CHAPTER 25: INTERNATIONAL DIVERSIFICATION

CHAPTER 25: INTERNATIONAL DIVERSIFICATION

PROBLEM SETS

1. “International Investing Raises Questions” was published in The Wall Street

Journal in 1997. Some of the arguments presented in the article may no longer be
compelling more than a decade later. For example, the following statement from
the article is no longer true for many U.S. multinationals: “When you look at these
multinationals, the factor that drives their performance is their home market.” The
same can also be said of the assertion that “… most of their costs—especially labor
costs—will be incurred in the U.S.” However, the following argument from the
article is still valid: “U.S. multinationals tend to be owned by U.S. investors, who
will be swayed by the ups and downs of the U.S. market.” An additional argument
that is not mentioned in the piece is the fact that, when investing in U.S.
multinationals, it is essentially impossible to determine the degree of one’s
international exposure. A portfolio of foreign stocks provides an investor a better
understanding of this exposure. The correlation between portfolios of foreign stocks
and the U.S. equity market is likely to be less than the correlation of a portfolio of
U.S. multinationals with the U.S. market.

2. Which of the returns is more relevant to an investor depends on whether the

investor hedges the local currency. If the foreign exchange risk has been hedged,
then the relevant figure is the stock market returns measured in the local currency.
If the foreign exchange risk is not hedged, then the relevant returns are the dollar-
denominated returns.

3. a. $10,000/2 = £5,000
£5,000/£40 = 125 shares

b. To fill in the table, we use the relation:

E1
1 + r(US) = [(1 + r(UK)]
E0
Dollar-Denominated Return (%)
Price per Pound-Denominated for Year-End Exchange Rate
Share (£) Return (%) $1.80/£ $2.00/£ $2.20/£
£35 -12.5% -21.25% -12.5% -3.75%
40 0.0 -10.00 0.0 10.00
45 12.5 1.25 12.5 23.75

c. The dollar-denominated return equals the pound-denominated return when the

exchange rate is unchanged over the year.
4. The standard deviation of the pound-denominated return (using 3 degrees of
freedom) is 10.21%. The dollar-denominated return has a standard deviation of
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CHAPTER 25: INTERNATIONAL DIVERSIFICATION

13.10% (using 9 degrees of freedom), greater than the pound-denominated standard

deviation. This is due to the addition of exchange rate risk.

5. a. First we calculate the dollar value of the 125 shares of stock in each scenario.
Then we add the profits from the forward contract in each scenario.
Dollar Value of Stock
Price per at Given Exchange Rate
Share (£) Exchange Rate: $1.80/£ $2.00/£ $2.20/£
£35 7,875 8,750 9,625
£40 9,000 10,000 11,000
£45 10,125 11,250 12,375
Profits on Forward Exchange: 1,500 500 -500
[ = 5000(2.10 – E1)]
Total Dollar Proceeds
Price per at Given Exchange Rate
Share (£) Exchange Rate: $1.80/£ $2.00/£ $2.20/£
£35 9,375 9,250 9,125
40 10,500 10,500 10,500
45 11,625 11,750 11,875
Finally, calculate the dollar-denominated rate of return, recalling that the initial
investment was $10,000:
Rate of return (%)
Price per at Given Exchange Rate
Share (£) Exchange Rate: $1.80/£ $2.00/£ $2.20/£
£35 -6.25% -7.50% -8.75%
0 5.00 5.00 5.00
45 16.25 17.50 18.75

b. The standard deviation is now 10.24%. This is lower than the unhedged dollar-
denominated standard deviation and is only slightly higher than the standard
deviation of the pound-denominated return.

6. Currency Selection
EAFE: [0.30 × (–10%)] + (0.10 × 0%) + (0.60 × 10%) = 3.0%
Manager: [0.35 × (–10%)] + (0.15 × 0%) + (0.50 × 10%) = 1.5%
Loss of 1.5% relative to EAFE.
Country Selection
EAFE: (0.30 × 20%) + (0.10 × 15%) + (0.60 × 25%) = 22.50%
Manager: (0.35 × 20%) + (0.15 × 15%) + (0.50 × 25%) = 21.75%
Loss of 0.75% relative to EAFE.
Stock Selection
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CHAPTER 25: INTERNATIONAL DIVERSIFICATION

[(18% – 20%) × 0.35] + [(20% – 15%) × 0.15] + [(20% – 25%) × 0.50] = – 2.45%
Loss of 2.45% relative to EAFE.

