Introduction
Investing in a share or bond at times can give negative returns to an investor, which is a loss. It is difficult to predict whether the current market price of a share will increase or reduce in the future. Investors seek advice from an economist who uses derivatives to predict market prices in the future. Every investor aims to generate good interest from his investment and thus make a profit. People purchase securities with the possibility of high returns, such as global investments, international diversification, and local investments. It is at times advisable for investors to acquire a security when its market price falls and sell it when its market price rises, thus making a profit. This paper evaluates potential risk and uncertainty in financial markets and investments, the relationship between risk and return, and critically demonstrates an understanding of the investment planning process and designing an investment approach for Jerold Munoz.
Case Study
Part 1
For example, if Munoz reallocates 30 percent of his current U.S. equity portfolio to the international portfolio, Chen recommends calculating the standard deviation of the portfolio. The variability of returns is determined through standard deviation calculations.
Expected return= Security weight * earlier return estimates
Munoz security weight =30% = 30/100 =0.3.
The standard deviation of all securities = 10.4%=10.4/100 =0.104.
Standard Deviation = (variance) 1/2
10.4= (variance) 1/2
Variance=20.8% or 0.208
Variance= expected return multiplied by allocation
20.8%= 100%*expected return
0.0208=E
Expected return=0. 0208 or 20.8%
30% allocation =100*e= 0.208*0.3
=0.0624 or 6.24%
100% securities = standard deviation of 10.4%
30% securities =? SD
Current allocation standard deviation= SD * 100%=10.4%*30%
SD (30% allocation standard deviation) =3.12.
Comprehensive data gives a high deviation value, and variance square root gives rise to standard deviation. Standard deviation determines the volatility of an investment and is thus used by investors to gauge the expected volatility of securities. Munoz’s standard deviation is low, indicating that the investment has reduced volatility, which is beneficial to an investor. These securities are safe for an investor with an interest in trading securities. The expected return is not a guarantee of an investment return, but it is useful for calculating future portfolio value and guiding measures of actual returns. Investors like Munoz will become interested in securities with high return probability in the future. Some investors purchase many securities from companies that are likely to offer good returns tomorrow (Bekaert & Ravina et al. 2017, p. 86). Chen is an experienced and competent investment advisor, as she carefully takes Munoz through his investment details and gives the best investment suggestions.
From Munoz’s perspective, calculate the contribution of currency risk to the international stock investment in Chen’s example.
Return on Currency risks= (1 + rCAN) = (1 + rFM) (1 + rFX)
Market rate=9
Exchange rate risk=6
Correlation=0.4
The exchange rate of the United States dollar against the sterling pound
=1.4008
Expected exchange rate of 0.4 correlation=?
0.5 correlation=0.0624 expected return
0.4*0.0624= expected rate*0.5
Expected return=0.04992 or 4.99%
= {1+ 0.0499}* {1+ 0. 06}
= {1.0499+1.06}
Contribution of currency risk =2.10%
Munoz should invest in the international market when currency risks show positive outcomes in the future. The value of currencies fluctuates with time, which makes it advisable to calculate before buying a share or a bond in the international markets. Before investment, an investor should study the market trends of a currency. The expected return of Munoz’s security is high, thus tempting him to acquire more stocks and bonds in the international markets. There is always a risk when an investor buys stocks from a foreign market due to exchange-rate fluctuations. In Chen’s example, currency contribution risk is minimal, meaning it is safe to invest.
Of the three statements Munoz makes about currency risk, Chen should be least likely to agree with Statement 1, 2, or 3. Please justify your answer. Chen is expected to disagree with Statement 1, which says that there is difficulty in eliminating currency risks. Eradicating currency risks through hedging international investments is possible. Hedged indices make it possible to measure currency-hedged equity index performance. The exchange rate of money affects the performance of a bond if investing abroad. Calculating currency risk helps investors avoid losses when they invest in international markets. Currency risk computation encourages investors to buy foreign bonds. Every investor wants to have a positive return on their investments. Political instability is among the significant contributors to the depreciation of a country’s currency value. If an investor purchases a bond in euros and political instability rises in the future, the money returned at maturity may be lower than the initial amount.
