Currency risk analysis in global investing

Global Investments

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Seiler Performing Financial Studies: A Methodological Cookbook

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The Prentice Hall Series in Finance

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Global Investments

Bruno Solnik HEC PARIS

HONG KONG UNIVERSITY OF SCIENCE & TECHNOLOGY

& Dennis McLeavey

CFA INSTITUTE UNIVERSITY OF VIRGINIA

EMERITUS, UNIVERSITY OF RHODE ISLAND

SIXTH EDITION

Editor in Chief: Denise Clinton Executive Editor: Donna Battista Editorial Assistant: Kerri McQueen Managing Editor: Nancy H. Fenton Senior Production Supervisor: Kathryn Dinovo Design Manager: Joyce Cosentino Wells Supplements Coordinator: Heather McNally Senior Media Producer: Bethany Tidd Senior Marketing Manager: Andrew Watts Senior Author Support/Technology Specialist: Joe Vetere Senior Prepress Supervisor: Caroline Fell Rights and Permissions Advisor: Dana Weightman Senior Manufacturing Buyer: Carol Melville Cover Designer: Susan Raymond Text Design, Production Coordination, Composition, and Art: Nesbitt Graphics, Inc.

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Library of Congress Cataloging-in-Publication Data

Solnik, Bruno H., 1946– Global investments / Bruno Solnik & Dennis McLeavey.—6th ed.

p. cm.—(The Prentice Hall series in finance) Rev. ed. of: International investments. 5th ed. 2003. Includes bibliographical references. ISBN-13: 978-0-321-52770-7 1. Investments, Foreign. I. McLeavey, Dennis W. II. Solnik, Bruno H., 1946–

International investments. III. Title. HG4538.S52 2008 332.67'3—dc22

2007050462

Copyright © 2009 Pearson Education, Inc.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopy- ing, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. For information on obtaining permission for use of material in this work, please submit a written request to Pearson Education, Inc., Rights and Contracts Department, 501 Boylston Street, Suite 900, Boston, MA 02116, fax your request to 617-671-3447, or e-mail at http://www.pearsoned.com/legal/permissions.htm.

IBSN-13: 978-0-321-52770-7 ISBN-10: 0-321-52770-4

1 2 3 4 5 6 7 8 9 10—CRW—12 11 10 09 08

http://www.pearsoned.com/legal/permissions.htm
To Catherine, who remains, after three decades of marriage and medical prac- tice, the heart of my life. She has now enjoyed all the exciting aspects of the leading financial cities of the world. She has also shared numerous sleepless, interminable airplane hauls and middle-of-the-night phone calls from Hong Kong, Tokyo, New York, and Chicago. Let this book add to the long list of pleasures and suffering we happily share.

To Alexandra and Vincent Solnik, CFA, my children and former students, who have learned to suffer through and enjoy the previous edition of this book.

Bruno Solnik

To Janet, my wife and best friend. Her teaching preparation and awards as a mathematics professor have constantly inspired me with the knowledge that even the most difficult concept is intelligible if enough effort and care is taken in the presentation. She has been remarkably tolerant of book deadlines.

To Andy and Christine McLeavey who continue to fill our lives with joy. Dennis McLeavey

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Preface xix

Chapter 1 Currency Exchange Rates 1 Learning Outcomes 1 Currency Exchange Rate Quotations 3

Direct and Indirect Quotations 4 Cross-Rate Calculations 5 Forex Market and Quotation Conventions 6 Bid–Ask (Offer) Quotes and Spreads 8 Cross-Rate Calculations with Bid–Ask Spreads 10 No-Arbitrage Conditions with Exchange Rates 12

Forward Quotes 14 Interest Rate Parity: The Forward Discount and the Interest

Rate Differential 15 Forward Exchange Rate Calculations with Bid–Ask Spreads 20

Summary 22 Problems 23

Chapter 2 Foreign Exchange Parity Relations 27 Learning Outcomes 27 Foreign Exchange Fundamentals 28

Supply and Demand for Foreign Exchange 28 Balance of Payments 30 Current Account Deficits and Financial Account Surpluses 31 Factors Affecting the Financial Account 33 Government Policies: Monetary and Fiscal 35 Exchange Rate Regimes 36

International Parity Relations 38 Some Definitions 39 Interest Rate Parity 40 Purchasing Power Parity: The Exchange Rate and the Inflation

Differential 40 International Fisher Relation: The Interest Rate and Expected Inflation

