INTERNATIONALINVESTING:

Theory, Practice, and Results

ByRay A. Campbell III

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ECONOMIC EDUCATION BULLETIN

Published by

AMERICAN INSTITUTE FOR ECONOMIC RESEARCHGreat Harrington, Massachusetts

Copyright American Institute for Economic Research 1990

ECONOMIC EDUCATION BULLETIN

Vol. XXXIII No. 6 June 1993

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Contents

Preface 1

INTRODUCTION 3

I. THE BENEFITS OF INTERNATIONALDIVERSIFICATION 5

More Effective Risk Reduction 5Greater Investment Choice 9Higher Returns and an Improved Risk-Return Ratio 12Currency Fluctuation Opportunities 12

II. THE RISKS OF INTERNATIONAL INVESTMENTS 15Foreign-Exchange Risk 15Political Risk 15Taxes and Capital Controls 15Informational Limitations 16

III. THE INTERNATIONAL MONETARY SYSTEM 17

IV. THE MARKET FOR FOREIGN EXCHANGE 21

V. EXCHANGE RATE THEORY VS. PRACTICE 24Balance of Payments Analysis 24Purchasing Power Parity 26Interest-Rate Parity 28Forward Exchange Rates 29Central Bank Intervention 30

VI. MANAGING CURRENCY RISK 33Forward Foreign-Exchange Markets 33Foreign Currency Futures 33Foreign Currency Options 34Cross-Hedging 34Currency Swaps 34

VII. INTERNATIONAL INVESTMENT VEHICLES 36American Multinational Corporations 36Global and International Mutual Funds 36Stock in Foreign Companies Traded on American Exchanges.. 37Domestic Capital Markets in Foreign Countries 37International Capital Markets 37

VIII. HISTORICAL RETURNS ON FOREIGN

GOVERNMENT BONDS 40

IX. PROSPECTS FOR THE FUTURE 47

X. CONCLUSION 54

Preface

M ANY of the policy issues related to international monetary,fiscal, and commercial practice have long been familiar to reg-ular readers of American Institute for Economic Research

publications. Elsewhere we have described the on-going attempts of theinternational authorities to stabilize exchange rates, coordinate fiscalpolicies, and liberalize trade regimes among the industrialized nations —all of which contain "macro-economic" implications for the allocation ofworld capital resources and the prospects for growth in the worldeconomies. For many years we also have suggested the personal advantagesof holding assets denominated in foreign currencies. For example, Swiss-franc bank accounts and Swiss-franc annuities, which we introduced toour readers more than 2 decades ago, demonstrably have preserved thepurchasing power of savings threatened by the continual erosion of thedollar.

The liberalization of international financial markets and the proliferationof foreign investment vehicles over the past decade or so have createdgreater opportunities than ever before for individuals even of moderatemeans to participate in the international investment arena. Even so, thecomplexities of international investments probably remain a puzzle toaverage investors, even though, with a little effort, they may providesubstantial benefits.

International Investing: Theory, Practice, and Results presents in a singlebrief volume an introduction to international financial markets and adescription of the principal factors that shape them. This booklet does notgive specific investment advice, which interested persons can obtain fromother qualified sources, including our wholly owned investment advisory,American Investment Services, Inc. Rather, our hope is that InternationalInvesting will provide readers with an understanding of internationalfinancial markets that is adequate for making informed judgments about,say, the usefulness of the daily international business news (whose "instantanalysis" often relies on rigid adherence to one or another textbook theories)or the desirability of a particular type of investment (that brokers workingon commission always will find reason to promote).

It is our view that carefully chosen international investments can providea number of direct and indirect benefits. From the point of view ofpersonal financial security, they may offer protection against the effects ofdomestic policies that reduce the competitiveness and profitability of U.S.businesses at the same time that they diminish the value of savingsdenominated in dollars. In a larger sense, international investing promises

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much longer-term civic benefits. If a substantial proportion of Americans

freely select investments internationally on the basis of their underlying

merits, they may achieve through "voting with their savings" what they

have been unable to accomplish with their votes at the ballot box: i.e., they

may force the U.S. authorities to adopt more sensible policies at home.

In global terms, the integration of world financial markets may provide

the opportunity for millions of individuals from many countries to

participate directly in shaping the "New World Order" according to their

perceptions of the market. In our view, this prospect seems immeasurably

more favorable for promoting the allocation of world resources to their

best uses than the actions of various international regimes devoted to

promoting agenda that are shaped by momentary political considerations.

INTRODUCTION

ONE of the most profound changes in economic analysis over thepast decade has heen the increased importance of internationaldevelopments for the health of the American economy and the

prosperity of its citizens. Today's financial news is saturated with storiesabout the level of foreign investment in the United States, the importanceof foreign trade and access to foreign markets, cross-border mergers andacquisitions, the performance of global mutual funds, complaints of acredit crunch, the prospects for European economic integration, and so on.It now is accepted as common knowledge that commerce and finance are"going global." Despite their recognition of the importance of worldevents for America's economic well-being, most individual investors prob-ably remain confused and uncertain about the international dimensions ofpersonal finance.

This booklet seeks to provide a broad description of important issues ininternational finance that affect individual investors. The goal is not tofurnish advice about specific investment opportunities, but rather to helpindividuals better understand the daily flood of information about devel-opments in international finance that can significantly affect personalinvestments. The first step in this process is a description of the advan-tages and disadvantages of international investments, with particular em-phasis on the application of portfolio theory for reducing risks throughdiversification (see Chapters I and II). Next, to provide a context forunderstanding the whole range of issues that arise in international finance,a description of the evolution of the international monetary system isincluded (Chapter III).

Although it is possible to achieve a measure of international diversifi-cation with dollar-denominated investments, most international invest-ment vehicles require an investor to exchange dollars for some type offoreign currency and then, eventually, to convert the foreign currencyback into dollars. In view of the crucial importance of foreign-exchangetransactions in international investments, a description of the market forforeign exchange, and the determinants of foreign-exchange rates, is pre-sented in Chapters IV and V. Exchange rates have been extremely volatileover the past 20 years, since fixed exchange rates were abandoned in favorof floating rates, and such volatility can dramatically affect the performanceof foreign investments. Accordingly, various techniques for hedging for-eign currency risk are discussed in Chapter VI.

Chapter VII considers the many possible investment vehicles for inter-national diversification, while Chapter VIII compares dollar rates of re-

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turn on long-term bonds issued by the governments of the United Statesand seven other developed countries. Aside from serving as a usefulcomparison of bond returns for investors who hold U.S. Governmentbonds alone, this exercise furnishes a "real" world example of resultsobtained from the application of the theories that have been developedabout the benefits of international portfolio diversification. Chapters IXand X discuss some of the major issues of the day in international financethat frequently are mentioned in financial publications and discuss someprospects for the future.

I.

THE BENEFITS OF INTERNATIONAL DIVERSIFICATION

ALTHOUGH largely overlooked until fairly recently, internationalinvestments offer American investors unique advantages in theselection of investment opportunities. There are four primary rea-

sons for investors to consider foreign investments. First, internationalinvestments provide a degree of portfolio diversification, and hence riskreduction, that is unattainable in the U.S. market alone. Second, expand-ing one's investment horizon beyond U.S. markets dramatically increasesthe universe of investment opportunities. Third, foreign investments canoffer an appreciably higher rate of return than can be achieved in the U.S.market, particularly in light of growth forecasts for the 1990s. Finally,although exchange-rate fluctuations can either increase or decrease dollarrates of return, and are very difficult to predict, foreign investments offerinvestors an opportunity to make judgments about, and profit from, cur-rency fluctuations that are only indirectly possible with domestic invest-ments. The following sections discuss these possibilities in greater detail.

More Effective Risk Reduction

International investments offer a way to reduce portfolio risk throughmore effective diversification, a topic that forms a major part of modernportfolio theory. Since the 1950s, a great deal of scholarly attention hasfocused on the relationships between risk, return, and diversification, andthis has produced a substantial body of knowledge that can be invaluableto the individual investor. Nobel Prize laureate Harry M. Markowitz pio-neered portfolio theory and his studies in the 1950s gave birth to themodern study of portfolio theory and established one of the most popularmeasures of portfolio optimization, known as Markowitz mean-varianceefficiency. An appreciation of his procedures is useful in analyzing allinvestment opportunities, not just those available abroad.

An investment's risk is an expression of the variability, and henceuncertainty, of possible investment outcomes. The historically observedrange of returns on most investments, as well as informed judgmentsabout future returns on most investments, tend to have a "normal distribu-tion." Variables that have a "normal," as opposed to a random, distributionlend themselves to useful quantitative analysis. The analysis of normaldistribution curves is at the heart of modern theories about risk reductionthrough portfolio diversification.

In the context of investment returns, a normal distribution implies that agraph showing observed or expected rates of return on the horizontal axis,and the number of times each such rate of return has been observed or is

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expected to occur, on the vertical axis, will be in the shape of a symmetri-cal bell curve.1 Normal distribution curves for returns on two hypotheticalinvestments, A and B, are shown in Chart 1. The rate of return predicted tooccur most frequently for investment A is 8 percent, and all of the pre-dicted returns are clustered fairly tightly around this rate. For investmentB the most frequently predicted rate of return is 12 percent, but thedispersion of returns is much greater. While actual returns in the "realworld" seldom have a perfectly normal distribution, they typically ap-proximate a normal distribution closely enough to make such curvespowerful analytical tools. For example, Chart 2 shows the actual distribu-tion of 186 monthly returns on the portfolio of U.S. and foreign govern-ment bonds discussed in Chapter VIII.

The most interesting statistical feature of normal distribution curves isthat they can be completely described by two numbers: the mean and thestandard deviation. The mean is simply the average, and for normaldistribution curves the mean is the number that lies under the peak of thecurve, 8 percent for curve A and 12 percent for curve B in Chart 1.Economists and financial analysts call the mean the "expected" return.This is both because the mean corresponds to the return that is predicted tooccur most frequently, and because it is the average value of the entirerange of predicted returns.

Chart 1

NORMAL DISTRIBUTION CURVES

A

+8 +12

Rates of Return

16 +20 +24

Chart 2

DISTRIBUTION OF RETURNS

Diversified Government Bond Portfolio

•10.00% | -6.50% | -3.50% | -0.50% 2.50% 5.50% | 8.50% |-8.00% -5.00% -2.00% 1.00% 4.00% 7.00% 10.00%

Observed Monthly Rates of Return

Of course, the notion that an investment's expected return lies in the

middle of a symmetrical bell curve is an "ideal" statistical construct that is

rarely, if ever, achieved in actual situations. But for any given investment it

is reasonable to assume that more returns will be slightly above or below

the anticipated average return than will be far wide of this mark. This is not

to say that much higher or lower returns will not be observed, only that

they will be relatively rare compared with returns nearer the average.

The standard deviation is an expression of how widely the expected

outcomes vary, and is a measure of the width of the curve. A tall, narrow

curve, such as the one for investment A, has a lower standard deviation

than a short, wide curve, such as the one for investment B. Standard

deviation, which is always measured in the units shown on the horizontal

axis (in this case rate of return), tells how wide is the range around the

mean that contains two-thirds of all the expected returns. Thus, if the

standard deviation for investment A is 3 percent, two thirds of all the

expected returns lie within 3 percent of the mean (8 percent), or between

6.5 and 9.5 percent. If the standard deviation for investment B is 10

percent, two thirds of all expected returns lie between 7 and 17 percent,

which are 5 percent above and below the mean, respectively. While the

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standard deviation of a series of returns can be calculated manually, it iscumbersome and time consuming for large series of numbers.2 In suchcases a computer can greatly reduce the time it takes to derive the standarddeviation.

When economists and financial analysts talk about the risk of an invest-ment, they are referring to its standard deviation, which measures theuncertainty or variability of its expected returns. A small standard devia-tion indicates that the returns are expected to be clustered tightly aroundthe mean, or "expected," return. This implies there is a high likelihoodthat the observed returns will correspond closely to the expected returnand the investment carries little risk. A large standard deviation indicatesthat the returns will be scattered widely around the expected return,sometimes much higher but sometimes much lower, and therefore theinvestment is risky. This view of risk is consistent with investors' ob-served preferences. If two investments have the same expected return butdifferent standard deviations, most investors will choose the investmentwith the lower standard deviation. If two investments have the samestandard deviation but one has a higher expected return most investorswill choose the one with higher return. In general, investors will onlychoose an asset with a higher standard deviation (a riskier asset) if it offersa higher expected return.

