Shaheed Sukhdev College of Business Studies

INTERNATIONAL PORTFOLIO: MANAGEMENT & CHALLENGES

TERM PAPER ON INTERNATIONAL FINANCE

Submitted by: Srijan Saxena (4601) Raghav Bhatnagar (4624) Akshay Kharbanda (4627) Vineeth Vijayan (4644) BBS- 3FA

ACKNOWLEDGEMENT We would like to express our deep sense of intellectual debt to our mentor and teacher Mr. Kumar Bijoy, who provided valuable comments and suggestions from time to time as to methodology, style and substance that went a long way in completion of the term paper in its present form. Without his help, guidance and encouragement, the making of this project would not have been possible.

TABLE OF CONTENTS Ridiculed in the west for a long time but with his firm making headway with positive net returns in both the 1998 and the present crash Nassim Nicholas Taleb (born 1960) is a literary essayist, epistemologist, researcher, and former practitioner of mathematical finance. Taleb is a specialist in financial derivatives. Universa, where Taleb is adviser, made returns of 65% to 115% in October 2008 in its approximately $2 billion Black Swan Protection Protocol Higher frequency ......34 -Limited human knowledge.......................................................................................34

INTRODUCTION The topic given to us for our international finance assignment is international portfolio management-risk. During the course of this project we have tried to analyze and study the various issues related to the subject and derive conclusions from the same. Initially we have looked into the basic principles of the investment portfolio management and how different mathematical tools are applied in it. Then we moved on to the relative merits and the risks that have been found in the international portfolio that are managed. In the next step we have gone a step ahead and talked about the specific country to country correlation and how it affects the diversification risk of a portfolio with an in-depth comprehensive study of one major mutual fund. In addition a comprehensive study of the different risk management was also done with a look into the investment strategy of a major SWF. At first sight, the idea of investing internationally seems exciting and full of promise because of the many benefits of international portfolio investment. By investing in foreign securities, investors can participate in the growth of other countries, hedge their consumption basket against exchange rate risk, realize diversification effects, and take advantage of market segmentation on a global scale. Even though these advantages might appear attractive, the risks of and constraints for international portfolio investment must not be overlooked. In an international context, financial investments are not only subject to currency risk and political risk, but there are many institutional constraints and barriers, significant among them a host of tax issues. These constraints, while being reduced by technology and policy, support the case for internationally segmented securities markets, with concomitant benefits for those who manage to overcome the barriers in an effective manner. In recent years, economic activity has been characterized by a dramatic increase in the international dimensions of business operations. National economies in all parts of the world have become more closely linked by way of a growing volume of cross-border transactions, not only in terms of goods and services but even more so with respect to financial claims of all kinds. Reduced regulatory barriers between countries, lower cost of communications as well as travel and transportation have resulted in a higher degree of market integration. Alongside the increase in international trade one can easily observe the globalization of financial activity. Indeed, the growth of cross-border, or international, flows of financial assets has outpaced the expansion of trade in goods and services. These developments are underpinned by advances in communication and transportation technology. As a consequence, investment opportunities are no longer restricted to domestic markets, but financial capital can now seek opportunities abroad with relative ease. Indeed, international competition for funds has caused an explosive growth in international flows of equities as well as fixed-income and monetary instruments.

Emerging markets, in particular, as they have become more and more accessible, have begun to offer seemingly attractive investment alternatives to investors around the globe. International capital flows are further driven by a divergence in population trends between developed and developing countries. The underlying demand for savings vehicles is further reinforced by the necessary shift from pay-as-you-go pension schemes towards capital market-based arrangements. By the same token, developing countries with their relatively young populations require persistent and high levels of investment in order to create jobs and raise standards of living in line with the aspirations of their impatient populations. All this provides significant incentives for the growth of international markets for all kinds of financial claims in general and securities in particular. While the environment has undoubtedly become more conducive to international portfolio investment (IPI), the potential benefits for savers investors have lost none of their attractions. There are the less-than-perfect correlations between national economies, the possibility of hedging an increasingly international consumption basket, and the participation in exceptional growth opportunities abroad, which can now be taken advantage of through IPI. Furthermore, there is not only additional upside potential, but there are also some extra risks involved in IPI. Such unique risks arise especially from unfavorable changes in exchange and interest rates as well as regulatory developments. Even though it might on balance look attractive to the investor to purchase some foreign securities for his portfolio, this might not easily be feasible due to institutional constraints imposed on IPI. Obstacles like taxation withholding tax, taxation of foreign income and multiple taxation., exchange controls, capital market regulations and, last but not least, transactions cost can represent valid reasons why the scope and thus the potential of IPI might be limited.

PRINCIPLES OF INTERNATIONAL PORTFOLIO INVESTMENT An important issue that arises if portfolios are composed of securities from different countries is the choice of a numeraire for measuring risk and expected return. The Capital Asset Pricing Model (CAPM) has been developed with respect to major capital markets in the world. It is well accepted and widely used by professional portfolio managers to analyze the pricing of securities in national financial markets. In the CAPM, the rate of return required for an asset in market equilibrium depends on the systematic risk associated with returns on the asset, that is, on the covariance of the returns on the asset and the aggregate returns to the market. Risk in asset returns that is uncorrelated with aggregate market returns is called 'specific risk', 'diversifiable risk', or 'idiosyncratic risk'. Given diversified holdings of assets, each individual investors exposure to idiosyncratic risk associated with any particular asset is small and uncorrelated with the rest of their portfolio. Hence, the contribution of idiosyncratic risk to the riskiness of the portfolio as a whole is negligible. It follows that only systematic risk needs to be taken into account. Particularly, as there are many barriers and obstacles to IPI, mean-variance efficiency of all securities cannot be assumed automatically. There is no common real risk-free rate of interest, because of real exchange risk caused by deviations from purchasing power parity. By the same token, it is difficult to determine a global market portfolio. For national capital markets the use of value-weighted portfolios as benchmarks is quite defensible, but this might not be true in an international context, where (a) Financial markets are still segmented to some degree; (b) Investors have different risk preferences; and (c) Expected risk and return change over time. Beta measures only systematic risk, while standard deviation is a measure of total risk (systematic or market risk, and unsystematic risk, the risk of the security) .The two components of international diversification are Potential for risk reduction through diversification and Added foreign exchange risk We can illustrate the use of expected risk and the correlation to find out the risk that can arise from the total transaction as given below. The standard deviation and the expected return of a portfolio with 40% invested in the following Indian equity and 60% invested in the following US equity index. Indian equity index (IND) US equity index (US) Correlation coefficient (US,GER) Expected Return 14% 18% 0.34 Expected Risk () 15% 20%

2 2 2 2 P = wUS US + wGER GER + 2 wUS wGER US ,GER US GER

P = (40%) 2 (15%) 2 + (60%) 2 (20%) 2 + 2(40%)(60%)(.34)(15%)(20%) = 15.13%

E ( RP ) = wUS E ( RUS ) + wGER E ( RGER ) E ( RP ) = (40%)(14%) + (60%)(18%) = 16.4%

Alternative Portfolio Profiles

19.00% 18.00% 17.00% 16.00% 15.00% 14.00% 13.00% Maximum Risk and Maximum Return Portfolio Initial Portfolio Minimum Risk Combination Domestic Only Portfolio

-Effects of Changes in the Exchange Rate Returns to investors investing in foreign markets depend on two factors: a) The 12.00% on the foreign asset or security, and return 1.50% 2.00% 2.50% 3.00% b) The change in the exchange rate relative to the domestic currency. 3.50%
Expected portfolio risk

Expected portfolio return

4.00%

4.50%

Return on foreign asset depends on the performance of the asset and the performance of the foreign currency. Rate of Return in Dollars (R$) RF + e ( % Spot Rate), {where RF is the foreign return in foreign or local currency (%); e is % change in the foreign currency over the holding period.} If the foreign currency appreciated (depreciated), e is pos. (neg.) and increases (decreases) the effective dollar return to the investor.

