international stock market indices was fluctuating with a mean of 0.36 until the mid-1990s, but it has been generally increasing since then.

Optimal International Portfolio Selection

Rational investors would select portfolios by considering returns as well as risk

World beta measures the sensitivity of a national market to world market movements, with a higher number indicating greater sensitivity to world market movements

Sharpe performance measure (SHP) provides a risk-adjusted performance measure

i and σi are respectively, the mean and standard deviation of returns, while Rf is the risk-free interest rate

15-11

Exhibit 15.4 provides the mean and standard deviation (SD) of monthly returns and the world beta measure for each market.

The Sharpe measure represents the excess return (above and beyond the risk-free interest rate) per standard deviation risk.

Optimal International Portfolio Selection (Continued)

The optimal international portfolio (OIP) has the highest possible Sharpe ratio

The OIP can be solved by maximizing the Sharpe ratio with respect to the portfolio weights

SHP = [E(Rp) − Rf]/σp

After obtaining OIPs, we can measure gains from holding these portfolios over purely domestic ones in two ways:

Increase in the Sharpe performance measure

Increase in the portfolio return at the domestic-equivalent risk level

15-12

EXHIBIT 15.6
Composition of the Optimal International Portfolio by Investor’s Domicile, 1980.1 – 2018.12

15-13

Exhibit 15.6 presents the composition of the OIP from the perspectives of investors domiciled in different countries using the stock market parameters and the average risk-free rate computed over the study period of 1980–2018. It is clear that four markets (i.e., Hong Kong, Sweden, Switzerland, and the United States) are included in every national investor’s optimal international portfolio.

In their optimal international portfolio, U.S. investors allocate the largest share, 52.67 percent, of funds to the U.S. home market, followed by the Swedish (30.04 percent), Hong Kong (13.97 percent), Dutch (2.82 percent), and Swiss (0.50 percent) markets.

EXHIBIT 15.7 – Selection of the Optimal International Portfolio for U.S. Investors

15-14

The realized dollar return for a U.S. resident investing in a foreign market will depend not only on the return in the foreign market but also on the change in the exchange rate between the U.S. dollar and the foreign currency

Rate of return in dollar terms from investing in the ith foreign market, Ri$, is given by:

where Ri is the local currency rate of return from the ith foreign market and ei is the rate of change in the exchange rate between the local currency and the dollar

Effects of Changes in the Exchange Rate

15-15

Exchange rate changes affect the risk of foreign investment as follows, where the ΔVar term represents the contribution of the cross-product term, Riei, to the risk of foreign investment

Exchange rate fluctuations contribute to the risk of foreign investment through three possible channels:

Its own volatility, Var(ei)

Its covariance with the local market returns, Cov(Ri,ei)

Contribution of the cross-product term, ΔVar

Effects of Changes in the Exchange Rate (Continued)

15-16

International Bond Investment

World bond market is comparable in terms of capitalization value to the world stock market, but it has not received as much attention in international investment literature

Existing studies show that when investors control exchange risk by using currency forward contracts, they can substantially enhance the efficiency of international bond portfolios

The advent of the euro altered the risk-return characteristics of the euro-zone bond markets, enhancing the importance of non-euro currency bonds

15-17

EXHIBIT 15.10 – Summary Statistics of the Monthly Returns to Bonds and the Composition of the Optimal International Bond Portfolio

15-18

Exhibit 15.10 provides summary statistics of monthly returns, in U.S. dollar terms, on long-term government bond indexes from seven major countries: Australia, Canada, Germany, Japan, Switzerland, the United Kingdom, and the United States. It also presents the composition of the optimal international portfolio for U.S. (dollar-based) investors.

International Diversification: Mutual Funds

Purchasing foreign stocks directly from foreign exchanges can entail significant transaction costs

Other modes of international diversification are less cumbersome:

U.S.-based international mutual funds invest in securities from countries other than the U.S.

Advantages of international mutual funds:

Investors can save any extra transaction and/or information costs they may have to incur when they attempt to invest directly in foreign markets

Circumvent many legal/institutional barriers to direct portfolio investments in foreign markets

Benefit from the expertise of professional fund managers

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Most international funds are open-end mutual funds.

International Diversification: Country Funds

A country fund invests exclusively in stocks of a single country

Popular means of international investment in the U.S., as well as in other developed countries

Using country funds, investors can

Speculate in a single foreign market with minimum costs

Construct their own personal international portfolios using country funds as building blocks

Diversify into emerging markets that are otherwise practically inaccessible

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The majority of country funds available have a closed-end status.

EXHIBIT 15.11 – U.S. and Home Market Betas of Closed-End Country Funds and their NAVs

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Exhibit 15.11 provides the historical magnitude of premiums/discounts for a sample of CECFs. Average premium varies a great deal across funds, ranging from 63.17 percent (for the Korea Fund) to −24 percent (for the Brazil Fund).

International Diversification: ETFs

In the last several years, there has been a broad shift from actively managed mutual funds to passive investment vehicles

An exchange-traded fund (ETF) is an investment vehicle that seeks to track the performance of a specific index, typically an equity index

ETFs are highly liquid, and it is easy to buy and sell them

Most ETFs are passive, though some active ETFs exist

A family of ETFs called iShares (managed by BlackRock) has the broadest range of country ETFs with 65 funds across 42 countries

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International Diversification: ADRs

American depository receipts (ADRs) represent receipts for foreign shares held in the U.S. (depository) banks’ foreign branches or custodians

ADRs are traded on U.S. exchanges like domestic American securities

Because the majority of ADRs are from such developed countries as Australia, Japan, and the U.K., U.S. investors have a limited opportunity to diversify into emerging markets using ADRs

However, in a few emerging markets like Mexico, investors can choose from several ADRs.

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International Diversification: Hedge Funds

Hedge funds that represent privately pooled investment funds have experienced a tremendous growth in recent years

May invest in a wide spectrum of securities, such as currencies, domestic and foreign bonds and stocks, commodities, real estate, etc.

Many aim to realize positive returns, regardless of market conditions

Legally, hedge funds are private investment partnerships

Tend to have relatively low correlations with various stock market benchmarks and thus allow investors to diversify their portfolio risk

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International Diversification with Industry, Style, and Factor Portfolios

Investors can enhance the gains from international investment by augmenting their portfolios with industry, small-cap, or factor funds

Studies document greater diversification benefits from investing across not just countries, but also industries

International diversification can be further enhanced by employing factor and style investing

Style investing refers to categorizing assets into different styles based on common characteristics (e.g., large-cap and value stocks)

Three factors—size, book-to-market, and momentum—have been widely used in asset pricing models to explain stock returns

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Home Bias in Portfolio Holdings

In portfolio holdings, the tendency of an investor to hold a larger portion of the home country securities than is optimum for diversification of risk is home bias

Though investors could benefit a great deal from international diversification, the actual portfolios that investors hold are quite different from those predicted by the theory of international portfolio investment

U.S. mutual funds, for instance, invested about 87% of their funds in domestic equities on average during 1998–2007, when the U.S. stock market only accounted for about 45% of the world market capitalization value during the period

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EXHIBIT 15.13 – The Home Bias in Equity Portfolios: Selected Countries, 1998 – 2007

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Why Home Bias in Portfolio Holdings?

Observed home bias in portfolio holdings leads to the following possibilities:

Domestic securities may provide investors with certain extra services, such as hedging against domestic inflation, that foreign securities do not

There may be barriers, formal or informal, to investing in foreign securities that keep investors from realizing gains from international diversification

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