Unit V: International Investment and Challenges
International Portfolio Investment
International portfolio investment means investing in foreign financial assets such as:
- Shares
- Bonds
- Mutual funds/ETFs
- Money market instruments
These investments do not involve control over the foreign company (unlike FDI).
Foreign Investment Analysis
When investing internationally, investors analyze:
A. Economic Factors
- GDP growth
- Inflation
- Interest rates
- Political stability
B. Market Factors
- Stock market performance
- Bond yields
- Currency stability
C. Institutional Factors
- Tax rules
- Capital controls
- Foreign investment policies
D. Risk Factors
- Exchange rate risk
- Sovereign risk
- Liquidity risk
International Bond Investing
Investing in foreign bonds for:
- Higher yields
- Currency diversification
- Lower correlation with domestic markets
Types of International Bonds
- Foreign Bonds (e.g., Yankee, Samurai, Bulldog)
- Eurobonds (issued outside domestic market, usually in USD or EUR)
- Global Bonds (issued simultaneously in multiple markets)
Key Risks in International Bond Investing
- Currency risk
- Country risk
- Credit risk
- Interest rate risk
Why invest?
- Diversification
- Potential for higher returns
- Hedging domestic market fluctuations
Direct Investment Strategies
Direct investments involve owning or controlling assets in foreign countries.
Forms of Direct Investment
1. Foreign Direct Investment (FDI)
- Establish subsidiaries
- Acquire foreign companies
2. Joint Ventures
Shared ownership with foreign firms
3. Strategic Alliances
Partnerships for technology, distribution, etc.
Benefits
- Access to new markets
- Lower production cost
- Tax benefits
- Improved global competitiveness
Optimal International Asset Allocation
Optimal allocation = deciding how much to invest in different countries and asset classes to balance risk and return.
Key Principles
- Diversification - Reduce risk by investing in markets with low correlation.
- Risk–Return Trade-off - Higher return requires taking higher risk.
- Currency Diversification - Exposure to multiple currencies stabilizes the portfolio.
- Hedging - Use forwards, options, or currency ETFs to reduce FX risk.
- Modern Portfolio Theory (MPT) - Choose international assets with the best risk-adjusted returns.
International Foreign Exchange Risk
Foreign exchange risk arises due to fluctuations in currency values.
Three Types of FX Exposure
- Transaction Exposure (short-term)
- Translation Exposure (accounting exposure)
- Economic Exposure (long-term operating exposure)
Transaction Exposure
Transaction exposure is the risk arising from contracted but unsettled foreign currency transactions.
Where it occurs?
- Export receivables
- Import payables
- Foreign currency loans
- Investment income (interest/dividends)
Why risky?
If the foreign currency:
- Appreciates, importer pays more
- Depreciates, exporter earns less
Managing Transaction Exposure
A. Internal Methods
- Leading and Lagging
- Netting (offset payables & receivables)
- Invoicing in Home Currency
- Matching inflows & outflows
B. External Methods (Financial Hedging)
- Forward Contracts
- Futures Contracts
- Currency Options (call/put)
- Money Market Hedge
- Currency Swaps
Short Summary Table
| Concept | Meaning | Importance |
|---|---|---|
| International Portfolio Investment | Buying foreign stocks/bonds | Global returns & diversification |
| Foreign Investment Analysis | Study economic, risk, and market factors | Reduce investment losses |
| International Bond Investing | Buying foreign country bonds | Higher yield & currency gain |
| Direct Investment Strategies | FDI, JV, alliances | Market expansion & cost reduction |
| Optimal Asset Allocation | Choosing best mix of assets globally | Maximize returns, minimize risk |
| Transaction Exposure | FX risk on future cash flows | Must be hedged |
International Portfolio Investment & Foreign Exchange Risk
1. International Portfolio Investment
International portfolio investment means investing in financial assets (shares, bonds, mutual funds, etc.) outside your home country.
The main purpose is earning higher returns, diversification, and reducing risk.
A. Foreign Investment Analysis
When investing in foreign assets, companies or investors analyze:
1. Expected Returns
-
Profit expected from foreign stocks/bonds.