E.g.: - Japanese stock market increases by 4% and the Yen appreciates by 5% (USD return = 9%) - British security increases by 15% and the BP depreciates by 5% (USD return = 10%) Holding a foreign security is like having two assets: a) The foreign security and b) The foreign currency. Exchange rate changes affect the risk (variability) of a foreign investment as follows: Var (R$) = Var (Rf ) + Var (e) + 2 COV (Rf, e) If exchange-rates were certain, or fixed (or unified), the terms with e would be zero, and the only risk would be the Var (Rf ), the variability of the foreign asset. E.g.: - U.S. investment in Argentina (under 1:1 peg) or Ecuador ($), German investment in France, U.S. investment in Panama ($), etc. With ex-rate uncertainty, currency risk would contribute to the riskiness of foreign investments by: 1) Exchange rate volatility: Var (e). 2) Covariance between ex-rates and the local market stock returns COV(R f, e), could be pos or negative. For further details please refer to appendix 3 -International Bond Market We know that U.S. bond market is highly correlated with Canada (.76), less so with France, Germany, Japan, Switzerland, and UK (all around .30 correlations). We can use the same approach to calculate the OIP for bonds for say, U.S. investor, Fixed income securities are heavily exposed to currency risk, but can still benefit from diversification (higher returns, lower risk) if they can manage FX risk. Also, hedging strategies could control, minimize or reduce currency risk, boosting returns/lowering risk, improving intl. bond investment performance, e.g., Forwards, futures, options, etc. Recent change: Euro currency would eliminate FX risk for Eurozone countries, enhance and increase the use of non-Euro Swiss and British bonds for fixed-income diversification. -International Mutual Funds: Performance U.S. investors can cost-effectively diversify internationally by buying one of more than 1000 international mutual funds: 1) at very low transaction cost, 2) without legal and

institutional barriers compared to investing directly in foreign market, and 3) with the benefit of professional fund managers. Point: International diversification increases risk-adjusted returns. Note also that the MSCI World Index SHP outperformed the Average, .186 vs. .150, suggesting that further diversification would be good, e.g., World Index fund. Alternative strategy to well-diversified international mutual fund: Invest in a single market country fund (China, Russia, Turkey, Brazil, India, etc.), often sold as a closedend country fund (CECF), a portfolio of a fixed number of shares, which are then exchange-traded on NYSE, see Exhibit 15.12 on p. 371. For some emerging markets this might be the only way to invest in these segmented markets, at least at a low cost. Unlike most mutual funds, CECFs don't always trade at Net Asset Value of the securities. The reason for this that CFs are generated in foreign currency outside the U.S., but the securities are traded in U.S. Market value in U.S. usually different than the NAV, and sell at a premium or discount.

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THE BENEFITS FROM INTERNATIONAL PORTFOLIO INVESTMENT There are several potential benefits that make it attractive for investors to internationalize their portfolios. These perceived advantages are the driving force and motivation to engage in IPI and will, therefore, be dealt with first, i.e., before looking at the risks and constraints. Specifically, the attractions of IPI are based on: The participation in the growth of other (foreign) Markets; Hedging of the investors consumption basket; Diversification effects and, possibly; and Abnormal returns due to market segmentation. All else being equal, an investor will benefit from having a greater proportion of wealth invested in foreign securities because: expected return higher variation of returns lower lower correlation of returns of foreign securities with the investors home market, and possibly, Greater share of imported goods and services in his consumption. -Participation in Growth of Foreign Markets High economic growth usually goes hand in hand with high growth in the countrys capital market and thus attracts investors from abroad. IPI allows investors to participate in the faster growth of other countries via the purchase of securities in foreign capital markets. This condition applies particularly to the so-called emerging markets of Europe, Latin America, Asia, the Middle-east and Africa. Countries are classified as emerging if they have low or medium income according to World Bank statistics, but enjoy rapid rates of economic growth. Typical examples are Mexico or Turkey as well as newly industrialized countries such as Korea or Taiwan. Driven by the general economic expansion, the financial markets in these countries have exhibited tremendous growth. This means that the security holdings of investors attained values several times worth the original investment after just a few years. -Hedging Of Consumption Basket Since the international investor is at the same time a consumer of real goods and services, the return of his financial investment must be related to his consumption pattern. This implies that goods are perfect substitutes domestically as well as internationally. If one assumes, realistically, that goods are not perfect substitutes, then deviations from Purchasing Power Parity (PPP) and Law of One Price (LOP) are possible. * Consumer-investors who consume purely domestic goods and have no international portfolio investment are exposed to unexpected change in domestic inflation, but not to foreign inflation risk or foreign exchange rate risk.

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If consumer-investors consume some imported goods something that will be true for many investors today, but have no foreign securities in their portfolio, they face domestic inflation, foreign inflation, and exchange risk. However, if PPP holds exactly over the investment horizon, then the combination of foreign inflation and exchange rate changes will always be equal to the domestic inflation rate. Thus, consumer-investors only face the domestic inflation risk. In these examples, whenever PPP holds, exchange risk is not a barrier to international portfolio investment. Finally, in case consumer-investors have some foreign assets in their portfolios and also consume foreign goods, they face domestic inflation, foreign inflation, and exchange risk, because the consumption pattern includes some imported goods. The exchange risk, however, can be hedged through appropriate foreign investment. Therefore, exchange risk on the consumption side could serve as an incentive for international portfolio investment. Again, when PPP holds, the exchange risk is the same as the inflation risk and, thus, there is no incentive for international portfolio investment. Nevertheless, if consumer & investors consume some imported goods and have proportionately matching. International portfolio investments, they are able to hedge the exchange risk. Therefore, regardless of whether PPP holds, they may be able to avoid exchange risk

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BENEFITS FROM INTERNATIONAL PORTFOLIO DIVERSIFICATION It has been shown, that the crucial factor determining portfolio risk for a given level of return is the correlation between the returns of the securities that make up that portfolio. Risk adverse investors will try to make use of the effect of diversification and select securities with low correlation. Investors benefit from diversification, both domestically and internationally. Since perfect negative correlation between different securities is rare, the lowest correlations possible will be chosen. This is the point where foreign securities come into play. Investors who compose their portfolio only of domestic securities restrict themselves to a smaller number of securities to choose from. Since they exclude the large set of foreign stocks, bonds and other securities, they limit the power of diversification a priori and forgo the possibility of further reducing portfolio risk by picking some foreign stocks that exhibit very low correlation with the domestic portfolio. Securities returns are less correlated across countries than within countries. Because of the fact that political and institutional, factors vary across countries - e.g., currency markets, regulation/deregulation, general economic conditions, business cycle differences, political issues, central bank issues, fiscal policy, industry structure, etc. Indeed, there is reason to expect the correlation of returns between foreign securities and domestic securities to be lower than that between only domestic securities. In the latter case, all returns will be partially affected by purely national events, such as real interest rates rising due to a particular governments anti-inflation policy. Within any single country, a strong tendency usually exists for economic phenomena to move more or less in unison, giving rise to periods of relatively high or low economic activity. The reason for this is that the same political authority is responsible for the formulation of economic policies in a particular country. For example, the monetary, fiscal, trade, tax, and industrial policies are all the same for the entire country, but may vary considerably across countries. Thus, regional economic shocks induce large, country-specific variation of returns. A second explanation for international diversification consists of the industrial diversification argument which is based on the observation that the industrial composition of national markets varies across countries; e.g., the Swiss market has a higher proportion of banks than other markets. As industries are less than perfectly correlated, investing in different markets enables the investor to take advantage of diversification effects simply because of the composition of his portfolio with respect to different industries. E.g.: U.S. market performance in 2006 was about 10%, stock markets in other countries have done much better, e.g., Mexico (+35%), Brazil (+22%), China (+44%), India (+40%), Spain (+32%), etc.

