Foreign

Portfolio
Investments
SUBMITTED BY:
DEVIKA V B VILSON
FEMI.PIUS
FERZANA REHMAN
GISHMA PAULSON
HASNA M A
 THE PATTERN OF CAPITAL FLOWS TO DEVELOPING COUNTRIES AND
COUNTRIES IN TRANSITION IN THE 1990S HAS TWO SALIENT
FEATURES:

PRIVATE FLOWS ARE THE MAJOR SOURCES OF CAPITAL, WITH FDI AND
FPI BEING THE DOMINANT COMPONENTS, AND FLOWS HAVE BECOME
MORE SUBJECT TO SHARP BOOM-AND-BUST SWINGS.

THE GLOBALIZATION OF CAPITAL CAN BRING BENEFITS BUT IS ALSO

FULL OF RISKS.

DEVELOPING COUNTRIES AND COUNTRIES IN TRANSITION ARE

FACING A POLICY DILEMMA BETWEEN THE NEED TO ATTRACT
EXTERNAL SOURCES OF FINANCE FOR DEVELOPMENT, INCLUDING
SHORT TERM FINANCE, AND THE NEED TO BE SELECTIVE IN THE
TYPES OF FINANCE IN ORDER TO REDUCE THE LIKELY NEGATIVE
IMPACT RESULTING FROM THE VOLATILITY OF FLOWS.
 PORTFOLIO INVESTMENTS
Investments by a resident entity in one country in the equity and debt
securities of an enterprise resident in another country which seek
primarily capital gains and do not necessarily reflect a significant and
lasting interest in the enterprise.

Includes investments in bonds, notes, money market instruments and

financial derivatives other than those included under direct investment,
or in other words

investments which are both below the ten per cent rule and do not
involve affiliated enterprises.

In addition to securities issued by enterprises, foreigners can also

purchase sovereign bonds issued by governments.

According to the IMFs 1996 Coordinated Portfolio Investment Survey

Guide the essential characteristic of instruments classified as portfolio
instruments is that they are traded or tradable.
 Equity securities have been defined as instruments and
records acknowledging, after the claims of all creditors have
been met, claims to the residual values of incorporated
enterprises (shares, stocks, participation, American deposit
receipts (ADRs), mutual funds, and investment trusts).

C Debt securities include bonds and notes, money market

securities (instruments such as treasury bills, commercial and
finance paper, negotiable certificates of deposit with maturities
of one year or less), and financial derivatives or secondary
instruments, such as options. However, in the survey no
guidelines or definitions were given for the recording of money
market instruments and financial derivatives.
 Direct Investments
Direct investment is the category of international investment in which a resident
entity in one country obtains a lasting interest in an enterprise resident in another
country.

A lasting interest implies the existence of a long-term relationship between the

direct investor and the enterprise and a significant degree of influence by the
investor on the management of the enterprise.

The criteria used to distinguish direct investment from other types of investment is
that a direct investment is established when a resident in one economy owns 10
percent or more of the ordinary shares or voting power, for an incorporated
enterprise, or the equivalent, for an unincorporated enterprise .

All subsequent transactions between affiliated enterprises, both 2 incorporated and

unincorporated, are also classified as direct investment transactions. Direct
investment is divided into equity capital, reinvested earnings, and other capital.
Benefits of
International
Portfolio
Investment
 Securities returns are found to be less
correlated across countries than within a
country
a. Industrial structure
b. Business cycle
c. economic policies, politics
 Gain from stock diversification
As provided by the research of Bruno Solnik

The gain from diversification through holding

equities of different countries turns out to greatly
exceed the gain through holding equities within a
single country
 Investing in Emerging Markets
a. Offers highest risk and returns
b. Low correlations with returns
elsewhere
c. As impediments to capital market
mobility fall, correlations are
likely to increase in the future.
 In case of Bonds
Foreign bonds provide higher returns
The combination of stock + bond in the
portfolio gives a reduced risk for given return
Measuring Total Returns
From Portfolio Investing
MEASURING TOTAL RETURNS
A. Bonds

Dollar = Foreign x
Currency
return currency gain
(loss)
return
Measuring Total Returns
From Portfolio Investing
Bond return formula:

1 + R$
(1+g)
= [1 + B(1) - B(0) + C ]
B(0)
whereR$ = dollar return
B(1) = foreign currency bond price at time 1
C = coupon income
g = depreciation/appreciation of foreign
currency
Measuring Total Returns
From Portfolio Investing
B. Stocks (Calculating return) Formula:

1 + R$
(1+g)
= [ 1+ P(1) - P(0) + D ]
P(0)

whereR$ = dollar return

P(1) = foreign currency stock price at
time 1
D = foreign currency annual
dividend
Sample Problem

