International asset allocation

Question 1

Why do we care about global investment?>

Answer 1

1) larger range of risk-return choices
2) Barriers for global investment are reducing.
3) Diversification reduces portfolio risk.

Question 2

What is total return on foreign assets? ( its different from domestic owns we calculated earlier in the pack)?

Answer 2

Total return on foreign assets is determined by both the investment return and movement in exchange rates.
It is often not possible to completely hedge a foreign investment against the exchange rate risk.

Question 3

The US investor cares about return evaluated in US dollars, so lets say the investors converts pounds into dollars, lets say the pound depreciates to $1.80 a year later , the pound remains at $2.00 a year later and the pound appreciates to $2.20 a year later work out the return in dollars and as a percentage? What does this show ?

Answer 3

So movements in Fx can have large effects, thus investors must consider return and exchange rate.

Question 4

Lets sat the the home country is the us ( currency dollar), what is the expected dollar return on a foreign asset?

Answer 4

Expected return in foreign country valued in foreign currency evaluated in units of foreign currency + expected return change in currency + expectation of the intereaction term.

Question 5

Lets sat the the home country is the us ( currency dollar), what is the dollar variance?

Answer 5

Variance of our investment = variance of the foreign investment evaluated in units of foreign currency + variance of the fluctuation in exchange rate + variance of interaction terms. ( these terms not usually important)

Question 6

Analyse this? the variance of returns in the foreign country when the return is evaluated in units of foreign currency ( different countries on the 1st column? what can we see? Btw for simplicity we have normalised the dollar variance to 1.

Answer 6

The main source of risk comes from variation in terms in this country ( same thing for return in domestic country, it is the only source)

Question 7

Analyse this looking at bonds

Answer 7

the variance in exchange rates contributes a lot of the overall riskiness of the investment.

Question 8

What risks should investors be taking into account when they invest In foreign countries, this is important as it will affect the variance of exchange rates and variance of returns in foreign countries? ( don’t like to learn but you should know some of them )

Answer 8

Also there are international informational risk ( e.g. different legal systems, language barriers too)

Question 9

What is a way of reducing our international exchange rate risk when we invest internationally/ can we reduce our exposure to FX risks? and what is a caveat of this using US dollars as a foreign currency example.?

Answer 9

Buy and sell currency forwards would be a natural way to do this. However when investing in foreign assets like US stocks, the returns are uncertain and can vary over time. You cannot predict exactly how many US dollars you will have in a year due to factors like market fluctuations and the stock’s performance. As a result, it becomes more challenging to use forward contracts to hedge against foreign exchange risk, because you can’t accurately predict the amount of foreign currency you’ll need to exchange in the future.

Question 10

Consider this, now what is the difference component of price here? what can investors hedge and not hedge?

Answer 10

realised price = Expected foreign currency payoff + unexpected foreign currency payoff. Investors can hedge the expected payoff ( they can calculate this and hedge using buying or selling forwards) but the unexpected payoff e unexpected portion of a foreign investment’s payoff must be exchanged at the future spot rate because the forward contract only covers the initial expected amount. Any unanticipated gains or losses are not included in the contract and must be converted at the prevailing market rate upon maturity or conversion.

Question 11

FJF

Answer 11

FHF

Question 12

What are integrated financial markets and what are segmented financial markets? What do asset prices depend on?

Answer 12

Integrated financial markets = there are no barriers to financial flows, asset prices in different countries are determined jointly

Segmented financial markets = prices are set independently in each national market due to factors like differing regulation, capital flow restrictions extra.

Asset prices depend on the level of market segmentation.

Question 13

Why is it important to think about segmentation?

Answer 13

Market segmentation affects the measurement of systematic risk.

In fully integrated markets, systematic risk is measured against the entire market, considering global risk factors.

In completely segmented markets, with no cross-market trading opportunities, systematic risk is measured against the local market portfolio, as it is the primary source of risk for investors.

Question 14

What is international CAPM ( determines how returns are determined) ?

