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the private sector. China™s policies of freeing up economic activities contributed to the re-
markable growth in market capitalization over 1996“2001. The expected continuation of
this process will likely move China toward the predicted relationship in coming years.

Home-Country Bias
One would expect that most investors, particularly institutional and professional investors,
would be aware of the opportunities offered by international investing. Yet in practice, in-
vestor portfolios notoriously overweight home-country stocks compared to a neutral indexing
strategy and underweight, or even completely ignore, foreign equities. This has come to be
known as the home-country bias. Despite a continuous increase in cross-border investing,
home-country bias still dominates investor portfolios.

Opportunities in international investments do not come free of risk or of the cost of special-
ized analysis. The risk factors that are unique to international investments are exchange rate
risk and country-specific risk, discussed in the next two sections.

Exchange Rate Risk
It is best to begin with a simple example.

Consider an investment in risk-free British government bills paying 10% annual interest in
British pounds. While these U.K. bills would be the risk-free asset to a British investor, this is
21.1 EXAMPLE not the case for a U.S. investor. Suppose, for example, the current exchange rate is $2 per
pound, and the U.S. investor starts with $20,000. That amount can be exchanged for
£10,000 and invested at a riskless 10% rate in the United Kingdom to provide £11,000 in
Rate Risk
one year.
What happens if the dollar“pound exchange rate varies over the year? Say that during the
year, the pound depreciates relative to the dollar, so that by year-end only $1.80 is required
to purchase £1. The £11,000 can be exchanged at the year-end exchange rate for only
$19,800 ( £11,000 $1.80/£), resulting in a loss of $200 relative to the initial $20,000
investment. Despite the positive 10% pound-denominated return, the dollar-denominated re-
turn is a negative 1%.

We can generalize from Example 21.1. The $20,000 is exchanged for $20,000/E0 pounds,
where E0 denotes the original exchange rate ($2/£). The U.K. investment grows to
(20,000/E0)[1 rf (UK)] British pounds, where rf (UK) is the risk-free rate in the United King-
dom. The pound proceeds ultimately are converted back to dollars at the subsequent exchange
rate E1, for total dollar proceeds of 20,000(E1 /E0 )[1 rf (UK)]. The dollar-denominated return
on the investment in British bills, therefore, is
1 r(US) [1 rf (UK)]E1 /E 0 (21.1)

We see in Equation 21.1 that the dollar-denominated return for a U.S. investor equals the
pound-denominated return times the exchange rate “return.” For a U.S. investor, the invest-
ment in British bills is a combination of a safe investment in the United Kingdom and a risky
investment in the performance of the pound relative to the dollar. Here, the pound fared
poorly, falling from a value of $2.00 to only $1.80. The loss on the pound more than offsets
the earnings on the British bill.
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition

21 International Investing

F I G U R E 21.2
New Zealand Return (in local currency) Stock market returns
in dollars and local
Return (in $) 10.7
17 currencies for 2001
Spain Source: Datastream.
Ireland 3.1
Hong Kong
United Kingdom
40 30 20 10 0 10 20

Figure 21.2 illustrates this point. It presents rates of returns on stock market indexes in
several countries for 2001. The dark boxes depict returns in local currencies, while the light
boxes depict returns in dollars, adjusted for exchange rate movements. It™s clear that ex-
change rate fluctuations over this period had large effects on dollar-denominated returns in
several countries.

1. Using the data in Example 21.1, calculate the rate of return in dollars to a U.S. in- Concept
vestor holding the British bill if the year-end exchange rate is: (a) E1 $2.00/£; (b)
E1 $2.20/£.
Pure exchange rate risk is the risk borne by investments in foreign safe assets. The investor exchange
in U.K. bills of Example 21.1 bears only the risk of the U.K./ U.S. exchange rate. We can rate risk
assess the magnitude of exchange rate risk by examination of historical rates of change in vari- The uncertainty in
ous exchange rates and their correlations. asset returns due to
Table 21.3A shows historical exchange rate risk measured from monthly percent changes movements in the
exchange rates
in the exchange rates of major currencies over the period 1997“2001. The data shows that cur-
between the
rency risk is quite high. The annualized standard deviation of the percent changes in the ex-
U.S. dollar and
change rate ranged from 5.01% (Canadian dollar) to 14.18% (Japanese yen). The standard foreign currency.
deviation of monthly returns on U.S. large stocks for the same period was 18.81%. Hence,
major currency exchange risk alone would amount to between 27% (5.01/18.81) and 75%
(14.18/18.81) of the risk on stocks. Clearly, an active investor who believes that Japanese
stocks are underpriced, but has no information about any mispricing of the Japanese yen,
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition

