GLOBAL INVESTMENT

by Bruno Solnik & Dennis McLeavey

Lecturer: Dr. Nguyen Thi Cuc Hong

Faculty of Economics

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Course Contents

1. INTERNATIONAL CURRENCY MARKET

2. INTERNATIONAL ASSET PRICING

3. EQUITY MARKET & INSTRUMENTS
6 learning
units 4. EQUITY: CONCEPT & TECHNIQUES

5. GLOBAL BOND INVESTING

6. INT’L DIVERSIFICATION & RISKS

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 INTERNATIONAL
Unit 1 FOREIGN CURRENCY
MARKET pages 15-88

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 Unit 1 Content

1. International Foreign Currency Markets (IFCM) Who trade Forex

and Why?
2. The principles of Ex-rate quotations
3. Convert and calculate different types of exchange rates, cross-rates
4. Calculate forward discount or premium on annual rates
5. Interest rate parity and covered interest arbitrage

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 FX market players
Participants from around the
world buy & sell different
currencies through

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Type of FX Instrument

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Forex Market & Quotation Conventions
Forex Market Quote Convention

Foreign exchange market FX Trading Platform

A worldwide Forex center Forex trading screen;
(wholesale, market makers
interbank deal with large Ask-Bid quote for any
transactions); currency
OTC market
A retail market (Investors, Not all exchange rate
corporations <-> local banks) are traded

Large commercial and Description of the

investment banks company’s sub contents
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How IFCM work
• Largest financial market: daily trading volume of $5 trillion
• No single exchange transaction, but global computer network of large banks and
brokers from around the world.
• Facilitate currency exchange for foreign trade.
• Allowing companies to sell their goods globally and get paid in their local
currency.
• Transactions occur directly between parties without an intermediary to ensure that
each party complies with its obligations.
• Currencies do not come with a single price but are priced in terms of other
currencies.
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Major currency pairs
EUR/USD: the Euro versus the US dollar
USD/JPY:
GBP/USD:
USD/CHF:
USD/CAD:
AUD/USD:

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 Major, Minor, Exotic currency pairs

Pair Currencies
• Major currency pairs are most-
EUR/USD Euro (€) vs. US dollar ($)
USD/JPY US dollar ($) vs. Japanese Yen (¥) traded in the world
GBP/USD British pound (£) vs. US dollar ($) • Minor currency pairs are less
USD/CHF US dollar ($) vs. Swiss Franc (SFr.)
popular than the major pairs
AUD/USD Australian dollar (AU$) vs US dollar ($)
USD/CAD US dollar ($) vv. Canadian dollar (CA$) • Exotic currency pairs are more
NZD/USD New Zealander dollar (NZ$) vs US dollar volatile and less liquid

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Most major currency

• US$ is world's reserve currency due to this country stable economy and
financial system.

• US$ involved in most of major transactions and currency exchanges since

products, commodities, and investments are transacted in US$.

• Countries with unstable market or currency exchange rate might opt to trade in
dollars to attract investment and facilitate trade.

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 Typical FOREX quotations

Symbol Bid Ask Spread Status

EUR:GBP (Euro/British Pound) 0.8471 0.84802 0.00092 SELL BUY

EUR:USD (Euro/US Dollar) 1.13219 1.1329 0.00071 SELL BUY

GBP:USD (British Pound/US Dollar) 1.33492 1.33653 0.00161 SELL BUY

USD:JPY (US Dollar/Japanese Yen) 113.499 113.567 0.068 SELL BUY

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Principles of FX quotation

a
The formular S=
b
a: the quoted currency or based currency = the numerator = ĐỒNG YẾT (foreign currency)

b: the currency in which the price is expressed = the denominator = ĐỒNG ĐỊNH (local currency)

S = the price of the quoted currency a in units of currency b

For example: $:€ = 0.8 => 1$ is priced at 0.8€

€
Conversely, = 1.25 => 1€ is priced at 1.25$ => $: ¥ = 120 or ¥: $ = 0.8333
$

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Direct & Indirect quotation

𝒂
An = a:b Ex. €:$
Direct 𝒃
(a is foreign, b is domestic currency)
quote
DQ: €:$=1.25 or 1€ costs $1.25
DQ & IQ are reciprocal to each other
IQ: $:€=0.8 or 1$ purchase €0.8

𝒂
Indirect An = a:b Ex. $:€
𝒃
quote (a is domestic, b is foreign currency)

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 Direct and indirect quotation

Direct: Foreign currency / Domestic currency or a:b

if a = foreign currency and b = domestic currency

Ex: €:$ = 1.25 is direct quote to American investors

Indirect: Domestic currency / Foreign currency or b:a

if a = domestic currency and b = foreign currency

Ex: $:€ = 0.8 is indirect quote to American investors

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DIRECT & INDIRECT QUOTATION

Domestic Currency Foreign Currency Direct Ex. Rate Indirect Ex. rate (Domestic
(Foreign currency quoted) currency quoted)

Appreciates Depreciates Decreases Increases

Depreciates Appreciates Increases Decreases

• Appreciation in domestic currency (DC is strong); and

• Depreciation in foreign currency (FC is weak)
• DC strong -> Indirect exchange rate increases; and
• FC weak -> Direct exchange rate decreases

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Exchange rate Problem pg#19

On April 1, £:$ = 1.80 when a month later, £:$ = 1.90.

• What are the direct-indirect quote from the viewpoint of American and
British investors?
• Which currency is depreciated or appreciated?

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Solution pg#19

• £:$ = 1.80 is direct quote to American investors and indirect quote to

British investor

• Conversely, $:£ = 0.55556 is indirect to American investors and

direct to British investors

• In £:$, £ is quoted currency; over a month $1.80 ↑ $1.90

=> £ is appreciated and $ is depreciated

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Bid-Ask Quotations
• Spot market Price interaction among banks

• Bid/Ask spread of banks

• Bank’s bid (buy) < its ask quote (sell) = difference for bank’s costs

• Ex 1: If you have $1,000 and plan to travel to UK. Before leaving, you should convert $1,000 to
British pound; bid rate is at $1.52 and ask rate is $1.60. The converted amount is calculated at:

Amount to be converted in US dollar $1,000

= = £625
price charged by bank per pound $1.60

• Unfortunately, you could not go, so the reconverted amount will be:

£625 x (bank’s bid rate of $1.52/pound) = $950

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Bid-Ask among currencies

• Charlotte Bank quotes a bid price for Yen of $0.007 and an ask price of $0.0074.
In this case, the nominal bid/ask spread is $0.0074 – $0.007 = $0.004 (chênh
lệch tỷ giá).
• The bid/ask spread in % in the case of the traveler who sells $1,000 for yen at
bank’s ask price $0.0074, he received the amount of $1,000 / 0.0074 = ¥135,135
• The bank may buy back ’s bid price is $0.007 at $946 (¥135,135x0.007) which is
$54 difference or 5.4%

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Bid-Ask quotes & spreads

• Bid price = Buying quote

• Ask price = Selling quote
• Midpoint price = (ask + bid)/2
• Spread = difference between Ask & Bid quotes
• Pip = price interest point (smallest fluctuation in the price of currency)

Ask rate – Bid rate 1.2014 -1.2011

Percentage spread = =
Bid rate 1.2011

= 0.00025 = 0.025% = 2.5 basic point

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Cross-rate calculations
An exchange rate between 2 currencies inferred from each one’s exchange rate with
a 3rd country’s currency (referred currency).

1. (a:b) x (b:c) = a:c

If €:$ = 1.25 and $: ¥ = 120
=> (1) (€:$) x ($: ¥) = €:¥ = 1.25 x 120= 150
2. (a:b) : (a:c) = c:b
If $:won=1012.5 and $:R$=2.297
 (2) R$:won = ($:won) : ($:R$) = 1012.5/2.297
= W440.79

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Example 2

A US portfolio manager wants to buy $10 million worth of French bonds.

He wants to know how many euros can be obtained to invest using the $10 million,
then calls several banks to get their €/$ quotation, without indicating whether a sale
or a purchase of euros is desired.
Bank A quotes €:$ = 1.24969 – 1.25
which are consisted of $:€ = 0.80000 – 0.80020
Different quotes from Bank A Bank B Bank C
$:€ = 0.8-20 0.79985-05 0.79995-15

Note that the ask for all three quotes adds 0.00020 to the bid.
How many euros will the portfolio manager get to invest?
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Solution to Ex.2
How many euros will the portfolio manager get to invest?
AMOUNT: Bank A, buying €8 million for $10 million.
AT BANK: The euros should be transferred to an account with Société
Générale in Paris (Citibank in NY is manager’s business bank)
FORMALITIES: Electronic messages and faxes are exchanged to confirm the
oral agreement
PLACE: The settlement of the transaction takes place both in NY and
Paris

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Example 3 – Cross-rate calculations

Calculate the cross rate between €:won based on the following quotes:
$:won = 1012.0-1013.0
€:$ = 1.24969 – 1.25
Since, €:won = (€:$) x ($:won)
Hence, the bid & cross rates are
(€:won)bid = (€:$)bid x ($:won)bid = 1.24969 x 1012.0 =
= 1264.69 won/euro
(€:won)ask = (€:$)ask x ($:won)ask = 1.25 x 1013.0 =
= 1266.25 won/euro
Check 1: Use the right currency symbol
Check 2: Maximize the bid-ask spread by combining bid-ask ex rate to yield the lowest cross rate

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FOREX arbitrage

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What is ARBITRAGE

• The trading that exploits the tiny differences in price between identical assets in
two or more markets;
• Arbitrager buys the asset in one market and sells it in the other market at the same
time in order to pocket the difference between the two prices.
• Arbitragers are usually working on behalf of large financial institutions.
• The transaction involves trading a substantial amount of money, and the split-
second opportunities it offers can be identified and acted upon only with highly
sophisticated software.

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Forex arbitrage: example
• Suppose you have $1 million, and you are provided with the exchange rates:
EUR/USD = 1.1586
GBP/EUR = 1.4600, and
GBP/USD = 1.6939.
• With these exchange rates there is an arbitrage opportunity:
1. Sell dollars to buy euros: $1 million ÷ 1.1586 = €863,110.65
2. Sell euros for pounds: €863,110.65 ÷ 1.46 = £591,171.68
3. Sell pounds for dollars: £591,171.68 x 1.6939 = $1,001,385.71
4. Subtract the initial investment from the final amount: $1,001,385.71 – $1,000,000 = $1,385.71

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Forex arbitrage: example
• The formula:
net profit
Profit rate = ≈ 0.1386%
initial invested capital

• From these transactions, you would receive an arbitrage profit of $1,384 (assuming
no transaction costs or taxes).

