The benefits of international portfolio investment - Essay Example

?International Portfolio Investment Introduction In recent years, the dependence of world economies on each other has increased significantly due to globalization. The economies are not involved in cross border exchange of goods and services but also of financial transactions. Hence, the markets are now too integrated and consumption pattern has become internationalized. (Bartram & Dufey, 2001) The need for international portfolio investment has risen because there is a need to reduce the level of risk. By diversifying the portfolio, the risk can be reduced significantly. International portfolio investment is a term used to define investment done in different economies worldwide. (Santis & Ehling, 2007) The benefits of international portfolio are evident as it allows countries to diversify the risk, hedge and participate in growing economies. However, there are risks or potential disadvantages that are involved with international portfolio investment. These risks include institutional constraints, exchange rate policy, interest rate policy, tax rates and investment policy. These benefits and risks are mentioned in detail in later sections. (Varshney & Saigal) Advantages There are numerous benefits of internationalizing the portfolio. By internationalizing, the individual or firm will be able to minimize the risk; invest in growing markets thus benefiting from their growth; hedge the prices of goods in the consumption basket; enjoy higher return than expected; diversify investments; and enjoy lower variation of return. (Greco) High economic growth leads to the higher GDP and high growth level. This attract other investors from other countries in invest in the growing economies. Growing economies are determined by the World Bank as the ones which have average income levels but high economic growth levels. These emerging economies can be of Middle East, Asia, Africa or Latin America. The growth levels attract the foreign investment which further improves their economy. These economies including some of the developed ones such as Japan and Netherlands provide tremendous opportunities to foreign investors. The financial investment in these countries enable individuals and firm to increase their investment by two fold within a couple of years. Hence, it is seen as a good opportunity by investors. (Perry) However, the small economies are still riskier compared to developed economies. In small economies, the prices might fluctuate rapidly and in case of liquefying the investment, losses might have to be borne. Also, the emerging economies might not be too stable politically. Thus, there is a political risk involved such as instability of political system, change of policies regarding foreign investment and remittances, change in foreign exchange policy and change of property rights. These factors make the investment in emerging markets riskier compared to developed economies where there is political stability. (Yavas, 2007) In contrast to this, the overall portfolio risk will be reduced because there will be less, no or negative correlation between markets which will be beneficial for the investor. On the other hand, there is a difference in taxes, potential information and forecasts. Some of the forecast made by countries might differ significantly from actual result. Thus, the exact picture or perfect information regarding investment might not be available. The markets are seemed to have integrated over the years and are considered negatively or not at all correlated to each other. Thus, the investors benefit from investing worldwide because it one investment’s return are falling, other investment’s return might increase or remain same. Thus, the investor will be better off. However, each country has its own investing and currency exchange policy which might be a hindrance for the investor. The investor benefits from ‘pure diversification’ by investing worldwide but might face policy restrictions. (Bartram & Dufey, 2001) Factor influencing the structure of International Portfolio Investment The factors that determine the level of investment in a country are the Capital Asset Pricing Model (CAPM) and the portfolio theory. These both theories have to be adjusted to take the international aspect in to account. The mean and variance of return on foreign investment is calculated in terms of the local currency. Thus, the return has to be adjusted for any gains or losses on currency. Moreover, international trade in goods and services form a significant portion of the balance of payment. In order to maintain the level of purchasing power, the country should not maximize try to maximize the return on currency. (Dufey & Bartram, 2001) Capital Asset Pricing Model has been developed while considering the global perspective. It is a very popular and well known method for calculating the price of the asset and analyzing the different investment models with in a nation. However, if the international portfolio is seen as the integration of all the economies around the globe with little or no restriction in obtaining the