Global Finance 16 Foreign Security Risk and Return

Global finance topic 16 foreign securities risks and expected returns copyright louganis in this topic we’re gonna look at the types of foreign securities methods of saying buying equities in foreign markets talk about the costs and benefits of foreign investing and then we’ll compute the expected return recites it’s a holding period return and risk of foreign

Securities the benefits of holding foreign securities are kind of obvious first of all you a diversification benefit by holding a security whose returns aren’t perfectly correlated with your domestic market you can reduce the risk of your overall portfolio also with exposure to emerging markets like china and other areas in asia and eastern europe you have the

Possibility of having much faster growth but the rest of foreign investing are many in addition to just exchange rate risk which will cover a lot there’s just a lickle acquittee of smaller markets lack of information and transparency of public companies rely on some farm legal remedies in case some investment goes wrong you know what remedies do you have as an

American to say get compensated for for something that farm company has done there’s foreign taxes and then there’s overall political and economic risk of that area we talk about the returns of a security i’m just going to talk about a holding period return not holding period is you buy a security at p0 the initial price p1 will be the new price at the end of the

Period p 1 minus p 0 is your capital gain and then any dividend or interest payment will also go into the computation of holding pares return so here’s a case of a holding period return from the perspective of a japanese investor buying sony stock they buy the stock for 5000 yen it’s selling for fifty five hundred yen in one year and also pays a dividend of 250

Yen in one year in this case they get a 500 yen capital gain 250 yen dividend payment divided by our $5,000 investment you can see this japanese investor got a 15% return on their japanese stock now the question is well will the return be if this were an american investor what would be the us dollar return well to know that you need to know what the exchange rates

Were at the time of purchase and sale of the stock so say when the stock was purchased the exchange rate was a hundred yen per dollar at the purchase price of 5000 yen and at the time of sale and receiving of the dividend the exchange rate was 105 so we’ll now compute the us dollar rate of return of this investment my initial cash flow in dollar is a $5,000 i’m

Sorry 5,000 yen cost times the dollar yen exchange rate 1 over 100 so the initial cost will be $50 and then at the end of the year you’ll get 50 500 yen plus 250 and dividend payment and we’ll multiply times the new exchange rate of 105 so instead of multiplying times 1 over 105 i’ll just divide this by 105 and you can see an american investor would have received

54 dollars and 76 cents so our us dollar rate of return is going to be our 5476 minus our initial cost of 50 over 50 so our us dollar return is 9.5 2 percent so the japanese investor receives 15% in yen or for an american would be nine and a half percent return in dollars and the difference is because the exchange rate over this period of time the yen must have

Devalued and we can look at that we said the exchange rate went from 100 to 105 so we look at the appreciation of the yen since this is an indirect quote yen over dollar and i want to know the appreciation of the end i will use 100 – 105 over 105 that’ll tell me what happened to the yen and you can see the yen is down four point seven six percent so the return the

Yen return of sewing was fifteen percent we said that the dollar return of sony was nine and a half percent and we know that the yen devalued for point seven six percent there is a shorthand way of trying to compute a us dollar return given the appreciation of the currency and the return in the foreign currency that’s given by this equation here the dollar return

Of a foreign investment is one plus the foreign return plus one plus the appreciation of the currency where c is denoted as the appreciation of the foreign currency this is my dollar return it’s going to be the yen return times one plus the appreciation that’s a negative and you can see that we can calculate directly that we knew that we had a fifty percent return

In yen and then the n devalued for point seven six percent we have a nine and a half percent return in us and approximation for this formula it would be just take the yen return add in the appreciation of the currency and that gets you about a 10% return which is an approximation of what happened here was actually nine and a half so this formula here tells you how

To compute the dollar return of foreign investment directly from the far and return in the local currency and the appreciation of the currency using that formula we can answer another question so you expect the toyota to increase by 10 percent in yen inflation in the us and japan are given so here’s our yen inflation here’s our dollar inflation so once the expect

A return us dollar return up toyota well you’re given that the return is expected to be 10 percent in yen so now i just need to compute the expected appreciation of the yen to see well using interest rate parity i know that the expected appreciation of the yen is going to be the ratio of dollar / yen inflation or interest rates minus 1 there’s my dollar inflation

Yet inflation and you can see the yen is expected to appreciate by 1.90 for 8% and we could make an approximation right you know here that japan has 5% lower inflation so i can just assume that they’re roughly going to appreciate by about 2% and if i take that 2 percent appreciation of yen plus my 10 percent appreciation of the stock price in yen i get about a 12

Percent return in the security which does give you the right answer but let’s do it more precisely my dollar return it’s going to be the return in yen plus my yen appreciation and that’s how i solved that problem so again this formula allows you to think about the returns in dollar the returns in the local currency and also the relationship with the return of the

Currency or the appreciation of the currency this next problem ask a slightly different question with that same formula so we’re still going to use our formula dollar return 1 plus the far and return times 1 plus the appreciation of the foreign currency minus 1 in this case it says the u.s. notes treasury notes are yielding 2% german boons which are their treasury

Notes are yielding three and a half percent what’s the appreciation of the euro to ensure the bonds have the same us dollar return well i can approximate that i can say that if a buddha gives me three and a half what appreciation of the euro will make it give us the return of the us bond two percent you can see that it’s approximately one and a half percent negative

So if i get a three and a percent return in euro and the euro depreciates by about two one and a half percent now i’m going to be a to two percent return in u.s. but we can solve this problem using the formula my us dollar return is two percent my return in euros from the boond it’s three and a half and then i can solve for c in this equation and see turns out to

