Assessing Risks with International Diversification
I believe that all investors hope to get a higher than expected return on their investment at a minimum downside risk. Investing in global markets has begun to make sense for an increasing number of investors as U.S. equities only make up less than 40 percent of world equities and an even small fraction of the total world wealth (Bodie, Kane &Marcus, 2014).By 2011, more than 50 countries had an aggregated market capitalization of $1 billion and above, making investing in foreign capital markets much more easier than ever before (Bodie et al, 2014).
Financial Exchange Risk
I believe that investing in a foreign country might be risky for an investor from U.S. because the other country obviously uses a different currency other than the U.S. dollar, therefore any movement of the exchange rate between the U.S. dollar and the foreign currency, will be a cause for concern for the U.S. investor. Consider a U.S. investor who wants to invest in British government bills, which are paying 10% annual interest in British pounds (Bodie et al., 2014).While the U.K. bills are risk-free for a British investor, it is not the case for a U.S. investor because of the foreign exchange risk (Bodie et al., 2014).Suppose that, at the time of investment the exchange rate is $1.8 per pound, an initial investment of $20,000 can be exchange for £11111.11 and would grow to £12,222.22 in one year (Bodie et al., 2014).Supposing that at the end of the year the British pound has depreciated against the dollar and the exchange rate is now $1.60 per pound (Bodie et al., 2014).The £12,222.22 can be exchanged back to U.S. dollars for $19555.55(=1.6*12222.22), which is a loss of $444.45(Bodie et al., 2014).Therefore despite earning a 10% return on the U.K. bills the U.S. investor suffers a 2.22% loss on his investment (Bodie et al., 2014).
Now suppose that the exchange rate had gone the other way and at the end of one year the exchange rate was $2 per pound. The $12,222.22 would have been exchanged for $24,444.44(=2.0*12,222.22) giving a profit of $4,444.44 or a 22.22% return, which is a 12.22% exchange rate premium. I think that investors would be interested to look at long-term exchange rate trends, and consider diversifying only in the countries that the U.S. dollar is likely to appreciate against local currency rather than depreciate, so that they can reap an exchange rate premium on top of the return on their investment.
Lack of transparency in foreign capital markets has hindered U.S. investors from diversifying to foreign capital markets (Bodie et al., 2014).However cross-border investments have grown as more resources have been invested in analyzing the risks involved in international investing (Bodie et al., 2014). According to Bodie et al. (2014) ,the Political Risk Services (PRS) group a leader in analyzing country specific political risks, produces a country composite risk rating on a scale of 0(most...