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International Finance
Part 1: International Cost of Capital
1
Reading
• Shapiro, A. (2010), Multinational Financial Management,
Ninth Edition, Wiley, ISBN 978-0-470-45035-2
• Tenth Edition is also available now
• International Cost of Capital: Ch 14
• International Portfolio Investment: Ch 15.
N.B. There are many copies in the library
2
Introduction
• Part 1:
• Revisit the CAPM very quickly
• Look at how we can use the CAPM to calculate the cost of equity
capital for MNC subsidiaries.
• See if the cost of a project in a foreign country should have a
lower cost of capital than a similar project domestically.
• Address some of the issues in calculating this cost of equity
capital via the CAPM.
3
Capital budgeting
• Investment selection
• Capital budgeting process of selecting capital investments to maximise MNC
shareholder value
• NPV
• A project’s NPV determines the project’s impact on shareholder value.
• You will recall the following:
where
• Only accept +ive NPV projects.
4
∑
=
+
+=
n
t
NCFt = net cash flow in time t
I0 = initial investment
k = cost of capital (i.e. WACC)
n= investment horizon
t
t
k
NCFNPV -I
1
0 )1(
Cost of capital
• WACC (ignoring taxes)
• α = Firm's debt structure (debt to total assets)
• Ke = Cost of equity capital
Required return on the firm's stock given the particular debt ratio
selected
• Kd = Cost of debt
• The minimum rate risk adjusted return required by shareholders of the firm
to undertake a given investment.
• i.e. minimum rate of return to induce investors to hold the firm’s stock
• Or alternatively, think of the cost of capital as the weighted average return
required for each of the firms activities.
• Therefore the company represents the sum of those projects, and the sum of
the value of those projects should equate to the value of the company.
5
de kkk αα +−= )1(
CAPM and Equity Cost of Capital
CAPM RECAP
• CAPM tells us there exists an equilibrium relationship between an
assets required return and its associated risk.
• That intelligent risk-averse investors will diversify away risk, the
remainder being the risk that attracts a risk premium.
• Diversification: essentially spreading your investments broadly
across industry sectors, countries, and asset types to reduce risk.
• How is risk reduced? By trying to get a collection of assets into your portfolio
that move together (co-vary) as little as possible.
6
CAPM and Equity Cost of Capital
• Though diversification we are able to get rid of diversifiable risk
(sometimes called non-systematic or idiosyncratic risk)
• What is left is nondiversifiable risk (sometimes called systematic or
market risk)
• It is this risk that attracts the premium.
• Indeed, why should the market pay you for holding diversifiable
risk?
7
CAPM and Equity Cost of Capital
The CAPM:
where
ri = equilibrium expected return for asset i
rf = rate of return on the risk free asset
rm = expected return on the market portfolio consisting all risky
assets.
βi = how the expected return of a stock is correlated to
the return of the market portfolio
8
)( fmifi rrrr −+= β
CAPM and Equity Cost of Capital
• More on beta:
where
cov(ri, rm) = covariance between ri and rm
ρim = correlation between ri and rm
σm = standard deviation of market
Positive β : Moves with market
Negative β : Moves against the market
Zero β : not correlated with the market
9
m
iim
m
mi
i
rr
σ
σρ
σ
β == 2 ),cov(
Beta and MNC
• Importance of Beta
• Consider a multinational firm
• The effect of a foreign project’s risk on its cost of capital depends
only on that project’s systematic risk.
• i.e. the proportion of return variability that cannot be eliminated
through diversification.
• The standard view is that much of the risk faced by the MNC is
diversifiable.
• But surely investing overseas can be quite risky?
10
Beta and MNC
• Yes and no. Where it is risky, low correlation between project
and market returns can sometimes offset the effects of higher
project risk.
• Consider now market risk
• Assume we define the market portfolio proxy to be the domestic
index
• The constituents of market portfolio will, to an extent, be
correlated due to the fact they are in the same economy.
• Consider then two similar projects, one domestic and one
foreign.
11
Beta and MNC
• Given that the foreign project is unrelated to the domestic
economy (e.g. business cycle etc), it will maybe be less correlated
with the market portfolio, thus having a lower market risk.
• Consider now an LDC – they can often provide even more
diversification benefits than a project in a foreign DC, despite the
fact that they are be seen as risky. Why? Such economies are
going to be far less influenced and in tune with DC’s.
12
MNC and LDC
• We just stated that a project in the LDC might have more
diversification benefits for the MNC and help lower market risk.
• However it depends on the nature of the project – might not be
reduced much –v- domestic/investment in foreign industrialised
countries.
• The difference will be very small where projects are focused on, say,
extraction of resources.
• Why? Because you trade the resources on the world market.
You are subject to the world price.
• Just as you would be if you extracted domestically.
• However, for a service orientated project in the LDC the reduction
in systematic risk should be more pronounced.
13
MNC and the investor
• Two concepts at play here:
• Corporate international diversification
• International portfolio diversification (more on this in Part 2).
• Investors will accept a lower rate of return from a MNC if they
supply low cost international diversification.
• Motivation: might exist a potential barrier to international portfolio
diversification. As MNC have been further able to reduce risk will
accept lower rate of return.
• Equally, the risk premium on these international projects may
be lower than for similar domestic ones implying MNCs might
undertake overseas projects it would otherwise reject
domestically.
• As they are less correlated
14
MNC and the investor
• But how well do investors diversify?
• Evidence that they do not take enough advantage of portfolio
diversification. “Home bias?”
• Some estimates of US holdings of foreign equities is around 8%.
• Capital controls/taxes cannot explain why gains from holding foreign
equity are not exploited.
• Foad (2006) report a decrease in equity home bias in Europe following
the introduction of Euro – trade flows, common language, and
contiguity all factors.
• Possible reasons for home bias?
These include:
• Lack of information about foreign based companies
15
MNC and the investor
• Desire to consume domestic goods and services potential for purchasing power to
be eroded through changes in FX (unless PPP holds!)
