CHAPTER XI

INTERNATIONAL EQUITY MARKETS

This chapter studies the specific characteristics of national stock markets. National stock markets
tend to have not only different legal and physical organization, but also different transaction and
accounting methods. Recall that stock markets provide valuable information about publicly traded
corporation. Different organizations and macroeconomic environments will affect the quality of the
information disseminated by a stock market. The better a market is at disseminating information, the
more attractive it becomes to international investors. This chapter begins with a general review of
the major differences among international equity markets and market microstructure issues. Then,
the chapter looks at some practical issues, relevant to international investors. We end this chapter
analyzing why international investors care about international markets.

I. General Overview and Differences

In this section we discuss the broad differences among international equity markets. We focus on
three areas where markets differ: liquidity, taxation, and stock market benchmarks.

1.A Liquidity

Liquidity refers to the ability to transform a non-cash asset into its cash equivalent without a loss of
principal. That is, liquid markets are markets where exit is relatively easy. Other things being equal,
international money managers will prefer to invest in liquid markets. Given the preference for liquid
stocks, illiquid stocks should offer a higher compensation. This compensation is called the liquidity
premium. In the U.S., Ang et al. (2011), in a comparison of listed (liquid) stocks and OTC
(illiquid) stocks, report an average estimated liquidity premium of 2.51% per year, but this return
will be realized only if investors demand liquidity –i.e., can wait- once a year. But, if investors
demand liquidity once a month, the liquidity premium is negative: -5.07%! In emerging markets,
the liquidity premium has been estimated at 3.2% per year.

There are several ways to measure the liquidity of a market. Measures based on size, volume and
bid-ask spreads are good liquidity indicators.

1.A.1 Measures of Size

1.A.1.i. Capitalization/GDP

A broad measure of liquidity -and easy to calculate- is total market capitalization (see Table XI.1).
According to this measure, the largest equity market in the world is the U.S. market, with a market
capitalization of USD 26.2 trillion in 2014. For the same year, the second largest equity market was
the Chinese market with a market capitalization of USD 4.0 trillion, while the third largest market
was the Japanese market with a market capitalization of USD 3.8 trillion.

XI.1
The U.S. capital market is large compared to the U.S. economy. In 2014, the U.S. stock market
capitalization represented roughly 150% of the U.S. GDP. During the same year, the market
capitalization/GDP figure for Germany was only 44%, while the corresponding figure for Mexico
was 38%. There are different reasons that explain these different ratios.

TABLE XI.1
Market Capitalization in 2014 (in USD trillions)

Stock Exchange Market Cap Nominal GDP Market Cap/GDP

USA (NYSE Euronext +NASDAQ) 26.240 17.416 151%
China (Shangai + Shenzen) 6.005 10.355 57%
Japan (Tokyo SE) 4.378 4.770 92%
UK (London SE Group) 6.370 2.847 224%
India (Bombay + National SE) 3.324 2.047 162%
Hong Kong Exchanges 3.233 0.274 1,180%
Canada (TMX Group) 2.094 1.827 146%
Brazil (BMM&FBOVESPA) 844 2.244 38%
Australia (Australian SE) 1.289 1.506 86%
Germany (Deutsche Börse) 1.739 3.820 37%

In many European countries corporations are undercapitalized and rely heavily on bank financing. In
Europe, banks tend to provide corporations with all financial services. They assist them in their
commercial needs as well as in their long-term debt and equity financing. It is common for European
banks to own shares of their clients. In Germany 15% of large German firms are bank controlled,
while the percentage reaches 30% in Belgium. In the U.S., commercial banks were prohibited by the
Glass-Stegall Act to participate in their clients' equity. Thus, U.S. companies, especially small ones,
are used to go public to raise capital in the marketplace.

In other countries, many large firms are state owned and some of them are not listed on the capital
markets. In a recent study of corporate control of large firms in 27 countries, most of them industrial
countries, La Porta, Lopez de Silanes, and Shleifer (1999) estimate that 18% of firms are state
owned. In Italy, for example, a large part of arms-manufacturing, oil, chemical, electronic,
automobile, banking, insurance, and transportation industries is owned by the government.

Family ownership is another factor that influences market capitalization. Many family-owned firms
are reluctant to list their stock in an exchange for fear of losing family control. Family ownership of
large firms is unusual in the U.S. In other countries, however, family ownership is extremely
common. For example, in Israel 50% of large firms are considered family-controlled. In Hong Kong,
the percentage of family-controlled large firms is 70%.

As a final note regarding this measure, some analysts, including Warren Buffet, use the MC/GDP
measure as a valuation metric to identify what markets are under-/over-valued. Under this view, the
higher the ratio, the more overvalued the market.

XI.2
1.A.1.ii Transaction volume

Another measure of liquidity and exchange activity is transaction volume. Not surprisingly, New
York and Tokyo have the largest share turnover. Depending on market activity, these figures can
vary widely from one year to the next, but in general most major markets enjoy a similar degree of
liquidity in terms of transaction volume. In fact, the annual turnover ratio (TR) -i.e., the ratio of
annual transactions in USD to year-end USD market capitalization- varies significantly over time.
Therefore, comparison of national market liquidity based on the TR could lead to different
conclusions if different years are taken into account.

Example XI.1: From 1995 to 2002 the U.S. annual turnover varied from 65% to 94%, while the same statistic
ranged from 45% to 90% for Thailand. In contrast, for the same period, the TR changed from 101% to 235%
for Korea. ¶

The main problem with transaction volume is that it is reported as an average, usually monthly or annual
number. Some stocks may have a good average, say daily average turnover, but the average is not
representative; there are many days with no trading. That is, the stock seems on average liquid, but in many
days it would be very difficult to trade. Using this intuition, it is common to use the number of non-trading
days as a liquidity measure. For example, the average proportion of non-trading days (90-08) in U.S. listed
stocks is 10%, while in Thailand the average proportion is 37%.

If daily volume is not available, the number of zero return days can be used as a proxy. After all,
if a stock price is unchanged, it should be the result of two events: (1) no information, or (2) no
trading. The proportion of zero return days is an easy measure to calculate. Stock prices are the
only input needed. Lang, Lins and Maffett (2009), in a study of well-developed EAFE markets,
report that the median listed stock has a zero return on 24.5% of the trading days per year and has
a bid-ask spread of 1.9%.

1.A.1.iii Degree of concentration found in the major markets

Another informative statistic related to liquidity is the degree of concentration found in the major
markets. It is important for the investor to know whether a national market is made up of many small
firms or concentrated in a few large firms. Institutional investors are reluctant to invest in small
firms for fear that they offer poor liquidity. In addition, this statistic can be indicative of
diversification opportunities for passive investors. The more concentrated a national equity market is
in a few stocks, the less diversification benefits arise for a passive investor.

Table XI.2 presents the market share of the 10 largest companies in each national stock market.

XI.3
 TABLE XI.2
Market share of the 10 largest companies in each national stock market (1994 and 2014)

Country 1994 2014

U.S. 11.9 13.3
Japan 20.2 16.3
U.K. 23.2 12.2
Canada 25.2 11.5 (2010)
Malaysia 35.6 31.1 (2013)
Australia 40.6 54.1
Italy 51.7 80.2 (2011)
Spain 56.2 46.8
Switzerland 67.0 69.2
Netherlands 74.3 81.3
Source: Emerging Markets Factbook, IFC, World Federation of Exchanges.

It is worth noticing that, in 2015, the largest company in the U.S. was Apple (APPL) with a 2.7%
share of total market capitalization (in 1994, the largest company was GM, with a 1.8% share). By
contrast, in the Netherlands the largest company was Royal Dutch/Shell with a 30% share of the
market capitalization.

1.A.2 The bid-ask spread

A market maker buys and sells shares of a company. When a market maker buys shares (at the bid
quote), she expects to sell those shares in the future (at the ask quote). The longer it takes to receive
a buy order, the costlier the transaction becomes for the market maker. The market maker will
require a higher compensation for shares that takes longer to sell. A higher compensation for a
market-maker means a higher bid-ask spread. A market maker will have small bid-ask spread for the
shares of a company that he/she expects to receive frequent buy and sell orders. The smaller the bid-
ask spread for the shares of a company is, the more liquid those shares are. Similarly, the higher the
average bid-ask spread of a stock market, the less liquid that stock market.

For example, in the NYSE the average bid-ask spread, as a percentage of the price, is around 0.6%,
while in Thailand the average bid-ask spread is 5.14%. For the EAFE sample, studied by Lang et al.
(2009), the median bid-ask spread is 1.9%.

1.B Stock Market Benchmarks

XI.4
Stock market benchmarks allow an investor to measure the average performance of a national stock
market. There are several stock market indexes that are used to benchmark the performance of a
given market. That is, one or several indexes may track a national market at any given time.

1.B.1 International Stock Indexes

For many years, Morgan Stanley Capital International (MSCI) has been publishing a monthly
newsletter, Morgan Stanly Capital International Perspectives, with national market value-
weighted indexes on 22 developed markets based on approximately 2600 stocks. Their indexes are
constructed to avoid double counting. These indexes have been available since 1970 and cover at
least 60% of the market capitalization for each country. They also publish regional indexes. The
most popular regional indexes are the World Index, and the European, Australasia, and Far East
(EAFE) Index. These indexes are used widely by international money managers for asset
allocation decisions and performance measurements. In 2004, MSCI acquired Barra, the
consulting firm. MSCI Barra publishes related information on their sample of stocks, including
financial ratios such as price earnings, price to book value ratios, yield, as well as risk models.
Today, MSCI Barra calculates over 120,000 equity and REIT indices daily. All the MSCI indexes
can be found at MSCI Barra’s website at www.mscibarra.com.

Since 1987 the Financial Times publishes the FT-Actuaries world indexes in association with
Goldman Sachs and Wood MacKenzie. Twenty-two national indexes are provided as well as
numerous industrial and regional indexes. The most important of the regional indexes are the World
index, the Europe Index, the Pacific Basin Index and the Europe and Pacific Index. The FT-
Actuaries indexes have a wider coverage than the MSCI indexes since they are based on a sample of
around 2400 stocks and cover more than 60% of each market capitalization.

More recently, the Dow Jones Co., started to publish similar indexes, which are available through
the Wall Street Journal. Other popular international equity benchmarks are produce by Salomon
Brothers and Frank Russell, Union de Banques Suisses (UBS), and First Boston.

1.B.2 Domestic Indexes

Local indexes are widely used by domestic investors to calculate performance, market betas, hedge
ratios, etc. Private international investors often prefer domestic indexes for the following reasons:

(1) local indexes have a broader coverage of stocks (they give the idea of the market portfolio).
(2) local indexes are available immediately.
(3) local indexes have been used for several decades and therefore there is more data available.

Example XI.2
: On February 15, 1996, the Wall Street Journal published the following international domestic (MSCI Stock
Market Indexes are also published in the same page of the WSJ):

XI.5
Stock Market Indexes
2/14/96 NET PCT
EXCHANGE CLOSE CHG CHG
--------------------------------------------------------------------------------------------------------------------
Amsterdam ANP-CBS General 343.6 + 0.8 + 0.23
Argentina Merval Index 545.04 - 9.22 - 1.66
Australia All Ordinaries 2300.8 + 11.1 + 0.48
Brazil Sao Paulo Bovespa 53308 - 547 - 1.02
Brussels Bel-20 Index 1661.61 - 1.83 - 0.11
Euro, Aust, Far East MSCI-p 1145.8 + 4.4 + 0.39
Frankfurt DAX 2427.07 - 6.84 - 0.28
Hong Kong Hang Seng 11364.46 + 164.27 + 1.47
Johanesburg J'burg Gold 1747 + 34 + 1.98
London FT 30-share 2738.7 - 10 - 0.36
London 100-share 3745 - 2.6 - 0.07
Madrid General Index 330.7 - 0.23 - 0.07
Mexico I.P.C. 2971.25 + 50.53 + 1.73
Milan MIBtel Index 9713 - 365 - 3.62
Paris CAC 40 1956.38 - 26.95 - 1.36
Singapore Straits Times 2401.79 - 20.88 - 0.86
S. Korea Composite 869.98 + 11.8 + 1.38
Stockholm Affarsvariden 1819 - 6.1 - 0.33
Taiwan DJ Equity Mkt 119.39 - 0.35 - 0.29
Tokyo Nikkei 225 Average 20943.59 + 159.36 + 0.77
Tokyo Nikkei 300 Index 302.36 + 1.53 + 0.51
Tokyo Topix Index 1617.41 + 7.18 + 0.45
Toronto 300 Composite 50059.69 + 14.38 + 0.29
Zurich Swiss Market 3266.1 + 6 + 0.18

p-Preliminary
na-Not available

Pension funds or passive approach investors, on the other hand, prefer to use the MSCI, FT or other
international indexes for the following reasons:

(1) Pension funds do not need up-to-the-minute indexes.

(2) The indexes on all stock markets are available in a central location.
(3) All MSCI or FT indexes are calculated in a single consistent manner, allowing for direct
comparisons between markets.

The choice of index is important. Although they are highly correlated, the difference in performance
between two indexes for the same market can be significant by as much as several points.

Example XI.3: In Graph XI.1 we plot two widely used market value-weighted German stock indexes from
December 1987 to December 2011. The pink line represents the MSCI index and the blue line is the DAX
index.

XI.6
 GRAPH XI.1
Local vs. International Index

German Indexes: DAX and MSCI

6000
5000
4000
3000 MSCI
DAX
2000
1000
0
Jan-88

Jan-90

Jan-92

Jan-94

Jan-96

Jan-98

Jan-00

Jan-02

Jan-04

Jan-06

Jan-08

Jan-10

Jan-12
In general, both indices move together, but not always. For example, in April 2000 there is slight departure
from the usual co-movement between the two EUR denominated indices. ¶

 What's in the Index?

The Nikkei 225 is Japan's most widely used index. This index is not a very reliable index. The
Nikkei 225 has many failings as a true indicator of market value.

The Nikkei 225 is practically unweighted, calculated by adding up the individual stock prices and
dividing by 225. The result means that Shimura Kako, a specialized nickel alloy processor with 29
employees and sales of USD 100 million, has the same weighting as Toshiba, the electronics giant
that employs 67,900 staff and generates sales of USD 32,000 billion. This lack of weighting has
significant implications. It makes it easy for the government or private institutions to manipulate the
index. They need only buy or sell small quantities of low liquidity stocks to drive the index up or
down. This is important, given the volume of trading in Osaka and Singapore of Nikkei 225 futures.

The Nikkei 225's constituents have barely changed since it was set up in 1950. The rules governing
the index emphasize the need for continuity, therefore, the 225 represents the Japan of the 1950s and
1960s. The obsession with continuity has excluded 17 of the 50 largest stocks on the first section of
the Tokyo Stock Exchange from the Nikkei 225. Maruzen, a bookseller with sales of USD 123
million is in the Nikkei 225, but Ito-Yokado, Japan's second biggest retailer with sales of USD
13,000 million and eight largest capitalized stock on the market, is not in the Nikkei 225.

It is true, that rules have been introduced in 1991 that permit stocks to be expelled on the grounds of
low liquidity, rather than simply bankruptcy or merger. But since 1993, only one company -Japan
Wool of Textile- has been withdrawn for liquidity. The liquidity criteria for inclusion leads to some
strange entrants. For example, Asahi Bank entered the 225 in 1998, but not its bigger rivals

XI.7
Industrial Bank of Japan and Tokai Bank. One European broker suggested that Asahi's entry might
reflect the better than expected performance of Asahi.

The Nikkei has responded to these criticisms by creating the Nikkei 300 index, which is weighted
and its constituents are based on market capitalization. Source: Financial Times, October 19, 1998.


1.C Stock Index Futures and Options: Hedging Market Risk in International Markets

In Chapters VI to VIII we studied different hedging techniques. Our goal, in those chapters, was to
hedge currency risk. Now, we will learn how to use stock index futures and options to hedge the risk
in a well-diversified portfolio.

1.C.1 Stock Index Futures

In the Review Chapter we studied that the relation between the return on a portfolio of stocks and the
return on the market can be summarized by ß. When ß=1, the return on the portfolio tends to change
one-on-one with the market. When ß<1 (ß>1), the excess return on the portfolio tends to be smaller
(greater) that the excess return on the market.

Suppose we want to hedge against changes in the value of a portfolio during a period of time, T-t.
Define
rp: return of USD 1 invested in the portfolio.
rm: return of USD 1 invested in the market index.
St: current value of the portfolio.
Ft: current value of one index futures contract at time t.
N: Optimal number of contracts to short when hedging the portfolio.

The value of one contract, Ft, is the futures price multiplied by the contract size. In the case of the
S&P 500 futures contract, one contract is on 250 times the index. That is, USD 250 per full index
point. In the case of the FT-100, traded in LIFFE, one contract is on GBP 25 times the index.

Example XI.4: On November 24, 1995, the Financial Times published the following futures quotes for the
FT-SE 100 index.

FUTURES AND OPTIONS

FT-SE 100 INDEX FUTURES (LIFFE) 25 per full index point

Open Sett price Change High Low Est. vol Open Int.
Dec 3463.0 3610.0 -34.0 3643.0 3605.0 5269 64944
Mar 3663.0 3634.0 -33.5 3663.0 3634.0 685 8971
Jun 3640.0 -34.0 0 134

For example, the value of the Dec 1995 FT-SE 100 futures contract is
GBP 25 x 3610.0 = GBP 90,250. ¶

XI.8
From the definition of ß, it is approximately true that

rp =  + ß rm,

where  is a constant. The change in the value of the portfolio between times t and T is Srp or

S  + ß S rm.