Rate Differentials 42

Contents

vii

viii Contents

Uncovered Interest Rate Parity 44 Foreign Exchange Expectations: The Forward Premium (Discount) and the

Expected Exchange Rate Movement 46 Combining the Relations 48 International Parity Relations and

Global Asset Management 48 Exchange Rate Determination 50

Purchasing Power Parity Revisited 51 Fundamental Value Based on Absolute PPP 51 Fundamental Value Based on Relative PPP 54 The Balance of Payments Approach 56 The Asset Market Approach 61

Summary 68 Problems 70 Bibliography 74

Chapter 3 Foreign Exchange Determination and Forecasting 75

Learning Outcomes 75 International Monetary Arrangements 76

A Historical Perspective 76 The Empirical Evidence 83

Interest Rate Parity 83 International Fisher Relation 84 Purchasing Power Parity 85 Foreign Exchange Expectations 88 Practical Implications 90

Exchange Rate Forecasting 91 Is the Market Efficient and Rational? 92 The Econometric Approach 94 Technical Analysis 95 Central Bank Intervention 97 The Use and Performance of Forecasts 99

Summary 102 Problems 103 Bibliography 106 Chapter 3 Appendix: Statistical Supplements on Forecasting Asset Returns 109

Some Notations 109 Traditional Statistical Models with Constant Moments 110 Traditional Statistical Models with Time-Varying Moments 111 Nontraditional Models 113 Data Mining, Data Snooping, and Model Mining 115

Contents ix

Chapter 4 International Asset Pricing 117 Learning Outcomes 117 International Market Efficiency 118 Asset Pricing Theory 121

The Domestic Capital Asset Pricing Model 121 Asset Returns and Exchange Rate Movements 123 The Domestic CAPM Extended to the International Context 125 International CAPM 126 Market Imperfections and Segmentation 135

Practical Implications 136 A Global Approach to Equilibrium Pricing 136 Estimating Currency Exposures 139 Tests of the ICAPM 146

Summary 148 Problems 151 Bibliography 155

Chapter 5 Equity: Markets and Instruments 157 Learning Outcomes 157 Market Differences: A Historical Perspective 158

Historical Differences in Market Organization 159 Historical Differences in Trading Procedures 159 Automation on the Major Stock Exchanges 161

Some Statistics 167 Market Size 167 Liquidity 170 Concentration 171

Some Practical Aspects 171 Tax Aspects 172 Stock Market Indexes 172 Information 176

Execution Costs 177 Components of Execution Costs 177 Estimation and Uses of Execution Costs 179 Some Approaches to Reducing Execution Costs 182

Investing in Foreign Shares Listed at Home 185 Global Shares and American Depositary Receipts 185 Motivation for Multiple Listing 186 Foreign Listing and ADRs 186 Closed-End Country Funds 189 Open-End Funds 193 Exchange Traded Funds 193

x Contents

Summary 196 Problems 197 Bibliography 202

Chapter 6 Equity: Concepts and Techniques 203 Learning Outcomes 203 Approaching International Analysis 204

The Information Problem 205 A Vision of the World 206

Differences in National Accounting Standards 207 Historical Setting 208 International Harmonization of Accounting Practices 209 Differences in Global Standards 212 The Effects of Accounting Principles on Earnings and Stock Prices 215

Global Industry Analysis 217 Country Analysis 217 Industry Analysis: Return Expectation Elements 222 Industry Analysis: Risk Elements 227

Equity Analysis 232 Global Risk Factors in Security Returns 242

Risk-Factor Model: Industry and Country Factors 246 Other Risk Factors: Styles 247 Other Risk Factors: Macroeconomic 247 Practical Use of Factor Models 249

Summary 251 Problems 252 Bibliography 257

Chapter 7 Global Bond Investing 256 Learning Outcomes 256 The Global Bond Market 260

The Various Segments 260 World Market Size 262 Bond Indexes 263 The International Bond Market 264 Emerging Markets and Brady Bonds 269

Major Differences Among Bond Markets 271 Types of Investments 271 Quotations, Day Count, and Frequency of Coupons 272 Legal and Fiscal Aspects 274

A Refresher on Bond Valuation 276 Zero-Coupon Bonds 276 Bond with Coupons 278

Contents xi

Duration and Interest Rate Sensitivity 280 Credit Spreads 282

Multicurrency Approach 284 International Yield Curve Comparisons 284 The Return and Risk on Foreign Bond Investments 287 Currency-Hedging Strategies 288 International Portfolio Strategies 289