• Or indeed the need to meet domestic liabilities (e.g. Pension fund)
16
Estimating Foreign Project Discount Rates
• Consider a potential foreign project, e.g. a subsidiary of the MNC.
• Use CAPM to evaluate cost of capital?
• Problem: We are considering a new project - there are no past
history of returns.
• Solution? To get around this we can use publicly traded firms that
share similar risk characteristics and use the average of their beta’s
as a proxy for the subsidiary beta.
17
)( fmifi rrrr −+= β
Estimating Foreign Project Discount Rates
However in doing so we have to address the following issues:
1. Local companies in the foreign country might not exist.
• Local companies in the foreign country might be a better indicator –
however they may not exist.
• Use data from similar companies from the domestic country? Is the
domestic proxy company likely to behave as the foreign?
2. What is the relevant market portfolio? The domestic market
portfolio, the local market portfolio (in foreign country), or the
world market portfolio?
• Important decision.
• A risk that is systematic to one economy, might be diversifiable
internationally.
18
Estimating Foreign Project Discount Rates
• e.g. if you use the local index, this will result in a higher beta, and therefore
a higher required return and hence a less desirable project as discounting
cash flows more.
3. What is the market risk premium? (rm-rf)
• Use local measure as it is the risk premium demanded by investors in that
market?
• Maybe not too relevant to the investors in the MNC – maybe the majority
of its investors are domestic and therefore use the domestic risk premium.
19
Estimating Foreign Project Discount Rates
4. How do we factor (should we factor?) country risk into the cost of
capital?
• Could add a country risk premium to the CAPM calculated discount rate.
• Country risk premium often calculated based upon the difference in the
returns of the domestic and foreign government bonds (ideally issued in
the same currency, e.g. USD)
…but is this consistent with CAPM? Double counting of risk?
20
3 ways of estimating proxy betas
Alternatives of estimating proxy betas:
• We have discussed the issues – so what should a MNC do? We
have the following “ranking” of alternatives as set forth in Shapiro
1. Local Companies
• Returns on MNC local operations will be linked to a large extent on the local
economy, hence corporate proxies should be local companies.
• Timing/magnitude etc of these returns will differ from domestic projects.
• So for an international investor implies degree of market risk may be lower in
foreign country than for the same project in the investor’s home country.
• i.e. Using domestic companies & their returns to proxy for the returns of a
foreign project will upward-bias the risk premium demanded by MNC investors
21
3 ways of estimating proxy betas
Exposition of upwards bias:
Foreign market beta = Correlation with dom. Market x s.d of foreign market
s.d of domestic market
Aside: just beta using correlation instead of cov(.)
• Taking data from 1990-2020 and the market index of a foreign country
as the asset, we find the beta is less than unity.
• Note by definition we get a beta of unity when using the domestic market
index as the asset.
22
3 ways of estimating proxy betas
• We see this from the table above
• This tells us that if we are considering a project (subsidiary) in a foreign country,
and based on our proxy of that company on similar domestic companies rather
than local, we will be over-estimating the beta. (as we see a lower beta for the HK
market w.r.t US)
• Also note the volatility in the HK returns -v- US, yet HK yields a lower beta. This is
because much of this risk can be diversified away internationally.
Corr
with US
market
s.d. of
returns(%)
Beta from “US”
perspective
Hong Kong 0.33 135.55 0.85
US (“domestic”) 1 53.20 1
23
3 ways of estimating proxy betas
• So to use a domestic project returns to proxy the returns of a foreign
project leads to an upwards bias in the estimate of the risk premium
demanded by the MNC’s investors
• Implication: Rejection of potentially viable projects?
2. Proxy Industry
• If foreign proxies are not available, you could find a proxy industry in the local
market.
• i.e., find, domestically, an industry that has a similar beta to the project’s
industry. Then look to that industry in the foreign country to get your proxy for
beta.
• It would be a sensible idea to see if the industry betas are similarly across other
countries also.
24
3 ways of estimating proxy betas
25
You want to invest in a
project in industry type
A
Industry Type A not
available in local
country
Therefore, find a domestic
industry that has same
beta as industry type A
Look at the beta of that similar
industry in the foreign country
to get the appropriate beta
3 ways of estimating proxy betas
3. Adjusted Domestic Industry Beta
• Take the domestic industry beta for the project, βdom,proxy
• Multiply it by the foreign market beta relative to the domestic market (i.e. foreign
market beta is garnered using CAPM with domestic index as market portfolio and
foreign index as the “stock”)
• The beta for the foreign project should be the product of the two:
β foreign sub = βforeign mkt * βdom,proxy
26
3 ways of estimating proxy betas
• This is the least preferred option as:
• It imposes the same domestic “relative riskiness” on the foreign project.
e.g. project A has a beta of 0.8 and B of 0.6 in the domestic country. The
ordering of these betas will be the same when expressed in terms of the
beta of the foreign project.
• The environment in the foreign country may be different to the domestic,
and the above order might not be the same.
• Possible to get a situation where there is a low correlation with the local
market, but a high correlation with say the US market (e.g. an oil firm.)
Given we are using the US proxy we cannot account for this.
27
Recommendation 1: Base portfolio
• Given globalisation and the linking up of international
markets, it might be appropriate to use the global market
portfolio as the CAPM market portfolio.
• This will give a cost of capital that is representative of the risk
of a given project in an international setting.
• If however we take the view that investors are not as
internationally diversified as they should be (again, home
bias), maybe we should revert to the domestic market
portfolio.
28
Recommendation 1: Base portfolio
Recommendation
Shapiro: “pragmatic recommendations is for US MNCs to measure the betas of
international operations against the US market portfolio”
Why?
• The lack of (overall) international diversification by US investors implies that the
relevant market portfolio is the US market portfolio.
• Easy comparison of foreign and US investments, as evaluated relative to the US
market index
• However, for non-US companies from smaller (open) countries it might make
more sense to use the global CAPM as they may be more internationally
diversified out of necessity.
29
Recommendation 2: Market risk premium
Recommendation
Shapiro: “…[Ideally should choose a] methodology that is as consistent as
possible with [that]… used to calculate the cost of capital for U.S investments.”
