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Growth in Int. Trading:  Reduction of Transaction Costs  Reduction in Information Costs  Hedging Exch R. Risk Not all currencies have fwd ctrc to hedge Dealer markets: Dealer participates as principal executing public orders by buying or selling from their inventory. Agency markets: public orders are matched with public orders through brokers who deal with other brokers. Continuous markets: trading occurs throughout the trading day. E.g NYSE Call markets: orders collected+executed when the market is called during trading day at predetermined time intervals Reason to Cross-List firm in Foreign Mkt:  Improve Int. stakeholder/host gov visibility  Improve liquidity + decrease cost of capital  Establish second mkt to use shares 4 M&A  Inc. share p. by overcoming home mispricing

Simplifying Port. Analysis: Factor Models Used to reduce computational inputs. Impose simplified assumptions on correlation structure of stock returns using single or multi factor models. Single Index Model Reps time movement of stock i’s returns

Rit =E ( R it ) + β t F t + eit E ( Rit ) :sec i’s exp.return. at

Correlation Struct + Risk Diversification: Returns are less correlated across countries than within. Due to varying economic, political, institutional + psych factors affecting security returns. Business cycles are asynchr (not same). Effects of Change in Exch Rates: Realised $ return for US investor depends on return + exch r btw home and foreign country.

1+ei

( 1+Ri ) (¿)−1 Home Bias: Portfolio concentrated with domestic equities. Despite diversification benefits, actual int. portfolios have lots more home b. than there should be in theory. Wealthier + experienced investors have less home bias due to confidence levels etc.

Sharpe Performance Measure: Is a "risk-adjusted" performance measure, as well as the excess return (above and beyond the risk-free interest rate) per standard deviation risk. Finds risk amnt per 1 reward.

Shp R=

R p−R f

Multifactor Model:

F β

t : sensitivity of sec i’s return to macro news

We can examine how diff stocks respond to GDP and IR shocks separately; Examine for factor sensitivities, loadings and factor beta Security Market Line: Same applic as above

Arbitrage Pricing Theory (APT) Relies on 3 concepts; 1.Security returns r described by factor model 2.There r enough securities to allow diversification of idiosyncratic risk (only systematic risk remaining). 3. Mkt is rational in that arb doesn’t last. APT does not tell us which factors we should use.

Exposure of an MNC’s Portfolio: Measurement The standard deviation statistic measures the degree of movement for each currency. In any given period, some currencies clearly fluctuate much more than others. Correlations coefficients indicate degree to which two currencies move in relation to each other. Exposure MNCs StockP to translation Effects Because an MNC’s translation exposure affects its consolidated earnings, it can affect the MNC’s valuation. Signals that complement translation effects: exchange rate conditions that cause a translation effect can also signal changes in expected cash flows in future years. Such change could influence the stock price. Exposure of managerial compensation to translation effects: Since an MNC’s stock may be subject to translation effects and since managerial compensation is often tied to the MNC’s stock price, it follows that managerial compensation is affected by translation effects. Derivation of Purchasing Power Parity Relationship between relative inflation rates (I) and the exchange rate (e). Use expected exchange rate for (e) in IFE calcs.

e

it : unanticipated firm specific events (to add extra factors if needed).

Multifactor APT: Each factor has zero expected value - measures the systematic variable. Firm-specific component also has zero expected value. Factor portfolio is given by a well-diversified portfolio with beta of one on a given factor and zero on any other factor. Factor portfolio is regarded as a tracking portfolio which tracks the evolution of a particular source of macro risk, but it is uncorrelated with any other sources of risk.

APT vs. CAPM When market portfolio is the well-diversified portfolio and the systematic risk factor is given by the unexpected market return, then the expected return-beta relationship under APT; This is the same as SML under CAPM. SML is obtained under APT without imposing restrictive assumptions like those of CAPM. APT does not require benchmark portfolio to be the true market portfolio as in CAPM as long as it is well-diversified. APT applies to well-diversified portfolios but not necessarily to all individual stocks as in CAPM.

Transaction Exposure based on Value at Risk (VaR) Measures the potential maximum 1-day loss on the value of positions of an MNC that is exposed to exchange rate movements. Factors that affect the maximum 1-day loss: 1. Expected percentage change in the currency rate for the next day. 2. Confidence level used. 3. Standard deviation of the daily percentage changes in the currency. (see e.g. in formulas)

Measuring Economic Exposure Using sensitivity analysis: Consider how sales and expense categories are affected by various exchange rate scenarios: Use of regression analysis:

3 Currency Portfolio

R i $=¿

beginning of p.t

t : unanticipated comp of macro factor in p.t

Exchange Rate Exposure: Transaction Exposure The sensitivity of a firm’s contractual transactions in foreign currencies to exchange rate movements. Assessing transaction exposure: Estimating net cash flows in each currency Exposure of an MNC’s portfolio

International Fisher Effect (IFE) The International Fisher Effect (IFE) is an economic theory stating that the expected disparity between the exchange rate of two currencies is approximately equal to their countries' nominal interest rates.