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Gains from international portfolio diversification depend on the degree of correlation (-1 +1) between the home country and a foreign country. As a general rule: the greater (or lower) the degree of correlation between two countries' markets, the lower (or greater) the benefit of combing those countries in a portfolio. E.g.: Canada and U.S. are highly correlated, better for U.S. investor to combine U.S. + China or India, versus U.S. + Canada. Inter-country correlations for U.S. and other countries (bottom row of Exhibit 15.2) is from .137 (Japan) to .304 (Australia), all less than .439 (intra-country). Point: Stocks have a lower correlation between countries than within a country. Implication: Intl. diversification can benefit investors, by reducing risk.

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UNIQUE RISKS FOR INTERNATIONAL PORTFOLIO INVESTMENT -Currency Risk The major point is that improved portfolio performance as a result of international portfolio investment must be shown after allowing for these risk and cost components. For convenience as well as analytical clarity, the unique international risk can be divided into two components: exchange risk (broadly defined) and political (or country) risk. E.g.: if an investor considers U.S. dollar-denominated and EUR-denominated Eurobonds listed on the Singapore Exchange, one class of risks is attached to the currency of denomination, dollar or euro, and another is connected with the political jurisdiction within which the securities are issued or traded. As foreign assets are denominated, or at least expressed, in foreign currency terms, a portfolio of foreign securities is usually exposed to unexpected changes in the exchange rates of the respective currencies (exchange rate risk or currency risk). These changes can be a source of additional risk to the investor, but by the same token can reduce risk for the investor. The net effect depends, first of all, on how volatility is measured, in particular whether it is measured in real terms against some index of consumption goods, or in nominal terms, expressed in units of a base currency. In any case, the effect ultimately depends on the specifics of the portfolio composition, the volatility of the exchange rates, most importantly on the correlation of returns of the Securities and exchange rates, and finally on the correlation between the currencies involved. If total risk of a foreign security is decomposed into the components currency risk and volatility in local-currency value, exchange risk contributes significantly to the total volatility of a security. Nevertheless, total risk is less than the sum of market and currency risk. For equities, currency risk represents typically between 10% and 15% of total risk when measured in nominal terms, and the relative contribution is generally even higher for bonds. But by following different methods currency risks can be reduced. In addition to diversification which can be followed easily, exchange risk can also be reduced by means of hedging, i.e., establishing short or long positions via the use of currency futures and forwards, which represent essentially long or short positions of fixed income instruments, typically with maturities of less than one year Basically, the issue boils down to the nature of the correlation between returns of securities and currencies in the short and the long run. With respect to large industrialized countries with reputations for monetary discipline, currency values and returns on securities, especially equities, tend to exhibit positive correlation. In contrast, in countries where monetary policy seems to have an inflationary bias, returns on equities and external currency values tend to be negatively correlated. To make things even more complex, countries do not stay immutably in one category or the other over longer periods of time. It is not surprising, therefore, that prescriptions as to the proper hedge ratio as well as the empirical findings are found in all ranges.

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-Country Risk The fact that a security is issued or traded in a different and sovereign political jurisdiction than that of the consumer-investor gives rise to what is referred to as country risk or political risk. Country risk in general can be categorized into transfer risks (restrictions on capital flows), operational risks (constraints on management and corporate activity) and ownership-control risks (government policies with regard to ownership/managerial control). It embraces the possibility of exchange controls, expropriation of assets, changes in tax policy (like withholding taxes being imposed after the investment are undertaken) or other changes in the business environment of the country. In effect, country risk is local government policies that lower the actual (after tax) return on the foreign investment or make the repatriation of dividends, interest, and principal more difficult. Malaysias actions in 1997-98 represent a textbook example why country risk is still a concern to foreign portfolio investors. Political risk also includes default risk due to government actions and the general uncertainty regarding political and economic developments in the foreign country. In order to deal with these issues, the investor needs to assess the countrys prospects for economic growth, its political developments, and its balance of payments trends. Interestingly, political risk is not unique to developing countries. In addition to assessing the degree of government intervention in business, the ability of the labor force and the extent of a countrys natural resources, the investor needs to appraise the structure, size, and liquidity of its securities markets. Information and data from published financial accounting statements of foreign firms may be limited; moreover, the information available may be difficult to interpret due to incomplete or different reporting practices. This information barrier is another aspect of country risk. Indeed, it is part of the larger issue of corporate governance and the treatment of foreign (minority) investors, mentioned earlier. At this point it is worth noting that in many countries foreign investors are under a cloud of suspicion which often stems from a history of colonial domination. Perception of country risk is, therefore, a reason for the unwillingness of many international investors to hold a portion of their securities in some of the less developed countries and those that face political turmoil, despite evidence that investments in these countries could contribute to improving the risk return combination of a portfolio.

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INSTITUTIONAL INVESTMENT

CONSTRAINTS

FOR

INTERNATIONAL

PORTFOLIO

Institutional constraints are typically government-imposed, and include taxes, foreign exchange controls, and capital market controls, as well as factors such as weak or nonexistent laws protecting the rights of minority stockholders, the lack of regulation to prevent insider trading, or simply inadequate rules on timely and proper disclosure of material facts and information to security holders. Their effect on international portfolio investment appears to be sufficiently important that the theoretical benefits may prove difficult to obtain in practice. This is, of course, the very reason why segmented markets present opportunities for those able to overcome the barriers. -Taxation When it comes to international portfolio investment, taxes are both an obstacle as well as an incentive to cross-border activities. Not surprisingly, the issues are complex- in large part because rules regarding taxation are made by individual governments, and there are many of these, all having very complex motivations that reach far beyond simply revenue generation. Since tax laws are national, it is individual countries that determine the tax rates paid on various returns from portfolio investment, such as dividends, interest and capital gains. All these rules differ considerably from country to country. Countries also differ in terms of institutional arrangements for investing in securities, but in all countries there are institutional investors which may be tax exempt (e.g., pension funds) or have the opportunity for extensive tax deferral (insurance companies). However, countries do not tax returns from all securities in the same way. Income from some securities tends to be exempt in part or totally from income taxes. Interest paid on securities issued by state and municipal entities in the United States, for example, is exempt from Federal income taxes. A number of countries, e.g., Japan, provide exemptions on interest income up to a specified amount, but only on interest received from certain domestic securities. Almost all countries tax their resident taxpayers on returns from portfolio investment, whether the underlying securities have been issued and are held abroad or at home. This is known as the worldwide income concept. -Foreign Exchange Controls While the effect of taxation as an obstacle to international portfolio investment is only incidental to its primary purpose, which is to raise revenue, exchange controls are specifically intended to restrain capital flows. Balance of payment reasons or the effort to reserve financial capital for domestic uses lead to these controls. They are accomplished by prohibiting the conversion of domestic funds for foreign moneys for the purpose of acquiring securities abroad. Purchases of securities are usually the first category of

