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Chapter 9

The Case for International Diversification


Note: In the sixth edition of Global Investments, the exchange rate quotation symbols differ from previous
editions. We adopted the convention that the first currency is the quoted currency in terms of units
of the second currency.
For example, :$ = 1.4 indicates that one euro is priced at 1.4 dollars. In previous editions we used
the reversed convention $/ = 1.4, meaning 1.4 dollars per euro.
All problems in this test bank still use the old convention and have not been adapted to reflect the
new quotation symbols used in the 6th edition.
Questions and Problems
1. The annualized performance, in U.S. dollars, of the United States and EAFE stock indices are:
Return
US
= 12% o
US
= 15.5%
Return
EAFE
= 14.6% o
EAFE
= 18.2%
Correlation = 0.47
a. What would be the return and risk of a portfolio invested half in the U.S. market and half in the
EAFE index?
b. What if the correlation increases to 0.6?
Solution
a. Return
portfolio
= 50% Return
US
+ 50% Return
EAFE
= 13.3%.
o
2
portfolio
=
2 2
US EAFE US EAFE
(0.5 ) (0.5 ) 2 0.47 0.5 0.5 209.166 o o o o + + = .
o
portfolio = 14.46%.

b. The return of the portfolio remains unchanged at 13.3%. The risk is higher at:
o
2
portfolio =
2 2
US EAFE US EAFE
(0.5 ) (0.5 ) 2 0.60 0.5 0.5 227.50 o o o o + + =
.

o
portfolio
= 15.08%.
2. The annualized performance, in U.S. dollars, of the U.S. and European stock indices are:
Return
US
= 10% o
US
= 16%
Return
europe
= 11% o
europe
=18%
Correlation = 0.60
106 Solnik/McLeavey Global Investments, Sixth Edition
a. What would be the return and risk of a portfolio invested half in the U.S. market and half in the
European index?
b. What if the correlation increases to 0.8?
Solution
a. Return
portfolio
= 50% Return
US
+ 50% Return
europe
= 10.5%.
o
2
portfolio
=
2 2
US europe US europe
(0.5 ) (0.5 ) 2 0.6 0.5 0.5 231.4 o o o o + + = .
o
portfolio = 15.21%.

b. The return of the portfolio remains unchanged at 10.5%. The risk is higher at:
o
2
portfolio =
2 2
US europe US europe
(0.5 ) (0.5 ) 2 0.8 0.5 0.5 260.2 o o o o + + =
.

o
portfolio
= 16.13%.
3. Here are the expected returns and risks of two assets:
E(R
1
) = 10% o
1
= 16%
E(R
2
) = 14% o
2
= 16%
a. Assume a correlation of 0.5 and draw all the portfolios made up of the two assets in an Expected
Return/Risk graph.
b. Same question assuming successively a correlation of 1, 0, and +1.
c. Looking at the four graphs, what do you conclude about the importance of correlation in
risk-reduction?
Solution

Chapter 9 The Case for International Diversification 107



Conclusion: The lower the correlation the more risk reduction can be achieved without sacrificing
return.
108 Solnik/McLeavey Global Investments, Sixth Edition
4. Try to find some reasons why:
a. Stock and bond markets should be strongly correlated and,
b. Stock and bond markets should be weakly correlated.
Solution
a. Stock and bond markets should be strongly correlated for several reasons:
Both react negatively to interest rate movements.
Both are affected by the risk attitude of investors: when economic uncertainties or investors
risk aversion increase, investors require a larger risk premium on assets and the price of
bonds and stocks fall.
Foreign capital flows are influenced by exchange rate expectations. Foreigners may buy
U.S. bonds and stocks when they believe the dollar is strong but sell their U.S. assets in fear
of a dollar depreciation. This foreign attitude creates a positive correlation between the
domestic bond and stock markets.
b. Stock and bond markets should be weakly correlated for the following reason:
Stocks are real assets influenced mostly by real variables while bonds are nominal assets
influenced by monetary variables. The two sets of variables are quite independent.
5. The French stock market has a sigma of 20%, when computed in euros. The U.S. stock market has a
sigma of 16% in US$ and the /US$ exchange rate has a sigma of 6%.
a. Assuming that the correlation between stock market and currency movements is zero, what is the
sigma of the U.S. stock market when expressed in .
b. Using this number, calculate the sigma, in , of a portfolio made up of 50% of French stocks and
50% of U.S. stocks (zero-correlation between the two markets).
Solution:
a. Total risk of U.S. stocks in :
2