The change in the value of one futures contract price during this time is approximately Frm. The
uncertain component of the change in the value of the portfolio is therefore approximately ßxS/F
times the value of one futures contract. Therefore,

N = ß x S/F.

 Zero beta, but there is still risk

This hedge creates a situation where the stock position is indifferent to changes in the market
portfolio. That is, the beta has been reduced to zero. Risk, however, exists as long as the underlying
position does not perfectly correlate with the market index. 

Example XI.5: On November 24, 1995, Mr. Hill, a U.S. portfolio manager, has invested GBP 4 million in a
U.K. mutual fund. He feels very comfortable with the medium and long-run perspectives of the U.K. stock
market, but he forecast that the U.K. market will not do very well in the next four months. He decides to hedge
the U.K. position using a March 96 FT-SE 100 index futures contract. The current futures price (see Example
XI.4) is 3663.0 and the ß of his portfolio is 1.3. The value of one futures contract is GBP 91,575. The number
of futures contracts to short is

N = 1.3 x 4,000,000/91,575 = 56.78 (or 57 contracts.) ¶

A stock index hedge, if effective should result in the hedger's position growing at approximately the
risk-free interest rate (in Example XI.5, the U.K. risk-free interest rate).

1.C.1.i Changing Beta

Stock index futures can be used to change the beta of a portfolio. Consider the situation in Example
XI.5. To reduce the beta of the U.K portfolio from 1.3 to 0, we needed to sell 56 contracts. To reduce
the beta to 1.0, it is necessary to short (56.78 - 43.68) 13 contracts; to increase the beta from 1.3 to
2.6 a long position in 57 contracts is needed; and so on.

In general, to change the beta of the portfolio from ß to ß1, where ß > ß1, a short position in

(ß - ß1) x S/F

contracts is needed. When ß < ß1, a long position in

XI.9
(ß1 - ß) x S/F

contracts is needed.

1.C.2 Stock Index Options

The value of a stock index options is equal to the stock index price multiplied by the contract size. In
the case of the S&P 500 index option, traded at the CBOT, the contract size is USD 100. The S&P
500 stock index option is European. The S&P 100 stock index option, also traded at the CBOT, has a
contract size of USD 100 and it is American. LIFFE trades stock index options on the FT-SE 100
index. LIFFE offers American and European contracts. The contract size for the FT-SE 100 is GBP
10. All contracts are settled in cash.

Stock index options are routinely used to hedge market risk. For example, put options are used to
buy portfolio insurance. We will derive the number of contracts needed to buy portfolio insurance.

Suppose a manager decides to put a floor on the value of her portfolio. Assume that the value of her
portfolio is perfectly correlated with the stock index.

Notation:
St = value of portfolio,
Indext = Value of the index at time t,
N = number of options,
Floort = floor on the value of portfolio set at time t,
X = strike price,
m = contract size (multiplier),
p = option's premium.

Given the above assumptions, we have that

St = a + b Indext.

If at time T, the index is lower than X (IndexT < X), the manager wants to select N such that the
value of the new portfolio -i.e., value of St plus the value of N options- is never lower than the floor.
That is,

b IndexT + N m (X-IndexT) - N m p  Floort.

The first term represent the value of the portfolio at time T. The second term represents the value of
the N put options in-the-money at time T. Finally, the third term represents the cost of the N put
options.

The goal of the manager is to select N. Now, we rewrite the above equation as:

(b - N m)IndexT + N m (X-p)  Floort.

XI.10
Note that if (b - N m)=0, then the value of the portfolio is independent of market fluctuations at time
T. That is, IndexT has no influence on the value of the portfolio. Therefore,

N = b/m.

If IndexT < X, the options expire worthless and the value of the overall portfolio is:

b IndexT - N m p  Floort.

If the portfolio and the market index are not perfectly correlated, the use of index options only
provides partial insurance. In this, more realistic, case we should adjust N by the beta of the portfolio.
That is, the number of contracts used to hedge market exposure is given by: ß x b/m.

 Futures and Options Hedge against the Market

The portfolio is insured against movements on the market, not against movements of the stocks in
the portfolio. 

Example XI.6: It is January 2, 1997. Today, the FT-SE 100 closed at 4060. Ms. Howe manages a British
portfolio valued at GBP 12 million. Ms. Howe's portfolio has ß=.93. She is concerned about a possible drop of
the British market during the next two months. She does not want the value of her portfolio to drop below
GBP 10 million. That is, Ms. Howe is interested in buying insurance such that the floor for her portfolio is
GBP 10 million. She decides to use FT-SE 100 index put options to establish this floor. On January 3, 1997,
the March put option with a strike price of 4,000 is trading at 69. That is, the cost of each contract is: 69 x
GBP 10 = GBP 690.

Using historical data, Ms. Howe has estimated that b = 2790.

Ms. Howe wants to determine the number of options to hedge her exposure.

N = .93 x 2790/10 = 259.47

Now, we want to check if the floor really works. Suppose that in March, IndexM = 3,500.

Then the value of her portfolio is:

N m (X-m p)  Floort.
259.47 x 10 (4000 - 69) = GBP 10,199,765.70  Floort = GBP 10,000,000.

If in March, IndexM = 4500, then

2790 4500 - 259.47 x 10 x 69 = GBP 12,375,965.70  Floort = GBP 10,000,000.

The total cost of this floor is GBP 690 x 259.47 = GBP 179,034.30 (1.50% cost relative to amount insured).¶

II. Market Microstructure

2.A Basic Organization

XI.11
The typical organization for a stock market is the private stock exchange model. Private stock
exchanges are founded by independent members for the purpose of trading securities. A typical
example of the private stock exchange is the New York Stock Exchange (NYSE). There might be
several private stock exchanges in a country and they may compete with each other. The multiple
private stock exchange structure is observed in the U.S., Japan, and Canada. In other countries, like
the U.K., Mexico, and Taiwan, one leading exchange has emerged through either attrition or
absorption of its leading competitors.

The exchanges are private, but they are subject to public regulation. The mix of self-regulation and
government supervision is oriented more toward self-regulation. Private exchanges often require
members to perform all of their transactions on the floor of the exchange. Commissions are either set
by the exchange or imposed by the public authority. In many countries, commissions are fully
negotiable.

Another organizational model for stock exchanges is the public stock exchange. This structure was
created in France, using the Napoleon legal code. This structure gives the brokers, who are
appointed by the government, a monopoly over all transactions. Brokerage firms are private and new
brokers are proposed to the state for nomination by the broker's association. Many European stock
exchanges were organized under this model. The stock exchanges of Paris, Athens, and Madrid,
among others, used this model.

Some countries have organized their stock exchanges around banks. Under the bankers stock
exchange, banks are the major securities traders. The SWX Swiss Exchange is a typical example of
a bankers exchange. The seventy-six members of the SWX are all banks, a quarter of them foreign.
Some of the members are “remote members.” These remote members are foreign banks with no
physical presence at the exchange. Bankers exchanges may be either private or semipublic
organizations. Bankers exchanges are found in the German sphere of influence: Austria,
Switzerland, and Scandinavia.

During the last twenty years, deregulation and competition from other stock exchanges have
progressively affected all public exchanges. Today, the majority of the exchanges have been
reorganized following the private stock exchange model. For example, the Borsa Italiana S.p.A., the
group leader and responsible for the organization and management of the Italian stock exchange.
The company, founded in 1997 following the privatization of the exchange, is responsible for
defining and organizing the functioning of the markets; defining the rules and procedures for
admission and listing on the market for issuing companies and brokers; managing and overseeing
the market; supervising the listed companies' disclosure. The Borsa Italiana's primary objective is to
ensure the development of the managed markets, maximizing their liquidity, transparency and
competitiveness and at the same time pursuing high levels of efficiency and profitability.

 Privatization of a Stock Exchange: The Athens Stock Exchange

The Athens Stock Exchange (ASE) was established in 1876, by the issuance of the first Stock
Exchange Law based on the French Commercial Code. Stock Exchange began to operate as a self
regulated public institution. Later, in 1918, Law 1308 set up ASE as a public entity

XI.12
In early 1994, a series of laws were approved to modernize the ASE. In 1995, Law 2324
transformed the ASE into a joint stock company, supplemented the listing regulations, allowed over
the counter (OTC) transactions and short selling (under specific circumstances). The Law 2324
defined the conditions for the disposal of shares through private placement, broadened the scope of
activities of brokerage companies, allowed remote brokering, deregulated commissions and
introduced amendments to the Capital Markets Commission regulations. Finally, in 1997, Law 2533
provided the legal framework for the privatization of the ASE. The same Law created three new
markets, the derivatives market, the parallel market for emerging markets and the market for fixed
income securities.

Today, the ASE is owned by a holding company called Hellenic Exchanges S.A. (HELEX)
established and listed on ASE in March 2000. 

A more recent development is the transformation of many exchanges --e.g., the Paris Bourse,
Deutsche Börse, Athens Stock Exchange (ASE) and Australian Stock Exchange (ASX)-- into
business organizations. They are adopting corporate-type ownership and governance, segmented
markets and performance-driven organizational structure and culture. For example, on March 15,
2000, the London Stock Exchange’s (LSE) shareholders voted to demutualize and, thus, enable the
exchange to become a public company. A month later, shares of LSE started to be traded at the LSE.
In March 2006, the NYSE also went public, trading under the tick symbol NYX.

On December 6, 2002, the Chicago Mercantile Exchange (CME) -the largest U.S. futures exchange-
listed on the NYSE, becoming the first U.S. financial market to go public. Similarly, in 2005, the
Chicago Board of Trade (CBOT), also went public.

Exchanges are competing for listings with one another like businesses. Competition and
technological change have created the conditions for consolidation and cooperation agreements in
the stock exchange industry around the world. Since the late 1990s, there has been a big wave of
consolidation among stock exchanges.

In June 1999, the four French market operators (SBF, Matif SA, Monep SA, and Société du
Nouveau Marché) merged to form a single entity, Paris Bourse. Later, in September 2000, the
Amsterdam Exchange (AEX), the Brussels Exchange (BXS) and the Paris Bourse merged to form
the first European exchange Euronext N.V. Euronext became the first fully integrated cross-border
single currency stock, derivatives and commodities market. In January 2002, Euronext acquired the
London International Financial Futures and Options Exchange. Almost immediately, in February
2002, Euronext merged with the Lisbon Stock Exchange (BVL). Years later, in May 2006, NYSE
agreed to buy Euronext NV for USD 10 billion. This purchase created the first transatlantic stock
market, which became NYSE Euronext. In 2008, NYSE Euronext but the old American Stock
Exchanges for USD 260 million in stock.

In January 1998, Stockholmsbörsen (OM) and the Copenhagen Stock Exchange (KFX) signed a
cooperation agreement to form NOREX, a common Nordic equity market. Although the OM and the
KFX remain independent, they allow cross-membership and use a single buy-and-sell order book for
each security. NOREX has also adopted common trading rules and a uniform trading platform,

XI.13
SAXESS -Stockholmsbörsen’s trading engine. In 2000, the Iceland Stock Exchange (ISX) and the
Oslo Exchange joined NOREX. In another Nordic consolidation move, in September 2003, the OM
and HEX (Helsinki Exchanges) merged and formed OMX group. Immediately, OMX bought KFX
for DKK 1.2 billion. In 2006, OMX also bought ISX for SEK 250 million. On February 27, 2008,
after long and complicated negotiations also involving LSE and the Dubai Burse, OMX was
purchased by NASDAQ. The expanded NASDAQ was renamed the NASDAQ OMX group. In
2011, NASDAQ OMX tried to buy NYSE Euronext for USD 11.2 billion. NYSE's board twice
rejected the NASDAQ OMX’s unsolicited offer in favor of a European Commission blocked merger
with Deutsche Boerse.

In 2007, the biggest deal in a global consolidation of the financial exchanges was the blockbuster
merger which saw Chicago Mercantile Exchange Holdings buying its smaller rival CBOT
Holdings Inc. for about USD 8 billion, giving the new company a then record book value of USD
26 billion. These deal followed the decision by the CME and the CBOT to go public. Previous
attempts at merging had been stonewalled by floor-traders, who once owned both exchanges. The
new entity was renamed CME group. Two years later, in August 2008, CME group bought
NYMEX Holdings for USD 8.9 billion.

In December 2007, the Toronto Stock Exchange (TSX Group) agreed to merge with the Montreal
Exchange (MX) in a CAD 1.3 billion deal that created an integrated, multi-asset class execution
venue for equities and derivatives in Canada. Toronto was the main cash equities market, while
Montreal was the main derivatives market in Canada.

Trying to keep up with NYSE’s expansion, LSE has had its share of acquisitions and attempted
mergers. In 2007, it acquired Milan-based Borsa Italiana fro USD 2.5 billion, though, LSE agreed
to keep the two exchanges separated, and MTS (Mercato dei Titoli di Stato), the Italian fixed
income exchange. In 2011, LSE agreed with Canada’s TMX to a USD 3 billion all-share merger,
but TMX shareholders did not agreed to the deal.

2.B Differences in Trading Procedures

Besides the legal environment, numerous differences are found in the operation of national stock
markets. The most important differences are in the trading procedures.

2.B.1 Cash versus futures markets

The terms cash and forward refer to the settlement of stock exchange transactions. An investor buys
securities and the seller sells securities, but the buyer will have to pay for the securities she bought
and the seller will have to deliver the securities he sold. On both markets, this settlement is executed
in a different way. On the cash market, an executed order has to be settled soon after the execution
of the order. For example, at the NYSE, transactions must be settled in three days after execution.
This means the investor has a maximum of three trading days to pay/deliver the securities traded on
the NYSE. On the forward market, all orders of the same fortnightly period are executed soon after

XI.14
the closing of this fortnightly period. For example, at the Brussels Stock Exchange (BXS) forward
transactions are settled within four days of the carry over day.

Most stock exchanges are organized as cash markets, and transactions must be settled within a
couple of days. In some countries, such as Germany and Japan, trading in forward and futures used
to be explicitly forbidden.

To allow more leveraged investment, margin trading is available on many cash markets such as
those of the U.S., Canada, Japan, and Switzerland. In margin trading, the investor borrows money
from a broker to finance a transaction. Margin trading, however, is costly compared to trading on an
organized futures market because private contracts must be arranged for each deal. This is still a
cash market transaction and delivery of the shares takes place immediately; however, a third party
steps in to lend money (shares) to the buyer (seller) to honor a cash transaction commitment.

In contrast, futures or forward stock markets provide an organized exchange for levered stock
investment. The Paris Bourse is an example of a forward market. A deposit is required to guarantee
a position, as on most forward markets. Some of these forward stock markets, such as those in Rio
de Janeiro and the Far East, have sprung up quite recently as competitors to old cash stock markets.

Some stock exchanges have both forward and cash markets. For example, at the Brussels Stock
Exchange (BXS) large firms are traded on a forward market basis, while medium and small firms
are traded on a cash market basis. That is, the BXS market is split up into two segments on the base
of the liquidity or the negotiability.

2.B.2 Fixed versus continuous quotation

U.S. investors are accustomed to a continuous market, where transactions take place all day and
where large market-makers assure market liquidity at virtually any point in time. In some markets,
the market maker has a monopoly for a given security, as is the case for the specialist on the NYSE.
In other markets, the market makers, also called dealers or jobbers, compete with one another. An
example of a dealership market is the London Stock Market. The client will turn to the market
maker who provides the best bid-ask quote. Market makers adjust their quotes continuously to
reflect supply and demand conditions.

In other countries, an asset is traded only a few times per day and its price is determined through a
competitive auction system. This is known as a call or fixing market, where a single price applies to
all transactions. The call system is used in markets where there is not enough liquidity to support a
continuous system. In most of the continuous markets, a call auction system is used to determine the
opening price at the start of the sessions (for example, Tokyo Stock Exchange, NYSE, and Buenos
Aires Stock Exchange).

The increased volume of transactions as well as computerization has made continuous trading easier
to implement. The 1990s wave of modernization of stock exchanges around the world has caused
the pure call systems to disappear. The Tel-Aviv Stock Exchange (TASE) abandoned the pure call
system by the end of 1997, and replaced it with an electronic continuous trading system. In many

XI.15
markets we find a mixture of call and continuous trading. The Wiener Börse (Vienna Stock
Exchange) uses the continuous system for the most active securities, while a call system is used for
the less active securities. Similarly, the BSX offers two price fixings (“semi-continuous system”) a
day for the less liquid stocks.

2.B.3 Computerization

An important component of the modernization of trading systems implemented by most of the

exchanges around the world has been a change toward a higher degree of automation. Trading on a
floor where participants noisily meet is progressively being replaced by computerized trading.

At the NYSE and other exchanges, floor traders, however, execute all the orders, according to a set
of rules, specified by the exchange. This set of rules can easily be entered into a computer program
and an electronic exchange is born. Thus, in an electronic exchange, the need for floor traders
disappears. In the simplest form of an electronic exchange, when bid and offer prices match, orders
automatically execute against one another on screen, bringing increased speed and efficiency to
the market. It has been shown that electronic exchanges deliver significant cost savings to
investors. At the LSE, an independent study by The Plexus Group has shown that, since the
introduction of the electronic order book (STS), the cost of trading for institutions in the U.K.
equity market has more than halved, from an average of 60 basis points to 25 basis points.