Portfolio diversification reduces the risk, or standard deviation, ofone's investments becaise the returns on different assets generally do notmove synchronously. When returns on one investment go down, returnson another may decrease less or may even increase. Thus, fluctuations inthe returns on one asset will be offset, at least partially, by the differentfluctuations of another asset's returns. For example, if an investor putsmoney in stocks of oil companies and alternative energy companies it islikely that developments that increase the returns of one group will depressreturns in the other group, and vice versa. The measure of the extent towhich rates of return on two assets behave alike is referred to as thecorrelation of the two assets.3 Determining the future degree of correlationbetween two securities requires both looking at their historical performanceand making judgments about their likely performance in the future.

If such an analysis of hypothetical assets X and Y shows that the returnon asset X always changes by the same percentage and in the samedirection as changes in the return on asset Y, then the two assets have acorrelation coefficient of 1. If the return on asset X changes by half asmuch as the return on asset Y, but in the same direction, they have acorrelation coefficient of 0.5. If the returns on two assets are completelyrandom in their relation to one another they have a correlation coefficientof 0. If the return on one asset increases when the return on the other falls,

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the assets are negatively correlated, and if the percentage changes areidentical but in opposite directions the correlation coefficient is - 1 . Assetswith low correlations, and ideally negative correlations, provide the great-est risk reduction when combined into a portfolio because they eitherdampen or offset return variations in other assets.

This ability to reduce risk through diversification has led to the theo-

retical division of risk into two components. Risk that can be eliminated

through diversification is known by a number of names such as unique

risk, diversifiable risk, unsystematic risk, specific risk, and residual risk.

All of these terms describe the risk that is unique to the particular invest-

ment as a result of the specific hazards that it faces in the market. In a

well-diversified portfolio there is very little unique risk.

Risk that cannot be eliminated by diversification is known as marketrisk, undiversifiable risk, or systematic risk, which is the level of risk thatis shared by all investments in the market. This is just another way ofsaying that there is a certain degree of correlation between assets in anygiven market because their performance is at least partly a function of thehealth of the market itself. In a well-diversified portfolio nearly all of therisk is market risk.

Investors can choose any number of strategies to diversify their hold-ings so as to minimize risk. Diversification can be sought within a particu-lar asset category (i.e., buying common stock in several different industries)as well as between asset categories (i.e., buying stocks, bonds, preciousmetals, real estate, etc.), and it is prudent to pursue both strategies. Ingeneral, however, investments within a single national economy tend toshow a fairly high degree of correlation because they all are subject to thesame overall economic climate and "investor psychology." Internationaldiversification is uniquely attractive, however, because returns on invest-ments in different countries often have lower, or even negative, correla-tion coefficients and therefore may significantly reduce portfolio risk.

Greater Investment Choice

The second advantage offered by international investments is that, byexpanding the universe of possible investment opportunities, the investorhas more flexibility in determining portfolio composition. It is important torealize that these expanded opportunities are not limited to speculative ormarginal investments. By now, few Americans need to be reminded thatmany of the world's largest and most profitable financial, pharmaceutical,chemical, automotive, manufacturing, and electronics firms are foreignentities. A willingness to consider investments in foreign firms enablesinvestors to participate in industries that are mature or may be declining inthe United States but that are growth industries abroad. Thus, an interna-

9

10

i

tional investment focus need not dilute the quality of one's holdings, butrather can offer expanded possibilities across the entire risk-return spec-trum.

Higher Returns and an Improved Risk-Return Ratio

International investments also offer an opportunity to participate inmarkets that have grown faster than U.S. markets in the past and seemdestined to do so in the future. As for the outlook for the future, aconsensus of "expert" opinion now seems to be that the U.S. economywill experience relatively low growth rates over the next several yearscompared with many other industrial nations. Reasons for this include apersistently low national savings rate, low levels of net national investment,high costs of capital, and an aging infrastructure and physical plant, all ofwhich are related phenomena. An international focus, therefore, offers theability to allocate investment capital to markets with higher expectedgrowth rates.

In addition to higher rates of return, international investments can offermore favorable risk-return ratios because global capital markets are notfully integrated. Global capital market integration is a function of theextent to which there are barriers to capital flows between nations. Barri-ers can be governmentally imposed, such as exchange controls and taxeson capital movements; market imposed, such as high transaction costs; orcan result from a lack of understanding or interest in foreign markets.When capital markets are fully integrated, as they tend to be within anational economy, investments of equal perceived risk will offer equalreturns regardless of their geographical location. When capital marketsare segmented, on the other hand, risk-return characteristics can differfrom place to place.

There is general agreement among economists that international capitalmarkets are not fully integrated, although they are becoming more so.Capital markets in smaller developed countries and less-developed coun-tries have traditionally received less investor interest and been less inte-grated into the global capital markets, and as a result they may containinvestment opportunities that provide higher rates of return for a givenlevel of risk, or lower risks without lower returns, as compared to moreadvanced capital markets. This market segmentation may afford ambi-tious investors the opportunity to seek out investments with higher returnsthat do not involve higher risk.

Currency Fluctuation Opportunities

Finally, participation in international capital markets allows investorsthe opportunity to benefit from exchange rate fluctuations. Dollar rates of

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return are increased when the dollar depreciates during the life of aforeign investment and decreased when the dollar appreciates. That is, arelatively stronger dollar at the beginning of the investment term providesan American investor with greater purchasing power in the foreign mar-ket, while a weaker dollar at the end of the term allows the investor toconvert his foreign currency into relatively more dollars. Put another way,the international investor wants to buy foreign investments low (strongdollar) and sell them high (weak dollar).

The unpredictability of exchange rates, however, also means that cur-rency fluctuations can either significantly enhance or reduce the dollarrate of return on investments denominated in foreign currencies. Forinstance, from January 1983 to January 1985 the dollar appreciated againstthe Swiss franc by approximately 24 percent. An investor who purchaseda Swiss franc-denominated certificate of deposit that produced a com-pound yield of 20 percent in Swiss francs over this period would haveachieved a dollar rate of return of-8 .6 percent. Oppositely, from January1985 through January 1987 the dollar depreciated against the Swiss francby nearly 77 percent, so that a certificate of deposit that yielded a 20percent Swiss franc return over this period would have achieved a dollarrate of return of 95 percent.

Foreign-exchange rates have been quite volatile since the Bretton Woodsfixed exchange rate system was abandoned in 1973, and, as the foregoingdiscussion demonstrates, these fluctuations can have an enormous effecton the returns achieved on foreign investments. Charts 3 through 9 showU.S. dollar exchange rates as of the first trading day of each month for theCanadian dollar, French franc, Deutsche mark, Italian lira, Japanese yen,Swiss franc, and British pound, respectively.4 The underlying exchange ratesused in these charts follow the North American convention and are ex-pressed in dollars per unit of foreign currency, rather than units of foreigncurrency per dollar. An upward sloping line represents a depreciation ofthe dollar while a downward sloping line signals an appreciation of thedollar. While this inverted approach might seem confusing, it is easier tounderstand when one realizes that the vertical axis in these graphs measuresthe dollar price of one unit of the foreign currency, so upward movementon the graph indicates the foreign currency is becoming more expensive indollar terms while downward movement indicates the foreign currency isbecome less expensive to purchase with dollars.

1 Distribution curves can be constructed both for observed historical returns and antici-pated future returns. In either case they tend to have normal distributions. For simplicitythe remainder of this discussion will talk about such curves in the context of anticipatedfuture returns.2 Mathematically, the standard deviation of a series of numbers is derived by subtracting

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the mean from each number in the series, squaring each resulting number, adding togetherall of the resulting squares, and then taking the square root of this sum.3 Another common term for this relationship is covariance, although covariance is differentfrom, and more complex than, correlation.4 Based on noon buying rates in New York City for cable transfers payable in foreigncurrencies, as reported in the Federal Reserve Weekly Statistical Release.

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II.

THE RISKS OF INTERNATIONAL INVESTMENTS

Foreign-Exchange Risk

AS Charts 3 through 9 make clear, exchange rates can changesubstantially over fairly short periods of time. It follows that theactual dollar value of both dividends and interest payments, as

well as capital and principal redemptions, are at the mercy of the foreign-exchange market unless they are reinvested abroad. Eventually, however,an American investor will have to convert a foreign currency to dollars inorder to use that wealth at home. The extent to which the dollar rate ofreturn on an investment can be influenced by these fluctuations, bothpositively and negatively, was suggested in the preceding chapter. Thereare, however, techniques available for managing or hedging foreign ex-change risk, and these will be discussed in Chapter VI.

Political Risk

Political instability in foreign countries is a potentially serious risk thatinvestors must consider. An unstable political climate can have manyadverse results, such as depressing economic activity, unsettling investorsand thereby reducing securities prices, resulting in a depreciation of thenation*s currency, or even precipitating the nationalization of foreign-owned assets. While such considerations are generally less importantwhen considering investments in the major industrial nations such asJapan, Germany, the United Kingdom, France, and the like, Canada'sconstitutional crisis in the summer of 1990 over Quebec's "special status"shows that even the major industrial democracies occasionally experiencepolitical problems that can shake investor confidence.

Many of the most promising investment opportunities abroad, how-ever, are in countries whose political stability is less certain, such as thenewly industrialized nations of the Pacific rim, certain countries in Cen-tral and South America, and the formerly communist nations of EasternEurope. Investors interested in the possibilities offered by such countriesmust carefully consider the additional risks entailed in placing funds in anuncertain political environment. The need to be broadly diversified andavoid excessive concentration of assets is particularly important in thecontext of such investments.

Taxes and Capital Controls

As with all investments, tax considerations are important for investorsconsidering foreign markets. It is beyond the scope of this discussion toprovide a detailed discussion of the complexities of U.S. and foreign tax

15

liabilities for the international investor. Before investing in overseas mar-

kets the prudent investor should seek expert guidance on the tax implica-

tions of such a move. Generally, the Internal Revenue Code treats capital

gains and losses on sales of foreign securities by individuals the same as

those on domestic securities. Furthermore, taxpayers are allowed to offset

foreign dividend withholdings in computing dividend income for U.S. tax

purposes.

While most foreign countries do not tax capital gains received byforeign citizens, withholding taxes on dividends are common. Amongdeveloped nations the withholding tax is usually 15 percent, but it canvary widely among emerging market countries. There does seem to be atrend, however, for newly developed and developing nation's to reducethe barriers to foreign investment so that they can attract the investmentcapital necessary for economic development. Furthermore, the EuropeanCommunity intends to eliminate all controls on capital movements withinits borders, which will make it easier for American investors to shift theirinvestments within the Community. Discussions with EC officials haveyielded promises that American investors in the EC will receive the sametreatment EC citizens receive in the United States. Thus, at present there isreason to expect that controls on international capital movements maydecrease over time.

Informational Limitations

Another risk that looms much larger in the international context than in

the domestic arena is the ability to obtain timely, accurate, and standardized

information about investment vehicles. The U.S. financial services indus-

try operates in a comprehensively regulated environment, probably the

world's strictest. One consequence has been the wide dissemination of

standardized information about investment choices. Practices in foreign

countries differ widely, both as to the quantity and quality of information.

Even in the more advanced markets with extensive financial reporting

requirements, the differences from U.S. accounting practices and conven-

tions may confound any easy understanding of foreign financial statements,

prospectuses, and the like. For example, a corporation's net income often

is calculated differently in different countries. Nevertheless, the trend is

toward greater availability of useful information, both because of the

increasingly global orientation of financial service and accounting firms,

and the previously mentioned desire of various nations to make their

markets more hospitable for foreign investment capital.

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III.

THE INTERNATIONAL MONETARY SYSTEM

AN acquaintance with the international monetary system can pro-vide a useful backdrop to many of the issues that individualscontemplating investments abroad must understand, particularly

the workings of the foreign-exchange markets. Furthermore, a generalfamiliarity with the characteristics of the system can be invaluable inenabling the investor to appreciate the significance of international finan-cial news that may not directly influence, but sometimes can have a verysignificant indirect effect, on one's foreign holdings. Following is a sketchof the evolution and current state of the international monetary system.

