Keywords

American depositary receipts; cost of capital; diversification; global depositary receipts; globalized equity market; international investment; portfolio diversification; segmented market; stock markets; FDI

Portfolio Diversification

No doubt the differences in the returns on various countries’ assets provide an incentive for capital flows. However, we would not expect interest rates to be equalized throughout the world, since risk differs from one asset to another. Furthermore, we would anticipate a certain random component in international capital flows, because money flows to new investment opportunities as they open up in various countries. Given the short time needed to shift funds around the world, the expected profit (adjusted for risk differences) from investing in different assets should be equal. If this were not the case, then money would flow internationally until it was true.

Yet even with constant interest rates internationally, there would still be an incentive for international capital flows. This additional incentive is provided by the desire to hold diversified portfolios. It is this diversification motive that leads to the two-way flows of capital between countries. Besides the return on an investment, investors are concerned with the risk attached to the investment. It is very unlikely that an individual who has $100,000 to invest will invest the entire amount in one asset. By choosing several investment alternatives and holding a diversified portfolio, the investor can reduce the risk associated with his or her investments. Modern financial literature has emphasized the concept of variability of return as a measure of risk. This is reasonable in that investors are interested in the future value of their portfolios, and the more variable the value of the portfolios, the less certain they can be of the future value.

By diversifying and selecting different assets (including assets of different countries) for a portfolio, we can reduce the variability of the portfolio returns. To see the effects of diversification, let us consider a simple example of an investor facing a world with two investment opportunities: asset A and asset B. The investor will hold a portfolio of A and B, with the share of the portfolio devoted to A denoted by a and the share devoted to B denoted by b. The shares, a and b, are fractions of the portfolio between 0 and 1, where a+b = 1. Thus, if the investor holds only A, then a = 1 and b = 0. If only B is held, then a = 0 and b = 1. Most likely the investor will choose some amount of diversification by holding both A and B.

The return on the portfolio (R_p) can be written as a weighted average of the returns on the individual assets (R_A and R_B):

$R_p=a{R}_A+b{R}_B$ (10.1)

(10.1)

The expected future return on the portfolio will then be determined by the expected future return in the individual assets:

$R_p^{*}=a{R}_A^{*}+b{R}_B^{*}$ (10.2)

(10.2)

where $R_p^{*},R_A^{*},\text{and}{R}_B^{*}$ are the expected values of the portfolio and individual asset returns, respectively. We said earlier that the idea of portfolio risk was associated with the variability of the return on the portfolio. The measure of the degree to which a variable deviates from its mean or average value is known as the variance. The variance of the portfolio will depend on the share of the portfolio held by each asset and the variance of the individual assets, as well as their covariance. Specifically,

$\text{var}(R_p)=a^2\mathrm{var}(R_A)+b^2\mathrm{var}(R_B)+2ab\mathrm{cov}(R_A,R_B)$ (10.3)

(10.3)

where var stands for variance and cov stands for covariance. The covariance is a measure of the degree to which the two assets move together. If, when one return is higher than average, the return on the other asset is lower than average, the covariance is negative. Looking at Eq. (10.3), we see that a negative covariance could contribute greatly to reducing the overall portfolio variance and, therefore, risk.

To see the effects of diversification more clearly, let us use a simple example. Table 10.1 shows a set of hypothetical investment opportunities. This table is a hypothetical assessment of the investment opportunity that is available. If we hold only asset A, our expected return is 10%, with a variance of 0.00605. If we hold only asset B, our expected return is 8% with a variance of 0.00545. Thus, asset A yields a higher expected return than asset B, but the variability of the returns is also higher with asset A than B. By holding 50% of our portfolio in A and 50% in B, our expected return is R_p = 0.5(10%)+0.5(8%)=9% with a variance (using Eq. (10.3)) of

$\begin{array}{ll}\mathrm{var}(R_p)\hfill & =.25(0.00605)+.25(0.00545)+2\text{×}.25(\text{−}0.0048252)\hfill \\ \hfill & =0.0004625\hfill \end{array}$

We need not be concerned with the statistical theory underlying the example. The important result for our use is the large reduction in variability of return achieved by diversification. By investing half of our wealth in A and half in B, we expect to receive a return on our portfolio that is halfway between what we would expect from just holding A or B alone. However, the variance of our return is much less than half the variance of either R_A or R_B. The substantially lower risk achieved by diversification will lead investors to hold many different assets, including assets from different countries.