7. 1 + r(US) = [1 + rf (UK)]  (F0/E0) = 1.03 × (1.45/1.35) = 1.1063  r(US) = 10.63%

8. You can now purchase: $10,000/$1.35 = £7,407.41

This will grow with 3% interest to £7,407.41× (1.03) = £7,629.63. Therefore, to
lock in your return, you would sell forward £7629.63 at the forward exchange rate.

9. A naïve investment by an investor who resides in Foreign Country A might include

only a small fraction of the portfolio invested in the home country, and a relatively
greater weight invested in U.S. securities. This might not be an appropriate
approach for a foreign investor who is likely to be comfortable with a home bias,
just as American investors seem to be. A reasonable way to scale down the weight
invested in foreign countries (for example, the portfolio weight maintained by the
investor from Foreign Country A in U.S. securities) is to focus on the weight of
U.S. imports in the entire consumption basket of the investor (including durable
goods) rather than emphasizing market capitalization. Since this consumption
basket includes health care, for example, as well as other substantial items that have
no import component, the resultant desired weight in U.S. securities will be smaller
than market capitalization would suggest.

CFA PROBLEMS

1. Initial investment = 2,000  $1.50 = $3,000

Final value = 2,400  $1.75 = $4,200
Rate of return = ($4,200/$3,000)  1 = 0.40 = 40%
2. a.

3. c.

4. a. The primary rationale is the opportunity for diversification. Factors that

contribute to low correlations of stock returns across national boundaries are
i. Imperfect correlation of business cycles.
ii. Imperfect correlation of interest rates.
iii. Imperfect correlation of inflation rates.
iv. Exchange rate volatility.
b. Obstacles to international investing are

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CHAPTER 25: INTERNATIONAL DIVERSIFICATION

i. Availability of information, including insufficient data on which to base

investment decisions. Interpreting and evaluating data that is different in form
and/or content than the routinely available and widely understood U.S. data is
difficult. Also, much foreign data is reported with a considerable lag.
ii. Liquidity, in terms of the ability to buy or sell, in size and in a timely manner,
without affecting the market price. Most foreign exchanges offer (relative to
U.S. norms) limited trading, and experience greater price volatility. Moreover,
only a (relatively) small number of individual foreign stocks enjoy liquidity
comparable to that in the U.S., although this situation is improving steadily.
iii. Transaction costs, particularly when viewed as a combination of commission
plus spread plus market impact costs, are well above U.S. levels in most
foreign markets. This, of course, adversely affects return realization.
iv. Political risk, including the extreme case of expropriation and the more
common case of blocked funds.
v. Foreign currency risk, although to a great extent, this can be hedged.
c. The asset-class performance data for this particular period reveal that non-U.S.
dollar bonds provided a small incremental return advantage over U.S. dollar
bonds, but at a considerably higher level of risk. Each category of fixed income
assets outperformed the S&P 500 Index measure of U.S. equity results with
regard to both risk and return, which is certainly an unexpected outcome. Within
the equity area, non-U.S. stocks, represented by the EAFE Index, outperformed
U.S. stocks by a considerable margin with only slightly more risk. In contrast to
U.S. equities, this asset category performed as it should relative to fixed income
assets, providing more return for the higher risk involved.
Concerning the Account Performance Index, its position on the graph reveals an
aggregate outcome that is superior to the sum of its component parts. To some
extent, this is due to the beneficial effect on performance resulting from multi-
market diversification and the differential covariances involved. In this case, the
portfolio manager(s) (apparently) achieved an on-balance positive alpha, adding
to total portfolio return by their actions. The addition of international (i.e., non-
U.S.) securities to a portfolio that would otherwise have held only domestic
(U.S.) securities clearly worked to the advantage of this fund over this time
period.
5. The return on the Canadian bond is equal to the sum of
Coupon income +
Gain or loss from the premium or discount in the forward rate relative to the
spot exchange rate +
Capital gain or loss on the bond.
Over the six-month period, the return is
Coupon + Forward premium/Discount + Capital gain =
7.50%
 ( 0.75%)  Price change in % = 3.00% + % capital gain
2

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CHAPTER 25: INTERNATIONAL DIVERSIFICATION

The expected semiannual return on the U.S. bond is 3.25%. Since the U.S. bond is
selling at par and its yield is expected to remain unchanged, there is no expected capital
gain or loss on the U.S. bond. Therefore, in order to provide the same return, the
Canadian bond must provide a capital gain of 0.25% (i.e., 1/4 point relative to par
value of 100) over and above any expected capital gain on the U.S. bond.