For most of this Nation's history, the value of the U.S. dollar wasestablished by its relationship to gold. The Government accomplished thisby minting coins with a specific gold content. Since paper money, includ-ing private money such as bank notes, could be exchanged for coinmoney, the value of paper money was effectively tied to gold as well. Thistype of system is known as a gold coin standard, and membership in sucha system is maintained by a government's willingness to convert itscurrency into gold at an established parity.

The modern international gold standard effectively began in 1819 whenthe British government resumed its practice of exchanging pound cur-rency notes for gold at an established parity. The primary advantages of agold standard are that exchange rates between currencies are fixed, therebyfacilitating the movement of goods and capital between nations, and theability to expand the domestic money supply is restrained, thereby limit-ing inflationary pressures.

In such a system the foreign-exchange value between any two curren-

cies is established by their relationship to gold. For example, if the dollar

price of gold is $35 per ounce and the pound price of gold is £15 per

ounce, then the dollar/pound exchange rate is $35 per £15, or $2.33 per

pound. The U.S. Government occasionally suspended gold convertibility

during times of severe financial strains, such as from 1861-1879 as a

result of Civil War expenditures, and from 1933-1934 during the Great

Depression. In January 1934, the Government pegged the value of the

dollar at $35 per ounce of gold, where it remained until the 1970s.

In order to understand the current international monetary system it maybe useful to describe the chaos that characterized international financialrelations during the 1930s. At that time most nations had returned to thegold standard after it was largely suspended during World War I. Wheninvestors began to fear that a nation was unable or unwilling to support the

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value of its currency, people tried to convert their holdings of that cur-rency into gold or other currencies.

In response to a run on its currency, a government would typicallyimpose exchange controls to prevent the outflow of reserves, or woulddevalue its currency (known as "beggar-thy-neighbor" policies becausethey were designed to benefit the home country at the expense of itstrading partners). A currency devaluation makes a nation's exports moreaffordable, and results in trading partners losing official reserves. Thetypical response of nations harmed by such action was either to resort to"competitive devaluation" of their own currency or to institute tariffs,quotas, and exchange controls. In such a climate, the costs and benefits ofinternational trade and finance became increasingly difficult to discern,and this pervasive uncertainty resulted in a sharp drop in the volume ofworld trade.

In 1944, a new blueprint for the international monetary system wasestablished by international agreement among 44 nations at the BrettonWoods conference in New Hampshire. The allied nations were propelledby a conviction that one of the factors that led to World War II was theeconomic damage done to national economies by the exchange-rate insta-bility and predatory trade practices of the 1930s. The Bretton Woodsconference established the International Bank for Reconstruction and De-velopment (the World Bank) and the International Monetary Fund (theIMF). The World Bank was designed to provide financial assistance foreconomic development, and its efforts were initially centered on the war-ravaged economies of Western Europe, although it subsequently turned itsattention to the world's developing nations, which now are its exclusivefocus.

The IMF, on the other hand, was designed to ensure exchange-ratestability. The Articles of Agreement of the IMF established a fixed ex-change-rate regime in which the value of the U.S. dollar was set at $35 perounce of gold, and all the other member countries established a parity fortheir currencies relative to the U.S. dollar (which also established thevalue of their currencies in gold). These members obliged themselves toprevent their currencies from diverging from the established rate by morethan 1 percent by intervening in the foreign-exchange markets to balancesupply and demand.

Upon joining the IMF a nation must contribute a quota subscription,basically a membership fee, 25 percent of which must be in gold and theremainder in the nation's currency. As a practical matter, the IMF's pool ofusable funds is limited to its holdings of gold and widely demandedcurrencies (U.S. dollars, yen, pounds sterling, Deutsche marks, and French

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francs). This pool of funds is used to provide financial assistance tonations that are experiencing severe payments deficits. This situationarises when a country's imports exceed its exports and there is not acompensating flow of foreign money into the economy in the form offoreign investment. Rich nations can often sustain large current accountdeficits, such as the United States during the 1980s, because other nationsare willing to balance these capital outflows by pouring money into thecountry in the form of investment.

Poorer countries often are unable to attract sufficient investment capitalto offset serious current account deficits, and this poses multiple threats tothe value of their currencies. First, because of the lack of foreign invest-ment the only way to finance the payments deficit is to draw down officialforeign reserves, which decreases the central bank's ability to interveneand support the currency. Second, people begin to anticipate a devaluationof the currency as a way to improve the country's export position, andthese expectations of a devaluation can result in capital flight, wherecitizens and foreigners scramble to convert their holdings of the currency,and this further diminishes foreign reserves and the central bank's abilityto support the currency.

The net result of such actions is severe downward pressures on thecurrency. Members with such problems can immediately withdraw 25percent of their quota contribution from the IMF. Beyond this point,however, members can borrow up to four times their quota only if the loanis repaid as soon as the balance of payments problem is resolved and if themember demonstrates to the IMF that it is taking steps to bring about sucha result. Typically, this means introduction of an austerity plan that isapproved by the IMF. In the event of a fundamental balance of paymentsdisequilibrium, a member country can revalue its currency in accordancewith established procedures.

The Bretton Woods system functioned reasonably well until the 1960s,when it began to unravel. First, the United States began to experiencepersistent, large capital outflows both as a result of decreasing currentaccount surpluses and because of continued U.S. investment abroad (which,like imports, involves capital outflows). This resulted in a situation inwhich the value of foreign dollar holdings exceeded the value of U.S. goldreserves. Despite a broad array of policies designed to limit U.S. pay-ments abroad this situation worsened and foreign countries, nervous abouttheir ability to exchange their dollars for gold, began to seek reserve assetsother than dollars, primarily gold.

When the demand for gold exceeded world production of gold, au-thorities began to search for new reserve assets. In 1967, IMF members

19

agreed to create a new reserve asset called Special Drawing Rights (SDRs)

that were designed to serve as a unit of account between governments,

thereby reducing reliance on dollars and gold. The value of SDRs is

determined by the foreign-exchange values of a basket of major world

currencies. At the time of their introduction it was anticipated that SDRs

would be used to settle payments imbalances, but they were introduced

too late to prevent the collapse of the Bretton Woods system.

In addition to U.S. balance of payments problems, the enormous fiscal

expansion from the costs of the Vietnam War and Great Society programs

fueled price inflation in the United States. This led to a further increase in

imports and made the $35-per-ounce price of gold increasingly at odds

with market actualities. Either the U.S. price level would have to be forced

down through a painful adjustment or the dollar would have to be deval-

ued relative to other currencies. Since most observers believed the former

course was politically impossible there was a renewed rush to sell dollars.

Finally, in early 1973 central banks stopped supporting their currencies at

their pegged values and the fixed exchange rate system broke down.

While floating rates were initially viewed as a temporary measure, they

have been the hallmark of the international monetary system ever since.

Rather than a uniform system of floating exchange rates, however, the

world currently has a variety of different exchange rate systems. Some

countries permit the value of their currencies to be determined in the

market (the United States, the United Kingdom, Canada, and Japan).

Rather than being a pure floating rate system, however, the central banks

of these countries frequently intervene in the foreign-exchange markets to

influence their currency's exchange rate. This has led to the current float-

ing rate system being called a dirty or managed floating rate regime.

Other countries belong to an exchange rate union, the most prominentof which is the European Monetary System (EMS), in which each currencyis fixed within a band of values with respect to other member's currenciesbut that float with respect to nonmembers' currencies. The central banksof these nations intervene in the foreign-exchange markets both to keeptheir currencies within their established band of values and to influenceexchange rates with the currencies of major nonmember countries such asthe United States and Japan. Finally, over 100 smaller nations continue topeg their currencies to some other currency, usually that of a major tradingpartner, so that they avoid the economic dislocations that can result fromfluctuations in a major trading partner's exchange rate.

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IV.

THE MARKET FOR FOREIGN EXCHANGE

THE market for foreign exchange brings together buyers and sellersof different national currencies. Most transactions in foreign-exchange markets involve transferring ownership of bank demand

deposits rather than actual currencies in circulation, the primary exceptionbeing purchases of foreign currency by persons traveling abroad. None-theless, the overwhelming majority of foreign-exchange transactions areconducted by commercial entities and do not involve any physical transferof currency. Foreign-exchange markets are crucial to international tradebecause most firms will not accept payment for their goods and services inanything other than their home currency. Thus, in order to import winefrom France an American importer must pay the French exporter in francs.This is accomplished by buying francs with dollars in the foreign-ex-change market.

The price of one currency expressed in units of another currency isknown as an exchange rate. Foreign currencies may be bought or sold inthe spot exchange market, at the spot exchange rate, for immediate deliv-ery. As a practical matter, the spot market delivery date, known as thevalue date, is 2 days later for most foreign currencies, 1 day later forCanadian dollars purchased in New York. Foreign currencies may also bebought and sold in the forward exchange market, at the forward exchangerate, for delivery at some specified future date, usually 1 month, 2 months,3 months, 6 months, or 1 year later. Compared to the spot rate, the price ofa currency in the forward market tends to be either more expensive (aforward premium) or less expensive (a forward discount).1

When one currency increases in value compared to another currency itis said to have appreciated, and when it has decreased in value it hasdepreciated.2 All other things being equal, when the dollar appreciatesforeign goods become relatively more affordable and American producedgoods become relatively less affordable. When the dollar depreciatesforeign goods become relatively more expensive and domestic goodsbecome relatively more affordable. The relative price change is experi-enced by both domestic and foreign purchasers, because while a dollarappreciation does not change dollar prices at home, American producedgoods have become relatively more expensive. Thus, a currency apprecia-tion tends to increase imports and decrease exports while a currencydepreciation tends to increase exports and decrease imports.

The largest participants in the foreign-exchange markets are centralbanks, commercial banks, and nonbank financial institutions. While the

21

abandonment of the Bretton Woods fixed exchange rate regime in 1973has eliminated the necessity of central bank intervention to maintainexchange rates at or near their established parity, central banks still inter-vene frequently in order to influence the exchange rates at which theirnational currencies are traded. Central bank intervention is undertaken inorder to influence supply and demand conditions by buying and sellingvarious currencies in foreign-exchange markets. When the Federal Re-serve buys dollars it is trying to force the dollar's value against othercurrencies upward {i.e., to force its appreciation), and when it sells dollarsit hopes to drive the dollar's value down against other currencies {i.e., todepreciate it). A primary reason given for such interventions is to influencethe level of imports and exports, which in turn affects the level of priceinflation, output, and employment.

Commercial banks participate in the foreign-exchange markets at boththe retail and wholesale levels. Retail transactions are undertaken as aservice to customers that desire foreign currencies, primarily corporations.For example, an American corporation that wishes to purchase Germanmachine tools will typically have to pay the seller in Deutsche marks ratherthan dollars. The American importer's bank would debit the corporation'saccount by the necessary dollar amount and then would either transfer theappropriate amount of Deutsche marks to the German exporter's bank orwould transfer dollars to the German bank that would then credit theexporter's account in Deutsche marks. Wholesale transactions, known asinterbank transactions, make up most of the volume on foreign-exchangemarkets and are undertaken primarily as investments for the bank's ownaccount and as a means of obtaining foreign currencies with which tosatisfy the demands of customers. While historically only a small player inthe foreign-exchange markets, investment companies and other financialservice firms have become increasingly active in recent years.

Most major financial centers around the world have institutions thattrade foreign currencies. Unlike many markets, however, most foreign-exchange markets have no centralized meeting place because most tradesare accomplished by electronically transferring ownership of demanddeposits. The sophisticated information and trading systems of the majorplayers in the foreign-exchange markets ensure that exchange rates aroundthe world are very closely linked, because any significant discrepancieswould create opportunities to profit from arbitrage (buying a currency inthe lower cost market and selling it in the higher cost market). The largevolume of such transactions that can be accomplished by means of elec-tronic trading would force the prices to converge rapidly.

In the United States, foreign-exchange quotations are expressed in

terms of the amount of local currency required to purchase one unit of the

22

foreign currency. For example, on April 30,1993 the dollar/Deutschemark exchange rate was $O.63O6/DM, meaning that it cost 63.06 U.S.cents to purchase a single Deutsche mark. It is also common to see theexchange rate expressed in terms of units of foreign currency per dollarrather than in dollars per unit of foreign currency. Thus, the dollar/DMexchange rate on April 30, 1993 could also be expressed as being 1.5858Deutsche marks per dollar, even though the participants in the foreign-exchange market would express the rate as $O.63O6/DM. Both expres-sions of the exchange rate indicate the same thing, however.