information, then this model can be applied on a global portfolio rather than just national portfolio. The risk of investing will be judged on the basis of global beta in contrast to market beta of a nation. Beta is a notation used to measure the level of risk involved in investing in a particular financial opportunity. (Varshney & Saigal) The CAPM model can be translated in to International Capital Asset Pricing Model (ICAPM) by changing the variables to take international perspective in to account. The mathematical formula for calculating the ICAPM is: RPw and RPk are the risk premium of world and currencies. The ? (beta) shows the risk involved and it keeps changing. In this equation, the beta shows the world market risk. Rf is the risk free rate. The risk free rate has to be calculated differently because the there are other risks involved in international dimension apart from the market portfolio risk. In this regard, the exchange rate risk is also involved; thus, there is a need to hedge the currency risk and incorporate this rick to market risk to calculate the risk free rate. However, this is not a perfect model because there are so many assumptions involved. The mean and variance cannot be perfectly estimated and there are a lot of with exchange risks due to the purchasing power parity. Hence, other models such as ARCH and GARCH have been developed to determine the desirability of the portfolio. (Bartram & Dufey, 2001) Risks Involved One of the risks involved which might change the decision of the investor is the currency issue or risk. In order to gain the advantage of ‘pure diversification’ some of the risks have to be taken in to account. Without taking in to account the political risk and the exchange risk, decision cannot be taken as these two have serious implication on the investment portfolio. The exchange rate risk might be of a disadvantage or advantage to the investor. The exchange rate risk is defined as the volatility of a currency. It shows how quickly the exchange rate fluctuates. If the investment is in Euros and Dollars and both the currencies are highly volatile, then it is better to investment in a variety of currencies and not just dollars and Euros to reduce the level of risk. The level of risk of currency is dependent on the correlation between different currencies. The currencies which have zero or negative correlation will eliminate this risk altogether. However, dollar is a currency which affects all other currencies. (Bartram & Dufey, 2001) Moreover, this risk can be reduced by hedging. By hedging, the future price of currency will be fixed; thus, the investor will not have to face extreme changes in currency rates. (International Portfolio Investment) Furthermore, other risk involved is the country or political risk. This risk can be further sub-divided in to transfer risk, ownership risk and operational risk. Transfer risk is a risk or restriction involved in transferring money or conducting financial transactions. Ownership risk means every country’s government has different policies and laws for control and ownership of asset or for investing in the foreign country. Operational risk involves the restriction that is imposed by the government on operational activity. Thus, these risks have to be considered before investing in a country. Also, other factors such as labor, infrastructure, technology and other things have to be considered before investing in a foreign country. (Dufey & Bartram, 2001) These risks cannot be overlooked as they can have a significant impact on investment and investors might face heavy losses by ignoring these factors. The investors will have to work to reduce these risks so that they can earn a better return on their investments. (International Portfolio Investment) Institutional constrictions The government enforces foreign exchange laws, tax laws, minority laws and capital market laws to protect the locals of a country. Otherwise, all the companies and shares will be owned by foreigners rather than the residents of the country. Thus, it is an obligation on the government to protect its own people. (Greco) These laws cannot be ignored by the investors as these laws together with exchange and country risks can impact the investment decision. The investors might not be able to gain timely information in one market but might be able to get perfect information in other. It depends on the laws and rules of the country. Diversified market enables investors to gain advantage in markets where they can overcome these barriers. (Greco) Every country has different tax laws and policies regarding interest, capital gains tax and dividend policies. These policies can benefit the investor or can be of a disadvantage. In some countries, some securities are exempted from tax or less income tax is charged. In United States, the securities issued by state are exempted from federal tax. In Japan, tax is waived to a certain amount and after that amount, the tax is charged. To avoid tax, the investors can invest an amount which will give them a return to an amount equal to the exempted amount. In United Kingdom and Japan, the