The objective of this report is to address the strategy of international diversification and the application of international capital asset pricing model (ICAPM). This report address how efficient is domestic stock market and foreign market and how manages utilise and managed companies asset. Calculate international bonds will be looked into and recommendation will be made either to invest on the entire bonds or to reallocate the money to US bonds.
Introduction
Recently, economic activities have increased dramatically in international aspect of business operations. National economy has been linked closely by way of growing volume of cross border transaction (Madura J and Obrien T. J 1991). This is due to advancement in communication, IT, and transportation technology. Companies are increasingly moving into foreign markets as part of their growth strategy which is closely linked to the effect of globalisation and the rising intensity of competition. Investment opportunities are no more limited to domestic markets; business can now seek opportunities overseas with ease. Access to opportunities in foreign markets can overcome growth challenges, and might enhance a company's overall performance. Globalisation has caused explosive growth in international flow of equity, fixed income and monetary instrument. Emerging markets are now more accessible and offer series of attractive investments to investors round the globe. According to Ang siah Hwee 2007, International diversification is geographical breadth of a company's international presence, it provides an indication of the company's extent of dependence on foreign markets
Strategy of international diversification and application of ICAPM
Globalisation of investment ownership is part of the integration of the world's financial markets made possible by technology advances and worldwide liberalization of regulations regarding foreign ownership (Mardura Jand Obrien T. J, 1991). Ang Sia Hwee (2007) defined diversification as a means of spreading the base of business to achieve improved growth and to reduce overall risk that may take the form of investments which addresses new products, services, customer segments and geographic market.
Theoretical foundations such as portfolio investment theory and foreign direct investment theories suggest that economic of scale and scope, operation flexibility, learning, and stable profits can be achieved through international diversification. Firms may even diversify into new markets to reap synergistic benefits, reduce overall risk exposure and minimize transaction costs (Li, J and Yue, D.R, 2007). Three models have been proposed in regards to firm's diversification strategy; the product and market portfolio model, this highlights the attractiveness to target market in terms of characteristics such as profit, market size and growth rate. The strategy model emphasises the interrelationship between the core business market and targeted market .The third approach is risk and return model, this is derived from financial theories and reflects the concern and interest of investors.
Solnik 1974 cited in Ang Saiah Hwee 2007 that international diversification of equity reduces risk and the idea of this risk reduction is based on modern portfolio theory. Presently there are two contending views on international diversification value, according to Rockefeller 2001, International diversification reduces risk and the other view is that diversification is favourable because additional qualitative risks of foreign investment outweighs potential returns.
By diversifying across nations whose market cycles were not perfectly correlated, investors could lower the volatility of portfolio returns at any level of expected returns. In general terms, access to international equity markets offers considerable gains from portfolio diversification. These gains are measured based on changes in efficient frontier as additional foreign assets are included to the invested securities. Madura, J and O'Brien T J stated that efficient frontier methodology in international diversification employed return parameters on a home currency based that home currency returns included not only the performance of international investment in their local markets but also the appreciation and depreciation of home currency verse foreign currency. Numbers of studies show that international financial markets offer gains from diversification is strong and many investors primarily holding domestic securities have been dubbed the home bias puzzle (Santis G,D and Gerard B, 1997).
Cost of Diversification
There are cost that are associated with international investment, these are information cost, legal cost, and political risk, economical risk control of the free flow of capital and currency risk. Solnil, 2000 explains some of the all this downsides
Information cost: Is the real financial cost of ensuing correct information are received, and the non-financial cost are the cost of understanding the culture, accounting standards.
Political costs are the cost associated with legislation of the country and it could affect the profit, capital investment from foreign country.
Currency risk (exchange risk), can affect the value of the firm (returns and the volatility of the investment), these can be managed by selling forward or future currency contract, also by lending foreign currency to finance the investment (debt or equity)
Operating risks, these are the risks of not keep proper records of investment transactions by the brokers and the additional risk are shortages of skilled workers, corruptions, lack of or inadequate infrastructure, weak and indiscipline leaders.
Cost of Capital
Being able to access global capital market allows companies to reduce their cost of capital, through acquisitions and mergers with other companies, direct foreign investment and other global activities. According to Li J and Yue, D.R , companies will attract international portfolio investors if they can sources capital in liquid market.
