Term
What is Equity Market Liquidity |
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Definition
Liquidity refers to how quickly an asset can be sold without a major price concession.
In a liquid market, investors can buy and sell stocks quickly at close to the current quoted prices. |
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Term
How do you determine if a market is liquid? |
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Definition
market capitalization as a percentage of GDP
and
Turnover ratio: the ratio of stock market transactions over a period of time divided by the size, or market capitalization, of the stock market. |
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Term
What is the concentration ratio and what does it mean? |
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Definition
The concentration ratio is a measurement of the depth of a stock market.
When a country’s stock market concentration ratio is high, there are few opportunities for investment in that country and proper diversification within the country may be difficult.
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Term
How is the concentration ratio calculated? |
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Definition
The concentration ratio is often calculated as the percentage of market capitalization represented by the 10 largest stocks of the market.
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Term
Why did international Equity Trading rise in the 1980s? |
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Definition
Portfolio diversification by investors
Market liberalization, e.g., elimination of fixed trading commissions, reduction in government regulation, EU capital market integration
Improvements in computer and communications technology facilitating trading, clearance, & settlement
Increased demand by MNCs for sourcing capital globally.
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Term
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Definition
Cross-Listing refers to a firm having its equity shares listed on one or more foreign exchanges. |
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Term
What are the advantages of cross-listing? |
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Definition
-Expands the investor base for a firm and therefore increase demand for the stock.
•Very important reason for firms from emerging market countries with limited capital markets.
•An increase in demand will generally increase the stock price and improve its market liquidity.
–Establishes name recognition for the firm in new capital markets, paving the way for new issues in those markets.
–May offer marketing advantages (re corporate governance).
–May mitigate possibility of hostile takeovers. |
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Term
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Definition
•Foreign stocks often trade on U.S. exchanges as ADRs.
•Each ADR is issued by a U.S. depository bank and can represent a fraction of a share, a single share, or multiple shares of the foreign stock.
–An owner of an ADR has the right to obtain the foreign stock it represents, but US investors usually find it more convenient simply to own the ADR.
•The depository bank serves as a transfer agent for the ADRs
–A transfer agent performs functions such as issuing and canceling receipts to reflect change of ownership, paying dividends, etc. |
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Term
| What are the advantages of ADRs over direct investment of foreign shares? |
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Definition
–ADRs are denominated in U.S. dollars, trade on U.S. exchanges and can be bought through any U.S. broker. They are priced in a trading range that is typical for the US market.
–Dividends are paid in U.S. dollars.
–While most underlying stocks are bearer securities, the ADRs are registered. ADRs can be re-issued if lost or stolen.
•Empirical evidence suggests that adding ADRs to domestic portfolios has a substantial risk reduction benefit. |
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Term
What are some limitations of ADRs? |
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Definition
–Most ADRs are from developed countries. US investors have limited opportunity to diversify into emerging markets using ADRs.
–Limited selection: Not all foreign companies are available as ADRs. For example, Japan's Toyota Motor has an ADR, but Germany's BMW does not.
–Liquidity: Plenty of companies have ADR programs available, but some may be very thinly traded. |
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Term
What is a global depository receipt? |
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Definition
•A Global Depository Receipt or Global Depositary Receipt (GDR) is a certificate issued by a depository bank, which purchases shares of foreign companies and deposits it on the account.
–Sold outside of the US and outside of the home country of the issuing company
–Normally 1 GDR = 10 shares, but not always.
–Most are denominated in USD, although some in EUR or GBP.
–GDRs facilitate trading of shares, and are commonly used to invest in companies from developing or emerging markets.
–Prices of GDRs are often close to values of related shares, but they are traded and settled independently of the underlying share.
•The number of GDRs has recently surpassed ADRs because of the lower expense and time savings in issuing GDRs, especially on the London and Luxembourg stock exchanges. |
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Term
What are three factors affecting international equity returns? |
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Definition
•Macroeconomic Factors
–Data do not support the notion that equity returns are strongly influenced by macro factors.
–That is correspondent with findings for U.S. equity markets.
•Exchange Rates
–Exchange rate movements generally explain a larger portion of the variability of foreign bond indices than foreign equity indices.
–Cross-correlations among major stock markets and foreign exchange markets are relatively low, but positive.
§This implies that the exchange rate changes in a given country may reinforce the stock market movements in that country, as well as in other countries.
•Industrial Structure
–Studies examining the influence of industrial structure on foreign equity returns are inconclusive. |
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Term
| Are security returns more correlated across countries or within a country? Why |
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Definition
•Historically, security returns are much less correlated across countries than within a country.
–This is so because economic, political, institutional, and even psychological factors affecting security returns tend to vary across countries, resulting in low correlations among international securities.
–Business cycles are often highly asynchronous across countries.
§Decoupling |
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Term
| What is one concern of international diversification? |
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Definition
A Major Note of Caution:
•International stock markets tend to move more closely together when the market volatility is higher. For example,
–During the October 1987 market crash, most developed markets declined together.