2 2
in in $ /$
in
0 292
17.1%.
o o o
o
= + + =
=

b. Risk of a diversified portfolio 50 French/50 U.S., all measured in , with zero correlation:
o
2
portfolio
= (0.5 o
french
)
2
+ (0.5 o
US in
)
2
+ 2 0.5 0.5 0 o
french
o
US in
= 173
o = 13.15%.
6. The Japanese stock market has a sigma of 18%, when computed in yen. The U.S. stock market has a
sigma of 17% in US$ and the US$/ exchange rate has a sigma of 6%. The correlation between the
Japanese stock market and $/ currency movements is 0.1; in other words, the Japanese stock
market tends to go up when the yen goes down. The correlation between the Japanese and U.S.
stock markets is equal to 0.4, measured either in local currency of in dollars.
a. What is the sigma of the Japanese market when expressed in dollars?
b. Using this number, calculate the sigma, in dollars, of a portfolio made up of 50% of Japanese
stocks and 50% of U.S. stocks.
Chapter 9 The Case for International Diversification 109
Solution
a. Total risk of Japanese stocks in $:

2 2 2
in $ in $/ in $/
in
2 338.4
18.4%.
o o o o o
o
= + + =
=

b. Risk of a diversified portfolio 50 US/50 Japan, measured in $:
o
2
portfolio
= (0.5 o
US
)
2
+ (0.5 o
japan
)
2
+ 2 0.5 0.5 0.4 o
US
o
japan
= 219.45
o = 14.8%.
7. Assume that the domestic volatility (standard deviation in yen) of the Japanese stock market is 18%.
The volatility of the yen against the U.S. dollar is 6%.
a. What would the dollar volatility of the Japanese stock market be for a U.S. investor if the
correlation between the Japanese stock market returns and exchange rate movements were zero?
b. Suppose the dollar volatility of the Japanese stock market is 18.4%, what can you conclude about
the correlation between the Japanese stock market movements and exchange rate movements?
Solution
a. If the correlation between stock market returns and exchange rate movements were equal to zero,
the dollar volatility of the Japanese stock market would be:

2 2 2 2 2
in $ in $/ in $/
2
in $
2 (18) (6) (2)(0)(18)(6) 360
18.97%.
o o o o o
o
= + + = + + =
=

b. Because the actual dollar volatility is 18.4%, we conclude that the correlation between Japanese
stock market returns and exchange rate movements is negative. The actual correlation is 0.1.
This can be explained by the idea that a weak currency is associated with rising stock prices;
a depreciation of the yen is good for Japanese corporations.
8. Assume that the domestic volatility (standard deviation in yen) of the Japanese bond market is 8%.
The volatility of the yen against the U.S. dollar is 6%.
a. What would the dollar volatility of the Japanese bond market be for a U.S. investor if the
correlation between the Japanese stock market returns and exchange rate movements were zero?
b. Suppose the dollar volatility of the Japanese stock market is 11.35%, what can you conclude
about the correlation between the Japanese bond market movements and exchange rate
movements?
Solution
a. If the correlation between bond market returns and exchange rate movements were equal to zero,
the dollar volatility of the Japanese bond market would be