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international financial transactions to be subjected to, and the last to be freed from, foreign exchange controls. While countries are quite ready to restrict undesired capital inflows and outflows, they prove reluctant to remove controls when the underlying problem has ceased to exist, or even when economic trends have rev ersed themselves. The classic example is provided by Japan where, during the early seventies, exchange controls prevented Japanese investors from purchasing foreign securities. At the same time, new measures were taken to prevent a further increase in Japanese liabilities through foreign purchases of Japanese securities. At times, countries have resorted to more drastic measures by requiring residents to sell off all or part of their foreign holdings and exchange the foreign currency proceeds for domestic funds. -Capital Market Regulations Regulations of primary and secondary security markets typically aim at protecting the buyer of financial securities and try to ensure that transactions are carried out on a fair and competitive basis. These functions are usually accomplished through an examining and regulating body, such as the Securities & Exchange Board of India(SEBI), Securities and Exchange Commission(SEC).in the United States, or the Committee des Bourses et Valeurs in France. Supervision and control of practices and information disclosure by a relatively impartial body is important for maintaining investors confidence in a market; it is crucial for foreign investors who will have even less direct knowledge of potential abuses, and whose ability to judge the conditions affecting returns on securities may be very limited. Most commonly, capital market controls manifest themselves in form of restrictions on the issuance of securities in national capital markets by foreign entities, thereby making foreign securities unavailable to domestic investors. Moreover, some countries put limits on the amount of investment local investors can do abroad or constrain the extent of foreign ownership in national companies. While few industrialized countries nowadays prohibit the acquisition of foreign securities by private investors, institutional investors face a quite different situation. Indeed, there is almost no country where financial institutions, insurance companies, pension funds, and similar fiduciaries are not subject to rules and regulations that make it difficult for them to invest in foreign securities. -Transaction Costs Transaction costs associated with the purchase of securities in foreign markets tend to be substantially higher compared to buying securities in the domestic market. Clearly, this fact serves as an obstacle to IPI. Trading in foreign markets causes extra costs for financial intermediaries, because access to the market can be expensive. The same is true for information about prices, market movements, companies and industries, technical equipment and everything else that is necessary to actively participate in trading. Moreover, there are administrative overheads, costs for the data transfer between the domestic bank and its foreign counterpart be it a bank representative or a local partner institution. etc. Therefore, financial institutions try to pass these costs on to their customers, i.e., the investor. Simply time differences can be a costly headache, due to the fact that someone has to do transactions at times outside normal business hours.

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-Familiarity with Foreign Markets Finally, investing abroad requires some knowledge about and familiarity with foreign markets. Cultural differences come in many manifestations and flavors such as the way business is conducted, trading procedures, time zones, reporting customs, etc. In order to get a full understanding of the performance of a foreign company and its economic context, a much higher effort has to be made on the investors side. He might ace high cost of information, and the available information might not be of the same type as at home due to deviations in accounting standards and methods e.g., with regard to depreciation, provisions, pensions., which make their interpretation more difficult.

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CAPITAL FLOWS KEY ASPECTS As an economy becomes more sophisticated, we need to recognise that as other countries find it profitable to invest in India, we too can benefit from selective investments abroad. It is in this context that we have to view Indian investments abroad. It is erroneous to equate all capital outflows with capital flight. In fact, selective investments abroad which are being progressively liberalized could ultimately make a significant contribution to the resilience of Indian industry. Self-reliance relates more to the strengthening of the economy and building a capacity to withstand vulnerabilities to external or domestic shocks, rather than merely concentrating on achieving self-sufficiency. In other words, self reliance now acquires an outward looking bias rather than the earlier inward looking orientation Traditionally, capital flow was usually in direction of relatively less developed countries (EMEs). International capital movements should respond to differences in expected rates of return on capital across countries, therefore typically there should be a flow from highincome countries to developing countries, boosting growth for some years and allowing developing countries to run current account deficits. This trend continued for over a century, but now some emerging market economies themselves have contributed to the significant increase in global liquidity by channeling their excess of domestic saving over investment abroad. The World Bank (2007) reported that, since 2004, FDI flows from India into UK have exceeded flows in the opposite direction, though a significant portion of FDI flows into India from different countries are routed through Mauritius due to tax benefits. Capital flows are known to be volatile as a shock in investing countries and those in which investments are made, contribute to volatility. While a country goes through the transformation, from being a developing country to a relatively developed one, a change a registered in disbursement of its capital inflows from fiscal deficit financing or sustaining private consumption to capital formation. Table 1: Capital flows in EMEs: various episodes compared1 In billions of US dollars Inflows Outflows Forex change 1993- 280 110 90 96 1997- 269 193 89 2001 2002- 951 818 584 07

reservesCurrent balance -85 21 429

account

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All EMEs as defined in the IMF World Economic Outlook plus Hong Kong SAR, Korea, Israel, Singapore and Taiwan (China); annual average. Sources: IMF, Balance of Payments Statistics; Central Bank of China (Taiwan). The table makes a comparison of capital inflows and outflows of all EMEs over a period of 44 years . Outflows as a percentage of inflows has risen from 39% in 1993-96 to 72% in 1997-2001 and further increased to 86% in 2002-07. This indicates a global trend of EMEs making more and more investment abroad to satisfy their objectives as they become economically stronger. -Broad factors affecting investment These factors can be observed as: External (a) When ample liquidity is available in a country, it would push money towards foreign investment options. The liquidity would generally be associated with a wide range of price and quantity measures of the monetary stance in industrial economies. For example: fall in interest rate in G3 countries in early 1990s and 2000s caused a higher investment in emerging markets. However despite an increase in the real interest rates investment may increase if they still remain comparatively low. (b) Industrial cycle in investor country: a slow down in investor country would affect the country in which investment is made both positively and negatively. (c) Portfolio diversification: Risk diversification by global investor through holding of different asset classes would in turn lead to a more stable trend growth in capital flows to the economy. Internal A major element that pulls international capital to the growing economies is the higher expected risk-adjusted returns. -Affects on financial stability of economy with composition of investment involved: 1. Equity vs. Debt Equity form of investment serve to transfer risk to the supplier of the funds and away from the user of the funds. 2. Short-term vs. Long term Borrowers reliant on long- term debt to finance long-term projects are less vulnerable to interest rate and refinancing risks.

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3. Investment vs. Consumption Inflows associated with increased real fixed capital formation are more relevant and thus more welcomed than those used to finance private consumption. 4. Foreign vs. Domestic currency Foreign currency inflows should be used to invest in foreign currency earning assets, otherwise the country faces currency mismatches. -Current scenario Indian investors are investing more and more in foreign equity and debt. RBI raised the limit for international investment to $200,000 a year for individuals. Indian investment in overseas equity and debt has immensely increased from a dismal $20/7m in 2006-07 to $144.7m in 2007-08, which has further increased to $151.4m in 2008-09. According to a newspaper article, mostly equity as an asset class received a lot of interest than debt which was mostly through Mutual Funds because there is an active fund management process. -Analyzing the net international position Gross foreign assets held by India are $340,264mn (Dec 08), whereas the foreign liabilities are at $420,311m which makes Indias net position at -$80,047m. This figure has deteriorated from Dec 07 when Indias net position was -$73,612m, predominantly as a result of fall in portfolio investments made abroad which were very volatile especially due to the global economic meltdown. -Challenges faced by India in managing its capital flows: 1. Ensuring stability of inflows Controlling volatility arising due to global factors. 2. Monetary management challenge The challenges for monetary policy with an open capital account are exacerbated if domestic inflation rises. In the event of demand pressures building up, increases in interest rates might be advocated to sustain growth in a non-inflationary manner, but such action increases the possibility of further capital inflows if a significant part of these flows is interest sensitive and explicit policies to moderate flows are not undertaken. These flows could potentially reduce the efficacy of monetary policy tightening by enhancing liquidity.

