INTERNATIONAL PORTFOLIO INVESTMENT SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1.

What factors are responsible for the recent surge in international portfolio investment (I I!" #ns$er% The recent surge in international portfolio investments reflects the globali&ation of financial mar'ets. Specificall() man( countries have liberali&e* an* *eregulate* their capital an* foreign e+change mar'ets in recent (ears. In a**ition) commercial an* investment ban's have facilitate* international investments b( intro*ucing such pro*ucts as #merican ,epositor( -eceipts (#,-s! an* countr( fun*s. #lso) recent a*vancements in computer an* telecommunication technologies le* to a ma.or re*uction in transaction an* information costs associate* $ith international investments. In a**ition) investors might have become more a$are of the potential gains from international investments. /. Securit( returns are foun* to be less correlate* across countries than $ithin a countr(. Wh( can this be" #ns$er% Securit( returns are less correlate* probabl( because countries are *ifferent from each other in terms of in*ustr( structure) resource en*o$ments) macroeconomic policies) an* have non0s(nchronous business c(cles. Securities from a same countr( are sub.ect to the same business c(cle an* macroeconomic policies) thus causing high correlations among their returns. 1. E+plain the concept of the $orl* beta of a securit(. #ns$er% The $orl* beta measures the sensitivit( of returns to a securit( to returns to the $orl* mar'et portfolio. It is a measure of the s(stematic ris' of the securit( in a global setting. Statisticall() the $orl* beta can be *efine* as% 2ov(-i) -3!45ar(-3!) $here -i an* -3 are returns to the i0th securit( an* the $orl* mar'et portfolio) respectivel(.

6. E+plain the concept of the Sharpe performance measure. #ns$er% The Sharpe performance measure (S7 ! is a ris'0a*.uste* performance measure. It is *efine* as the mean e+cess return to a portfolio above the ris'0free rate *ivi*e* b( the portfolio8s stan*ar* *eviation. 9. E+plain ho$ e+change rate fluctuations affect the return from a foreign mar'et measure* in *ollar terms. ,iscuss the empirical evi*ence on the effect of e+change rate uncertaint( on the ris' of foreign investment. #ns$er% It is useful to refer to E:uations 11.6 an* 11.9 of the te+t. E+change rate fluctuations mostl( contribute to the ris' of foreign investment through its o$n volatilit( as $ell as its covariance $ith the local mar'et returns. The covariance ten*s to be positive in most of the cases) impl(ing that e+change rate changes ten* to a** to e+change ris') rather than offset it. E+change ris' is foun* to be much more significant in bon* investments than in stoc' investments. ;. Woul* e+change rate changes al$a(s increase the ris' of foreign investment" ,iscuss the con*ition un*er $hich e+change rate changes ma( actuall( re*uce the ris' of foreign investment. #ns$er% E+change rate changes nee* not al$a(s increase the ris' of foreign investment. When the covariance bet$een e+change rate changes an* the local mar'et returns is sufficientl( negative to offset the positive variance of e+change rate changes) e+change rate volatilit( can actuall( re*uce the ris' of foreign investment. <. Evaluate a home countr(8s multinational corporations as a tool for international

*iversification. #ns$er% ,espite the fact that 3N2s have operations $orl*$i*e) their stoc' prices behave ver( much li'e purel( *omestic firms. This is pu&&ling (et un*eniable. #s a result) 3N2s are a poor substitute for *irect foreign portfolio investments. =. ,iscuss the a*vantages an* *isa*vantages of close*0en* countr( fun*s (2E2>s! relative to the #merican ,epositor( -eceipts (#,-s! as a means of international *iversification.