tax is not charged to foreign investor until and unless they divest. It is to encourage the foreigners to invest in the country. Thus, it proves that some countries’ tax policies can benefit the investors. Hence, investors should look for such policies so that they can gain most benefit. Also, there are other taxes such as withholding tax which can affect the investors return. Thus, the investor has to analyze all the avenues before investing in a country. (Dufey & Bartram, 2001) Moreover, foreign exchange controls are imposed by countries to prevent the outflow of their currency which will lead to the depreciation of the currency. The countries impose so that investors do not invest abroad rather they should invest in the national economy. Also, restrictions are imposed in the primary and secondary stock markets to ensure that there is no illegal work or unfair trading practices. The Security Exchange Commission of each country keeps a stringent check on the security market to protect the right of investors. In some countries, there is restriction on foreign securities being listed on the national market; thus, preventing locals to buy foreign securities. (International Portfolio Investment) Furthermore, the transaction cost for buying foreign securities is higher compared to the cost of investing locally. The transaction cost is high because the cost of obtaining and transferring information is high. The setup cost for participating in the foreign market is expensive. Thus, the brokers and financial institution pass all these costs to the investors. Thus, the investors have to analyze these costs before deciding where to invest. (Bartram & Dufey, 2001) Moreover, the investors should be familiar to the foreign market they are investing in. each country has different culture, time zones, tastes and preferences. Thus, it is necessary that the investors are familiar with foreign country’s culture to know how trading is done and how customers are treated so that the investor does not face too much difficulty in doing business there. (Perry) Channels for portfolio investment There are two broad channels of investment, direct and indirect foreign portfolio investment. The investor can directly place an order of securities in the home country and the firm with the help of foreign broker will place the order on the investor’s behalf. Apart from this method, the investor can open a financial security account in foreign country and can purchase the stocks or securities directly. Another way is to buy the shares of foreign companies that are listed on the domestic stock exchange. This will enable the investor to have legal protection and it will be easy for the investor to trade. However, the investor will have to pay the transaction cost in terms of brokerage fee. (Santis & Ehling, 2007) The direct investment is done by purchasing the foreign investment in the issuers’ market or the foreign market. The investors can buy the initial public offering or the outstanding shares directly by ordering to the financial institutions or brokers in home country or foreign country. However, certain problems are associated with buying directly in the foreign market. The certificated have to mailed or couriered to the investor. The investor might not have perfect information regarding the market. The investor might be misinformed or cheated by giving false information about the market. There might be a conflict of interest between the investor and the foreign firm. Thus, there are a lot of risks involved in investing in a foreign country. The investor has to be confident about the information before investing abroad. Switzerland, New York, Latin America, Luxemburg, Hong Kong, and Singapore hold nonresident account and prefer foreign investment. (Bartram & Dufey, 2001) Moreover, the investors can invest in foreign market indirectly. Some companies not only offer stocks in their local market but also in foreign market. They register their stocks in more than one stock exchange. Thus, it becomes convenient for the investors to invest directly from their domestic market. A limited number of stocks has to be traded by the issuer in the foreign market in order to be listed on the stock exchange. (Santis & Ehling, 2007) Moreover, the concept of shipping the stocks has been eliminated and central depository system is now becoming common. In every country, there is central depository where the investor can open the account and the transactions will automatically be updated in the account without the need for physical transfer of stocks. Thus, it is has now become convenient to buy the stocks directly from foreign market. However, there are still issues related to the transfer of correct information to the investor and frauds committed by securities’ issuers. (Stulz, 1997) Investment in India Emerging markets such as India has shown substantial growth in the past few years. Many investors have become interested in the economy after seeing its growth rate. The Reserve bank of India has issued a liberalized remittance scheme according to which the residents are allowed to remit 200000 dollars in capital