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COUNTRY BETA & CORRELATION FOR FOREIGN INVESTMENTS Market participants may observe that world markets have been moving in a synchronized fashion due to technical reasons such as capital flows as well as the increasingly interconnected nature of country-specific macro economic environments. Can we properly measure individual country risks? Or, has the country risk become less important given the global roller coaster nature of the financial markets? There are various ways and methodologies of measuring country risks. Yet as far as stock market movements are concerned, we should keep in mind that as markets are more integrated than ever, it is very likely that stocks of many of these countries will go up and down depending on the daily momentum observed in the world markets. When Asian markets have a good day, it may be an extension of the good mood in the U.S., which may or may not be followed by European markets. The trend may continue or change course depending on global economic developments of the day. Also percentage moves up or down are generally sharper and more volatile than those observed in the world markets in general. If you have been following a foreign market closely, you may have noticed similar observations. Certain country performances have been more volatile than others. Also as the global markets have become more volatile, the correlations between countries have increased. - The International Capital Asset Pricing Model In the Capital Asset Pricing Model, a stocks beta signifies the risk of that stock with respect to the market. Beta is directly proportional to the correlation of the stock return to that of the market as well as its relative volatility with respect to the market. Its a measure of the stock risk for one unit of market risk. The higher the risk of stock with respect to the market, the higher the expected compensation of the investor with respect to the particular stock. To keep the matters simple, a high beta signifies high risk, while a low beta signifies low risk. The beta of the market itself is one. The International Capital Asset Pricing Model is the extension of the Capital Asset Pricing Model where the risk of a specific country can be specified in a likewise fashion with respect to a chosen world index. We wanted to compare the daily moves of all markets and calculate the observed country risks in terms of betas to see how risky one country is with respect to another. That way we would have a valid methodology to rank countries because I could quantify market risks. The easiest way for us to come up with the betas was to regress the equity returns of individual countries to the world index of my choice. We wanted to keep the variables

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as simple as possible in order to include as many countries as possible in this study. We wished to come up with a risk-ranking system for the stock markets of all countries for which there is trading data available. Calculating country betas is not the only way to compare country risks and it is entirely dependent on past stock returns as well as the global market index returns one chooses to compare the performances to. There are many criticisms of the beta measurement as well as the CAPM theory in general, and I will state a few of them here. For instance, beta will vary depending on the time frame chosen, which may make it unreliable depending on the degree of change. Beta also captures systematic risk only, and thus it may give an incomplete picture of the total risk that includes unsystematic risk. While there is no guarantee that the future beta will look like the past data, its a reasonable indicator (as good as any) of the risks one can expect in a certain market. There are different ways of calculating country betas, and they may involve more sophisticated models than the good-old fashioned OLS regression that readers may have seen in an econometrics class. We wish to keep this article accessible by many, so we will keep such terminology to a minimum. But suffice it to say that such models may explicitly state a countrys degree of non-integration to the world market and involve various country-specific factors ranging from the level of interest rates, inflation and the like. They may also include other global information variables to further specify world risk. Yet the more sophisticated the model is, the stronger the false sense of security becomes and the more difficult it is to evaluate its shortcomings. Not to mention that such complexities in the model specification would have led me to decrease the number of countries in the study because of data issues, and the depth of the model would have necessitated concentrating on a region or a limited number of countries. We wanted breadth rather than depth. So what we have done was still data intensive, but more straightforward. -Data, Methodology and Results We used index data available at the Standard & Poors Index Services where they keep daily data for closing index prices of many countries for which trading data exists. For the series of regressions to be performed, I calculated daily returns of all countries in terms of U.S. dollars. The country betas are calculated by regressing each index return against the global equity portfolio. Beta is estimated as the slope of the fitted line from the linear leastsquares calculation. We wanted to experiment with data that was available. Knowing that markets have become more volatile in the past year or more, we calculated each country beta in two

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ways: 2-year betas involved 522 observations (daily returns) covering the past two years from December 4, 2006 until December 2, 2008. 10-year betas, on the other hand, involved 2610 observations from December 2, 1998 until December 2, 2008. Given the lack of data for some of these periods, we calculated betas for those countries for which there were adequate observations. However, either due to lack of significant tvalues to validate the beta coefficients, or due to other extraordinary issues such as the collapse of the Icelandic market we decided to exclude these countries from the various data matrices we designed. Luxembourg was excluded due to the fact that the equity index houses 10 stocks with 3 firms making up more than 60% of the index and some 45% of the weighting belongs to bank stocks headquartered in Belgium, thus making the calculated beta meaningless. (Note: the weights may have shifted but the idea is that the beta of such an index is not representing the risk associated with the country of Luxembourg). In order to make sure that there were no errors within the Excel regression package, we checked the betas by multiplying the correlation coefficients of all countries (with respect to the world index) by the relative standard deviation of the each country. This was also a good way to see the composition of the beta of each country. An example of the display for the country of Brazil is given below:

Note: This regression is done with daily beta, thus the standard deviations seen above represent daily numbers. Numbers are rounded to two decimal points, so if you do the math above you may find that the Brazilian beta is 1.79. This error is due to rounding. Brazilian markets indeed exhibited the highest daily beta for the last two years. Series of regressions covering the ten-year time frame also put Brazil at the top of the list in terms of beta. Another interesting but predictable observation is that two-year betas for almost all countries are considerably higher than their respective ten-year betas. This is due to the fact that both correlations as well as individual country standard deviations have increased recently. But note that the global standard deviation placed at the denominator has also increased. If you look at the composition of the betas, you may see the contribution of various parts of the equation to the betas themselves. Notable observations include high-beta countries, specifically Brazil, Hungary and Turkey. The emerging nature of these markets attract attention, however some developed markets have also registered riskier betas such as Norway, Austria, Sweden. On the other hand, Mexico, Russia and Argentina are also among the notable emerging markets with higher than average betas. All of these high-beta countries exhibit higher correlations as well as higher than average standard deviations. A lot of European markets have registered a beta closer to one, which indicates that these markets exhibit an average risk with respect to the rest of the world. The U.S. market

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with a beta of 1.06 seems to exhibit average risk with respect to the rest of the world as well. However, this is mainly due to the fact that American stock market is the largest constituent of the global market index. Indeed, when the U.S. stock returns are regressed against a global index that excludes the U.S., the resulting beta is 0.57 with an observed correlation of 0.49 as opposed to the high correlation of 0.84 of the original regression. This indicates that the U.S. market beta above is overstating the U.S. market risk. According to the beta of the second regression, the U.S. is actually towards the bottom of the list of these countries. Asian countries are the winners of this exercise in terms of lower risks associated with their markets. It is remarkable that some of the emerging markets of the Asian region have registered lower betas associated with a lower degree of risk, among them Thailand, Philippines, Taiwan, and Malaysia. Hong Kong showed a lower beta than we expected, and the presence of Japan towards the bottom of the list with a beta of 0.41 was another surprise for us. Among the lower beta countries were those of the Middle East and North Africa, namely Israel, Egypt, and Morocco. We must add that Jordan, Pakistan, and also Nigeria would have made it into the bottom of the list if we had included the results we were able get from the regressions we ran (notwithstanding some insignificant t-statistics associated with the regressions). We may include these countries in a following write-up if I am able to get hold of more complete data sets. Ten-year table country betas are strikingly lower than their respective two-year betas. There are a few exceptions: Finland occupies the second place in the ten-year list with a beta of 1.29 whereas during the last two years, its beta has decreased to 1.10 placing it towards the middle of the same list. Even more interesting is the fact that Israel registered a beta of 0.78 for the last ten years whereas its beta has fallen to 0.42 during the present time when the world has become a more volatile place. Japan seems to have resisted the trend somewhat but its ten-year beta of 0.46 is not strikingly different from its two-year beta of 0.41. Brazil occupies the first place in both tables as the riskiest of the bunch. Furthermore, a quick look at the former ranks at the ten-year table shows that Turkey, Hungary, Russia, and Norway have gained significant risk in terms of their respective betas during the last two-years. Turkey and Russia deserve extra attention in terms of their standard deviations for the last ten years. Despite the fact that Turkey registered the highest daily standard deviation of 3.33% during the last ten years, its relatively low correlation of 0.32 managed to keep the country from occupying a higher rank. This was also true for Russia who had the second highest standard deviation of 2.65% and a somewhat lower correlation of 0.41. However, during the last two years, the correlations of these two countries have increased to 0.69 and 0.62 respectively, thus placing their betas higher on the two-year list.