• i.e. we should use the domestic market risk premium
Why?
• Domestic risk premium is the risk premium most likely to be demanded by
the domestic company’s mainly domestic investors.
• Consistency: If we are going to use the domestic market portfolio, it makes
sense to use the domestic market risk premium.
30
Part 1 - Conclusion
You should be able to:
• Discuss whether the required rate of return on foreign projects
should be higher, lower, or the same as the domestic economy (via
CAPM).
• Linking into this first point, discuss the use of CAPM to help us
determine this rate, and in particular the attendant issues that
have to be addressed: foreign company proxies, choice of market
portfolio, etc.
31
International Finance
Part 2: International Portfolio Investment
32
Introduction
• Part 2:
• Costs and benefits of international diversification
• Efficiency frontier
• Barriers to international diversification
• Home bias
33
Introduction
• We have touched on diversification from the perspective
of the firm and their activities.
• Next, we will explore the concept of international
diversification.
34
Preamble
• When we invest in equity, we are subject to risk
• When an investor constructs a well diversified portfolio,
the non-systematic (diversifiable) risk is reduced.
• What remains, systematic risk, is the risk that we are
unable to diversify away.
• The market compensates us for taking on this risk by
offering a commensurate return.
• So how does the nature of risk change when we look at
an international portfolio?
35
Risks of International Equity Investing
Changes in currency exchange rates
• Investment return is going to be a function of exchange rate
movements.
• This means that your returns can be either helped or hindered by
changes in the exchange rate.
Example:
Current Microsoft price (March 2022): 15.15 USD
3 months old Microsoft price (Dec 2021): 20.61 USD
Note: We can see we, as expected, a drop in Microsoft given the
recent economic turmoil.
36
Risks of International Equity Investing
• So what is the return on holding a share in Microsoft over this
period if you are a living in the United States? (ignoring dividends
for simplicity)
• The current exchange rate (March 2022) is 1.3800 USD/GBP. The rate
three months ago (Dec 2021) was 1.4775 USD/GBP.
• What is your return on holding a share in Microsoft over this period
if you are living in the United Kingdom?
2649.0
61.20
61.2015.15
,
−=
−
=USmsR
37
(I could have taken log returns)
Risks of International Equity Investing
• Cost of a share in Microsoft in Dec 2021:
20.61/1.4775 = 13.95 GBP
• Cost of a share in Microsoft in March 2022:
15.15/1.38 = 10.98 GBP
• Cost of a share in Microsoft in March 2022 if the exchange rate had
not changed from December 2021:
• 15.15/1.4775 = 10.25 GBP
38
Risks of International Equity Investing
• We can clearly see that the current cost of a Microsoft share to a
UK investor is higher than it would have been using the exchange
rate applicable 3 months ago.
• The change in the exchange rate, for a UK investing in the US, has
mitigated some of the loss of investing in Microsoft.
• The return for a UK investor holding a share of Microsoft:
2129.0
95.13
95.1398.10
,
−=
−
=UKmsR
39
Risks of International Equity Investing
• The return of the UK investor is approximately 5% better than for a
US investor, due to changes in the exchange rate.
• Note – this is a positive example. The exchange rate could have
moved in the opposite direction. If that had been the case the
returns would have been worse.
40
Risks of International Equity Investing
Dramatic changes in market value
• In the previous example we showed that exchange rate changes will
affect the returns when investing internationally by looking at the
change in a stock price.
• When investing internationally an entire market might suffer a drop
in price.
• Domestically investors can sometimes employ various
models/statistical techniques to try and judge when to enter/exit
the market/industry sector etc.
• This is difficult enough to do (and much debated!) in the domestic
economy. How will you do this in foreign economies?
41
Risks of International Equity Investing
• The argument is you should invest for the long term and ride out
the short-term periods when the market moves against you.
Political, economic, and social events
• By investing in many countries, our portfolio of stocks will be
subject to a variety of different political, economic, and social
factors/events.
• It is these differences that help us with diversification.
• However, it is all these factors that might contribute to risk, or
indeed cause difficulty in assessing risk.
42
Risks of International Equity Investing
Lack of Liquidity
• In foreign markets you might not have the same level of access you
are used to in your domestic market.
• Lower trading volumes
• Limited trading hours
• Restrictions on quantity and type foreign investors can borrow
• Pay a premium to purchasing foreign equity.
Lack of information
• Different countries have different systems and rules in place
regarding disclosure of information. 43
Risks of International Equity Investing
• This might mean that information routinely available domestically
might not be readily available abroad, which might hamper your
ability to assess a given company.
• Language barriers.
Foreign legal remedies
• Domestically you know what recourse you have to the courts to
address any dispute.
• If there is a dispute in a foreign country, you will in all likelihood
have to use foreign legal remedies to address this.
44
Risks of International Equity Investing
Different market operations
• Structure and operation of foreign markets may be different from
your own.
e.g. Rules providing for the safekeeping of shares held by
“custodian banks” may not be well developed in some foreign
markets.
Aside: Quick definition of a Custodian Bank – financial institution
responsible for the management of a firm’s funds. So they will hold
a firms assets, make settlement for any buying/selling of securities.
45
International Diversification
• Despite the above risks we advocate, in principle, a portfolio that is
international in nature, due to the additional benefits garnered
from diversification.
• So for a given rate of return, an international portfolio should
contain less risk (versus a domestic portfolio)
• Conversely for a given level of risk an international portfolio should
yield a greater return (versus a domestic portfolio)
• The broader the diversification the more stable the returns and the
more diffuse are the risks
• Shapiro: A fully diversified US portfolio is only about 27% as risky
as a typical individual stock.
46
International Diversification
• This figure of 27% cannot be further reduced domestically.
• Given the constituents of this portfolio are all in one country, they
are going to be subject to some of the same factors, e.g. regulator
structure, tax regime, business cycle.
• This will induce a degree of correlation in returns, making further
diversification impossible.