Through investment advisors like Chen, investors make sound decisions, thus reaping good returns on securities. Companies that operate internationally are exposed to exchange-rate risk, as there are sometimes unpredictable losses and gains due to changes in one currency’s value relative to another. For example:
(1 + rCAN) = (1 + M) (1 + X)
Where:
I CAN = Return on the foreign investment in United States Dollars
FM = Return on the foreign market in local currency
rFX = Return on the foreign exchange
Example: Foreign investment return in American Dollars
Initial Investment: $35,000
Initial Exchange Rate: $2.13 / Pound Sterling
Final Exchange Rate: $1.99 / Pounds Sterling
Return on British Security Investment (rFM): 11%
(1 + rCAN) = (1 + rFM) (1 + rFX)
(1 + rCAN) = (1 + .11) (1 + .9342)
(1 + rCAN) = (1.11) (.9342) = 1.036
rCAN = 3.6%
Do you agree with Chen’s statement regarding hedged and unhedged returns, and why? Chen states that there is a small difference between the correlations of hedged and unhedged returns, which is correct. International bond hedging refers to translating a hedged foreign bond back into an investor’s home currency. The global obligation in unhedged relates to the translation of a diplomatic relationship and the currency return back to an investor’s home currency.
Hedging the risk of a currency allocated to an international bond minimizes the volatility of an asset as significant risks get introduced to stable relationships. Currency return is through hedging an investment. Hedging gives investors returns that differ from the hedged currency return and the underlying bond return. An investor’s total performance results from the hedged return or from hedging currency risk. The implementation of a hedging program by international bond investors helps to adjust returns to their expectations in the long term. Inflation and interest levels, due to the long-term impact of the hedge return, make investors interpret that the yield maturity of a hedged investment is small. Domestic and international market yields become meaningless (Bekaert & Ravina et al. 2017, p. 112). Fixed-income assets are a significant portion of investors’ local-market bond investments. For investors to play a role in the portfolio, they invest in international or foreign bonds, thus benefiting from diversification. Changing political regimes, unstable interest rates, and economic-cycle risks are more likely to be experienced by fixed-income international bond investors than by domestic-market investors. Diversification benefits make investors exposed to currency movements, which determine the risk and return of a global bond. The impact of currency fluctuations is offset by investment managers when the portfolio is fully hedged. It ensures capital gains/losses and income are the only factors influencing return.
Some people say that investors should adopt currency hedging, as it results in long-term international bond returns, together with local bond returns and abandons diversification of global bonds. Diversification potential is most likely to be unaffected by the low volatility of hedged returns. The central bank aims to manage inflation and the output of an economy, thus picking short-term interest rates by hedging investments. In currency hedging, two parties decide to exchange one currency for another at a specific exchange rate for a future date.
Unhedged returns on foreign bonds have two components: the return on the bond and the return on the foreign currency used to purchase the bond. Covariance returns of a bond can be either positive or negative and can vary over time. European investors with unhedged international securities experience a negative impact on their profits when the Euro currency value increases. On the other hand, European investors suffer a positive effect on returns when the currency value depreciates. Trying to improve profits at times is costly and time-consuming, which, in the end, may yield minimal benefits; economists and investment experts make incorrect forecasts as often as correct ones. There are additional diversification benefits if investors hedge or leave investments in foreign countries unhedged. For example, if a person invests in an unhedged United States share fund and later the Australian dollar value decreases relative to the US dollar, the cost of the investor’s portfolio would rise. Investors will receive more for their investment if it’s converted back into Australian dollars (Topaloglou, Vladimirou & Zenios 2017).
(Average Annualized Returns of MC Hedged Indices and Their Unhedged Parent Indices, Gross Monthly Return)
Unhedged Hedged Unhedged Hedged
Mc World 5.09% 3.32% -5.02% -4.93%
Mc EAFE 6.16% 2.37% – 11.73% -11.69%
Mc Emerging Markets 15.82% 11.65% -18.17% -14.12%
Mc Brazil 23.53% -2.00% -21.59% -17.44%
MC Canada 10.91% 8.08% -12.16% -9.88%
MC Japan 4.02% 0.60% -14.19% -18.36%
Source: Mc Data for Brazil begins in September 2010.