Forward exchange rates can be quoted in two different ways. First, theycan be expressed in terms of the amount of local currency per unit offoreign currency, as described above. This is called the outright rate.Alternatively, forward exchange rates can be quoted by reference to thediscount or premium in the forward market above or below the rateprevailing in the spot market. This is called the swap rate. Outright ratesare typically quoted to retail customers while swap rates are quoted forinterbank transactions.

1 There are actually two rates for each currency both in the spot and forward foreign-exchange markets at any given time, and these are known as the bid and offer prices. Thebid price is the price a foreign-exchange trader is willing to pay for a particular currencywhile the offer price is the price at which the trader is willing to sell that currency. Thedifference between the two is the spread demanded by the trader to cover the costs of doingbusiness.2 Two related terms, previously used, are devaluation and revaluation, which describe thesame thing as depreciation and appreciation, respectively. The former usually is used onlyto refer to exchange-rate changes in a system of fixed exchange rates, while the latterusually refers to exchange-rate changes in a floating rate system.

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V.

EXCHANGE RATE THEORY VS. PRACTICE

PREDICTING exchange rates is a hazardous undertaking. While noone has devised a procedure for accurately describing or predictingexchange rate movements, there are several "models" that describe

some of the factors that affect exchange rates. Although in practice none

of these models has proved adequate for predicting exchange rate move-ments, they form the basis of most financial analysis that is presented inthe business press and popular media. Even a brief acquaintance withexchange rate theory may be useful for understanding the (often consider-able) difference between the forecasts of the financial pundits and theactual performance of the foreign-exchange markets.

At the most basic level, and in common with nearly all commodityprices, the price of a currency (its exchange rate) is determined by thelaws of supply and demand. An increased demand for a currency, with nochange in the supply, will result in a currency's appreciation while adecrease in demand, with no change in supply, will result in its deprecia-tion. Similarly, an increased supply of a currency, with no change indemand, will depreciate a currency while a decreased supply, with nochange in demand, will appreciate the currency. The foreign-exchangemarket is in equilibrium only at that exchange rate where the demand for acurrency matches the supply. All of the theories discussed below addressthemselves in one way or another to supply and demand conditions in theforeign-exchange markets.

Balance of Payments Analysis

The supply of, and demand for, a country's currency in the foreign-

exchange markets is a function of the nation's domestic money supply and

the demand generated by international trade and capital flows. Theoreti-

cally, each country's money supply is controlled by its central bank as it

seeks to exercise control over the money supply to provide what the

authorities believe to be a climate that fosters stable, noninflationary

economic growth. Some countries, such as Germany and Switzerland,

have proven more adept at this task than others. International trade and

capital flows are determined by the actions of individuals and firms as

they decide how best to allocate their wealth for consumption and invest-

ment, both at home and abroad. Economists record these flows in a

collection of accounts known as balance of payments accounts.

There are two principal types of balance of payments accounts. Importsand exports of goods and services, cross-border flows of investmentincome, tourist revenue, and unilateral transfers of untied foreign aid are

24

recorded in a series of accounts known collectively as the current account.Intercountry purchases and sales of capital assets such as stocks, bonds,and real estate are recorded in a series of accounts known collectively asthe capital account. A particularly important component of the capitalaccount are those accounts that track official reserve transactions, whichare the purchase and sale of official international reserve assets, primarilyforeign government bonds and currencies, by a country's central bank.

Balance of payments accounting is based on a double-entry bookkeep-ing system, just like a corporation's balance sheet. Balance of paymentsaccounting is different from financial accounting, however, in that it tracksonly currency flows, not the ownership of the underlying goods and assets.As a result, an initial entry and its offsetting entry need not occur simulta-neously and need not be directly related to one another. For example, whena country imports goods, such as cars, or an asset, such as stock in a foreigncorporation, there is a currency outflow that results in a debit in the balanceof payments accounts (in the current account in the case of cars and in thecapital account in the foreign stock example). The character and timing ofthe offsetting credit, however, is determined by the manner in which themoney reenters the country's domestic economy, and is not tied to theinitial transaction such as the acquisition of the cars or the stock.

For instance, to continue with the above example, when a foreignerreceives dollars from selling cars or stock to an American, the moneymight immediately reenter the U.S. economy as a deposit with an Ameri-can bank. This would constitute the purchase of a U.S. asset, a bankdeposit, and would enter the capital account as a credit. Alternatively, theforeigner might deposit the money with a foreign bank, which would notbe reflected in the U.S. balance of payments accounts. If the funds subse-quently were lent to a foreign firm to pay for the purchase of U.S. goodsthey would at that time be entered into the current account as a credit. Inthis way, every transaction must eventually have two offsetting entries,but they need not be directly connected to each other. This circumstancemakes it somewhat difficult to track a nation's balance of paymentsaccurately, and it is usually necessary to include a fairly large statisticaldiscrepancy entry to make the accounts balance.

If a nation's balance of payments accounts must balance, how can anation have a balance of payments deficit or a surplus? These terms referto a nation's balance of payments when certain transactions, such asofficial reserve transactions, are excluded from the calculation. The ratio-nale for excluding certain categories of entries is that they represent"compensating" transactions to obtain foreign currency and do not repre-sent "autonomous" currency flows.1 Thus, a less-developed country thathas a current account deficit, and which is not attracting sufficient foreign

25

investment capital, will be forced to satisfy its nation's appetite for foreign

currency by drawing down its official international reserves. Achieving

balance in this way is not the result of autonomous decisions by market

participants, and also cannot be sustained indefinitely because official

international reserves will eventually be depleted. Thus, there is some

logic in excluding the official reserve transactions and viewing the coun-

try as having a balance of payments deficit.

Individuals and firms often anticipate that a country with a balance ofpayments deficit will either devalue its currency, if the country pegs itsexchange rate, or experience a currency depreciation, if the country has afloating currency, and these expectations can be self-fulfilling. For ex-ample, if a country with a fixed exchange rate has a balance of paymentsproblem, domestic and foreign holders of its currency may anticipate thatit will be devalued in order to make the nation's exports less expensive andimports more expensive, and they will seek to reduce their holdings of thecurrency to avoid the losses resulting from the devaluation. The rush toreduce holdings of the troubled currency, which is accomplished by pur-chasing foreign currencies or assets denominated in foreign currencies,further aggravates the balance of payments problem as domestic wealthescapes abroad. In this way, expectations of a devaluation can precipitate £run on a currency (known as capital flight) and this can force a governmentto devalue its currency, or to devalue it earlier and by more than wasoriginally planned.

If a country with floating exchange rates experiences a persistent balance

of payments deficit, holders of its currency might anticipate a future

depreciation of the currency and they will be inclined to reduce their

holdings of the currency, which will result in a depreciation of the currency.

In such a situation, however, the holders are making judgments about the

future actions of other holders of the same currency rather than about the

future actions of the government.

Purchasing Power Parity

Another theory that attempts to understand exchange rates and howthey move is called the purchasing power parity theory (PPP). PPP ispremised on the "law of one price," which states that goods should costthe same regardless of where they are purchased and the currency withwhich they are purchased. To see why, imagine a world with no transpor-tation costs or trade barriers in which an identical television set costs $300in the United States and 480 Deutsche marks (DM) in Germany. If the $/DM exchange rate is $O.625/DM it is said to be at its equilibrium level,since it would take $300 to buy 48ODM and there would be no incentivefor Americans or Germans to buy the television overseas. If the exchange

26

rate is below the equilibrium level, say $O.55/DM, an American couldexchange $264 for 48ODM and buy the television in Germany, therebysaving $36. Alternatively, if the exchange rate were above the equilibriumlevel, say $O.75/DM, a German could exchange 400DM for $300 and save80DM on the price of the television. Thus, at any exchange rate below$O.625/DM Americans would demand Deutsche marks and German tele-visions, while at any exchange rate above $O.625/DM Germans woulddemand dollars and American televisions. Supply and demand pressuresin the market for foreign exchange and in the market for televisions wouldresult in price adjustments in both markets until the price differential wereeliminated. This is the "law of one price."

PPP is simply the law of one price applied across the range of goods andservices in an economy. According to this theory, the exchange rate betweentwo currencies acts to equalize the purchasing power of the two currencies.Since the purchasing power of a nation's currency is a reflection of theprice level in that country, the exchange rate between two currenciesshould equal the ratio between their two price levels. Thus, if a basket oftypical goods in the United States (measured by some index such as theConsumer Price Index) costs half as much as the same basket of goods in aforeign country, one would anticipate that one unit of the foreign currencyshould cost 50 cents. This strict correlation of exchange rates and pricelevels is known as absolute PPP.

There are, of course, numerous problems with applying this theory tothe "real world." For example, trade barriers and transportation costsweaken the link between prices across national boundaries and thus un-dermine the notion of PPP. In addition, the composition of a "typical"basket of goods is almost certain to differ from country to country. Fur-thermore, some of the components of a typical basket of goods, such ashousing, haircuts, medical services, and movie tickets, are not tradedbetween countries and are therefore irrelevant for purposes of PPP, sincethere are no arbitrage pressures to equalize their prices. Finally, pricedifferentials can result from imperfectly competitive market structures,such as monopolies and monopolistic competition, and this too weakensthe basis for PPP. Empirical analysis reveals that these practical problemsoverwhelm the theoretical basis for absolute PPP, and actual exchangerates do not equal the ratio of national price levels.

One attempt to address some of the defects in absolute PPP is known asrelative PPP, which states that while an exchange rate is not simply theratio of two countries' price levels, relative changes in price levels over acertain period of time should be matched by a proportional change inexchange rates. Thus, if over a 5-year period the U.S. price level rises by25 percent while the Japanese price level rises by 15 percent, one would

27

expect the dollar to depreciate against the yen by 10 percent so that therelative change in purchasing power is equalized.

Relative PPP comes much closer to describing "real world" develop-

ments than does absolute PPP, but wide divergences from its predictions

still are observed in the exchange rates of major countries. Economists

have had to resort to complicated models that are designed to partially

compensate for the distorting influence of trade barriers and nontraded

goods on relative PPP in order to force the theory into conformity with

historical exchange rate patterns.

Interest-Rate Parity

The interest-rate parity theory of exchange rate determination statesthat the foreign-exchange market is in equilibrium when the expected rateof return on deposits is the same for all currencies. The rate of return on aforeign currency deposit is a function of the interest rate offered on thedeposit as well as movements in the exchange rate during the life of thedeposit. For example, if the interest rate on a 1-year pound deposit with aBritish bank is 4 percent and the dollar appreciates against the pound by 2percent over the course of the year, the dollar rate of return on theinvestment would be approximately 6 percent.2 If the dollar had depreci-ated by 2 percent against the pound, the dollar rate of return would beapproximately 2 percent. The interest-rate parity theory implies that coun-tries with higher interest rates should have weaker currencies than coun-tries with lower interest rates. This is in general agreement with thepredictions of PPP because higher interest rates are typically associatedwith nations with high rates of price inflation.

For example, if 1-year deposits with U.S. banks are paying 5.5 percent

interest annually while 1-year deposits with Japanese banks of equal

creditworthiness are paying 4 percent, the interest-rate parity condition

requires that investors must expect the dollar to depreciate against the yen

by approximately 1.5 percent over the course of the year. If this were not

the case, the dollar rates of return on the two deposits would be different

and investors, particularly institutional investors that can quickly and

easily move huge sums of money between banks in different countries,

would shift their funds to the country offering higher dollar rates of return.

This would both increase the exchange rate for the currency offering the

higher return, as increased demand bids up its price, as well as lower

interest rates in that country as money flows into its banks. Eventually,

these market forces would result in a convergence of the rates of return.

Theoretically, the connections between interest rates, current exchangerates, and expectations of future exchange rates form a triangular rela-tionship that makes it possible to assess the possible effect of changes in

28

any one of these three variables. For example, if U.S. interest rates in-crease, either the dollar will appreciate, because there has been a realincrease in the expected return on dollar deposits, or it would be expectedthat market participants anticipate a corresponding decrease in expectedfuture dollar exchange rates. If U.S. interest rates increase but the dollardoes not appreciate, this presumably reflects the market* s collective ex-pectation that the dollar will depreciate in the future by enough to offsetthe increase in interest rates. The practical difficulty lies in guessing howthe other two variable will change, and by how much, in response to achange in one of the variables.