A trade execution function is an algorithm that performs order matching according to a set of rules
governing priority of submitted bids and offers. The priority rules determine the place of a bid or
offer in the queue awaiting execution. A match occurs under several circumstances, depending on
the design of the system. The best price is the highest priority on almost all systems. Almost all
systems have a time priority, which means first in, first out. Time, however, refers to time at a
particular price, not time in the system. Some systems also have priorities based on size, order type,
trader class, display, etc.

There are several examples of completely automated trading systems. The Computer Assisted
Trading System (CATS) developed by the Toronto Stock Exchange (TSE) allows the automated
execution of orders entered by traders in their office. It is a system well adapted to auction markets
without market makers, and CATS has been adopted by many foreign markets (Paris, Tokyo,
Madrid, Taiwan, etc.). The CATS system eliminated the need for a floor where participants meet.
Several markets have adapted the CATS system to their special needs and/or priorities. The
improvements made by the Paris Bourse to CATS, renamed CAC, were so attractive, that in 1996
the TSE bought the Paris Bourse’s CAC system. The new TSE system now is called TOREX.

In the U.S., the National Association of Security Dealers has developed an electronic system known
as SOES, which allows the electronic execution of small orders. The SOES system works alongside
the trading floor. In London, in October 1997, the electronic order book (STS) was introduced to
replace a competing quote-driven market maker system. The order book includes the FTSE 100,
the most liquid FTSE 250 securities, equities that have a LIFFE traded equity option and Irish
stocks traded in euro. London has implemented a NASDAQ-type system called SEAQ, which also
allows the electronic execution of small orders and non-STS transactions. The SWX Swiss

XI.16
Exchange has developed the first electronic trading platform, which integrates trading, clearing and
settlement. A single mouse-click initiates trading, payment, settlement and confirmation.

In Table XI.3 we present a list of the main fully automated stock and bond exchange.

TABLE XI.3
Some automated stock and bond exchanges
System (exchange) Date Hours Securities Country
SEATS (ASX) 1987 Day All ASX listed stocks Australia
TOREX (TSE) 2000 Day All TSE listed stocks Canada
MORRE (ME) 1990 Day All stocks Canada (Quebec)
SAXESS (NOREX) 1999 Day Listed CSE and SSE stocks and bonds Denmark, Sweden
CAC (Paris) 1986 Day All stocks, most bonds France
XETRA (FWB) 1997 Day All stocks, 370 bonds, 23 warrants Germany
HKTS (SEHK) 1993 Day SEHK listed stocks Hong Kong
GTB (Milan) 1991 Day Most stocks Italy
CORES (TSE) 1982 Day TSE listed stocks Japan
STS (OSE) 1991 Day 1,099 OSE stocks Japan
SENTRA Capitales (BMV) 1996 Day Listed stocks, bonds Mexico
CLOB (SSE) 1987 Day SSE, HK listed stocks Singapore
SIB (SSE) 1991 Day 116 stocks Spain
SWX (SWX) 1995 Day All securities Switzerland
STS (LSE) 1997 Day most liquid listed stocks UK
BEACON (BSE) 1987 Day Stocks trade over ITS USA
NSTS (CSE) 1985 Day 425 stocks (2,700 capability) USA
MAX (MSE) 1981 Day Exchange listed stocks USA
ABS (NYSE) 1976 Day Bonds USA
OHT (NYSE) 1991 Night NYSE stocks USA
SCOREX (PSE) 1969 Day Listed stocks USA
PACE (PHLX) 1976 Day Listed stocks USA
MAX-OTC (MSE) 1987 Day OTC stocks USA
OLS (NYSE) 1986 Day Odd lots for NYSE listed stocks USA
SOES (NASD) 1985 Day NASDAQ stocks USA

XI.17
There are more than 50 automated systems that trade stocks, futures and options. These can be
classified according to the degree in which the price discovery process has been automated. Ian
Domowitz, in a paper published in the Journal of Financial Services Research in 1992, describes
seven levels of automation.

vi. Level 1: Exogenously determined prices.

These are systems, which determine their transaction prices by taking them directly from a trading
floor or telephone market operating in tandem. Though trade matching is still executed according to
time and order priorities, the price discovery system per se cannot be considered as automated.
SOES is an example of this type of level of automation.

ii. Level 2: Exogenously determined prices with price improvement algorithm.

In these systems, transaction prices are also taken from a trading floor. A computer code, however,
assesses market conditions and assigns improved prices. The treatment of stopped orders in the
Midwest Stock Exchange's Enhanced SuperMax rules can be presented as an example since stopped
orders are assigned different prices than the stop price, depending on expected price movements in
the NYSE.

iii. Level 3: Systems with negotiation capability.

Some automated systems allow traders to advertise their quantities without price specification in
order to motivate negotiation. SOFFEX, the electronic system of the SOFFE (Swiss Options and
Futures Exchange), presents this level of automation.

iv. Level 4: Direct removal of quotes from the trading screen.

A trader, upon observing the bid-ask prices on the screen or the limit order book can access a trade
by pushing a button, executing the transaction at the best quote available on the screen. Orders are
not saved for a later execution at a different price. The GLOBEX system of the CME and the APT
system of the LIFFE are examples of this degree of automation.

v. Level 5: Automated continuous double auction.

Bids and offers are submitted in a continuous manner, transactions occurring when the orders cross.
The price discovery process is completely endogenous, within the context of certain priority rules.
These rules are set according to time, quantity, order type, and trader classification. The Madrid
Stock Exchange's electronic market is an example of this level.

vi. Level 6: Automated periodic single-price auction.

Bids and offers are accepted over some time interval and are then simultaneously executed at one
price. The execution price is calculated as the price that maximizes total trading volume. This
system is used by many of the automated continuous double auctions in order to determine their
opening prices. This system provides a very high degree of automation, since there is less human
interaction in the price discovery process. The price setting procedure only determines whether an
order will be executed and does not affect the probability of it being executed, as does a continuous
system which accepts limit orders and prioritizes them according to their prices. The SOM system of
the Swedish Options Market offers this level of automation.

vii. Level 7: Automated auction with pricing model.

XI.18
These systems match orders according to criteria other than price. The justification being that prices
may in fact not reflect changes in the underlying value of fundamentals, thus becoming "stale." The
SYCOM system of the SFE (the Australian Futures and Options Exchange) is an example of this
level of automation.

Domowitz also compares different automated and non-automated systems. He concludes that
automated trading systems exhibit less price volatility and a faster decline of standard deviation with
respect to market size. Liquidity, the size of the bid-ask spread, and depth (market's ability to absorb
quantity without an appreciable effect on price) seem to improve with automation. The introduction
of the SWX Swiss Exchange integrated electronic platform reduced the size of the bid-ask spread for
blue chips from .2% to .15%.

A higher degree of automation also has an impact on transparency and anonymity. Several authors
claim that the anonymity provided by automated systems is one of the main reasons for the success
of the off-exchange computerized trading systems currently competing against the NYSE (for
example, Instinet, Posit and Spaworks). The same reason is cited behind the implementation of a
London based off-exchange trading system.

As a result of the efficiency and transparency gains of electronic trading systems and the increased
international competition in the stock exchange industry, many stock exchanges have become
floorless exchanges. For example, the ASX (1990), Kuala Lumpur Stock Exchange (1992), the Paris
Bourse (1995), the Johannesburg Stock Exchange (1996), the Korean Stock Exchange (1997), the
Bombai Stock Exchange -Mumbai- (1997), and the Toronto Stock Exchange (1997) have chosen to
close the trading floor and became fully automated exchanges.

 The End of an Era

After 90 years of floor trading, on January 8, 1999, the last open outcry transaction (“viva voz”
transaction) was carried out in the floor of the Bolsa Mexicana de Valores (BMV), the Mexican
stock exchange. From January 11 on, all transactions are carried out through the computerized
system BMV-SENTRA Capitales. BMV-SENTRA Captiales is a totally decentralized and
automated system, which allows users to perform trades in real time through hundreds of computer
terminals interconnected by a network. The terminals are located in brokerage firm offices and
controlled by the Trading Control station at BMV. Transactions are closed or entered through on-
screen formats specifying issuer, series, amount and price of the securities the user wishes to buy or
sell.

A broker must send orders from the broker's headquarters to the Bolsa's central order book via the
electronic trading system for equities or BMV-SENTRA Capitales, where they are matched when a
similar but opposite order is received. 

2.C Internationalization

XI.19
To service international investors, securities firms have developed an international network of
offices. These networks provide an expensive medium for domestic investors to reach foreign
markets. A cheaper alternative for investors is to be able to access from their domestic markets other
international markets. With the advanced computerization of the major exchanges, accessing foreign
markets is very easy. There are no real technological impediments for cross-border automated
trading. The SWX Swiss Exchange allows its remote members to use the SWX electronic platform
from their home base. Xetra, the electronic platform of the Deutsche Börse, also takes orders from
any point in the globe, which then are automatically inputted into the order book on the central
computer.

Linkages of stock markets around the world (and around the clock) are becoming serious
alternatives. The main problem for linking national stock markets is the different sets of rules that
governed each market. Harmonization of trading rules and procedures is a tool that many stock
exchanges are using to become more competitive. In 1998, the OM Stockholm Exchange (OMX)
and the Copenhagen Stock Exchange (KFX) signed an agreement covering a common Nordic
exchange, NOREX. The OMX and KFX have thus implemented a cross-border trading system and a
common set of trading rules. The NOREX gives access to 80% of the Nordic equity market via one
joint electronic trading system, the SAXESS. The NOREX has expanded to include the Oslo Stock
Exchange (November 1999) and the Iceland Stock Exchange (March 2000).

In another example of linking different exchanges through a single trading platform, the Paris
Bourse, the AEX Amsterdam Exchange, and the BXS Brussels Exchange in March 2000 formed
Euronext, an integrated European stock exchange. Although the different jurisdictions and local
licenses of the individual exchanges are maintained, Euronext provides a single operating
umbrella for all three exchanges. Trading is centralized, and a uniform trading platform—the Paris
Bourse’s NSC trading engine—is used, allowing a single trade price to be established. Shares are
listed at a national level and companies can select their trading venue from among the three
exchanges.

True cross-border automated trading is also provided by the EURO.NM and by the EASDAQ. The
EURO.NM (NM stands for New Market) is a new stock exchange created to attract young, high
growth companies. The new market is a pan-European network of stock markets, with five
members: AEX Amsterdam Exchange, BXS Brussels Exchange, Deutsche Börse, Paris Bourse, and
Borsa Italiana. At the end of 1999, there were over 300 companies listed on the EURO.NM, with a
total market capitalization of over EUR 60 billion.

Competing with EURO.NM to attract high growth companies, the European Association of
Securities Dealers Automated Quotation (EASDAQ) offers a truly European stock market, governed
by a single legal system and subject to a single supervisory structure. EASDAQ is a screen-based,
quote-driven market, which uses a multiple market maker system similar to that used by NASDAQ
in the United States. EASDAQ has its own dedicated trading platform, which allows seamless
trading and settlement across the European Union. Trading on EASDAQ takes place through
EASDAQ's European members, currently situated in the U. K., France, Germany, the Netherlands,
Switzerland, Austria, Belgium, Portugal, Italy, Denmark, Finland, Greece, and Luxembourg. By the
end of 1999, the EASDAQ had over 50 companies listed, with a market capitalization of over EUR
20 billion.

XI.20
The best global reach is provided by INSTINET, which has terminals located around the world.
INSTINET is a proprietary automated trading system owned by Reuters.

 Exchange of the Future

Some experts believe that the best method would not be to join cooperative agreement with other
markets, but that stock exchanges should simply make their own automated trading system available
(i.e., cross-border automation) worldwide on a 24-hour basis. To be attractive, such a system
requires round-the-clock market makers and sufficient liquidity. Efficient clearing and settlement
procedures are also needed. 

III. Practical Aspects

3.A Dual-Listing

Multinational companies such as IBM or Sony are traded on many exchanges. The listing of the
same company in different exchanges is called dual-listing or cross-listing. Many European
exchanges have a large proportion of foreign listed companies. In 1998, Germany and Luxembourg
had more foreign companies listed than domestic companies. cross-listings have become
increasingly common in the U.S. For example, by the end of 1998, at the NYSE the number of
foreign listed companies grew to 391. This number represented nearly 170 more foreign companies
than at the beginning of 1996.

The procedure for admitting foreign stocks to a local market varies. In some markets the regulations
are quite lax. For example, as of 1986 the Quebec Securities Act allowed a foreign company to be
listed in Montreal simply by meeting the same regulatory requirements as those in its own
jurisdiction. In other markets, like the U.S., cross-listing means that foreign companies must satisfy
the local exchange and other regulatory requirements (which might be costly, for example,
producing quarterly reports in English).

Multiple listing implies that the share values of a company are linked on several exchanges. One
company should sell at the same share price all over the world, once adjustments for exchange rate
and transactions costs have been made. Arbitrage among markets ensures that this is so.

There are several reasons for being listed on several national markets. Cross-listings allows investors
from around the world to enjoy the benefits of international diversifcation by investing in a foreing
company. Greater market demand improves liquidity for the shares and might improve performance.
Entrenched management might like to have a diversified ownership, and, thus, reduce the risk of a
domestic takeover. Listing in international markets is a good advertising tool, especially for
emerging market companies. Cross-listing is also a signal that the company complies with disclosure
standards and good accounting practices.

XI.21
Double-listing has disadvantages. Foreign ownership might not be welcome by the local government
or by domestic residents and investors. The main disadvantage of dual listing, however, is increased
volatility.

Example XI.7: Bad political news in Chile has frequently been followed by an immediate outflow of
international capital, driving domestic share prices down in this illiquid stock market. Chilean shareholders
display less volatile behavior than foreign investors for two reasons: they are not as surprised by bad domestic
news; domestic controls and regulations give them few attractive investment alternatives. ¶

 Restricting Foreign Ownership

Many governments in both developed and developing countries often impose restrictions on the
maximum proportionate ownership of local firms by foreigners. In countries like India, Thailand,
and Mexico, for example, foreigners are allowed to control at most 49% of the outstanding chares of
local firms. In Switzerland, a local firm can issue two different classes of equity shares, bearer and
registered shares. Foreigners are often allowed to buy only bearer shares; only Swiss nationals are
eligible to buy registered shares. Chinese firms issue A share and B shares, and foreigners are
allowed to hold only B shares. 

3.A.1 American Depositary Receipts (ADRs)

In countries such as the U.S., the U.K., India, Singapore, and The Netherlands trading takes place in
special shares of the foreign company, depository receipts (DRs). Specifically, U.S. investors deal in
American depository receipts (ADRs). Depository receipts have been around since 1927, but their
popularity took off in the 1980s, propelled by investors globalizing their portfolios, and emerging
markets companies turning to the DR product in deregulated U.S. markets. European DRs were
created to be traded in London, Singapore DRs are traded in the Singapore Stock Exchange, and the
Continental DRs are traded in The Netherlands. More recently, the Global DRs (GDRs) were
created to meet the needs of European settlement systems (Cedel and Euroclear). DRs are
denominated and pay dividends in the domestic currency. They have become the most popular
vehicle for foreign companies to raise funds in the U.S. We will concentrate on the ADR market,
which is by far the largest.

As mentioned above, ADRs have a long history in the U.S. stock market. ADRs were invented by a
predecessor of Morgan Guaranty Trust Company of New York in 1927. These ADRs gave U.S.
residents the opportunity to invest in foreign securities without suffering the illiquidity and dividend
conversion expenses of direct foreign ownership. Initially, ADRs offered additional advantages:
reduction of the delay in transporting stock certificates, faster settlement and registration of
securities. The first ADR account to open was Selfridge Provincial Stores Limited. Another 17 ADR
accounts were opened around that time, three of them still survive: BAT Industries, Cortlaulds plc,
and The General Electric Co. plc. After the establishment of the original 18 ADR accounts, there
were no new ADRs created until 1955.

Note that by trading in ADRs a U.S. investor avoids the delays of trade settlement, the problems
associated with safeguarding the foreign stock certificates, and making currency transactions. No
additional tax burden is carried.

XI.22
Investment in ADRs is based on the performance of the underlying equities and their home markets
and home currency. The market value of an ADR reflects the current rate of exchange between the
U.S. and a foreign country and, taking transactions costs away, they trade at the same price that in
the foreign country. Trading on ADRs does not eliminate currency risk or country risk.

Example XI.8: If the British pound depreciates sharply, British Airways dollar returns will decrease, and
therefore, British Airways ADRs, trading in NYSE, will decline. Similarly, if there is political turmoil in
South Africa, it will be reflected in the DeBeers ADRs, which trade in NASDAQ. ¶

In 1995, there were more than 1,800 ADR programs available to U.S. investors, with a combined
market value of over USD 50 billion, representing companies from 58 countries. Originally created
to foster investment in European companies, ADRs came to be dominated by emerging market
companies. Therefore, even though most of the ADRs are large capitalization issues, there are an
increasing number of small capitalization issues, especially from Latin American countries.

The increasing number of ADR programs available to U.S. investors has been reflected on the
trading volume of U.S. equity markets. In 1991, purchases and sales of non-U.S. equities on the
NYSE, AMEX, and the NASDAQ totaled USD 267 billion, a figure, which had multiplied nearly
four-fold by 1996.