As the size of the investor’s portfolio grows, the investor will want to buy more assets in the proportions that are already held in order to maintain the desired degree of diversification. This means that as wealth increases, we could anticipate international capital flows between countries, as investors maintain these optimal portfolios. Thus, even with constant international interest rates, we should expect to observe two-way flows of capital as international wealth increases.

We should recognize that diversification will not eliminate all risk to the investor, since there will still exist systematic risk—the risk present in all investment opportunities. For instance, in the domestic context, we know that different industries have different time patterns of performance. While one industry is enjoying increasing sales and profits, another industry might be languishing in the doldrums. Then, at some later period, the reverse might be true, and the once-thriving industry is now the stagnant one. This is similar to the example of opportunities A and B previously presented. The negative covariance between them indicates that when one is enjoying better-than-average times, the other is suffering, and vice versa. Yet there is still a positive portfolio variance, even when we diversify and hold both assets. The variance that can be eliminated through diversification is called nonsystematic risk; this is the risk that is unique to a particular firm or industry. Systematic risk is common to all firms and remains even in diversified portfolios. Systematic risk results from events that are experienced jointly by all firms, like the overall business cycle of recurrent periods of prosperity and recession that occur at the national level.

By extending our investment alternatives internationally, we can gain by international diversification. There appears to be nonsystematic risk at the national level that can be reduced with international portfolio diversification. Moreover, business cycles do not happen uniformly across countries, so when one country is experiencing rapid growth, another may be in a recession. By investing across countries, we eliminate part of the cyclical fluctuation in our portfolio that would arise from the domestic business cycle. Therefore, some of what would be considered systematic risk, in terms of strictly domestic investment opportunities, becomes nonsystematic risk when we broaden our opportunities to include foreign as well as domestic investment. Thus, we can say that not only will investors tend to diversify their portfolio holdings across industries, but they can also realize additional gains by diversifying across countries.

One might wonder whether the gains from international diversification could be realized by investing in domestic multinational firms. If we consider a multinational firm—a firm doing business in many countries—to be affected significantly by foreign factors, then we may view multinational stock as similar to an international portfolio. Since multinational firms have operations in many countries, we may hypothesize that multinational stock prices behave more like an internationally diversified portfolio than like just another domestic stock. The evidence indicates that domestic multinational firms are poor substitutes for international diversification. While the variability of returns from a portfolio of US multinational stock tends to be somewhat lower than the variability of a portfolio of purely domestic-oriented stocks, a portfolio invested across different national stock markets can reduce portfolio return variance by substantially more.

Reasons for Incomplete Portfolio Diversification

Many studies have demonstrated the gain from international diversification. However, recent research has indicated that investors seem to greatly favor domestic assets and invest much less in foreign assets than one would expect given the expected gains from diversification. Tesar and Werner (1995) examined the foreign investment positions of major industrial countries for the 1970–90 period and found that international investment as a fraction of the total domestic market for stocks and bonds equaled about 3% for the United States, 4% for Canada, 10% for Germany, 11% for Japan, and 32% for the United Kingdom. Calculations of an “optimal” investment portfolio would have much higher fractions devoted to international assets.

Recent studies have shown an increase in the international investment positions, but nowhere near the levels of an “optimal” investment portfolio. For example, Ferreira and Miguel (2011) show that the foreign bond position for the 1997–2009 period was slightly above 4% for the United States, 5% for Canada, 25% for Germany, 21% for Japan, and 47% for the United Kingdom. In general, EMU countries had a high international investment position, with Ireland leading the sample of countries with a 91% international investment. However, the international investment for the European Monetary Union (EMU) countries was only 12%, implying that many of the “foreign” purchases of EMU countries were with other EMU countries.

Why do investors seem to have this bias in favor of domestic securities? There are several possible reasons: taxes, transaction costs, or something else that is missing from the standard model of international investment. Let us consider the alternatives in turn:

The puzzle of home bias has not been answered adequately. It may be that there is no answer that can be related easily to financial models of investment. The surprisingly low level of international securities in investment portfolios may reflect investors’ decisions to hold undiversified portfolios, both internationally as well as domestically. Further research is needed to understand these issues better.