Economic Exposure Definition: The sensitivity of the company’s cash flows to exchange rate movements, sometimes referred to as operating exposure. Exposure to local currency appreciation/depreciation Appreciation in the company’s local currency causes a reduction in both cash inflows and outflows. Depreciation causes increase The impact on a company’s net cash flows will depend on whether the inflow transactions are affected more or less than the outflow transactions

Fama and French (1993) model Market premium = market return minus riskfree rate Size premium = return on a portfolio consisting of small cap firms minus return on a portfolio consisting of large cap stocks Value premium = return on a portfolio consisting of high book-to-market-ratio value firms minus return on a portfolio consisting of low book-to-market-ratio growth firms Chen, Roll, and Ross (1986) model Industrial production growth Change in expected inflation Change in unanticipated inflation Term spread = excess return of long-term government bonds over T-bills Default spread = excess return of long-term corporate bonds over long-term government bonds Hedging opportunities: MM: borrow h$ and invest f$ 2hedge pybl MM: borrow f$ and invest h$ 2hedge rcvbl Fwd: borrow h$ forward 2 hedge pybl Fwd: sell h$ forward 2 hedge rcvbl Option: purchase f$ call option for pybls, purchase f$ put option for rcvbl.

Comparison of the IRP, IFE and PPP: Although all three theories relate to the determination of exchange rates, they have different implications. IRP focuses on why the forward rate differs from the spot rate and on the degree of difference that should exist. Relates to specific point in time PPP and IFE focus on how a currency’s spot rate will change over time Whereas PPP suggests that the spot rate will change in accordance with inflation differentials, IFE suggests that it will change in accordance with interest rate differentials PPP is related to IFE because expected inflation differentials influence the nominal interest rate differentials between two countries.

Translation Exposure: Definition: The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations. Determinants of translation exposure: Proportion of business by foreign subsidiaries: The greater the percentage of an MNC’s business conducted by its foreign subsidiaries, the larger the percentage of a given financial statement item that is susceptible to translation exposure. Locations of foreign subsidiaries: Location can also influence the degree of translation exposure because the financial statement items of each subsidiary are typically measured by the respective subsidiary’s home currency

Cross Exchange Rates Value of yuan = A$0.1972 Value of MYR = A$0.35 Value of yuan in MYR =

Value o Value o =

Lending: Dependent on Length International Money Market: Corporation need shortterm funds denominated in a currency different from their home currency. International Credit Market: MNCs obtain mediumterm funds through term loans from local financial institutions or through the issuance of notes (mediumterm debt obligations) in their local markets International Bond Market: Foreign bonds issued by borrower foreign to the country where bond is placed.

Purchasing Power Parity: PPP Interpretations of Purchasing Power Parity Absolute Form of PPP: Without international barriers, consumers shift demand to wherever prices are lower. Prices of same products in two different countries should be equal when measured in common currency Relative Form of PPP:Due to market imperfections, prices of the same basket of products in different countries will not necessarily be the same.

4 Explanations for SMB/HML effects: Belief1: The effects fairly compensate higher risk. (=efficient) Belief2: returns are a fluke and will end/be offset in future. (=efficient) Belief3: savvy investors consistent outperform using effects. (=no risk, inefficient.) Belief4: opportunity gone now due to use. (clear LT efficient, mayb ST inefficient.) 2011 evidence for existence of both. Investment-specific technological shock (IST): These are tech innovations that materialize through creation of new capital stock/reduce cost of capital goods. E.g. computers (2011=$5k. 1960=5mil). 2011 evidence: IST shocks decrease (c)… 2018 research shows IST innovations priced in the cross-section of E returns in int. mrtks.

Reasons for better returns for small firms: 1. Greater default risk: larger firms have bigger market power. 2. Quality/availability of info: larger firms have more analysts. 3. Lower liquidity, which makes it riskier to trade. Reasons for better returns for value firms: 1. Assets in place are riskier than growth options in recession because this causes risk to increase due to higher operating leverage/costs. 2. IST shocks cause resources to be reallocated from consumption to investment. low (c) is bad 4 high HML firms. 3. Behaviour – overreaction to low HML stocks, become ‘glamour stocks’.

Input for Multinational Capital Budgeting Forecast factors influencing the initial investment or cash flows of the project: Initial investment –include whatever is necessary to start the project and additional funds, such as working capital, to support the project over time. Price and consumer demand – Future demand ~influenced by economy. Costs – Future variable-costs developed from comparative costs of the components. Can find fixed costs without estimate of consumer demand. Tax laws – International tax effects must be determined on any proposed foreign projects. Remitted funds – The MNC policy for remitting funds to the parent influences estimated cash flows. Exchange rates – These movements are often very difficult to forecast. Salvage (liquidation) values –The success of the project and the attitude of the host government toward the project may affect this. Required rate of return – MNC should first estimate cost of capital, then can derive its required rate of return on a project based on the risk of that project