#ns$er% 2E2>s can be use* to *iversif( into e+otic mar'ets that are other$ise *ifficult to access such as In*ia an* Tur'e(. ?eing a portfolio) 2E2>s also provi*e instant *iversification. #,-s *o not provi*e instant *iversification@ investors shoul* form portfolios themselves. In a**ition) there are relativel( fe$ #,-s from emerging mar'ets. The main *isa*vantage of 2E2>s is that their share prices behave some$hat li'e the host countr(8s share prices) re*ucing the potential *iversification benefits. A. Wh( *o (ou thin' close*0en* countr( fun*s often tra*e at a premium or *iscount" #ns$er% 2E2>s tra*e at a premium or *iscount because capital mar'ets of the home an* host countries are segmente*) preventing cross0bor*er arbitrage. If cross0bor*er arbitrage is possible) 2E2>s shoul* be tra*ing near their net asset values. 1B. Wh( *o investors invest the lion8s share of their fun*s in *omestic securities" #ns$er% Investors invest heavil( in their *omestic securities because there are significant

barriers to investing overseas. The barriers ma( inclu*e e+cessive transaction costs) information costs for foreign securities) legal an* institutional restrictions) e+tra ta+es) e+change ris' an* political ris' associate* $ith overseas investments) etc. 11. What are the a*vantages of investing via international mutual fun*s" #ns$er% The a*vantages of investing via international mutual fun*s inclu*e% (1! save

transaction4information costs) (/! circumvent legal4institutional barriers) an* (1! benefit from the e+pertise of professional fun* managers. 1/. ,iscuss ho$ the a*vent of the euro $oul* affect international *iversification strategies. #ns$er% #s the euro0&one $ill have the same monetar( an* e+change0rate policies) the correlations among euro0&one mar'ets are li'el( to go up. This $ill re*uce *iversification benefits. 7o$ever) to the e+tent that the a*option of euro strengthens the European econom() investors ma( benefit from enhance* returns.

-O?CE3S 1. Suppose (ou are a euro0base* investor $ho .ust sol* 3icrosoft shares that (ou ha* bought si+ months ago. Dou ha* investe* 1B)BBB euros to bu( 3icrosoft shares for E1/B per share@ the e+change rate $as E1.19 per euro. Dou sol* the stoc' for E119 per share an* converte* the *ollar procee*s into euro at the e+change rate of E1.B; per euro. >irst) *etermine the profit from this investment in euro terms. Secon*) compute the rate of return on (our investment in euro terms. 7o$ much of the return is *ue to the e+change rate movement" Solution% It is useful first to compute the rate of return in euro terms% (1F-euro! G (1F -us*!(1Fe! eG(141.B; H 141.19!4(141.19! G B.B=6A -us* G (11901/B!41/B G B.1/9 (1F-euro! G 1.1/9 I 1.B=6A G 1.//B9 -euro G //.B9J This in*icates that this euro0base* investor benefite* from an appreciation of *ollar against the euro) as $ell as from an appreciation of the *ollar value of 3icrosoft shares. The profit in euro terms is Euros //B9) an* the rate of return is //.B9J in euro terms) of $hich =.6AJ is *ue to the e+change rate movement. /. 3r. Kames L. Silber) an avi* international investor) .ust sol* a share of NestlM) a S$iss firm) for S>9)B=B. The share $as bought for S>6);BB a (ear ago. The e+change rate is S>1.;B per U.S. *ollar no$ an* $as S>1.<= per *ollar a (ear ago. 3r. Silber receive* S>1/B as a cash *ivi*en* imme*iatel( before the share $as sol*. 2ompute the rate of return on this investment in terms of U.S. *ollars.