 Another investment vehicle: American Shares

American shares are shares of a foreign corporation issued directly to U.S. investors through a
transfer agent. The foreign corporation has to meet all S.E.C. regulations that apply to all listed U.S.
corporations. American shares are denominated in the currency of the foreign company; dividends
and capital gains are received in foreign currency. Many investors find American shares to be
inconvenient because they trade and pay dividends in the foreign currency. American shares have
low liquidity in the U.S. and, generally, are held by large investors. 

3.A.1.i The mechanics of ADRs

Under an ADR program, foreign shares are deposited with a U.S. bank or U.S. trust company that, in
turn, issues ADRs in the name of the foreign company. That is, for U.S. investors, ADRs are receipts
for stocks of specific foreign companies issued by U.S. banks and trust companies. A U.S. or foreign
bank holds the actual stock in a custodial account, receives dividends and converts them to dollars,
pays any foreign taxes, and passes the net amount on to the investors. These ADRs may trade freely,
just like any other security, either on an exchange or in the over-the-counter market, and can be used
to raise capital.

To avoid unusual share prices, ADRs may represent a combination or a fraction of several foreign
shares. For example, Japanese shares are often priced at only a few yen per share. They are therefore
combined into lots of 100 or more so that their value is more like that of a typical U.S. share price.
On the other hand, an ADR on a German stock may represent one-fourth of a share.

XI.23
On the depository side, three institutions --Bank of New York, Citibank and JP Morgan-- hold more
than 95% of the action. In the first six months of 1995 Bank of New York held an 81% share of new
ADR public U.S. offerings, against Citibank's 13% share. Citibank, on the other hand, has the more
actively (and liquid) traded ADRs.

3.A.1.ii Types of ADRs

There are two kinds of ADR facilities: sponsored and unsponsored. A sponsored ADR facility is
created pursuant to a deposit agreement between the issuer of the foreign security, the depositary,
and the holder of the ADRs. Unsponsored ADR facilites are created by a depositary alone and the
only document consists of the ADRs issued by the depositary. Once a depositary has created an
unsponsored ADRs, it is common practice for other deposiataries to copy it, creating duplicate
unsponsored ADR facilities. Sponsored facilities are exclusive to one depositary and cannot exist
simultaneously with unsponsored ADRs because sponsored and unsponsored ADRs trade at
different prices. The price is different because in sponsored ADR facilities the issuer reimbursed the
depositary for its expenses in disbursing dividends to ADR holders, while in unsponsored ADR
facilities ADR holders themselves bear such expenses.

Exchange listed ADRs are traded and quoted on stock exchanges (NYSE, the American Stock
Exchange (AMEX), and NASDAQ). In 1995 there were 316 listed ADRs, with a share trading
volume of almost 11 billion shares.

Unlisted ADRs include such variations as OTC Level I, Regulation S and Rule 144-A offerings.

OTC Level-I is the simplest way for a foreign company to access U.S. and non-U.S. capital markets
by allowing trading over-the-counter and on some non-U.S. exchanges. Level Is, commonly known
as pink sheets, are the fastest-growing segment of the DR business. A Level I ADR does not have to
comply with U.S. GAAP, it is not compelled to make a full disclosure to the S.E.C. Many
companies involved in OTC Level I programs, however, ultimately upgrade to Level II or Level III
programs, which mandate greater regulatory compliance in exchange for more visibility and
attractiveness to investors. OTC Level II ADRs are used by foreign companies that wish to be listed
on a U.S. exchange. OTC Level III ADRs are used by companies that wish to raise capital in the
U.S. through an equity offering.

Regulation S ADRs are programs that trade outside the U.S. among non-U.S. investors.

Rule 144-A (RADR) are ADRs that are privately placed in the U.S. They are allowed under Rule
144-A adopted by the S.E.C. in 1990. Rule 144-A greatly increased the liquidity of privately placed
securities by allowing qualified institutional buyers (QIBs) to resell these securities to other QIBs
without the earlier requirement of a three-year holding period. QIBs included institutions that
manage at least USD 100 million in securities and registered broker-dealers that own and invest on a
discretionary basis at least USD 10 million in securities of non-affiliates. The first Russian ADR was
a Rule 144-A program by Mosenergo, brought to market by Salomon Brothers in October 1995.

XI.24
Note that ADR programs can be terminated. When a company decides to terminate the Depositary
Agreement, ADR holders are given the choice of surrendering the ADRs –i.e., liquidating the shares
and receiving market values minus some fees- or request delivery of the underlying shares –i.e.,
retaining the shares, traded in the company’s home market. On January 28, 2015, The Bank of
Ireland (ticker symbol, NYSE:IRE) decided to terminate the ADR program, with an effective
termination date of April 22, 2015. Shareholders were given until April 22, 2016 to make a decision
regarding their shares, to surrender or to keep them.

In Table XI.4 we present a selected group of ADRs.

TABLE XI.4
Market Capitalization of Selected Major Foreign Stocks traded as ADRs

AUSTRALIA
BHP Billiton (NYSE:BHP) USD 22.151B
News Corporation (NYSE:NWS) USD 31.510B
BRAZIL
Companhia Vale do Rio Doce (NYSE:VALE) USD 3.19B
FRANCE
Total Fina Elf S.A. (NYSE:TOT) USD 98.37B
L'Oreal S.A. (OTC:LORLY) EUR 43.23B
PSA Peugeot Citroen S.A. (OTC:PEUGY) EUR 10.26B
GERMANY
BASF Aktien (NYSE:BF) USD 23.71B
Bayer Aktien (NYSE:BAY) USD 22.90B
Deutsche Bank AG (NYSE:DB) USD 36.02B
Siemens Aktien (NYSE:SI) USD 50.27B
JAPAN
Canon Inc (NYSE:CAJ) USD 26.98B
Fuji Photo (NasdaqSC:FUJIY) USD 15.57B
Honda Motor (NYSE:HMC) USD 18.66B
Toyota Motor (NYSE:TM) USD 90.65B
MEXICO
Turbo Aceros de Mexico S.A. (AMEX:TAM) USD 653.5M
Telefonos de Mexico (NYSE:TMX) USD 25.96B
NETHERLANDS
Heineken N.V. (OTC:HINKY) EUR 14.11B

XI.25
 Royal Dutch Petroleum (NYSE:RD) USD 106.0B
SWEDEN
LM Ericsson Telephone Co. (NasdaqNM:ERICY) USD 33.63B
Note: Market Capitalization as January 2002.

 NYSE and the ADR Market

In 1997, the NYSE listed nearly 3,000 companies. Of those companies, 326 are foreign companies.
Non-U.S. trading volume amounted to nearly a tenth of total volume traded on the NYSE in 1996.
This number is consistent with the so-called “home bias” in domestic portfolios, which will be
discussed in Chapter XI. U.S. institutional investors are now moving their holdings of non-U.S.
equities up to about 15-20 percent of their portfolio. This number still leaves a lot of room for further
expansion: the U.S. economy accounts for only a fifth of world gross product and for well under half
of the total value of the world's equity markets. The NYSE plans to grow by taking advantage of this
probable expansion of U.S. investment in foreign equities.

According to the NYSE, there are only 700-750 U.S. companies, which meet the NYSE's listing
requirements and are not already trading on the exchange. If NYSE got them all to sign up, the
market's total value would rise by less than 10 percent. By contrast, around 2,300 foreign companies
meet the NYSE's listing requirements. If the NYSE could persuade the largest third of these to sign
up, its market valuation would increase by more than two-thirds. In order to make the NYSE more
global in character, the exchange has committed itself to trading in decimals rather than fractions
over the next few years.

NYSE officials talk about a world, a few years in the future, in which their market will be trading on
a global clock, in global currencies and in international securities other than today's ADRS. 

3.B Exchange Traded Funds (ETFs)

One of the most successful financial instruments introduced in the past 25 years is the exchange-
traded fund (ETF), also known as exchange traded products, or (ETP). ETFs are like open-ended
mutual funds except that they can be bought and sold on an exchange like ordinary stocks.
Investors can purchase or sell them through their brokers during trading hours. An ETF holds
assets such as stocks, commodities, or bonds. Most ETFs track an index, such as the S&P 500, the
MSCI EAFE or the MSCI Switzerland.
Relative to mutual funds, ETFs are an attractive investment tool because of their low costs and
stock-like features. The growth of ETFs has been phenomenal, as illustrated in Graph XI.2. Since
the launch of the first ETF in 1993, the ETF industry has grown to over USD 2.4 trillion in assets
with over 5,700 ETFs available around the world in just 20 years –USD 1.7 trillion across over
1,500 products, as of December 2013.

XI.26
 GRAPH XI.2
The Growth of ETFs

3.B.1 ETFs: Mechanics

ETFs are similar to traditional mutual funds. They offer investors an undivided interest in a pool
of securities and other assets. But, unlike traditional mutual funds, shares in an ETF can be bought
and sold throughout the day like stocks on a securities exchange through a broker-dealer. Unlike
traditional mutual funds, ETFs do not sell or redeem their individual shares at net asset value
(NAV). Instead, financial institutions purchase and redeem ETF shares directly from the ETF, but
only in large blocks, varying in size by ETF from 25,000 to 200,000 shares, called "creation
units". Purchases and redemptions of the creation units generally are in kind, with the institutional
investor contributing or receiving a basket of securities of the same type and proportion held by
the ETF, although some ETFs may require or permit a purchasing or redeeming shareholder to
substitute cash for some or all of the securities in the basket of assets.
The ability to purchase and redeem creation units gives ETFs an arbitrage mechanism intended to
minimize the potential deviation between the market price and the NAV of ETF shares. Existing
ETFs have transparent portfolios, so institutional investors will know exactly what portfolio assets
they must assemble if they wish to purchase a creation unit, and the exchange disseminates the
updated net asset value of the shares throughout the trading day, typically at 15-second intervals.
Closed-end funds are not considered to be "ETFs", even though they are funds and are traded on
an exchange. ETFs have been available in the US since 1993 and in Europe since 1999. ETFs
traditionally have been index funds, but in 2008 the U.S. SEC began to authorize the creation of
actively managed ETFs.

XI.27
3.B.2 ETFs: International Investments
Investors can use ETFs to invest in international markets. Many ETFs have as their underlying
tracking instrument an regional index or other financial product focused on a single country index.
They are usually well diversified and designed to reflect the overall economic condition of the
country itself. The underlying index chosen is often the major index of the principal exchange
within the country. In the U.S., the NYSE has over 40 ETFs tracking an international index, while
NASDAQ has 35. In the Hong Kong SE, there are over 20 ETFs tracking international indexes.
Domestic investors choose international-based ETFs for several reasons. They wish to diversify
their portfolio, by holding a broadly based portfolio of shares from a country without having to
directly purchase shares within the country. They may also look for the extra yield in international
markets. International-based ETFs allow them to do this with a smaller investment and less
complication than directly purchasing shares.

3.C Financial Analysis

Financial analysis in an international context is not an exotic field to domestic analysts. Analysts
should consider foreign variables into account to price domestic firms. The product markets in
which many domestic industrial companies compete are international. The methods and data used to
analyze U.S., Mexican, or Malaysian companies are quite similar. The analysis of a company should
produce two pieces of information: a measure of expected return and a measure of risk.

The expected return on an investment can be measured by a quantitative measure, such as a rate of
return, or by a qualitative measure such as buy or sell recommendations. On the other hand, risk can
be measured by a single number or by a sensitivity analysis that measures how much a company's
value responds to changes in key factors such as economic activity, currency volatility, general
market conditions and political stability.

3.C.1 The information problem

Financial analysts usually follow a two-step process to value a company. In the first step, based on
the financial statements of a company, analysts assess the overall strength of the company, along
with the company’s growth possibilities. On the basis of this analysis, analysts make forecasts of the
company's future earnings. At the end of this first step, analysts should produce a forecasts for the
company’s earning per share (EPS). In the second step, analysts try to predict how the stock market
will value these forecasts. That is, analysts emphasize the relative valuation of the company within
the stock market.) The traditional measures for this second step are the price-earnings (P/E) ratio and
the market-to-book (M/B) ratio. (The M/B ratio is also called price-to-book (P/B) ratio.) The P/E
ratio represents what the market is willing to pay for a unit of earnings, while the M/B represents the
market’s evaluation of the employed capital per share versus what the capital cost.

To do the above mentioned two-step process, analysts require a good amount of information. In the
U.S., information on companies is very easy to obtain. If you have access to the Internet, Edgar
Online will give you the quarterly and annual reports of any listed company. In international

XI.28
markets, however, we will be faced with two major information problems. The most important
problem in some markets is the lack of information or, at least, good information. The second
problem is related to the interpretation of the data.

3.C.1.i Quality of information

In the U.S., companies publish their quarterly earnings, which are publicly available within just a
couple of weeks. Before the official release, U.S. companies issue "early earning warnings" if the
quarterly results are significantly different from what analysts have been expecting. British and
Japanese firms publish U.S.-style financial statements. In contrast, some European and Far Eastern
firms only publish their earnings once a year. The vast majority of multinational and large domestic
firms tend to publish both in their local language and in English. Many reports, especially for small
firms, are only available in a company's local language.

Insider trading affects the quality of information publicly released to the market. Insider trading --
trading on non-public information that could affect a stock price-- makes a stock market
unattractive, especially to international investors. International investors want to know that they are
trading on a level playing field, that they have access to the same company information that local
investors do. In the well-established markets, strict rules severely punish insider trading and,
therefore, the information released by a company has a potential impact in the value of its stock. In
many emerging markets, insider trading is a real problem. International investors have pushed for
change in insider trading rules from South America to Southeast Asia. There is, however, still room
for improvement (see the box “Dealing with Insider Trading: South Africa” below).

Many international brokerage houses and banks compile reports and guides summarizing accounting
information for foreign firms. The reports often include non-accounting information such as earning
growth forecasts, expected returns on equity investment, and risk measures such as betas, which are
discussed below.

 Dealing with Insider Trading: South Africa

After ten years of political transformation, the Johannesburg Stock Exchange (JSE) has decided that
it, too, must change. The JSE was notoriously famous among international investors by its insider
trading. With a newly enacted law, the Insider Trading Act, South African regulators are after
insider traders. In the first year under the new law, the regulators have won six settlements with
insider traders. Under the old law, not once did South Africa ever win an insider trading conviction.
South Africa, however, has nothing like the American S.E.C.’s army of investigators and
prosecutors with the skills and resources to turn complicated investigations into viable prosecutions.
But, giving potential insider traders cause for concern is seen as a step forward in South Africa.
Source: The New York Times, May 11, 2000. 

3.C.1.ii Comparative analysis

XI.29
Accounting methods are different across countries. Most non-U.S. methods provide less information
to investors of what lies behind the figures a firm reports on profit statements and balance sheets. It
is usually uninformative to compare financial statements from different countries without making
adjustments for the different standards.

Example XI.9: Many companies in Japan and South Korea do not report profits and losses on a consolidated
basis, instead they hide losses among subsidiaries while reporting profits for the entire company.¶

Example XI.10: Mexican companies still use inflation accounting. They increase the value of the assets of
the company to keep up with inflation, but then they record a gain from that increase value. While in the U.S.,
many firms take advantage of increasing prices (inflationary conditions) by using LIFO (Last-In-First-Out)
for inventory valuation, which can distort (lower) net income. ¶

Example XI.11: Because the treatment of depreciation and extraordinary items varies so much among
countries, an analyst would probably double the net income of Swedish or Japanese firms, in order to make a
meaningful comparison to the corresponding figures for U.S. or British firms. ¶

But even where the same accounting methods are used, cultural, institutional, and tax differences
can make cross-country comparisons of accounting numbers misleading.

Example XI.12: Comparing Japanese and U.S. earnings figures or accounting ratios is meaningless. The U.S.
accounting standards are more conservative than the Japanese standards. Most large Japanese companies,
however, publish secondary financial statements in English that conform to the U.S. GAAP and audited by
major U.S. accounting firms. Institutional factors, however, make these U.S.-style statements difficult to
interpret. For example, financial leverage is high in Japan compared to the U.S., which does not mean that
Japanese firms are riskier. (Recall that, in Japan, banks and clients have a closer relation than their U.S.
counterparts). ¶

The following list presents the major differences in international accounting practices:
 Publication of consolidated statements
 Inflation accounting
 Depreciation rules
 Inventory valuation
 Publication of accounts corrected for fiscal distortion
 Currency adjustment
 Treatment of extraordinary expenses
 Existence of "hidden" reserves

Misunderstanding asset values and reported profits played a major role in the 1997 Asian crisis. The
lack of uniform accounting standards is costly. International banks and investors charge higher
interest rates to companies that do not adjust their books to U.S. standards. Moreover, many foreign
firms do not have access to international capital markets because their national accounting standards
distort valuations. Japan, for example, ranks below Spain and South Korea on access to international
capital markets. This very surprising fact is partially explained by the Japanese accounting methods.

XI.30
Cross-country research by Fan and Wong (2002) and Leuz et al. (2003) suggests that managers
smooth earnings to create opacity to allow expropriation of assets. To the extent that the
accounting system creates opacity and information asymmetry, it is likely to reduce the
willingness of investors to trade and, thus, to increase the liquidity premium. In their sample of 21
EAFE markets, Lang et al. (2009) estimate that moving from the 25th to 75th transparency
percentile is associated with a 40% decrease in the median bid-ask and a 17% reduction in the
number of non-trading days.