Floating-Rate Notes and Structured Notes 293 Floating-Rates Notes (FRNs) 294 Bull FRNs 300 Bear FRNs 302 Dual-Currency Bonds 302 Currency-Option Bonds 306 Collateralized Debt Obligations (CDOs) 307

Summary 310 Problems 312 Bibliography 316

Chapter 8 Alternative Investments 317 Learning Outcomes 317 Investment Companies 319

Valuing Investment Company Shares 320 Fund Management Fees 320 Investment Strategies 320 Exchange Traded Funds 323

Real Estate 332 Forms of Real Estate Investment 333 Valuation Approaches 334 Real Estate in a Portfolio Context 342

Private Equity 344 Stages of Venture Capital Investing 346 Investment Characteristics 347 Types of Liquidation/Divestment 348 Valuation and Performance Measurement 349

Hedge Funds and Absolute Return Strategies 351 Definition of Hedge Funds 351 Classification 354 Funds of Funds 357 Leverage and Unique Risks of Hedge Funds 359 Hedge Funds Universe and Indexes 360 The Case for Investing in Hedge Funds 363

Closely Held Companies and Inactively Traded Securities 366 Legal Environment 366 Valuation Alternatives 367 Bases for Discounts/Premiums 367

xii Contents

Distressed Securities/Bankruptcies 368 Commodity Markets and Commodity Derivatives 369

Commodity Futures 369 Motivation and Investment Vehicles 370 Active Investment 371 The Example of Gold 372 Commodity-Linked Securities 373

Summary 375 Problems 378 Bibliography 383

Chapter 9 The Case for International Diversification 385

Learning Outcomes 385 The Traditional Case for International Diversification 388

Risk Reduction through Attractive Correlations 388 Portfolio Return Performance 398 Currency Risk Not a Barrier to International Investment 406

The Case against International Diversification 407 Increase in Correlations 407 Past Performance Is a Good Indicator of

Future Performance 411 Barriers to International Investments 411

The Case for International Diversification Revisited 415 Pitfalls in Estimating Correlation During Volatile Periods 415 Expanded Investment Universe and Performance

Opportunities 417 Global Investing Rather Than International Diversification 418

The Case for Emerging Markets 421 The Basic Case 421 Volatility, Correlations, and Currency Risk 422 Portfolio Return Performance 423 Investability of Emerging Markets 424 Segmentation versus Integration Issue 425

Summary 425 Problems 427 Bibliography 430

Chapter 10 Derivatives: Risk Management with Speculation, Hedging, and Risk Transfer 433

Learning Outcomes 433 Forward and Futures 434

The Principles of a Forward and a Futures Contract 434

Contents xiii

The Different Instruments 437 Forward and Futures Valuation 444 Use of Forward and Futures 447

Swaps 453 The Principles of a Swap 453 The Different Instruments 454 Swaps Valuation 456 Use of Swaps 460

Options 464 Introduction to Options 464 The Different Instruments 466 Option Valuation 468 Use of Options 473

Summary 476 Problems 478 Bibliography 483

Chapter 11 Currency Risk Management 485 Learning Outcomes 485 Hedging with Futures or Forward Currency Contracts 486

The Basic Approach: Hedging the Principal 487 Minimum-Variance Hedge Ratio 490 The Influence of the Basis 494 Implementing Hedging Strategies 496 Hedging Multiple Currencies 497

Insuring and Hedging with Options 499 Insuring with Options 499 Dynamic Hedging with Options 500 Implementation 504

Other Methods for Managing Currency Exposure 505 Strategic and Tactical Currency Management 509

Strategic Hedge Ratio 509 Currency Overlay 512 Currencies as an Asset Class 514

Summary 515 Problems 516 Bibliography 521

Chapter 12 Global Performance Evaluation 523 Learning Outcomes 523 The Basics 524

Principles and Objectives 524 Calculating a Rate of Return 527

xiv Contents

Performance Attribution in Global Performance Evaluation 534 The Mathematics of Multicurrency Returns 535 Total-Return Decomposition 537 Performance Attribution 540 More on Currency Management 545 Multiperiod Attribution Analysis 548 An Example of Output 555

Performance Appraisal in Global Performance Evaluation 557 Risk 557 Risk-Adjusted Performance 559 Risk Allocation and Budgeting 562 Some Potential Biases in Return and Risk 563

Implementation of Performance Evaluation 565 More on Global Benchmarks 565 Global Investment Performance Standards and Other Performance