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Example 4 – Triangular arbitrage on Cross-rates

American bank quotes: €:$ = 1.2 – 1.205

£:$ = 1.795 – 1.8

British bank quotes £:€ = 1.505 – 1.507

Is there an arbitrage opportunity?

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Example 4 – Solution
AB: (£:€)bid = (£:$)bid : (€:$)ask = 1.7950/1.2050 = €1.4896/GBP

(£:€)ask = (£:$)ask : (€:$)bid = 1.8000/1.2000 = €1.5/GBP

=> £:€ = 1.4896 – 1.500 or £:€ = 1.4896/00

Due to AB quotes < BB quotes, arbitrage on £:€ can be made as follows:

• Buy GBP at €1.5 from AB (£:€)ask €8mil. : 1.5= £5,333,333.33

• Sell GBP at €1.505 from BB (£:€)bid 5.333mil.x 1.505= €8,026,666.66

• Net profit = €1.505 – 1.5 = €0.0050 (€8.026- €8.0)/8.0= 0,33

• €8,026,666.67- € 8,000,000= € 26,666.67

• Profit rate: €26,666.67/8,000,000 ≈ 3.33%

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Forward quote
Spot exchange rate On the spot rate = S
Forward exchange rate F Today’s contracted rate for future transactions
One-month quotes €:$ = 1.24688 – 1.24719

In 1 month the bank will buy € at 1.24688 and sell € at 1.24719

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Forward quote

One-month rates F €:$ = 1.24688 EUR/USD

Spot rate S €:$ = 1.25 EUR/USD
Discount = 1.25000 – 1.24688 = 0.00312
Spot rate > Forward rate=> € is weaker (discount)

Premium F $:€ = 1/1.24688=0.802 (forward value)

S $:€ = 0.8 (spot value)
Spot rate < Forward rate=> $ is traded at premium

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Forward rates: Annualized deviation
The forward discount/premium is often calculated as an annualized
forward premium/discount, ex. a:b
Forward rate – Spot rate 12
x 100% (1)
Spot rate No. Month forward

Use the previous example, we have

0.802 - 0.8 12
x 100% = 3%
0.8 1
Another example $:SFr. S = 1.2932-1.2939 (midpoint = 1.2936), F = 1.2823 (3-month forward rate)
Annualized 3-month F premium =
0.0113 12
x 100% = 3.5%
1.2936 3

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Interest rate parity: Forward discount & IR
differential
Foreign Exchange Quotations
Dollar spot forward against the Dollar
August 30 Closing Mid Bid/Offer Three Months
point Ex.Rate % per annum
Euro € 0.9841 839-842 0.9802 1.6
UK £ 1.5492 490-494 1.541 2.1
Switzerland SFr. 1.4926 922-929 1.4887 1.1
Canada C$ 1.5612 610-614 1.566 -1.2
Japan ¥ 118.185 160-210 117.655 1.8

Interest rate parity (IRP) = relationship between ex rate, forward ex rate and interest rates.
IRP between 2 currencies is
Forward discount/premium = discounted interest rate (LS chiết khấu)

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Interest rate parity: Forward discount & IR
differential
Spot exchange rate $:€ = € 0.8000
1-year forward ex. rate $:€ = € 0.8080
1 year interest rate r€ = 14% and r$ = 10%

For every dollar borrowed, the forward hedge should cover €0.8 + interests rate of 14%, means 0.80
(1.14) = 0.912 (F-S)/S = (rb – ra) / (1+ra)
In which: ra is the interest rate of the quoted currency FC
rb is the interest rate of the measurement currency DC
S and F are the spot and forward exchange rates
=> F(1+ra) = S(1+rb) or F = S(1+rb)/(1+ra)

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Example 5

US$ quoted against EUR, arbitrage ensure that F(1+r$) = S(1+r€)

𝐹 − S r€ − r$
=
S 1 + r$
So, in case S = 1.05 and r$=1.76%(0.0176) and r€=3.39% (0.0339),
What is the forward premium/discount?
SOLUTION
F = S(1+ r€)/(1+ r$) = 1.05(1.0339/1.0176) = 1.0668 or $:€ = 1.0668
𝐹−S r€ − r $ 0.0339 −0.0176
= = = 1.6%
S 1+r$ 1.0176

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Example 6
S = $1.058
Annual risk-free interest rate 3-month maturity
r€ = 3.39% and r$ = 1.76% => what is 3-month forward ex rate €:$?

SOLUTION
3-month interest rate over the price are: r€ 3.39%(3/12) = 0.8475%
r$ 1.76%(3/12) = 0.44%
3-month forward rate is equal to:
1+ r€
Forward ex rate = spot ex rate x
1+r$
= 1.058(1.008475/1.0044) = $1.0623
=> 3-month forward rate is €1.0623/USD or $:t = $1.0623

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Forward ex-rate with Bid-Ask Spread
Bid interest rate Rate that bank is willing to borrow money (LSTG)
Ask interest rate Rate that bank is willing to lend money (LSCV)
Usually, Bid interest rate < Ask interest rate
An investor buys forward dollars (pay ask price $:€) with euros = $:t
• Borrowing euro (receiving ask interest rate, ask r€)
• Using bought euro to buy dollars spot (pay ask spot rate, ask spot $:€)
• Lending those dollars (receiving bid interest rate, bid r$)
To obtain the bid forward exchange rate, perform the reverse calculations:
• Borrowing dollars (to pay ask interest rate, ask r$)
• Selling those dollars to buy euro spot (receiving bid spot ex rate, bid spot $:€)
• Lending euros (receiving bid interest rate, bid r€)
In sum, the bid price of the forward exchange rate, bid forward $:€

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 Example 7

Consider S = $:SFr. = SFr1.2932-1.2939

Annual risk-free interest rate are
SFr. = 1.42%-1.44%
US$ = 4.5%-4.52%
What should be the bid-ask quote for 1-year forward exchange rate $:SFr.

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Example 7 - Solution
1+ rSFr
Forward rate formula F = S x
1+r$
Meanings: Borrowing SFr (pay ask interest rSFr)
Buying dollar spot (pay ask spot $:SFr.)
Lending dollar (receive bid interest r$)

Resulting in ask forward rate ($:SFr.) is

1+ rSFr 1+1.44%
• Ask forward rate F=Sx = 1.2939 x = SFr1.2560
1+r$ 1+4.5%
1+1.42%
• Bid forward ex rate F = 1.2932 x = SFr1.2548
1+4.52%
=> 1-year forward rate should be $:SFr. = SFr1.2548-1.2560

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Unit 2 INTERNATIONAL
ASSET PRICING
International Asset Pricing

Contents
1. International market efficiency
2. Asset pricing theory
3. Practical implications

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International Market Efficiency

Fama (1970) defined

A market in which prices always fully reflect available

information is called “efficient”.

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International Market Efficiency

Today International Asset pricing is based on

• Asset pricing reflects true fundamental value at all times;

• The degree of efficiency varies among countries, depending on
the maturity, liquidity and degree of regulations of the market;

• Foreign Investors and local security firms using their own

financial analysis.

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International Market Efficiency

In an efficient market, any Weak

new information would be
Semi-strong
immediately and fully
reflected in the price. Strong

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Asset Pricing Theories

1. The Domestic Capital Asset Pricing Model (DCAPM)

2. The International Capital Asset Pricing Model (ICAPM)

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 Domestic Capital Pricing Model

• Investors care about risk and return (risk-averse and prefer less risk and
more expected return)
• A concensus among all investors holds, and everyone agrees on the
expected return and risk of all assets.
• Investors care about norminal returns in their domestic currency;
• A risk-free interest rate exists, unlimitted borrowing or lending capacity
at this rate
• No transaction costs nor taxes

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 DCAPM

• CAPM describes the relationship between systematic risk and expected return
of assets, particularly STOCKS.
• CAPM is widely used throughout finance for pricing risky securities and
generating expected returns for assets given the risk of those assets and cost of
capital.
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 Understanding CAPM
Formula for calculating the expected return of an asset given its risk:
E(Ri)= R0 + 𝛽i (ERm – R0)

where: ERi = expected return of investment

R0 = risk-free rate
𝛽i = beta of the investment (the sensitivity of asset i to market movement)
(ERm – R0) = market risk premium

The goal of the CAPM formula is TO EVALUATE whether a stock is fairly valued
when its risk and the time value of money are compared to its expected return.

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 Example
An investor is contemplating a stock worth $100 per share today that pays a
3% annual dividend. The stock has a beta compared to the market of 1.3,
which means it is riskier than a market portfolio. Also, assume that the risk-
free rate is 3% and this investor expects the market rise in value by 8%/ year.

SOLUTION
The expected return of the stock (based on the CAPM formula) is 9.5%:
ERi = R0 + 𝛽 i (ERm – Rf)
= 3%+ 1.3(8%-3%)
= 0.095 => 9.5%

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Risk-Pricing relations
The risks pricing relation of the CAPM for asset i can be written as
E(Ri) = R0 +𝛽𝑖 x RPm (1)
where E(Ri): the expected return on asset i
E(Rm): the expected return on the market porfolio
R0: the risk-free interest rate
𝛽i: the sensitive of asset i to market movement
RPm: the market risk premium equal to E(Rm) – R0

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Risk-pricing relations

• Equation (1) describes the risk-pricing relation for all assets i. So RPm and R0
are constant, whereas E(Ri) and 𝛽𝑖 vary, depending on the asset i considered.
• There is a linear relation between the expected return on all assets and their
sensitivity to market movements. This straight line is usually called the
security market line SML.

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Asset return & Ex-rate movement
When expanding investment globally to include international assets,
the currency used to measure returns becomes an issue:
V = VFC x S (5)
For example:
• A Swiss investor holding the Swiss company Novartis measures
value and return in Swiss francs
• A U.S. investor would translate Novartis’ value and return into
dollars.