 Applied Corner: Pension Accounts

Japanese companies have assumed unrealistic capital gains for years for their pension accounts.
Now, corporate pension plans are greatly underfunded. In 1999, some experts estimate the pension
shortfall at USD 500 billion. This is a debt that companies will have to pay in the future.

Many European companies did not keep pension funds separate. They used the pension funds to
finance operations year in-year out. Now, many European firms are facing great liabilities. To
correct this problem, European companies are separating their pension accounts from the companies'
accounts, following the U.S. model. The U.S. model is governed by the Employee Retirement
Income Security Act or ERISA. In 1974, the U.S. Congress was worried that without separate
pension accounts, companies could go bankrupt and leave employees without a security net. Source:
Los Angeles Times, May 1999. 

3.C.1.iii Convergence

Bankers, investors, insurance companies, and pension funds are pushing for uniform international
accounting standards. In the past fifteen years, there has been an ongoing conversation about
converging accounting standards between the International Accounting Standards Board (IASB),
based in London, and the Financial Accounting Standards Board (FASB), based in the U.S. The
IASB sets and promotes the International Financial Reporting Standards (IFRS). The FASB caters to
the development of U.S. GAAP.

In 2005, IFRS overtook GAAP as the most widely used set of accounting standards in the world.
Graph XI.3, taken from Willmore (2015), shows the movement towards IFRS worldwide. With the
exception of U.S. and Colombia, most of the countries with no or unknown convergence plans are
underdeveloped countries in Africa, countries experiencing political unrest in the Middle East, and
communist Cuba. According to Seay (2014), those in favor of IFRS say it is the “gold standard.”

In general, there is agreement in the accounting profession that IFRS is a more principles-based
approach as opposed to GAAP, which is more rules-based. The principles based IFRS allows more
flexibility for its users than GAAP, since it allows business professionals to use their experience and
judgment to make decisions regarding financial reporting -see, Briginshaw (2008). It is said,
however, that many U.S. accountants prefer the rules based GAAP approach to help reduce their
liability as much as possible due to the high volume of lawsuits in the U.S.

XI.31
 . GRAPH XI.3
Worldwide Convergence Towards IFRS

It is easy to see the advantage of converging standards. They provide a universal set of standards that
make easy the comparison of financial reporting among businesses and across borders. It is also easy
to see the disadvantage: costs! Changing accounting standards would involve a major change for
U.S. companies, which would be costly. Lin (2013) estimates that the cost of a full switch to be
between 0.5% to 1% of annual revenues. This could be between USD 40-60 billion for companies in
the S&P 500.

The U.S. Securities and Exchange Commission (SEC) already oversees more than 1,300 foreign
firms that trade their securities in the U.S. These foreign firms had to adjust their accounting and
disclosure methods to the U.S. standards. The reverse is also true; U.S. companies listed abroad have
to adjust their accounting methods to the local standards. Converging standards would make the job
easier for international companies. In 2007, recognizing this situation and as part of the push in favor
of IFRS principles, the SEC allowed foreign private issuers in the United States to report their
financials under IFRS without reconciling them to U.S. GAAP.

By the end of 2008, the U.S. SEC published a roadmap with a convergence date: December 15,
2014. Under this roadmap, publicly traded companies faced a staged transition towards IFRS
standards. The stages depended on the market capitalization of each company. However, the

XI.32
roadmap faced many problems and pressures. As of 2015, convergence is unlikely to happen any
time soon. The issues of controversy have been fair value/mark-to- market accounting, revenue
recognition, financial statement presentation, rules for capitalization of leases, and inventory
valuation.

Progress towards convergence has been done in many of those areas. However, the issue where
convergence is seen as most difficult is inventory valuation. IFRS does not allow the last-in-first-out
(LIFO) method of valuing inventory. According to Reed and Pence (2013), the LIFO method is used
by approximately 36% of companies to value at least some part of their inventory. LIFO tends to
inflate costs and lower taxes.

3.D Valuation

Given the different accounting standards and financial practices around the world, we observe that
national stock markets seem to use different valuation criteria. For example, similar earnings
announcement can lead to different price reaction in different countries

Example XI.13: In Table XI.5 we observe that the average price-earnings ratio varies greatly among
countries in May 1994 (indexes are in U.S. dollars).

TABLE XI.5
AVERAGE FINANCIAL INDICATORS FOR DEVELOPED MARKETS

Index M/B P/CE P/E Yield

Australia 1.72 10.6 17.2 3.4
Hong Kong 2.16 14.2 16.6 2.9
Japan 2.33 11.9 88.0 0.7
New Zealand 1.89 10.1 13.7 4.3
Singapore 1.96 12.6 20.4 1.3
U.K. 2.22 9.7 15.5 4.2
France 1.55 7.7 27.2 3.1
Germany 2.10 6.2 60.3 2.4
Netherlands 1.71 7.8 17.6 3.5
Sweden 2.31 12.0 20.4 1.3
U.S 2.58 9.9 19.5 2.8
Canada 1.77 11.4 44.7 2.5
World 2.26 9.9 26.7 2.2
EAFE 2.13 9.9 33.8 1.9

Notes: M/B: market-to-book value; P/CE: price-to-cash-earning ratio. ¶

XI.33
The ratios presented in Table XI.5 are routinely used to compare valuations across firms or
industries. This way of comparing firms or markets is called valuation by multiples. Valuation by
multiples is a process in which a ratio for a given firm is compared to the ratio of similar firms. Let
us concentrate on the most popular multiple, the P/E ratio. Recall that a P/E ratio tells investors how
long they have to wait to recover their investment in terms of earnings –assuming that current
earnings are an excellent predictor of future earnings. For example, suppose Dell Computers
(NYSE:DELL) and Hewlett-Packard (NYSE:HWQ) are considered similar companies. If the P/E
ratio of Dell Computers is higher than the P/E ratio of Hewlett-Packard, analysts will conclude that
the market values more aggressively Dell’s earnings than Hewlett-Packard’s earnings.

Comparisons across international markets are trickier than comparisons across domestic markets.
U.K. firms have lower P/E ratios than firms from Germany or Japan; however, this does not indicate
that U.K. firms are cheaper companies. Table XI.5 indicates that there are national differences in
earnings accounting, rather than miss-pricing of comparable firms. For example, Japanese or U.S.
companies tend to sell well above their accounting book values if their M/B ratios are compared to
those of New Zealand or Canadian firms. But this does not mean that U.S. firms should be sold and
Canadian firms should be bought.

3.D.1 Discounted Dividend Model

The classic way of calculating the fair price of a company is to use some form of the discounted
cash flow (DCF) model. A popular variation of the DCF model is the discounted dividend model
(DDM). Under a DDM, the value of an asset is determined by the cash flows it generates for the
investor. In a DDM the stock market price is set equal to the discounted stream of forecasted
dividends.

Pt = Et[Dt+1]/(1+r1) + Et[Dt+2]/(1+r2)2 + Et[Dt+3]/(1+r3)3 + Et[Dt+4]/(1+r4)4 + ....,

where Et[Dt+j] represents the time t+j expected dividends, conditional on today’s information (time
t), Pt is current stock market price, and rj is the discount rate, or required rate of return, for j periods
ahead.

Note that to estimate a fair price for a company, we need to forecast future dividends (Et[Dt+1],
Et[Dt+2], etc.), and we need a to calculate an appropriate discount rate (rj). In addition, if the
company is a foreign company, foreign exchange rates need to be forecasted to translate expected
dividends to the domestic currency. As discussed in Chapter VIII, we can eliminate currency risk by
using the appropriate forward rates to convert futures expected dividends to the domestic currency.

A usual approach to estimate future dividends is to estimate the future path of the firm in three
phases:

(a) Near term (i.e., the next two years): earnings are forecasted individually.
(b) Medium term (i.e., the next two to five years): a general growth rate for the company's earnings
is estimated. (For example, the growth rate in earnings reverts to the average in the industry.)

XI.34
(c) Long term: the growth rate in earnings is supposed to revert to the average of all firms in the
market.

The second element needed to estimate the DDM for a company is an appropriate discount rate, rj. If
the risk of the expected cash flows is stable over time, firms can discount cash flows using risk-
adjusted cost of capital, which is represented by a risk-free rate plus a equity risk premium (ERP).
The Capital Asset Pricing Model (CAPM), discussed in the Review Chapter, or the 3-factor Fama-
French model provides a simple framework to estimate a risk premium.

 Discount Rates and Risk Premium

The discount rate is influenced mainly by two factors: bond yields and the equity risk premium
(ERP). For well-established markets, and keeping variables in real terms, government bond yields
are about 3%. Government bond yields are taken to represent risk-free rates. The size of the risk
premium, however, is more difficult to establish. As mentioned in Chapter X, there is no clear
consensus about how to estimate the ERP and what it should be, even for established markets, with
long data sets. For example, as reported by Duarte and Rosa (2015) for the U.S., ERP estimates
range from almost zero to 13%. Not very precise! 

Note that the DDM equation can be used to estimate a constant discount rate, or required rate of
return (r). If the expected dividends (Dt) and the current stock market price (P) are known, then a
firm will be able to estimate r. If, in addition, government bond yields are known (say, 3%), then the
ERP can be extracted!

Example XI.14: Using DDM to calculate the fair value of VALE ADRs
It is December 29, 2017. Suppose we want to use the DDM to value the ADR of Vale S.A. (NYSE:VALE),
Brazil’s mining giant. The company was privatized in 1997, but the Brazilian government still has a strong
influence. Mineral prices have been relatively low during the past 5 years; iron one, Vale’s main revenue
driver, has lost half its value, moving from USD 150 per ton in 2012 to USD 750 per ton in late 2017.We
need input values for Et[Dt+j], rt+j, and St+j, for j>1 Today's price of a VALE ADR is USD 12.60. Brazil has a
heavily managed exchange rate, with today’s St = 3.23 BRL/USD. In the past 18 months, the BRL/USD has
been in the 3.00 to 3.60 BRL/USD range.

(1) Estimation of Et[Dt+j].

One of the problems in emerging markets is developing a model for forecasting Dt+j; especially in companies
where the government still has a big say in the distribution of cash flows. In 2017, VALE paid a BRL 0.905
dividend per share. VALE’s dividends have been very volatile in the past 10 years, paying from BRL 0.166
per share in 2016 to BRL 2.260 per share in 2012; for an average dividend per share of BRL 1.22. The current
level of dividends is considered low and we attribute it to temporary low mineral prices and government
pressures. Dividends are expected to increase by an average 8% for the next two years. The predicted growth
rate of dividends (in BRL) after the next two year until the year 2024 is 16%. This level of dividend growth is
very low for international standards. It is unrealistic to expect this dividend growth forever. After the year
2024, we expect the company's dividend growth rate to revert to the level of international mineral companies,
which is estimated to be 125%.

(2) Estimation of rt+j.

The required rate of return is very complicated because we should make assumptions about how security
prices are determined. Suppose we use the integrated CAPM. According to CAPM, we should estimate:

XI.35
 E[rVALE] = rf + E[rm-rf] ßVALE.

We obtain the following inputs: ßVALE = 2.40; rf = .035; E[rm] = .08. Therefore,

E[rYPF] = .035 + (.08 - 035) x 2.40 = .143.

(3) Estimation of St+j.

Given Brazil’s history of price instability, there is an expectation that a volatile exchange rate will continue.
For this reason, analysts believe the USD will appreciate following PPP for an average rate of 4% a year
against the BRL for the foreseeable future.

Now, we are ready to value a VALE ADR (P).

First, we determine the USD discounted value of all the cash flows from 2018 until the year 2019 (year 2).
We call this value P1-2.

P1-2 = [BRL .903/(3.23 BRL/USD*(1.04))]*1.08/(1.143) + [BRL .903/(3.23 BRL/USD* (1.04)2)]*

(1.08)2/(1.143)2 = USD 0.445

Second, we determine the discounted value of all the cash flows from 2020 to 2024, P3-7.

After 2 years, the expected dividend is BRL 1.0533. Then, P3-7 is determined by:

P3-7 = BRL 1.0533*1.16/(3.23 BRL/USD*(1.04)3)/(1.143)3 + … +

+ BRL 1.0533*1.165 /(3.23 BRL/USD*(1.04)7)/(1.143)7 = USD 0.659

The discounted dividends per share in year 8 will be:

BRL 1.0533*(1.16)5/[3.23 BRL/USD*(1.04)7] = USD .5205.

The effective USD rate of dividend growth is [(1.125)x(.96) - 1] = .08.

The USD present value of all futures cash flows after year 7 is given by

P8+ = USD .5205 x (1.08)/[(.143 - .08)] = USD 8.923

The present value of a YPF ADR is P = P1-2 + P3-7 + P8+

P = USD 0.445 + USD 0.659 + USD 8.923 = USD 10.027.

Comparing this price to the December 2017 price of USD 12.60 indicates that the Vale ADR was overvalued
by the market, given our estimates of the variables in the DDM. ¶

The problem with the DDM is that companies have discretion over their dividend payments. Even
after financing capital expenditures, they do not need to pay the rest of their cash flows in dividends.
They can also use the money to repurchase shares, retire debt and make acquisitions. As a result,
payout ratios vary considerably. The U.S., for example, has a much lower payout ratio than the U.K.
This makes discounting dividends a complicated exercise.

XI.36
• Weighted Average Cost of Capital
An alternative approach is to discount free cash flows using the weighted average cost of capital (as
discussed in Chapter X), where free cash flows are defined as:

Free cash flows = EBITDA – Taxes - WC – CEx,

where EBITDA represents earnings before interest, taxes, depreciation and amortization, Taxes
represents taxes after interest deductions, WC represents change in net working capital, and CEx
represents capital expenditures already planned. These free cash flows represent the cash flows
available to the shareholders and creditors after all expenses, payments to government, and
necessary maintenance investments have been made. Once the free cash flows are calculated for
different years, the free cash flows are discounted using the weighted-average cost of capital, kc:

kc = kWACC = ke (E/V) + (1-t) kd (D/V),

where kWACC is the WACC, ke is the cost of equity (usually, it’s risk-adjusted), kd is the before-tax
cost of debt, t is the marginal tax rate, E is the market value of the company’s equity, D is the market
value of the company’s debt, and V is the market value of the firm (E+D).

3.D.2 Valuation by Multiples

Another popular use of the DCF model produces equilibrium price-earning (P/E) ratios. The P/E
ratio is the most popular valuation ratio and it is widely in the valuation by multiples process. To
derive equilibrium P/E ratios, we use a slightly different measure for free cash flows. We define free
cash flows as earnings after interest, tax, and capital expenditures, but before depreciation and
amortization –this information is calculated from ordinary after-tax earnings. To this measure of
cash flows, we make two downward adjustments. The first cut is because the cost of replacing worn-
out assets is higher than their original cost. The second is because companies invest also to expand.
These two factors -about 10% in the first case and 25% in the second- reduce free cash flows to
roughly two-thirds of earnings. Given these assumptions and assuming that in a steady state
corporate earnings grow in line with trend economic growth, it is possible to calculate steady state
(or equilibrium) fair price earning multiples for shares in different markets.

Example XI.15: Calculating the steady state P/E for the U.S.
It is February 2012. Assume that real economic trend growth (g) is 2.5% a year. That is, corporate earnings
(E), in the steady state, are growing at 2.5% a year. Assume that the real bond yield is 1.8% -long term bond
U.S. yield is 5% and long term U.S. inflation is 3.2%. The 2011 IESE Business Scholl Risk U.S. Market Risk
Premium reports a weighted average of 5.5%. Then the discount rate, r, is equal to (1.8%+5.5%) 7.36%.
Now, we are ready to discount free cash flows (CF), which we assume equal to two-thirds of earnings:

P = CF1/(1+r) + CF2/(1+r)2 + CF3/(1+r)3 + CF4 /(1+r)4 + CF5 /(1+r)5 + ....

P = 2/3 E(1+g)/(1+r) + 2/3 E(1+g)2/(1+r)2 + 2/3 E(1+g)3/(1+r)3 + 2/3 E(1+g)4/(1+r)4 + ...

This formula simplifies to:

XI.37
P = 2/3 E [(1+g)/(1+r)] / [1 -(1+g)/(1+r)].

Then,

P/E = 2/3 [1.025/1.073]/[1 - 1.025/1.073] = 14.24,

Today, at the end of February, the S&P 500 was at 1,352.49, while the S&P 500’s earnings were 90.08,
therefore, the market P/E Value was 15.01 (=1352.49/90.08).

Thus, according to our valuation, the U.S. equity market was a bit overpriced at the end of February. ¶

The global economy is not in a steady state. Growth rates change over time. Over the business cycle,
profits take different proportions of the GNP. For example, when countries are in the advanced
stages of the business cycle, wages rise at a faster pace. Therefore, P/E ratios have to be adjusted
according to the current economic conditions of each country.

Example XI.16: Suppose the European economy is in the early stages of a downturn. On the other hand,
suppose that China is advanced in the business cycle, but there is still plenty of room for improving the
efficiency of firms through restructuring. Therefore, the steady state multiplier for Europe needs to be
adjusted downward -say, by around 10%-, while the steady state P/E of China needs to be adjusted upward -
say, by 20%. ¶

 P/E Ratios Do Change

The P/E ratio for the U.S. S&P 500 index has varied mostly between 5.3 and 124 from 1872 to
2011, averaging only 15 for the entire period. The P/E ratio moved above 27 for the first time in
mid-1998 and reached a record high 124 in 2009, mainly due to a tremendous drop in earnings.

