Question

What do you think would be the biggest risk to consider when considering international markets?

Answer 1

These are the three biggest risks that international investors face:

1. Higher Transaction Costs

Likely the biggest barrier to investing in international markets are the transaction costs. Although we live in a relatively globalized and connected world, transactions costs can still vary greatly depending on which foreign market you are investing in. Brokerage commissions are almost always higher in international markets than domestic rates are.

In addition, on top of the higher brokerage commissions, there are frequently additional charges that are piled on top that are specific to the local market, which can include stamp duties, levies, taxes, clearing fees and exchange fees.

2. Currency Volatility

The next area of concern for retail investors is in the area of currency volatility. When investing directly in a foreign market (and not through ADRs), you have to exchange your domestic currency (USD for U.S. investors) into a foreign currency at the current exchange rate in order to purchase the foreign stock. If you then hold the foreign stock for a year and sell it, you will have to convert the foreign currency back into USD at the prevailing exchange rate one year later. It is the uncertainty of what the future exchange rate will be that scares many investors. Also, since a significant part of your foreign stock returns will be affected by the currency returns, investors investing internationally should look to eliminate this risk.

The solution to mitigating this currency risk, as any financial professional will likely tell you, is to simply hedge your currency exposure. However, not many retail investors know how to hedge currency risk, or which products to use. There are tools such as currency futures, options, and forwards that can be used to hedge this risk, but these instruments are usually too complex for a normal investor. Alternatively, one tool to hedge currency exposure that may be more "user-friendly" for the average investor is the currency ETF. This is due to their good liquidity, accessibility and relative simplicity.

3. Liquidity Risks

Another risk inherent in foreign markets, especially in emerging markets, is liquidity risk. Liquidity risk is the risk of not being able to sell your stock quickly enough once a sell order is entered. In the previous discussion on currency risk we described how currency risks can be eliminated, however there is typically no way for the average investor to protect themselves from liquidity risk. Therefore, investors should pay particular attention to foreign investments that are, or can become, illiquid by the time they want to close their position.

Further, there are some common ways to evaluate the liquidity of an asset before purchase. One method is to simply observe the bid-ask spread of the asset over time. Illiquid assets will have wider bid-ask spread relative to other assets. Narrower spreads and high volume typically point to higher liquidity. Altogether, these basic measures can help you create a picture of an asset's liquidity.