–Most developed markets declined sharply together in 2008 during the US-originated financial crisis.
•That is, you lose the benefit of international diversification just when you need it most.
•Nonetheless, unless investors liquidate their portfolio holdings during the turbulent period, they can still benefit from international diversification. |
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Term
| What is the Sharpe Performance Measure? |
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Definition
The Sharpe Performance Measure (SHP) measures the returns of national equity markets after adjusting for risks
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Term
| What is the optimal international portfolio? |
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Definition
•An Optimal International Portfolio (OIP) can be constructed by maximizing the Sharpe Performance Index. (See Textbook Appendix 15B for details.)
•The composition of OIP varies across national investors using different home-base currencies.
•Even within the same home country, legal constraints may result in different OIPs.
–Example, Japanese insurance companies and Spanish pension funds may invest at most 30% of their funds in foreign securities. |
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Term
How do you calculate the gains from international diversification?
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Definition
1.Compute the Increase in the Sharpe Performance Measures
DSHP = SHP(OIP) – SHP(DP)
2.Compute the increase in portfolio return from OIP at the “domestic-equivalent” risk level. This extra return, DR, accruing from international investment at the domestic-equivalent risk level.
The realized dollar return for a U.S. resident investing in a foreign market will depend not only on the return in the foreign market but also on the change in the exchange rate between the U.S. dollar and the foreign currency.
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Term
| What is exchange rate risk of foreign investments? |
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Definition
•The risk for a U.S. resident investing in a foreign market will depend not only on the risk in the foreign market but also on the risk in the exchange rate between the U.S. dollar and the foreign currency.
•The Covariance term Cov(Ri, ei) tends to be positive in most cases, implying that exchange rate changes tend to add to foreign investment risks, rather than offset it.
•Exchange rate risk is found to be much more significant in bond investments than in stock investments.
•Exchange rate risks need not always increase the risk of foreign investment. When the Covariance term Cov(Ri, ei) is sufficiently negative to offset the positive variance of exchange rate changes Var(ei), exchange rate volatility can actually reduce the risk of foreign investment.
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Term
| What are the pros and cons of international bonds and how do you hedge against the risk? |
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Definition
there is substantial foreign exchange risk in foreign bond investment, making it difficult to realize significant gains from international bond diversification.
–Generally, FX volatility is greater than bond market volatility.
Investors may be able to increase their gains if they can control this risk, for example with currency forward contracts or swaps.
Empirical evidence indicates that foreign bond portfolios outperform purely domestic bond portfolios if FX risks are hedged. |
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Term
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Definition
•A country fund invests exclusively in the stocks of a single county.
•The majority of available country funds are closed-end country funds (CECF).
–E.g., A CECF raises a fixed amount of capital through an initial public offering (IPO) and issues a given number of shares that trade in the NYSE or the AMEX as if the fund were an individual stock by itself.
–Unlike shares of open-end mutual funds, shares of a CECF cannot be redeemed at the underlying net asset value (NAV) set at the home market of the fund. A CECF may trade at a premium or discount against the NAV of its underlying stocks.
–CECF share prices generally behave somewhat like their host country’s share prices, reducing the potential diversification benefits. |
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Term
| What are World Equity Benchmark Shares or iShares MSCI Investment funds? What are the pros of these? |
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Definition
•WEBS or iShares MSCI Index Funds are exchange traded funds (ETFs) designed to replicate the country indexes of 22 countries and that of Hong Kong.
•iShares MSCI Index funds trade on the American Stock Exchange and are subject to U.S. SEC and IRS diversification requirements.
–Low cost, convenient way for investors to hold diversified investments in several different countries. Investors can trade a whole stock market index as if it were a single stock.
–For investors who desire international exposure, iShares MSCI may well serve as a major alternative to such traditional tools as international mutual funds, ADRs, and closed-end country funds.
•Being open-end funds, iShares MSCI trade at prices that are very close to their net asset values.
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Term
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Definition
Hedge funds may adopt flexible, dynamic trading strategies, often aggressively using leverages, short positions, and derivative contracts, in order to achieve their investment objectives.
•These funds may invest in a wide spectrum of securities across countries, such as currencies, domestic and foreign bonds and stocks, commodities, real estate, and so forth.
•Hedge funds tend to have relatively low correlations with various stock market benchmarks and thus offer diversification.
–Empirical evidence indicates that hedge funds tend to dominate purely domestic equity or bond portfolios in terms of risk-return efficiency; i.e., they have higher Sharpe performance measures. |
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Term
What are the three possible causes of home bias?
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Definition
1. Domestic equities may provide a superior inflation hedge.
2. Home bias may reflect institutional and legal restrictions on foreign investment.
•Deficiency in overseas reporting and disclosure requirements
•Uncertainty about foreign legal regimes and corporate governance
•Unsatisfactory shareholder protection for foreign investors
•Some countries used to restrict foreigners’ ownership share of domestic firms
•Some institutional investors may not invest more than a certain fraction of their portfolio overseas under the prudent man rule.
