Risk and Return from Investing in Foreign Securities Finance Essay

The purpose of this essay is to examine the implications, risks, and returns associated with foreign security investments. Analyzing these factors associated with investing in foreign securities has become extremely important due to the increasing number of foreign security investments in recent years. This essay introduces analytical factors to determine the attractiveness for investing in foreign securities. Analytical factors include implications of economic objectives and accounting standards, returns of increased profitability and portfolio diversification, and risks of exchange rate and currency fluctuations. The conclusive findings of this essay exacerbate the need for analysis of implications, risks, and returns when investing in foreign securities.

Introduction

Any security denominated or expressed in foreign currency is referred to as a foreign security. Foreign securities usually take the form of common or preferred stocks, bonds, debentures, and shares. For purposes of this paper, analysis of foreign security investments will take the form of common stocks. Analyzing the risks and returns associated with investing in foreign securities is becoming increasingly significant due to the growing international investment in the last several decades. Investing in foreign securities has just recently become increasingly efficient and instantaneous through technological advancements. The scope of this paper includes implications, risks, and returns associated with foreign security investments. A foreign security is similar to that of a U.S. security. Implications involved with foreign security investments include a thorough analysis of foreign governments' economic objectives, and standards of accounting. There are two chief reasons why people invest in foreign securities, which include returns of increased profitability, and portfolio diversification. However, integrating investments internationally requires analysis of two distinctly different factors of risk such as exchange rate and currency rate fluctuations. Foreign security investments, in recent years have become an integral piece of the global investments arena. Several ways to invest in international securities are available. Foreign and domestic markets exist for trading foreign securities. Foreign securities can be purchased through a broker in the United States market in the form of an American Depository Receipt (ADR), or in the same form as they appear in the foreign country. Some countries only trade their company's stock on a foreign stock market. In this case, your broker may process your order for you. One way in invest in foreign securities is to go through a brokerage firm.

Implications of Foreign Security Investments

Economic Objectives

Government economic objectives are of great importance when deciding to invest internationally. Countries economic objectives illuminate possible political risks associated with exchange rate movements. Also, economic objectives are considerably important in the analysis of a countries inflation risk. Economic objectives provide a picture of the countries stability, growth, or recess of a currency. Therefore, a thorough analysis of countries economic objectives is becoming more important than ever before in terms of making a wise investment decision. Company information is readily available to the investors seeking to invest in foreign securities. As mentioned by Ruben Shohet (1974), says that industrial countries with high inflation can cause adverse effects on equity investments. Economic objectives are extremely influential in the determination of a countries inflation rate. The government can intervene to affect the inflation rate by changing the nation's interest rate. Generally speaking, a national with high rates of expected and real inflation are less likely candidates for investments due to higher prices and lower interest rates. Chairman Ben S. Bernanke (2010), in his most recent speech, stated that helping households make more informed decision requires the understanding of central bank policies for lowering economic and financial uncertainty. A nation's economic objectives set the standards for all aspects of investing in the home countries assets. Economic objectives are mainly determined by a nation's government, and encompass standards of accounting, political climate, currency valuation, and exchange rate fluctuations. A thorough analysis of a nation's economic objectives is vital in determining countries investment attractiveness.

Accounting Standards

. Analysis of different accounting standards is highly recommended when investing in foreign securities. Many foreign enterprises are expected to present their accounts consistent with the U.S. capital market; this is because in recent years there is an increasing attractiveness in U.S. capital markets. Ruben Shohet (1974) says countries standards of accounting as well as auditing are substantially different. Some countries have similar accounting standards as the United States. However, other countries have considerably different accounting standards. Inevitably, accounting standards differ from culture to culture. A considerable amount of countries have different accounting standards and are legally enforced differently according to the economic objectives of a government. The United States accounting standards are in ordinance with Generally Accepted Accounting Principles (GAAP). Another widely adopted accounting standard is that of the International Accounting Standards Board (IASB). As mentioned earlier, some foreign securities can be purchased on the United States market with brokerage assistance. An advantage to purchasing foreign securities registered with the New York Stock Exchange (NYSE) is that all listings are required to submit audited and consolidated financial statements. This allows the investor to analyze the foreign securities financial statements to appropriately determine the investment potentiality. However, foreign firms that sell their securities on foreign markets require the investor to do additional research to determine whether or not to invest. The investor must be fully aware of the foreign accounting standards required by different nations in which they wish to invest. In recent years, many nations have adopted international accounting standards to gain access to the United States capital market.

Returns

Increased Profitability

Profitability is limited when a corporation solely invests in domestic stocks. Investing solely in domestic securities such as that found in the United States, strictly limits profitability to the returns available from domestic securities. However, expanding security investments to foreign securities increases potential profits exponentially. Corporations have only recently realized the increased profitability potential by investing internationally. Recent evidence provided reasons to expand investment opportunities to encompass foreign stocks as well as domestic stocks. According to Ruben Shohet (1974) international investments bring forth a universe of investment opportunities. It is a fact that expanding investments into the global arena encompassing foreign securities increases profit potentiality exponentially. Increasing your investment scope to include foreign securities introduces greater possibilities of increased profitability. Increased profits from expanding investment opportunities in the foreign security arena can be linked and associated with portfolio diversification. Expanding investment opportunities into the investment arena include returns from domestic securities as well as foreign securities. Also, investing in domestic and foreign securities ultimately reduce inherent risks associated with securities markets. This is due to the fact that when one market is doing poorly the other market should be doing much better. Ultimately, increasing profitability potentials should be one of the best reasons to expand investments to encompass foreign stocks. Given that many market makers have emerged in the past forty years, it has become extremely easy to begin investing in foreign securities to increase profitability.