• This is where international diversification comes in – different
political systems, tax structures, business cycles etc.
• Helps reduce the correlation of returns and hence aids in
diversification.
47
International Diversification
• In short – the risk that is systematic to the domestic economy is not
necessarily systematic to the world economy.
• e.g. oil price shock might hurt the domestic economy, but will help a
country in the Middle East.
48
International Diversification
49
International Diversification
• From the graph on the previous slide the benefits of international
diversification are clear.
• International portfolio seems to be less than half as risky as a fully
diversified US portfolio.
• We can look at this diversification gain in terms of the
efficiency frontier.
50
International Diversification
Efficiency Frontier – a reminder
51σ
A
B
E(R)
International Diversification
• Remember that all portfolios on the efficiency frontier offer the
best level of return for a given amount of risk. (e.g. A preferred to
B)
52
σ
E(R)
.
International Diversification
Numerical exposition of the benefits of international
diversification
• We will show how the standard deviation of a portfolio with a
mixture of a domestic and a foreign portfolio will have a lower
level of risk than a portfolio that is solely domestic.
• Toolbox:
211221
2
2
2
2
2
1
2
1
2121
2
2
2
2
2
1
2
1
2
),cov(2
σσρσσσ
σσσ
wwww
rrwwww
p
p
++=⇒
++=
53
International Diversification
• Subscript 1: domestic portfolio, subscript 2 = foreign portfolio
• w1+ w2 = 0.5 + 0.5 = 1 (the weighting of the domestic and foreign
portfolio sums to unity)
• Data:
• Shapiro gives an example where the following values have been
calculated from real data:
US (“domestic”) portfolio: σUS = 53.2%
Foreign portfolio: σrw = 58.1%
Correlation: ρUS,rw = 0.50
54
International Diversification
• So we can see there is less risk for the US “domestic” investor by
choosing an international portfolio vis-à-vis a purely domestic
portfolio as this investor has taken advantage of the risk reduction
from having an international portfolio.
• This risk reduction stems from the factors already mentioned,
business cycle etc.
%2.4850.01.582.535.021.585.02.535.0 22222 =××××++=pσ
55
International Diversification
56
International Diversification
The case against International Diversification
Correlations have increased over time:
Increases in real and financial integration results in higher
correlations in international asset prices:
(deregulation/capital mobility/free trade)
Correlations increase when markets are volatile:
• Why diversify?
• You want to get a handle on risk
57
International Diversification
58
International Diversification
• Unfortunately it materialises that just when you need diversification
the most, it can sometimes fail you.
• By this, I mean during volatile times.
• Contagious volatility: High vol in US market high vols elsewhere.
• Stocks correlate a lot more during volatile times than non-volatile
times.
• Stock markets seem to be asynchronous only in the good times. In the
bad they are synchronous.
Domestic market outperforms others
• Premise: stick with domestic. How well diversified? Past
performance indicator of future performance?
59
International Diversification
Barriers to diversification
• To recap, these can include:
• Lack of liquidity
• Currency controls
• Specific tax regulations
• Less-developed capital markets abroad
• Exchange rate risk
• Difficulty in garnering information
• The argument is that over time these barriers are being eroded as
we be become more “connected” globally, and more developed as
a world economy.
60
International Diversification
• Despite globalisation and increased connectivity of financial
markets, the level of international diversification has not reached
levels one would expect
• Once again, the problem of home bias.
• Many explanations, some centring on the barrier to international
diversification already mentioned.
• However what many see as a key driver is that investors are
uncomfortable with the unknown, and hence are reluctant to invest
abroad.
• This might be set to change more and more over time, as
international account standards are becoming more homogenised,
and there is more conformity regarding disclosure regulations for
financial markets
61
International Diversification
Country specific or Industry specific diversification?
• Given globalisation and increased correlation across markets,
should we still be looking at diversifying across countries?
• Evidence to suggest there are benefits through diversification
across industries.
• Certainly makes sense given that many listed countries trade
internationally, making it difficult to gauge ones exposure to specific
country risk.
If domestic companies diversify for us why bother?
• Some industries may not be present in the domestic country
• You are subject to a large extent to the whims of one government.
• That the domestic firms are “better” than foreign rivals 62
Home Bias in brief
• When we talk of the lack of portfolio diversification (the bias
towards investing domestically), we are referring to home bias
• Given what we know w.r.t globalisation/internationalisation of
financial markets… home bias is puzzling… yielding:
“equity home bias puzzle”
• A couple of good references for the adventurous:
French and Poterba (1991) AER.
Tesar and Werner (1995) JIMF
• Issues covered in texts as an issue in its own right, or as part of a
discussion on international portfolio diversification.
63
Home Bias in brief
• The tendency of investors to hold domestic assets in their investment
portfolios
• French and Poterba (1991) and Tesar and Werner (1995) provided
evidence of equity home bias of 94%, 98% and 82% in US, Japan and UK,
respectively.
• Baxter and Jerman (1997) argue that our individual ability to generate
returns (human capital) is not really internationally tradeable.
• They find it is highly correlated with the domestic returns but not with
foreign.
Implication: Increase investments in foreign assets when constructing
portfolios. Thus bias is less severe! 64
Home Bias in brief
Some explanations
Clearly our barrier to international diversification are relevant here.
In addition:
1.MNC’s diversify for domestic investors – we should expect to
therefore see some “bias”. Issue: Stock returns from MNCs tend to
correlate with domestic market index.
2.Informational asymmetries/transaction costs. Magnitude sufficient
to preclude investing into developed/industrialised countries?
65
Home Bias in brief
3. Behavioural finance. Strong and Xu (2003) find investors are more
optimistic about investing domestically than abroad.
4. Expertise. The more experienced/”sophisticated” you are, the
more likely you are to invest internationally.
5. Cultural/language barriers/commonalities.
66
Part 2 - Conclusion
You should be able to:
• Explain the costs and benefits of international diversification.
• Comment on the extent to which investors to diversify
internationally.
• Discuss the issue of home bias. What are the drivers/explanations for
this phenomenon?