2. Risk Assessment
- Currency risk (exchange rate fluctuations)
- Political risk (policy changes, instability)
- Market risk (volatility of foreign markets)
3. Economic Conditions
- Inflation
- Interest rates
- GDP growth
4. Taxation Policies
- Double taxation
- Withholding tax on dividends and interest
B. International Bond Investing
Investors buy foreign bonds to earn interest income.
Types include:
1. Foreign Bonds
-
Issued by a foreign company in the domestic market, using domestic currency. Example: A Japanese company issuing bonds in India (in INR).
2. Eurobonds
-
Issued in a currency that is not the home currency of the issuer. Example: Indian company issuing bonds in USD in London.
3. Global Bonds
-
Issued and traded in multiple markets at the same time.
Advantages:
- Higher returns
- Diversification
- Access to global interest rates
Risks:
- Currency volatility
- Default risk
- Interest rate differences
C. Direct Investment Strategies
Direct investment means investing physically in another country.
Examples:
- Setting up factories abroad
- Buying a foreign company (M&A)
- Opening retail stores overseas (e.g., Walmart India)
Key motives:
- Access to new markets
- Lower cost of production
- Control over operations
- Strategic expansion
D. Optimal International Asset Allocation
This means deciding how much of an investment portfolio should be allocated to:
- Domestic assets
- Foreign equity
- Foreign bonds
- Alternative assets (commodities, real estate)
Goal: Maximize return while minimizing global risk through diversification.
International Foreign Exchange Risk
Foreign exchange risk arises when companies deal in multiple currencies. Exchange rate fluctuations affect:
- Profits
- Cash flows
- Value of foreign assets
- Competitiveness
There are three major types of exposure:
A. Transaction Exposure
Risk arising from actual business transactions involving foreign currency.
Example: A US company buys goods from India and must pay ₹ after 3 months. If the rupee value increases, the cost becomes higher.
Impact:
- Gain or loss on receivables/payables
- Affects cash flows directly
Management / Hedging:
- Forward contracts
- Options
- Money market hedge
- Swaps
B. Translation Exposure
Risk when foreign subsidiaries’ financial statements are converted into the parent company’s home currency.
Example: An Indian MNC with a US subsidiary converts USD assets into INR. If USD falls, asset value drops.
Impact:
- Affects balance sheet
- Does not affect cash flow directly
- Impacts reported profits
Management:
- Currency swaps
- Balance sheet hedging
- Adjusting asset-liability structure
Economic Exposure
Long-term impact of exchange rate movements on a company’s future cash flows and competitive position.
Example: If the Japanese Yen depreciates, Japanese products become cheaper globally, giving them a competitive advantage.
Impact:
- Market share
- Pricing strategy
- Sales volume
- Long-term profitability
Management:
- Diversifying production locations
- Sourcing raw materials internationally
- Currency mix in debt
- Flexible pricing policy
Impact of Currency Volatility on MNCs
Currency volatility affects:
1. Profit Margins
Sudden depreciation/appreciation affects export-import costs.
2. Cash Flows
Delayed payments or loan repayments become uncertain.
3. Investment Decisions
Uncertainty reduces capital investment.
4. Competitiveness
A stronger local currency makes exports expensive.
Political and Sovereign Risk
A. Political Risk
Uncertainty caused by political factors:
Examples:
- Policy changes
- Government instability
- Civil unrest
- Changes in taxation
- Trade restrictions
Effects:
- Sudden losses
- Supply chain disruption
- Higher cost of business
- Withdrawal of foreign firms
B. Sovereign Risk
Risk that a foreign government may:
- Default on its debt
- Change interest or tax rules
- Impose capital controls
- Restrict profit repatriation
Example: Argentina and Sri Lanka sovereign debt crises.
Regulatory and Compliance Challenges
MNCs must follow rules in every country they operate in:
1. Exchange control rules
Limits on foreign currency transactions.
2. Tax regulations
Different tax regimes and double taxation rules.
3. Reporting standards
IFRS vs GAAP financial reporting.
4. Anti-money laundering (AML)
Strict compliance required for international funds transfer.
5. Trade sanctions
Prohibited countries or restricted goods.