International Finance

Lecture 6
Page 1

World Financial Markets and

Institutions
International Banking and Money

Market
International Bond Market
International Equity Markets
International Portfolio Investment
Futures and Options on Foreign
Exchange
Currency and Interest Rate Swaps

Page 2

International Portfolio
Investment
International portfolio ________________
Portfolio theory and _______________ investment
International mutual funds

International diversification through country

_____
International diversification through
__________
International diversification through
__________
Home ____________
Page 3

Portfolio return
Investment in international securities offer

opportunities for ______________ but increases

foreign exchange ____________;
For example,
A Canadian portfolio manager buys 10 UK
shares at 10 per share, at $2.30/;
At the end of the period, the shares have risen
in value to 110, but the pound falls to $2.10/:

Page 4

Portfolio return
Three rates of return:

Page 5

Portfolio risk
Two sources of uncertainly
Stock return volatility
Exchange rate volatility
2
2
international investment return stock
FX
rate change 2 stock , FX

Page 6

Portfolio risk and return

You are investing into a stock in the emerging market. The stock

return is expected to be 30% and the standard deviation of the

return is estimated 45%. The foreign currency is expected to
depreciate by 10% during the following year, with estimated
20% standard deviation of the currency depreciation. The
correlation between stock returns in that country and the
exchange rate changes is estimated -0.09.
What are the expected return and risk of holding this stock, in $?
What is the probability that you will lose money? earn no
more than the current $ riskless rate of 5% on this investment?
probability that you will earn return between 5% and zero ?
Assume normal distribution.

Page 7

Portfolio risk and return

Page 8

Portfolio theory and international

investment
Returns are not perfectly correlated with exchange

rates. Under certain conditions stocks:

Less risky for international investors than for domestic
investors.
i.e.
Provide higher returns for international investors than for
domestic investors
i.e.

International investments offer greater investment

opportunities compared to domestic investments

Page 9

Markowitz Efficient frontier

Portfolio risk and return

Mean portfolio return ___________

Portfolio variance _____________
Mean-variance efficiency
For any combination of stocks, it is possible to
construct a portfolio that will give the __________
return for a given level of risk, or the lowest risk
for a given _________ of required return
Capital Allocation with lending/borrowing
If you use a riskless asset in your investments,
or if you ___________, it is possible to achieve
higher returns compared with the case when
you do not use riskless investment / borrowing
Page 10

Markowitz Frontier and CML

40.00%
35.00%
30.00%

Return

25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
0.00%

50.00%

Actual spreadsheet. Doubleclick on graph and go to sheet

Markowitz to see
calculations.

Page 11

100.00%

150.00%

200.00%

Stdandard Deviation
Markow itz Efficient Frontier

CAL

250.00%

300.00%

International Portfolio
Diversification

Page 12

Optimal International Portfolio

Selection
Security returns are much less correlated across

countries than within a country.

__________, ___________, __________, and even _________ factors
affecting security returns tend to ____ across countries,
resulting in low correlations among international securities.

The correlation of Canadian stock markets with the

returns on the stock markets in other nations varies.

The correlation of the U.S. stock market with the Canadian
stock market is 58%.
The correlation of the U.S. stock market with the Japanese
stock market is 26%.
A U.S. investor would get ________ diversification from
investments in Japan than Canada.

Page 13

CAN$ - Based Equity

Correlations

Page 14

Summary Statistics for Monthly

Returns for 12 Major Stock
Markets

1/1980-12/2001
Page 15

Domestic v. International
Diversification

Page 16

Optimal Portfolio Investment

Various ways to optimize, the text suggests the

following technique:
______________ portfolios Sharpe Ratio subject
to the following:
1. Portfolio _________ = weighted average return
2. Portfolio ____________ = [ijij]0.5
3. Constraints:
Sum of ____________ weights x i= 1
Obtain optimal weights for each countrys
stock market index and call them OIP
weights, OIP optimal investment portfolio
Page 17

Composition of the OIP for a

Canadian Investor
Hong Kong
market

3.31%

Italian market

2.62%

Netherlands
market

28.53%

Swedish market

23.92%

U.S. market

41.62%

Total

100.00%

Page 18

OIP by Investors
Domicile
(1980-2001)

Page 19

International Mutual Funds:

An investor can easily achieve international

diversification by investing in international
mutual fund. View HSBC funds

1.
2.