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Asset return & Ex-rate movement
Consider an investor who uses his domestic currency (DC) to measure return
on some securities of a foreign country with a foreign currency (FC).
Simple calculation of return from time 0 to time 1 shows that the DC (dollar)
rate of return on an investment in Novartis,
R = (V1-V0)/V0
is equal to FC (Swiss Franc) rate of return on Novatis, plus the exchange rate
movement s = (S1-S0)/S0 plus the cross products of FRC and s.
RFC = (V1FC - V0FC )/ V0FC

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 Asset return & Ex-rate movement (cont)
This cross product comes from the fact that the exchange rate movement applies to the
original Swiss franc value of Novartis and also to the Swiss franc capital gain (loss), RFC:
R = RFC + s + (s x RFC) (6)
The last term is of second order and assumed to be small for short time periods, giving
the first-order approximation:
R = RFC + s (7)
Alternatively, investor can hedge currency risk in the forward exchange market. The F
replace S1, and the hedge return on the foreign share becomes:
R = RFC + (F – S0)/S0 (8)

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 DCAPM extended to International context
DCAPM can be extended into 2 unreasonable assumptions:
• Investors throughout the world have identical consumption baskets.
• Real prices of consumption good are identical in every country, with PPP (purchasing
power parity)
Exchange rates would simply mirror inflation differentials between two countries:
X = S x (PFC / PDC) (9)
Where X is the real exchange rate (direct quote FC:DC)
S is the nominal exchange rate (direct quote FC:DC)
PFC is the foreign country price level
PDC is the domestic country price level
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 DCAMP extended into International context
The relationships between the real and norminal ex.rate:
X = S x (PFC / PDC) (9)
Real exchange rate movements = x
Nominal exchange rate movement = s
x = s + IFC – IDC
or
x = s - (IDC-IFC) (10)
x and s are % movement in the real and norminal ex.rate
The ex rate SFr:USD stay constant over the month, the Franc appreciate by 1
percent (x=0%; s=1%)

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ICAPM – International CAPM
• Deviations from purchasing power parity is the major source of ex rate
variation; and
• Consumption preferrences can differ among countries.
• Risks from real prices of consumption goods (might not be identical) from
every country are:
• Real foreign currency risk
• Real exchange rate risk, or
• Purchasing power risk

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Example 1 – Constant Real Ex-rate
An investor wants to invest in foreign security with below data:
S=2.04; (1FC = 2 DC); after 1 year IDC = 3%; IFC=1%;
When the price level between two countries is 2 to 1, after
1 year, PFC and PDC influenced by % inflation to become:
PFC = 1+(1%x1)=1.01 and
PDC = 2+(3% x2)= 2.06 What is real exchange rate?

SOLUTION
Real exchange rate of this transaction can be computed:
X = S x (PFC/PDC) = 2.04 x (1.01/2.06) = 1

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S x (PFC / PDC) (9)
Example 1 – Constant Real Ex-rate

What is real exchange rate?

SOLUTION
Real exchange rate of this transaction can be computed:
X = S x (PFC/PDC) = 2.04 x (1.01/2.06) = 1

X = S x (PFC / PDC) (9)

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Example 2 – Foreign currency Risks

An investor wants to expand her portfolio to include 1-year bonds in foreign

countries:
IDC = 3%; IFC=1%; Ex.rate 1FC = 2 DC;
Price level between countries = 2 to 1
Interest rate per annum rFC = 3%; rDC = 5%
1. What is the expected ex.rate (S) and expected return (E) of foreign bonds
2. After one-year, IDC = 3%; IFC=1%; but FC depreciation at 1.80. What are real
ex.rate (X) and expected return (E) on investment?
3. How would you qualify the risk return characteristics of this investment

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 Example 2 – Solution
1. If present DC ex. rate = 2, real ex rate remain constant, x=0%
• Expected exchange rate SDC can be calculated as below:
x = s - IDC + IFC=> s= x + IDC - IFC = 0% + 3% – 1 % = 2%
=> Expected SDC= 2+(2*2%) = 2.04 (norminal ex.rate)
• EReturn = 1+3% x (2.04/2)-1 = 0.0506 = 5.06%
2. If S=1.80; PDC= 2+(3%*2)= 2.06 and PFC=1+(1*1%)=1.01
• X = S x (PFC/PDC) = 1.80 x (1.01/2.06) = 0.88 (real ex.rate)
• Post ER = 1+3% x (S1/S0)-1 = 1.03 x (1.80/2.0)-1= -7.3
3. This investment had ER similar to domestic risk-free rate but carried a lot of foreign currency risks (real
risks) since the I (inflation) is predictable, FC risk can be hedged.

x = s + IFC – IDC or x = s - (IDC-IFC) (10)

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ICAPM: IRP Interest Rate Parity

• Investors can freely lend or borrow in any currency

• IRP can be used in replicating forward currency contract to hedge foreign
currency risks
• In the world of foreign currency risk and ICAPM direct forward ex rate
imply pairity conditions.
• In IRP, direct spot ex. rate time 1 plus the domestic risk-free rate equals
direct forward rate time 1 plus foreign risk-free rate: F = S (1+rDC) / (1+
rFC)

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ICAPM: IRP Interest Rate Parity
• IRP with direct exchange rates is given by
F = S (1+rDC) / (1+ rFC) (11)
F is direct forward rate
S is direct spot rate
rDC is domestic risk-free rate
rFC is foreign risk-free rate
• In the first-order linear proximation
(F – S) / S ≅ rDC - rFC (12)
Calculation of F rate is in Ex.3

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Sample 3 - IRP
1-year domestic country risk-free rate of return is 5% and the 1 year foreign
country rate is 3%. The current ex-rate is 1FC=2DC.
What is the current level of F ex.rate that implies by these data?

SOLUTION
2DC units invest at rFC= 5% to get 2 x (1+ rFC) or 2.1 DC units/year => this
investment be encountered with 3 operations:
• Exchange 2DC units at spot ex. rate for 2/S= 1FC unit
• Invest FC unit at the foreign rate rFC= 3% = 1.03 unit/year
• Sell forward today the proceeds of 1+rFC = 1.03 to receive in a year the forward
ex.rate of F.
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IRP-Interest Rate Parity (cont)
In a year, investor will receive an amount of DC equal to
(2/S) x F x (1+ rFC) or F x 1.03

This combination should yield the same result as the first alternative because both
are riskless in DC and involve the same investment. If not, arbitrage will take place.

Hence, the forward ex.rate is F x 1.03 = 2.1 and F = 2.039 DC per 1 FC unit.
1+ rDC
Direct exchange rates will be 𝐹 = S x
1+ rFC

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 Foreign Currency Risk Premium
• A background of ICAPM, FCRP on any investment is simmply equal to its expected
return in excess of the risk-free rate
RP = E (R) – R0

• The foreign currency risk premium is defined as the expected return on an investment
minus the domestic currency risk-free rate.
• Thus, the foreign currency risk premium, denoted as Srp, is equal to the expected
movement in the exchange rate minus the Interest rate differential (rDC-rFC)

Srp = E[(S1-S0)/S0] – (rDC - rFC) = E(s) - (rDC - rFC) (13)

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 Foreign currency Risk premium (cont)
Srp = E[(S1-S0)/S0] – (rDC - rFC) = E(s) - (rDC - rFC) (13)
Substituting for rDC - rFC using the pairity approximation, expected
ex.rate [E(S1)-F]/S0 (example 4)
In ICAPM as in DCAPM, all investor determine in demanding the mean
variance optimization (expected utility maximization), using domestic
curency base currency.

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 2 Conclusions for ICAPM

Separation Theorem (normative conclusion)

Risk free asset in their own currency, and
the world market portfolio optimally hedge against foreign currency risk.

Risk-Pricing relation (descriptive conclusion)

In an international equilibrium risk-pricing is more complex than in domestic CAPM
Expected return on any asset is covariance of the asset with various exchange rates.
E(Ri)=R0+ 𝛽iwxRPw + 𝛾 i1 x SRP1 + 𝛾 i2 SRP2+....+ 𝛾 ikSRPk

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Foreign currency Risk premium

E(Ri)=R0+ 𝛽iwxRPw + 𝛾 i1 x SRP1 + 𝛾 i2 SRP2+....+ 𝛾ikSRPk (14)

Where
R0 = DC risk-free interest rate
𝛽iw= the sensitivity of asset i domestic currency return to market movement
(market exposure)
RPw= world market risk premium equal to E(Rw)-R0
𝛾i1 to 𝛾ik the currency exposure, the sensitivities of asset i domestic currency
returns to the exchange rate on currencies 1 to k
SRP1 to SRPk are the foreign currency risk premiums on currencies 1 to k
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INTUITION on Foreign currency Risk premium
• Risks premium should be earned for taking trivially risks eliminated by a naive
diversification of the portfolio;
• World market portfolio is sensitive to currency risks
• A non-zero currency risks premium comes from different risks aversions of different
investment positions
Example:
• Americans have international investments/wealth invested abroad > foreigners’
investments/wealth invested in the US => Americans’ net foreign investment is positive
while foreigners investment position is negative;
• Americans have risk-averse > foreigners => American have larger demand to hedge their
foreign currency position (sell foreign currency forward) > foreigners have to hedge their
dollar position (sell dollar forward)
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 Example 5 – Paying / Receiving SRP
An American investor has investment in Arland with strong demand on hedging Arlandian francs
into American dollars.
1-year risk-free interest rates of 5% in US
1-year risk-free interest rates of 3% in Arland
Ex.rate is S0= $2 for 1franc
Expected rate appreciation of the Arlandian franc is 3%.
Expected return on Arlandian stocks is 6 percent in francs
1. Whast is the expecteed return on Arlandian stocks in US$ if there is no currency hedging?
2. What is the expected return on Arlandian stock in dollars with full currency hedging?
3. What is the foreign currency risk premium on the Arlandian franc, and who pays/receives it?
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 Example 5 – Solution
1. ER on Arlandian stocks in dollars = ER in francs, 6 % + 3% currency appreciation = 9 %
2. Use currency hedging, the forward premium =to the interest rate differential of 2%. Hence,
the expected return on Arlandian stocks, hedged against currency risk, is 8% (6% + 2%).
The expected return is less than for an unhedged investment, but the risk is also less.
3. There is a 1% foreign currency risk premium, that is, the difference between the expected
currency appreciation of the franc and the forward premium on the franc. This risk premium
is “paid” by Americans and “received” by Arlandians.
In equilibrium, Americans are willing to pay this currency risk premium to remove currency
risks on their net foreign position in Arlandian stocks. Arlandians (and other speculators) are
willing to provide that hedge because of the expected return due to the currency risk
premium.
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 Problem 6
A European investor wants to invest in a foreign country:
World market risk premium est. 5%
Foreign currency = 1%
Current risk-free rates ≈5% in € and 3% in FC units; FC unit to appreciated against the € by an amount
equal to % interest differiential (=% expected inflation differential) plus the foreign currency risk premium, or
a total 3% as per following statistics:
Stock A Stock B Stock C Stock D a. Based on ICAPM, what
World beta 1.0 1.0 1.2 1.4 expected return on 4 stocks
Currency exposure (𝛾) 1.0 0.0 0.5 -0.5 in €

b. Stocks A & B have the same world beta but different expected returns. Give an intuitive
explanation for this difference?
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 Problem 6 - Solution
a. €= base currency with one FC, model ICAPM’s formula to be applied E(Ri)=R0+ 𝛽 iw x RPw
+ 𝛾i x SRPFC (14)
all returns are in €, RPw = world index risk premium
SRPFC = risk premium in foreign currency unit, assumed to be the only other currency.
If € is base currency => 𝛽‘s and 𝛾‘s should be measured using euro returns.
Using the exposures/sensitivities given, we have:
Stock A Stock B Stock C Stock D
Theoretical expected return € 11.0% 10.0% 11.5% 11.5%

Stock A = 5% € risk-free + 1x5% world equity risk premium

+ 1 x 1% foreign currency risk premium = 11%

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 Problem 6 – Solution (cont)
b. Expected return Stock A = 11% vs. Stock B = 10%
• The difference 1% = currency exposure to currency movement;
• Stock B’s euro value is insensitive to unexpected movement in FC: euro ex-
rate.
• Stock B is less risky than Stock A (currency risk exposure +1)
Therefore, StockB’s expected return ≠ StockB’s expected return due to the
difference in 1% foreign currency risk premium.