Answer 14

The CAPM assumes investors only invest domestically, while the ICAPM accounts for international investments and associated risks, like foreign exchange and varying market conditions.

Question 15

What is a caveat of a global investor investing in other countries?

Answer 15

For a Us investor where government bonds are based in the Us, it is virtually riskless for them but if your a foreign investor even if you invest in US bonds, you will face risk due to exchange rate. Hence, for the investor we are looking at we need to convert their currency in their home currency.

Question 16

In absence of cross - border frictions, CAPM is given by? Do investors only hold domestic bonds?

Answer 16

The market portfolio M here includes all risky assets in the market world weighted according to their market values under the same numeraire.

Investors hold foreign bonds are risky because of FX risk.

Question 17

Based on tests of ICAPM, how are assets priced?

Answer 17

Financial markets are becoming more integrated through technology, capital flow liberalization, and globalization. This enables investors to diversify portfolios globally.

Question 18

can we reduce risk through international diversification?

International investing can lower systematic risk compared to domestic-only investing true or false?

Answer 18

Foreign stock markets are imperfectly correlated, implying possible gains from international diversification. We can also expand the efficient frontier above the domestic frontier.

International investing can lower systematic risk compared to domestic-only investing by diversifying across assets from different countries, which have distinct market risk factors and lower correlations, thus reducing overall portfolio risk while potentially enhancing returns.

Question 19

Suppose that Us is completely isolated so their efficient frontier is the dashed pink line, now suppose borders are now fricitonless, explain how this shows benefit of investing globally?

Answer 19

The efficient frontier has expanded, meaning US investor can have higher level of return for the same level of risk .

Question 20

What is the fixed income investment of euro bond?
What is a Yankee bond?

Answer 20

Eurobond = is a bond issued in a currency other than the currency of the country where it is sold, e.g. Italy issues bond, not determined in euros but in dollars.

Yankee bond = A bond demanated in US dollars, sold in US, but issued by foreign government.

Question 21

What is American depository receipts?

Answer 21

ADRs are certificates issued by US banks that enable US investors to invest in foreign companies without buying shares on foreign stock exchanges. ADRs represent shares in foreign companies and can be traded on US markets like regular stocks, providing an easy way for US investors to access foreign markets.

Question 22

So far the implication of our studies is that investors should be holding diversified as it gives diversification benefits and better returns but suprinsgly, this is not what investors are doing, why?

Answer 22

Home bias = to the tendency of investors to favor domestic investments over foreign investments, even when the foreign investments may offer better returns or diversification benefits.

Question 23

What are 4 factors that determine home bias?

Answer 23

1) Domestic assets used as a hedge against domestic risk
2) Market frictions
3) Unequal access to information
4) Investor irrationality.

Question 24

What do the first 2 mean
1) Domestic assets used as a hedge against domestic risk
2) Market frictions

Answer 24

1) Banks and insurance companies with domestic liabilities have an incentive to hedge with domestic assets. e,,g pension funds and insurance companies hedge themselves.
2) Investing in foreign markets can be costly due to transaction costs, currency exchange fees, and other barriers that make it less appealing for investors to invest in foreign assets.

Question 25

What are these 2 about?
3) Unequal access to information
4) Investor irrationality. what empirical evidence do we have to support this one?

Answer 25

Unequal access to information makes investors feel more confident investing in local assets due to better understanding of the domestic economy and companies. ( asymmetric information)

Investor irrationality, including biases such as overconfidence and familiarity, can lead to suboptimal decisions and a preference for domestic assets over foreign ones. Cohen (2009) reports that employees tend to overweight own company stocks in their personal portfolios.

Question 26

What is the formulas ( similar to performance attribution of stocks ) ? contribution to total performance from currency, country, and stock selection for the manager

Answer 26

E = the change in the currency exchange rate between the base currency and the currency being evaluated

Question 27

Answer 27

Question 28

Do a check on your answers?

Answer 28