3. Extra taxes and transaction/information costs for foreign securities may give rise to home bias. |
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Term
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Definition
•In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. |
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Term
| What are the two types of swaps? |
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Definition
–Single currency interest rate swap: “Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps.
–Cross-Currency interest rate swap: This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies |
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Term
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Definition
A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties.
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Term
| What is the difference when a swap bank is either a broker or a dealer? |
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Definition
–As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap.
–As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty.
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Term
| What is a Quality Spread Differential (QSD)? |
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Definition
•The Quality Spread Differential represents the potential gains from the swap that can be shared between the counterparties and the swap bank.
•There is no reason to presume that the gains will be shared equally.
•For a swap to be possible, a QSD must exist. Beyond that, creativity is the only limit. |
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Term
| How is a QSD calculated for both a currency and interest swap? |
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Definition
–In a USD–GBP currency swap, it is calculated as the difference between the default-risk premium differential on the $ debt (D$ rate) and the default risk premium differential on the £ debt (D£ rate).
–In a fixed-for-floating interest rate swap, it is calculated as the difference between the default-risk premium differential on the fixed-rate debt (Dfixed) and the default risk premium differentail on the floating-rate debt (Dfloating). |
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Term
What are the pros and cons of Currency Swaps? |
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Definition
Pros:
1. Assured receipts of foreign currency that matches a company's needs
2. May result in lower funding costs or even access of financing that otherwise would not be available
3. Mainly used to hedge longer term regular transactions with maturities extending well beyond 10 years
4. Exit strategy: swaps can be unwound or sold to a third party with the permission of the counterparty
Cons:
1. Cannot benefit from a favorable currency move
2. Counterparty risk: one party in the swap may fail to meet its obligations during the swap or at maturity
3. Guarantees may be required because of credit risk
4. Not suitable for contingency exposure |
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Term
| What is a zero for floating swap? |
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Definition
A zero for floating swap is an interest rate swap in which the floating rate payments are made periodically while the fixed rate payments are paid in a single, lump sum payment. Also called zero coupon swap.
–Normally, the lump sum payment is made when the contract matures. But it can be made at the beginning of the contract in which case it would be known as a reverse zero coupon swap.
–If the lump sum payment is deferred until maturity the present value of the payment is normally adjusted to reflect the greater credit risk involved. Zero coupon swaps can be structured so that both floating and fixed rate payments are paid as a lump sum. |
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Term
| What is a floating for floating swap? |
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Definition
A floating for floating swap is a swap in which each counterpart is tied to a different floating rate index (e.g., $ LIBOR and $ T-bill), though of the same currency. |
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Term
| What are the two variations of Interest rate swaps? |
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Definition
1. Zero for floating
2. floating for floting |
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Term
| What are the four types of currency swaps? |
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Definition
•Fixed for Fixed
–Most basic form. Firm A swaps fixed-rate $ loan with Firm B for fixed-rate £ loan
•Fixed for Floating or Floating for Fixed
–Also known as cross-currency coupon swap
–Example: Firm A swaps fixed-rate $ loan with Firm B for floating-rate £ loan
•Floating for Floating
–Also known as cross-currency basis swap
–Example: Firm A swaps floating-rate $ loan with Firm B for floating-rate £ loan.
•Amortizing
–Incorporates an amortizing feature; notional principal decreases over the life of the swap according to a fixed or variable schedule. |
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Term
| What are the risks of interest rate and currency swaps? |
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Definition
Interest Rate Risk
Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position.
Basis Risk
If the floating rates of the two counterparties are not pegged to the same index.
Exchange rate Risk
The risk the swap bank faces from fluctuating FX rates during the time it takes for the bank to lay off a cross-currency swap it undertakes with one counterparty with an opposing counterparty.
Credit Risk
This is the major risk faced by a swap dealer—the risk that a counter party will default on its end of the swap.
Mismatch Risk
It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time.
Sovereign Risk
The risk that a country will impose exchange restrictions on a currency involved in a swap, thus interfering with performance on the swap.
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Term
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Definition
•The most important reason for swapping interest rates is to better match maturities or currency structures of assets and liabilities.
•Swaps offer market completeness and that has accounted for their existence and growth.
•Specifically, swaps assist in tailoring financing to the type desired by a particular borrower. Since not all types of debt instruments are available to all types of borrowers, both counterparties can benefit (as well as the swap dealer) through financing that is more suitable for their asset maturity structures.
Although swaps offer cost savings via the quality spread differential, cost savings are not the primary reason for the swap market’s rapid growth.
In an efficient market without barriers to capital flows, the cost savings argument of the QSD is difficult to accept because:
–It implies that an arbitrage opportunity exists because of some mispricing of the default risk premiums on different types of debt instruments.
–If QSD is the primary reason for interest rate swaps, one would expect arbitrage to eliminate it over time and that the growth of the swap market would decrease. |
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