Forward Exchange Rates

There is also a school of thought that believes that forward exchangerates represent the best judgement about future spot exchange rates, eventhough the actual future rate might be somewhat above or below thatpredicted by the forward rate. This raises the issue of how forward exchangerates are determined. The determination of rates in the forward exchangemarkets is largely driven by the interest-rate parity condition discussed inthe previous section. The interest-rate parity condition states that the rateof return on all foreign investments of equal risk will be the same whenmeasured in the same currency. Forward foreign-exchange rates are set sothat any interest rate advantage for a particular currency is exactly offsetby a corresponding forward discount on that currency. If this were not thecase, an investor could use the forward market to lock in the exchange rateat which the foreign currency can be converted at the end of the investmentterm, and thereby completely eliminate uncertainty respecting the domes-tic-currency rate of return on the foreign currency investment. If it werepossible to guarantee a higher rate of return by investing overseas, ariskless arbitrage opportunity would exist and buying and selling pressureswould soon eliminate any such net return.

For example, imagine the interest rate on a 90-day deposit at an Ameri-can bank is 3.5 percent and the interest rate on a 90-day deposit at aFrench bank of comparable creditworthiness is 5 percent. While such adeposit at the French bank is as safe as a deposit at the American bank,there is still a currency risk in that the French franc could depreciateagainst the dollar during the term of the deposit. Thus, what initiallyappears to be a net gain of 1.5 percent could be reduced, eliminated, oreven transformed into a net loss if the franc depreciates in the spotforeign-exchange market during the 90-day term of the deposit.

This currency risk can be eliminated in the forward foreign-exchangemarket by entering into a contract, at the time the funds are deposited withthe French bank, to sell francs and buy dollars at a fixed rate 90 days in the

29

future. This is known as selling francs forward and it eliminates the risk ofadverse exchange rate fluctuations.

Because efficient, competitive markets provide the same rate of returnon investments of equal risk, the absence of additional risk for investingwith the French bank implies that the return should be the same asinvesting the funds with the American bank. This will, in fact, be the casebecause, at a 1.5 annual discount to the spot rate, the 90-day forwardforeign-exchange rate for francs will equalize the two returns and thedollar rate of return on the franc investment will be 3.5 percent. Becausethe currency risk is "covered" by the forward contract, this condition isknown as covered interest-rate parity. If the relationship between the spotand forward foreign-exchange rates were not structured in this manner, itwould be possible to realize additional returns without incurring addi-tional risk.

If such a situation arose investors, particularly banks and other institu-tions, would allocate funds to take advantage of the higher returns availablein the French money market. In the spot foreign-exchange market investorswould bid up the price of the franc relative to the dollar while in theforward foreign-exchange market investors would push down the forwardprice of the franc relative to the dollar. Similarly, in the French moneymarket interest rates would decrease as deposits flow into French bankswhile American interest rates would rise in reaction to withdrawals. In thisway, market forces tend to prevent such arbitrage conditions from arisingand eliminate them once they do.

Central Bank Intervention

While not a theory of exchange rate determination, an important influ-ence on exchange rate movements is central bank intervention in theforeign-exchange markets. The central banks of all the large industrialcountries engage in foreign-exchange intervention to influence the valueof their currencies in the foreign-exchange markets.3 As noted previously,governments care about their currency's foreign-exchange value becauseits affect on imports and exports can significantly influence employment,output, and price inflation. In particular, intervention is frequently under-taken out of a conviction that the market has overshot the "proper** exchangerate for reasons of investor psychology and intervention is needed todampen such a speculative swing. Although there are many ways in whichcentral banks can intervene in the foreign-exchange markets, the goal isalways to increase the supply of one currency and decrease the supply ofanother.

For example, if the dollar is believed to be overvalued relative to theyen, the Federal Reserve can purchase yen-denominated deposits owned

30

by American banks at Japanese banks. To pay for this purchase the Fed-eral Reserve can credit the U.S. banks' reserve accounts at the FederalReserve, thereby increasing the U.S. money supply.4 The Federal Reservewill then deposit these funds with the Bank of Japan (the Japanese centralbank), which will subsequently debit the reserve accounts of the Japanesebanks, thereby decreasing the Japanese money supply. In the end, thisintervention increases the U.S. money supply and decreases the Japanesemoney supply. Because the dollar/yen exchange rate is presumed to re-flect the supply and demand for dollars and yen, the dollar should depreci-ate and the yen should appreciate.

The foregoing description assumes, however, that the United States andJapan are willing to have changes in their domestic money supply dictatedby exchange rate considerations, which in practice is rarely the case. Insetting targets for the domestic money supply governments generally areguided by the economic growth rate and the rate of price inflation in thedomestic economy. To keep foreign-exchange intervention from affectingdomestic economic policy, central banks usually "sterilize" their foreign-exchange intervention by simultaneously undertaking offsetting transac-tions in their domestic financial markets.

For example, to sterilize the purchase of yen and subsequent increase inthe U.S. money supply depicted in the above example, the open market deskat the Federal Reserve Bank of New York would sell U.S. Treasury securitiesin order to decrease the money supply by an exactly offsetting number ofdollars. At the end of the two transactions the money supply is unchanged.The only thing that has happened is that, in this example, the asset side of theFederal Reserve's balance sheet has a larger proportion of foreign assets todomestic assets than it had before the sterilized intervention.

Economists have devised a number of theories to explain the potentialeffects of sterilized foreign-exchange intervention and two of them de-serve some mention. One theory, known as the signaling effect of foreign-exchange intervention, argues that the intervention conveys signals aboutthe likely future course of the central bank's monetary policy, and henceinterest and exchange rates. Recall that the interest-rate parity theory ofexchange rate determination says that a decrease in interest rates, all elsebeing equal, should result in a currency depreciation. Using the aboveexample where sterilized intervention led to an increase in the proportionof foreign assets held by the Federal Reserve, the signaling theory saysthat, after taking such steps, the Federal Reserve will be more likely tofollow an expansionary monetary policy that will decrease both U.S.interest rates and the value of the dollar. Anticipating such a course ofaction, market participants will increase their demand for dollars and itwill appreciate.

31

Another popular theory used to describe the effects of sterilized interven-tion says that as private investors hold greater numbers of dollars they willdemand a risk premium above the expected return to compensate for theirgreater exposure to fluctuations in the foreign-exchange value of thedollar. Thus, the interest rate on dollar assets is a combination of a risk-free rate plus a risk premium. By increasing the supply of dollars held byprivate investors, as in the previous example, the Federal Reserve hasincreased the necessary risk premium required to induce investors to holddollar assets. Because the interest rates on dollar assets have not changed,while the risk premium demanded for holding dollar assets has increased,it is as if the real return on dollar assets has decreased. This results indecreased demand for dollars and the currency subsequently depreciates.Both of the foregoing theories attempt to describe how sterilized foreign-exchange interventions can affect the value of a currency. Another possi-bility, and one that has been gaining credence in recent years, is thatsterilized intervention has little affect on the foreign-exchange value ofthe dollar. At the June 1982 Versailles meeting of the Group of Sevennations (the United States, Canada, France, Germany, Italy, Japan, and theUnited Kingdom) a working group was commissioned to study the effectsof sterilized intervention on exchange rates. The working group's reportsuggests that while sterilized intervention may have some impact in theshort run, particularly when coordinated with other governments, it doesnot appear to have much long-run impact.5

1 Economists disagree about what types of transactions are autonomous and what typesare compensating. There is general agreement that the balance on current account, directinvestment (the purchase of 10 percent or more of a company), and long-term portfolioinvestment are autonomous, while official reserve transactions are compensating. There isdisagreement, however, about the category to which short-term capital flows should beassigned.2 Although it is not exactly accurate, the overall rate of return on a foreign investment canbe approximated by combining the percentage change in the exchange rate with thepercentage return on the foreign asset.3 In the United States, the Treasury Department makes the decision to intervene and theactual intervention is carried out by the Federal Reserve Bank of New York.4 The relation between bank reserves on deposit with the Federal Reserve and the size ofthe money supply is beyond the scope of this article. In brief, by increasing bank reservesthe Federal Reserve increases the level of deposits these banks can accept and conse-quently the amount of loans they can make.5 'Intervention in Foreign Exchange Markets," in Federal Reserve Bulletin 69 (November1983), p. 830.

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VI.

MANAGING CURRENCY RISK

Forward Foreign-Exchange Markets

A S discussed previously, the forward foreign-exchange market al-lows investors to exchange one currency for another at some futuredate at a predetermined price. By selling a foreign currency for-

ward at the time a foreign investment is made, the exact end-of-termexchange rate, and hence dollar rate of return, is known from the outset.This allows an investor to eliminate the possibility that an appreciation ofthe dollar relative to the foreign currency will depress the yield on a foreigninvestment because any gain (or loss) on the foreign currency investmentwill be offset by a corresponding loss (or gain) on the forward contract.Thus, the risk of losses from an appreciation of the dollar are eliminated asis the possibility of profiting from a depreciation of the dollar.

In addition to losing the opportunity to profit from a dollar deprecia-tion, there are certain drawbacks associated with using the forward ex-change market to hedge currency risk. First, forward contracts generallyare available only for periods of 1 month, 2 months, 3 months, 6 months,and 1 year. Thus, it is not possible to completely eliminate currency riskfor investments with terms of more than 1 year. Furthermore, forwardcontracts are available only for major currencies such as the British pound,Canadian dollar, French franc, Deutsche mark, Japanese yen, and Swissfranc. An investor desiring to manage currency risk for an investment inother countries must resort to more exotic hedging strategies.

Foreign Currency Futures

Another way to hedge currency risk is with currency futures contractstraded in the International Monetary Market of the Chicago MercantileExchange. Entering into a currency futures contract obliges the holder tobuy or sell a specified amount of currency at a future date at a set price. Aninvestor with a foreign currency investment can hedge the attendant cur-rency risk by entering into a currency futures contract to sell the foreigncurrency at a predetermined price at a future date. Each traded currencyhas a particular contract size and fractional contracts are not traded, so anyfutures contract must be some multiple of the basic contract size. Thedelivery dates for the contracts are the third Wednesday of March, June,September, or December, but there is an active secondary market allowinginvestors to close their positions at any time. As was the case with forwardcontracts, futures contracts are available only for major currencies. Unlikea forward exchange contract, however, there are margin requirements forfutures contracts that are settled daily.

33

Foreign Currency Options

Unlike forward exchange contracts and futures contracts, a foreigncurrency option contract gives the holder the right, but does not create anobligation, to buy or sell a specified asset at a predetermined price at somefuture date. Foreign currency options can help reduce currency risk becausethey allow an investor to establish a definite price at which foreign currencypositions can be exchanged for dollars at any time during the life of theoption. Because the option need not be exercised, the investor can chooseto let the option lapse if the exercise price is less favorable than theexchange rate prevailing in the spot foreign-exchange market.

Cross-Hedging

Cross-hedging is a risk reduction strategy that allows an investor to

hedge a portion of the risk entailed in holding a foreign currency for

which forward and futures contracts are not traded. This is accomplished

by using forward and/or futures contracts in other currencies, or even a

commodity such as gold, whose price is less than perfectly correlated with

the price of the currency being hedged. For example, in order to hedge a

position in Spanish pesetas an investor might purchase a British pound

futures contract in the belief that some of the fluctuation in the peseta will

be offset by fluctuations in the pound. In addition to single cross-hedges

an investor can employ multiple cross-hedges by purchasing forward or

futures contracts in numerous currencies.

Whichever approach is used, cross-hedging is a less effective way tohedge currency risk than a direct hedge using a forward or futures contractin the same currency. In fact, cross-hedging can even compound losses ifthe investor chooses the cross-hedges unwisely. In order to maximize theusefulness of cross-hedges, the investor must determine what other assetwill be used in the hedge and the size of the position in that asset that willmaximize the effectiveness of the hedge (known as the hedge ratio).Detailed analysis of historical data can provide guidelines, but not guaran-tees, about the type and quantity of assets to use in constructing aneffective cross-hedge.