Which part of Chen’s statement about emerging markets is least likely correct? What elements might affect emerging markets? Chen states that expected returns and risks are low in developed countries compared to emerging markets. Emerging markets are growing over time, meaning investment will also increase, thus producing positive returns. Brazil, Chile, China, Colombia, Hungary, Indonesia, India, Malaysia, Mexico, Peru, Philippines, Poland, Russia, South Africa, Turkey and Thailand are the major emerging markets. Developed countries are the United States, Sweden, Germany, Japan, France, Canada, Netherlands, Australia and Denmark. Emerging markets or developing countries are concentrating on increasing investment in productive capacity and abandoning traditional economies. Most developing countries’ securities increase their value as time passes, giving good returns to investors. In an emerging-market segment, people establish new industries that open other branches internationally. Emerging markets lack strict accounting standards, securities regulations and market efficiency to reach the status of developed countries. The above markets have banks, stock exchanges, and a unified currency, referred to as physical financial infrastructure. Emerging-market economies grow faster, thus generating high returns, which makes them targets for investors. Political instability, currency volatility, infrastructure problems, state-run or private companies, and limited equity opportunities in emerging markets put investments at high risk. Liquidity for outside investors may not be available on the local stock exchange. Developed countries have advanced technology infrastructure and a highly developed economy compared to developing countries. Gross domestic product (GDP), per capita income, gross national product (GNP), the standard of living, and the level of industrialization mostly determine the degree of a country’s economic development. Service sectors are more productive than industrial areas, thus, post-industrial economies (Liu 2016, p. 959).
Part 2
Currency risk in international markets is colossal; investors may not be sure about the stability of an economy tomorrow. In countries like Syria, Pakistan and Ethiopia, chaos erupts more often due to radical groups. In these countries, it becomes difficult to invest as a person may lose all his investments. When the value of a foreign currency depreciates, investors shy away from buying shares and bonds. On the other hand, an investor is attracted to purchasing securities in foreign countries with increasing currency values.
Potential Barriers to International Diversification in the Finance Industry
There are some constraints experienced when investing in foreign markets, which are mainly imposed by governments. Regulations by the government make currency trading difficult. Some of these barriers are taxation, foreign-exchange controls, capital-market controls, and nonexistent or weak laws protecting minority stockholders’ rights.
Taxation
Taxes can be both an obstacle and an incentive in cross-border international diversification activities. The government alone makes rules regarding taxation, through which it benefits from revenue and may negatively affect investors. Countries determine the tax rate paid on each investment return, for example, dividends, capital gains and interests. Taxation laws differ in each state, and the government drafts laws that benefit them. Securities taxation varies; some securities income is partially or entirely exempt from income taxes. Japan has exemptions on interest income of a particular amount, which is of domestic securities of received interest. Many countries tax residents’ returns on portfolio investments, both local and foreign, which is called the worldwide-income concept. In some countries like the United States and Singapore, tax returns from foreign securities abroad of people who migrate back to their home country.
It creates offshore investment and jurisdictions known as tax havens (Biener, Eling & Wirfs 2016, p. 353). The financial industry benefits from tax havens, thus accepting legal provisions of confidentiality. Through tax havens, people at times hide finances gained through theft, illegal drug sales proceeds, political corruption revenue and robbery. High-rate taxing countries have organizations like OECD and FATF that help reduce the power of tax havens. Qualifying foreign financial intermediaries system by the United States holds banks responsible for tax collection on securities by American taxpayers, believing they want to run business in the country’s financial markets. An international portfolio-investment barrier sometimes arises through tax withholding, which many nations collect from foreign investors on interest, dividends, and royalties paid by resident borrowers.
