Chapter 21

INTERNATIONAL INVESTING The Global Search

Prospects for Global Investing

The world is being swept by a second wave of globalisation at the beginning of the twenty first century. How would investors fare now? We believe that investors would fare better this time because of the following fundamental geopolitical changes that have taken place in this world. With the apparent demise of communism as a valid economic philosophy, the threat of nationalisation and government expropriation has decreased considerably. With the passing of colonialism, tensions among developed countries and between developed and developing countries have diminished. Capitalistic philosophy is maturing, leading to a kinder system a system that mitigates some of the destabilising political tensions that characterised free markets earlier.

Of course, the world is not perfect and is plagued by a new set

of problems at the beginning of the third millennium. The relative order imposed by colonial powers has given way to political instability in many countries. More important, problems like overpopulation, resurgence of nationalism, and environmental

pollution loom large. Notwithstanding these portents, we are fairly

optimistic about the prospects of global investing.

Opportunities for Indian Citizens

From early, 2003, Indian citizens have been allowed to invest abroad. To begin with, investment in mutual funds up to $25,000 in a calendar year was permitted. Since then, the Reserve Bank of India has enhanced the limit to $200,000 in a calendar year. You can now invest in stocks, mutual funds, hedge funds, foreign currencies, foreign currency derivatives, insurance policies, and real estate anywhere in the world. So, the vast array of financial products in the global markets may be just a click away.

Benefits of Global Investing

Attractive Opportunities

Diversification Benefits

Risks in Global Investing

Political Risk Currency Risk

Custody Risk
Liquidity Risk Market Volatility

Return on Foreign Investment

Formally, the rate of return in INR terms from investing in the ith foreign market is as follows: Ri, INR = (1 + Ri ) ( 1 + ei ) - 1 = Ri + ei + Riei

where Ri is the foreign currency rate of return in the ith foreign market and ei is the rate of change in the exchange rate between the foreign currency and the INR, ei will be positive (negative) if the foreign currency appreciates (depreciates) vis--vis the INR.

Illustration of Return Calculation

To illustrate, suppose an Indian resident just sold shares of IBM he purchased a year ago and earned a rate of return of 14 percent in terms of the US dollar (Ri = 0.14). During the same period the US dollar depreciated 4 percent against the INR (ei = -.04). The realised rate of return in INR terms from this investment is:

Ri, INR = (1 + 0.14) (1 - 0.04) 1

= 1.0944 - 1 = .0944 or 9.44 percent

Risk of Foreign Investment

The risk of foreign investment measured in terms of variance, is: Var (Ri, INR) = Var (Ri) + Var (ei) + 2Cov (Ri, ei) + Var

where Var (Ri) is the variance of foreign currency rate of return, Var (ei) is the variance of the exchange rate change, Cov (Ri, ei) is the covariance between the foreign currency rate of return and the exchange rate change, and Var reflects the contribution of the crossproduct term, Riei , to the risk of the foreign investment. If the exchange rate remains unchanged, implying that ei is zero, only one term, Var (Ri), remains on the right side of equation. From this equation, it is clear that exchange rate change contributes to the risk of foreign investment in three ways:
Its own volatility : Var (ei) Its covariance with the returns in the foreign market: Cov (Ri, ei) Its contribution to the cross-product term: Var

Empirical Evidence
Empirical evidence suggests the following:

Exchange rate uncertainty contributes more significantly to the risk associated with foreign bond returns and less significantly to the risk associated with foreign equity returns. Exchange rate changes tend to covary positively with foreign bond returns and, interestingly, negatively with foreign equity returns. little

The cross product term, Var, as expected contributes to volatility.

Equilibrium in International Capital Markets

We can use the capital asset pricing model (CAPM) or the arbitrage pricing theory (APT) to estimate expected returns in the

international capital market, just as we do for domestic assets.

However, these models have to be adapted to the international context.

Growing Importance of Global Factors

In recent years, stock markets across the world seem to have become more closely aligned. Several factors have contributed to a higher correlation between changes in stock prices in different countries.