Currency Swaps

All of the techniques for hedging currency risk discussed so far share

the disadvantage that they rely in one way or another on instruments of

limited duration, which limits their effectiveness for hedging long-term

positions in foreign currencies. One strategy for long-term currency hedg-

ing is to engage in a currency swap. While the available variety of currency

swaps is enormous, all currency swaps involve exchanging debt-service

obligations denominated in one currency for debt-service obligations de-

34

nominated in another currency. Because the parties have obligated them-selves to convert whatever amount of their national currency is required toobtain the necessary amount of the foreign currency needed to make thedebt payments, a currency swap is analogous to entering into a series offutures contracts extending until the end of the debt-service obligations.

For example, an American company that has issued bonds or obtained aloan in the U.S. capital market and a British firm that has issued bonds orobtained a loan in the British capital market could agree to trade the debt-service obligations on their respective bonds or loans. While each com-pany would remain primarily liable to their own lenders, the firms havecontractually bound themselves to make a series of foreign currencytransactions to service the other's debt. Such an arrangement would affordthe American firm a hedge for its holdings of British pounds and theBritish firm a hedge for its holdings of dollars. This is because the Ameri-can firm's dollar rate of return on its pound-denominated assets decreaseswhen the dollar appreciates relative to the pound. This would be partiallyoffset by the currency swap, however, because an appreciation of thedollar would cost the American company fewer dollars to purchase thenecessary pounds to service the swap. In this way the currency swaphedges the risk of an appreciation of the dollar against the pound. Inaddition to simple swaps such as this one, the firms could have swappedobligations with differing characteristics, such as fixed-rate for floating-rate notes, and thereby hedged national interest rates as well as exchangerates. The variety of currency swaps is limited only by the availability ofother parties willing to engage in the transaction.

35

VII.

INTERNATIONAL INVESTMENT VEHICLES

American Multinational Corporations

ONE of the easiest ways for an American investor to achieve inter-national portfolio diversification is to invest in shares of an Ameri-can multinational corporation (MNC). While not as "glamorous"

as some other international investments, MNC shares accomplish many ofthe objectives of international diversification with much greater ease.First, since a MNC conducts a portion of its business in foreign countries,its performance is more loosely correlated with the overall performance ofthe domestic economy, thereby achieving some of the risk-reduction ben-efits of international diversification. Second, MNC shares allow investorsto benefit from faster-growing foreign markets. Indeed, many U.S. multi-nationals are reporting an ever-larger percentage of their profits fromoverseas operations. Finally, because such firms' foreign sales are re-ceived in foreign currencies that are then converted to dollars, Americaninvestors can indirectly benefit from, or be hurt by, exchange rate fluctua-tions.

International diversification through investments in American MNCsdoes not, however, expand the universe of investment opportunities. Sincea large proportion of MNC operations usually is based in the UnitedStates, investments in them generally are a less efficient means of achiev-ing the other benefits of international diversification.

Global and International Mutual Funds

Another way for U.S. investors to achieve international diversificationwith minimum effort is to invest in shares of global or international mutualfunds. The term global applies to those funds that invest in both Americanand foreign investments, while international funds allocate all of theircapital overseas. This approach has several attractions. First, the researchand decision-making burdens on the individual investor are significantlyreduced because it is easier to investigate and choose from a handful ofdomestic mutual funds rather than thousands of foreign companies. Second,the actual selection of investments is made by an investment professionalwhose job is to understand foreign investments and to select the mostpromising alternatives. Third, investing in a single mutual fund, unless it isa highly focused fund, achieves a significant degree of diversification andtherefore risk reduction. Finally, the minimum necessary investment formutual funds is usually well within the reach of small investors and thecosts (loads) associated with such investments can be substantially lessthan commissions on foreign securities purchased directly.

36

Stock in Foreign Companies Traded on American Exchanges

Another investment vehicle that offers many of the benefits of interna-tional diversification is shares in foreign companies that are traded onAmerican stock exchanges, primarily the New York Stock Exchange.1

Such issues have proliferated as a result of a wave of privatizations in the1980s as foreign governments, particularly the British, sold off state-owned companies to raise funds and improve the efficiency of the firms.The vast size of some of these offerings has prompted governments tooffer the securities in multiple markets so as not to depress stock prices inthe home market by overwhelming local demand. An important factorlimiting the growth of these international equities is that the issuer mustcomply with all of the regulatory requirements of each country in whichthe stock is offered, and this can result in substantial delays and additionalcosts. In Chapter IX we discuss plans to eliminate these multiple regulatoryrequirements for member countries of the European Community and be-tween the United States and Canada.

Domestic Capital Markets in Foreign Countries

Domestic capital markets in foreign countries are simply the foreignequivalent of the U.S. domestic capital market, and usually are not con-sidered to be a part of the international capital market. These markets tendto be significantly smaller than the U.S. market, and there are a variety ofpractices and customs in foreign markets that can differ from those in theU.S. market. Fortunately, mere is a gradual trend toward greater uniformity,as countries compete with each other for foreign investment capital, andtoward greater understanding of foreign markets by American financialservice firms as U.S. investors increasingly look abroad. The myriaddistinctions between different national capital markets are too numerousto describe in this space. Prospective investors should consult detailedpublications and investment specialists to discover the various consider-ations that affect investing in particular foreign markets.

International Capital Markets

International capital markets, which are distinct from the domesticcapital markets of foreign countries discussed in the preceding section, areof two types — the foreign bond markets and the Euromarkets. A foreignbond is a bond issued in a nation's domestic market by a borrower from adifferent country. Although it might seem logical to call an ordinary bondissued in a foreign market a foreign bond, for example a franc-denomi-nated bond issued by a French company in France, the correct term forsuch a security is simply a French bond. Only if it had been issued by anon-French entity would it be correctly called a foreign bond. By far thelargest number of foreign bonds are issued in the Swiss market, although

37

there are also foreign bonds issued in the United States, Japan, Germany,the United Kingdom, and the Netherlands.

Euromarkets are of two types, Eurocurrency markets and Eurobondmarkets, and despite their names they are not confined to Europe. Rather,a Eurocurrency account is simply a bank deposit denominated in anycurrency other than that of the country in which the deposit is made and aEurobond is a bond denominated in any currency other than that of thecountry in which it is issued and trades. Thus, a Deutsche mark deposit ina London bank is a Eurocurrency deposit, specifically a Euromark de-posit, and a dollar-denominated bond issued in Singapore is a Eurobond,specifically a Eurodollar bond. The Eurocurrency market is considerablylarger than the Eurobond market.

Initially the vast majority of Eurocurrency deposits were dollar de-nominated, but as the markets have matured deposits denominated inDeutsche marks, pounds, Swiss francs, and yen have grown in impor-tance. Similarly, the Eurobond market was initially dominated by Eurodollarissues, although Eurodollar bonds now account for only 50 percent of newEurobond offerings. Because these deposits and bonds always are de-nominated in a currency foreign to the country in which they are located,these markets sometimes are called offshore markets. The largest offshorefinancial center is London, although significant activity also occurs inFrance, Germany, Belgium, Luxembourg, the Netherlands, Switzerland,Canada, Japan, and Singapore. The United States has not developed asignificant Eurocurrency or Eurobond market because the Governmenthas been unwilling to reduce the regulatory burden on offshore institutionsto the same degree as have other countries.

While there is no reason in principle why all dollar-denominated de-posits could not be placed in U.S. banks and all dollar-denominated bondsissued in the United States, Euromarkets nonetheless offer several advan-tages that help explain their formation and growth. One of the mostimportant advantages is that the major Euromarkets are almost completelyfree from government regulation, such as those pertaining to reserverequirements, deposit insurance, interest ceilings, and securities registration.The absence of regulatory costs allows banks to offer higher rates onEurocurrency deposits and lower interest rates on Euroloans than can beobtained in regulated national markets.

The most important reason for this is that in the major Eurocurrencyfinancial centers there are no reserve requirements for such offshoredeposits. Because reserves deposited with a central bank do not earninterest, reserve requirements force banks to cover their operating costswhile using less than 100 percent of their capital. This circumstance

38

requires a larger spread between deposit rates and loan rates than isrequired if there is no reserve requirement. Another important advantageoffered by the Euromarkets is that they allow investors to separate cur-rency from political risks. Thus, if an investor desires to hold a Frenchfranc investment but is concerned about the possibility of adverse regula-tory policies that might be enacted by the French government, a Euromarketinvestment enables him to purchase a French franc-denominated asset thatis not subject to French regulation. Conversely, the Euromarkets alsoallow investors to purchase assets trading on French markets that are notdenominated in French francs.

The ability to invest in a currency without incurring the political risksassociated with it is one of the principal reasons Euromarkets formed inthe first place. After World War II most nations, including those in theSoviet bloc, needed bank deposits denominated in U.S. dollars because alarge portion of international trade was priced and paid for in dollars.Communist governments were obviously reluctant to keep large amountsof money on deposit in the United States because of the fear that it couldbe seized by U.S. authorities. Thus, these countries deposited their dollarsin European banks and gave a major impetus to the Eurocurrency markets.

Another period of dramatic growth in the Eurocurrency markets cameduring the 1960s, when concerns about the U.S. balance of paymentsdeficit prompted the U.S. Government to introduce a variety of measuresdesigned to prevent the flow of dollars abroad. These capital controlsmade it very difficult for foreign entities to obtain dollars from Americans,and so they turned to the Euromarkets. Another factor that stimulated thegrowth of the Euromarkets was the large volume of OPEC petrodollarsdeposited in European banks to avoid the risk of U.S. retaliation after the1973 Arab oil embargo.

1 Equity securities that are underwritten and distributed to investors outside the homecountry of the issue are sometimes called Euro-equities, although this term is somewhatconfusing because these stocks, unlike other investments that carry the "Euro" prefix, aredenominated in the currency of the market in which they trade.

39

VIII.

HISTORICAL RETURNS ON FOREIGN GOVERNMENT BONDS

THIS chapter presents information on the dollar rates of return oninvestments in long-term government bonds issued by the nationsof the Group of Seven and Switzerland over the period January

1975 through December 1992. Bonds were chosen for this study sincethey avoid added complexities that arise in conducting a study of returnson foreign equities, such as choosing which stocks to use and properlyaccounting for dividends.1 Government bonds in particular were chosensince they provide a useful benchmark from which to infer returns onother debt instruments in these nations, and because they are consideredrisk-free in the financial community.

It is important to note that the results of this study should be regarded asapproximations rather than exact returns due to inconsistencies in the dataacross countries and the need to employ certain assumptions, whether tosimplify the calculations or because of data limitations. In calculating themonthly dollar returns for each foreign country, it was assumed that anAmerican investor took $1,000 on the first business day of each monthand converted it into the relevant foreign currency at the then-prevailingexchange rate. It then was assumed that the investor could purchase aforeign government bond, at par, with a price exactly equal to the amountof foreign currency obtained after the foreign-exchange transaction andbearing a coupon rate equal to the yield to maturity on similar bonds as ofthe end of the immediately preceding month.2

It was further assumed that at the end of the month the investor wouldreceive an interest payment equal to 1/12th of the coupon rate. Finally, itwas assumed the investor could sell the bond at a price that would give it ayield to maturity equal to the yield to maturity for government bonds as ofthe end of the month in which the bond was purchased.3 The sum of theinterest payment and the sale price then was converted to U.S. dollarsusing the foreign-exchange rate prevailing on the first day of the nextsucceeding month. American government bond returns were computed inthe same way, but without the necessity of foreign-exchange transactionsat the beginning and end of each month. In this way a series of monthlyreturns was derived for the January 1975 to December 1992 period.

Table 1 summarizes the results expressed both in terms of simplereturns and compound returns while Charts 10 through 17 show thecumulative compounded monthly values of an initial investment of $1,000,at year-end 1974, over the period for the various bond investments. Simplereturns are those that would be achieved by realizing any profit (or loss) at

40

the end of each month and beginning the next month with a $1,000

investment. Compound returns assume that any profit (or loss) is retained

and included in the amount reinvested at the start of the next month. Table

1 also contains total and annual return data for each country for each 6-

year period as well as for the entire 18-year period.4 In order to measure

the variability of monthly returns for each country, the standard deviation

of each series of returns is shown. The bottom three rows show the

maximum and minimum observed monthly (simple) returns and the range

encompassed by these two values.

