Instructor: Amy Ho

Chapter 15 International Portfolio Investment

1. Suppose that the standard deviations of the British and U.S. stock markets have risen to
38 percent and 22 percent, respectively, while the correlation between the U.S. and British
markets has risen to 0.67. What is the new beta of the British market from a U.S.
perspective?
Answer:

The beta of the British market = 0.67 ×(.38/.22) = 1.16.

2. A portfolio manager is considering the benefits of increasing his diversification by

investing overseas. He can purchase shares in individual country funds with the following
characteristics:

U.S. U.K. Spain

Expected return (%) 15 12 5

Standard deviation of return (%) 10 9 4
Correlation with U.S. 1.0 0.33 0.06
Correlation with U.K. 0.33 1.0 0.6
Correlation with Spain 0.06 0.6 1.0

(1) What is the expected return and standard deviation of return of a portfolio with 25
percent invested in Spain and 75 percent in the United States?
(2) What is the expected return and standard deviation of return of a portfolio with 25
percent invested in Spain, 25 percent invested in United Kingdom, and 50 percent in the
United States?
Answer:

(1) rp = wus rus + wrw rrw = (.75)(.15) + (.25)(.05)= 12.50%.

s p = [ wus2 s us2 + wrw

2
s rw
2
+ 2wus wrws uss rw r us ,rw ]1 / 2

= [(.75)2(.1)2 + (.25)2(.04)2 + 2(.75)(.25)(.1)(.04)(.06)]1/2 = 7.63%.

(2) rp = = (.5)(.15) + (.25)(.12) + (.25)(.05)= 11.75%.

s p = ( w12s 12 + w22s 22 + w32s 32 + 2w1w2s 1s 2 r12 + 2w1w3s 1s 3 r13 + 2w2 w3s 2s 3 r 23 ) 1/2
= [(.5)2(.1)2 + (.25)2(.09)2 + (.25)2(.04)2 + 2(.5)(.25)(.1)(.09)(.33)+ 2(.5)(.25)(.1)(.04)(.06)+
2(.25)(.25)(.09)(.04)(.6)]1/2 = (0.004179)1/2 = 0.06464 = 6.464%

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3. During the year the price of British gilts (government bonds) went from £102 to £106, while
paying a coupon of £9. At the same time, the exchange rate went from $1.76/£ to $1.62/£. What
was the total dollar return, in percent, on gilts for the year?

Answer:
Pound depreciation % = (e1-e0)/e0 = (1.62 - 1.76)/1.76 = -7.95%.

R$ = [1 + (106 - 102 + 9)/102](1 - .0795) - 1= (1.1275)(0.9205) - 1= 3.79%.

4. During the year Toyota Motor Company shares went from ¥9,000 to ¥11,200, while paying
a dividend of ¥60. At the same time, the exchange rate went from ¥145/$ to ¥120/$. What
was the total dollar return, in percent, on Toyota stock for the year?

Answer:
Yen appreciation % = (e1-e0)/e0 = [(1/120)-(1/145)]/(1/145) = 20.83%.

R$ = [1 + (11,200 - 9,000 + 60)/9,000](1+.2083) - 1 = (1.2511)(1.2083) - 1 = 51.17%.

5. Suppose that the standard deviation of the return on Honda in terms of yen is 23% and
the standard deviation of the percent change in the dollar:yen exchange rate is 17%. The
estimated correlation between the yen return on Honda and the exchange rate change is
0.31. What is the standard deviation of the dollar rate of return on investing in Honda
stock?

Answer:

s $ (Honda) = (0. 232 + 0.17 2 + 2 ´ .23 ´ .17 ´ .31 ) = 0.3256 = 32.56%.

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۞ Suggested Exercises - End-of-Chapter 15 Problems: #2, 3, 6, 8

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Instructor: Amy Ho

[EOC Problem #2] Mr. James K. Silber, an avid international investor, just sold a share of
Nestlé, a Swiss firm, for SF5,080. The share was bought for SF4,600 a year ago. The
exchange rate is SF1.60 per U.S. dollar now and was SF1.78 per dollar a year ago. Mr.
Silber received SF120 as a cash dividend immediately before the share was sold. Compute
the rate of return on this investment in terms of U.S. dollars.

