Chapter 3

Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Eighth Editionby

Frank K. Reilly & Keith C. Brown

Chapter 3

Selecting Investments in a Global Market

Questions to be answered: Why should investors have a global perspective

regarding their investments? What has happened to the relative size of U.S. and

foreign stock and bond markets? What are the differences in the rates of return on

domestic and foreign securities markets? How can changes in currency exchange rates affect the

returns that domestic investors experience on foreign securities?

Questions to be Answered

Is there an additional advantage of diversifying in international markets beyond the benefits of domestic diversification?

What alternative securities are available? What are their cash flow and risk properties?

What is the historical return and risk characteristics of the major investment instruments?

What is the relationship among returns for foreign and domestic investment instruments? What is the implication of these relationships for portfolio diversification?

Three Reasons for the expansion of foreign investment

opportunities1. Growth and development of foreign financial markets

2. Advances in telecommunications technology

3. Mergers of firms and security exchanges• 1999 - Vancouver & Alberta Stock Exchanges merge to form the

Canadian Venture Exchange (CDNX)

• 1999 – CDNX acquires The Canadian Dealing Network, Winnipeg Stock Exchange & the equities portion of the Montreal Exchange

• 2001 – TSX acquires CDNX to form TSX Venture Exchange

• NASDAQ merged with American Stock Exchange in 1998

• NYSE acquired EuroNext, the second largest Exchange in Europe in a $20 Billion dollar deal (June, 2006)

• On Dec 13, 2006, NASDAQ launched a $5.3 B hostile take-over offer to purchase a majority of shares in the London Stock Exchange (it already owns 28.75% of LSE shares)

Ten Reasons Canadians Should Invest Abroad

1. Canada is a small market2. The S&P/TSX is dominated by energy & financial

services3. Some industry sectors are not represented in the

S&P/TSX4. The Canadian market is highly cyclical5. International markets provide diversification6. International valuations look attractive7. Higher dividend yields can be found abroad8. International structural trends are positive9. Growth opportunities in emerging markets10. FX volatility should not deter foreign investing

Source: TD Economics, Special Report, Sept 5, 2006

Canadian Ownership of Foreign Securities: 2006


Canadian holdings of

foreign mutual funds peaked

at 38% in 2000. Since then, it has

fallen to 22% of total mutual fund assets.

Canada is a Small Market

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. Overall value of the total global capital market has increased from $2.3 Trillion in 1969 to $70.9 Trillion in 2003.

3. Canada’s capital markets comprise approximately 3.5% of the total global capital market and the Canadian economy is approximately 2% of the global economy.

4. The growing importance of foreign securities in world capital markets is likely to continue (see next page dealing with IPOs)

E&Y: Global IPO Trends Report 2006 Capital raised around the world rose by one-third to hit $167 billion, the highest

level since 2000, while deal numbers remained steady at 1,537, compared to 1,516 in 2004.

2005 was a watershed year for IPO activity in the Middle East and Africa: soaring liquidity from oil revenues contributed to many big ticket IPOs raising more than $500 million each.

In the next few years, assuming the necessary political stability, the Middle East is likely to become an important source of IPO activity as oil revenues are recycled into the local economy.

Asia continues to be a hotbed of activity. Towed along by mainland China and Hong Kong’s continuing strength, other economies in the area displayed vigorous IPO activity.

One of the three biggest deals to date this year was Lotte, the South Korean Department Store, which raised $3.5 billion when it dual-listed in London and Seoul.

Many Indian IPOs have been oversubscribed 20 to 30 times in markets that have been scaling record levels. Following Jet Airways’ successful launch — one of the most successful Indian IPOs of recent times — a number of state-run airlines are poised to float in the near future.

In Latin America, Brazil saw an increase in both the amount of capital raised and the number of transactions on the previous year. Brazilian companies currently account for one-third of all Latin American listings on the New York Stock Exchange.

Foreign Markets Can Add Return


Germany is the world’s largest

exporter, exceeding

even China, with exports last year of over US $1

Trillion.

Canadian Markets are Highly Concentrated


Over the last 4 years, energy has been responsible

for 50% of the increase in the

TSX. Financials have accounted

for 1/3 of the gain, leaving the other 8 major industry

groups contributing less

than 20%

Correlations Between TSX & International Indices


To reduce risk, must diversify

among securities with low

correlations. Because the

Canadian market is highly

concentrated, diversification is

difficult.

Dividend Yields Can Be Higher Abroad


Dividend yields in N.A. have

averaged 1.5 – 2% over the last

decade, while the FTSE 100

generally returns a dividend yield of twice that.

Dividends as a % of Total Return


Over a 20 year period in

Canada, the U.K. and the

U.S., reinvested dividends

accounted for 2/3 of the total

return on equities.

International Structural Changes are Positive


Productivity growth is

dramatically higher in many

countries than in Canada.

Japanese firms have cut costs, reduced excess

capacity & reduced liabilities.

Emerging Markets & High Growth


India’s benchmark index has had a

225% return, measured from the

trough in 2002 to Q2, 2006. China has been the world’s fastest growing

country for much of the last 20 years but the Shanghai index has had an average annual return of only

4.3% over the last four years.