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Market perfection & Segmentation

• ICAPM applies to all sercurities in an integrated world capital market => Financial
markets are segmented if securities have same characteristics but are listed in
different markets with different expected returns.
• Many countries request foreign investment to be denominated in their national
currencies.
• If currency hedging is not availabe, foreign investors might be expropriated on short
notice.

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Practical implications
ICAPM gives useful insights on asset pricing in an efficient world capital market and
in the absence of privileged information
• Currency hedging: every investor should hold the same risky portfolio with the
same amount of money hedging
• Expected return: equation #14 describes equilibrium asset pricing in fully efficient
global markets, and is used to quantify the risk premium for each asset.
• Using equation #14 we should estimate 2 type of variables:
• the market and currency exposures of each asset
• the risk premiums on the global market and currencies

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Unit 3 EQUITY: MARKET
& INSTRUMENTS
Equity: Market & Instruments

Contents

1. Definition of capital markets &

instruments

2. International securities
investment.

3. Factors impact Capital investment

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What is Equity Market?
James Chen (2020), Investopedia, defines that

• An equity market in which shares of companies are issued and traded in both stock
exchange or OTC;

• A stock market gives

(a) Companies access to grow their businesses

(b) Investors a piece of ownership in a company with the potential gains in their investment

• The meeting point for buyers and sellers of stocks

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Images of World Top Stock Exchanges

New York Stock Exchange London Stock Exchange -LSE

Tokyo Stock Exchange - TSE Nasdaq Stock Exchange

Why Equity Market important?

• Financial specialists are often struck by the differences among stock market
organizations across the world;
• National stock markets are different in terms of legal and physical organizations
and transaction methodologies;
• The differences are also in terms of market size, liquidity and concentration, taxes,
market indexes and the availability of information;
• Foreign investors should be able to estimate the execution cost in each market, the
determinants and magnitude of overall transaction costs as well as market impact.

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Why Equity Market important?
• Investment performance depends on the overall execution costs incurred in
implementing an investment strategy.
• Alternatives to direct international investing that involves the purchase of foreign
share listed at home including closed-end country funds and open-end funds, such
as:
• American Depository Receipts (ADRs); and
• Exchanged traded funds (ETFs)
Each of them has advantages and disadvantages as well, when directly investing
on foreign markets.

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World Top Stock Exchanges
No Country’s SX Company listed Market Capitalized

1 NewYork Stock Exchange 2,400 $22.9 trillion

2 NASDAQ 3,000 $17.2 trillion
3 Tokyo Stock Exchange 3,600 $5.67 trillion
4 Shanghai Stock Exchange 1,000 $6.98 trillion
5 Hongkong Stock Exchange 2,538 $6.11 trillion

6 Euronext (European NET) 1,500 €4.4 trillion

7 Shenzen Stock Exchange 2,375 $5.24 trillion
8 London Stock Exchange 2,483 $4.59 trillion
9 Toronto Stock Exchange 2,270 $3.10 trillion
10 Bombay Stock Exchange 5,439 $2.80 trillion
International Stock market
• The New York stock exchange is the world’s largest stock exchange with the highest
market capital and gross value. it has a long history of 223 years of operation.
• The NASDAQ stands for National Association of Securities Dealers Automated
Quotations. It is the second-largest stock market after the NYSE.
• The Tokyo stock exchange is the national stock exchange of Japan.

• As one of the three stock exchanges in China, the Shanghai stock exchange stands on
position 4
• Hong Kong Stock Exchange

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 Stock market organization Type

Private
bourses
Founded by
individual & entities
Bankers’ for security trading
Security traders at bourses Public
either public or bourses
semi-public [bʊəs] Public institution with
organization; taking brokers appointed by the
place at banks’ floor government
under government
regulations

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Automation: Stock market organization types

• Trading on computer (electronic) has replaced the traditional trading on a floor;

• Automation allows more efficient handling a large number of small orders;
• Computerized system pushed up the increasing of volume of trading, such as price
quotation, order routing, and automatic order matching;
• The automatic trading system has two different systems:
a. Cash versus forward market
b. Price-driven versus order-driven system

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Automation: Stock market organization types

Cash vs. Forward market Price-driven vs. Order-driven market

Trading floor: Cash vs. Forward markets
• Stocks are traded on a cash basis in most
cash markets and transaction must be
settled within 3 business days;

• To allow more leveraged investment,

Margin trading encourage investors
borrow money/share from a broker to
finance a transaction.

• The third party lends money/share to the

buyer/seller to honor cash transaction
commitment;

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Trading floor: Cash vs. Forward markets
• The Forward market in London, Paris, etc. , all transactions made during the month
must be settled at the end of the month on the settlement day.
• This periodic settlement system REQUIRES a deposit to guarantee a position.
• The transaction price is fixed during the time of transaction and remain its value
even if the market price has changed substantially by the settlement time.
• Settling all accounts once a month opens the door to short-term speculation and to
frequent micro-conception on foreign investors who are unfamiliar with the
technique.

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Example 1 – Order driven market
ORDER to LVMH Moet Hennesy Louis Vuitton (listed on Paris Bourse) can be accessed
directly on internet
Sell orders Buy orders
Quantity Limit Limit Quantity
1,000 58 49 2,000
3,000 54 48 500
1,000 52 47 1,000
1,000 51 46 2,000
500 50 44 10,000

• You enter market order to buy 1,000 shares. A market order will be executed against the
best matching order. At what price to buy?
• Unless a new sell order is entered at a price below 51 before your order is executed,
yours will be 500 shares at 50 and 500 shares at 51

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Automation Advantages
• Automation brings many improvements
in the speed and costs of trading;
• This system requires little human
intervention and less running costs;
• Most today’s markets move to an
automated order-driven system called
SETS (Stock exchange Electronic
Trading System)

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Automation Drawbacks
• Inability to execute large trade
• In the absence of active market maker, trading block (large transaction) on
automated order-driven system is difficult;
• The lack of depth in the market, it takes longer for the block to be traded;
• The danger of placing market order
• Order with no price limit: without competitive market maker who provides
liquidity, a sell market order will be immediately crossed with the highest buy
limit order, which could be very far from the lowest sell limit order
• One party Transparency risk
• The risk of being picked off.

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Example 2 – Exposition Risks
LVMH is traded on the Paris Bourse, and the last transaction was at €50/share.
• An investor entered on the French electronic trading system NSC a limit order to
sell LVMH shares at €51 vs. market price was €50.
• LVMH is also traded as an ADR on NASDAQ 1xADR = 1/5 LVMH French share
(=> 5 ADRs = 1 LVMH share).
• S = $1/€, ADR price is quoted by a market maker at 10–10.20. Assume that the
exchange rate remains constant over time.
• Suppose that favorable information suddenly arrives that justifies a higher price for
LVMH—say, €55.
Who are the parties exposed to losses on the Paris Bourse and on NASDAQ if they do
not react immediately?

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Example 2 – Solution
• On Paris Bourse, informed market participants the option €4/share, and the investor who has
a standing order in the electronic order book gets picked off (the informed participant can
buy at €51/share now worth €55/share).
• On NASDAQ, the market maker posts a firm bid–ask quote for LVMH of 10–10.20 for the
dollar ADR, which is equivalent for the French share of LVMH quoted in euros to a quote of
50–51. Informed market participants suddenly get a free option worth $0.8/ADR or four
euros per French share (they can buy at $10.2 from the market maker a share now worth
$11). In a price-driven market, dealers run the risk of being picked off.
• The danger of automation is that market liquidity ↓ because dealers (in a price-driven
system) or public investors (in an order-driven system) may be less willing to publicly place
limit orders.

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Crossing

There are two types:

• Electronic communication networks; and
• Electronic crossing networks
Both are called ECN and are private owned electronic trading systems, offer trading on
stock of one market or of a region.

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Electronic communication networks

• Order driven-systems
• Limit order book play central role
• Many of them co-exist in the US
• Virt-x is a pan-European ECN specialized in blue chip

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Electronic Crossing networks

• Allows a substantial reduction in execution cost for large trades

• Order systems anonymously match the buy and sell orders of a pool of participants
(institutional investors and broker-dealers
• Participant enter market orders that crossed at prespecified times (once or a few times
every day)
• Prices determined in the primary market for security, usually at midpoint price
• POSIT is a major electronic crossing network in the US, Asia and Europe

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Advantages of Crossing network

There are two advantages of large order of institutional investors:

• Low transaction costs
• Anonymity
Both are called ECN and are private owned electronic trading systems, offer trading on
stock of one market or of a region.

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Distinct disadvantages of Crossing network

No trading immediacy
• The trader must wait until crossing time to execute a trade
• The trade takes place only if there are offsetting order entered by other participants
• Only a small portion of order are executed at each crossing session and the order must
wait in the system or to be worked through other market mechanism

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Example 3 - Crossing
Market orders for LVMH have been entered on a crossing network for European
shares.
Participant A to buy 100,000 shares
Participant B to sell 50,000 shares
Participant C to sell 70,000 shares.

