Chapter Seven
International Investment and Diversification
KEY POINTS
Diversifying internationally makes sense because the evidence shows that doing so can
reduce the level of risk in a portfolio. Replication of the Evans and Archer study results
in a lower level of undiversifiable risk when the security universe includes international
securities. The reason that international stocks lower the level of undiversifiable risk is
that international markets and the U.S. market are less than perfectly correlated. This is
an application of the concepts in Chapters 5 and 6. There are, however, additional risks
associated with international investments.
Because foreign securities are denominated in a currency other than dollars, the
international investor faces foreign exchange risk: there is a chance of loss due to
changing currency values. Foreign exchange rates are partially determined by relative
interest rates and inflation rates among the world's countries.
The extent to which someone faces foreign exchange risk is called exposure. Exposure
can be hedged via the futures market, the forward market, or the options market.
Political risk is another dimension of risk that concerns the international investor. It
stems from changes in the political environment in which a firm conducts its business.
While it is possible to invest directly in foreign securities, many investors find the
purchase of ADRs or international mutual funds a simpler alternative.
TEACHING CONSIDERATIONS
Not all students will be able to take a course in international business or international
finance. This chapter covers several principal topics contained in such a course.
From a portfolio perspective, the main teaching point here is the diversification benefit
which empirical research shows is available through the addition of foreign securities to a
portfolio. From an “education of the business student” perspective, the new sources of
risk (foreign exchange and political) are key points.
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Chapter Seven
International Investment and Diversification
ANSWERS TO QUESTIONS
1. Ideally, the decision to invest internationally is based on some analytics. In practice,
the decision is usually a subjective one based on qualitative rather than quantitative
factors. Some firms, though, do view international securities as a separate asset class.
If this is the case, it is not clear the concept of superfluous diversification is relevant.
2. Many world exchanges have fewer securities and fewer industry effects. This means
the existing securities tend to move together, or that a given security contributes
heavily to the total “market” performance.
3. Capital constraints keep many people from diversifying properly. Mutual funds could
be used for this purpose, but some people feel they are “not exciting.” It is likely that
many people are unfamiliar with the ease with which many foreign securities can be
acquired.
4. When all the players are of equal caliber, there may be some truth to this statement.
Often, however, the U. S. dollar rises or falls against most of the rest of the world
currencies simultaneously.
5. A succession of short-term hedges is usually more expensive than a single long-term
hedge. You do have more flexibility in a sense, but you pay for it.
6. An increase in inflation results in an upward adjustment in the level of interest rates.
If both countries experience an equal increase in inflation and everything else remains
constant, it is likely that the relative exchange rate would not change.
7. Economic exposure results in an actual dollar change in the performance of an
investment. Accounting exposure is of concern to a multinational corporation that
must prepare consolidated financial statements.
8. Yes. Congress could easily change the rules regarding tariffs, withholding taxes, or
tax credits.
9. Political risk is sometimes partially insurable through an insurance company. It
generally cannot be hedged with a normal financial instrument.
10. Financial investment, as this is associated with securities.
11. Investor A, because the greatest diversification benefits occur with the early additions
to a portfolio.
12. Probably micro risk.
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Chapter Seven
International Investment and Diversification
13. ADRs enable you to trade foreign securities on a U. S. exchange quickly through a
U.S. brokerage firm.
14. First check the Weissenberger and Morningstar services to see if it happened to be
listed. You also could check the Wall Street Journal index. If you had no luck here
the best bet, frankly, is to ask for help from your local reference librarian. Most
libraries have some information regarding foreign securities.
15. The currency forward market is not designed as a speculative arena. Forward
contracts are purely hedging devices. You do not expect to "make money" in them.
16. They could easily be included in the equity portion.
17. Some type of goal programming, regression, or linear programming model could be
used to identify securities that meet certain criteria or offer the "best" package of
predetermined characteristics. A business climate index, being a numerical measure,
could easily be incorporated.
18. Yes. Changes in relative foreign exchange rates will still affect the value of the
security underlying the ADR
19. Some Wall Street firms are currently advertising international fixed income products,
but it is not immediately obvious what role these have in a diversification sense.
20. Lack of liquidity could prevent institutional investors from entering the market. The
large trades institutional investors typically make would likely have a significant price
impact and result in higher total trading costs. Individual investors, who trade in
much smaller lots, would not experience these costs. The absence of institutional
traders means the individual investor might be able to exploit inefficiencies that the
larger traders cannot.