The advantages include

__________ on ____________ and ___________ costs.
Circumvention of legal and institutional ___________ to
direct portfolio investments abroad.
Professional _____________ and record ___________.

3.

A country fund invests exclusively in the stocks of a

single county. This allows investors to:
1. Speculate in a _________ foreign market with minimum cost.
2. Construct their own ___________ international portfolios.
3. Diversify into ___________ markets that are otherwise
practically inaccessible.
Page 20

International Mutual Funds: A

Performance Evaluation

Page 21

American Depository
Receipts
Foreign stocks often trade on U.S. exchanges as ADRs.
It is a receipt that represents the number of foreign

shares that are deposited at a U.S. bank.

The bank serves as a _________ agent for the ADRs

There are many advantages to trading ADRs as

opposed to direct investment in the companys

shares:
ADRs are in U.S. dollars, trade on U.S. exchanges and
can be bought through any broker.
Dividends are paid in U.S. dollars.
Most underlying stocks are bearer securities, the ADRs
are registered.
Page 22

i Shares
World Equity Benchmark Shares (WEBS)
Country-specific _________ of stocks designed
to replicate the country indexes of 14
countries.
WEBS are subject to U.S. SEC and IRS
diversification _______________.
Low ____________, convenient way for
investors to hold diversified investments in
several different countries.
Re-named into iShares in 2000.
Page 23

The Home Bias in Equity

Portfolios

Country

Share in World Market

Value

Proportion of Domestic
Equities in Portfolio

France

2.6%

64.4%

Germany

3.2%

75.4%

Italy

1.9%

91.0%

Japan

43.7%

86.7%

Spain

1.1%

94.2%

Sweden

0.8%

100.0%

United Kingdom

10.3%

78.5%

United States

36.4%

98.0%

Page 24

Total

100.0%

Why Home Bias in Portfolio

Holdings?

Three explanations come to mind:

1. Domestic equities may provide a
superior _____________ hedge.
2. Home bias may reflect institutional and
legal ___________ on foreign investment.
3. Extra taxes and transactions/information
costs for __________ securities may give
rise to home bias.

Page 25

Example
You are a French investor holding a portfolio of US bonds. Over

the month, the value of your portfolio increases from $1 million

to $1.05 million. The exchange rate moves from 1.00 EUR/USD
to 1.02 EUR/USD. (i) what is your rate of return in dollars? (ii)
what is your rate of return in Euros? Is the difference exactly
equal to the percentage movement in the exchange rates, and
why?

Page 26

Example
Consider a Canadian pension fund with the following characteristics:

% invested

Total $
Return

Std. Dev. of
Dollar Return

Correlation
with Canadian
Stock Index

Canadian equity

90%

10%

15%

0.99

Foreign Equity

10%

11%

20%

-0.10

Is the risk-return of the foreign portfolio attractive?

Page 27

Taxes
Types of taxation
Tax environments
Tax planning

Page 28

Example
On June 1, 2005 you bought a 182-day T-bill at a price of

97.905 of its maturity value. Your average tax rate is

26.5% and you marginal tax rate of 33.0%. What is your
after-tax EAR on the T-bill?

Page 29

Example
What is the after-tax real rate of return on this t-

bill for a person whose marginal tax rate is

48%? Inflation rate is 3%.
Assume that interest rates do not change
during the year and there is opportunity for reinvestment at the same rate.