Although the investor risk considered so far has focused on the variability of portfolio return, it should be realized that in international investment there is always the potential for political risk, which may involve the confiscation of foreigners’ assets. The next chapter will consider the analysis of such risk and includes a recent ranking of countries in terms of the perceived political risk attached to investments made in that country.

International Investment Opportunities

As with domestic markets, there are international investment opportunities in stocks, bonds, and mutual funds. The United States is the largest market. Ferreira and Miguel (2011) show that the United States has a share of 41.3% of the world’s bond market, with Japan a distant second with 14.2%, followed by Germany with 6.7%. The differences in size of the various national markets can (and does at times) prove problematic for investors seeking to trade quickly in the smaller markets.

A good example of the problems that can arise in turbulent times is provided by the stock market collapse of October 1987. In mid-October, prices collapsed dramatically in all stock markets around the world. The price fall brought huge orders to sell stocks as investors liquidated their positions and mutual funds raised cash to pay off customers’ redemption requests. Stock exchanges in the United States are relatively deep—meaning that there are enough potential buyers and sellers and a large number of securities traded so that the market permits trading at all times. Other markets are relatively thin—with a much smaller number of potential buyers and sellers and a smaller volume of securities traded.

During the stock market collapse in 1987, the New York Stock Exchange was able to trade 600 million shares, while markets in Hong Kong, Singapore, Italy, Spain, France, and Germany were not as liquid. In fact, at the peak of the trading frenzy, the Hong Kong market closed for a week. Can you imagine the frustration of a US portfolio manager wanting to sell shares in Hong Kong while trading has stopped?

The Globalization of Equity Markets

If we go back to just a couple of decades ago, many countries had equity (stock) markets that were segmented. A segmented market is one in which foreign investors are not allowed to buy domestic stocks and domestic investors are not allowed to buy foreign stocks. Part of the process of the globalization of world economies is the liberalization of stock market restrictions to open markets to the world. Table 10.2 provides dates of first stock market liberalizations for several countries.

What happens when a country moves from a segmented market, cut off from foreign investors and foreign markets, to a globalized market in which the domestic restrictions are lifted, the domestic stock market is now freely open to the world, and domestic investors can hold stocks of both domestic and foreign firms?

To answer this question, we shall assume that risk is represented by the variance of the return on a portfolio of assets as discussed earlier in the chapter. Now, we can think about a risk premium that must be paid to compensate investors for taking risk. Let us denote the return on the risk-free asset (like a US government security) as Rf. Then we can consider the risk premium on small country C’s assets as being equal to the return on C’s assets minus the risk-free rate of return, or: Risk Premium=R_C−Rf. The size of this risk premium should depend upon the variance of the return on the market portfolio and the price of risk.

In a segmented market, the variance of returns is just the variance of the domestic market return, so the risk premium before globalization is:

$\text{Risk Premium in segmented market}=P\mathrm{var}[R_C]$ (10.4)

(10.4)

where P is the price of risk. So, the risk premium required on domestic stocks in segmented financial market C will just depend upon the variance of stock prices in country C multiplied by the price of risk P. P is determined by the degree of risk aversion of investors. If all investors are the same everywhere, then P is a constant across countries. In a world of segmented markets, a country with a variance of returns twice as high as another country would have twice the risk premium on its stocks. This risk premium is what investors require in order to willingly hold shares of the stocks.

In the globalized equity market we can think of the portfolio return volatility for the residents of small country C as the variance of a portfolio comprised of the stocks of country C and the stocks of the rest of the world. Using the formula for portfolio variance introduced earlier in the chapter, this would be:

$\text{Var}[R_p]=w^2\mathrm{var}[R_w]+c^2\mathrm{var}[R_C]+2wc\mathrm{cov}[R_w,R_C]$ (10.5)

(10.5)

where w and c are the fraction of the portfolio devoted to stocks from the rest of the world and the small country, respectively; R_W and R_C are the returns on the stocks of the rest of the world and small country C, respectively. Eq. (10.5) shows that the variance of the portfolio is determined by the amount invested in each area, the variance of returns on the stocks of the two areas, and the covariance between the returns on the two kinds of stocks.