Do High P/E ratios have implications for stock prices and earnings? Campbell and Shiller (1998)
found that higher P/E ratios are usually followed by lower stock price growth during the following
decade. Reinforcing these results, Campbell and Shiller also found that higher P/E ratios are
usually not followed by faster earnings growth. 

Recall that investors do not care about returns denominated in foreign currencies. All cash flows
(dividends and capital gains) should be multiplied by the exchange rate. Therefore, to make an
international comparison of expected returns, analysts need to forecast currency movements, which,
as we have studied already, are very difficult to forecast.

The presence of so many different factors explains why most international money managers value
corporations relative to their domestic markets, before even trying to value them globally in relation
to their direct product market competitors.

IV. International Investing

International investing is not a new trend of the 1990s. In fact, the London Stock Exchange traces its
origin to international investing. In 1553, the first joint-stock company, where the public subscribed
to ownership in equal shares, was founded in London following advice from the famous explorer

XI.38
Sebastian Cabot. Merchants at that time wanted to trade with the then mysterious Far East and were
attracted by Cabot's suggestion of searching for a North-East passage. On May 10, 1553 three ships
departed from Deptford, near London and headed north. The expedition never reached the Far East,
but one of the ships ended up in Russia. The captain of the ship was able to secure a treaty with the
Czar Ivan the Terrible, who granted freedom of trade to English ships. The Muscovy Company was
founded out of this event. The Muscovy Company was the first company where ownership and day-
to-day management were separated with shares freely traded.

In the economic development of the Victorian Age international investment played what was
recognized to be an essential part. International trade grew rapidly. Great Britain took the leading
part in this process, and the amazing expansion of British economic power in the nineteenth century
is to be attributed in on small part to international investment. The process of international
investment did not work with uninterrupted smoothness. It was punctuated by occasional financial
crises (notably, for example, the Baring crisis in the 1890s), by the 1930s depression, by currency
difficulties, by wars, and by periods of default on the part of the borrowing nations. More recently,
international investing took on a faster pace. International investment has increased four times,
during the past 15 years.

International investing has probably been around for centuries, and probably for thousands of years.
This fact might be a bit surprising. International investing does not seem easy. International
investors need to analyze assets from a huge number of asset classes (stocks, bonds, derivatives,
etc.), and from different national markets and currencies. The number of individual securities to
invest presents a big challenge for international investors. The challenge is not a valuation problem
since the same techniques and models used to value a domestic asset are usually used to value a
foreign asset. The challenge is a practical once: international investors have to reduce each
investment to a tractable number of parameters, otherwise the resources spent on international
investing would be too high. Therefore, international investors need to (1) identify the major factors
influencing international security price behavior, and (2) determine the sensitivity of each security to
these factors.

4.A Risk-Return in International Markets

Table XI.6 reports the USD mean annual returns on MSCI equity indexes from 11 developed
markets, along with the World and EAFE Indexes. The data cover the 1970-2017 period and are
reported monthly.

Over the past 47 years, Hong Kong and Singapore show the best returns in Developed Markets, but
we need to take into consideration the risk taken by an investor. Using the Sharpe ratio (with a
4.74% risk-free rate) to measure the risk-return trade-off, Switzerland and Hong Kong have the
best performances over the past 47 years.

We can use the above numbers to compute the equity risk premium. If we consider that the average
U.S. T-bill rate during the 1970-2017 period was 4.74%, the realized equity risk premium for the
U.S. is 3.45% (= 8.19 - 4.74). There is no agreement on what the equity risk premium should be; in

XI.39
general, the reported numbers for the U.S. market are between 3% and 8%, which place our 3.45%
estimate on the lower side of the range.

Table XI.6
MSCI Index USD Annual Returns: (1970-2017)

Market Return Standard Sharpe

Deviation Ratio
U.S. 8.19 15.04 0.2295
Canada 8.22 19.35 0.1801
France 9.02 22.17 0.1927
Germany 9.37 21.67 0.2135
Italy 5.08 25.38 0.0315
Switzerland 10.44 17.83 0.3193
U.K. 7.77 21.44 0.1411
Japan 9.94 20.74 0.2506
Hong Kong 16.80 33.72 0.3578
Singapore 12.26 27.79 0.2705
Australia 7.68 23.79 0.1233

World 7.70 14.58 0.2026

EAFE 8.00 16.78 0.1945

Since stock returns are calculated with error (even for large portfolios, like the above indexes), using
a long data set is important: the longer the data set, the smaller the sampling error and, thus, the
more precise the estimation. Dimson, Marsh and Staunton (2011) used data from 1900-2010 to
report for mainly 19 developed markets. For example, they calculated mean annual return (standard
deviation in parenthesis) for the U.S., Switzerland and Italy are 7.2% (19.8%), 5.1% (18.9%), and
9.8% (32%), respectively. The numbers are a bit different from the ones reported in Table XI.6,
though within the usual estimation error.

For emerging markets, the estimation error is considerable, given that quality data, following
international standards, started to be collected in 1988 (Brazil, Greece, Ireland, Malaysia, Mexico,
Thailand, etc), and for Russia, India and China, considered then the major "frontier markets," data
started to be collected in 1993 (along with Israel, Pakistan, Poland, South Africa, etc). In Table XI.7,
we report annual USD returns, standard deviation and Sharpe Ratio (using the U.S. T-bill average
rate in the period, 2.43%) for the period 1993-2017 for some emerging markets, two emerging
market indexes (EM-Asia and EM-Latin America), and, for reference purposes the U.S., World and
EAFE Indexes.

In general, we observe the typical emerging market behavior: high returns and high volatility. In
terms of Sharpe ratios, in Table XI.7, the U.S. market provided the best trade-off, closely followed
only by the Russian market.

XI.40
 Table XI.7
MSCI Index USD Annual Returns: (1993-2017)

Market Return Standard Sharpe

Deviation Ratio
Brazil 16.58 37.54 0.3768
China 5.40 33.25 0.0785
Greece -0.18 35.46 -0.0736
India 12.05 28.99 0.3318
Malaysia 6.54 27.82 0.1477
Mexico 10.00 27.75 0.2728
Pakistan 6.79 34.91 0.1248
Poland 18.62 44.78 0.3615
Russia 22.65 50.09 0.4035
South Africa 11.30 26.30 0.3373

EM-Asia 7.24 24.13 0.1990

EM-Latin America 10.65 27.68 0.2969
U.S. 8.72 14.25 0.4409
World 7.06 14.44 0.3207
EAFE 5.48 16.06 0.1899

We see a big dispersion in expected returns (and risk!) in international markets, which cannot be
explained by the usual World CAPM. Several papers have been proposed to explain these
differences, among them:

⋄ Global economic risks Ferson and Harvey (1994).

⋄ Currency risk Dumas and Solnik (1995).
⋄ Inflation risk Chaieb and Errunza (2007).
⋄ Momentum and a global cash-flow-to-price factor Hou, Karolyi, and Kho (2011).
⋄ Liquidity risk Karolyi, Lee, and van Dijk (2012), Malkhozov, et al. (2014).
⋄ Investment restrictions Karolyi and Wu (2014).
⋄ Currency risk Dumas and Solnik (1995).

There is also an international version of the 3-factor Fama-French model, extended by Fama and
French (1998, 2012, 2015), which finds that only two factors matter in their model: world (say, a
global equity benchmark) and value (HML). Fama and French (2015) favor a 5-factor regional
model in a study of stock returns in 4 regions (North America, Europe, Japan and Asia-Pacific) from
1990 to 2015. They find that the 5-factor model tends to explain average returns (HML is the most
important factor), but the model struggles to explain the behavior of average returns for small firms
that tend to invest a lot.

Note: Having a good model that explains expected returns is not a trivial matter: We use risk-return
models to estimate the cost of equity (ke) and the cost of capital (kc).

XI.41
4.A.1 Moments in International Markets

As discussed above, in finance, we associate standard deviation with risk, and, thus, higher standard
deviation is associated with higher expected returns. Recent research has found that higher moments
also have information about expected returns.

Chang, Christoffersen, and Jacobs (2013) and Conrad, Dittmar, and Ghysels (2013) find that
domestic stock traders are compensated when their cross-sectional domestic indices/stock portfolio
returns have high volatility, low skewness, or high kurtosis. Skewness is associated with “crash
risk,” and kurtosis with “tail risk.”
Table XI.8
MSCI Index USD Monthly Returns: (2006-2017) along with Implied Higher Moments

Monthly Implied Implied Implied

Country
Return Volatility Skewness Kurtosis

Euro Area 0.0003 0.1057 -0.9016 6.6929

Germany 0.0043 0.1669 -0.8655 7.2734
France 0.0019 0.1493 -2.0033 11.4318
Italy -0.0029 0.2463 -2.5396 15.1776
UK 0.0001 0.2136 -1.5305 10.4403
Australia 0.0031 0.1935 -1.1564 7.8827
Switzerland 0.0035 0.1103 -1.0811 9.1301
Japan 0.0017 0.1894 -3.1633 31.4871
Sweden 0.0040 0.1460 -1.1022 7.4215
Spain 0.0003 0.1467 -0.6460 5.8272
Canada 0.0030 0.1402 -1.2425 8.3353
Brazil 0.0045 0.1846 -0.6298 6.5996
Mexico 0.0024 0.1575 -0.3518 4.1037
Korea 0.0067 0.1679 -0.2389 3.3512
Singapore 0.0042 0.2850 -2.5537 16.7907
Malaysia 0.0038 0.2271 -1.8902 13.3735
Taiwan 0.0044 0.1880 -2.0633 17.7618
Hong Kong 0.0064 0.1687 -1.5824 11.8461
US 0.0058 0.1936 -0.6456 9.8318

XI.42
Shu-Hsiu Chen (2018) finds similar results in international markets. To calculate the higher
moments, he uses option prices from ETFs representing 20 stock indices. The results are shown in
Table XI.8. Chen (2018) also tried to forecast returns next month using this month implied skewness
and kurtosis. He was successful in some markets (in particular, for both measures, Australia &
Malaysia).

4.B Why Do Investors Care about International Equity Markets?

The case for international investing rests on a very simple argument: portfolio diversification.
Diversification is a risk management tool. As long as one class of domestic assets is less than
perfectly correlated with another class of domestic assets, a balanced portfolio that includes both
classes of assets is likely to exhibit more stable performance over time. This argument leads to the
conclusion that domestic investors should be well-diversified. This argument easily extends to
foreign markets. International diversification, by increasing the number of markets and assets to
invest in, provides an improved risk-return tradeoff. The case for international diversification
remains as relevant for investors today as it was one hundred years ago.

Diversification is more attractive in international markets than in domestic markets. The benefits of
diversification are driven by correlations. In general, the correlations across national markets are
lower than the correlations across securities in most domestic markets.

Example XI.17: In Table XI.9 we calculate the cross-country correlation coefficients for monthly stock
returns for the period January 1970 to February 2015 (542 observations). The returns are calculated from
MSCI country indexes.
TABLE XI.9
MSCI Indexes: Correlation Matrix (1970-2015)
A. European Markets
MARKET Bel Den France Gerrn Italy Neth Spain Swed Switz U.K. World
Belgium 1.00 0.59 0.72 0.70 0.54 0.75 0.56 0.55 0.68 0.59 0.69
Denmark 1.00 0.53 0.59 0.48 0.62 0.51 0.54 0.55 0.49 0.61
France 1.00 0.73 0.59 0.73 0.59 0.57 0.68 0.63 0.73
Germany 1.00 0.56 0.78 0.58 0.64 0.71 0.54 0.71
Italy 1.00 0.55 0.57 0.50 0.50 0.57 0.57
Netherlands 1.00 0.59 0.63 0.75 0.69 0.81
Spain 1.00 0.57 0.50 0.47 0.62
Sweden 1.00 0.57 0.52 0.69
Switzerland 1.00 0.62 0.72
U.K. 1.00 0.73
World 1.00

B. Pacific Markets
MARKET Australia HK Japan Korea Singap Taiwan U.S. World
Australia 1.00 0.32 0.37 0.50 0.51 0.33 0.56 0.65
Hong Kong 1.00 0.34 0.40 0.57 0.41 0.39 0.48
Japan 1.00 0.48 0.39 0.24 0.36 0.67
Korea* 1.00 0.46 0.33 0.45 0.53
Singapore 1.00 0.45 0.53 0.60
Taiwan* 1.00 0.35 0.38

XI.43
C. North American Markets
MARKET Canada U.S. Mexico World EAFE EM-LA EM-ASIA
Canada 1.00 0.74 0.54 0.77 0.62 0.60 0.65
U.S. 1.00 0.58 0.88 0.62 0.57 0.61
Mexico * 1.00 0.56 0.49 0.72 0.52

Notes:
*: The sample for South Korea, Taiwan, Mexico, the EM-Latin America and the EM-Asia indexes start in January 1988.

You should note that, with some exceptions, returns correlations are moderate, with an average correlation of
all the markets in Table XI.9 of 0.48. The exceptions tend to be geographically closed countries, like Belgium
and Netherlands, or Germany and France. Economic integration and common economic policies play a big
role. For example, the average intra-European developed market correlation is 0.57, while the average intra-
Asian develop market correlation is 0.46. ¶

Roll (1992) argues that the moderate correlations among international stock markets are partly
attributable to the technical procedures of index construction. Some markets indexes have a small
number of stocks (less than thirty) while others have a large number. Some national markets are
industrially concentrated while others are very diversified. These diversification elements explain
part of the observed intermarket difference in price index, not individual stock behavior.

Most stock market indices reflect the industrial structure of a country. We can think of the index
from a country as analogous to a managed portfolio with particular industry sector "bets." Therefore,
countries with different (and uncorrelated) industrial composition might display very low index
intercorrelations.

Other economists disagree with Roll (1992). For example, Heston and Rouwenhorst (1994) present
evidence showing that the low correlation between country indices is almost completely due to
country specific sources of variation, not industrial structure.

We should also note that correlations are not constant. We tend to see that during periods of
economic or financial crisis, correlations around the world increase. Figure XI.1 presents the
correlation between Japanese and U.S. stock monthly returns, using a 1.5-year rolling window to
calculate the correlation coefficient. For example, during the 2008 financial crisis the correlation
between U.S. stocks and Japanese stocks increases to over .80. The average correlation between
U.S. and Japanese stocks is close to 0.35.

Higher correlations during periods of crisis also occur at the domestic level. Between October 2008
and February 2009, at the height of the 2008 financial crisis, the average correlation of stocks in
the S&P 500 was around .80%. When stocks rallied in 2010, the average correlation fell to 40%,
then it spiked back over 80% during the European debt crisis.

The empirical fact that correlations tend to increase during periods of crisis is not a good one for the
advocates of international diversification: when you really want to be diversified –i.e., bad times-,
diversification does not work as expected!

XI.44
 Figure XI.1
Correlation between MSCI Japan and MSCI U.S. index returns (1970-2015)

4.B.1 Lower risk

Solnik (1974) was the first to quantify the risk reduction benefits of international equity
diversification. Solnik shows that U.S. domestic portfolio volatility decreases as the number of
domestic stocks increases, but asymptotically converges to a lower limit. This domestic lower limit
is 27% of the average stock volatility in the U.S. For portfolios of the same size, using both U.S. and
foreign stocks, the overall portfolio risk is substantially lower. The asymptotic lower (risk) limit is
11.7%.

Solnik's results have been verified many times, using different time periods and subsets of countries,
with similar results. Solnik's findings had a very important effect on investors and money managers
in the 1970s. In addition, in 1974 ERISA gave U.S. pension funds the freedom to invest overseas.
These factors helped U.S. investors to start to think about internationally diversifying their
portfolios.

4.B.2 Expected Returns are Unaffected

Lowering risk is only a part of the answer to the above posed question. For example, an investor can
invest all his money in cash. This all-cash strategy has no nominal volatility, and therefore a lower
volatility than a portfolio of stocks. The expected returns, however, are also substantially lower, and
then an all-cash strategy provides no risk-adjusted benefits.

International diversification, on the other hand, seems to provide a "free lunch": it allows investors
to lower risk at no opportunity cost. The rationale for this result is simple. Investors who extend their
horizons to international markets can often find securities promising more rapid growth and more
attractive valuations. Many economists make this observation a second argument for international
diversification.

XI.45
Example XI.18: During the period 1978-1993, adding foreign stocks to a U.S. stock portfolio increases
returns by almost 1% and reduces volatility by almost 2%. The correlation between foreign stocks and U.S.
stocks during this period was 0.42. ¶

The problem with the above studies and example is the use of "ex-post" returns. While variances and
covariances are estimated with reasonable precision, expected returns are not (see the Appendix to
the Review Chapter). In general, expected returns require long periods, on the order of decades, to
obtain the required statistical accuracy.

But, similar numbers are obtained using longer time periods. For example, from 1970-2011,
including 25% EAFE stocks in a U.S. portfolio increased returns by an average 2.1%, while
decreasing volatility by an average 2.2%.