2 2 2 2 2
in $ in $/ in $/
2
in $
2 (8) (6) (2)(0)(8)(6) 100
10%.
o o o o o
o
= + + = + + =
=

b. Because the actual dollar volatility is 11.35%, we conclude that the correlation between Japanese
bond market returns and exchange rate movements is positive. The actual correlation is 0.30.
This can be explained by the idea that a weak currency is associated with rising interest
rates (and negative bond returns) to defend the currency.
110 Solnik/McLeavey Global Investments, Sixth Edition
9. In 1994, the United States was experiencing a fairly strong economic recovery, ahead of other nations.
Fears of an overheating economy led to sudden inflationary fears for the next few years.
a. Would you expect U.S. interest rates to rise or drop?
b. Would you expect the dollar to depreciate or appreciate?
c. Would you expect a foreign bond portfolio to be a good investment compared to a U.S. dollar
portfolio under this scenario?
Solution
a. Inflationary fears will cause interest rates to rise, even if the real interest rate remains constant.
Economic growth could also lead to higher real interest rates.
b. The dollar is likely to depreciate because of higher expected inflation. This could be offset by
higher real interest rates, which could attract foreign capital flows.
c. The rise of U.S. interest rates will cause the market price of U.S. bonds to fall. It is, therefore,
appropriate to invest in foreign bonds rather than U.S. bonds. The likely depreciation of the
dollar makes such an investment even more interesting (the foreign currency in which the bonds
are denominated will appreciate against the dollar during the investment period and the investor
will make a foreign exchange profit when reselling his bonds).
10. Suppose that you overheard the following statements at a conference for institutional investors:
(A German national): My money manager knows the German firms very well; why should I
bother to invest in French and American shares? I am not familiar with their names or their
operations, and I will have to pay much higher costs to buy them.
(A French national): Why should I buy German and American shares? The foreign brokers will
give preferential treatment to their domestic clients, and I am going to get a lousy deal in terms of
prices and costs. Furthermore, I cant read the financial statements of these companies, as they
are written in German or English, and with different accounting methods.
(An American national): I cant even pronounce the names of these foreign companies; how
could I defend investing abroad in front of my board of trustees? By the way, what is the capital
of Switzerland: Geneva or Zurich?
How would you try to convince these people to diversify their portfolios if you were the marketing
representative of a big international money manager?
Solution
I would use all the arguments and evidence presented in Chapter 4 of International Asset Pricing.
Two specific arguments quoted are that:
- Foreign is exotic and therefore that an investor feels safer by staying at home.
- Foreign investment would be more costly in terms of transaction cost and price execution.
The first argument is very practical. Today, a finance professional should be able to deal with the
world and invest globally if it makes financial sense. The second argument is getting outdated by
market deregulation and competition among brokers. Local brokers will do their utmost to attract
foreign clients. It is often claimed that competition among brokers leads to lower costs and better
prices for new foreign clients than for captive domestic clients. In any case, the automation of all
stock exchanges reduces the risk for any investor of being treated unfairly.
Chapter 9 The Case for International Diversification 111
11. Assume that the domestic and foreign assets have standard deviations of o
d
= 16% and o
f
= 19%,
respectively, with a correlation of
df
= 0.6. The risk-free rate is equal to 5% in both countries.
a. The expected returns of the domestic and foreign assets are both equal to 10%, E(R
d
) = E(R
f
) =
10%. Calculate the Sharpe ratios for the domestic asset, the foreign asset, and an internationally-
diversified portfolio equally invested in the domestic and foreign assets. What do you conclude?
b. Assume now that the expected return on the foreign asset is higher than on the domestic asset,
E(R
d
) = 10% but E(R
f
) =12%. Calculate the Sharpe ratio for an internationally diversified
portfolio equally invested in the domestic and foreign assets, and compare your findings to those
in Question (a).
Solution
a. The domestic asset has an expected return of 10% and a standard deviation of 16%. Its Sharpe
ratio is equal to
Sharpe ratio =
( ) Risk-free rate 10% 5%
0.313.
16%
E R
o

= =
The foreign asset has a Sharpe ratio of
10% 5%
0.263.
19%

=
A portfolio equally invested in the domestic and foreign assets has an expected return of 10%
and a standard deviation o
p
given by:
2 2 2 2
2 2
0.5 (2 )
0.5 [256 361 (2 0.6 15 19)] 245.45.
p d f df d f
p
o o o o o
o
( = + +