If country C is a segmented market, then the portfolio return variance would just be equal to the variance of the return on country C stocks as in Eq. (10.4), as w would equal zero and c would equal one. Now, think what would happen if the government of country C would liberalize its financial markets to become more globalized. The risk premium on C’s stock should depend upon the contribution of C’s stock to the variance of the world portfolio, which is given by the covariance of the return on stock in country C with the returns in the rest of the world, or

$\text{Risk}\text{Premium}\text{in}\text{globalized}\text{market}=P\mathrm{cov}[R_W,R_C]$ (10.6)

(10.6)

Should we expect the risk premium on country C stock to rise or fall with globalization? To answer that question, compare Eqs. (10.4) and (10.6). For globalization to reduce the risk premium on country C, we need var(R_C) > cov(R_W, R_C). Note that the square root of the variance is known as the standard deviation (SD). So SD(R_C) is equal to the sqrt(var(R_C)). The SD is just another measure of how a variable deviates from its mean or average value. What is useful for our purposes is that the covariance is equal to the correlation coefficient between two variables multiplied by the product of their SDs, or cov(R_W, R_C)=ρSD(R_W)SD(R_C) where ρ is the correlation coefficient. The correlation coefficient is a number between 1 and −1 that indicates how these two variables change together. If ρ = 1, then the two variables are perfectly correlated and move together about their respective means. If ρ=−1, then the two variables are perfectly negatively correlated and move exactly opposite to each other, so that when one is above its mean value, the other is below its mean value. If ρ = 0, then the two variables are independent and have no relationship.

Now we can find the conditions under which globalizing a financial market will reduce the risk premium on a country’s stock. Comparing Eqs. (10.4) and (10.6) again, we need var(R_C)>cov(R_W, R_C), which may be written as:

$\mathrm{var}(R_C)\text{>}\rho \text{SD}(R_W)\text{SD(}{R}_C\text{)}$ (10.7)

(10.7)

If we divide both sides of this inequality by SD(R_W)SD(R_C), we have:¹

$\text{SD(}{R}_C\text{)/SD(}{R}_W\text{)}\text{>}\rho$ (10.8)

(10.8)

So the risk premium on country C stock will fall with globalization, if the ratio of the SD of the stock returns in C to the stock returns in the rest of the world is greater than the correlation coefficient between the two. Since SDs are always positive, if the correlation coefficient is negative, then this must always be true. In this case, country C stock prices would tend to rise when the rest-of-the-world stock prices tend to fall, and the risk premium on C’s stock will always fall with globalization. In general, we need a relatively small ρ and a large SD(R_C) relative to SD(R_W). This is, in fact, what one usually observes in the world. Small countries with segmented stock markets typically have relatively small correlations of their stock prices with the rest of the world. In addition, the volatility of their stock prices tends to be high relative to rest-of-the-world volatility. So, in general, we expect that when a government liberalizes its financial markets to become globalized, or integrated with the rest of the world, the risk premium on its stock falls.

This, then, points out a major benefit of globalized financial markets: A lower risk premium on domestic financial assets allows domestic firms to lower their cost of capital. The cost of capital is what firms have to pay investors to raise new funds. If a domestic firm sells new shares of stock, then the lower the risk premium, the smaller dividends or cash flows the firm must pay stockholders. This allows firms to raise money more cheaply and will allow greater investment spending and expansion than otherwise.

Foreign Direct Investment

The previous sections have dealt with international portfolio investment. A particular type of portfolio investment is labeled Foreign Direct Investment (FDI). FDI is the spending by a domestic firm to establish foreign operating units. In the US balance of payments, direct investment is distinguished from portfolio investment solely on the basis of percentage of ownership. Capital flows are designated as FDI when a foreign entity owns 10% or more of a firm, regardless of whether the capital flows are used to purchase a new plant and equipment or to buy an ownership position in an existing firm. The growth of FDI spending corresponds to the growth of the multinational firm. Although FDI is properly emphasized in international trade discussions of the international movement of factors of production, students should be able to distinguish portfolio investment from direct investment.