Part 1: International Cost of Capital
1
Reading
• Shapiro, A. (2010), Multinational Financial Management,
Ninth Edition, Wiley, ISBN 978-0-470-45035-2
• Tenth Edition is also available now
• International Cost of Capital: Ch 14
• International Portfolio Investment: Ch 15.
N.B. There are many copies in the library
2
Introduction
• Part 1:
• Revisit the CAPM very quickly
• Look at how we can use the CAPM to calculate the cost of equity
capital for MNC subsidiaries.
• See if the cost of a project in a foreign country should have a
lower cost of capital than a similar project domestically.
• Address some of the issues in calculating this cost of equity
capital via the CAPM.
3
Capital budgeting
• Investment selection
• Capital budgeting process of selecting capital investments to maximise MNC
shareholder value
• NPV
• A project’s NPV determines the project’s impact on shareholder value.
• You will recall the following:
where
• Only accept +ive NPV projects.
4
∑
=
+
+=
n
t
NCFt = net cash flow in time t
I0 = initial investment
k = cost of capital (i.e. WACC)
n= investment horizon
t
t
k
NCFNPV -I
1
0 )1(
Cost of capital
• WACC (ignoring taxes)
• α = Firm's debt structure (debt to total assets)
• Ke = Cost of equity capital
Required return on the firm's stock given the particular debt ratio
selected
• Kd = Cost of debt
• The minimum rate risk adjusted return required by shareholders of the firm
to undertake a given investment.
• i.e. minimum rate of return to induce investors to hold the firm’s stock
• Or alternatively, think of the cost of capital as the weighted average return
required for each of the firms activities.
• Therefore the company represents the sum of those projects, and the sum of
the value of those projects should equate to the value of the company.
5
de kkk αα +−= )1(
CAPM and Equity Cost of Capital
CAPM RECAP
• CAPM tells us there exists an equilibrium relationship between an
assets required return and its associated risk.
• That intelligent risk-averse investors will diversify away risk, the
remainder being the risk that attracts a risk premium.
• Diversification: essentially spreading your investments broadly
across industry sectors, countries, and asset types to reduce risk.
• How is risk reduced? By trying to get a collection of assets into your portfolio
that move together (co-vary) as little as possible.
6
CAPM and Equity Cost of Capital
• Though diversification we are able to get rid of diversifiable risk
(sometimes called non-systematic or idiosyncratic risk)
• What is left is nondiversifiable risk (sometimes called systematic or
market risk)
• It is this risk that attracts the premium.
• Indeed, why should the market pay you for holding diversifiable
risk?
7
CAPM and Equity Cost of Capital
The CAPM:
where
ri = equilibrium expected return for asset i
rf = rate of return on the risk free asset
rm = expected return on the market portfolio consisting all risky
assets.
βi = how the expected return of a stock is correlated to
the return of the market portfolio
8
)( fmifi rrrr −+= β
CAPM and Equity Cost of Capital
• More on beta:
where
cov(ri, rm) = covariance between ri and rm
ρim = correlation between ri and rm
σm = standard deviation of market
Positive β : Moves with market
Negative β : Moves against the market
Zero β : not correlated with the market
9
m
iim
m
mi
i
rr
σ
σρ
σ
β == 2 ),cov(
Beta and MNC
• Importance of Beta
• Consider a multinational firm
• The effect of a foreign project’s risk on its cost of capital depends
only on that project’s systematic risk.
• i.e. the proportion of return variability that cannot be eliminated
through diversification.
• The standard view is that much of the risk faced by the MNC is
diversifiable.
• But surely investing overseas can be quite risky?
10
Beta and MNC
• Yes and no. Where it is risky, low correlation between project
and market returns can sometimes offset the effects of higher
project risk.
• Consider now market risk
• Assume we define the market portfolio proxy to be the domestic
index
• The constituents of market portfolio will, to an extent, be
correlated due to the fact they are in the same economy.
• Consider then two similar projects, one domestic and one
foreign.
11
Beta and MNC
• Given that the foreign project is unrelated to the domestic
economy (e.g. business cycle etc), it will maybe be less correlated
with the market portfolio, thus having a lower market risk.
• Consider now an LDC – they can often provide even more
diversification benefits than a project in a foreign DC, despite the
fact that they are be seen as risky. Why? Such economies are
going to be far less influenced and in tune with DC’s.
12
MNC and LDC
• We just stated that a project in the LDC might have more
diversification benefits for the MNC and help lower market risk.
• However it depends on the nature of the project – might not be
reduced much –v- domestic/investment in foreign industrialised
countries.
• The difference will be very small where projects are focused on, say,
extraction of resources.
• Why? Because you trade the resources on the world market.
You are subject to the world price.
• Just as you would be if you extracted domestically.
• However, for a service orientated project in the LDC the reduction
in systematic risk should be more pronounced.
13
MNC and the investor
• Two concepts at play here:
• Corporate international diversification
• International portfolio diversification (more on this in Part 2).
• Investors will accept a lower rate of return from a MNC if they
supply low cost international diversification.
• Motivation: might exist a potential barrier to international portfolio
diversification. As MNC have been further able to reduce risk will
accept lower rate of return.
• Equally, the risk premium on these international projects may
be lower than for similar domestic ones implying MNCs might
undertake overseas projects it would otherwise reject
domestically.
• As they are less correlated
14
MNC and the investor
• But how well do investors diversify?
• Evidence that they do not take enough advantage of portfolio
diversification. “Home bias?”
• Some estimates of US holdings of foreign equities is around 8%.
• Capital controls/taxes cannot explain why gains from holding foreign
equity are not exploited.
• Foad (2006) report a decrease in equity home bias in Europe following
the introduction of Euro – trade flows, common language, and
contiguity all factors.
• Possible reasons for home bias?
These include:
• Lack of information about foreign based companies
15
MNC and the investor
• Desire to consume domestic goods and services potential for purchasing power to
be eroded through changes in FX (unless PPP holds!)