ANSWERS TO PROBLEMS
1. $1.00 = G1.4456 ==> $0.6918/G Spot
US T bill = 8.68%
60 day forward rate = $0.7100/G
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Chapter Seven
International Investment and Diversification
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
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%
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Chapter Seven
International Investment and Diversification
Therefore, the markets are not in equilibrium.
9. CFA Guideline Answer (reprinted with permission from the CFA Study Guide,
CFA Institute, 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.
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
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Chapter Seven
International Investment and Diversification
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 Euro deposit yields.
 Green forgot to include the cost of holding currency in his assessment.
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.
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Chapter Seven
International Investment and Diversification
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 under hedging.
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, CFA
Institute, 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
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.
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Chapter Seven
B.
International Investment and Diversification
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.
11. CFA Guideline Answer (reprinted with permission from the CFA Study Guide, CFA
Institute, Charlottesville, VA. All Rights Reserved).
A. i. To eliminate the currency risk arising from the possibility that the ZAR will
appreciate against the CHF over the next 30-day period, Omni should sell 30day forward CHF against 30-day forward ZAR delivery (sell 30-day forward
CHF against USD and buy 30-day forward ZAR against USD).
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Chapter Seven
International Investment and Diversification
ii. The calculations are as follows:
(1) Using the currency cross rates of two forward foreign currencies and three
currencies (CHF, ZAR, USD), the exchange would be made as follows:
 30 day forward CHF are sold for USD. Dollars are bought at the
forward selling price of CHF 1.5285 = $1 (done at the ask side
because going from currency into dollars)
 30 day forward ZAR are purchased for USD. Dollars are
simultaneously sold to purchase ZAR at a rate of 6.2538 = $1
(done at the bid side because going from dollars into currency)
 For every 1.5285 CHF/6.2538 ZAR are received; thus the cross
currency rate is 1.5285 CHF/6.2538 ZAR = 0.244411398.
(2) At the time of execution of the forward contracts, the value of the 3 million
CHF equity portfolio would be 3,000,000 CHF/0.244411398 =
12,274,386.65 ZAR.
(3) To calculate the annualized premium or discount of the ZAR against the
CHF requires comparison of the spot selling exchange rate to the forward
selling price of CHF for ZAR.
Spot rate = 1.5343 CHF/6.2681 ZAR = 0.24477912
30 day forward ask rate 1.5285 CHF/6.2538 ZAR = 0.244411
The premium/discount formula is:
[(forward rate – spot rate)/spot rate]  (360/# day contract) =
[(0.244411398 – 0.24477912]  (360/30) =
-1.8027125% = -1.80% discount ZAR to CHF
B. i. Purchasing power parity (PPP) states that exchange rates should change
to offset differences in inflation rates. The PPP formula is:
et = e0  [(1+ih)t / (1+if)t ]
where:
et = spot exchange rate in period t, or the PPP rate
e0 = dollar (home currency) value of one unit of foreign
currency at the begining of the period (base period)
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Chapter Seven
International Investment and Diversification
ih = price level or inflation in home country
if = price level or inflation in foreign country
Relative price levels now, which reflect past inflation rates, are used to
calculate current PPP spot rates that would have been expected now;
relative rates of inflation (price level increases) are used to forecast
future spot PPP rates.
Thus the implied current ZAR exchange rate, using current price levels
from Exhibit 31-2, that would have been forecast by PPP is:
Current ZAR estimated spot rate (PPP) =
=
=
=
$0.175  (105 / 115)
$0.175  (0.9130)
$0.1598
$0.160
ii. The International Fisher Effect (IFE) states that currency exchange rates
can be forecast using current spot exchange rates and expected interest
rates.
Forecast 1-year ZAR (IFE) = Current ZAR spot rate  (IRUS/IRSA)
Where:
IRUS = expected 1-year U.S. interest rate
IRSA = expected 1-year South African interest rate
Forecast 1-year ZAR (IFE)
=
=
=
=
$0.158  (1.10 / 1.08)
$0.158  1.0185
$0.1609
$0.161
iii. Using PPP to forecast a future expected ZAR spot rate requires using
the current ZAR spot rate and expected relative inflation rates, as
follows:
Forecast 4-year ZAR (PPP)
64
=
=
=
=
=
$0.158  (1.07/1.05)4
$0.158  1.0194
$0.158 1.0784
$0.1704
$0.170