Investment Management FX markets and International Portfolio Management

Transcription

1 Investment Management FX markets and International Portfolio Management Road Map International portfolio diversification Home bias FX risk FX markets Spot and forward/futures FX rates FX parities Hedging FX risk with forwards

2 Recall: portfolio diversification Assume that expected return E(r i )= μ variance of returns σ i = v covariance of returns cov(r i,r j )= c Equally-weighted portfolio, that is w i = 1/n i=1,2,,n Expected return and variance on portfolio p: for 1 E( rp) = we i ( ri) = n μ = μ i n 2 v 1 σ p = ww i jcov ( ri, rj) = + 1 c i j n n Portfolio diversification (cont d) Diversification can eliminate specific risk: 2 v 1 σ p = + 1 c n n 1. n = 1 E(r p ) = μ σ p = v 2. n E(r p ) = μ σ p = c Spread wealth over infinite number of assets expected return unchanged variance reduction Problems with holding an infinite number of assets?

3 Portfolio diversification (cont d) Diversifying internationally?

4 International diversification The lower the value of c = cov(r i,r j ), the greater the benefits from diversification Want to select securities with minimum possible value of c Correlations with US equity and bond markets are relatively low and varying over time (Elton and Gruber, 2001): equity bond UK Japan Germany France Can increase benefits of diversification by including international assets in portfolio World equity market

5 Global portfolio allocation Home bias Large evidence suggests that investors internationally diversify their portfolios much less than recommended by conventional models of portfolio choice

6 Home bias (cont d) Reasons for not diversifying internationally Exchange-rate risk Regulations institutional investors often constrained on the proportion of foreign assets they can hold some countries (e.g. emerging markets) limit the amount of foreign ownership of companies Taxes foreign investments may be subject to different tax rates compared to domestic investments tax-exempt investors (e.g. Pension Funds) do not receive domestic tax credit for any tax withheld by foreign government

7 Reasons for not diversifying internationally (cont d) Transactions costs different for buying/selling domestic and foreign assets Political risk foreign governments may restrict the amount of money that can be expatriated Cultural differences foreign markets perceived as more risky because they are unfamiliar Foreign investment risk?

8 FX risk? Intermezzo: Forex quotation conventions A foreign exchange rate is the price at which one currency is converted in another (e.g. X HK dollars per 1 US dollar) Since the interbank market is mostly a US dollar market (explained later), all currencies are mostly quoted against the US dollar Direct exchange rate (or domestic price of foreign currency) = amount of local or domestic currency to buy one unit of foreign currency Indirect exchange rate (foreign price of domestic currency) = amount of foreign currency needed to buy one unit of domestic currency

9 Forex conventions: Why bother? Example What is the (arithmetic) average in each market below from the point of view of a US or a Japanese investor?

10 Example (cont d) Step 1: calculate the gross rate of change from FX (i.e. 1+R FX ). Pay attention to the definition of the exchange rate Period FX changes (for US investor) FX changes (for Japanese investor) 1 200/180 = /200 = /190 = /180 = /150 = /190 = /170 = /150 = /180 = /170 = Example (cont d) Step 2: calculate the rate of return from foreign stocks expressed in domestic currency. For example the return on Japanese stocks expressed in US$ is calculated as: US investor: ( )( ) JPUS JP FX R = 1+ R 1+ R 1 Period From U.S. Investment From Japan Investment 1 12% (1.111)(1.18) 1 = 31.10% 2 15% (0.947)(1.12) 1 = 6.06% 3 5% (1.267)(1.1) 1 = 39.37% 4 10% (0.882)(1.12) 1 = 1.22% 5 6% (0.944)(1.07) 1 = 1.01% Average 9.6% 15.26%

11 Example (cont d) The return on US stocks expressed in Japanese yen is calculated as: ( )( ) USJP US FX R = 1+ R 1+ R 1 Japanese investor: Period From Japan Investment From U.S. Investment 1 18% (0.9)(1.12) 1 = 0.80% 2 12% (1.056)(1.15) 1 = 21.44% 3 10% (0.789)(1.05) 1 = 17.16% 4 12% (1.133)(1.1) 1 = 24.63% 5 7% (1.059)(1.06) 1 = 12.25% Average 11.8% 8.39% FX markets Source: Watanabe (2005)