Foreign Exchange Controls
The aim of currency controls is to restrain the flow of capital. The reservation of financial capital for domestic use and the balance of payments contribute to foreign-exchange controls. Currency control is achieved through the prohibition of converting local money into foreign funds to obtain securities abroad. When economic trends are positive and stable, countries may hesitate to get rid of controls. Many nations are armed to restrict significant capital outflows and inflows. For example, in Japan in the seventies, Japanese investors were limited by exchange controls when buying foreign securities. Later, Japanese liabilities prevention from continued rise is through foreign purchases of Japanese investments. Some countries make people trade a part or all foreign investments to exchange the money for local funds. Domestic-company equities accessible to external investors are few due to inflow constraints. Inflow constraint, which is bidding, makes people’s domestic asset prices different. For example, Sweden Markets companies have foreign ownership of 20% (voting rights) and 40% (equity), which results in the presence of a foreign and domestic class of stocks. The capital amount of an internal investor and outflow constraint make them spend little on foreign investments.
Capital Markets Regulations
The goal of regulations is to safeguard buyers of financial securities and to make individual transactions fair and competitive. Regulatory and examination bodies put measures in place to regulate foreign investments. Supervision and controls are beneficial to foreign investors with less potential abuse knowledge and have limited ability to judge factors affecting securities return. Foreign securities may be unavailable to local investors due to restrictions placed on securities in international markets by national entities during issuance. Some countries decide on the amount investors can invest abroad. A small number of nations prevent the purchase of securities by an investor. Financial institutions, pension funds, and insurance companies have rules and regulations in every country that may prevent them from investing abroad. For example, the United States’ various federal government regulations prevent a significant proportion of investment of insurance companies in foreign countries. Commercial banks adhere to state banking regulations. Other countries mostly have the same control or different restrictions.
Transaction Costs
At times, foreign securities are much more expensive than local securities, which is a challenge for investors with little money. Financial intermediaries add more funds to trade in international markets. The cost of data transfer between foreign, domestic, and overheads rises, thus making them transfer these costs to investors. Liquidity, breadth, depth, and strength of various capital markets provide mitigating factors. Thus, an international country investment is induced. Security price stability differs in each country. The United States and British markets have a considerable amount of foreign investment, as they are known for expertise in financial-market trading. They attract and absorb many types of securities like bonds, preferred shares, convertibles, ordinary shares and instruments of money markets. Continents such as Europe and Asia experience securities thinness, thus having price volatility. If the market has reduced the cost of borrowing and lending, investors come in to purchase various securities. The most efficient market in the world is in New York State. Non-United States securities are more expensive compared to American stocks (Chernov, Graveline and Zviadadze 2018, p. 34).
Foreign Markets Familiarity
During investment abroad, an investor requires adequate knowledge of foreign markets. Countries have different procedures for trading, customs reporting and time zones. The investor has to make a good effort to understand the economy and international company performance. Deviations in methods like depreciation and standards of accounting make companies’ security costs vary and hard to interpret (Yu and Lindsay 2016, p. 771). Currently, companies publish financial statements in English on their websites and in newspapers. Intermediaries give information about foreign companies to investors due to the essence of international securities gains.
International Portfolio Diversification Channels
An investor can place an order for the security of his choice in a security company at home, thus through a broker, obtaining investments from a foreign issuer. Secondly, investors purchase assets in a local or international country through investment account establishment in the country. Through brokers, an investor is protected from domestic regulations and laws, with only transaction cost payment (Biener, Eling & Wirfs 2016, p. 703). Some investors with substantial investments trade securities through mutual funds dealing with foreign assets.
Conclusion
Investors should read the company journal to get more details about the financial stability in the past years. Investment advisors are always present to aid in making sound decisions. The government should minimize regulation and eradicate laws that prohibit foreign investments. A stable economy attracts investors, thus further benefiting the country. Stockbrokers are essential as they carry the investor’s burden. Investors should always pay attention to the market trend of different securities for future investments. Fear of a decrease in foreign currency value at times makes investors shy away. The government should exempt foreign investment from taxation to encourage more investment in the country, especially in developing countries. Leaders should avoid bringing up the political temperature to make the environment conducive for foreign investors. Bond issuance is a way to raise money for a company to enable daily operations to progress.