But, there is another reason to rely on long periods of time to make inferences about the benefits of
international diversification. During short periods of time, the higher correlations during high
volatility periods (usually, bear markets) can make international diversification inefficient. From
Figure XI.1, it should be clear, that during the 2008 financial crisis, U.S. investors diversifying in
Japanese equity markets did not enjoy the benefits of diversification. But, over long horizons,
international diversification works. During the 1970-2001, including 25% Japanese stocks in a U.S.
portfolio, increased returns by an average 8%, while decrease volatility by an average 3.2%. Using a
comprehensive data set from 1950, Asness et al. (2010) show that international diversification pays
off in the long run.

4.B.3 Staying at Home: The Home Bias

As mentioned in the Review Chapter, the lower the correlation between the assets, the greater are the
benefits due to diversification. As we have mentioned above, international equity markets offer a
domestic manager a wonderful opportunity to improve the risk-return profile of a domestic portfolio.
The empirical evidence, however, displays a puzzle: domestic portfolios largely ignore international
markets. This allocation reflects a so-called home bias.

French and Poterba (1991) and Tesar and Werner (1995) report that portfolio compositions based on
actual data indicate a strong home bias. French and Poterba's (1991) estimates suggest that in 1989,
Americans' foreign equity investment was less than 7% of the capitalized value of the U.S. stock
market. A surprisingly low number, given that the U.S. share of the world equity market was close
to 30% --if we look at the world GDP, we find a similar U.S. share. Tesar and Werner (1995) use
data on international financial transactions across five OECD countries including the U.S., the U.K.,
Canada, Germany and Japan for the period 1979-1990. They find evidence of a home bias in
portfolio compositions for investors in all the five countries they examine. While investors have
increased their holdings of foreign stocks in recent years, the fraction of the portfolio invested
abroad remains far less than the share implied by standard models of optimal portfolio choice. In
2002, a study done by UBS, reports the proportion of foreign bonds and foreign equities in the
total equity and bond portfolio of local residents for several OECD countries. The most
internationally diversified investors are in Netherlands (62%), followed by Japan (27%) and the
U.K. (25%). At the bottom of the list was the U.S., with an 11% international share. More recent

XI.46
studies found that the home bias has been decreasing, but it still significant. For example,
Coeurdacier and Rey (2013) estimate the equity home bias (EHB) as:

EHBi = 1 - Share of Foreign Equity in Country i Equity Holding

Share of Foreign Equity in World Market Portfolio

In Figure XI.2, we report Coeurdacier and Rey’s (2013) estimate of the EHB over time, since
1987. It is decreasing, but it is still significantly different from each region’s share of the world
GDP or world market capitalization.

Figure XI.2
EHB from 1987 to 2010, as reported by Coeurdacier and Rey (2013)

Institutional investors also show a similar home bias, as shown in Figure XI.3, taken from J.P.
Morgan Asset Management “Guido to the Markets –Asia.”

Figure XI.3
Institutional Investors’ Asset Allocation by Region

XI.47
It is interesting to note that the home bias is not limited to international portfolios. Investors tend
to invest locally. Coval and Moskowitz (1999) showed that the preference for investing close to
home also applies to portfolios of domestic stocks. Specifically, they showed that U.S. investment
managers exhibit a strong preference for locally headquartered firms, particularly small, highly
leveraged firms that produce non-tradable goods.

4.B.4 Problems with International Diversification

Many problems associated with international investing may explain the low correlations and the
home bias. The main problems are:

(1) Currency risk.

(2) Information costs.
(3) Controls to the free flow of capital.
(4) Country or political risk.
(5) Cognitive bias

We have already studied the first problem, currency risk. It is really not a "problem," since currency
risk can be managed with the different techniques studied in Chapters VI to VIII. Furthermore,
currency risk can be diversified away in a well-diversified international portfolio. The second
problem, however, is more difficult to control. Information costs includes not only the actual
monetary costs of acquiring information, but the nonmonetary costs associated with understanding
different cultures, accounting standards, legal environments, etc. We have discussed many of these
points in Chapter XI. In the next two sections, we will two of the problems: capital controls and
country risk.

The last problem, the cognitive bias, belongs to the field of behavioral finance. A cognitive bias is
a pattern of deviation in judgment that occurs in particular situations, leading to perceptual
distortion, inaccurate judgment, illogical interpretation, or what is broadly called irrationality. In
the home bias case, domestic investors believe that they have better information regarding the
value of domestic companies than they have for foreign companies. Investors tend to over-invest
in markets (home markets) where they believe they have a comparative advantage. Thus, a home
bias is created.

Field surveys conducted in 2003 and 2005 on Japanese institutional investors showed that they
held relatively optimistic views for their domestic stock market than for the foreign stock market.
Their one-year expected returns for the Nikkei Stock Average were on average much higher than
those for the Dow Jones Industrial Average.

4.B.5 International Diversification through Multinational Corporations

Domestic or international multinational companies operate in many countries. In principle, MNCs

are exposed to the domestic factors of the countries they operate. For example, in 1998, a company

XI.48
in the Dow Jones Industrial Average now derives on average, about 40 percent of its revenue from
outside the US, up from 35 percent in 1988. Thus, one might think that MNC stocks are good
alternative to enjoy the benefits of international portfolio diversification. The evidence from U.S.
MNCs suggests, however, that multinational firms do not provide all the benefits available from
direct investment in foreign securities. Moreover, the evidence suggests that all MNCs do not even
provide additional diversification benefits to a portfolio of purely domestic firms (i.e., a portfolio of
MNCs have a higher SD than the S&P 500).

Jacquillat and Solnik (1978) examined firms from nine countries and found that MNC stock prices
behave very much like those of purely domestic firms. Their approach was to formulate a multi-
factor market model, where each factor represents a national market index. In Table XI.10, we
present their estimates of average betas for each country. Their results show that MNC stock prices
are more strongly affected by domestic factors than foreign factors, in most cases. This is especially
true for U.S. and British firms, where the addition of foreign factors to the domestic market does not
significantly improve its explanatory power (R2). This is less true for French, Swiss, Belgian and
Dutch MNCs.

TABLE XI.10
Multifactor Market Model for MNC

Nationality National Index Single Index

of MNC
US NL BEL GER ITA SWE FRA SWI UK R2 beta R2
U.S. MNC .94 .12 -.05 -.01 -.04 .04 .02 -.01 -.07 .31 1.02 .29
Dutch MNC .31 .76 .09 .16 -.02 -.28 .25 -.21 -.06 .63 0.98 .50
Belgian MNC -.27 .07 1.04 .06 .03 .19 .06 .08 .07 .58 1.03 .45
German MNC .24 .03 -.21 1.18 -.02 -.01 .10 -.15 -.11 .74 1.18 .65
Italian MNC -.10 .06 .10 .01 .83 .11 -.19 -.16 .20 .51 .91 .47
Swedish MNC .06 -.15 -.02 .08 -.10 .96 .01 .15 .02 .50 .92 .42
French MNC -.10 .14 .33 .18 .02 -.16 .95 -.22 .03 .62 1.08 .45
Swiss MNC -.12 -.23 -.04 -.09 -.02 .16 -.11 1.74 .16 .75 1.39 .52
British MNC -.10 -.11 .30 .09 -.04 -.13 -.09 .07 .84 .49 1.06 .44

Source: Jacquillat and Solnik (1978), Journal of Portfolio Management

Senchack and Beedles (1980) contrasted the risk, returns and betas of portfolios of multinationals
with portfolios of domestic and international stocks and found that multinationals did not deliver
diversification benefits.

XI.49
In a more recent study, Rowland and Tesar (2001) find evidence that, over the 1984-92 period,
multinational corporations may have provided diversification benefits for investors in Canada,
Germany and the United States. They also find, however, that the addition of foreign market
indices to a domestic portfolio - inclusive of multinationals - provides substantial diversification
benefits in all countries.

The impact of national control and management policy, as well as government constraints on a
firm's performance, may explain why multinationals are not a good substitute for international
portfolio diversification.

4.C International Factors and Linkages

Recall that international investing involves a huge number of variables and factors. Investors would
like to have this huge number of factors reduced to only a few key factors. If this were possible, it
would greatly simplify the task of structuring a well-diversified international portfolio. The first step
in this process is to determine whether the price of an individual security is primarily affected by
international or purely domestic factors.

4.C.1 Domestic versus International Factors

Different studies have shown that domestic factors are more important than international factors.
International industry effects appeared weak compared to national effects. A simple approach to
determining the relative importance of each factor is to separately correlate each individual stock
with

i. the world stock index

ii. the appropriate (international) industrial sector index
iii. the currency movement
iv. the appropriate national market index.

The first three factors may be regarded as international, and the last one as domestic.

Example XI.19: Solnik and de Freitas, in a paper published in Recent Developments in International
Finance and Banking in 1988, performed the following experiment. They used monthly observations on a
sample of 279 international firms from eighteen countries over the period December 1971 to December 1984.
The country, industrial, and world indexes come from MSCI. The currency movement is that of the local
currency relative to the USD. They regressed each individual stock on each factor and obtained its R2.

Recall that a measure of correlation is the R2. The R2 is a measure of correlation that tells us how much of the
variability of the dependent variable is explained by the independent(s) variable(s).

Table XI.11 reports the average R2 for all companies from a given country in the first four columns. The
average R2 for the multiple regression (multi-factor Market Model) is reported in the last column.

XI.50
 TABLE XI.11
2
Average R of Regression on Factors

Single-Factor Model All Factors

Market
World Industrial Currency Domestic

Belgium .07 .08 .00 .42 .43

Germany .08 .10 .00 .41 .42
Norway .17 .28 .00 .84 .85
Spain .22 .03 .00 .45 .45
Sweden .19 .06 .01 .42 .43
France .13 .08 .01 .45 .60
Italy .05 .03 .00 .35 .35
Netherlands .12 .07 .01 .34 .31
U.K. .20 .17 .01 .53 .55
U.S. .26 .47 .01 .35 .55
Canada .27 .24 .07 .45 .48
Australia .24 .26 .01 .72 .72
Hong Kong .06 .25 .17 .79 .81
Japan .09 .16 .01 .26 .33
Singapore .16 .15 .02 .32 .33

All .18 .23 .01 .42 .46

Note:
1. The various correlations do not add up; the four factors are correlated with each other.
2. The world factor and industrial factors explain an average of 18% and 23% of the variability of stock
returns.
3. Domestic factors are the most important influence on stock returns.
4. The currency factor is almost negligible, with the exception of Hong Kong and Canada.

The simple regression of stock returns on the domestic market index return has an average R2 of .42. When
we add the three international factors, the average R2 increases to .46. This is a rather small change in R2.
However the story differs among countries; the increase is rather large for the U.S. and France.

A detailed analysis of the results indicates that the marginal contribution of the international factor is
generally positive and significant. The marginal contribution of the currency factor is extremely
weak but positive, and appears to be country specific but not company specific. A local currency
appreciation tends to be good for the local stock market. ¶

XI.51
Other studies have used different methodologies, however the results are similar. In an article
published in the Journal of Portfolio Management in 1989, Grinold, Rudd and Stefek find that some
industry factors are more "global" than others. For example, they found that the oil industry factor is
highly significant, which is not the case of the factor for consumer goods.

4.C.2 Currency Factor and Hedging

In Example XI.19 we found that the currency factor on average was negligible. The average R2 was
.01, which indicates that only 1% of the variation in local currency is explained by changes in the
exchange rates. The low explanatory power of the currency factor has currency hedging
implications. If stock returns are independent of exchange rate changes, currency risk is not a
systematic factor in the APT model and, then, is not priced in the stock market. That is, hedging
currency risk cannot affect the systematic risk of multinational firms.

Jorion (1991) analyzes the importance of the currency factor using a simple CAPM model with a
currency factor added. He also uses a similar APT model than the one used by Solnik and de Freitas.
Jorion uses more sophisticated tests and obtains a similar result as Solnik and de Freitas: the
currency factor is already incorporated into the other factors. Therefore, currency risk is diversifiable
and is not priced in aggregate in the stock market.

Jorion also analyzes the importance of the currency factor at a disaggregate level. Jorion finds that
different firms and industries have different and significant exposures to the currency factor.
Exporters tend to benefit from a depreciation of the domestic currency, while importers tend to
benefit from an appreciation of the domestic currency. In another paper published in the Journal of
Business in 1990, Jorion finds that the sensitivity of a U.S. firm's returns to the currency factor is
positively related to its percentage of foreign operations.

4.C.3 Linkages among Stock Markets

As it was mentioned in Section I, the positive but moderate correlation coefficients in international
stock markets are the main reason behind internationally diversifying portfolios. The low correlation
in some markets is surprisingly low, given the increasing global financial integration.

The analysis of correlation coefficients might not be the correct tool to study the issue of linkages
between international markets -or the issue of integration versus segmentation. For example, one
could conceive of a situation where no movement of capital is allowed between national stock
markets, but common shocks to growth or monetary policies induce positive correlations between
the two markets. In such a case, ex ante, or expected, returns could be very different across markets,
even with highly correlated ex post, or realized, returns. Thus, it is very useful to study the linkages
among international stock markets without focusing on the correlation coefficients.

Big and unusual stock market movements (“extreme events”) seem to drive markets together.
During these events all markets move together in the same direction and with similar changes. The
Crash of October 1929 is one of these events. Another event that highlighted the links between

XI.52
international stock markets during big market movements was the Crash of October 1987. The
Crash of October 1987 is a recent and very well studied event, which might provide an opportunity
to understand international linkages. In the next section, we will analyze the Crash of October 1987
and its consequences.

3.B.3.i Extreme Linkages: The Crash of October 1987

Roll (1989) points out that the October 1987 Crash was the only month during the 1980's where all
the stock markets around the world moved in the same (negative) direction. The international
transmission of the crash started in non-Japanese Asian countries and continued through European
markets, the U.S. and finally Japan.

In Table XI.11, we reproduce the daily returns during the Pre-Crash period, the Crash period and the
Post-Crash period by country.
TABLE XI.12
Daily Returns (percent/day) by Country
Country 1/2/87-10/12/87 10/12/87-10/30/87 11/2/87-3/31/89
Australia .2239 (0.850) -3.5160 (8.315) .0475 (1.216)
Hong Kong .2218 (1.121) -5.4174 (12.072) .1083 (1.353)
Japan .1543 (1.274) -0.9777 (5.567) .0810 (0.946)
Malaysia .2821 (1.171) -3.6080 (6.026) .0128 (2.754)
N. Zealand .0291 (1.091) -2.0473 (5.296) -.0755 (1.366)
Singapore .2508 (1.075) -3.9675 (10.182) .1004 (1.327)
Austria -.0202 (0.736) -0.8255 (1.663) .0699 (0.557)
Belgium .0808 (0.814) -1.6531 (4.316) .0906 (0.965)
France .0114 (0.920) -1.6526 (4.568) .1018 (1.254)
Germany -.0296 (1.251) -1.5913 (4.178) .0254 (1.292)
Italy -.0338 (1.017) -1.3943 (3.184) .0293 (1.149)
Netherlands .0672 (0.993) -1.5985 (5.296) .0633 (1.301)
Spain .2143 (1.276) -2.4154 (3.286) .0555 (0.927)
Sweden .1272 (1.009) -1.8998 (4.534) .1202 (1.242)
Switzerland .0156 (0.917) -2.0706 (5.409) .0025 (1.305)
U.K. .1852 (0.865) -2.0759 (4.947) .0524 (0.962)
Canada .1143 (0.689) -1.5150 (5.413) .0405 (0.772)

XI.53
 Mexico .9831 (2.509) -3.4050 (6.892) .0128 (2.754)
U.S. .1213 (0.965) -1.4128 (7.253) .0428 (1.094)

Notes to Table XI.12: Standard deviation in parenthesis.

There is a major question of interest: what were the causes of the Crash? Roll (1989) analyzes four
candidates that were extensively discussed after the Crash by academic researchers, politicians and
journalists:

(1) Portfolio insurance and computer systems?

Just after the Crash, many journalist and politicians blamed the Crash on a variety of sources ranging
from portfolio insurance to inadequate computer systems. Empirical studies have found these claims
totally unfounded. For example, many studies have found that markets with portfolio insurance
crashed less than markets without it.

(2) Futures markets?

Another allegation points to all uses of stock index futures or other related futures contracts, not just
portfolio insurance. The argument seems to be that irrational speculators cause instability. However,
stock markets with related futures markets crashed in the same way as countries without futures
exchanges.

(3) Specific event?

The search for a triggering event has been very unsuccessful. Several reasons have been advanced in
the U.S.: announcement on October 14 of a worse than expected trade balance, poor performance of
Asian markets in the week before the Crash, etc.

The most likely event was the introduction in the U.S. Congress of a tax bill that would have
severely penalized corporate takeover, leverage buyouts, and other similar activities.

The evidence for this event is the most persuasive for all the events advanced; however, it is difficult
to believe that it had such an extraordinary effect in other markets.

(4) Speculative bubble?

Eugene Fama, from the University of Chicago, says that the most questionable aspect of 1987 was
not the Crash itself, but the incredible market advance during the previous five years. There is strong
evidence that fundamental factors from January through September of 1987 could not explain such
large increases as were observed in the U.S. The same seems to be true for other markets.

Example XI.20: Go back to Table XI.12. The rate of return from January 1, 1987 to October 9, 1987 was
37.62% for the U.S., 44.45% for the U.K., 36.12% for Japan, and a spectacular 687% for Mexico. ¶

This apparent behavior has been attributed to a speculative bubble. Under this view, the most
plausible theory for the Crash is that a speculative bubble burst in October 1987.