• Or indeed the need to meet domestic liabilities (e.g. Pension fund)
16
Estimating Foreign Project Discount Rates
• Consider a potential foreign project, e.g. a subsidiary of the MNC.
• Use CAPM to evaluate cost of capital?
• Problem: We are considering a new project - there are no past
history of returns.
• Solution? To get around this we can use publicly traded firms that
share similar risk characteristics and use the average of their beta’s
as a proxy for the subsidiary beta.
17
)( fmifi rrrr −+= β
Estimating Foreign Project Discount Rates
However in doing so we have to address the following issues:
1. Local companies in the foreign country might not exist.
• Local companies in the foreign country might be a better indicator –
however they may not exist.
• Use data from similar companies from the domestic country? Is the
domestic proxy company likely to behave as the foreign?
2. What is the relevant market portfolio? The domestic market
portfolio, the local market portfolio (in foreign country), or the
world market portfolio?
• Important decision.
• A risk that is systematic to one economy, might be diversifiable
internationally.
18
Estimating Foreign Project Discount Rates
• e.g. if you use the local index, this will result in a higher beta, and therefore
a higher required return and hence a less desirable project as discounting
cash flows more.
3. What is the market risk premium? (rm-rf)
• Use local measure as it is the risk premium demanded by investors in that
market?
• Maybe not too relevant to the investors in the MNC – maybe the majority
of its investors are domestic and therefore use the domestic risk premium.
19
Estimating Foreign Project Discount Rates
4. How do we factor (should we factor?) country risk into the cost of
capital?
• Could add a country risk premium to the CAPM calculated discount rate.
• Country risk premium often calculated based upon the difference in the
returns of the domestic and foreign government bonds (ideally issued in
the same currency, e.g. USD)
…but is this consistent with CAPM? Double counting of risk?
20
3 ways of estimating proxy betas
Alternatives of estimating proxy betas:
• We have discussed the issues – so what should a MNC do? We
have the following “ranking” of alternatives as set forth in Shapiro
1. Local Companies
• Returns on MNC local operations will be linked to a large extent on the local
economy, hence corporate proxies should be local companies.
• Timing/magnitude etc of these returns will differ from domestic projects.
• So for an international investor implies degree of market risk may be lower in
foreign country than for the same project in the investor’s home country.
• i.e. Using domestic companies & their returns to proxy for the returns of a
foreign project will upward-bias the risk premium demanded by MNC investors
21
3 ways of estimating proxy betas
Exposition of upwards bias:
Foreign market beta = Correlation with dom. Market x s.d of foreign market
s.d of domestic market
Aside: just beta using correlation instead of cov(.)
• Taking data from 1990-2020 and the market index of a foreign country
as the asset, we find the beta is less than unity.
• Note by definition we get a beta of unity when using the domestic market
index as the asset.
22
3 ways of estimating proxy betas
• We see this from the table above
• This tells us that if we are considering a project (subsidiary) in a foreign country,
and based on our proxy of that company on similar domestic companies rather
than local, we will be over-estimating the beta. (as we see a lower beta for the HK
market w.r.t US)
• Also note the volatility in the HK returns -v- US, yet HK yields a lower beta. This is
because much of this risk can be diversified away internationally.
Corr
with US
market
s.d. of
returns(%)
Beta from “US”
perspective
Hong Kong 0.33 135.55 0.85
US (“domestic”) 1 53.20 1
23
3 ways of estimating proxy betas
• So to use a domestic project returns to proxy the returns of a foreign
project leads to an upwards bias in the estimate of the risk premium
demanded by the MNC’s investors
• Implication: Rejection of potentially viable projects?
2. Proxy Industry
• If foreign proxies are not available, you could find a proxy industry in the local
market.
• i.e., find, domestically, an industry that has a similar beta to the project’s
industry. Then look to that industry in the foreign country to get your proxy for
beta.
• It would be a sensible idea to see if the industry betas are similarly across other
countries also.
24
3 ways of estimating proxy betas
25
You want to invest in a
project in industry type
A
Industry Type A not
available in local
country
Therefore, find a domestic
industry that has same
beta as industry type A
Look at the beta of that similar
industry in the foreign country
to get the appropriate beta
3 ways of estimating proxy betas
3. Adjusted Domestic Industry Beta
• Take the domestic industry beta for the project, βdom,proxy
• Multiply it by the foreign market beta relative to the domestic market (i.e. foreign
market beta is garnered using CAPM with domestic index as market portfolio and
foreign index as the “stock”)
• The beta for the foreign project should be the product of the two:
β foreign sub = βforeign mkt * βdom,proxy
26
3 ways of estimating proxy betas
• This is the least preferred option as:
• It imposes the same domestic “relative riskiness” on the foreign project.
e.g. project A has a beta of 0.8 and B of 0.6 in the domestic country. The
ordering of these betas will be the same when expressed in terms of the
beta of the foreign project.
• The environment in the foreign country may be different to the domestic,
and the above order might not be the same.
• Possible to get a situation where there is a low correlation with the local
market, but a high correlation with say the US market (e.g. an oil firm.)
Given we are using the US proxy we cannot account for this.
27
Recommendation 1: Base portfolio
• Given globalisation and the linking up of international
markets, it might be appropriate to use the global market
portfolio as the CAPM market portfolio.
• This will give a cost of capital that is representative of the risk
of a given project in an international setting.
• If however we take the view that investors are not as
internationally diversified as they should be (again, home
bias), maybe we should revert to the domestic market
portfolio.
28
Recommendation 1: Base portfolio
Recommendation
Shapiro: “pragmatic recommendations is for US MNCs to measure the betas of
international operations against the US market portfolio”
Why?
• The lack of (overall) international diversification by US investors implies that the
relevant market portfolio is the US market portfolio.
• Easy comparison of foreign and US investments, as evaluated relative to the US
market index
• However, for non-US companies from smaller (open) countries it might make
more sense to use the global CAPM as they may be more internationally
diversified out of necessity.
29
Recommendation 2: Market risk premium
Recommendation
Shapiro: “…[Ideally should choose a] methodology that is as consistent as
possible with [that]… used to calculate the cost of capital for U.S investments.”