Assume that orders were entered in that chronological order and that the network
gives priority to the oldest orders.
At the time specified for the crossing session, LVMH transacts at 51 euros on the
Paris Bourse, its primary market.
1. What trades would take place on the crossing network?
2. Assume now that all the orders are AON (all or nothing), meaning that the whole
block has to be traded at the same price. What trades would take place?

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Example 3 - Solution
1. A total of 100,000 shares would be exchanged at €51. Participant A would buy
100,000.
Participants B and
C would sell 50,000. Participant B’s order has priority, so Participant C’s order
would not be executed entirely (20,000 shares remain unsold).
2. There is no way that the AON condition could be achieved for the three orders, so,
no trade would take place.

All or none (AON) is an order type with the instruction to fill the order completely or
cancel it; partial fills are not allowed.

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Example 4 – Cross holdings
Three companies belong to a group and are listed on the stock exchange:
■ Company A owns 30% of Company B.
■ Company B owns 20% of Company C.
■ Company C owns 10% of Company A.
Each company has a total market cap of 100 million.
You wish to adjust for cross-holding to reflect the weights of these companies in a
market cap–weighted index. What adjustment would you make to reflect the free
float?

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Example 4 – Solution

• The apparent market cap of these three companies taken together is 300 million.
• But because of their cross-holding, there is some double counting. The usual free-
float adjustment would be to retain only the proportion that is not owned by other
companies within the group.
• Hence, the adjusted market capitalization is:
90 + 70 + 80 = 240 million

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Applicable taxes in international investment
Taxes will be added to the cost of int’l investment and will be applied in the following 3 areas:
a. Tax on transaction by investment country
UK applies 0.5% on purchasing domestic securities
France levies 19.6% VAT on commission not on transaction value
15% withholding tax on gross foreign dividend
b. Capital gain tax by investors’ country of residence
Capital gain tax
c. Income tax by both investor’s & investment country
Taxing income is based on gross foreign dividend
Deduction of tax credit depends on two countries’ tax treaty
Note: Tax exempted for trade of market makers’ own account
Tax-free for foreign investor from public party (ex.Pension Fund)
Reclaiming a withholding tax may take few months or several years

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Example 5 –
• A U.S. investor buys 100 Heineken shares listed in Amsterdam bourse for
€40. She goes through a U.S. broker, and the current exchange rate is $1.1/€.
Her total cost is $4,400, or $44/share of Heineken (40 x 1.1 $/€).
• Three months later, a gross dividend of €2 is paid (at 15% withholding tax),
and she decides to sell the Heineken shares. Each share is now worth 38 euros,
and the current exchange rate is $1.2/€. because the euro has sharply risen
against the dollar. The same exchange rate applied on the dividend payment
date.
What are the cash flows received in U.S. dollars?

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Investing in foreign share listed at home
Amsterdam

Heineken share
Neitherland European investor
Tax
treaty
Amsterdam
NYSE
Bourse
The US
Heineken
share
New York Stock Exchange

American investor
Example 5 – Solution
Two cash flows are calculated as follows:
(1) Dividend payment – Withholding tax (€:$ = $1.2/ €)
Net Dividend Tax credit

In euro per share €1.70 €0.30

In dollars per share $2.04 $0.36
Net in dollars (100 shares) $204 $36

(2) Sale of Heineken shares (€:$ = $1.2/ €)

Net Sales Tax credit

In euro per share €38

In dollars per share $45.6
Net in dollars (100 shares) $4,560
Capital gain tax: $160= $4,560 - $4,400
Income tax on gross dividend of $240 (€2 x $1.2x100)
Deductable $36 (as tax credit per US-Neitherland Treaty)
Execution costs
Transactional costs are incurred on executed trade during the investment are the following 3
sections:
a. Commissions paid to brokers
Commissions to brokers are negotiable depend on the characteristics of the trade, such as market,
liquidity of the stock, size of the order, etc.
b. Service fees
Some additional fees are paid to compensate for various services including post-trade settlement
costs
c. Taxes
Some taxes are levied in various countries
Besides, opportunity cost shall be applied in case of non-execution due to delay in
completion of, failure to complete a transaction following an initial decision on trade.

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Uses of Execution costs
Transactional costs are incurred on executed trade among the following 3 sections:
a. Global surveys
Provide market averages for typical trade in each country which will affect the return on a
portfolio invested in emerging market.
e.g. 1% for trading on emerging market but
0.74% for purchase and 0.26% on sales of UK securities
b. Detailed measures
• VWAP (volume-weighted average price): benchmark price ≠ actual trade price.
• Implementation of shortfall: measure the impact of trade and of intervening market events
until the transaction is completed.
c. Expected execution costs

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Using expected Execution Costs
Factors forecasted execution costs into expected return are:
• E(R) is the annual expected return on a strategy before execution costs
• Execution costs are measured in % as the average costs of a round trip trade
(purchase and sale) on the portfolio
• The annual turnover ratio is % of the portfolio traded during the year, measuring
as the lesser of purchases or sales for a year divided by the average market value
of the portfolio during that year.
Net expected return = E(R) – Turnover ratio x Execution costs

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Example 6
An asset manager follows an active international asset allocation strategy.
The average execution cost for a buy order = 0.5%
a sell order = 0.5 %
The portfolio turned over 1.5 times/year
The annual expected return before transaction costs is 10% What is the annual
expected return net of execution costs?

Solution
E(R)= 10%; turnover ratio=1.5; Execution costs = 0.5%+0.5% The net annual
expected return = 10%- 1.5 x 1% = 8.5%

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Approach to Execution Costs

Several approaches can be used to reduce execution costs (pg.196):

• Internal crossing
• External crossing
• Principal trade
• Agency trade
• Use of dealer “indication of interest” (IOI)
• Use of futures (derivatives)

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Example 7
DaimlerChrysler are listed in both XETRA and NYSE
German investor bought 10,000 shares in Frankfurt at €51/share at 0.25%
commission (broker charge);
US broker quotes DaimlerChrysler traded on NYSE at
$44.70-$44.90 net commission €:$= $0.880-$0.882/€
Would it have been better to buy the share in New York rather than in Frankfurt,
knowing that they the same global shares?

Solution ->

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Example 7 - Solution
Would it have been better to buy the share in New York rather than in Frankfurt,
knowing that they the same global price?

SOLUTION
* Calculate € price of 1share listed on NYSE:
Buy share from the broker at $44.90 -> pay $44.90/0.88= €51.0227
* The cost of purchasing share directly in Frankfurt (plus 0.25% commission)
€51x 1.0025 = 51.1275
* Investor save
€51.1275- €51.0227 = €1.048 or €1,048 for 10,000

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Example 8 -
• Paf is an emerging country with severe foreign investment restrictions but an
active stock market open mostly to local investors.
• The exchange rate of the pif to the U.S. dollar is fixed at $:Pif = 1.
• Paf Country Fund has been approved, its NAV = $100; trades in New York at 30%
premium
Questions:
1. Give some intuitive explanations for this positive premium?
2. Paf unexpectedly announces that it will lift all foreign investment restrictions
with 2 effects (a) ↑ stock price to 20%; (b) premium of Paf Country Fund drops
to zero.
Is this scenario reasonable? What would be your total gain/loss on the shares of
Paf Country Fund?
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Example 8 - Solution
1. Some intuitive explanations for Paf’s positive premium:
There is no alternative to investing in the close-end fund for foreign investors. Foreign investor may
find Paf shares so attractive from a risk-return viewpoint that they complete and bid up the price.
2. The 2nd scenario is reasonable.
What would be your total gain/loss on the shares of Paf Country Fund?
The net result can be calculated for original NAV=$100
Before restriction lifting, the fund worthed $130 for $100 NAV
After the lifting, the NAV ↑ $120 and the fund = NVA=$120
 Rate of return for foreign investor is
120 −130
= -7.7%
130

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Investing in foreign share listed at home
Investors can diversify internationally by investing in the foreign share listed in their domestic
market:
• Global shares and ADR (American Depositary Receipts)
• Motivation for multiple listing
• Foreign listing and ADRs
• Level I: non-SEC compliance, trades on OTC market (excl. NASDAQ)
• Level II: SEC compliance, trades on NYSE, ASE or NASDAQ
• Level III: company ADR’s trades on NASDAQ and others PO of ADRs
• Closed-End country funds
Fund market price = NAV + Premium
The fund market price ≠ value of the assets held in its portfolio
NAV = net asset value; Premium = % of NAV (or discount)
Pricing of country funds

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Investing in foreign share listed at home

XETRA
DaimlerChrysler share Germany German investor
NYSE
(US)
XETRA
Germany

DaimlerChrysler share

American investor
NYSE
(US)

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Investing in foreign share listed at home
• Opened-End funds
Shares can be purchased redeemed at the NAV of the asset owned by the fund.
• Exchange traded Funds (ETF)
ETF = trades on a stock market like shares of any individual company
ETF = shares of a portfolio (not of an individual company)
= are designed to closely track the performance of a specific index
Notes: Redemption in cash by individual ETF shareholders is discourage in 2 ways:
1. Redemption is based on the NAV computed one or a couple of days after the
shareholder commits to redemption. So, the redemption value is unknown when the
investor decides to redeem.
2. A large fee is assessed on in-cash redemptions.

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Example 9 – ETF pricing
•An ETF indexed on Japanese stock index and is listed in New York NY
9am=11pm in Tokyo).
•The NAV based on Tokyo closing price = ¥10,000; S USD/JPY= ¥100 (9am
EST)
Questions:
1.What is the $NAV of this ETF at the opening of trading in NY?
2.When NY closes at 4pm EST, Tokyo is still closed (6am local time), ex.rate
is now ¥99/$. What is the $NAV at closing time?
3.Bad international news affect to 5% dropped on European and US markets
after Tokyo closing.
Should the ETF price have remained at its NAV ?

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Example 9 – Solution
1. The $NAV = 10,000 / 100 = $100
2. The closing $NAV = 10,000/99 = $101.01
3.In reaction of the bad news, Tokyo stock index will drop by 5% ( if the
markets are strongly correlated).
10,000 x (1-5%)/99 = $95.96
This estimated price is calculated based on the current price of the ETF; it
will trade at 5% discount from its official NAV

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Unit 4 EQUITY: CONCEPT
& TECHNIQUES
EQUITY: CONCEPTS & TECNIQUES

Contents

1. Approaching international analysis

2. Differences in national accounting standards

3. Global industry analysis

4. Global risk factors in security returns

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International investment Environment
To structure investor’s analysis of expected return and risk of stocks from a view
of the world:
• What are the worldwide factors affecting stock prices
• In an open-economy world, companies should be valued relative to their
global industry analysis
• Understanding the differences in national accounting standard that affect the
raw information used
• Global industry analysis of expected returns and risks leads to risk factor
models used to structure global portfolio and manage their risks

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Approaching International Analysis
• Expected return: can be measured by rate of return, including potential price
appreciation, over some time period, or by some other quantified form of buy-
or-sell recommendation.
• Risk exposure: measure how much a company’s value responds to certain key
factors as
• economic activity
• energy costs
• interest rates
• currency volatility
• general market conditions
• Risk analysis enables investor to simulate the performance of an investment in
different scenarios, and diversified portfolios.