 A Bubble at Work: The South Seas Bubble

XI.54
In March 1711 the Chancellor of the Exchequer announced to Parliament plans to convert the
National Debt, then GBP 9 million, into shares in a joint-stock company called "The Governor and
Company of Merchants of Great Britain trading to the South Seas and other parts of America, and
for the encouraging of the Fishery." This company was better known as the South Seas Company. In
exchange for GBP 9 million, the South Seas Company was going to receive a 6% annual payment
from the government, plus the monopoly rights to trade with South Seas territories. The issue was
quickly fully subscribed. Within four years the capital of the company was increased to GBP 10
million. By 1717, nearly half of the wealth of the country was invested in the company. In 1720, Sir
John Blunt, a well-known banker and also director of the South Seas Company, proposed to the
Government a merger with the remaining National Debt -at that time GBP 31 million. In April 1720,
the Parliament approved this idea and the South Seas Act was passed. Within days of the Act
receiving royal assent, the company announced its first “money subscription” at a price of GBP 300
for GBP 100 par. After several promises from the company of dividends of 30% annually and even
50% annually, the issue was oversubscribed. Approximately GBP 1.5 million was subscribed in less
than a day -even the King and the Prince of Wales bought stock at 400%. The interest in this
company was such that other "bubble" companies were set up. It was calculated that the value of all
these bubble companies, valued at market prices, was close to GBP 500 million -five times the value
of all the cash in Europe. The bubble soon burst.

Some investors made huge profits with the bubble, like the Prime Minister, Sir Robert Walpole, and
the Prince of Wales. Others were ruined. After the collapse of the South Seas shares, the Bank of
England and the East India Company took over the South Seas Company, and its shares traded for
another 100 years. The company, however, was never successful.

As a result of the South Seas bubble, the British government put severe restrictions on joint stock
issues. These restrictions left two insurance companies, the Bank of England, the East India
Company and what remained of the South Seas Company as the main components of the English
stock market for the rest of the century.

Another result of the South Seas bubble was a long poem written called “The Bubble” by Jonathan
Swift, the author of Gulliver’s Travels, published in January of 1721. The poem included the
following line:

While some build Castles in the Air,

Directors build ’em in the Seas;
Subscribers plainly see ’um there,
For Fools will see as Wise men please. 

It is difficult to test for bubbles. It is very difficult to measure the structure of the speculative bubble.
Some popular tests are based on the structure of the autocorrelations. During a speculative bubble,
the degree of serial correlation could be highly non-stationary, swinging up and down and yet still
being positive during most of the bubble's expansion. (Traditional methods, like the Q test, usually
assume stationarity and they may have weak detecting power as a consequence.)

XI.55
Several studies have used non-standard tests (two popular test are the so-called variance ratio test
and the BDS -Brock, Dechert, and Sheinckman- test) and have dismissed it as a plausible
explanation for the October 1987 Crash.

 Can a Crash be avoided?

The immediate consequence of the Crash was a couple of reports by official agencies, the most
famous one is the report by the Presidential Task Force on Market Mechanisms. Not surprisingly,
these reports call for more controls and regulations, especially of futures markets. The objective of
these measures is to reduce volatility.

The proposed measure included:

(1) Increase in margin requirements.
(2) Imposition of price limits.
(3) Differential taxing for short and long positions.

There is no evidence that margin requirements or price limits have any impact on stock price
volatility.

The Crash was an international event. In Table XI.10, we have countries with different regulations,
controls, taxes and trading systems. However, all experienced a significant negative shock in
October 1987. 

4.C.4 Average Linkages

We know, from the previous section, that markets display similar movements during periods of
extreme stock market movements. We also know that on average correlations are low to moderate.
Are there any patterns in those correlations? Some studies have pointed out certain regularities. Big
movements (not of the extreme kind) increase the correlation between international markets. There
seems to be a lead-lag relation between the U.S. market and the rest. Markets around the world seem
to pay close attention to the U.S. market open. An important question for investors and traders is the
following: are changes in stock markets related across time? For example, if there is a big
(surprising) change in the U.S., do we expect a similar change in Japan, the next day? That is, the
nature of correlations among international markets might be very important for investors. We should
already suspect that the answer to this question has very important portfolio implications.

4.C.4.i Big Movements, Higher Correlations

When price changes are moderately big, transaction costs become relatively unimportant.
Transaction costs are a barrier for instantaneous arbitrage. Therefore, big price changes will bring
world markets together.

Example XI.21: DuPont and IBM are U.S. stocks with listings on the Tokyo and the London exchanges.
From October 21, 1987 to June 15, 1988, the stock movements were tightly linked across international
markets only if the price movement was bigger than the transaction cost. For example, if the price movement

XI.56
was bigger than the roundtrip transaction costs, the response to a change in Tokyo or London exchanges in the
NYSE was one to one. If the price movement was less than the roundtrip transaction cost, the response was
close to zero. ¶

Cross-market correlations tend to be positively correlated with measures of price volatility.

4.C.2.ii Leads, lags and the U.S. market open

In a study published in the Journal of Financial and Quantitative Analysis, in 1989, Eun and Shim
examine the international transmission mechanism of daily movements of stock prices by estimating
a vector autoregressive (VAR) model of nine major stock markets. A VAR model is a simultaneous
equation model where all the variables are considered endogenous. The explanatory variables are
lagged endogenous variables. This approach allows us to decompose returns into a component due
to previous domestic innovations, and a second component representing previous foreign returns.

Their result shows that a substantial part of daily movements in innovations is attributable to other
countries. On the other hand, the magnitude of the impact by those countries is not symmetric; the
U.S. market is found to be by far the most influential country.

The Eun and Shim (1989) study uses daily data. Using daily data has a disadvantage, some markets
in the world have overlapping trading hours. It is very difficult for some markets to distinguish what
is a common movement (caused by world factors) and what is the influence of a specific
international market. Therefore a positive co-movement between NY and London (they share 2:30
hours of trading) might either reflect common information or the influence of one specific market in
the other.

In other studies, using hourly data, a U.S. market opening effect has been discovered. The intra-daily
evidence between New York and London is that they only affect each other around the time New
York is opening (9:30 AM, EST). At all other times, they behave like independent units. There is
evidence for an opening effect connected to NYSE.

4.C.3 Application: High Volatility, Correlations and Portfolio Choice

As we have seen above, in Section I, the home bias is a puzzle. The papers that discovered the home
bias puzzle examine gains to diversification using a time invariant correlation structure. Changes in
the correlation structure, no doubt, will affect the composition of optimal portfolios across time.
Bicksler (1974) shows that if correlations among international stock markets change over time, the
gains from international portfolio diversification may not necessarily be realized. As we have
discussed in Chapter V, variances and covariance are time-varying and ARCH models are popular
ways to model them. Several articles find that, in general, international correlations are unstable over
time.

As discussed above, in this Section, higher interrelations are found when markets are more volatile.
Karolyi and Stulz (1995) find that while co-movements exhibit day-of-the-week effects,
macroeconomic shocks do not adequately explain these co-movements; neither does controlling for

XI.57
industry effects. More importantly they find that covariances are high when returns on the national
indices are high and when "markets move a lot."

The above results suggest that while variances and covariances across markets are changing over
time, the spillover effects are also a function of the magnitude of the volatility shocks. In other
words, variances, covariances and correlations could be both time and state varying.

In Table XI.13, the correlations between the U.S. and other major markets are calculated for two
U.S. volatility regimes: high volatility and low volatility. In other words, using the U.S. market as
the home market and based on the state of the variance of the home market return, the correlation
between the home and foreign markets is calculated. The results show that except in the case of Italy
and Sweden, higher correlations between the U.S. and other major stock markets are associated with
periods of high domestic volatility and vice versa. On average the correlations are 1 to 2.6 times
higher in the U.S. high volatility state.

The last column of Table XI.13 also provides an indication of the proportion of times that a positive
foreign market return would have hedged a negative U.S. return when the U.S. is in a high volatility
regime. For instance, a positive return on the U.K. market would hedge a negative return in the
home (U.S.) market about 11% of the time when the home market is in the high volatility state.
Similarly, a portfolio with the U.S. and the world weighted in terms of market capitalization would
have provided no risk reduction benefits to a U.S. investor when the U.S. is in a high volatility
regime.

As the U.S. investor is concerned, the benefits of diversification change depending on the state of
the volatility structure. For example, during the U.S. high volatility state, the correlation between
U.S. and EAFE returns significantly increases, but since the EAFE volatility is below the U.S.
volatility, the EAFE weight significantly increases. This result might explain a finding reported by
Tesar and Werner (1995). They point out that one would expect that U.S. investors would decrease
their purchases of equity from a market when that market covaries more strongly with the U.S.
market. Tesar and Werner, however, cannot find evidence for such a pattern in the data, which is
consistent with the above findings.

The results discussed above do not provide a complete explanation of the home bias phenomenon. If
investors, however, forecast that during high volatility periods the correlations increase, but the
foreign market variance increases more than the domestic variance, the portfolio weights would
show an "ex-post" home bias.

XI.58
 TABLE XI.13
Correlations between the U.S. and other markets in the two volatility regimes

High volatility Low volatility % Hedging

U.K. 0.7251 0.3124 11.11%
Germany 0.4275 0.2546 22.22%
Japan 0.2400 0.2344 22.22%
Canada 0.7983 0.6386 2.78%
Spain 0.2775 0.1481 19.44%
France 0.5471 0.2079 22.22%
Hong Kong 0.3208 0.2144 22.22%
Australia 0.2400 0.2344 19.45%
Denmark 0.3103 0.1980 16.67%
Belgium 0.3937 0.2114 22.22%
Italy 0.1160 0.1632 30.55%
Netherlands 0.7382 0.4454 19.44%
Norway 0.4735 0.2873 27.78%
Singapore 0.3762 0.2105 19.44%
Sweden 0.1730 0.2095 13.88%
Switzerland 0.5763 0.3318 13.88%
EAFE 0.5098 0.3474 11.11%
World 0.8628 0.7658 0.00%

V. Looking Ahead

We have studied the major differences among national stock markets. Stock markets tend to have
different rules, legal frameworks, taxes, and cultural practices. These issues might affect the
informational content of equity prices. In some markets obtaining reliable information is
expensive and difficult. Investing in foreign equity also involves country risk. Given these
problems and costs, many investors may not see the real attraction of international stock markets:
great diversification. In the next chapter, we move to a different asset class in international
markets: bonds.

XI.59
Related readings:

A nice description of different market structures and their implications is in The Microstructure of
Securities Markets, by K.J. Cohen, S. Maier, R. Schwartz and D. Whitcomb.

In Chapter 13 of A Random Walk down Wall Street, by Burton Malkiel, there is a clear exposition
of the passive and active approach.

For an overview of stock market automatization see "Automating the Price Discovery Process:
Some International Comparisons and Regulatory Implications," by Ian Domowitz, in the Journal of
Financial Services Research, 1992.

For an applied approach to Mutual Funds and their methods, read How Mutual Funds Work, by
Albert J. Fredman and Russ Wiles (international funds are in Chapter 7).

For a broad overview of international accounting practices, see International Accounting, by F.D.
Choi and G.G. Mueller.

Ang, A., A. A. Shtauber, and P. C. Tetlock (2001), “Asset Pricing in the Dark,” working paper,
Columbia University.

Campbell, John Y., and Robert J. Shiller (1998). “Valuation Ratios and the Long-Run Stock
Market Outlook,” Journal of Portfolio Management, vol. 24, no. 2, pp. 11-26.

Fan, J., and Wong, T. (2002). “Corporate Ownership Structure and the Informativeness of
Accounting Earnings in East Asia. Journal of Accounting and Economics, 33, 401-425.

Lang, M., K. V. Lins and M. Maffett (2009). “Transparency, Liquidity, and Valuation:
International Evidence,” working paper, UNC.

Leuz, C., D. Nanda, and Wysocki, P. (2003). “Earnings Management and Investor Protection: An
International Comparison,” Journal of Financial Economics, 69: 505-527.

XI.60
Exercises:

1. A Mexican investor buys 5,000 shares of GE on January 6, 2015 on the NYSE at USD 30.50. The
exchange rate is 17.50 MXN/USD. Over the year, the investor receives a gross dividend of USD
0.92 per share; the net dividend per share received is equal to USD 0.782 because of a 15%
withholding tax levied by the U.S. The exchange rate at the time of dividend payments is 8.90
MXN/USD. On February 15, the investor resells the shares at USD 31.25. The exchange rate has
dropped suddenly to 16.20 MXN/USD. Ignoring commissions, what is the rate of return on the
investment (in USD and in MXN), gross and net of taxes. Our investor is taxed at 40% on income
and 15% on capital gains; the U.S. withholding tax can be used as a tax credit in Mexico.

2. Newly privatized Latin American firms such as oil giant Petrobras have larger trading volume in
New York, where they trade as ADR, than in their home stock exchange. Propose an explanation for
this empirical fact.

3. Suppose you have the following data (January 1980- July 1994) from MSCI: the 90 days Treasury
Bill rate, ten country indexes, the World Index and the excess home currency return on an asset that
is riskless in terms of the currency of each country. How would you test the mean-variance
efficiency of the World Index?

4. A Jensen measure, with respect to the FT-World Index, for an international money manager is
.354. The standard error of this estimate is .201. Is the managed portfolio outperforming the FT-
World Index?

5. It is July 17, 2015. The DAX closed at 11,673. Ms. Chambers manages a German portfolio valued
at EUR 12 million. Ms. Chambers' portfolio has ß=.89. She is concerned about a possible drop of the
German stock market during the next two months. She does not want the value of her portfolio to
drop below EUR 8 million. She decides to use DAX index put options to establish a floor. On July
17, 2015, the September put option with a strike price of 11,000 is trading at 81. (The DAX
multiplier is EUR 5.) Ms. Chambers has estimated that b = 3933.

(1) Determine the number of options needed to establish a floor for Ms. Chambers' portfolio.
(2) Determine the cost of the insurance.
(3) For different scenarios for the DAX, show that the floor works.

6. You want to calculate the P/E ratio for the U.K. market. Assume that real economic, long term,
trend growth (g) is 2.5% a year. Assume that the real bond yield is 3% and the risk premium is
3.5%. Calculate the steady state P/E ratio.

7. It is April 2015. The U.K. economy is very advanced in the business cycle. According to British
expert, the earnings estimates for the FTSE-100 are in the range of 600-650. The FTSE-100 is
trading around 7000. Adjust accordingly the steady state P/E ratio, calculated in Exercise 6, to
determine if the U.K. market is overvalued.

8. Suppose JRV Corp is considering a project in Colombia (T=5 years), which requires an
investment of COP 2000M (COP: Colombian peso). JRV is planning to use the usual 70/30 D/E

XI.61
split. Colombia has a 25% effective corporate tax rate. To calculate the cost of capital, JRV
gathers the following data (all annualized):
JRV can borrow in Colombia at 8% and in the U.S. at 2.5%.
5-year government (risk-free) rates: 6.5% in Colombia and 1.5% in the U.S.
Effective corporate tax rate in Colombia: 25%
Expected Colombian stock market return: 13%
U.S. stock market return: 8%
Beta of project: 1.3
E[ICol] = 5%
E[IUS] = 2%
Stock market volatility: 35% in Colombia, 15% in the U.S.
Bond market volatility: 26% in Colombia, 12% in the U.S.

a. Using WACC, calculate the cost of capital for the Colombian project.

b. Suppose JRV does not trust the expected return reported for Colombia and decides to use the
Relative Equity Market Approach to estimate the Colombian risk premium (kM – kf). Recalculate
the cost of capital for the Colombian project.

c. JRV believes the project would not have full exposure to Colombian country risk, since 80% of
its production would be exported to the U.S. Assume that exports contribute 18% to Colombian
GDP. Recalculate the cost of equity and the cost of capital under this scenario.

9. Suppose you work for the investment consultant CFS following the ADRs of Grupo Aval
Acciones y Valores (NYSE:AVAL), Colombia’s largest holding company, which recently went
public in Bogotá and in New York. After fifteen years of growth and better prospects for peace with
armed guerrilla groups, Colombia is considered one of the Latin America's most appealing emerging
markets, though it has recently shown some growth pains.

It is January 6, 2015. AVAL does not have a long history, its IPO was held on September 23, 2014.
Its EPS in 2016 are projected to be USD 0.65, while the estimated EPS in 2017 are USD 0.69. The
estimate for the annual dividend in 1996 is USD .39, for an estimated dividend yield of 6%. Many
analysts believe that the short-term dividend growth rate will be 0%. Given the global economic
problems, you believe that this level will be maintained for another two years. After that, you expect
the company's dividend growth rate to revert to the long-term growth forecast level, which you
estimate to be 10%.

CFS estimates required rates of return using CAPM. You have the following inputs: ßAVAL=1.05; rf
=.06; E[rm]=.13.

Analysts believe the USD will appreciate at an average rate of 15% a year against the Colombian
peso (COP) for the next two years. After that, analysts predict a 4% depreciation of the COP against
the USD for the foreseeable future.

XI.62
On January 6, 2015, the closing price on NYSE for AVAL was 6.30, while the exchange rate was
3,225 COP/USD. What is your recommendation for AVAL: a buy, a hold or a sell?

XI.63