International Investment and Diversification
ANSWERS TO PROBLEMS
1. $1.00 = G1.4456 ==> $0.6918/G Spot
US T bill = 8.68%
60 day forward rate = $0.7100/G
Forward premium or discount =
=
forward rate - spot rate 12
x x100
spot rate
N
$0.7100  $0.6918 12
x x100
$0.6918
2
= 15.78% premium
Therefore, G interest rate = US rate + premium
= 8.68% + 15.78% = 24.46%
2. Student response.
3. Student response.
4. C$1.00 = $0.75
1% inflation in US ==> US $ will depreciate by 1%
C$1.00 = $0.75(1.01) = $0.7575 ==> $0.76
5. Student response.
6. There are SF 125,000 in one futures contract.
a. In the forward market, sell the principal (and last interest check, if desired)
forward for delivery in 90 days.
b. With futures, sell
SF 1 million
 8 contracts
SF 125,000 per contract
7. Buy SF puts (SF 62,500 per contract)

SF 10 million
 160 contracts
SF 62,500
International Investment and Diversification
or write deep in the money calls (or a mixture of long puts and short calls)
8. Forward premium or discount =
¥135.90 - ¥ 136.15 12
x x100  0.37%
¥136.15
6
If the Japanese rate is 8%, the US rate should be 8.00% + 0.37% = 8.37%
Therefore, the markets are not in equilibrium.
9. CFA Guideline Answer (reprinted with permission from the CFA Study Guide,
Association for Investment Management and Research, Charlottesville, VA. All
Rights Reserved.
A. The following briefly describes one strength and one weakness of each manager.
1. Manager A
Strength. Although Manager A’s one-year total return was slightly below
the EAFE Index return (-6.0 percent versus –5.0 percent, respectively), this
manager apparently has some country/security return expertise. This large
local market return advantage of 2.0 percent exceeds the 0.2 percent return
for the EAFE Index.
Weakness. Manager A has an obvious weakness in the currency
management area. This manager experienced a marked currency return
shortfall compared with the EAFE Index of 8.0 percent versus –5.2 percent,
respectively.
2. Manager B
Strength. Manager B’s total return slightly exceeded that of the index,
with a marked positive increment apparent in the currency return. Manager
B had a –1.0 percent currency return versus a –5.2 percent currency return
on the EAFE index. Based on this outcome, Manager B’s strength appears
to be some expertise in the currency selection area.
Weakness. Manager B had a marked shortfall in local market return.
Manager B’s country/security return was –1.0 percent versus 0.2 percent on
the EAFE Index. Therefore, Manager B appears to be weak in
security/market selection ability.
B. The following strategies would enable the Fund to take advantage of the strengths
of the two managers and simultaneously minimize their weaknesses.
International Investment and Diversification
1. Recommendation: One strategy would be to direct Manager A to make no
currency bets relative to the EAFE Index and to direct Manager B to make
only currency decisions, and no active country or security selection bets.
Justification: This strategy would mitigate Manager A’s weakness by
hedging all currency exposures into index-like weights. This would allow
capture of Manager A’s country and stock selection skills while avoiding
losses from poor currency management. This strategy would also mitigate
Manager B’s weakness, leaving an index-like portfolio construct and
capitalizing on the apparent skill in currency management.
2. Recommendation: Another strategy would be to combine the portfolios of
Manager A and Manager B, with Manager A making country exposure and
security selection decisions and Manager B managing the currency
exposures created by Manager A’s decisions (providing a “currency
overlay”).
Justification: This recommendation would capture the strengths of both
Manager A and Manager B and would minimize their collective
weaknesses.
C. Expected Return
Return Premium
Currency Premium
Germany
6% - 4% = 2%
2% + 4% = 6%
Japan
7% - 6% = 1%
-1% + 6% = 5%
United States
8% - 7% = 1%
7%
or
Green
Advisor
Japan
Local
7% +
DM
Exchange
2% +
DM
Yield
(4% -
Yen
Yield
6%) =
7%
German
Local
6% +
U.S.
Exchange
0% +
U.S.
Yield
(7% -
DM
Yield
4%) =
9%
 Complete return includes the return on the local market, the expected return on
currency, and the cost/benefit of holding that currency.