The returns summarized in Table 1 are a function of the coupon ratesand changes in exchange rates and bond yields over the investment pe-riod. The higher the coupon rate the greater is the amount of foreigncurrency received during the term of the investment. As for changes in theexchange rate, an appreciation of the dollar during the investment termwill depress dollar returns, because a unit of foreign currency will purchasefewer dollars at the end of the term, and a depreciation of the dollar willincrease dollar returns. Changes in bond yields affect returns: if bondyields decrease during the term, the bond will sell at a premium when it issold; if bond yields increase, the bond will sell at a discount. It is importantto bear in mind in analyzing these results that the hierarchy of returns ongovernment bonds provides no guidance as to which country has offeredthe best returns on other types of assets. For instance, higher coupon rates,which increase bond returns, could be a reflection of higher overall inter-est rates, which would tend to depress returns on equities.

The interplay between these factors can produce some unexpectedresults. For example, Swiss bonds, despite being denominated in a strongcurrency, achieved an average annual (simple) return of only 10.03 per-cent while French bonds, despite the relative weakness of the Frenchfranc, produced an average annual (simple) return of 11.98 percent.5 Thiscan be understood by reference to the other two factors, coupon rates andchanges in bond yields, that influence dollar rates of returns on foreignbonds. During much of the past 15 years French coupon rates have been asmuch as two or three times higher than Swiss rates. Thus, the domesticrate of return on French bonds has been higher than on Swiss bonds. Inaddition, while still higher than Swiss bond yields, French bond yieldshave dropped more dramatically since the early 1980s, thereby boostingbond sale prices.

An examination of the return data also confirms what was said in

Chapter II about risk, return, and diversification. The countries with the

two highest average returns (Japan, 14.81 percent, and the United King-

dom, 12.50 percent), also had the highest standard deviations and the

largest ranges of observed returns, while the country with the lowest

41

Table 1: RETURNS ON LONG-TERM GOVERNMENT BONDS,

1975

1976

1977

1978

1979

1980

6-Yr. Total

Average

1981

1982

1983

1984

1985

1986

6-Yr. Total

Average

1987

1988

1989

1990

1991

1992

6-Yr. Total

Average

1 8-Yr. Total

Average

Monthly

Average

Std. Dev.

Maximum

Minimum

Range

Canada

Simple

2.16

17.09

-1.26

-5.03

2.35

3.23

18.54

3.09

4.21

31.50

8.84

9.23

15.59

20.28

89.64

14.94

6.84

19.41

16.43

5.11

20.19

2.59

70.57

11.76

1 78.75

9.93

0.83

3.41

15.63

-11.26

26.89

Compound

1.83

18.17

-1.36

-5.01

1.97

1.94

17.20

2.68

1.49

34.69

8.81

9.11

15.95

21.72

129.06

14.81

5.94

20.63

17.36

4.70

21.93

1.94

95.19

11.79

408.47

9.46

France

Simple

17.05

-4.13

16.81

28.23

2.20

-10.61

49.55

8.26

-15.64

7.28

0.70

11.31

43.44

39.96

87.06

14.51

21.90

6.56

7.78

19.59

16.67

6.53

79.03

13.17

215.64

11.98

1.00

3.87

12.70

-16.22

28.91

Compound

17.80

-4.19

18.02

31.50

1.79

-12.11

56.71

7.77

-15.85

6.33

0.47

11.11

52.18

46.28

122.36

14.25

22.90

6.23

7.11

20.96

16.45

6.01

108.83

13.06

597.52

11.39

Germany

Simple i

12.48

26.31

30.81

15.12

2.74

-10.32

77.16

12.86

-5.76

15.85

-8.90

2.95

38.41

35.44

77.98

13.00

24.29

-4.98

5.39

6.14

3.71

12.03

46.57

7.76

201.71

11.21

0.93

4.13

12.08

-13.69

25.78

Compound

12.15

29.33

35.25

15.50

2.12

-11.85

103.97

12.61

-7.32

16.15

-8.88

2.17

44.43

39.63

102.12

12.44

25.65

-5.66

4.37

5.56

2.91

12.01

50.53

7.05

424.78

9.65

Italy

Simple

15.60

-31.24

20.20

24.70

12.16

-8.00

33.42

5.57

-22.24

12.57

5.11

12.93

33.82

50.03

92.21

15.37

22.78

2.42

7.04

26.32

19.72

-23.97

54.31

9.05

1 79.94

10.00

0.83

3.95

11.25

-16.65

27.90

Compound

16.21

-28.31

22.03

27.42

12.63

-8.65

33.26

4.90

-20.80

12.76

5.01

12.84

38.62

62.16

137.86

15.54

24.38

1.88

6.56

29.21

20.31

-23.84

59.85

8.13

403.98

9.40

42

JANUARY 1975 - DECEMBER 1992 (All Amounts in Percent)

Japan

Simple <

11.95

15.03

46.25

29.24

-28.97

23.38

96.87

16.15

12.03

7.62

11.68

-4.84

34.98

39.34

100.82

16.80

31.61

8.64

-20.01

7.73

25.91

14.93

68.81

11.47

266.50

14.81

1.23

5.10

19.47

-12.49

31.96

Compound

12.17

15.94

57.15

31.39

-26.42

22.40

141.85

15.86

11.22

5.31

11.79

-5.01

39.38

45.06

151.44

16.61

29.89

7.54

-19.05

5.88

28.18

15.47

77.20

10.00

873.59

13.48

— Switzerland —

Simple

12.43

20.75

32.97

35.08

0.85

-10.26

91.81

15.30

3.20

1.66

-5.65

-14.06

31.84

32.25

49.24

8.21

28.49

-12.04

-8.58

21.30

4.87

5.44

39.47

6.58

180.51

10.03

0.84

4.26

13.06

-9.64

22.70

Compound

12.24

22.62

37.46

38.87

0.07

-11.33

133.14

15.15

1.54

1.00

-5.79

-13.57

35.21

35.79

53.33

7.38

31.21

-12.05

-9.15

23.19

3.54

4.16

39.29

5.68

312.43

8.19

United Kingdom

Simple

14.47

-10.28

52.99

2.00

14.31

27.13

100.62

16.77

-16.36

20.24

4.06

-11.33

37.54

15.70

49.84

8.31

39.62

6.43

-2.82

36.39

2.05

-7.03

74.63

12.44

225.08

12.50

1.04

5.15

16.46

-11.73

28.19

Compound

13.63

-11.56

66.15

1.32

13.50

29.65

148.94

16.42

-16.42

21.47

3.25

-11.32

42.28

13.84

50.56

7.06

45.49

5.24

-3.94

41.19

-0.23

-8.72

89.11

11.20

540.59

10.87

— United States —

Simple

3.53

14.29

-0.90

-1.93

-1.11-5.17

8.72

1.45

6.83

31.11

2.77

13.93

23.28

28.49

106.42

17.74

-5.39

7.16

18.78

7.92

17.11

10.15

55.73

9.29

170.87

9.49

0.79

2.86

10.80

-9.88

20.69

Compound

3.50

15.17

-1.04

-1.99

-1.35

-6.53

6.61

1.07

6.11

34.93

2.64

14.44

25.53

31.54

1 77.73

18.56

-5.85

6.89

20.09

7.89

18.04

10.38

69.88

9.23

387.15

9.20

Diversifh

Simple

11.21

5.98

24.73

15.93

0.57

1.17

59.58

9.93

-4.22

15.98

2.33

2.51

32.36

32.69

81.65

13.61

21.27

4.20

3.00

16.31

13.78

2.58

61.14

10.19

189.55

11.24

0.94

2.97

10.13

-8.42

18.56

43

<X> CO

44

8 Sr

45

average return (the United States, 9.49 percent), had the lowest standarddeviation and the smallest range of observed returns. This pattern, with

slight exceptions, holds for all countries. Thus, the notion that investments

with higher risks should offer higher returns seems to be supported by

these data.

In addition, Table 1 provides a demonstration of the benefits of portfo-lio diversification. The column to the far right of Table 1 presents theresults achieved by investing an equal amount in bonds of each of theeight countries. The average annual return achieved by this investment isthe exact average of the other eight returns, since this hypothetical portfo-lio is equally weighted between all eight countries.6 The more interestingresult is that the standard deviation of average annual returns for thehypothetical portfolio is 2.97 percent. This standard deviation is lowerthan that achieved for bond investments in any single country other thanthe United States, whose bonds had an average return of only 9.49 percentper year. Thus, a person who pursued an equal-weighted diversificationstrategy over the past 18 years instead of holding U.S. bonds alone wouldhave substantially increased returns while only marginally increasing vola-tility (risk).

1 One way around these difficulties is to use aggregate data, such as market indexes. Suchstudies can be obtained from financial advisors, finance journals, or agencies such as theInternational Monetary Fund's International Finance Corporation.2 The end-of-month exchange rates and yield to maturity data are those published by theInternational Monetary Fund.3 This price is derived by discounting to present value the stream of future interestpayments and the future par payment using the new end-of-month yield to maturity as thediscount rate.4 The annual simple return is also called the arithmetic mean, and it is simply the total ofall the observed simple returns divided by the number of years spanned by the study. Thecompound annual return is also called the geometric mean, and it measures the compoundincrease in value each year over the period for which it is measured.5 To avoid confusion, the following analysis of bond returns will focus on simple, asopposed to compound, returns.6 A number of different strategies can be pursued in determining what proportion of fundsto put into each investment, of which equally weighted is the easiest. Alternatively, aninvestor could allocate capital according to each country's GNP, bond market size, or someother such criteria.

46

IX.

PROSPECTS FOR THE FUTURE

T HE world's financial markets have changed greatly since 1944,when the International Monetary Fund and World Bank were cre-ated, and even since 1973 when the Bretton Woods regime was

abandoned in favor of today's ad hoc exchange rate system. Over thisperiod international financial transactions have increased in volume, speed,and complexity. Even today these changes continue apace. This chaptersketches some of the most important changes in international capitalmarkets and investing as well as proposals for dealing with them, anddiscusses several current developments that have important implications.

One of the most significant changes in the international monetarysystem since World War II has been the shift from a fixed to a floatingexchange rate regime. At the time this change was ushered in, proponentsof floating exchange rates argued that such a system would provide anumber of improvements over the fixed rate arrangements. First, it wasclaimed that market-dictated changes in exchange rates would act asautomatic stabilizers and prevent or minimize balance of payments dis-equilibria by allowing for more rapid currency adjustments than werepossible with fixed rates.

Second, it was widely believed that floating rates would free govern-ments from having to use monetary policy to support exchange rateparities, making it possible to employ monetary policy in pursuit of othergoals such as managing growth and inflation. Third, eliminating the re-quirement that currencies be pegged to the value of the dollar would allowthe United States to change the value of its currency in relation to othercurrencies, thereby addressing the Nation's balance of payments deficit,and would relieve U.S. monetary authorities of responsibility for "manag-ing" the world's money supply.

The record of the past 20 years suggests that the floating exchange rateregime has been neither an unqualified success nor an unmitigated disaster.While exchange rates are now free to change more rapidly than waspreviously possible, this has not eliminated balance of payments disequi-libria as evidenced by the persistent, large current account surpluses inJapan and Germany and the U.S. current account deficit. In addition, whilemonetary policy no longer is dictated by the need to maintain foreign-exchange parities, national governments have shown great concern overperceived exchange rate misalignments and have frequently resorted toforeign-exchange intervention. Finally, although the dollar no longer is aglobal benchmark for exchange rates, and can therefore change in value

47

relative to other currencies, the United States experienced large currentaccount deficits throughout the 1980s, despite the sharp depreciation of thedollar since 1985. Although other currencies — particularly the Deutschemark — have gained prominence as reserve currencies, the dollar still isthe principal reserve currency in the world.

Perhaps the most frequent complaint about the floating exchange rate

regime since 1973 has been the accompanying exchange rate volatility,

which has reflected underlying economic fundamentals. Such volatility

can depress both cross-border investment, by increasing the uncertainty of

returns on foreign investments, and cross-border trade because of exchange

rate induced fluctuations in the home currency price of foreign goods and

services. As a result, there has been considerable discussion in academic

and policy-making circles about ways to reduce such volatility.