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Information problems
• Lack of information on foreign firms since they are difficult to obtain
• Problems arise from the language and presentation of the financial reports
• Today, many large global brokerage houses and banks provide analysts’guides
covering companies from a large number of countries. The guides include
information ranging from summary balance sheet and income statement
information to growth forecasts, expected returns on equity investments, and
risk measures, such as betas

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International Accounting Standard
Technical terms:
 DCF = discounted cashflow analysis
 CAGR = compound annual growth rates
 EV = Enterprise value
 ROE = return on equity
 EBIDTA = earnings before interest, taxes, depreciation & amortization
 BV = book value
 NVA = net asset value
 CE = capital employed
 ROCE = return on capital employed
 WACC = weighted average cost of capital

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International Accounting Standard
 Merger & acquisition forced investors seek to diversify their holdings and take
advantage of opportunities across national border;
 Different countries employed different accounting principles, accounting
numbers hazardous and misleading, such as:
• Treatment of depreciation and extraordinary items
• Net income of one company different countries needed adjustment for differences in
currency
• Different national tax incentives made the creation of PROVISION (secret or hidden
reserves) in certain countries
• Provisions for contingent liabilities and future uncertainty
• M&A in some countries bypassing income statement to report based on balance sheet and
netbook value

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International Accounting Standards
Investors in various countries pressured to set up the following harmonize national
accounting principles:
o 1973 IASC The International Accounting Standards Committee was set up in 1973 by leading
professional accounting organizations in nine countries: Australia, Canada, France, Germany,
Japan, Mexico, the Netherlands, the United Kingdom and Ireland, and the United States.
Over time, additional countries became members of the IASC:
o In 1974 the IASC issued its first international accounting standard (IAS), the Disclosure of
Accounting Policies.
o In 2001, the IASC was renamed the International Accounting Standards Board (IASB), and
publishes both International Accounting Standards (IAS) and International Financial Reporting
Standards (IFRS)

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International Accounting Standards
Investors in various countries pressured to set up the following harmonize national
accounting principles:
o 1973 IASC The International Accounting Standards Committee was set up in 1973 by
leading professional accounting organizations in nine countries: Australia, Canada,
France, Germany, Japan, Mexico, the Netherlands, the United Kingdom and Ireland, and
the United States.
Over time, additional countries became members of the IASC:
o In 1974 the IASC issued its first international accounting standard (IAS), the Disclosure
of Accounting Policies.
o In 2001, the IASC was renamed the International Accounting Standards Board (IASB),
and publishes both International Accounting Standards (IAS) and International Financial
Reporting Standards (IFRS)

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International Accounting Practices
• 1973: All countries joined IASC to have the same Accounting principles,
especially listed companies
• 1974: IASC issued IAS international accounting standards
• 2001: IASB International Accounting Standard Board launched
• 2002: IFRS International Financial Reporting System
• Convergence of IFRS and GAAP (American accounting principles & policies).

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Differences in Global standards
Huge differences between the new IFRS adopters and the existing
GAAP:
o Generous provisions for all types of general risks in German and
Swiss corporations in the ways of build provisions to boost reported
earnings (bad times) and reduce earnings growth (good times)
o Reconciliation statements provided by foreign firm listed in US stock
exchange.

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Accounting Principles on Earning & Stock Prices
o The same company is using different national A/C standards could report different
earnings
o Radebaugh & Gray’s comparative studies measure the conservativeness of
national accounting standards:
• American A/C principles > conservative than UK’s but < conservative than Japan and
Continental European A/C standards
• US earnings are arbitrarily scaled at 100, Japan 66, German 87, French 97 and UK 125
• National A/C principles affect the reported book value of equity
• Japanese companies have P/E (Price-earnings) traded ratio > US
• Japanese firms tends to report nonconsolidated statements despite the extend of cross-holding

Example in pg 230

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Example 1 – Employee Stock Option
A company has 100,000 shares outstanding at $100 per share.

• 5,000 shares stock option granted to its senior management at a price of $105 any time
during the next 5 years.

• For five years, the employees thus have the right but not the obligation to purchase shares
at the $105 price, regardless of the prevailing market price of the stock.

• Using price volatility estimates for the stock, a standard Black-Scholes valuation model
gives an estimated value of $20 per share option. Without expensing the options, the
company’s pretax earnings per share are reported as $1 million/100,000 = $10 per share.

What would they have been if they had been expensed?

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Example 1 - Solution

What would they have been if they had been expensed?

= $9 per share.
The pretax income per share would be
($1,000,000 - $100,000)>100,000
The expense is 5000 * $20 = $100,000.

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Global Industry Analysis
Country analysis is based on business activities, especially a large number of
economic, social, and political variables:
• anticipated real growth
• monetary policy
• fiscal policy (including fiscal incentives for investment
• wage and employment rigidities
• competitiveness
• social and political situation
• investment climate
• business cycle
• long-term sustainable growth
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Global Industry Analysis

Classification of business cycle

stages:
• Recovery
• Early upswing
• Late upswing
• Economy slows or goes into
recession
• Recession

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Industry Analysis: Return & Expectation Elements
An investor must find companies that can earn return on equity (ROE) above the
required rate of return.
• Worldwide demand analysis
• Value creation (the learning curved, economic of scale, economies of scope,
network externalities)
• Industry life cycle
• Competition structure
• Competitive advantages
• Competitive strategies (cost leadership, differentiation, focus)
• Co-opetition and the Value net
• Sector rottion
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Industry Analysis
• Demand analysis
• Value chain competition
• Rivalry intensity
• Substitute
• Buyer power
• Supplier power
• New entrants
• Government participation
• Risk and covariance

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Industry Analysis: Risk Elements
• Market competition
• Value chain competition
• Rivalry intensity
• Substitute
• Buyer power
• Supplier power
• New entrants
• Government participation
• Risk and covariance

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Equity Analysis

• Industry valuation or country valuation

• Financial analysis
• Relative valuation of stock prices between stock home
market vs. global industry

• Global financial ratio analysis

• DuPont model
• Valuation model

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Dupont Model
DuPont model
𝑁𝐼 𝑁𝐼 𝐸𝐵𝑇 𝐸𝐵𝐼𝑇 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠
= 𝑥 𝑥 𝑥 𝑥
𝐸𝑞𝑢𝑖𝑡𝑦 𝐸𝐵𝑇 𝐸𝐵𝐼𝑇 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
• NI/EBT: 1-tax rate (tax retention rate with max value of 1.0 if there were no taxes)
NI : net income
EBT : earnings before taxes
• EBT/EBIT: interest burden with a max value of 1.0 if there are no interest payment
• EBIT: earnings before interest and taxes (operating income)
• EBIT/Sales : operating margin
• Sales/Assets: Asset turnover ratio (efficiency in the use of asset)
• Assets/equity: leverage (higher value imply greater debt burden)
• NI/Equity: return on equity (ROE)

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2-factor Dupont Model

DuPont model factors can be combined in different ways:

• 𝑅𝑂𝐸 = 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 𝑥 𝐴𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑥 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒

𝑁𝐼
• 𝑅𝑂𝐴 = = 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 𝑥 𝐴𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
𝐴𝑠𝑠𝑒𝑡𝑠

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Example 2 – Dupont Analysis compare 2 companies
2 companies in an industry with Ratio DuPon Analysis A B
following information:
1 NI/EBT = 1 minus tax rate 0.6 0.5
• ROEA = 15%; ROEB = 7%
2 EBT/EBIT = one minus interest burden 0.19 0.7
• B has superior net profit margin
3 EBIT/Sales = operating margin 0.16 0.12
but inferior ROE
4 Net profit margin = 1 x 2 x 3 0.02 0.04
• A’s operating margin = 16%, tax
rate = 40% 5 Sales/Assets=efficiency = asset 0.6 0.7
turnover
• B’s interest burden = 30% (<A’s) 6 Assets/Equity = leverage 14.0 2.5
-> distinct advantage in net profit
7 ROE = 4 x 5 x 6 0.15 0.07
margin of 4%
Example 2 – Dupont Analysis compare 2 companies
Raw comparison of ROE:
A = 15% > B = 4% profit and 0.07 efficiency
A’s asset burden at 81% => more leverage with a 14 to 1 ratio
Leverage means volatility and a question on the required return on equity; which
company will have higher beta?
SOLUTION:
A should have a much larger beta since its highly leveraged that led to more volatile
than B;
A’s ROE > B’s ROE in good time but much lower in bad time
Valuation model

DuPont model factors can be combined in different ways:

• D𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑎𝑛𝑎𝑙𝑦𝑠𝑖𝑠 𝐷𝐶𝐹)
• D𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑚𝑜𝑑𝑒𝑙 (𝐷𝐷𝑀)

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Valuation formulas for Franchise Analysis
𝐷𝐼 𝐷2 𝐷3
(1) Justified price P0 = + + …..
(1+𝑟) 1+𝑟)2 1=𝑟 3
𝐷𝐼 𝐷2(1+𝑔) 𝐷3 1+𝑔 2 𝑫𝑰
(2) Future earning: P0 = + + => P0 =
(1+𝑟) 1+𝑟)2 1=𝑟 3 𝒓−𝒈
𝐸𝐼 (1−𝑏)
(3) Payout ratio: P0 =
𝑟−𝑔
• P0: the justified or intrinsic price at time 0 (now)
• E1: next year earnings
• b: the earning retention ratio
• r: the required rate of return on the stock
• g: the growth rate of earnings
Example: E1 = €20; g= 5%/year with 50% payout ratio; next year D = €10;
assuming r = 10% (6% risk-free+4$ risk premium)
10 1−𝑏 0.50
Solution: P0 = = €200 => P/E = = = 10
(0.10−0.05) 𝑟−𝑔 0.10−0.05