 The cost is the differential of the respective one-year Eurodeposit yields.
 Green forgot to include the cost of holding currency in his assessment.
International Investment and Diversification
D. The following describes a strategy for temporarily hedging away both the local
market risk and the currency risk of investing in Japanese stocks. If Green had a
$200,000 position in Japan, the strategy would be to sell futures to offset that
amount or to buy put options in the offset amount, thereby creating the necessary
delta hedge on the market. Then, $200,000 in Yen currency futures would be sold
to hedge the currency exposure, or put options on the Yen bought to provide the
desired delta hedge.
E. The hedge strategy described in Part D might not be fully effective for the
following reasons:
1. The options could expire before the expected correction took place.
2. The delta of the options constantly changes and, therefore, does not provide
a perfectly symmetrical hedge.
3. The action involves costs in the form of the option premia. Repeated
rollovers would be especially costly.
4. The contract size available on the listing exchange may be too large or may
not readily match the size of Green’s position.
5. Counterparty failure is an added risk.
6. The hedge vehicle may not match the underlying asset.
7. Fluctuation in the underlying capital value of the asset, or uncertainty of
cash flows from the asset, may result in over- or underhedging.
8. Occasional mispricing of the futures price relative to the spot price may
result in tracking error.
10. CFA Guideline Answer (reprinted with permission from the CFA Study Guide,
Association for Investment Management and Research, Charlottesville, VA. All
Rights Reserved.
A.
The consultant is alluding to the behavior of cross-country equity return
correlations during different market phases, as reported in various research
studies. Specifically, the consultant is referring to the fact that correlations in
down markets tend to be significantly higher than correlations in up markets. In
other words, equity markets appear to be more correlated when they are falling
than when they are rising.
One of the reasons why investors invest in equity markets abroad is to reduce
the risk of large losses. That is, when the domestic market is expected to fall,
some other market may be expected to rise, thus reducing the impact of price
declines in the overall equity portfolio. Unfortunately, the evidence referred to
above suggests that global equity investing may not prove to be very helpful in
terms of avoiding large losses in the total equity portfolio (i.e., when protection
is needed the most). If markets are highly correlated when they are falling, then
International Investment and Diversification
it will be unlikely for foreign equity markets to rise when the U.S. market is
expected to fall. In such a situation, benefits from international diversification
are likely to be substantially reduced. The implication is that in the short run,
average historical correlations will overestimate investment performance if the
equity markets happen to be in a down-market phase.
B.
Although cross-country equity return correlations can vary significantly in the
short run, they remain surprisingly low when measured over long periods of
time. This implies that, from a policy standpoint, international investing still
offers the potential to construct more efficient portfolios, in a risk-return tradeoff sense, than ones constructed using domestic assets only. This is so because
global investing has the potential to reduce risk without sacrificing returns, even
with adverse short-run outcomes.
For example, Odier and Solnik show that the average correlation of the U.S.
equity market with 16 other equity markets was only slightly higher than the
correlation of U.S. stocks with U.S. bonds. Yet research on past data shows the
potential for achieving higher returns is much larger with 16 foreign stock
markets than with U.S. bonds.
C.
Appreciation of a foreign currency will, indeed, increase the dollar returns that
accrue to a U.S. investor. However, the amount of the expected appreciation
must be compared with the forward premium or discount on that currency in
order to determine whether hedging should be undertaken or not.
In the present example, the yen is forecast to appreciate from 100 to 98 (or 2
percent) by the manager. However, the forward premium on the yen, as given
by the differential in one-year eurocurrency rates, suggests an appreciation of
over 5 percent, as shown below:
Forward premium = (1 + one-year eurodollar rate)/(1 + one-year euroyen rate)
= (1 + 0.06)/(1 + 0.008)
= 1.0516 or 5.16 percent
Thus, the manager’s strategy to leave the yen position unhedged is not an
appropriate one. The manager should, in fact, hedge because by doing so, a
higher rate of yen appreciation can be locked in. Given the one-year
eurocurrency rate differentials, the yen position should be left unhedged only if
the yen is forecast to appreciate to over 95 yen per U.S. dollar.
International Investment and Diversification