Of the approaches that have been suggested, one, exemplified by theEuropean Monetary System (EMS), is to establish regional currency unionsor exchange rate mechanisms (ERMs) that set specified ranges, or mar-gins, to constrain the extent to which the currencies of member countriescan float against each other. In the case of the EMS, each country'scurrency may fluctuate by no more than 2.25 percent (6 percent in the caseof Italy) above or below its parity established against the European Cur-rency Unit (ECU), a basket of members' currencies. Central bank inter-vention is used to maintain currencies within their respective margins.Despite the apparent logic of such an arrangement, underlying economicconditions have forced frequent realignments of the EMS currencies withthe result that traditionally stronger currencies, such as the Deutsche markand Swiss franc, have continued to appreciate against traditionally weakercurrencies, such as the pound and Italian lira. Furthermore, it is doubtfulthere are many other nations with the desire, or necessary degree ofeconomic and cultural similarity, to enter into similar arrangements.

Another proposal for stabilizing exchange rates that has enduring ap-

peal is the return to a gold standard where the value of each currency is

fixed in relation to gold. The virtue of such an approach is that it would

constrain central banks from allowing excessive money supply growth

and would therefore contribute to price stability. Shortly after entering

office President Reagan impaneled a special commission to study this

option, but the commission eventually recommended against such a move.

Critics of the gold standard insist that it would place excessive constraints

on the use of monetary policy to influence economic conditions and

would give too much power over the world money supply to major gold-

producing countries such as Russia and South Africa, countries not noted

for their political stability of late.1

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Other proposals range from calls for the establishment of target zones,similar to those employed in the European Monetary System, to the farmore ambitious suggestion that the nations of the world move towards asingle global currency managed by a world central bank. At the presenttime, however, there is little reason to believe many countries are willingto relinquish the degree of control over national economic policy thatthese proposals would entail. It therefore seems likely that the currentsystem, or nonsystem as some have called it, will remain in place for theforeseeable future. If this is the case, exchange rate volatility probablywill continue despite (and sometimes on account of) economic policy"coordination" and exchange rate interventions among the major indus-trial nations. Policy coordination is the goal of the Group of Seven, but sofar it has failed to produce either the desired short-term exchange ratemovements or long-term exchange rate stability.

Another dominant trend in international finance has been the ever-increasing integration of the world's capital markets. A myriad of indepen-dent but interrelated factors are behind this change. For one, recent techno-logical advances in computers and telecommunications have allowed firmsand financial institutions to move huge amounts of capital around the globeat incredible speed and very low cost. This ability, along with the increas-ingly intense competition in the financial services industry, has increasedpressures for deregulation of national financial markets as funds flow tothose locations that offer less-regulated environments. These flows havecreated arbitrage pressures that seriously diminish the effectiveness ofindividual national tax and regulatory policies, forcing many governmentsto abandon ineffectual policies designed to control capital movements.

A great increase in the volume of international trade has further con-tributed to the integration of world capital markets. One reason for thisincrease has been the emergence of advanced industrial economies inmany of the nations devastated in World War II. This development hasbeen greatly assisted by improvements in transportation technology andthe lowering of trade barriers under the auspices of the General Agree-ment on Tariffs and Trade (GATT). Lower trade barriers also have promotedthe globalization of production, as firms have moved to locate operationsin countries that have the lowest costs. As the volume of internationaltransactions in goods and services has increased, a corresponding increasehas occurred in cross-border transactions in financial assets to meet theinvestment, funding, and hedging requirements of firms engaged in inter-national trade. The increased movements of goods, services, and capitalacross borders have tied national economies closer together. This integra-tion was dramatically demonstrated in October 1987, when the stockmarket break in the United States cascaded across national boundaries and

49

dragged down equity prices throughout the industrial world. One impor-tant consequence of this development is that national authorities haveconsiderably less discretion to fashion economic policies than academicadvocates of floating exchange rates had predicted.

In short, whether exchange rates are fixed or floating, internationaleconomic integration and the global diversification of production make itharder for national governments to fashion policies whose effects arenarrowly tailored to the "national good." This complication partly reflectsthe current difficulty in saying what precisely is, for example, an "Ameri-can*' corporation. For instance, does America benefit more when a British-owned firm in the United States expands production or when a U.S.-owned firm in Britain expands production?

Properly viewed, the integration of international markets for goods,services, and capital are strongly positive developments. The resultingincrease in competition has led to a proliferation of financial instrumentsand lowered the costs of financial intermediation for borrowers and saversalike. This, in turn, has increased the efficiency with which capital isallocated around the globe and made possible gains in global output andwealth. In addition, individuals and business entities now have greaterchoices and can make more rational decisions about how and where theyallot their investment capital to obtain their preferred mix of risk andreturn.

In addition to informal economic integration, which results largelyfrom free-market pressures, there have been several notable efforts atformal economic integration, namely integration brought about by theliberalization of government policy. The most ambitious attempt at formaleconomic integration is the European Community plan to remove allbarriers to the movement of goods, services, capital, and people betweenmember nations, thereby creating a single, integrated market. The progressachieved to date, as well as the problems the EC members have encoun-tered, offer valuable hints about the future course of economic integration,both formal and informal, for the other nations of the world.

Although the prospect of a more united Europe first arose during the19th century, the movement toward formal integration had its origins inthe 1940s, when the noncommunist nations of Europe, struggling to re-build their war-shattered economies, formed the Organization for Euro-pean Economic Cooperation (OEEC).2 In 1951, Germany, France, Italy,and the BeNeLux countries formed the European Coal and Steel Commu-nity to create a common market for coal and steel. In 1957, these sixnations signed the Treaty of Rome, giving birth to the European EconomicCommunity (EEC), in an attempt to broaden their economic cooperation

50

by eliminating trade barriers between members, harmonizing tax policies,and erecting a common external tariff. Another step toward economicintegration came in 1979, when the six original members of the EEC,along with Denmark and Ireland, formed the European Monetary System,discussed previously.3

While the foregoing were significant accomplishments, the nationaleconomies of Europe were still distinctly segmented. A profound pessi-mism spread over most of Europe during much of the 1970s and early1980s as a result of lackluster economic performance, particularly com-pared with that in countries such as the United States and Japan. ManyEuropeans began to believe that they would be relegated to second-classstatus if they could not overcome the numerous divisions that still sepa-rated their economies. In 1985, the EC Commission, the executive branchof the European Community, released a White Paper on "Completing theInternal Market" that identified barriers to economic integration, sug-gested a far-reaching series of measures to remove them, and proposedchanges in the 1957 Treaties designed to bring about such changes. TheWhite Paper's suggestions were adopted in the Single European Act of1987.

The Single European Act replaced the requirement of unanimity for ECdecisions with a weighted majority procedure, making it easier for the ECto pass directives and regulations, and supposedly committed the ECmembers to achieving a single, unified market for goods, services, capital,and persons by December 31, 1992 — a goal that proved overly ambi-tious. While there was skepticism all along about the EC's ability toimplement all the necessary changes by that date, the costs and uncertain-ties that have resulted from German reunification and the collapse ofcommunism in Eastern Europe have made it clear that in all likelihood thegoals of the Single European Act will not be fully realized soon. Althoughsome commentators have expressed the view that the internal preoccupa-tions of Germany, the most powerful economy in the EC, could derail thesingle market plan, the German government has been steadfast in pro-nouncing its continued commitment to further unification.

One of the aspects of the EC's single market program that has far-reaching implications for the ongoing process of global capital marketintegration is the prospect of mutual recognition of national financial lawsand regulations. In seeking to create a "European Financial Area" with nobarriers to capital movement and a Community-wide market for financialservices, the EC soon recognized that it would not be possible to harmo-nize fully the labyrinth of national laws and practices governing financialservices and markets. Therefore, it adopted the view that once a certainlevel of harmonization is achieved each member country should recognize

51

the validity and sufficiency of each other member's controls over its own

financial markets and institutions so that firms are not subject to multiple

regulatory schemes.

As a result, a British bank that wants to establish a branch in Paris, and

an Italian company that wants to sell stock to German investors, need only

comply with their home-country's laws on banking and securities disclo-

sure, respectively. Such mutual recognition would be expected to create a

single market for financial products and services and significantly in-

crease competition throughout the EC. It also would be expected to in-

crease pressures for deregulation, inasmuch as a process of regulatory

arbitrage would ensue in which firms would seek to establish their head-

quarters in countries with less onerous regulatory regimes. Companies

benefit from such an arrangement because they can more easily enter new

markets and raise capital at less cost while individuals can choose from a

greater variety of lower-cost financial services and products.

The ability of non-EC entities to gain access to the single market isgoverned by the principle of reciprocity. As originally planned, non-ECfirms would be permitted to undertake only those activities in the EC thatEC firms could undertake in the foreign firm's home country. Americanand Japanese banks were particularly critical of this proposal, because theirsubsidiaries in the EC would have to abide by restrictions, such as branch-ing limitations and restrictions on securities activities, that would not applyto the EC firms with which they would compete. In December of 1989,however, the Second Banking Directive was amended to provide that non-EC banks would not be discriminated against in the EC if EC banks are notdiscriminated against in the foreign firm's home country. This more liberalview of reciprocity has not yet been extended to all areas outside ofbanking, but EC officials have indicated that it eventually will be.

Mutual recognition and reciprocity may offer promising approaches for

other countries now experiencing informal capital market integration byallowing them to begin formal integration without first undertaking the

complex task of regulatory harmonization. As an example, the Securities

and Exchange Commission proposed a Multijurisdictional Disclosure Sys-

tem for the United States and Canada whereby American companies could

register public securities offerings in Canada using U.S. disclosure docu-

ments and Canadian firms could register offerings in the United States

with Canadian disclosure documents.

In view of the tangible benefits that formal integration offers in the face

of global competition, one might expect that it, too, will gain greater favor

among nations. The recent U.S.-Canada free trade agreement, and the

decision to begin negotiations on a U.S.-Mexico free-trade agreement, are

52

examples of formal integration undertaken, at least in part, in response tothe prospects of a single European market. However, past history stronglysuggests that nations do not always follow the wisest course, even whenthey may be inclined toward it. There are no guarantees that world eco-nomic integration will proceed smoothly — and should domestic reversesoccur, the political pressure to disintegrate markets could again becomeintense.

1 For an extended discussion of the possible usefulness of a gold standard, see our booklet"Why Gold?," price $6 (postpaid).2 The OEEC subsequently evolved into the Organization for Economic Cooperation andDevelopment (OECD) and full membership was opened to non-European nations such asthe United States, Canada, Japan, Australia, and New Zealand.3 Membership in the EMS has since expanded to include Greece, Portugal, Spain, andBritain.

53

X.

CONCLUSION

THE economic realities of the modern world dictate that, if they are tocontribute to and benefit from progress toward global economic ad-vancement, American investors must develop a greater understanding

of the international economic system and make more sophisticated judg-ments about where to place their investment capital. While the obstaclesencountered along the road to this objective are formidable, the potentialbenefits — personal, national, and international — are even greater. The ben-efits of such sophistication extend well beyond the increased returns that canbe achieved by the individual. The American economy as a whole is virtuallycertain to benefit from a more informed, international outlook on the part ofits citizens, and the world economy itself will function more efficiently whenthe distribution of funds is driven by the underlying merits of the investmentrather than an excessive bias in favor of investments in one national marketover another.

In order to realize these benefits, however, an investor must be able to

make informed judgments about events and trends that were until recently

deemed largely irrelevant by most Americans. In broadening one's invest-

ment horizons to include overseas opportunities, all the issues that must be

evaluated in the domestic context are present, but they are supplemented by

an entire range of considerations that adds an additional layer of complexity.

While this complexity necessarily increases the effort required to understand

the factors that influence the success of one's investments, it is a responsibil-

ity that must be undertaken by individuals or else relinquished to government

or nongovernment entities that may have agenda contrary to the markets.

Fortunately, information about international investments is available ingreater quantity and quality than ever before. Financial firms and publica-tions are increasingly realizing the importance of global economic develop-ments and are devoting a correspondingly greater share of their resources toanalyzing and presenting news about such issues. Furthermore, as internationaleconomic integration proceeds, common standards for financial practices andprocedures are coalescing so that the educated investor can more confidentlyrely on financial information originating from abroad. With a basic under-standing of the advantages and disadvantages of international investing, theworking of the foreign-exchange market, and the types and availability ofinternational investment vehicles, investors can assume greater control overtheir portfolios so as to make them more genuinely reflect their judgmentsand objectives than is possible with domestic investments alone. At bottom,achieving greater control over one's investments is the most persuasivereason for devoting time to the study of financial matters.

54

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