Increase in cross-border trading Multiple listing

Spurt in cross-border mergers and acquisitions

Internet

Investing in Developed Markets

You can buy stocks of domestically-oriented companies in various developed markets as well as stocks of multinational companies such as Coca Cola, Toyota, and Unilever. A convenient way of investing in major multinational companies, not headquartered in the US, is to buy their American Depository Receipts (ADRs).

If you find investing on your own to be daunting as is the case with most individual investors your best bet will be to invest through mutual funds. In this context, the following options seem attractive: Index funds

Exchange-traded funds like the World Equity Benchmark Securities (covering developed markets)

Just as equity investors seeking to diversify globally may buy ADRs, bond investors wanting to diversify globally may find it convenient to buy Yankee bonds.

Investing in Emerging Markets

You can invest in emerging markets through mutual funds or on your own. For most investors, the mutual fund route is the most sensible route. While there are hundreds of emerging markets investment funds available, the following appear to be the more attractive options. Close-ended mutual funds selling at a significant discount Open-ended index funds like the Vanguard Emerging Markets Index Fund. Exchange-traded funds like the World Equity Benchmark Securities (covering emerging markets)

Although the mutual fund route is the generally recommended route for individual investors, some investors love the excitement and challenge of investing on their own. If you have such an inclination, you will find the following tips useful: (a) Invest in countries that have low price-earnings ratio, low price-to-book value ratio, and high dividend yield. (b) Choose countries where political risk is diminishing. (c) Trade minimally. (d) Do not hedge currency risk.

How to Invest
To invest in equities abroad you need a bank account with a brank that allows foreign remittances and an account with a domestic

broker who has a tie up with a foreign broker. Alternatively, you

must have an account with a foreign broker. (You can sign up

directly with an online broker abroad). You have to transfer the investible amount to your brokerage account by filling up Form A2. Once the money is transferred, you can buy shares online on your

trading screen. Likewise, you can sell shares online and transfer
money electronically to your bank account.

How to Invest
Another option to invest in foreign securities is to buy a foreign exchangetraded fund (ETF) listed on an Indian stock exchange. For example, the

Hang Seng BeES, an open-ended index scheme, which tracks the Hang
Seng index on a real-time basis is listed on the National Stock Exchange. (Hang Seng index, comprising 42 stocks, is the benchmark of Hang Seng

BeES). Through Hang Seng BeES you can buy into China, the largest
manufacturing economy in the world. Hang Seng BeES NAV replicates Hang Sengs total return index minus expenses on a currency adjusted

basis. The taxation rules that apply to Hang Seng BeES will be the same as
the ones applicable to buying or selling of non-equity mutual funds.

Tracking Global Markets

Morgan Stanley capital International (MSCI) compiles indices for individual countries, regions, developed markets, emerging markets, and the entire world. The premier MSCI benchmarks used by investment managers to measure the performance of global markets are as follows: The MSCI World Index The MSCI EAFE (Europe, Australia, Far East) Index The MSCI Emerging Markets Free Index.

Summary
The world is being swept by a second wave of globalisation at the beginning of the twenty first century. Within limits, Indian citizens can invest in various assets abroad. Global investing provides two advantage viz., attractive opportunities and diversification benefits. There are several risks which exist or become more pronounced in global investing: political risk, currency, risk, custody risk, liquidity risk, and market volatility. The rate of return in INR (Indian national rupee) terms from investing in the ith foreign market is: Ri, INR = Ri + ei + Riei The risk of foreign investment measured in terms of variance is: Var (Ri, INR) = Var (Ri) + Var (ei) + 2Cov (Ri, ei) + Var

 With some adaptation, we can use the capital asset pricing model (CAPM) or the arbitrage pricing theory (APT) to estimate expected returns in the International capital market. In recent years, stock markets across the world have become more closely aligned.

There is a bewildering range of investment options available globally for developed markets as well as emerging markets. The premier Morgan Stanley Capital International (MSCI) benchmarks used by investment managers to measure the performance of global markets are as follows: the MSCI World Index, the MSCI EAFE (Europe, Australasia, Far East) Index, and the MSCI Emerging Markets Free index.