• i.e. we should use the domestic market risk premium
Why?
• Domestic risk premium is the risk premium most likely to be demanded by
the domestic company’s mainly domestic investors.
• Consistency: If we are going to use the domestic market portfolio, it makes
sense to use the domestic market risk premium.
30
Part 1 - Conclusion
You should be able to:
• Discuss whether the required rate of return on foreign projects
should be higher, lower, or the same as the domestic economy (via
CAPM).
• Linking into this first point, discuss the use of CAPM to help us
determine this rate, and in particular the attendant issues that
have to be addressed: foreign company proxies, choice of market
portfolio, etc.
31
International Finance
Part 2: International Portfolio Investment
32
Introduction
• Part 2:
• Costs and benefits of international diversification
• Efficiency frontier
• Barriers to international diversification
• Home bias
33
Introduction
• We have touched on diversification from the perspective
of the firm and their activities.
• Next, we will explore the concept of international
diversification.
34
Preamble
• When we invest in equity, we are subject to risk
• When an investor constructs a well diversified portfolio,
the non-systematic (diversifiable) risk is reduced.
• What remains, systematic risk, is the risk that we are
unable to diversify away.
• The market compensates us for taking on this risk by
offering a commensurate return.
• So how does the nature of risk change when we look at
an international portfolio?
35
Risks of International Equity Investing
Changes in currency exchange rates
• Investment return is going to be a function of exchange rate
movements.
• This means that your returns can be either helped or hindered by
changes in the exchange rate.
Example:
Current Microsoft price (March 2022): 15.15 USD
3 months old Microsoft price (Dec 2021): 20.61 USD
Note: We can see we, as expected, a drop in Microsoft given the
recent economic turmoil.
36
Risks of International Equity Investing
• So what is the return on holding a share in Microsoft over this
period if you are a living in the United States? (ignoring dividends
for simplicity)
• The current exchange rate (March 2022) is 1.3800 USD/GBP. The rate
three months ago (Dec 2021) was 1.4775 USD/GBP.
• What is your return on holding a share in Microsoft over this period
if you are living in the United Kingdom?
2649.0
61.20
61.2015.15
,
−=
−
=USmsR
37
(I could have taken log returns)
Risks of International Equity Investing
• Cost of a share in Microsoft in Dec 2021:
20.61/1.4775 = 13.95 GBP
• Cost of a share in Microsoft in March 2022:
15.15/1.38 = 10.98 GBP
• Cost of a share in Microsoft in March 2022 if the exchange rate had
not changed from December 2021:
• 15.15/1.4775 = 10.25 GBP
38
Risks of International Equity Investing
• We can clearly see that the current cost of a Microsoft share to a
UK investor is higher than it would have been using the exchange
rate applicable 3 months ago.
• The change in the exchange rate, for a UK investing in the US, has
mitigated some of the loss of investing in Microsoft.
• The return for a UK investor holding a share of Microsoft:
2129.0
95.13
95.1398.10
,
−=
−
=UKmsR
39
Risks of International Equity Investing
• The return of the UK investor is approximately 5% better than for a
US investor, due to changes in the exchange rate.
• Note – this is a positive example. The exchange rate could have
moved in the opposite direction. If that had been the case the
returns would have been worse.
40
Risks of International Equity Investing
Dramatic changes in market value
• In the previous example we showed that exchange rate changes will
affect the returns when investing internationally by looking at the
change in a stock price.
• When investing internationally an entire market might suffer a drop
in price.
• Domestically investors can sometimes employ various
models/statistical techniques to try and judge when to enter/exit
the market/industry sector etc.
• This is difficult enough to do (and much debated!) in the domestic
economy. How will you do this in foreign economies?
41
Risks of International Equity Investing
• The argument is you should invest for the long term and ride out
the short-term periods when the market moves against you.
Political, economic, and social events
• By investing in many countries, our portfolio of stocks will be
subject to a variety of different political, economic, and social
factors/events.
• It is these differences that help us with diversification.
• However, it is all these factors that might contribute to risk, or
indeed cause difficulty in assessing risk.
42
Risks of International Equity Investing
Lack of Liquidity
• In foreign markets you might not have the same level of access you
are used to in your domestic market.
• Lower trading volumes
• Limited trading hours
• Restrictions on quantity and type foreign investors can borrow
• Pay a premium to purchasing foreign equity.
Lack of information
• Different countries have different systems and rules in place
regarding disclosure of information. 43
Risks of International Equity Investing
• This might mean that information routinely available domestically
might not be readily available abroad, which might hamper your
ability to assess a given company.
• Language barriers.
Foreign legal remedies
• Domestically you know what recourse you have to the courts to
address any dispute.
• If there is a dispute in a foreign country, you will in all likelihood
have to use foreign legal remedies to address this.
44
Risks of International Equity Investing
Different market operations
• Structure and operation of foreign markets may be different from
your own.
e.g. Rules providing for the safekeeping of shares held by
“custodian banks” may not be well developed in some foreign
markets.
Aside: Quick definition of a Custodian Bank – financial institution
responsible for the management of a firm’s funds. So they will hold
a firms assets, make settlement for any buying/selling of securities.
45
International Diversification
• Despite the above risks we advocate, in principle, a portfolio that is
international in nature, due to the additional benefits garnered
from diversification.
• So for a given rate of return, an international portfolio should
contain less risk (versus a domestic portfolio)
• Conversely for a given level of risk an international portfolio should
yield a greater return (versus a domestic portfolio)
• The broader the diversification the more stable the returns and the
more diffuse are the risks
• Shapiro: A fully diversified US portfolio is only about 27% as risky
as a typical individual stock.
46
International Diversification
• This figure of 27% cannot be further reduced domestically.
• Given the constituents of this portfolio are all in one country, they
are going to be subject to some of the same factors, e.g. regulator
structure, tax regime, business cycle.
• This will induce a degree of correlation in returns, making further
diversification impossible.