Be equal to negative 0.01 for five so that’s how we’re going to calculate the holding period return off a foreign investment holding period term depends on both the local return and the return of the currency or the appreciation of the currency that’s the way to think about a foreign investment the foreign investment is an equal investment in both the security say

The boone door sheriff sony or a share of toyota an equal investment in the currency the returns as an american depends on both now to calculate the risk of a foreign investment we’re going to use standard deviation so standard deviation is the standard measure for risk in finance gives us an idea the dispersion around the mean when we try to calculate the standard

Deviation or the variance of a foreign investment it’s a little more complicated though the variance of a dollar return of a foreign investment for example the variance of holding variance of the dollar returns of saying a share of sony depends on the variance of sony in yen the variance of the exchange rate plus two times the correlation between these two factors

Times the standard deviation of these two factors and if this formula familiar from other investment classes it’s because it’s almost the two-asset portfolio formula so if you remember from other classes if you’re looking for say the variance between holding stocks say a and b you probably had a formula looks something like this the weight of a squared times sigma

A squared plus the weight of b squared plus sigma b squared plus 2 times the correlation times the standard deviation standard deviation of a and b times the weight of a times the weight of b well this is the formula that we’re using here except in this case that the two assets are both the stock and the currency and you’re actually invested a hundred percent in

Both so if i put fifty dollars into a share of sony stock i have a fifty dollar investment in sony and a fifty dollar investment in the yen so my weights turned out to be a hundred percent invested in both that’s why these w’s go away and i get this formula here that looks like the two acid variants formula where the w’s are gone because the weights are a hundred

Percent in both asset so i can now calculate this problem the standard deviation of sony for japanese investors 23% so they just look at the standard deviation of yen returns and i know the standard deviation of the yen say the dollar price of the n changes is 17% and the correlation between these two factors is 0.3 1 i can calculate the standard deviation for an

American holding sony stock so if i want standard deviation i’ll get rid of the squared term and i can just take my variance to the square root so the standard deviation in dollars for sony it’s going to be the square root of the variance of sony square sony’s shares returns plus the variance of the exchange rate returns plus 2 times the correlation times the 2

Standard deviations in this term in this problem it turns out to be 32.6% so what you see is holding a foreign security is generally riskier than holding a local security of the similar business risk because you have two sources of risk you have the risk of the stock and the risk of the currency so this will be our general formula for calculating the standard

Deviation of a foreign security in dollars or the standard deviation of dollar returns of a foreign security so the last thing we’ll talk about is follow say i want to buy sheriff sony how do i buy it well there’s the hard way and there’s an easier way the hard way would be to say take 50 dollars go to a bank convert it into yen have those yen deposited at a

Broker have the broker buy shares on the tokyo exchange and then every day that the share would pay a dividend it would be paid in yen i can then have the bank convert the yen dividend back to dollars using the bid-ask spot prices and then when i finally sell the house sell the stock i can also convert are the cash flows into yet from the end a dollar so you can

Buy shares on farm markets but for an american we can also buy an ad our ad yards or american depository receipts are a system in which a bank buys a share of say sony stock or a bond buys a bunch of shares of sony stock puts them in a portfolio effectively and then sell shares of that portfolio to americans where the price is quoted as a dollar and each share of

The portfolio is really a share of sony stock you have level 180 ours you have level 2 and level 3 a trs level 180 yards are a little riskier they’re not registered with the sec they’re not gaap compliant so they are pretty speculative investment level 2 and level 3 a trs are securities registered registered with the sec and are gaap compliant so i can look at

Say a sony adr and i can look at their financial statements knowing that they are gaap compliant and i can compare them with other us securities there are many advantages of a drs namely is everything’s conducted in dollars dividends are paid in dollars you pay a price in dollars prices are quoted in dollars if in fact never would see a yen quoted also a bank is

Able to save investors on average between 10 and 40 basis points compared to doing the shares directly so the banks have better access to exchange rates and at the purchase of shares at a better price however atrs do not reduce any of the exchange rate risk well for example let’s take a look at the sony adr so a sony adr it’s called sne that’s the stock symbol it

Trades on the new york stock exchange and you can see the price is $22 and six cents so i can call my broker and say give me a share of sne and you’ll be charged twenty two dollars and six cents assuming that’s say the the asking price of the stock and if any dividends paid you’ll receive those in dollars when you sell the stock you’ll receive dollars right when

You can see is the sne the sony adr was down say 40 basis points today right what we don’t know is if the reason that the stock is down is because the price of sony and tokyo is down in yen or if the exchange rate say the dollar price that the yen is down 40 basis points so those are two likely outcomes it could be that the sheriff’s of sony in tokyo are unchanged

But the yen is devalued 40 basis points or it could be that the exchange rate has not changed but the price of sony has decreased by 40 basis points so this just reaffirms the fact that the holding a adr does not reduce any of the exchanger at risk it just you just don’t see it you just see price changes those price changes are combinations of exchange rate changes

And security changes in the foreign currency there’s also gdrs kind of like a drs so g drs are securities just like a drs but they are placed in ad institutions so hopefully we learned exactly how to buy a foreign security either at a farm market or through an adr talked about the costs and benefits of owning foreign securities and talked about how to calculate a

Holding period return and standard deviation of a foreign security

Transcribed from video
Global Finance 16 Foreign Security Risk and Return By Lou Gattis