6. a. We exchange $1 million for foreign currency at the current exchange rate and sell
forward the amount of foreign currency we will accumulate 90 days from now. For
the yen investment, we initially receive:
1 million/0.0119 = ¥84.034 million
Invest for 90 days to accumulate:
¥84.034 × [1 + (0.0252/4)] = ¥84.563 million
(Note that we divide the quoted 90-day rate by 4 because quoted money
market interest rates typically are annualized using simple interest, assuming
a 360-day year.)
If we sell this number of yen forward at the forward exchange rate of
0.0120¥/dollar, we will end up with
84.563 million × 0.0120 = $1.0148 million
The 90-day dollar interest rate is 1.48%.
Similarly, the dollar proceeds from the 90-day Canadian dollar investment will be
$1 million  0.0674 
 1    0.7269  $1.0148 million
0.7284  4 
The 90-day dollar interest rate is 1.48%, the same as that in the yen investment.

b. The dollar-hedged rate of return on default-free government securities in both

Japan and Canada is 1.48%. Therefore, the 90-day interest rate available on
U.S. government securities must also be 1.48%. This corresponds to an APR
of 5.92%, which is greater than the APR in Japan and less than the APR in
Canada. This result makes sense, as the relationship between forward and spot
exchange rates indicates that the U.S. dollar is expected to depreciate against
the yen and appreciate against the Canadian dollar.

7. a. Incorrect. There have been periods of strong performance despite weak

currencies. It is also possible that an appreciating currency could enhance
performance.

b. Correct.

c. Correct.

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CHAPTER 25: INTERNATIONAL DIVERSIFICATION

d. Incorrect. Correlations are not stable over time. Also, the portfolio can move
dramatically away from the efficient frontier from one period to the next.

8. a. The following arguments could be made in favor of active management:

Economic diversity: the diversity of the Otunian economy across various sectors
may offer the opportunity for the active investor to employ "top-down" sector
timing strategies.
High transaction costs: very high transaction costs may discourage trading activity
by international investors and lead to inefficiencies that may be exploited
successfully by active investors.
Good financial disclosure and detailed accounting standards: good financial
disclosure and detailed accounting standards may provide the well-trained analyst
an opportunity to perform fundamental research analysis in order to identify
inefficiently priced securities.
Capital restrictions: restrictions on capital flows may discourage foreign investor
participation and serve to segment the Otunian market, thus creating exploitable
market inefficiencies for the active investor.
Developing economy and securities market: developing economies and markets are
often characterized by inefficiently priced securities and by rapid economic change
and growth. The active investor may exploit these characteristics.
Settlement problems: long delays in settling trades by nonresidents may serve to
discourage international investors, leading to inefficiently priced securities which
may be exploited by active management.
The following arguments could be made in favor of indexing:
Economic diversity: economic diversity across a broad sector of industries implies
that indexing may provide a diverse representative portfolio that is not subject to the
risks associated with concentrated sectors.
High transaction costs: indexing would be favored by the implied lower levels of
trading activity and costs.
Settlement problems: indexing would be favored by the implied lower levels of
trading activity and settlement requirements.
Financial disclosure and accounting standards: wide public availability of reliable
financial information presumably leads to greater market efficiency, reducing the
value of both fundamental analysis and active management, and favoring indexing.
Restrictions of capital flows: indexing would be favored by the implied lower
levels of trading activity and thus smaller opportunity for regulatory interference.

b. A recommendation for active management would focus on short-term

inefficiencies in, and long-term prospects for, the developing Otunian markets
and economy, inefficiencies and prospects which would not generally be found in
more developed markets.

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CHAPTER 25: INTERNATIONAL DIVERSIFICATION

A recommendation for indexing would focus on the factors of economic

diversity, high transaction costs, settlement delays, capital flow restrictions, and
lower management fees.

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