= + + =

Hence, the standard deviation o
p
is given by 245.45, or 15.67%. The Sharpe ratio of the
portfolio is equal to:
Sharpe ratio =
( ) Risk-free rate 10% 5%
0.319.
15.67%
E R
o

= =
The foreign asset has a lesser Sharpe ratio than the domestic asset because it has the same
expected return but a larger standard deviation. However, the equally-weighted portfolio benefits
from risk diversification and a lower standard deviation. Hence, its Sharpe ratio is better than the
ratios of both the domestic and the foreign assets.
b. A portfolio equally invested in the domestic and foreign asset now has an expected return of
11% (0.510% + 0.512% = 11%). Hence, the Sharpe ratio is equal to
11% 5%
15.67%
0.383.

= The
portfolios Sharpe ratio is now better than that of the domestic asset (0.313), both because of risk-
diversification benefits and because of the superior expected return of the foreign asset [new
Sharpe ratio of
12% 5%
19%
0.368].

=
12. You consider investing in an emerging market. Its stock market volatility (standard deviation of
returns measured in U.S. dollars) is 25%. The volatility of the World index of developed markets is
15%. The correlation between the emerging market and the World index is 0.2.
a. What would be the volatility of a portfolio invested 95% in the World index and 5% in this
emerging market?
b. Compare the result found in the previous question with the volatility of the World index and give
an intuitive explanation.
112 Solnik/McLeavey Global Investments, Sixth Edition
Solution
a.
world em world em
2 2 2
portfolio
portfolio
(0.95 ) (0.05 .) 2 0.2 0.95 0.05 . 211.75
14.55%.
o o o o o
o
= + + =
=

b. The portfolio has a smaller volatility than the World index. Although we add an asset with high
volatility (25% compared to 15%), the net result is a drop in total volatility. This is because this
new investment has a low correlation with the World index of developed markets. There will be
periods when the world index will experience a negative return while the emerging market will
experience a positive return (and even a large positive return given its high volatility).
13. You consider investing in some emerging country. Its recent economic growth rate is around 7%,
well above the average growth rate of developed countries estimated at 2% by the OECD. Its annual
inflation rate is around 10%, well above the average inflation rate of developed countries estimated at
2% by the OECD. The currency of the emerging country has been depreciating at an annual rate of
around 8% against major currencies. While the volatility of the World stock index (standard deviation
of dollar returns) is around 15%, the stock market of this emerging country has a volatility of 25%.
The correlation of this emerging stock market with the World index is only 0.2.
a. Are the high inflation rate and weak currency sufficient reasons to avoid investing in this
emerging country?
b. Is the high volatility of the local market a sufficient reason to avoid investing in this emerging
country?
c. Suggest why you would consider investing in this emerging country.
Solution
a. The local currency depreciates because of the high local inflation rate (see Chapter 2). According
to purchasing power parity, the currency depreciation is expected to be equal to the inflation
differential between the emerging country and developed countries. But real economic growth is
high. Inflation is not necessarily bad, if stock prices appreciate by the inflation rate plus a real
return commensurate to the local growth rate.
b. The local market volatility is high. But most of it will get diversified away in a globally diversified
portfolio. The contribution of this emerging market to the global portfolio risk will be much
smaller than indicated by its high volatility.
c. This emerging market offers high growth potential, so the contribution to return could be high.
Its low correlation also offers some risk-reduction potential.
14. You have collected some risk and return estimates for various market indexes. These indexes are the
World stock market index of developed markets, the Morgan Stanley Capital International (MSCI)
Europe, Australasia and Far East (EAFE) index, and the International Finance Corporation (IFC)
Composite index of emerging markets. Here are some risk and return estimates for the future:
Market Return Risk
World 10% 16%
EAFE 12% 17%
Composite 15% 25%

