Foreign Investment Analysis
In the introductory chapter it was mentioned that an integrated financial system results in a more efficient allocation of capital across the globe, and provides diversification benefits to the investors. One of the ways through which capital moves across countries is through investment in the equity capital of foreign companies. This chapter discusses this aspect of integration and covers such investments where the holdings are not big enough to let the investor enjoy control over the management of the company.
Gains from Cross – Border Diversification
Investment in foreign securities offers the same diversification benefits, as investment in a diversified domestic portfolio does. According to the CAPM, diversifying investments over a number of securities can help an investor in reducing his risk level for a given level of return or increasing his return for a given level of risk, provided that the returns on the securities are having a negative correlation or low positive correlation. Extending the same logic to international investments, diversifying across national boundaries would result in the investor reducing his risk or increasing the returns. This happens because different countries would be generally at different points of the economic cycle at a given time. Secondly, a number of factors that affect share prices (like tax structures, fiscal and monetary policies, political scenario etc.) differ from country to country. Furthermore, industrial structures differ across countries and hence an international event affecting the whole world affects them differently. These factors provide scope for the correlation between the returns from these economies to be less than perfect, hence providing diversification benefits. Recalling CAPM, even if the returns offered by the foreign securities are less than that offered by the domestic securities, diversification may still benefit by reducing the risk more than the reduction in returns.
The returns on a foreign security would be denominated in the foreign currency. The rate at which the realizations from the security would be converted into the domestic currency is most likely to be different from the rate at which currency conversion took place at the time of investment, due to the volatile nature of the forex markets. Due to this, the returns from a foreign security in terms of the domestic currency has two components – the return from the security in foreign currency terms, and the returns due to changes in the exchange rate over the period of investment. Hence, the expected returns on a foreign security can be represented by the following equation:
Expected domestic returns on foreign currency = rf + S~ ...Eq. (9.1)
where rf is the expected return in foreign currency terms and S~ is the expected change in the exchange rate.
Risks From Cross – Border Diversification
Investments in foreign securities carry some additional risks when compared to domestic investments. These risks stem from the uncertainties related to the conversion of the realization proceeds into the domestic currency which can be broadly classified as country risk (also known as political risk) and currency (or exchange) risk.
Country risk is the uncertainty as to whether the investor would be able to convert the realization proceeds into the domestic currency. This risk arises due to the possibility of the foreign government preventing the conversion of its currency for various reasons. The government may even expropriate the security, which would result in a complete loss to the investor.
Currency risk is the uncertainty as to the rate at which the realization proceeds would be converted into the domestic currency. As this rate would not be known in advance, there would be the risk of a loss due to an unfavorable movement of the exchange rate. This risk can be hedged to a certain extent by covering it in the forwards, futures or option markets. Yet, the costs of the hedging have to be considered while taking such a step. Another way to reduce these risks is to invest across many countries, so that a loss suffered due to the weakening currency of one country would get at least partially offset by the gains on the stronger currencies. Sometimes there may not be a currency risk at all as investors may be buyers of other goods (other than securities) in those very markets in which they invest, thus eliminating the need to convert the currencies.
While it is not possible to measure the political risk, currency risk can be measured and factored into the risk of foreign investment. From Eq. 9.1 it follows that
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