Presentation Standards 568 Summary 570 Problems 571 Bibliography 579

Chapter 13 Structuring the Global Investment Process 581

Learning Outcomes 581 A Tour of the Global Investment Industry 582

Investors 582 Investment Managers 584 Brokers 585 Consultants and Advisers 585 Custodians 587

Global Investment Philosophies 587 The Passive Approach 587 The Active Approach 589 Balanced or Specialized 590 Industry or Country Approach 591 Top-Down or Bottom-Up 591 Style Management 592 Currency 593 Quantitative or Subjective 594

The Investment Policy Statement 595 Capital Market Expectations 600

Defining Asset Classes 603 Long-Term Capital Market Expectations: Historical Returns 603 Long-Term Capital Market Expectations: Forward-Looking Returns 605 Short-Term Capital Market Expectations 608

Global Asset Allocation: From Strategic to Tactical 610 Strategic Asset Allocation 610 Tactical Asset Allocation 614

Global Asset Allocation: Structuring and Quantifying the Process 615 Research and Market Analysis 617 Asset Allocation Optimization 619 Portfolio Construction 620 Performance and Risk Control 620

Summary 624 Problems 625 Bibliography 627

Glossary 629 Index 643

Contents xv

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Bruno Solnik is Distinguished Emeritus Professor of Finance at HEC Paris and Visiting Professor of Finance, Hong Kong University of Science and Tech- nology. He holds an Engineering degree from Polytechnique in Paris and a Ph.D. from Massachusetts Institute of Tech- nology. Before joining HEC Paris, he was on the faculty of the Graduate School of Business of Stanford University.

Professor Solnik has been a visiting professor at the University of California at Berkeley, U.C.L.A., Strathclyde University, Université de Genève, Uni- versity of New South Wales, and Todai (University of Tokyo). He was the founding president of the European

Finance Association. In addition to writing seven books, five in France and two in the United States, he has published some fifty articles in leading finance journals. Professor Solnik serves on the editorial board of several major finance journals in America, Europe, and Asia, and was a Trustee of the Research Foundation of CFA Institute. His many awards include two Graham & Dodd awards of excellence by the Financial Analysts Journal, the Finance Award of the Year at the 1998 Interlaken Finance Symposium, and the Nicholas Molodovsky award, presented on May 22, 1999 by the CFA Institute Board of Governors with this introduction, “This award is given periodically only to those individuals who have made outstanding contributions of such significance as to change the direction of the profession and to raise it to higher standards of accomplishment.”

Professor Solnik’s expertise has been called upon by many pension funds and banks in Europe, the United States, and Asia. Among others, he advised the pension plans of Royal Dutch and Calsters and the Nobel Foundation. From 1999 to 2004, he acted as advisor to the investment committee of UBS Global Asset Management. He sits on the Investment Management Advisory Council, a major global insurer.

About the Authors

xvii

Dennis McLeavey, CFA, DBA, is Head of Professional Development Content in the Education Division at CFA Institute, Professor Emeritus at the University of Rhode Island, and Visiting Professor of Finance at the University of Virginia Darden Graduate School of Business Administration. The sixth edition of Solnik and McLeavey’s Global Investments and the new Bodie, McLeavey and Siegel book, The Future of Life-Cycle Saving and Investing, reflect Dr. McLeavey’s interests in investor wel- fare. In the CFA Institute Investment Series, he is co-author of Quantitative Methods for Investment Analysis and Analysis of Equity Investments: Valuation, as well as co-editor of Managing Investor

Portfolios. His texts, Production Planning and Inventory Control and Operations Research for Management Decisions, reflect his interest in risk management. His research has been published in journals such as Management Science and the Journal of Operations Research. At the University of Rhode Island, Dr. McLeavey founded and served as advisor to a student-managed investment club, the Ram Fund. He has also served as chairperson of the CFA Institute Retirement Investment Policy Committee and continues to serve as a New York Stock Exchange Arbitrator. After earning a B.A. in economics at the University of Western Ontario in 1968, Dr. McLeavey received a Ph.D. in production management and industrial engineering at Indiana University in 1972.

xviii About the Authors

Global Investing: The Current Perspective

More than thirty years ago, Bruno Solnik published an article entitled “Why not diversify internationally rather than domestically?” in the Financial Analysts Journal (July/August 1974). At the time, the combination of poor information, low exper- tise, stringent regulations, and high costs inhibited global investing. Thirty years later, the investment scene has changed dramatically.