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The higher beta associated with the U.S. is misleading in this list as well. Indeed, when ten-year U.S. returns are regressed against global returns excluding the U.S., the resulting beta is 0.57 (same as the two-year beta) with a correlation coefficient of 0.46. Asian countries occupy lower ranks in the ten-year list as well. Among them are emerging (or so classified) markets of India, Indonesia, Thailand, Taiwan, Philippines, and Malaysia, besides the developed markets of Japan, Hong Kong, and New Zealand. Egypt and Morocco occupy the last two places in the ten-year list similar to the pattern observed in the two-year list. -Conclusion An obvious conclusion of this exercise is that country risks have increased over the past two years when compared with ten years of data. It would be interesting to do the same study with weekly or monthly data as well, and perhaps by going back further in time. However, going back further in time risks capturing certain fundamentals or situations that no longer exist in todays marketplace. Increased correlations due to the effects of globalization are examples of such fundamental or regime changes. Another notable observation of this exercise is that certain countries manifest higher risk than others on a consistent basis. The results of this exercise have captured what has been familiar to careful observers of world markets. As the Capital Asset Pricing Theory suggests, higher risk results in higher return expectations on the part of investors. Thus a higher risk should be evaluated according to return expectations of these countries. Conclusively, it may be a valid decision to invest in countries (or stocks) that exhibit higher levels of risk depending on long-term growth expectations, cheap valuations exhibited by fundamentals, or both. Yet another remarkable observation of this exercise is that there are emerging markets with higher expectations of return that also manifest lower risk. Certain emerging markets of Asia as well as North Africa and the Middle East have exhibited lower risks as measured by their betas. An inference of this study (or so we reckon) is that if all else is equal, it is more advisable to invest in nations with higher than average growth potential that also show a low degree of risk with respect to the world markets. The diversification effects are also valuable. Of course, all else is never equal and such quantitative studies should always be complemented by fundamental analysis as well as due diligence. A disclaimer related to this exercise should be announced in the sense that todays highrisk countries may become tomorrows low-risk ones as well. Nevertheless, given what we can observe in the world markets today, investors should evaluate whether their return expectations are worth the risks.

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SOVEREIGN WEALTH FUND (SWF) AND INTERNATIONAL PORTFOLIO A sovereign wealth fund (SWF) is a state-owned investment fund composed of financial assets such as stocks, bonds, property, precious metals, or other financial instruments. Sovereign wealth funds invest globally. Some of them have grabbed attention making bad investments in several Wall Street financial firms including Citigroup, Morgan Stanley, and Merrill Lynch. These firms needed a cash infusion due to losses resulting from mismanagement and the sub prime mortgage crisis. Some sovereign wealth funds are held solely by a central bank, which accumulate the funds in the course of their management of a nation's banking system; this type of fund is usually of major economic and fiscal importance. The accumulated funds may have their origin in, or may represent foreign currency deposits, gold, SDRs and International Monetary Fund reserve positions held by central banks and monetary authorities, along with other national assets such as pension investments, oil funds, or other industrial and financial holdings. The reason why sovereign wealth funds came into limelight for its international portfolio construction was when suddenly many major funds like those of Kuwait, Norway and china which suffered in hands of the global meltdown and suffered drop in performance. Overall performance for international institutional investors during 2008-09 fell. In the face of this systematic crisis, which has affected even large institutional investors, many traditional investment methods have been invalidated. Strategies that were effective and complementary under normal conditions did not work this time. These included the Assets allocation strategy, investment strategy and investment portfolios The use of Beta and Alpha investment strategies Strategies for hedging against inflation and deflation. All we see is one result: a slumping stock market and most companies suffering enormous losses or even bankruptcy, affecting Wall Street as well as Main Street. Among major institutional investors, mutual funds and pension funds have suffered the largest losses, as their strategies are based on diversification, also known as passive investment. Comparatively, as sovereign wealth funds and donations funds took rather active management and larger adjustment, losses were overall less severe. For example, the Norwegian pension fund enjoyed sound investment returns for years but hit a negative return at -23.3 percent in 2008, a loss about US$ 90 billion. All investment earnings since the fund was established 12 years ago suddenly evaporated. Indeed, only 1 percent hedge funds made money by adopting some unusual strategies. Among investment types, only government bonds issued by developed countries were profitable last year, as they served as a temporary safe harbor that raised values. Regarding the performance of sovereign wealth funds them as a model system for managing sovereign assets and during a half-century of development, sovereign wealth funds have contributed to their home countries as well as the countries targeted by their

28

investments. They are long-term investors and pursue long-term returns with a capacity for controllable risk. In this section we try and study how one of the worlds biggest SWF china investment corporation allocates its funds and manages its risks in its international portfolio management.

China Investment Corporation (CIC) is a sovereign wealth fund responsible for managing part of the People's Republic of China's foreign exchange reserves. CIC was established in 2007 with approximately US$200 billion of assets under management, making it one of the largest sovereign wealth funds. Since then, CIC's assets have grown to $298 billion at the end of 2008. CICs mission is to diligently seek long-term investments that maximize returns while maintaining a rigorous approach to managing risks for the benefit of shareholders. Thus, through its management style, CIC sticks with a commercial orientation that maximizes financial returns. In terms of risk tolerance, CIC can afford rather high, short-term risk fluctuations to maximize long-term returns. In strategic assets allocation, CIC is more aggressive than traditional central banks in managing forex reserves by investing both traditional equity and fixed-income investments that have rather low liquidity but are forecast for rather high investment returns. Affected by limited talent and capital, CIC developed an investment strategy based on an investment approach that is a mixture of international financial products, with most assets invested in public market products and the rest invested in alternative assets. Meanwhile, direct investment should not be abandoned. Investments are mainly made through external fund managers with a gradual increasing weight of proprietary investments. In the past year, the global financial crisis has had impact on the immature CIC in terms of all its businesses, especially overseas financial products investments. But CIC is young and has a relatively limited investment volume at this early stage. Meanwhile, studying some of the material we can on CIC and based on our talks we have observed that it has worked hard to analyze and understand the global financial market and macroeconomic trends. The fund made timely adjustments to annual assets allocation by slowing equity-product investments and ensuring a prudent, cash-management-led investment strategy esp. In the wake of the global economic slowdown. The fund holds a rather high percentage of cash assets to prevent major risk and losses.