SEE Table 1
Table 1: Dimensions of the Cost and Availability of Capital Strategy
Source: Eiteman et al (2001)
International equity market used to be very strict on investors from other countries, so therefore when domestic market is closed and investors are restricted, domestic assets cannot be priced internationally. Globalisation and the coming up of the emerging market open the equity market to all investors who are interested in trading (deregulated). Asset pricing became global. The flow of portfolio investments to emerging markets has increased since they opened up their capital markets to foreign investors in the 90's. The main reason of this interest is high expected returns due to their high volatility compared to more developed markets and their low correlation with developed market. High volatility is important for expected return and low correlation is important to portfolio diversification. Reeb et al (1998), stated that the gains from diversification might be weak if correlations are higher than normal during volatile time. Madura J and O'Brien T. J explain that returns of less developed countries were commonly less correlated with other market returns and generally assigned more weight in the efficient portfolios; the correlations of returns among industrialisation countries were relatively higher, so that diversification among market offered less benefit.
Application of ICAPM
The relationship between markets and the level of systematic risk of markets is very important to international portfolio investors. Different expected return gained is by taking different risk levels. International investment , stock price are affected by domestic events so that systematic risk of portfolio could be decreased without decline in expected return by investing different capital market (Reeb et al, 1998), in short domestic systematic risk can be diversified away by investing internationally without paying a prices in terms of lower returns. International Capital Asset Pricing Model (ICAPM) is useful to diversify portfolio for international portfolio investors. The ideal of ICAPM is based on CAPM. CAPM can be obtained by integrating index returns of each country, world index return and global risk free rate into domestic CAPM, while ICAPM generally take account if world market portfolio instead of domestic market portfolio. If companies are exposed to global risk than international models to measure the cost of capital is valid.
The empirical models
The model predicts that the expected return on any traded asset in excess of a risk free return is proportional to the systematic risk of the asset as measured by its covariance with a market wide portfolio return.
Rit- Rft =ai +β (Rmt-Rft) +Eit
Where i = 1, 2, …, n, t = 1, 2, …, T and Eit ~ iid N (0,In Equation (1), Rit, Rmt and Rft indicate index return of country i, world index return as a market return and risk free rate, respectively. In ICAPM, β is affected by three factors: (i) correlations among the country and world index return, (ii) volatility of country index return, and (iii) volatility of world index return.
CAPM and ICAPM
Capital asset pricing model is one of the most recognised explanations of stock prices and expected returns; it is described as that systematic risk, the main factor to expected returns (Martal et al, 1999). It has been developed with respect to major capital markets in the world. CAPM is an application to company valuation and capital budget of a business. It is a model used to estimate expected returns presupported that the return, that investors would require of an asset depends primarily on the manner in which the asset is financed. In other word gives insight about what kind of risk is related to return.
CAPM Assumption
Investors are risk averse
No transaction cost
The rate receives is the same as the cost of borrowing
Rational investors would hold efficient portfolios that are full diversified
Investors have the same investment time horizons
Investments are not tax related
All investors have same expectations about expected rate of rete and how capitalisation rate are generated
The markets have perfect liquidity and divisibility.
The objective of international portfolio diversification is to eliminate unsystematic risk (unsystematic risks are the risks that can be eliminated by appropriate diversification of assets) according to CAPM, in a world not characterized by imperfections it would be sufficient to make proportionate investments in the world market portfolio to achieve such an elimination of unsystematic risk. In reality where transaction costs imperfect information and capital control do exist; it would be virtually impossible to acquire every security proportionately to its market value and thus, own a pro rata share of the world market portfolio.
The assumption made by CAPM allows it to focus on the relationship between return and systematic risk, the ideal world created with the assumptions is not the same as the real world in which investment decisions are made. For example, in the real world ,markets are clearly not perfect, even though it can be said that developed stock market do, in practice exhibit a high degree of efficiency, there is a scope for stock market securities to be priced incorrectly and as a result, for their return ,not to plot on to the Security Market Line
The assumption of single-period transaction horizon appears reasonable from a real-world perception, because even though ,most investors hold securities for much longer than one year, returns on securities are usually quoted on an annually.
The assumption that investors hold diversified portfolios means that all investors would want to hold a portfolio that replicates the stock market as a whole. Although it is not likely to own the market portfolio itself, it is quite easy and inexpensive for investors to diversify away specific or unsystematic risk and construct portfolios that 'track' the stock market. Assuming that investors are concerned only with receiving financial compensation for systematic risk seems therefore to be quite reasonable. The problem is that, in reality, it is not possible for investors to borrow at the risk-free rate (for which the yield on short-dated
Government debt is taken as a proxy). The reason is ,,the risk associated with individual investors is much higher than that associated with the Government. This inability to borrow at the risk-free rate, means that the slope of the Security Market Line is shallower in practice than in theory. Overall, it seems reasonable to conclude that while the assumptions of the CAPM represent an idealised world, rather than real-world view. there is a strong possibility, in reality, of a linear relationship existing between required returns and systematic risks.