Nextel Peru: Calculating Cost of Capital. Can’t use CAPM without including country risk factor of Peru. Therefore: CostofCap= rf + β (market premium) + β2 (country risk premium) Use the Latin MSCI data as addition country risk factor (w/out second beta this formula is just CAPM. Beta= Covariance (measure of stock’s return relative to the market) / Variance (measure of how the market moves relative to the mean… Beta is the risk of an [asset] in relation to the risk of the overall market. QUESTIONS: 1. Assume you are an analyst for XYZ firm, an asset holding firm with diversified assets across South America. You are trying to figure out the cost of capital, and as the first step, you are trying to estimate equity betas for comparable firms. a) Which equity beta should you use? S&P equity beta, MSCI world equity beta, MSCI Latin equity beta, or local equity beta? Why? Answer: It is more appropriate to use the MSCI Latin equity beta because XYZ firm a Latin American diversified firm. b) To calculate the cost of capital, is it appropriate to use the equity betas directly? Answer: No. You need to compute the unlevered equity betas. The capital structure of a firm will affect the beta. Un-levered beta is a linear combination of equity and debt betas:

( V ) βun−levered =( E ) β equity + ( D ) β debt , V is the value of the levered firm. Dividing by V E D β un−levered = β + β . V equity V debt

where

( )

How do individual firms’ illiquidity affect their stock returns?

The greater the illiquidity (i.e. the costlier it is to trade a stock), the higher the premium the firm must pay to investors. Illiquidity “risk” premium: Illiquidity “risk” for stock i is given by the sensitivity of its return to market illiquidity:

Market illiquidity: gives us:

( )

How does illiquidity affect stock returns?

c) Calculate the average asset beta for a firm in wireless industry in Latin America.

β

Other Factors affecting budgeting: -Exchange rate fluctuations – important -Inflation – not too much -Financing arrangement – not too much -Blocked funds - important -Uncertain salvage value - important -Impact of project on prevailing cash flows -Host government incentives. -Real options. Country risk ratings are incorporated into the discount rate, and discount rate = cost of capital.

Transaction Exposure – VaR e.g. Australian MNC will receive MXP10 million tomorrow (Mexican pesos). It wants to determine max one day loss (with 90% confidence level) due to decline in pesos. Std dev (σ) over last 100 days ~= 2% Assume a normal distribution:

Answer: From the equation in part (b), we can calculate the for each un−levered comparable firm. e.g. For America Movil, you compute: Asset Beta = (1-17.73%)*0.75 + 17.73%*0.12 = 0.8227*0.75 + 0.1773*0.12 = 0.617+0.021 = 0.64 3. Assume the market risk premium for S&P 500 is 5.1%, Global index is 5.3%, Latin American index is 4.8%, and local index is 8.4%. Calculate the required rate of return for this acquisition. Answer: From Exhibit 6, we know that the risk-free rate is 3.08%, which is the current U.S. 30-year Treasury rate. The average asset beta is 0.62 (from Question 1. part c). The market premium is 4.8% for Latin American index. Required rate of return:

Derivation of interest rate parity:

Determining fwd premium:

Transaction Exposure:

Breakeven Salvage Value:

Multifactor Model:

SML: Premium or discount on fwd rate: F = S(1 + p) where: F is the forward rate S is the spot rate P is the fwd premium

0.6 2 (¿¿ 2) ( 0.0049 ) +( 0.4 ) ( 0.0064 )+ 2(0.6 )(0.4 )(0

The greater the illiquidity risk of a firm, the higher the premium it must pay to investors. EXAMPLE QUESTION ANSWER: iv) What is an easy and effective way to examine whether illiquidity is priced in the crosssection of the emerging market stocks? Answer: Compute illiquidity ratio of a stock by calculating the price impact of trade. Sort stocks in to portfolios (for example, 5 portfolios) by their illiquidity ratio. Compare the difference between the highest illiquidity portfolio and the lowest illiquidity portfolio. You may find a difference in the average returns between the most illiquid and the least illiquid portfolios. v) How would you test whether a premium exists for the illiquidity factor, using five portfolios sorted according to their illiquidity? Answer: You can examine the illiquidity premium by performing a two-step Fama and Macbeth regression. Step 1: Run time series regressions to estimate the betas for each portfolio.

r f + βun−levered∗Market risk premium=3.08 %+ 0.62∗4.8

Maximum 1−day loss = E ( e ) − ( 1.65 x σ mxp )

t NB: E(et) = expected change in MXP | 1.65 = 90% C.I. = 0 – (1.65 x 2%) = -3.3% IF St = A$0.08/MXP, then max 1-day loss is = St x (1 + max 1-day loss) = A$0.08/MXP x (1 + -3.3%) therefore, St+1=A$0.0774/MXP Calculating VAR for portfolio: where, Indonesia  A$600,000 @ today St w/ 60% weight Thailand  A$400,000 @ today St w/ 40% weight Wants to know max expected 1mo loss @ 90% C.I -Based on last 20mo, σR=7%, σB=8%, CORRRB=0.5

Illiquidity Premium: Illiquidity can be measured by the bid-ask spread; or Illiquidity for stock i is measured by the price impact of the trade:

Sensitivity analysis for NPV (same calc as avg weighted returns): NPV = (prob. of NPV being x * x) + (prob. of NPV being y * y)...