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Overall CIC posted minor, book-value losses for outsourced investment in 2008. But overall financial conditions were stable and basically met the goals set in early 2008 by the board of directors. Its financial conditions were far better than for some other sovereign wealth funds. In addition, CIC has strengthened its corporate governance system to provide the skills and supervisory mechanism for managing market risks. CIC established clear investment guidelines, a risk framework, governance structure, and operational mechanism by using all kinds of resources to ensure systemized risk management. Since its establishment, CICs operations have been based on economic and financial interests. One thing that deserves emphasis is that CIC seeks financial returns for outsource investments; it does not take over companies or resources. CIC hopes to achieve win-win solutions so that the fund receives necessary investment returns, while the companies that receive its investments can develop and benefit, making CIC a fund thats welcomed by governments. -Investments China has invested two-thirds of its reserves in US dollars, mostly US treasury bonds and agency bonds. The US dollar's devaluation on world currency markets has provided poor returns, prompting the Chinese to create the CIC to manage China's investment in equities. Credit Suisse predicted CIC would only take a 5-10% stake in each company, remaining a passive investor to avoid political hassles in overseas markets. CIC bought a $3 billion stake in Blackstone, one of the largest US private equity firms. CIC has refrained from influencing Blackstone's investment strategy. The company will mainly pursue combined investments in overseas financial markets. CIC is thought to engage in building influence for the government by buying up significant stakes in companies that have influence in western governments including airline companies as also target firms that have heavily invested in China. The investments would help the government to influence the policies of multinational companies and to protect China's interests in international spheres. Market watchdogs want to know what would happen if China, Russia and Arab countries were to systematically acquire significant holdings in sensitive industries such as telecommunications, energy and defense. Based on our readings we can say that it could prove difficult to draw the line between sound government policies and neoprotectionism.

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The new fund has been placed under the authority of Chinese Premier Wen Jiabao. Lou has been assigned the rank of a minister. During daily operations, he will answer to a host of other agencies, including the powerful National Development and Reform Commission, a successor to the former influential State Planning Commission. Lou said CIC will operate on the principle of "commercial operation", and will abide by local laws of countries where it invests. Based on some reports published earlier some state owned company will invest $67bn to buy the assets of Central Huijin, the investment arm of the central bank which holds shares in most state-run banks. It was later reported that Huijin was acquired by CIC from the State Administration of Foreign Exchange for $200 billion. China's leadership has debated the right strategy for the government investment fund. Vice Premier Zeng Peiyan has suggested that China should invest in natural resources to increase its strategic reserves. Other high-ranking party officials would rather see the country acquire shares in high-tech companies to help China more rapidly close the gap with leading industrialized nations. Three years ago, dealers working for China Aviation Oil in Singapore, China's sole supplier of aviation fuel, suffered losses of $500 million from miscalculations and rising oil prices. Last year, news leaked out that the former head of the Communist Party in Shanghai and his subordinates had illegally siphoned off hundreds of millions of dollars from the state pension fund and channeled the money into projects run by corporate cronies. CIC bought a US $3 billion stake of Blackstone Group in June and a 9.9% stake of Morgan Stanley worth US$ 5 billion on December 19, 2007. The Chinese Internet community regularly vents its anger over government losses of the people's money, and there is widespread skepticism among Chinese party leaders and the public over the extent to which the country should get involved in global equities investments Western investment banks Goldman Sachs and Morgan Stanley will provide expert knowledge to China's state-sponsored venture capitalists. On March 2, 2009, Chinese media reported that the CIC was shifting its investment strategy to focus more on real estate, resources, and other areas more tied to the "real economy Overall as we can observe through the details are rather sketchy with the deals being kept secret china has followed the policy of avoiding systematic risks by carefully investing in high beta countries like US in large number and complimenting it with investments in euro zone and now moving to real economy by investing in real assets they are trying to spread their risk and lock in their earnings in direct proportion to that of the real growth of highly lucrative yet volatile industries like real estate, natural resources in Africa and middle east and infrastructure bonds in developing countries.

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PORTFOLIO ANALYSIS Based on our study, we analysed the portfolio of Birla Sun Life Opportunity A-G mutual fund, which served as a perfect example of an internationally diversified portfolio. Following are our findings in relation to the investment pattern of the fund. In Asia, out of the 8 foreign equities in which the mutual fund have invested, 4 are from China, having 2-year country beta 1.02, which cater to the Infrastructure, Telecom & Oil Sector(China Oilfield Services, the Stock that earned Warren Buffet Billions) in China, basically the sectors catering to the mass markets. In rest of Asia, other than 2 investments in Hong Kong in major Infrastructure Companies which alone constitute 10% of the the top 25 holdings, there is investment in 2 Manufacturing Companies, in Taiwan (country beta .48) & India. Most of the funds investments are concentrated in North America, which alone constitute 38% of the top 25 holdings, with 10 equity investments in USA & 1 in Texas. In the USA, its investment is quite diversified in terms of the sectors invested in, as its investment in the USA range from FMCG & healthcare to Software & Capital Goods Industry. In Texas, it has invested in Exxon Mobil Corporation. Coming to Europe, which have only 4 equity investments out of the 25 top holdings, have 2 investments in Industrial Goods Sector & 1 each in Health-Care & FMCG. Till 31/07/2009, all these 4 holdings of the fund were green showing the fact that the fund manager has been very selective in terms of the quality of Investment in Europe, carefully doing the EIC analysis & properly analyzing the most rewarding sectors of each economy. In rest of the world, it has invested in Middle-East in a Pharmaceutical Company, wellestablished for long, in Israel(country beta .42) & largest Banking Company of Brazil, a country which has the highest beta on our list of 1.80, but both these stocks were in green till 31/07/2009 according to the Portfolios report.

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Table: Region-wise Investment Percentages Country Region Europe North America Asia Middle East South America

4 11 8 1 1

13.55% 27.30% 24.97% 4.07% 2.80% 72.69%

Europe North America Asia Middle East South America

5.6% 3.9% 18.6%

18.6% 37.6% 34.4% 5.6% 3.9%

Europe North America Asia 34.4% Middle East South America 37.6%

Sector Weightings As on 31/07/09 FMCG Financial Diversified Construction Energy Chemicals Cons Durable Metals Textiles Engineering % Net Assets 13.11 12.40 7.09 3.49 3.36 2.64 2.60 2.24 1.55 1.49

-For the list of holdings, please refer to Appendix-5.

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ALTERNATE RISK MANAGEMENT PHILOSOPHY Ridiculed in the west for a long time but with his firm making headway with positive net returns in both the 1998 and the present crash Nassim Nicholas Taleb (born 1960) is a literary essayist, epistemologist, researcher, and former practitioner of mathematical finance. Taleb is a specialist in financial derivatives. Universa, where Taleb is adviser, made returns of 65% to 115% in October 2008 in its approximately $2 billion Black Swan Protection Protocol Higher frequency Based on our study of his highly successful work The Black Swan sold we based on our opinion on his philosophy and why it can be followed by investment houses world over. -THE APPROACH According to the author Rare and improbable events do occur much more than we dare to think. Our thinking is usually limited in scope and we make assumptions based on what we see, know, and assume. Reality, however, is much more complicated and unpredictable than we think. Also, assumptions relevant to average situations are less relevant to irregular situations, especially when the "rules of the game" themselves do change. Extreme events do happen and have a big effect. Examples abound, including September 11th. The Internet with its various effects was scarcely anticipated, and it is a development that has had a significant effect. The effects of extreme events are even higher due to the fact that they are unexpected. -Limited human knowledge Humans are caught off guard to the rare event called black swan. Partly because built into the very nature of our experience is the propensity to extend existing knowledge and experience to future events and experiences; and to exacerbate this natural propensity much of our cultural education both formal and otherwise is built upon historical knowledge forced on us by others. Based on our study we come to the following conclusion about how he has tried to avoid risks in international portfolio and earn returns. Taleb has tried to learn from the financial Black Swans and has worked out an unorthodox investment strategy. Based on it is to avoid what financial advisers call medium risk and to combine being hyper conservative (in order to avoid harmful Black Swans) and hyper aggressive (in order to catch beneficial Black Swans). Invest most of your money up to 90 percent in the safest possible way, in US Treasury bills, for example. The rest you should invest in a highly speculative way, such as in venture capital portfolios, spread over as many firms as possible. Alternatively, have a highly risky portfolio but insure against possible losses of more than, say, 15 per cent.

