Recent Surge in International Portfolio Investment - Essay Example

PART A What factors are responsible for the recent surge in international portfolio investment (IPI)? The globalization of financial markets is one of the major factors that have seen the recent surge in international portfolio investments. The recent dramatic increase in globalization in the world financial markets has caused global capital flows to rise as high as 14.8 percent of the global GDP in 2006, which has increased to more than three times since 1995. This drastic growth has been driven by advanced economies. These developments are also common in developing countries and the emerging markets, which have since become more financially integrated. More investment capital has been attracted by different countries following significant growth in the capital markets, which has also encouraged sharing of international risks (Ahmed and Gooptu, 1993). Also, deregulation and liberalization of capital and foreign exchange markets has been practiced by many countries in the recent decades. This has been achieved through relaxing and withdrawal of statutory barriers on capital account transactions hence boosting many emerging market economies. Furthermore, many countries have realized the benefits of capital inflows through liberalization of domestic financial markets. In the recent years, investment is no longer tied on the sum of domestic savings. In addition, developments in technological innovation and capital accumulation have contributed to economy’s growth, which is spurred by foreign capital inflows. Other important developments that have led to a major reduction in information and transaction costs related to international investments include computer and telecommunication technologies (Tara, 2005). Products such as country funds and American Depository Receipts (ADRs) have been introduced by investment and commercial banks, hence facilitating international investments. Furthermore, the potential gains from international investments must have become more visible amongst many investors and hence the surge in international portfolio investment (New features of the stock market surge, 2005). 2. Security returns are found to be less correlated across countries than within a country. Why can this be? The security returns amongst different countries differ because different countries differ in terms of resource endowment, industry structure and macroeconomic policies. This difference also results from the fact that different countries have business cycles that do not occur simultaneously, meaning that a particular country could be experiencing a boom while another one experiences recession at the same time. As such, securities from the same country undergo similar macroeconomic policies, and business cycles thus their security returns are highly correlated (Fleischer, 2003). 3. Explain the concept of the world beta of a security. The world beta is used to estimate a security’s sensitivity of returns in respect to the world market portfolio (Vandell, 1981). This metric evaluates the systematic risk of the security in a global context. A measure of the sensitivity of rates of returns on securities is weighed against the rates of return on the entire market. The implication of this beta is that a high beta (greater than 1) represents high volatility, which means that such most suitable in strong bull markets and not suitable in a bear market. Statistically, the world beta is represented as follows: Cov(Ri, RM)/Var(RM), Where: Ri = i-th security; and, RM = the world market portfolio 4. Explain the concept of the Sharpe performance measure. The Sharpe performance measure (SHP) is a performance metric which is adjusted for risk (Sharpe, 1994). It is a portfolio’s mean excess return, which exceeds the risk-free rate divided by the standard deviation of the portfolio. The Sharpe ratio is defined the following equation: Whereby: = the asset return = the return on a yardstick asset, such as the risk free rate of an index return (such as S&P 500) = the anticipated value of the stock return, which is above the benchmark return = the standard deviation of the anticipated excess return. The Sharpe ratio shows the extent to which an asset pays off the investors for the risk they have taken. When two stocks are weighed against a common benchmark such as S&P 500, then the stock that has the highest ratio is assumed to have better returns for commoner risk. Just like any other mathematical model, Sharpe ratio depends on the accuracy of the data being used. For example, pyramid schemes that exhibit long period of operation would generally show a high Sharpe ratio when resulting from reported returns, though the inputs are not true. When assessing the investment performance of stocks with profits funds, the Sharpe ratio should be computed from the performance of the primary stocks instead of the returns of the funds. A Sharpe ratio can also be highly deceptive if the benchmark is wrongly specified (Jobson and Korkie, 1981). PART B A commodity trader believes that average volume of wheat he traded can be described by a Normal model with a mean of 32,000 metric tons and standard deviation of 2,500 metric tons. a) If a client buys some bushels of his wheat, would it be reasonable for the client to hope that the transactions will reach 40,000 metric tons? Explain. Whether it will be reasonable to reach 40,000 metric tons will depend on the probability computed from z-score, assuming a normal distribution statistics. Therefore, given the normal variable, x with mean = μ and standard deviation = ϐ, the value of the standard normal distribution is computed as shown in the following equation: Z = The value of the random variable is x = 40,000, μ = 32,000 and ϐ = 2,500 Z = = 3.2 This means that x = 40,000, is 3.2 standard deviation above the mean. So, p [x=40, 000] = 3.2 (320%) likelihood that the transaction will reach 40,000 metric tons, hence it is reasonable to hope so. b) Approximately what fraction of the transactions can be expected to reach less than 30,000 metric tons? X = 30, 000 Z = = -0.8 So, p [x Read More