Solution% 3r. Silber must have pai* E/)9=6./< (G6);BB41.<=! for a share of NMstle a (ear ago. When the share $as li:ui*ate*) he must have receive* E1)/9B NG(9)B=B F 1/B!41.;BO. Therefore) the rate of return in *ollar terms is% -(E! G N(1)/9B0/)9=6./<!4/9=6./<O + 1BB G /9.<;J. 1. In the above problem) suppose that 3r. Silber sol* S>6);BB) his principal investment amount) for$ar* at the for$ar* e+change rate of S>1.;/ per *ollar. 7o$ $oul* this affect the *ollar rate of return on this S$iss stoc' investment" In hin*sight) shoul* 3r. Silber have sol* the S$iss franc amount for$ar* or not" Wh( or $h( not" Solution% The *ollar profit from selling S>6);BB for$ar* is e:ual to% rofit (E! G 6);BB (141.;/ H 141.;B! G 6);BB (B.;1<1 H B.;/9! G 0E19.6/. Thus) the total return of investment is% -(E! G N(1)/9B0/)9=6./<019.6/!4/9=6./<O + 1BB G /6.1AJ. With Phin*sight8) 3r. Silber shoul* not have sol* the S> amount for$ar* as it re*uce* the return in *ollar terms. 6. Kapan Cife Insurance 2ompan( investe* E1B)BBB)BBB in pure0*iscount U.S. bon*s in 3a( 1AA9 $hen the e+change rate $as =B (en per *ollar. The compan( li:ui*ate* the investment one (ear later for E1B);9B)BBB. The e+change rate turne* out to be 11B (en per *ollar at the time of li:ui*ation. What rate of return *i* Kapan Cife reali&e on this investment in (en terms" Solution% Kapan Cife Insurance 2ompan( spent Q=BB)BBB)BBB to bu( E1B)BBB)BBB that $as investe* in U.S. bon*s. The li:ui*ation value of this investment is Q1)1<1)9BB)BBB) $hich is obtaine* from multipl(ing E1B);9B)BBB b( Q11B4E. The rate of return in terms of (en is% N(Q1)1<1)9BB)BBB 0 Q=BB)BBB)BBB!4 Q=BB)BBB)BBBO+1BB G 6;.66J.

9. #t the start of 1AA;) the annual interest rate $as ; percent in the Unite* States an* /.= percent in Kapan. The e+change rate $as A9 (en per *ollar at the time. 3r. Korus) $ho is the manager of a ?ermu*a0base* he*ge fun*) thought that the substantial interest a*vantage associate* $ith investing in the Unite* States relative to investing in Kapan $as not li'el( to be offset b( the *ecline of the *ollar against the (en. 7e thus conclu*e* that it might be a goo* i*ea to borro$ in Kapan an* invest in the Unite* States. #t the start of 1AA;) in fact) he borro$e* Q1)BBB million for one (ear an* investe* in the Unite* States. #t the en* of 1AA;) the e+change rate became 1B9 (en per *ollar. 7o$ much profit *i* 3r. Korus ma'e in *ollar terms" Solution% Cet us first compute the maturit( value of U.S. investment% (Q1)BBB)BBB)BBB4A9!(1.B;! G E11)19<)=A9. The *ollar amount necessar( to pa( off (en loan is% (Q1)BBB)BBB)BBB!(1.B/=!41B9 G EA)<AB)6<;. The *ollar profit G E11)19<)=A9 0 EA)<AB)6<; G E1)1;<)61A. 3r. Korus $as able to reali&e a large *ollar profit because the interest rate $as higher in the U.S. than in Kapan an* the *ollar actuall( appreciate* against (en. This is an e+ample of uncovere* interest arbitrage. ;. >rom E+hibit 11.6 $e obtain the follo$ing *ata in *ollar terms%

Stoc' mar'et Unite* States Unite* Ling*om

-eturn (mean! 1./;J per month 1./1J per month

-is' (S,! 6.61J 9.99J

The correlation coefficient bet$een the t$o mar'ets is B.9=. Suppose that (ou invest e:uall() i.e.) 9BJ each) in the t$o mar'ets. ,etermine the e+pecte* return an* stan*ar* *eviation ris' of the resulting international portfolio. Solution% The e+pecte* return of the e:uall( $eighte* portfolio is% E(-p! G (.9!(1./;J! F (.9!(1./1J! G 1./9J The variance of the portfolio is% 5ar(-p! G (.9!/(6.61!/ F (.9!/(9.99!/ F/(.9!/(6.61!(9.99!(.9=! G 6.A1 F<.<B F <.11 G 1A.<6 The stan*ar* *eviation of the portfolio is thus 6.66J.