Portfolio Diversification

Diversifying your portfolio with both domestic and foreign stocks substantially reduces the overall investment risk. United States Securities and Exchange Commission (2007) stated that benefits of diversification include the compilation of foreign company and market investments that differ from the U.S. economy. United States investment returns sometimes move in a different direction than international market investment returns. Also, even if both domestic and international returns are adversely affecting overall portfolio returns they do so at a substantially different rate. Diversifying an investment portfolio can reduce portfolio risk while simultaneously increasing possible returns. However, according to the United States Securities and Exchange Commission (2009), "if you don't include enough risk in your portfolio, your investments may not earn a large enough return to meet your goal." Diversifying a portfolio using foreign stock markets can help balance overall losses when U.S. stock markets are performing poorly. The U.S. stock market remains the largest in the world; however, foreign stock markets now account for more than 50% of all global stock market capitalization. Taking advantage of growth rates abroad and diversifying portfolios globally is becoming increasingly important in reducing portfolio risk. Cathy Pareto (2010), states that Modern Portfolio Theory (MPT) establishes that global markets fluctuate in different intervals and by integrating low correlation assets in an investment portfolio appropriately, risk will be reduced despite the assets volatility. Generally speaking, market conditions that cause one asset category to have positive returns often cause another asset category to have the opposite effect. A foreign security investment strategy for portfolio diversification is to invest in a group of differently categorized securities, that when one investment category is negatively affected the other investment category is positively affected. By investing in more than one category of foreign securities the risk of losing money is greatly reduced. The ultimate goal of portfolio diversification with foreign securities is to balance risks with returns, and hope for a larger return than losses.

Risks

Exchange Rate Risk

As investors begin to broaden their investment universe and take advantage of foreign stocks, one must also assume the risks associated with foreign exchange rate fluctuations. There are several ways that changes in exchange rates can affect investments in foreign securities. According to the U.S. Securities and Exchange Commission (2007) explains how investment returns can increase or decrease when exchange rate fluctuations between foreign currencies and the U.S. dollar change. Ultimately, exchange rates affect investment returns when you sell the foreign securities, and the need arises to convert the money you receive back into dollars. A thorough analysis of future exchange rate fluctuations, based on your personal techniques, must be conducted in order to foresee beneficial or adverse fluctuations. There are techniques commonly used to reduce the inherent risk of exchange rate fluctuations. Such techniques include hedging exchange rate risks by purchasing insurance. Insurance strategies available include financial derivatives such as options and/or futures. Examples of options are calls, puts, straddles, strangles, and spreads. All of these examples of options are used exclusively, or by combining specific options, to hedge portfolio risk due to exchange rate fluctuations. Futures, for example, are used to lock in the price of an exchange rate in the future. Futures are very useful if you predict the exchange rate has high volatility, or will have an adverse effect on your portfolio. Also, futures are prominently used as a hedging technique by exporters to insure minimum required profits, by locking in the sales price in the future. Speculation is inherent in purchasing financial derivatives as insurance, because you are in essence "betting" on the future exchange rate movement based on your prediction techniques.

Currency Risk

The risks associated with the depreciation or appreciation of currency is inherent when investing internationally. Cathy Pareto (2010) exacerbates the notion of how currency fluctuations can affect foreign investments, and how such fluctuations increase or decrease the risks of investing in foreign securities. Therefore, analyzing factors that influence currency risk is vital when investing in foreign securities. The analysis of currency risk factors encompasses a nation's political climate, inflation rate, and interest rate expectations. A nation's political environment is a major determinant of currency valuation in the short and long term. This is because in some cases governments intervene to set short and long term currency valuation. The political environment of a nation that an investor wishes to invest in foreign securities must be analyzed and researched thoroughly to determine the risks inherent with investing in that particular country. "In the long term, inflation erodes a portfolio's purchasing power," Richard Barrington (2010). A nation's current or expectation of inflation rates can make or break foreign security investment decisions. Inflation rate expectations are good determinants of a nation's purchasing power in the future. A nation's economic objectives can determine inflation rate, which in turn set the bar for expected future imports and exports. "Despite the perceived dangers of foreign investing, an investor may reduce the risk of loss from fluctuations in exchange rates by hedging with currency futures," Cathy Pareto (2010). In general, financial derivatives are an excellent way to hedge inherent risks associate with any financial asset. In the case of currency futures, reducing inherent risk is important especially if predictions of currency fluctuations are highly volatile or adverse.

Conclusion

Analyzing the risks and returns associated with investing in foreign securities is becoming increasingly significant decision making process in determining where to invest as well as what to invest in. It can be concluded that before you invest in foreign securities, you should learn as much about the company and its home country as you can. Obviously implications of foreign security investments stand with high importance and relevance when determining which securities to invest in. Expanding an investment portfolio to encompass foreign securities is an excellent way to increase potential profits. The returns associated with expanding investments to include foreign securities are exponential. As you can see there are several risks associated with foreign investments such as that of exchange rate and currency fluctuation risks. However, several techniques are available to reduce the inherent risks associated with foreign investments. As mentioned earlier, techniques for hedging risk of foreign investments include purchasing insurance such as options or futures. These portfolio hedging techniques are commonly used to decrease risks associated with foreign investments. Also, returns of foreign security investments can be hedged and increased through the process of portfolio diversification. In conclusion, investing in foreign securities has risks and returns associated with expanding investment portfolio. Analysis of foreign security implications must be conducted to determine investment potential. Risks associated with investing in foreign securities are an important ingredient for analysis, and can be reduced with commonly used insurance strategies. Investing in foreign securities has exponential returns that in most cases outweigh the perceived risks.

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