CHAPTER 15 INTERNATIONAL PORTFOLIO INVESTMENT
ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS
QUESTIONS
1. What factors are responsible for the recent surge in international portfolio investment (IPI)?
Answer: The recent surge in international portfolio investments reflects the globalization of
financial markets. Specifically, many countries have liberalized and deregulated their capital and
foreign exchange markets in recent years. In addition, commercial and investment banks have
facilitated international investments by introducing such products as American Depository
2. Security returns are found to be less correlated across countries than within a country. Why
can this be?
Answer: Security returns are less correlated probably because countries are different from each
other in terms of industry structure, resource endowments, macroeconomic policies, and have
3. Explain the concept of the world beta of a security.
Answer: The world beta measures the sensitivity of returns to a security to returns to the world
market portfolio. It is a measure of the systematic risk of the security in a global setting.
4. Explain the concept of the Sharpe performance measure.
Answer: The Sharpe performance measure (SHP) is a risk-adjusted performance measure. It is
5. Explain how exchange rate fluctuations affect the return from a foreign market measured in
dollar terms. Discuss the empirical evidence on the effect of exchange rate uncertainty on the
risk of foreign investment.
Answer: It is useful to refer to Equations 15.4 and 15.5 of the text. Exchange rate fluctuations
mostly contribute to the risk of foreign investment through its own volatility as well as its
6. Would exchange rate changes always increase the risk of foreign investment? Discuss the
condition under which exchange rate changes may actually reduce the risk of foreign
investment.
Answer: Exchange rate changes need not always increase the risk of foreign investment. When
the covariance between exchange rate changes and the local market returns is sufficiently
7. Evaluate a home country’s multinational corporations as a tool for international
diversification.
Answer: Despite the fact that MNCs have operations worldwide, their stock prices behave very
8. Discuss the advantages and disadvantages of closed-end country funds (CECFs) relative to
the American Depository Receipts (ADRs) as a means of international diversification.
Answer: CECFs can be used to diversify into exotic markets that are otherwise difficult to
access such as India and Turkey. Being a portfolio, CECFs also provide instant diversification.
9. Why do you think closed-end country funds often trade at a premium or discount?
Answer: CECFs trade at a premium or discount because capital markets of the home and host
10. Why do investors invest the lion’s share of their funds in domestic securities?
Answer: Investors invest heavily in their domestic securities mainly because there are barriers
to investing overseas. The barriers may include excessive transaction costs, information costs
11. What are the advantages of investing via international mutual funds?
Answer: The advantages of investing via international mutual funds include: (1) save
12. Discuss how the advent of the euro would affect international diversification strategies.
Answer: As the euro-zone has the same monetary and exchange-rate policies, the correlations
among euro-zone markets are likely to go up. This will reduce diversification benefits. However,
1. Suppose you are a euro-based investor who just sold Microsoft shares that you had bought
six months ago. You had invested 10,000 euros to buy Microsoft shares for $120 per share; the
exchange rate was $1.15 per euro. You sold the stock for $135 per share and converted the
dollar proceeds into euro at the exchange rate of $1.06 per euro. First, determine the profit from
this investment in euro terms. Second, compute the rate of return on your investment in euro
terms. How much of the return is due to the exchange rate movement?
Solution: It is useful first to compute the rate of return in euro terms:
r ≃r$+e
¿
(
135−120
120
)
+
(
1
1 . 06 −1
1. 15
1
1 . 15
)
¿0 .125+0. 085
¿0 .210
This indicates that this euro-based investor benefited from an appreciation of dollar against the
euro, as well as from an appreciation of the dollar value of Microsoft shares. The profit in euro
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.
€
Solution: Mr. Silber must have paid $2,584.27 (=4,600/1.78) for a share of Néstle a year ago.
3. In the above problem, 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?
Solution: The dollar profit from selling SF4,600 forward is equal to:
Thus, the total return of investment is:
By ‘hindsight’, Mr. Silber should not have sold the SF amount forward as it reduced the return in
4. Japan Life Insurance Company invested $10,000,000 in pure-discount U.S. bonds in May
1995 when the exchange rate was 80 yen per dollar. The company liquidated the investment
one year later for $10,650,000. The exchange rate turned out to be 110 yen per dollar at the
time of liquidation. What rate of return did Japan Life realize on this investment in yen terms?
Solution: Japan Life Insurance Company spent ¥800,000,000 to buy $10,000,000 that was
5. At the start of 1996, the annual interest rate was 6 percent in the United States and 2.8
percent in Japan. The exchange rate was 95 yen per dollar at the time. Mr. Jorus, who is the
manager of a Bermuda-based hedge fund, thought that the substantial interest advantage
associated with investing in the United States relative to investing in Japan was not likely to be
offset by the decline of the dollar against the yen. He thus concluded that it might be a good
idea to borrow in Japan and invest in the United States. At the start of 1996, in fact, he borrowed
¥1,000 million for one year and invested in the United States. At the end of 1996, the exchange
rate became 105 yen per dollar. How much profit did Mr. Jorus make in dollar terms?
Solution: Let us first compute the maturity value of U.S. investment:
The dollar profit = $11,157,895 – $9,790,476 = $1,367,419.
Mr. Jorus was able to realize a large dollar profit because the interest rate was higher in the
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.
Solution: The expected return of the equally weighted portfolio is:
7. Suppose you are interested in investing in the stock markets of 7 countries–i.e., Australia,
Canada, Germany, Japan, Switzerland, the United Kingdom, and the United States–the same 7
countries that appear in Exhibit 15.9. Specifically, you would like to solve for the optimal
(tangency) portfolio comprising the above seven stock markets. In solving the optimal portfolio,
use the input data (i.e. correlation coefficients, means, and standard deviations) provided in
Exhibit 15.4. The risk-free interest rate is assumed to be 0.2% per month and you can take a
short position in any stock market. What are the optimal weights for each of the seven stock
markets? What is the risk and return of the optimal portfolio? This problem can be solved using
MPTSolver.xls spreadsheet.
Solution:
Sample Period: 1980.1 -2012.12 (in U.S. dollar terms)
Correlation Coefficients
Stock Market AU CN GM JP SW UK
U
S
Mean
(%)
SD
(%)
Optimal
Weight
Australia (AU) 1 0.550 7.18 -0.0557
Canada (CN)
0.6
9 1 0.549 6.11 -0.2081
0.5
0.6
The monthly mean return and standard deviation of the optimal portfolio are 0.772% and