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Franchise Value & Growth Progress
𝐸𝐼 (1−𝑏)
Converting the intrinsic price: P0 =
𝑟−𝑏 𝑥 𝑅𝑂𝐸
𝑃0 (1−𝑏)
into intrinsic P/E ratio: = or
𝐸1 𝑟−𝑏 𝑥 𝑅𝑂𝐸
𝑃 1 𝑏(𝑅𝑂𝐸−𝑟)
(4) 𝐸0 = 𝑟[1+ 𝑟−𝑅𝑂𝐸 𝑥 𝑏]
1
𝑃0 1 𝑅𝑂𝐸−𝑟 𝑔 𝑃0 1
(5) 𝐸 = +[ ][ ] => = + FF x G
1
𝑟 𝑅𝑂𝐸𝑥 𝑟 𝑟−𝑔 𝐸1 𝑟
Where:
• Franchise factor FF = (ROE-r)/(ROExr) or 1/r-1/ROE
• The growth factor G = g/(r-g)

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Example 3 – Franchise Values
A company’sROE of 15% and has an earnings retention ratio of 0.60, next year E1 = $100mil.; if
r = 12%, what are the company’s tangible P/E value, franchise factor, grow factor, and franchise
P/E value?
Solution:
1
(a) company’s tangible P/E value 1/r = = 8.33
0.12
(b) Company’s franchise factor is 1/r-1/ROE=1/0.12-1/0.15=1.67
(c) Since company’s sustainable growth rate is 0.6 x 0.15 = 0.09 => company’s growth factor =
g/(1-g) = 0.09/(0.12-0.09) = 3
(d) Company’s franchise P/E value = 1.67 x 3 = 5.01
(e) Since P/E value = 8.33, and franchise P/E = 5.01 => company’s intrinsic P/E = 8.33 + 5.01
= 13.34 or intrinsic P/E = (1-b)/(r-g) = 0.4/(0.12-0.09) = 13.33
Thus, the franchise value method breaks this P/E into basic components.

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 5
GLOBAL BOND
Unit INVESTING
Contents
1. The global bond market

2. The differentiation in
international bond market

3. Bond pricing

Syndicates:

face value:

maturity: ngày đáo hạn

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What is bond market

 Bond market or the debt market, fixed-income market, or credit

market
 is the collective name given to all trades and issues of debt securities.
Governments typically issue bonds in order to raise capital to pay
down debts or fund infrastructural improvements.
Adam Hayes (2021), Investopedia
1. STOCK: cổ phiếu
2. BOND: trái phiếu
3. DERIVATIVES: CK phái sinh

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Types of bonds in the market

Corporate bonds Government bonds Thu nhập cố định

Minicipal bonds High yield debts Bond valuation

The global Bond Market

Debt certificates have been traded internationally

for several centuries
Domestic bonds issued locally by a domestic
borrower and denominated in the local currency.
Foreign bonds are issued on a local market by a
foreign borrower and are usually denominated in
the local currency.

International bonds are underwritten by a multinational syndicate of banks and are

placed mainly in countries other than the one in whose currency the bond is
denominated.
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The global Bond Market

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Types of bonds in the market
Corporate Bonds long term debt with maturity of 20 years
Government Bonds (sovereign bond) has face value listed on the bond certificate, on
the agreed maturity date:
• Treasury bill (T-Bill)
• Treasury note (T-Note)
• Treasury bond (T-bond)
Municipal bonds - Trái phiếu đô thị
Mortgage-Backed Bonds (MBS) – Trái phiếu thế chấp
Emerging Market Bonds – Trái phiếu ở thị trường mới nổi
Bond Indices – Chỉ số trái phiếu
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World Bond Market Size
Market capitalization of Domestic Bond market
15%

17% 45%

2%

21%

United State United Kingdom Euroland Yen Others

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Emerging market & Brady bonds

Investors can buy bonds issued by emerging countries with

certain alternatives:
• Direct access to domestic bond markets
• Buy foreign bonds issued by emerging countries on a major
bond market in the national currency of that market
• Buy international bonds issued by emerging countries.
• Buy Brady bonds on the international market

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Brady Bonds
In 1990, emerging country’s international debts were allowed to transform into Brady
bonds to be able to trade in international bond market with a condition:
• In return, emerging countries must initiate a credible economic reform program that
receives approval from WB and IMF, and regional development banks (Asian
Development Bank, or European Bank for Reconstruction and Development).
• Once IMF and WB agrees the Economic reform plan will reduce the risk of new
insolvency problems, they will provide funding.
• Brady plan is basically a debt-reduction program in which sovereign debt is repackaged
into tradable Brady bonds general with collateral.
• International commercial bank are major market makers on the Brady bond
market.

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Types of Brady Bond
3 types of Guarantees are not available on all type of Brady bonds
• Principal collateral (tài sản thế chấp chính): long-term (30year) zero coupon
bonds to collateralized the principal of the Brady bonds, is paid by WB and IMF
and the emerging country until it reaches par value at maturity of the Brady
bond.
• Rolling-interest guarantee (đảm bảo lãi suất luân chuyển): 1st semiannual
coupons are guaranteed by securities deposited in escrow with the NY Federal
Reserved Bank to protect the bondholder from interest suspension or default.
• Value recovery rights (quyền thu hồi giá trị): bonds issued by Mexico &
Venezuela linked to the priced of oil. Extra interest can be get if oil export
increases over time.

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Types of Brady Bond
2 major types of Brady bonds
• Par bonds (PARs-trái phiếu mệnh giá): fixed coupons that trades as its face-
value and can be exchanged dollar-for-dollar for existing debt. Most PARs
have long term maturity (30 years), be repaid in full on final maturity.
Example: A 5-year maturity and a coupon rate of 5% = 5% market interest
rate
• Discount bonds(DISCs-trái phiếu chiết khấu): are exchanged at a discount
to the par value of the existing debt with market-rate coupon.
Example: A 5-year maturity and a coupon rate of 5% < 6% market interest
rate

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Types of Brady Bond

4 other types of Brady bonds

• Front loaded interest-reduction bonds (FLIRBfs-trái phiếu giảm lãi
suất được báo trước): low initial coupons, floating rate is required.
• New memory bonds(NMBs-trái phiếu tiền mới) and
• Debt-Conversion bonds (DCBs-Trái phiếu chuyển đổi nợ):
• Past-due interest bonds (PDIs-trái phiếu lãi suất quá hạn)

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Example 1 – Convertible bonds

Japanese firms have frequently issued Swiss franc–denominated bonds

convertible into common shares of a Japanese company.
This is a bond issued in Swiss francs, paying a fixed coupon in Swiss francs, and
repaid in Swiss francs. But the bond can also be converted into shares of the
Japanese issuing company.

Q: What are various scenarios that would benefit a buyer of this bond?

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Example 1 – Solution
A Swiss investor can benefit from purchasing this bond in any one of three
situations:
■ A drop in the market interest rate on Swiss franc bonds (as on any straight Swiss
franc bond)
■ A rise in the price of the company’s stock (because the bonds are convertible into
stock)
■ A rise in the yen relative to the franc (because the bond is convertible into a
Japanese yen asset)
A non-Swiss investor would also benefit if the franc appreciates relative to the
investor’s currency.
Unfortunately, the reverse scenarios would lead to a loss.

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Bond Valuation
Quotation, Day count & Frequency of Coupon

Quotation: Bonds are quoted on the basis of price plus accrued interest
(%) of face value.

Full price P P = Q + AI (1)

𝐷ays since last coupon date

Accrued interest AI = Coupon x
Days in coupon period

Example 2 illustrates calculation of the full price of a bond

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Example 1 - Bond Valuation

The clean price of a Eurobond is quoted at Q = 95%

The annual coupon is 6%, and the investor is exactly 3 months from the past
coupon payment. What is the full price of the bonds?

Solution: P = Q + accrued interest = 95%+90/360x 6%=96.5%

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Coupon Frequency & Day counts

In USA: straight bonds pay a semiannual coupon = ½ coupon reported

Day-count: 30 days in a year of 360 days (despite 28 or 31 days long)
=> investor is holding a month-bond receives 30/360 (1/12) of the annual
coupon
Canada, Japan use 365-day year basis

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Coupon Frequency & Day counts
Coupon Characteristics of Major Bond Markets
Characteristics United States US Treasuries Canada
Usual frequency of coupon Semiannual Semiannual Semiannual
Day count (month/year) 30/360 Actual/actual Actual/365
Characteristics Australia United Kingdom Switzerland
Usual frequency of coupon Semiannual Semiannual Annual
Day count (month/year) Actual/actual Actual/actual 30/360
Characteristics Germany Neitherland France
Usual frequency of coupon Annual Annual Annual
Day count (month/year) 30/360 30/360 Actual/actual
Characteristics Japan International bonds FRNs
Usual frequency of coupon Semiannual Annual Quarter or Semiannual
Day count (month/year) Actual/365 30/360 Actual/360

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Yield to Maturity YTM

YTM based on a simple-interest calculation:

Simple Coupon (100−Curent Price) 1
= + x (2)
Yield Current Price Curent Price Years to Maturity

Example 3
A 3-year bond has exactly three years till maturity, and the last coupon has just
been paid. The coupon is annual at 6%, price 95%. What is its simple yield?
6 (100−95) 1
Simple yield = + x = 8.07%
95 95 3

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Yield to Maturity: Zero-Coupon Bonds
A bond that promises a payment of C1=$100 one year from now, current market value of
P=$90.91, has a YTM r1 given by:
C1 100
P= or 90.91 =
(1+r1) (1+r1)
Hence, r1 = 10%
Similarly, we can use the following formula to compute the YTM of zero-coupon bonds
maturing in t year:
Ct
P= (3)
(1+ rt)t
Where rt :expressed yearly interest rate => 1/(1+rt)t is the discount factor for year t. YTM
is defined as the interest rate at P dollars should be invested today in order to
realize Ct dollar t year from now
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Yield to Maturity: Zero-Coupon Bonds
Ct
P= (3)
(1+ rt)t
Where rt :expressed yearly interest rate => 1/(1+rt)t is the discount factor for year t.
YTM is defined as the interest rate at P dollars should be invested today in
order to realize Ct dollar t year from now
Example: a two-year zero-coupon bond paying C2=$100 two years from now and
currently selling at a price P=$81.16 has a YTM r2 given by:
100
81.16 =
1+r2 2 => r2 = 11%
Finally, if the price is P=32.2 and maturity t=10 years, we have r2 = 12%

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Prices & Yields
All bonds of the same issuer (e.g. government bonds) with the same maturity and
other contractual terms must have the same YTM. Otherwise, an arbitrage would
exist.
(3) can be used to derive bond price if market YTM for the relevant maturity is
known.
Example: assume that the one-year market yield moves from 10% to 9%; then the
price of the one-year zero-coupon should move from 90.91% to 91.74%:
C1 100
P= 1= = 91.74%
1+ r1 1.09

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Valuing a Bond with Coupon
Most bonds issued pay a periodic coupon.
The coupon to be paid in two years should be discounted at the two-year rate, and, a
coupon-paying bond is a combination of zero-coupon bonds with different
maturities.