The motives for portfolio investment are easily seen in terms of the risk and return concepts already examined. In a general sense, the concern with a firm’s return, subject to risk considerations, may be thought of as motivating all firm decisions, including those of direct investment. However, a literature has developed to offer more specific motives for desiring domestic ownership of foreign production facilities. Theories of FDI typically explain the incentive for such investment in terms of some imperfection in free-market conditions. If markets were perfectly competitive, the domestic firm could just as well buy foreign securities to transfer capital abroad rather than actually establishing a foreign operating unit. One line of theorizing on foreign investment is that individual firms may not attempt to maximize profits, which would be in the interest of the firm’s stockholders; instead, they would attempt to maximize growth in terms of firm size. This is a concept that relies on an oligopolistic form of industry that would allow a firm to survive without maximizing profits. In this case, FDI is preferred since domestic firms cannot depend on foreign-managed firms to operate in the domestic firm’s best interests.

Other theories of FDI are based on the domestic firm possessing superior skills, knowledge, or information as compared to foreign firms. Such advantages would allow the foreign subsidiary of the domestic firm to earn a higher return than is possible by a foreign-managed firm.

FDI has become an increasingly important source of finance for both developing and developed countries. Fig. 10.1 illustrates how inflows of FDI to developed and developing countries have changed in recent times. Developing and transition economies have seen a fairly steady upward trend on FDI inflows during the 1990–2015 period, except following the US recessions of 2000 and 2008. Fig. 10.1 also shows an upward trend in FDI in the developed countries. In addition to the trend, there are two periods of higher than usual investment. From the mid-1990s to the end of the 1990s, Europe and the United States saw a sharp increase in the investment flow. This has been called the “the great IT investment boom.” A similar boom occurred about 2003–07 and was associated with increased housing speculative activity. Also here Europe and the United States were the favorite targets for the investment flows. By 2009 the investment boom had disappeared and FDI appears to be back at its normal trend. Recently FDI has increased, especially in 2015. However, this increase is not due to an increase in new FDI (greenfield investment projects). Instead it is mainly due to mergers and acquisitions and restructuring of companies.

FDI occurs in both developing and developed countries. Fig. 10.1 shows that in most years the FDI is slightly larger in the developing and transition countries as opposed to developed economies. However, in 2015 developing economies experienced a substantially higher FDI at $936 billion compared to $764 billion for the developing and transition nations. The dominance of FDI in developed countries is mainly due to mergers and acquisitions, and due to a slowdown in investment in the BRIC countries (Brazil, Russia, India, and China).

FDI is often politically unpopular in developing countries, and increasingly so also in developed countries, because it is associated with an element of foreign control over domestic resources. Nationalist sentiment, combined with a fear of exploitation, has often resulted in laws restricting direct investment. Although FDI is feared, it may be very beneficial for countries. FDI may contribute more to economic development than do bank loans, since more of the funds go to actual investment in productive resources. In contrast, bank loans to sovereign governments were (and are) often used for consumption spending rather than investment. If foreign firms make a bad decision regarding an FDI, the loss is sustained by the foreign firm, and no repayment would be necessary. In contrast, if the domestic government uses bank loans inefficiently, the country still faces a repayment obligation to the foreign banks. In addition, FDI may involve an adoption of new technologies and productive expertise not available in the domestic economy. Empirical work has shown benefits of FDI for developing nations, but some argue that the primary benefit may be the greatest contribution of FDI. For example, Wang and Wang (2015) found that Chinese companies benefitted more from the access to global financial markets rather than the adoption of new technologies.

Capital Flight

In the discussion of portfolio investment, we emphasized expected risk and return as determinants of foreign investment. When the risk of doing business in a country rises sharply or the expected return falls, we sometimes observe large outflows of investment funds so that the country experiences massive capital account deficits. Such net outflows of funds are often descriptively referred to as capital flight. The change in the risk–return relationship that gives rise to capital flight may be the result of political or financial crisis, tightening capital controls, tax increases, or fear of a domestic currency devaluation.

One of the issues arising from the developing-country debt crisis of the 1980s was an assertion by bankers that some of the borrowed money was not put to use in the debtor nations but, instead, was misappropriated by individuals and deposited back in the developed countries. In addition to allegedly misappropriated funds, wealthy individuals and business firms often shipped capital out of the debtor nations at the same time that these nations were pleading for additional funds from developed-country banks.

It is estimated that over the period from 1977 to 1987, $20 billion of flight capital left Argentina. This $20 billion is almost half of the debt, totaling $46 billion, that was incurred through 1984. The data suggest a crude interpretation that for every $1 borrowed by Argentina, about 50 cents came out of the country as flight capital. Similar statements might be made for other countries. An important aspect of the capital outflows is that fewer resources are available at home to service the debt, and more borrowing is required. In addition, capital flight may be associated with a loss of international reserves and greater pressure for devaluation of the domestic currency.