12 FX markets (cont d) FX market is the largest financial market in the world. It operates around the clock (24h a day, 7 days a week) Its volume equals US$2 trillion per day. The busiest trading day in the history of NYSE (19 April 1999) recorded a trading volume of US$ 58 billion! Spot and derivatives transactions share about 50% of the overall market transactions. More recently derivatives reach nearly 70% of the overall transactions. FX markets (cont d) 75% of the FX trading belongs to the interbank market Why? FX profits

13 FX markets (cont d) Half of the transactions are in US dollar, followed by the German mark/euro, and the Japanese yen FX market (cont d) London is the world s largest FX center with more than 30% of the overall turnover history (British sterling as vehicle currency in the past) geography (trading with Tokyo and HK in the morning and NY in the afternoon) high regulatory standards UK US Euro-zone Japan

14 Structure of the FX market Structure of the FX market (cont d)

15 Concentration in the FX market FX market products Spot contract, represents a binding commitment for an exchange of funds with normal settlement and delivery within two business days Forward contract, is an agreement made today for an obligatory exchange of funds at some specified time in the future (e.g. 1, 2, 3, 6, 12 month) FX swaps, is simultaneous sale of a currency for spot delivery and purchase of that currency for forward delivery two legs : e.g. 1) sale of US$/purchase of JPY, 2) sale of JPY/purchase of US$

16 FX market products (cont d) Spot exchange rates Quoted in most financial press against US Dollar, Euro and Sterling Examples (from FT, June 1 st, 2007) HK$/USD = can exchange USD 1 for HK$ S$/USD = can exchange USD 1 for S$ HK$/S$ cross-rate is not listed in FT, but can be inferred as follows: HK$ HK$ USD 1 = = = S$ USD S$

17 Forward exchange rates Example (from FT.com, May 29 th, 2007) can agree now to exchange S$ for US$ in one month s time at S$ (-38) per US$ 1 in one year s time at S$ (-410) per US$ 1 FX parities Interest-Rate Parity Difference between spot exchange rate and forward exchange rate is explained by difference in nominal interest rates in the two countries Forward Rate Unbiased Hypothesis Forward exchange rate is an unbiased predictor of future spot exchange rate Purchasing Power Parity Expected change in spot exchange rate is explained by difference in expected future inflation rates in the two countries

18 Purchasing power parity (PPP) McCurrencies (The Economist, February 2007): Country FX Rate Price in US$ Relative Price Implied FX Rate US 1.00 $ Euro area 0.74/$ $ /$ Japan 121/$ $ /$ HK HK$7.81/$ $ HK$3.73/$ China RMB7.65/$ $ RMB3.42/$ Absolute PPP says Price Relative should equal 1 Relative PPP says Price Relative should remain fixed (but not necessarily equal to 1) How does relationship change with time? price of basket of goods rises with inflation if inflation rates in two countries are different, prices will move out of line unless exchange rate also changes PPP (cont d) Relative PPP implies e.g. for US vs. Singapore: US 1 + π t Et( St+ 1) = S t S 1 + πt where E t (S t+1 ) is expected spot exchange rate in one year s time and π US, π S denote expected inflation rates in US and Singapore, respectively If US inflation rate is expected to exceed Singapore inflation rate, US$ is expected to depreciate against S$ For PPP to hold, there must be free international trade in basket of goods no storage or transportation costs PPP holds only in the long run consumers slow to recognise that goods can be bought more cheaply in another country governments may manage exchange rates (market friction acts to inhibit PPP)

19 PPP (cont d) PPP (cont d)

20 What about RMB? Exchange rate What about RMB? ( ) Jan-95 May-95 Sep-95 Jan-96 May-96 Sep-96 Jan-97 May-97 Sep-97 Jan-98 May-98 Sep-98 Jan-99 May-99 Sep-99 Jan-00 May-00 Sep-00 Jan-01 May-01 Sep-01 Jan-02 May-02 Sep-02 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan ln(cpi differential) ln(rmbus) ( ) 2.08 ( ) ( ) 2.07 ( ) 2.06

21 Readings BKM Chapter 25 (up to 25.4 included) Other readings (optional) Levich, R.M. International Financial Markets, 2 nd Edition, McGraw-Hill, Chapter 3