• This is where international diversification comes in – different
political systems, tax structures, business cycles etc.
• Helps reduce the correlation of returns and hence aids in
diversification.
47
International Diversification
• In short – the risk that is systematic to the domestic economy is not
necessarily systematic to the world economy.
• e.g. oil price shock might hurt the domestic economy, but will help a
country in the Middle East.
48
International Diversification
49
International Diversification
• From the graph on the previous slide the benefits of international
diversification are clear.
• International portfolio seems to be less than half as risky as a fully
diversified US portfolio.
• We can look at this diversification gain in terms of the
efficiency frontier.
50
International Diversification
Efficiency Frontier – a reminder
51σ
A
B
E(R)
International Diversification
• Remember that all portfolios on the efficiency frontier offer the
best level of return for a given amount of risk. (e.g. A preferred to
B)
52
σ
E(R)
.
International Diversification
Numerical exposition of the benefits of international
diversification
• We will show how the standard deviation of a portfolio with a
mixture of a domestic and a foreign portfolio will have a lower
level of risk than a portfolio that is solely domestic.
• Toolbox:
211221
2
2
2
2
2
1
2
1
2121
2
2
2
2
2
1
2
1
2
),cov(2
σσρσσσ
σσσ
wwww
rrwwww
p
p
++=⇒
++=
53
International Diversification
• Subscript 1: domestic portfolio, subscript 2 = foreign portfolio
• w1+ w2 = 0.5 + 0.5 = 1 (the weighting of the domestic and foreign
portfolio sums to unity)
• Data:
• Shapiro gives an example where the following values have been
calculated from real data:
US (“domestic”) portfolio: σUS = 53.2%
Foreign portfolio: σrw = 58.1%
Correlation: ρUS,rw = 0.50
54
International Diversification
• So we can see there is less risk for the US “domestic” investor by
choosing an international portfolio vis-à-vis a purely domestic
portfolio as this investor has taken advantage of the risk reduction
from having an international portfolio.
• This risk reduction stems from the factors already mentioned,
business cycle etc.
%2.4850.01.582.535.021.585.02.535.0 22222 =××××++=pσ
55
International Diversification
56
International Diversification
The case against International Diversification
Correlations have increased over time:
Increases in real and financial integration results in higher
correlations in international asset prices:
(deregulation/capital mobility/free trade)
Correlations increase when markets are volatile:
• Why diversify?
• You want to get a handle on risk
57
International Diversification
58
International Diversification
• Unfortunately it materialises that just when you need diversification
the most, it can sometimes fail you.
• By this, I mean during volatile times.
• Contagious volatility: High vol in US market high vols elsewhere.
• Stocks correlate a lot more during volatile times than non-volatile
times.
• Stock markets seem to be asynchronous only in the good times. In the
bad they are synchronous.
Domestic market outperforms others
• Premise: stick with domestic. How well diversified? Past
performance indicator of future performance?
59
International Diversification
Barriers to diversification
• To recap, these can include:
• Lack of liquidity
• Currency controls
• Specific tax regulations
• Less-developed capital markets abroad
• Exchange rate risk
• Difficulty in garnering information
• The argument is that over time these barriers are being eroded as
we be become more “connected” globally, and more developed as
a world economy.
60
International Diversification
• Despite globalisation and increased connectivity of financial
markets, the level of international diversification has not reached
levels one would expect
• Once again, the problem of home bias.
• Many explanations, some centring on the barrier to international
diversification already mentioned.
• However what many see as a key driver is that investors are
uncomfortable with the unknown, and hence are reluctant to invest
abroad.
• This might be set to change more and more over time, as
international account standards are becoming more homogenised,
and there is more conformity regarding disclosure regulations for
financial markets
61
International Diversification
Country specific or Industry specific diversification?
• Given globalisation and increased correlation across markets,
should we still be looking at diversifying across countries?
• Evidence to suggest there are benefits through diversification
across industries.
• Certainly makes sense given that many listed countries trade
internationally, making it difficult to gauge ones exposure to specific
country risk.
If domestic companies diversify for us why bother?
• Some industries may not be present in the domestic country
• You are subject to a large extent to the whims of one government.
• That the domestic firms are “better” than foreign rivals 62
Home Bias in brief
• When we talk of the lack of portfolio diversification (the bias
towards investing domestically), we are referring to home bias
• Given what we know w.r.t globalisation/internationalisation of
financial markets… home bias is puzzling… yielding:
“equity home bias puzzle”
• A couple of good references for the adventurous:
French and Poterba (1991) AER.
Tesar and Werner (1995) JIMF
• Issues covered in texts as an issue in its own right, or as part of a
discussion on international portfolio diversification.
63
Home Bias in brief
• The tendency of investors to hold domestic assets in their investment
portfolios
• French and Poterba (1991) and Tesar and Werner (1995) provided
evidence of equity home bias of 94%, 98% and 82% in US, Japan and UK,
respectively.
• Baxter and Jerman (1997) argue that our individual ability to generate
returns (human capital) is not really internationally tradeable.
• They find it is highly correlated with the domestic returns but not with
foreign.
Implication: Increase investments in foreign assets when constructing
portfolios. Thus bias is less severe! 64
Home Bias in brief
Some explanations
Clearly our barrier to international diversification are relevant here.
In addition:
1.MNC’s diversify for domestic investors – we should expect to
therefore see some “bias”. Issue: Stock returns from MNCs tend to
correlate with domestic market index.
2.Informational asymmetries/transaction costs. Magnitude sufficient
to preclude investing into developed/industrialised countries?
65
Home Bias in brief
3. Behavioural finance. Strong and Xu (2003) find investors are more
optimistic about investing domestically than abroad.
4. Expertise. The more experienced/”sophisticated” you are, the
more likely you are to invest internationally.
5. Cultural/language barriers/commonalities.
66
Part 2 - Conclusion
You should be able to:
• Explain the costs and benefits of international diversification.
• Comment on the extent to which investors to diversify
internationally.
• Discuss the issue of home bias. What are the drivers/explanations for
this phenomenon?