Page 30

Types of Taxation
Income Tax
Withholding Tax
Value-Added Tax
Other taxes

Page 31

Income Tax
An income tax is a tax on __________ and

___________ __________.
Many countries in the world obtain a
significant portion of their tax _________
from income taxes.
An income tax is a _________ tax, that is
one that is paid directly by the taxpayer
upon whom it is levied.
Page 32

Corporate Income Tax Rates in

Selected Countries

Page 33

Withholding Tax
Withholding taxes are withheld from the

payments a corporation __________ to the

taxpayer.
The taxes are levied on __________ income
earned by an individual or corporation of
one country within the tax jurisdiction of
another country.
Passive income includes dividends and
interest income, income from royalties,
patents, or copyrights.
A withholding tax is an ____________ tax.
Page 34

Value-Added Tax
A value-added tax (_______) is an indirect

national tax levied on the value added in

production of a good or service.
In many European and Latin American countries
the VAT has become a major source of taxation
on private citizens.
Many ________________ prefer a VAT to an
income tax because the incentive effects of the
two taxes differ sharply.

Page 35

Value-Added Tax
An income tax has the incentive effect of

discouraging _________.
A VAT has the incentive effect of
discouraging ___________ (thereby
encouraging saving).
VATs are easier to administer as well.
While taxpayers have an incentive to hide
their income, producers have an incentive
to make sure that their upstream suppliers
in the production process declare the
value added (and pay the tax!).
Page 36

Value-Added Tax
Calculation
Production
Stage

Selling
Price

Value
Added

100

100

300

200

380

80

Incremental
VAT

Total VAT

In this example, the tax rate is 15 percent. Suppose that stage one is
the sale of raw materials to the manufacturer; stage two is the sale of
finished goods to a retailer; stage three is the sale of inventory from
the retailer to the consumer.
Page 37

Other Types of Taxation

A __________ tax is a tax levied not on income

but on the wealth of a taxpayer. __________

taxes are an example.
A poll tax is a tax on your _____________. It is so
called because it was collected from those who
wished to vote.

Page 38

The National Tax Environments

Worldwide Taxation
Tax national residents of the country on their
worldwide income no matter in which country
it was __________;
Creates the _____________ for double taxation.
Territorial Taxation

Territorial taxation tax residents based

upon __________ the taxable event
occurred.
Foreign Tax ___________
Page 39

Foreign Tax Credits

Allows taxpayers to recover somewhat

from _________ taxation.

Direct foreign tax credits are computed
for direct taxes ______ on active
foreign-source income of a foreign
branch of a MNC or on withholding
taxes ________ from passive income.
Indirect foreign tax credits are for
income taxes ______________ by the
subsidiary.
Page 40

Organizational Structures for

Reducing Tax Liabilities
Branch & Subsidiary Income
Payments to and from Foreign

Affiliates
Tax Havens

Page 41

Branch & Subsidiary

Income

An overseas affiliate of a MNC can be

organized as a _______ or a ____________.

A foreign branch is not an independently
incorporated firm separate from the parent.
Branch income passes ____________ through to the
parents income statements.

A foreign subsidiary is an affiliate

organization of the MNC that is

independently incorporated.

Income may not be _________ in domestic country

until it is ______________, under certain
circumstances.
Page 42

Foreign Corporations
US tax law
_______________ foreign corporation
______ < ownership stake < ________
Active and passive income taxed only when
remitted to parent in the _________________

Controlled foreign corporation

_________ < ownership stake
Active and income taxed only when
__________ to parent, passive income taxed
when ________ even if not remitted to parent
Page 43

Transfer pricing
Having foreign affiliates offers transfer

price tax arbitrage strategies.

The transfer price is the accounting value
assigned to a good or service as it is
transferred from one affiliate to another.
If one country has ______ taxes, dont
recognize income therehave those
affiliates pay _________ transfer prices. If
one country has _________ taxes,
recognize income therehave those
affiliates pay ________ transfer prices.
Page 44

Tax Havens
Tax havens are countries with ______

corporate income tax rates and ______

withholding tax rates on _________
income.
Tax havens were once useful as
___________ for a MNC to establish a shell
company.

Page 45

 Continue with Lecture 7 if time

permits

Page 46