Answer:

Mr. Silber must have paid I0 = $2,584.27 (=4,600/1.78)

When the share was liquidated, he must have received I1 = $3,250 [=(5,080 + 120)/1.60].

R($) = [(3,250-2,584.27)/2584.27] x 100 = 25.76%.

[EOC Problem #3] In problem 2, suppose that Mr. Silber sold SF4,600, his principal
investment amount, forward at the forward exchange rate of SF1.62 per dollar. How would
this affect the dollar rate of return on this Swiss stock investment? In hindsight, should Mr.
Silber have sold the Swiss franc amount forward or not? Why or why not?

Answer:

Profit ($) = SF 4,600 (1/1.62 – 1/1.60) = 4,600 (0.6173 – 0.625) = -$35.42.

R($) = (I1 – I0 - $35.42)/I0 = [(3,250-2,584.27-35.42)/2584.27] x 100 = 24.39%.

By ‘hindsight’, Mr. Silber should not have sold the SF amount forward as it reduced the

return in dollar terms. But this is only by hindsight. Obviously, hedging decision must be

made ex ante.

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[EOC Problem #6] Suppose we obtain the following data in dollar terms:

Stock market Return (mean) Risk (SD)

United States 1.26% per month 4.43%

United Kingdom 1.23% per month 5.55%

The correlation coefficient between the two markets is 0.58. Suppose that you invest equally,
i.e., 50% each, in the two markets. Determine the expected return and standard deviation
risk of the resulting international portfolio.
Answer:

E(Rp) = (.5)(1.26%) + (.5)(1.23%) = 1.25%

Var(Rp) = (.5)2(4.43%)2 + (.5)2(5.55%)2 +2(.5)2(4.43%)(5.55%)(.58) = 0.1974%

The standard deviation of the portfolio is 4.44%.

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[EOC Problem #8 – CFA Problem] The HFS Trustees have solicited input from three
consultants concerning the risks and rewards of an allocation to international equities. Two
of them strongly favor such action, while the third consultant commented as follows: “The
risk reduction benefits of international investing have been significantly overstated. Recent
studies relating to the cross-country correlation structure of equity returns during different
market phases cast serious doubt on the ability of international investing to reduce risk,
especially in situations when risk reduction is needed the most.”
a. Describe the behavior of cross-country equity return correlations to which the consultants
is referring. Explain how that behavior may diminish the ability of international investing to
reduce risk in the short run. Assume that the consultant’s assertion is correct.
b. Explain why it might still be more efficient on a risk/reward basis to invest internationally
rather than only domestically in the long run.
The HFS Trustees have decided to invest in non-U.S. equity markets and have hired Jacob
Hind, a specialist manager, to implement this decision. He has recommended that an
unhedged equities position be taken in Japan, providing the following comments and the
table data to support his view: “Appreciation of a foreign currency increases the returns to
a U.S. dollar investor. Since appreciation of the Yen from ¥100/$U.S. to ¥98/$U.S. is
expected, the Japanese stock position should not be hedged.”

Market Rates and Hind’s Expectations

U.S. Japan
Spot rate (yen per $U.S.) n/a 100
Hind’s 12-month currency forecast (yen per $U.S.) n/a 98
1-year Eurocurrency rate (% per annum) 6.00 0.80
Hind’s 1-year inflation forecast (% per annum) 3.00 0.50

Assume that the investment horizon is one year and that there are no costs associated with
currency hedging.
c. State and justify whether Hind’s recommendation (not to hedge) should be followed.
Show any calculations.

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Answer:

a. Cross-country correlations tend to increase during the turbulent market phase, reducing

the benefits from international diversification in the short run.

b. Unless the investor has to liquidate investments during the turbulent phase, he/she can

ride out the turbulence and realize the benefits from international investments in the long

run.

c. The interest rate parity implies that the forward exchange rate would be ¥95.09/$:

f = [1.06/1.008](1/100) = $0.010516/¥ = ¥95.09/$ < future spot rate = ¥98/$ = $0.010204/¥.

Clearly, the HFS Trustees can receive more dollar amount from selling yen forward than
from the unhedged position. Relative to the forward rate, Hind underestimates the yen’s
future strength.

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