The discussion of capital flight highlights the importance of economic and political stability for encouraging domestic investment. Business firms and individuals respond to lower risk and higher return. The stable and growing developing country faces little, if any, capital flight and attracts foreign capital to aid in expanding the productive capacity of the economy.

Capital Inflow Issues

The early 1990s were characterized by a surge of capital inflows to developing countries. Interest in countries with emerging financial markets stimulated both direct and portfolio investment in these countries. The inflows were welcome in that they helped poor countries finance domestic infrastructure to aid in development, and they provided additional opportunities for international diversification for investors. However, some countries that experienced particularly large capital inflows exhibited problems that could reduce the positive effects of the capital flows.

A large capital inflow in a short period of time can lead to an appreciation of the recipient country’s currency. This appreciation may reduce the competitiveness of the nation’s export industries and cause a fall in output and rise in unemployment in these industries. We learned in Chapter 3, The Balance of Payments that a large rise in the capital account surplus will be accompanied by a large rise in the current account deficit. The capital inflow may also be associated with a rapid increase in the country’s money supply, which would create inflationary conditions. As a result of potential problems associated with capital inflows, some countries have imposed policies aimed at limiting the effects of these inflows.

Fiscal restraint is a policy of cutting government expenditures, or raising taxes, so that the expansionary effect of the capital flows is partially offset by the contractionary fiscal policy. Chile, Malaysia, and Thailand followed such policies. Many countries have used some sort of exchange rate policy measures. Generally, these involved an appreciation of the currency in countries where the exchange rate has maintained little flexibility. Allowing the currency to appreciate may hurt export industries, but it allows the money supply to be insulated from the capital flow so that inflationary monetary policy does not occur. Some countries also permitted greater exchange rate flexibility as a way to insulate the domestic money supply from the capital flows. Some countries imposed capital controls to limit the inflow of capital. Such measures include taxes and quantity quotas on capital flows, increased reserve requirements on bank borrowing in foreign currency, or limits on foreign exchange transactions.

Overall, the experience of the 1990s has created an awareness that capital inflows can be both a blessing and a curse. The attempts to manage the risks associated with such inflows have met with varied degrees of success, and further studies of the experiences of countries that followed different policies will yield suggestions for appropriate government policy measures.

Summary

Exercises

Appendix A American Depositary Receipts

It is not always necessary to transfer funds abroad to buy foreign securities. Many foreign stocks are traded in the United States in the form of American depositary receipts (ADRs). ADRs are negotiable instruments certifying that shares of a foreign stock are being held by a foreign custodian. ADRs are popular because they offer an easy way for US investors to diversify internationally and allow non-US firms access to raising money in the United States. Even though these stocks are bought and sold on the US market, they are still subject to foreign exchange risk because the dollar price of the ADR shares reflects the dollar value of the foreign currency price of the stock in the foreign country of origin. Furthermore, foreign government policy will have an impact on the value of ADRs. For instance, in April 1987, the British government imposed a 5% tax on conversion of British stocks into ADRs. Trading in these ADRs dropped dramatically until the British government reduced the tax.

Firms that list their stocks as ADRs have some choice as to what type of listing they desire. The available types of ADR programs include the following:

In addition to ADRs, there are also global depositary receipts (GDRs), which are traded in more than one market location. For instance, a firm may have a GDR that is traded in the United States, London, and Tokyo.

Why do non-US firms list their shares in the United States? The US listing provides the following benefits: an enlarged investor base, the ability to raise new capital in the world’s largest financial market, and lower transaction costs than in the home market. In addition, a firm generally finds that the price of its home market shares rises with a US listing. This is likely due to the greater liquidity of trade in the firm’s stock, meaning that there are more counterparties with which to trade and the ease of buying or selling at a good price is enhanced. In addition, a firm that is located in a country with weak accounting standards sends a signal to investors of its quality when it lists in the United States and files financial statements conforming to US accounting standards. In addition, non-US firms may list on a US exchange to use the ADR as a means to take over a US firm. For instance, when Daimler Benz bought Chrysler Corporation, Daimler exchanged ADRs for shares of Chrysler stock.