728 Part SIX Active Investment Management

TA B L E 21.3
Rates of change in the value of the U.S. dollar against major world currencies, 1997“2001 (monthly data)

A. Standard Deviation (annualized)

Country Currency Euro (E) U.K. (£) Japan (¥) Australia ($A) Canada ($C)

Standard dev. 9.61 6.61 14.18 11.44 5.01

B. Correlation Matrix

Euro U.K. Japan Australia Canada

Euro 1.00
U.K. 0.64 1.00
Japan 0.29 0.21 1.00
Australia 0.29 0.22 0.35 1.00
Canada 0.02 0.02 0.13 0.53 1.00

C. Average Increases

Average Annualized %
Annualized Dollar Increase in the
Return on Cash Value of the U.S.
Investments Dollar

U.S. 5.67
France 2.64 Euro 7.28
Germany 2.82 Euro 7.28
Italy 1.81 Euro 7.28
Netherlands 2.88 Euro 7.28
Switzerland 1.48 Euro 7.28
U.K. 3.34 U.K. 3.47
Australia 2.74 Australia 9.46
Japan 0.97 Japan 3.44
Canada 1.90 Canada 3.17

would be advised to hedge the yen risk exposure when tilting the portfolio toward Japanese
stocks. Exchange rate risk of the major currencies is quite stable over time. For example, a
study by Solnik (1999) for the period 1971“1998 finds similar standard deviations, ranging
from 4.8% (Canadian dollar) to 12.0% (Japanese yen).
In the context of international portfolios, exchange rate risk may be mostly diversifiable.
This is evident from the low correlation coefficients in Table 21.3B. (This observation will be
reinforced when we compare the risk of hedged and unhedged country portfolios in a later sec-
tion.) Thus, passive investors with well-diversified international portfolios need not be con-
cerned with hedging exposure to foreign currencies.
The annualized average monthly increase in the value of the U.S. dollar against the major
currencies over the five-year period and dollar returns on foreign bills (cash investments) ap-
pear in Table 21.3C. The table shows that the value of the U.S. dollar consistently increased in
this particular period. For example, the total increase against the Japanese yen over the five
years was 18% and against the Australian dollar, 57%. This currency appreciation of the U.S.
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition

21 International Investing

dollar was not offset by higher interest rates available in other countries. Had an investor been
able to forecast the large exchange rate movements, it would have been a source of great
profit. The currency market thus provided attractive opportunities for investors with superior
information or analytical ability.
The investor in Example 21.1 could have hedged the exchange rate risk using a forward or
futures contract in foreign exchange. Recall that a forward or futures contract on foreign ex-
change calls for delivery or acceptance of one currency for another at a stipulated exchange
rate. Here, the U.S. investor would agree to deliver pounds for dollars at a fixed exchange rate,
thereby eliminating the future risk involved with conversion of the pound investment back
into dollars.

If the futures exchange rate had been F0 $1.93/£ when the investment was made, the
U.S. investor could have assured a riskless dollar-denominated return by locking in the year-
end exchange rate at $1.93/£. In this case, the riskless U.S. return would have been 6.15%:
rf (UK)]F0 /E0
Rate Risk
Here are the steps to lock in the dollar-denominated returns. The futures contract entered
in the second step exactly offsets the exchange rate risk incurred in step 1.

Initial Transaction End-of-Year Proceeds in Dollars

Exchange $20,000 for £10,000 and invest at
10% in the United Kingdom. £11,000
Enter a contract to deliver £11,000 for dollars at
E 1)
the (forward) exchange rate $1.93/£. £11,000(1.93

Total £11,000 $1.93/£ $21,230

You may recall that the futures hedge in Example 21.2 is the same type of hedging strategy
at the heart of the spot-futures parity relationship discussed in Chapter 16. In both instances,
futures markets are used to eliminate the risk of holding another asset. The U.S. investor can
lock in a riskless dollar-denominated return either by investing in the United Kingdom and
hedging exchange rate risk or by investing in riskless U.S. assets. Because the returns on two
riskless strategies must provide equal returns, we conclude

F0 1 rf (US)


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