Bond buying is, at times, between the investor and the company, meaning no restriction from an institution like a bank and raised interest rate, which comes as a result of third-party involvement. Bond issuance is better compared to obtaining a bank loan. Existing investors protect their interests, which at times are frustrated by sales of new shares to new investors. The sale of bonds at times generates positive returns, thus causing a rise in the company’s equity. A company reduces taxable income by the issuance of bonds since the interest expense on obligations is taxed. If a company issues bonds, the parties have an agreement; thus, at the maturity date, payment terms will remain the same.
An investor buys a warrant at a premium or discount, and as the time nears the maturity date, it declines to zero with its return to full face-value payment. Sales of a bond are either at a discount, premium, or face value, determined by the interest rates currently available in the market. Every investor aims to reach a high-interest performance in addition to the initial amount of money invested. Political stability is one of the primary factors in increasing currency value, thus attracting people from other countries to establish businesses.
Bibliography
Basher, S.A. and Sadorsky, P., 2016. Hedging emerging market stock prices with oil, gold, VIX, and bonds: A comparison between DCC, ADCC and GO-GARCH. Energy Economics, 54, pp. 235-247.
Bekaert, G. and Harvey, C., 2017. Emerging equity markets in a globalising world.
Bekaert, G., Hoyem, K., Hu, W.Y. and Ravina, E., 2017. Who is internationally diversified? Evidence from the 401 (k) plans of 296 firms. Journal of Financial Economics, 124(1), pp. 86-112.
Bell, P.N., 2015. Returns to tail hedging.
Bergin, P.R. and Pyun, J.H., 2016. International portfolio diversification and multilateral effects of correlations. Journal of International Money and Finance, 62, pp. 52-71.
Biener, C., Eling, M. and Wirfs, J.H., 2016. International cultural diversification and corporate social performance in multinational enterprises: The role of slack financial resources. Management International Review, 55(3), pp. 323-353.
Biener, C., Eling, M. and Wirfs, J.H., 2016. The determinants of efficiency and productivity in the Swiss insurance industry. European Journal of Operational Research, 248(2), pp. 703-714.
Chernov, M., Graveline, J. and Zviadadze, I., 2018. Crash risk in currency returns. Journal of Financial and Quantitative Analysis, pp. 1-34.
Chiu, S.W.K., 2018. City states in the global economy: Industrial restructuring in Hong Kong and Singapore. Routledge.
Cumming, D., Filatotchev, I., Knill, A., Reeb, D.M. and Senbet, L., 2017. Law, finance, and the international mobility of corporate governance.
Gao, W. and Chou, J., 2015. Innovation efficiency, global diversification, and firm value. Journal of Corporate Finance, 30, pp. 278-298.
Liu, E.X., 2016. Portfolio diversification and international corporate bonds. Journal of Financial and Quantitative Analysis, 51(3), pp. 959-983.
Manganelli, S. and Popov, A., 2015. Financial development, sectoral reallocation, and volatility: International evidence. Journal of International Economics, 96(2), pp. 323-337.
Narayan, P.K. and Sharma, S.S., 2016. Intraday return predictability, portfolio maximisation, and hedging. Emerging Markets Review, 28, pp. 105-116.
Riasi, A., 2015. Competitive advantages of shadow banking industry: An analysis using Porter diamond model. Business Management and Strategy, 6(2), pp. 15-27.
Topaloglou, N., Vladimirou, H. and Zenios, S.A., 2017. Integrated Dynamic Models for Hedging International Portfolio Risks.
Topaloglou, N., Vladimirou, H. and Zenios, S.A., 2017. Integrated Dynamic Models for Hedging International Portfolio Risks.
Whitelaw, R. and Bruno, S.J., 2016. Benefits of Managing International Equity Currency Risk with a 50-Percent Hedging Strategy.
Yu, Y. and Lindsay, V., 2016. Export commitment and the global financial crisis: Perspectives from the New Zealand wine industry. Journal of Small Business Management, 54(2), pp. 771-797.
Academic Master Education Team is a group of academic editors and subject specialists responsible for producing structured, research-backed essays across multiple disciplines. Each article is developed following Academic Master’s Editorial Policy and supported by credible academic references. The team ensures clarity, citation accuracy, and adherence to ethical academic writing standards
Content reviewed under Academic Master Editorial Policy.