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 That way, sudden and unexpected stock market downturns wont do you much harm; at the same time, you give yourself some chance of gaining from the next world changing technological breakthrough or from Harry Potters successor. Fund managers can benefit from "skewed bets, that is, to try to benefit from rare events, events that do not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur. Simply because rare events are not fairly valued, and that the rarer the event, the more undervalued it will be in price." So portfolio managers must actually try to benefit from the rare events, not avoid them. This can be done by placing bets on rare events with a large payoff. And this can further be synthesized by doing a country correlation risk analysis as discussed in other sections and using mathematical modals like CAPM to understand and derive the basic thrust of investments.

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BIBLIOGRAPHY -E-books International Portfolio Investment: Theory, Evidence & Institutional Framework (Sohnke M. Bartram and Gunter Dufey) Asymmetric risk and international portfolio choice (Susan Thorpe and George Milinthropovich) Sources of Gains from International Portfolio Diversification (Jose Manuel Campa & Nuno Fernandes) Black swan ( Nassim Nicholas Talib) -Websites http://www.china-inv.cn/cicen/investment/investment_investment.html http://www.sovereignwealthfundwatch.com/ http://www.bis.org/publ/bppdf/bispap44m.pdf http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=57 http://www.rbi.org.in

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APPENDICE APPENDIX-1: CAPM MODEL AND OTHER COMPONENTS The transfer of the CAPM logic to a global perspective leads to the International Capital Asset Pricing Model (ICAPM), which can be formally stated as: E [ Ri ] = R f + Biw RP w + y ik RPK
k =1 K

{where RPw and RPk are the risk premia on the world market portfolio and the relevant currencies, respectively; RF is the risk-free interest rate.} It rests on the assumption that investors make investment decisions based on risk and return in their home currency. Although this approach seems to be straightforward, there are subtle problems inherent in the ICAPM, because of the likelihood that many of the assumptions underlying the national market CAPM become very tenuous in an international context. Over time, more sophisticated models have been developed to accommodate special factors of the international context or to improve the realism of the model in general. Whereas the traditional CAPM is based on constant values for the parameters of equities (expected) return and variance, there exists increasing evidence to support the hypothesis that these characteristics are time-dependent. Therefore, conditional models have been used to model time-variant measures, i.e., expected return and variance are not assumed to be constant over time. This is because of the assumption that historical information and possibly expectations about interest rates, equity prices etc. are available to the investor, which means in technical terms that, e.g., the estimated conditional variance for time t-1 depends on the information set available at time t. The simplest of these models are autoregressive conditional heteroscedasticity (ARCH) models, in which the conditional variance is calculated as a weighted average of past squared forecasting errors. In generalized ARCH or GARCH models, the conditional variance depends on past error terms as well as on historic conditional variances. Overall, empirical evidence for an international CAPM is mixed, although there seems to be increasing support for this concept. The Approaches taken include conditional and unconditional models and the use of instrumental variables and Generalized GARCH-M methods. Testing the ICAPM is difficult because: 1. There is limited long-term historical data available on international capital markets; 2. An international benchmark portfolio is hard to specify; and 3. It is a challenge to capture the time-variation of the securities characteristics. Beta is a measure of the extent to which the returns of a given stock move with the stock market. (i.e. market risk)

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 i = im i m

Or

covim i = 2 m

{Where, the Greek letter rho, (im), is the correlation coefficient for the stock i and the market m.

im =

covim } i m

Therefore, the formula for the covariance of the stock with the market covim is: covim = im i m Beta measures only systematic risk, while standard deviation is a measure of total risk (systematic or market risk, and unsystematic risk, the risk of the security) The calculation for the estimated standard deviation is given below:

( r r)
n i =1 t

n 1

This is used to find out the total returns we can generate out of a given portfolio. For example as given below we have tried to find out the returns that we can generate from a hypothetical portfolio with international exposure.

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APPENDIX-2: OPTIMAL INTERNATIONAL PORTFOLIOS Portfolio theory, developed by Harry Markowitz (Nobel Prize 1990), can be used to determine the optimal intl. portfolio, taking into account risk-return trade off. For U.S., mean monthly return is 1.26% (15.12%/year), risk = std. dev = 4.43%. Crosscountry correlations with U.S. range from .29 (Italy) to .74 (Canada). Notice U.S. vs. Netherlands (.62). Netherlands has much higher correlation on average than U.S. Why? High Degree of internationalization in Dutch economy. Neighboring countries have higher correlations [US and Canada (.74) vs. US and Italy (.29)] than countries far away. Highest return? Sweden (1.71) Highest risk? Hong Kong. World Beta is given for each country, measures the co-movement between the returns in a country's stock market with the returns for the world stock market returns. Beta = % Change in a Country's Stock % Change in World Stock Market Market

Beta for U.S. market is .86, means that when the world stock market goes up (down) by 10%, the U.S. market goes up (down) by 8.6% (-8.6%). Betas range from .85 (Switz.) to 1.20 (Japan). Japan's market is most sensitive to world market. And U.S. and Switz. are least sensitive. The Sharpe ratio calculates the per unit average return over and above the risk-free rate of return for the portfolio. The Sharpe ratio measures how much excess return (return above the risk-free rate) an investor each per unit of portfolio risk. The formula for the Sharpe measure is shown below: Sharpe measure = SHPi = Ri R f

The Treynor measure looks at the systematic risk of the portfolio (beta) and compares it to the world market. The formula for the Treynor measure is shown below: Treynor measure = TRN i = Ri R f

To illustrate its application we give below a hypothetical example of hong kong and how using its different indicators we arrive at our decision. Country Hong Kong Mean return 1.5% 9.61% rf .42% 1.09

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Sharpe measure = SHPi =

Ri R f

i
Ri R f

1.5% .42% = 0.113 9.61% 1.5% .42% = 0.0099 1.09

Treynor measure = TRN i =

The risk-free rate is the annual risk-free rate of 5% divided by 12, (.42%). From the above we can observe that the country with the highest Sharpe and Treynor measures have the best reward for the risk.

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APPENDIX-3: TABLE-1 COUNTRY BETAS: TWO YEAR RETURNS

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TABLE-2 COUNTRY BETAS: TEN YEAR RETURNS

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APPENDIX-5: LIST OF TOP HOLDINGS OF THE PORTFOLIO

Top Holdings Name of Holding
MTR Corporation (HK) Taiwan Semiconductor Manufacturing (Taiwan) Nestle S.A (Switzerland) Coca Cola Co. (US) Teva Pharmaceutical Industries (Israel) China Construction Bank Corporation Pride International Inc (US) Statoilhydro Asa (Norway) Bayer (Germany) Wharf Holdings (HK) Procter & Gamble (USA) Itau Unibanco Holding SA Ind.& Commercial Bank of China Akzo Nobel Nv (Sweden) China Mobile Northrop Grumman Co. (US) Noble Corporation (US) Sterlite Industries Microsoft Corportion (US) Oracle Corporation (US) Wal-Mart Stores (US) Aetna Inc New (US) Foster Wheeler AG (Foreign) China Oilfield Services Exxon Mobil Corporation (Texas)

As on 31/07/09 Instrument Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity Foreign - Equity % Net Assets 4.37 4.30 4.27 4.08 4.07 3.83 3.66 3.33 3.31 3.26 3.15 2.80 2.68 2.64 2.60 2.58 2.29 2.24 2.22 2.15 2.09 1.75 1.69 1.69 1.64

Indicates an increase or decrease or no change in holding since last portfolio Indicates a new holding since last portfolio

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