and current transactions. (Santis & Ehling, 2007) India is one of the few countries which have a lot of potential and people from different countries are visiting and planning to invest in it. The Reserve Bank of India has compiled the foreign investment data through Foreign Exchange Transaction Electronic Reading System. This information is published monthly to provide investors with correct information and to attract more foreign investors. India has introduced favorable trade, fiscal and financial policies to attract more foreign direct investment. Indian economy has improved quite a lot after the introduction of liberalized policies in 1990-91. These policies have created a competitive economy and have boosted its economy to quite an extent. More and more foreign investors are willing to invest in the country in 2007 its foreign assets rose to $191.9 billion. In 1992, Indian market was opened to foreign institutional investors; they were allowed to invest in equity including pension and mutual funds, investments trusts, and asset management companies and since 1992, India is growing at a substantial rate. (Gaur) Conclusion The international portfolio investment is necessary for investors to diversify their risk and to earn more profit. If the two countries have strong negative correlation, then financial risk can be eliminated and high returns can be earned. However, there are certain disadvantages of investing in other countries. The investors have to pay high transaction charges or brokerage fee. Also, the investors cannot be sure whether the other person is providing accurate information regarding the foreign economy. Frauds can easily be committed by brokers. Thus, investors have to be careful when investing abroad. Scenario Percentage Investment Risk Return 100% Large Domestic companies 10.64% 17.97% 60% Large domestic companies 10.41% 18.54% 40% Large international companies 60% Large domestic companies 11.21% 18.33% 10% International large companies 10% International large value 10% International small growth 10% International small value It is necessary to diversify in order to gain higher return. Since 25 years, people are investing in large domestic companies for which the return is 10.64% and risk is 17.97%. However, if the investment is diversified by investing 60% in large domestic companies and 40% in international large companies, then the return will be 10.41% and risk 18.54%. However, if the 60% is not changed but the composition of 40% is changed, then more return can be earned. If 10% is invested in international large companies, 10% in international large value, 10% in international small growth and 10% in international small value, then the return will increase to 11.21% and risk will become 18.33%, which means that risk will reduce from 18.54% to 18.33%. This shows that it is necessary to diversify and invest globally in different countries. The more diversified the portfolio the better. Hence, the investment should be made in 45 different countries or more to increase the return and lower the risk. (International Portfolio Example) References 1. Bartram, S. M., & Dufey, G. (2001, February 23). International Portfolio Investment. Retrieved from http://deepblue.lib.umich.edu/bitstream/2027.42/35386/2/b2036022.0001.001.pdf 2. Dufey, G., & Bartram, S. (2001, May). International Portfolio Investment . Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=270196 3. Gaur, A. P. (n.d.). Trend in Portfolio Investment Statistics-India. Retrieved from http://www.bis.org/ifc/publ/ifcb28zj.pdf 4. Greco, J. F. (n.d.). Multinational Financial Management. Retrieved from www.siue.edu/~akutan/fin450docs/ch15%5B1%5D.ppt 5. International Portfolio Example. (n.d.). Retrieved from http://www.youtube.com/watch?v=1l3x4KQPJ78 6. International Portfolio Investment. (n.d.). Retrieved from http://finance.wharton.upenn.edu/~bodnarg/courses/nbae/IFM/Chapter15.pdf 7. International Portfolio Investment. (n.d.). Retrieved from http://www.cob.unt.edu/Firel/TRIPATHY/f5500/Lecture%20Notes/Eun%20and%20Resnick/f55%20ER%20Ch15%20International%20Portfolio%20Investments.pdf 8. Perry, M. J. (n.d.). International Portfolio Investment. Retrieved from www.umflint.edu/~mjperry/466-15.doc 9. Santis, R. A., & Ehling, P. (2007, September). Do International Portfolio Investors Follow Firms Foreign Investment Decision. Retrieved from http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp815.pdf 10. Stulz, R. M. (1997, August). International Portfolio Flows and Security Markets. Retrieved from http://www.google.com.pk/url?sa=t&rct=j&q=&esrc=s&source=web&cd=6&ved=0CGQQFjAF&url=http%3A%2F%2Fciteseerx.ist.psu.edu%2Fviewdoc%2Fdownload%3Fdoi%3D10.1.1.39.168%26rep%3Drep1%26type%3Dpdf&ei=GkXbT524J5C0rAfo9aGpCQ&usg=AFQjCNG9VL2PYY0U5OUzEDte2JbkuhAB3w&si 11. Varshney, S., & Saigal, V. (n.d.). International Portfolio Investment- Management and Challenges. Retrieved from http://www.scribd.com/devpriyacbs/d/22015509-International-Portfolio-Investment-Management-Challenges 12. Yavas, B. F. (2007). Benefits of International Portfolio Diversification. 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