What is the expected return of a portfolio with

35% invested in Japan returning 10% and 65%
in the U.S. returning 5%?
rp = a rUS + ( 1 - a)
rrw
= .65(.05) + .35(.10)
= .0325 + .0350
= 6.75%
RISK MEASUREMENT
IN
INTERNATIONAL
PORTFOLIIO
INVESTMENT
INTERNATIONAL DIVERSIFICATION

International Diversification
1. Risk-return tradeoff:

may be greater
Basic Portfolio Theory

Total Risk of a Securitys Returns may

be segmented into

Systematic Risk
can not be eliminated

Non-systematic Risk
can be eliminated by diversification
SYSTEMATIC RISK

2. International diversification and

systematic risk
a. Diversify across nations with
different economic cycles
b. While there is systematic risk
within a nation, outside the country
it may be nonsystematic and
diversifiable
INTERNATIONAL PORTFOLIO 1
INVESTMENT 9

3. Recent History
a. National stock markets have wide
differences in returns and risk.
b. Emerging markets have higher
risk and return than developed markets.
c. Cross-market correlations have
been relatively low.
INTERNATIONAL PORTFOLIO 2
INVESTMENT 0
3. Theoretical Conclusion

International diversification
pushes out the efficient frontier.
Investing in Emerging 2
1
Markets
D. Investing in Emerging Markets
a. Offers highest risk and returns
b. Low correlations with returns
elsewhere
c. As impediments to capital market
mobility fall, correlations are likely to
increase in the future.
Barriers to International 2
2
Diversification
E. Barriers to International Diversification
1. Segmented markets
2. Lack of liquidity
3. Exchange rate controls
4. Underdeveloped capital markets
5. Exchange rate risk
6. Lack of information
a. not readily accessible
b. data is not comparable
Other Methods to 2
3
Diversify
F. Diversify by a
1. Trade in American Depository
Receipts (ADRs)
2. Trade in American shares
3. Trade internationally diversified
mutual funds:
a. Global (all types)
b. International (no home
country securities)
c. Single-country
INTERNATIONAL PORTFOLIO 2
INVESTMENT 4

4. Calculation of Expected Portfolio Return:

rp = a rUS + ( 1 - a) rrw
where
rp = portfolio expected return
rUS = expected U.S. market
return
rrw = expected global return
Portfolio Return 2
5

Sample Problem
What is the expected return of a portfolio with
35% invested in Japan returning 10% and 65%
in the U.S. returning 5%?

rp = a rUS + ( 1 - a)
rrw
= .65(.05) + .35(.10)
= .0325 + .0350
= 6.75%
 INTERNATIONAL PORTFOLIO 2
INVESTMENT 6
Calculation of Expected Portfolio Risk
1/ 2
P a (1 a) 2a(1 a) US rw
2 2
US
2 2
rw

where = the cross-market
correlation
US2 = U.S. returns variance
r w2 = World returns variance
Portfolio Risk
What is the risk of a portfolio with 35%
invested in Japan with a standard deviation of
6% and a standard deviation of 8% in the U.S.
and a correlation coefficient of .7?
1/ 2
P a
2 2
US (1 a ) 2a (1 a ) US rw
2 2
rw

= [(.65)2 (.08) 2 + (.35) 2(.06) 2 +2(.65)(.35)

(.08)(.06)(.7)] 1/2
= 6.8%
27
INTERNATIONAL PORTFOLIO 2
INVESTMENT 8

IV. MEASURING TOTAL RETURNS

FROM FOREIGN PORTFOLIOS
A. To compute dollar return of a foreign
security:

e1 e0
or RUS $ ( RForeignCurrency )( )
e0
e0 e1
RUS $ ( RForeignCurrency )( )
e1
Flash Back! 2
9

For currency appreciation:

e1 e0
RUS $ ( RForeignCurrency )( )
e0

For currency depreciation:

e0 e1
RUS $ ( RForeignCurrency )( )
e1
 INTERNATIONAL PORTFOLIO 3
INVESTMENT 0
Bond (calculating return) formula:

B(1) B(0) C
1 R$ 1 (1 g )
B(0)

where R$ = dollar return

B(1) = foreign currency bond price at time 1
(present)
C = coupon income during period

g = currency depreciation or appreciation

INTERNATIONAL PORTFOLIO
INVESTMENT
B. Stocks (Calculating return)
Formula:

P(1) P(0) D
1 R$ 1 (1 g )
P(0)

where R$ = dollar return

P(1) = foreign currency stock price at time 1
D = foreign currency annual
dividend

31