The benefits of international diversification in terms of risk and return have increasingly been recognized, as detailed in this book. This has led to a push toward guidelines and legislation more favorable to foreign investment. A sec- ond factor in the rapid pace of global investing is the deregulation and interna- tionalization of financial markets throughout the world. This global integration of financial markets has led to reduced costs, easier access to information, and the development of worldwide expertise by major financial institutions. Computerized quotation and trading systems that allow global round-the-clock trading have been developed. Restrictions to capital flows were removed within the countries of the European Union (EU); European-based investment management firms can freely market their products to residents of any EU mem- ber state. Hence, American or Japanese asset managers established in London can easily provide their services to any European client. This globalization of investment management has led to increased competition among money man- agers of all nationalities. It has also led to a wave of alliances, mergers, and acquisitions among financial institutions seeking to extend their global manage- ment expertise and the geographic coverage of their client base. The rapid pace of global investing is further accelerated by the general acceptance of a common set of standards and ethical principles by investment professionals. Debt issues are rated by the same rating agencies worldwide. Listed corporations are progressively adopting common or related international accounting standards. The Chartered Financial Analyst® (CFA®) designation of CFA Institute has progressively been adopted as a standard by the worldwide investment profes- sion. A majority of the CFA candidates are non-U.S. citizens. The Global Investment Performance Standards (GIPS®), developed and administered by CFA Institute, are adopted by asset managers worldwide and are recognized as the leading global industry standard for ethical presentation of investment performance results.

Preface

xix

Target Audience

This book is designed for MBA students, advanced undergraduates, investment professionals, and financial managers. It is appropriate for undergraduate and graduate business school electives in international finance as well as for master’s courses in fields such as engineering or economics. The book is self-contained and does not take a specific national viewpoint; hence, it has been successfully used in courses and professional seminars throughout the world.

Why is the book good for these students? In a global environment, students need to grapple with such concerns as how to value global companies as well as when and how (1) monetary and fiscal policies affect exchange rates; (2) foreign exchange risk affects companies and investment portfolios; (3) global correlations collapse; (4) foreign exchange risk should be hedged; and (5) multiperiod perfor- mance attribution distinguishes skill from luck. Today all investing is global and this edition of Global Investments gives the student the tools needed to operate in an environment of global finance, investments, and competition. Indeed this book can be summarized by updating the globalization argument to “Why not learn in- ternationally rather than domestically?”

Structure of This Book

The global investor is faced with a complex task. The financial markets throughout the world are quite different from one another, and information on them is some- times difficult to obtain. Trading in different time zones and languages further complicates the task. But the most important aspect of global investment is the use of multiple currencies. An American investing in France must do so in euro; there- fore, the performance (and risk) of the investment will depend in part on changes in the euro to U.S. dollar exchange rate. Because of the importance of exchange rates in global investment, this book begins with a description of foreign exchange transactions.

In this text, we develop the analysis needed for the global investment and port- folio management process. The first three chapters lay the foundation of exchange rates, which link the economies of different countries and regions. In Chapter 1, we introduce the basic facts of foreign exchange quotation, their interpretation, and arbitrage implications. In Chapter 2, we develop the theory of international parity conditions. The theory helps in defining real foreign currency risk, an important factor to be managed in global investing and portfolio management. Chapter 3 then discusses the empirical validation of the theories introduced in Chapter 2 and explores the techniques and empirical results in the difficult task of exchange rate forecasting.

The next five chapters explore the various assets available for global investing. Chapter 4 is the lead chapter in a series of chapters on international assets. In it we

xx Preface

develop international asset pricing in general with attention to foreign currency risk. Chapter 5 places a particular focus on the transaction costs involved in various equity markets and instruments allowing entry into global investments. Following this general introduction to international asset pricing, Chapters 6, 7, and 8 focus on the available international assets and investments themselves: equities, bonds, and alternative investments, respectively.

The final five chapters develop the techniques and perspective of global portfolio management. After building the case for and against international diversification in Chapter 9, we move into the foreign currency risk and return analysis needed for international portfolio management. We develop the risk control techniques available with derivatives in Chapter 10 and then apply these techniques in currency risk management in Chapter 11. In Chapter 12, we examine the performance measures to judge the risk and return contribu- tions of global diversification. Finally, we summarize the global investment and portfolio management process in Chapter 13. Throughout the text, we attempt to isolate those elements of the process that have unique international aspects.