Chapter 9 The Case for International Diversification 113
All return and risk measures are calculated in U.S. dollars and are expressed in % per year. The
correlation matrix is given below:
World EAFE Composite
World 1.0 0.5 0.2
EAFE 0.5 1.0 0.1
Composite 0.2 0.1 1.0
a. Calculate the return and risk of a portfolio invested in the following proportions:
Portfolio World EAFE Composite
A 50% 50% 0%
B 45% 45% 10%
C 40% 40% 20%
b. Try to derive some estimate of the efficient frontier obtained by using these three indexes
(no short sales are allowed).
Solution
a. Risk and return:
Portfolio Return% Volatility%
A: 50%World + 50%EAFE 11.00 14.29
B: 45%World + 45%EAFE + 10%Composite 11.40 13.52
C: 40%World + 40%EAFE + 20%Composite 11.80 13.24
b. Efficient frontier:







114 Solnik/McLeavey Global Investments, Sixth Edition
Mean Return Volatility % WORLD % EAFE % Composite
11.76 13.24 42 38 20
11.80 13.24 41 38 21
12.00 13.29 36 41 24
12.20 13.40 30 43 27
12.40 13.59 24 46 30
12.60 13.84 19 49 33
12.80 14.16 13 51 35
13.00 14.53 08 54 38
13.20 14.96 02 56 41
13.40 15.46 00 53 47
13.60 16.16 00 47 53
13.80 17.05 00 40 60
14.00 18.10 00 34 66
14.20 19.28 00 27 73
14.40 20.57 00 20 80
14.60 21.95 00 14 86
14.80 23.40 00 07 93
15.00 25.00 00 00 100
Note: In this table the weights of the efficient portfolios have been rounded to the nearest
percentage point. Mean return and volatility calculations use the exact weights.
15. The currencies of several emerging countries depreciate at a rapid pace. Does it imply that you should
not invest in their stock markets? For example, the Polish zloty went from 15,767 to 21,444 zlotys
per U.S. dollar in 1993. The Polish stock market went from 1,040 to 12,439 during the same period.
Guess why the zloty depreciated.
Solution
No. A rapid depreciation of a currency is generally caused by a rampant inflation. Stocks are claims
on real assets and their prices tend to go up with inflation. The question is whether they go up faster
or slower than the inflation rate?
During 1993, the Polish inflation rate was around 40%, explaining the zlotys depreciation. The
Polish stock market appreciation was extremely high. The privatization program drew enormous
interest in 1992 and 1993. The rise in stock prices was either based on expectations of very high
future economic growth or was somewhat irrational. The 1994 performance of the stock market was
very bad.
16. You consider investing in four very volatile emerging markets. These are small countries just opening
up to foreign investment. You spread your money equally across them. After a year, the following
observations are made on the performance of each market:

Country
Return in
Local Currency
Currency
Depreciation

Comment
A 400% 20% High inflation, high growth
B 60% 10%
C 0 40% High inflation, low growth
D 100% 80% Foreigners got expropriated
Chapter 9 The Case for International Diversification 115
a. Calculate the return, in dollars, on each market. The currency depreciation is equal to the drop in
the dollar value of one unit of local currency. For example, if the peso moves from 1 dollar per
peso to 0.8 dollar per peso, the depreciation of the peso is measured as 20%.
b. What is the return on a portfolio equally invested in each market?
Solution
a. Lets remember the relations linking the dollar and local-currency value of an asset:
V
$
= V S
where V
$
is the dollar value of asset,
V is the local currency value of asset,
S is the exchange rate ($/local currency).
In rate of return form, we have:
$
1 (1 ) (1 ). R R s + = + +
Where R
$
, R, and s are the percentage variations in the above variables.
Then:
Country Dollar Return
A 300%
B 44%
C 40%
D 100%
b. The return on an equal-weighted portfolio is 51%.
17. Project : Take monthly values of the stock indexes of a selected group of developed and emerging
stock markets over a period of ten years.
a. Calculate the correlation of returns among them, in local currency.
b. Break the period into two five-year subperiods and compare the calculated correlations over the
two subperiods.
c. Multiply the stock prices by the exchange rate and calculate the correlation of U.S. dollar returns.
Do the figures change dramatically for developed markets? Do the figures change dramatically
for emerging markets?
d. Focus on emerging markets experiencing high inflation. Why is it important to perform the
calculations using a single-base currency when looking at countries with high inflation from a
foreign viewpoint?

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