Some Foreign Indexes: 5 Years

Source: Yahoo Finance

FX Volatility


FX volatility can either enhance or reduce a foreign return. Foreign

returns are enhanced when the domestic currency depreciates against

the foreign currency. Domestic returns are

reduced when the domestic currency appreciates against the foreign currency.

Domestic Returns & Foreign Assets

The domestic return is equal to the percentage return in the foreign market times the percentage change in the foreign exchange rate.

For example, you earn a 30% return in a foreign market. Over the same period, the Canadian dollar appreciates against the foreign currency by 10%. What is the percentage Canadian dollar return?

Solution

To calculate the domestic dollar return

1 1 ' 1

1.30 0.90 1

1.17 1

17%

Domestic ForeignR R Dep n in Exchange Rate

Global Investment Choices1. Fixed-income investments

• bonds and preferred stocks

2. Equity investments3. Special equity instruments

• warrants and options

4. Futures contracts5. Investment companies6. Real assets

Municipal Bonds

Issued by US state and local governments, usually to finance infrastructural projects.

Exempt from taxation by the US 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)• Revenue bonds

International Bond Investing Eurobond

• An international bond denominated in a currency other than the currency of the country where the bond is issued.

• Example: Shogun bond – denominated in Yen but issued outside of Japan

Foreign bond• Issued by a foreign company but in the currency of the

country where it is issued• Yankee bond Matilda bond• Samurai bond Bulldog bond• Matador bond

Acquiring Foreign Equities

1. Purchase of American Depository Receipts (ADRs)

2. Direct purchase of foreign shares listed on a stock exchange

3. Purchase of international mutual funds

American Depository Receipts (ADRs)

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

As of January, 2007, 305 ADRs are listed on the NYSE & 3 on the American Stock Exchange.

Buy and sell in U.S. dollars Dividends in U.S. dollars May represent multiple shares Listed on U.S. exchanges Very popular To check www.globeinvestor.com Then use Filters

http://www.globeinvestor.com/

Direct Purchase or Sale of Foreign Shares

Direct investment in foreign equity markets - difficult and complicated due to administrative issues, lack of information, taxation issues and market efficiency problems

Purchase foreign stocks listed on a Canadian or U.S. exchange – limited choice

Purchase or Sale of Global Mutual Funds or ETFs

Global funds - invest in both domestic and foreign stocks

International funds - invest mostly outside of Canada

Funds can specialize• Diversification 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 (see next page)

Exchange Traded Funds DIAMONDs Shares in an ETF that tracks the Dow Jones

Industrial Average. The fund is structured as a unit investment trust.

iShares A group of ETFs advised and marketed by Barclays Global Investors. iShares are structured as open-end mutual funds.

HOLDRs Holding company depository receipts, a type of ETF marketed by Merrill Lynch. Unlike other ETFs, HOLDRs can only be bought and sold in 100-share increments. Investors may exchange 100 shares of a HOLDR for its underlying stocks at any time. Existing HOLDRs focus on narrow industry groups. Each initially owns 20 stocks, but they are unmanaged, and so can become more concentrated due to mergers, or the disparate performance of their holdings.

Exchange Traded Funds Qubes (QQQ) The Nasdaq-100 tracking stock, an

ETF that tracks the Nasdaq 100 index. The popular name, Qubes, derives from the ETF's ticker symbol, QQQ. Qubes are by far the most heavily traded ETF.

Spiders SPDRs, or Standard & Poors' Depository Receipts. A group of ETFs that track a variety of Standard & Poors' indexes. SPDR Trust, Series 1, usually referred to as "Spiders," tracks the S&P 500 index. Select Sector SPDRs track various sector indices that carve up the S&P 500 index into separate industry groups.

Horizons BetaPro S&P/TSX 60 Bear Plus ETF & Horizons BetaPro S&P/TSX 60 Bull Plus ETFs began trading January 9, 2007.

Using derivatives, the funds are designed to return a positive return equal to twice the percentage change in the S&P/TSX 60 Index (before fees & expenses)

For example, the Bear ETF should have a 4% positive return given a 2% drop in the Index.

The Bull ETF should have a 4% positive return given a 2% increase in the Index.

Exchange Traded Funds

Special Equity Instruments Warrants are similar to long call options written by the

company whose stock can be acquired Rights are similar to short call options written by the company

whose stock can be acquired Call options give the buyer the right but not the obligation to

purchase a stock for a given period of time for a fixed price Put options give the buyer the right but not the obligation to

sell a stock for a given period of time for a fixed price

Futures & Forwards

Allows both buyer and seller to lock in a price today for an exchange to take place in the future.

Futures and forwards are economically identical but they differ in their institutional characteristics.

Commodities trading is largely in futures contracts

Current price depends on expectations

Real Estate

Negative correlation between residential

and farm real estate and stocks

Low positive correlation between

commercial real estate and stocks

Potential for diversification

Chapter 3

Documents

foreign stock

foreign securities markets

foreign investingsource

world capital markets

world stock

bond markets

total global capital

winnipeg stock exchange