There are lot of good sides to the CAPM over other methods of calculating required returns, which is why it being one of the most popular models used.
Systematic risk is the only risk CAPM considers, this reflects reality, in that most investors have diversified portfolios, from which the unsystematic risk is eliminated.
CAPM creates a theoretically derivative relationship between systematic risk and required returns and this has been subjected to recurrent empirical research and testing.
CAPM have been seen as better method of calculating the cost of equity than dividend growth model (DGM) because it considers company's level of systematic risk which are relevant to the stock market
CAPM provide discount rates for the use in investment appraisal
Downside of CAPM
ACCA article 2007 discussed the downside of CAPM which are,
Value has to be allocated to risk free rate of retune, the equity risk premium (ERP) or the market return and beta in order to apply CAPM. The yield on short-term Government debt, which is substitute risk free rate, is not fixed but according to economic situation charges, takes place every day. Short-term average value can be used level out the validity. Getting a correct value for the ERP could difficult. The return on a stock market is the sum of the average capital gain and the average dividend yield. In the short term, a stock market can provide a negative rather than a positive return if the effect of falling share prices outweighs the dividend yield. It is therefore usual to use a long-term average value for the ERP, taken from empirical research, but it has been found that the ERP is not stable over time In the UK; an ERP value of between 2% and 5% is currently seen as reasonable. However, uncertainty about the exact ERP value introduces uncertainty into the calculated value for the required return. Beta values are now calculated and published regularly for all stock exchange-listed companies. The problem here is that, uncertainty arises in the value of the expected return because the value of beta is not constant, but changes over time. www.acca.org.com
Using CAPM in calculating a specific project discount rate could be problem. For example, to find a suitable proxy beta, since proxy companies do not undertake only one business activity. The proxy beta for a proposed investment project must be untangled from the company's equity beta. In this case, equity beta can be treated as an average of the betas of different areas of proxy company activity, weighted by the relative share of the proxy company market value arising from each activity. However, information about relative shares of proxy company market value may be quite difficult to obtain. A similar difficulty is that ,the ungearing of proxy company betas uses capital structure information that may not be readily available. Some companies have complex capital structures with many different sources of finance, other companies may have debt that is not traded, or use complex sources of finance such as convertible bonds. The simplifying assumption that the beta of debt is zero will also lead to inaccuracy in the calculated value of the project-specific discount rate. One disadvantage in using the CAPM in investment appraisal is that the assumption of a single-period time horizon is at odds with the multi-period nature of investment appraisal. While CAPM variables can be assumed constant in successive future periods, experience indicates that this is not true in reality.
ICAPM generally takes into account of the world market portfolio instead of domestic market portfolio. In addition to market risk, ICAPM takes currency risk and inflation risk into consideration. ICAPM is a multifactor models and it tend to outperform single factor models in both domestic and international forms. Limitation of ICAPM .exchange rate and inflation uncertainty is very small compared to stock market risk so that they could be ignore to simplify the computation
Domestic market V foreign market
Domestic markets are highly efficient, but efficiency in cross border trading has been impended by national regulations, legal framework conditions, regulation and supervision, accounting as well as clearing and settlement (Financial times). Domestic market efficiency could have been increase by cross listing in two, Firstly, stocks could now be traded by a larger number of investors (expansion of the shareholder base) and liquidity would rise which could increase efficiency domestically on those stocks and Finally, arbitrage arguments could be used to explain why stocks prices listed in two stock exchanges should converge and in this sense there could be a spillover effect from one market to the other, increasing efficiency.
Foreign markets have always been an object od envy to domestic investors because the indexes in some foreign countries produces double to triple digit returns in the past http://www.investopedia.com/ask/answers/05/foreignstocks.asp.
Conclusions
Theoretical model provide a positive explanation and normative rules for diversification of risky asset but the degree to which diversification can reduce risk depend upon the correlations among security returns. Diversification could eliminate risks; if security returns are perfectly correlated no amount of diversification can affect risk. ICAPM assume that countries can be viewed as a stock portfolio in global market, the starting point on international investments is that the stock prices are affected by domestic or local events so that domestic systematic risk can be diversified away by investing internationally without paying a price in terms of lower returns. I will advise to reallocated the money to US bonds