We call C1, C2, . . ., Cn, the cash flows paid by the bond at times 1, 2, to n. The last
cash flow will generally include a coupon and the principal reimbursement. We then
have the pricing formula:
C1 C2 Cn
P= 1+ 2 + ........+ n (4)
1+ r1 1+ r2 1+ rn

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Yield to Maturity: Coupon Bonds
Portfolio managers dealing with a large number of bonds wish to obtain summary
information on the yield promised by a bond on its entire life.
The YTM of a coupon bond can still be defined as the internal rate of return r, which
equates the discounted stream of cash flows to the current bond market price:
C1 C2 Cn
P= 1+ 2 + ........+ n (5)
1+ r 1+ r 1+ r

For an annual coupon bond, the equation is where the same discount rate is applied
to each cash flow.

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Yield to Maturity: Coupon Bond
In practice, coupons may be paid semiannually or quarterly, and a valuation may be
made at any time during the coupon period. This call for the more general valuation
formula to determine YTM:
Ct1 Ct2 Ctn
P= t1 + t2 + ........+ tn (6)
1+ r 1+ r 1+ r

where r is the annualized YTM, and t1, t2, to tn are the exact dates on which the cash
flows occur, expressed in number of years from the current date. Hence, these dates
are usually fractional.

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Yield to Maturity: Coupon Bond

Ct1 Ct2 Ctn

P= t1 + t2 + ........+ tn (6)
1+ r 1+ r 1+ r

For example, consider a bond with a semiannual coupon to be

paid three months from now (one-fourth of a year); the next
cash flow dates are t1 = 0.25, t2 = 0.75, etc. The cash flows
include coupons and principal redemption.
Again, P represents the total value of the bond, or full price

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European vs. US YTM

Formula 7 uses for computing an annualized semiannual yield r’ can be

describe by
Ct1 Ct2 Ctn
P= 2t1 + + ........+ (7)
1+ r′ /2 1+ r′ /2 2t2
1+ r′ /2 2tn

Equation 6 allows us to determine the annual YTM on a bond if we know its cash
flows and observe its market value. This is the standard compounding, or actuarial,
method that can be used whatever the frequency and dates of coupons.

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European vs. US YTM

where r’ is the U.S. yield, and the cash flow dates are still expressed in number of
years.
 The logic of Equation 7 is to use six months as the unit of time measurement.
 It is to verify that it uses a semiannual yield r’/2 to discount the cash flows and
that the exponents (2t1, 2t2, ..., 2tn) are the number of six-month periods from the
valuation date.
 The difference between r’and r comes from the difference between
compounding and linearizing semiannual yields to get annual yields.

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European vs. US YTM

If a semiannual yield of 3% is found,

U.S. method r’= 3 x 2 = 6%
European method r’= (1.03) x (1.03) - 1 = 6.09%
In general, we have (1+r ) = (1+r’/2)2 (8)

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Example 4 – European and US YTM
A 3-year bond has exactly 3 years till maturity, and the last coupon has just been
paid. The coupon is annual and equal to 6%. The bond price is 95%. What are its
European and U.S. YTMs?

SOLUTION:
The European YTM is r, given by the formula
6 6 106
95 = 1 + 2 + 3
1+ r 1+ r 1+ r
Using a spreadsheet, we find r = 7.94%, the US YTM is r’, given by the formula
6 6 106
95 = + +
1+ r′ /2 2
1+ r′ /2 4
1+ r′ /2 6

Hences, r’ = 7.79%, to be verified that 1.0794 = (1+7.79%/2)2

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 6
INTERNATIONAL
Unit DIVERSIFICATION
& RISK MGMT
Alternative Investment Instruments

Contents

1. Alternative investment

2. International diversification

3. Risk reduction & Portfolio

return management

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What is Alternative Investment?
 A financial asset that does not fit into the conventional investment categories such
as stock, bonds, and cash;
 Alternative investments can include
• Private equity or venture
• Hedge fund
• Arts and antiques
• Commodities
• derivatives and contracts
• Real estate

James Chen, Gordon Scott, Skylar Clarine (2021), Investopedia

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Is Alternative Investment be useful to investors?

 Low correlation with stock and bond markets => they maintain their
values in a market downturn.
 Hard assets such as gold, oil, and real property are effective hedges
against inflation.
 Many large institutions such as pension funds and family offices seek to
diversify some of their holdings in alternative investment vehicles.
James Chen, Gordon Scott, Skylar Clarine (2021), Investopedia

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Risk reduction & Portfolio return Managment

A portfolio partly invested in domestic assets and partly foreign assets

(wd+wf=100%):

covdf = Pdf x 𝜎d x 𝜎f
wd is the proportion invested in domestic assets
wf is the proportion invested in foreign assets
Rp = the return of portfolio
Rd = the return of domestic assets
Rf = the return of foreign assets
Pd,f = the correlation between the two assets

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Risk reduction
The return on foreign assets is subject to currency risks 𝜎
𝜎p = total risks of the portfolio
𝜎 d = the risks of domestic assets
𝜎 f = the risks of foreign assets
Expected return of the portfolio
(1) E(Rp) = wd E(Rd) + wf E(Rf)
Total risk of the portfolio
(2) 𝜎p = (wd2 𝜎d2 + wf2 𝜎f2 + 2wd wf Pdf 𝜎d 𝜎f)1/2

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Example 1-International risk diversification
When 𝜎 d = 15%, 𝜎 f = 17%, and Pdf = 0.4
a. Calculate 𝜎p equally invested in domestic & foreign assets? b. b. Calculate
𝜎f when 40% investment in foreign asset?
c. Calculate 𝜎p when equally invested in domestic and foreign assets if covdf = 0.5
and covdf=0.8?

SOLUTION
a. The variance of the total portfolio equally invested (wd = wf = 50%) in both
assets, 𝜎p2 , is given by
𝜎p2 = 0.52[𝜎d2 + 𝜎f2 + (2Pdf 𝜎d 𝜎f)]
𝜎p2 = 0.52[225+ 289 + (2x0.4x255)] = 179.5
=> 𝜎p = 179.5 = 13.4%
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Solution

a. The variance of the total portfolio equally invested (wd = wf = 50%) in both
assets, 𝜎p2 , is given by
𝜎p2 = 0.52[𝜎d2 + 𝜎f2 + (2Pdf 𝜎d 𝜎f)]
𝜎p2 = 0.52[225+ 289 + (2x0.4x255)] = 179.5
=> 𝜎p = 179.5 = 13.4%

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Solution (cont)

b. The risks reduction depends on the % invested in each asset. A portfolio invested 60%
in domestic and 40% in foreign assets has a variance given by
𝜎p2 = (0.62 x𝜎d2 ) + (0.42 x𝜎f2 ) + (2x0.4x0.6x Pdf 𝜎d 𝜎f)
= 176.2 => 𝜎p = 13.27% this is the lowest-risk

c. The risk reduction also depends on the level of correlation.

 If the correlation is 0.5 instead of 0.4, the risk of the portfolio equally invested
becomes 𝜎p = 13.87%
 If the correlation is 0.8, the risk of the portfolio equally invested becomes 𝜎p =
15.18%

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Portfolio return performance?

 In the traditional CAPM framework E(R) on a security is equal to

the risk-free rate plus a risk premium.
 In an efficient market, reducing the risk level of a portfolio by
adding less-risky investments implies reducing its expected return.
 International diversification, however, implies no reduction in
expected return but evaluate a porfolio’s risk-adjusted performance
is to evaluate its SHARPE RATIO

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Sharpe ratio
 Is the ratio of the return on a portfolio, in excess of the risk-free rate, divided by its
standard deviation.

E(R) – Risk free rate

Sharpe ratio =
𝜎
• Money managers maximize Sharpe ratio for the excess return per unit of risk.

• Global investing increase the Sharpe ratio because of the reduction in risk.

• Investing in foreign assets allows a reduction in portfolio risk (the denominator of the Sharpe
ratio) without necessarily sacrificing expected return (the numerator of the Sharpe ratio).
• Both domestic and foreign investors can see their Sharpe ratio increase if they diversify away
from purely local assets.
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Example 4-International diversification & Sharpe ratio

When 𝜎 d = 15%, 𝜎 f = 17%, and Pdf = 0.4. Risk free rate = 4% in both countries
a. If E(Rd) = E(Rf) = 10% calculate the sharpe ratio for the domestic assets, foreign
assets and an and an internationally diversified portfolio equally invested in the
domestic and foreign assets. What do you conclude?
b. Assume now that the expected return on the foreign asset is higher than on the
domestic asset, E(Rd) = 10 percent but E(Rf) = 12 percent.
Calculate the Sharpe ratio for an internationally diversified portfolio equally
invested in the domestic and foreign assets, and compare your findings to those in
question 1.

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Solution 4 - International diversification & Sharpe ratio
1. The risks reduction depends on the % invested in each asset. A portfolio invested 60% in
domestic and 40% in foreign assets has a variance given by
E(R) – Risk free rate 10%−4%
Sharpe ratio d = = = 0.4
𝜎d 15%
10% − 4%
Sharpe ratio f = = 0.353
17%
A portfolio equally invested in domestic and foreign assets has an expected return of 10%
and 𝜎p given by
𝜎p2 = 0.52[𝜎d2 + 𝜎f2 + (2Pdf 𝜎d 𝜎f)]
𝜎p2 = 0.52[225+ 289 + (20.4x255)] = 179.5
 𝜎p = 179.5 = 13.4%
The sharpe ratio is equal to
E(Rp) – Risk free rate 10%−4%
Sharpe ratio = = = 0.448
𝜎p 13.4%

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Solution 4 - International diversification & Sharpe ratio (cont)

2. A portfolio equally invested in the domestic and foreign asset has an

expected return of 11%
(0.5 x 10% + 0.5 x 12%) = 11%
The sharpe ratio is equal to (11%-4%) / 13.4% = 0.522
The portfolio’s sharpe ratio is now better than that of the domestic asset
(0.4), both because of risk-diversification benefits and because of superior
expected return of the foreign asset.
(12%−4%)
New sharpe ratio = = 0.471
17%

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