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
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
3. a. $10,000/2 = £5,000
b. To fill in the table, we use the relation:
0
1
E
E
Price per
Pound-Denominated
Dollar-Denominated Return (%)
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
25-3
6. Currency Selection
Country Selection
EAFE: (0.30 20%) + (0.10 15%) + (0.60 25%) = 22.50%
Stock Selection
8. You can now purchase: $10,000/$1.75 = £5,714.29
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
CFA PROBLEMS
1. Initial investment = 2,000 $1.50 = $3,000
Chapter 25 – International Diversification
25-4
2. a.
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
b. Obstacles to international investing are:
i. Availability of information, including insufficient data on which to base investment
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.
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
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,
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
25-5
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 =
+−+ %)75.0(
2
%50.7
Price change in % = 3.00% + % capital gain
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:
Invest for 90 days to accumulate:
(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:
The 90-day dollar interest rate is 1.48%.
Similarly, the dollar proceeds from the 90-day Canadian dollar investment will be:
0148.1$7269.0
4
0674.0
1
7284.0
million 1$ =
+
million
The 90-day dollar interest rate is 1.48%, the same as that in the yen investment.
Chapter 25 – International Diversification
25-6
b. The dollar-hedged rate of return on default-free government securities in both
7. a. Incorrect. There have been periods of strong performance despite weak currencies. It
is also possible that an appreciating currency could enhance performance.
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.
Chapter 25 – International Diversification
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
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.