Lecture 3 - International Diversification

Question 1

What does MSCI do?

Answer 1

Investment research firm that provides indicies, portfolio risk and performance analytics

Question 2

3 Types of Markets

Answer 2

1) Developed
2) Emerging
3) Frontier

Question 3

North American Developed Markets

Answer 3

Canada & USA

Question 4

European Developed Markets

Answer 4

UK, Italy, Germany, France, Spain

Question 5

Middle Eastern Developed Markets

Answer 5

Israel

Question 6

APAC Developed Markets

Answer 6

Australia, Japan, Hong Kong, Singapore

Question 7

Emerging Countries Classification

Answer 7

• Undergoing industrialization
• Transitioning into a modern economy with higher standard of living
• Economies growing faster than developed countries
• Higher political risk

Question 8

True or False: Emerging countries do not have a greater risk than developed countries (booms and busts)

Answer 8

False

Question 9

Frontier Market Classification

Answer 9

• Less advanced capital markets
• More established than least developed countries but still less established than emerging markets
• Offer above average returns and low correlations
• Political and economic risk

Question 10

Another term for frontier markets

Answer 10

Pre-emerging markets or the next wave

Question 11

Frontier market countries

Answer 11

Croatia, Serbia, Morocco, Kenya

Question 12

Home Country Bias

Answer 12

Investors underweight foreign equities and primarily hold equities from their home country

Question 13

Reasons for Home Country Bias

Answer 13

• Investor reflects their consumption patterns
• Lack of financial knowledge
• Used to be difficult to invest internationally

Question 14

How to invest internationally

Answer 14

• Purchase multinational corporations
• ADRs
• ETFs

Question 15

ADRs

Answer 15

American Depository Receipts

Question 16

What are ADRs

Answer 16

Certificate issued by the US bank that represents a share in foreign stock (1:1 or 1:5)

Question 17

Where do ADRs trade?

Answer 17

American stock exchanges

Question 18

Issue with international investing

Answer 18

Country risk rating hardly change

Question 19

Major Risks of International Investing

Answer 19

1) FX Risk
2) Political Risk
3) Economic Risk
4) Sovereign/Financial Risk

Question 20

FX Risk

Answer 20

Foreign investments may yield more or less home currency than expected

Question 21

rcan

Answer 21

return on foreign investment in CAD

Question 22

rFM

Answer 22

return on the foreign market in local currency

Question 23

E1

Answer 23

FX Rate at the end of the period

Question 24

E0

Answer 24

FX Rate at the beginning of the period

Question 25

Foreign Exchange Return Formula

Answer 25

(1 + rcan) = (1 + rFM)(E1/E0)

Question 26

How to hedge foreign currency exposure

Answer 26

1) Futures Contracts
2) Forward Contracts

Question 27

Political Risk

Answer 27

Risk that an investment’s returns could suffer as a result of political changes on instability in a country

Question 28

Economic Risk

Answer 28

Country’s ability to pay back its debts

Question 29

Sovereign/Financial Risk

Answer 29

Foreign central bank will alter its fx contracts or risk of imminent default on its bonds

Question 30

What factors does PRS Group use to rank countries?

Answer 30

1) Political Risk
2) Financial Risk
3) Economic Risk

Question 31

Integration

Answer 31

When assets in foreign markets have same risk/return as domestic markets

Question 32

Segmentation

Answer 32

When assets in foreign markets have different risk/return characteristics

Question 33

Factors Causing Segmentation

Answer 33

1) Legal barriers
2) Indirect barriers

Question 34

How to passively diversify your portfolio

Answer 34

Include Country Indexes in order of:

1) Market cap (high to low)
2) Beta against Canada (low to high)
3) Country index standard deviation (high to low)

Question 35

How to actively diversify your portfolio

Answer 35

1) Asset Allocation
2) Security Selection

Question 36

Can U.S. companies with global diversification give you international diversification?

Answer 36

U.S. companies with global operations do offer some international exposure, but not as much as directly investing in foreign stocks.

• U.S. multinationals are still heavily influenced by the U.S. market, so their performance is tied to how the U.S. economy does.
• It’s difficult to know exactly how much of a multinational’s business comes from abroad, making it unclear how much international exposure you really get.
• U.S. companies tend to follow U.S. market trends more closely than foreign stocks, so investing in foreign markets gives better diversification.

Question 37

Suppose a U.S. investor wishes to invest in a British firm currently selling for £40 per share. The investor has $10,000 to invest, and the current exchange rate is $2/£.

How many shares can the investor purchase?

Answer 37

$10,000/2 = 5000 Euros

5000 Euros / 40 Euros = 125 Shares

Question 38

Fill in the table below for rates of return after 1 year in each of the nine scenarios (three possible prices per share in pounds times three possible exchange rates).

Price Per Share (£) Return (%) $1.80/£ $2.00/£ $2.20/£
£35
40
45

Answer 38

1 + r(US) = [(1 + r(UK)] x (E1/E0)

Price Per 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

Question 39

You are a U.S. investor who purchased British securities for £2,000 one year ago when the British pound cost U.S.$1.50. What is your total return (based on U.S. dollars) if the value of the securities is now £2,400 and the pound is worth $1.75? No dividends or interest were paid during this
period.

Answer 39

(1 + rUSD) = (1 + rFM) (E1/E0)
rFM = 2400/2000 -1 = 20%
E1 = 1.75; E0 = 1.50
(1 + rUSD) = (1.20) x (1.75/1.50)
(1 + rUSD) = 1.40 rUSD = 1.40 -1 = .40 = 40%

Question 40

The correlation coefficient between the returns on a broad index of U.S. stocks and the returns on indexes of the stocks of other industrialized countries is mostly ________ , and the correlation coefficient between the returns on various diversified portfolios of U.S. stocks is mostly
________ .

Answer 40

less than .8; greater than .8.

Question 41

An investor in the common stock of companies in a foreign country may wish to hedge against the ________ of the investor’s home currency and can do so by ________ the foreign currency in
the forward market.

Answer 41

appreciation; selling.

Question 42

True or False:

“For an investor holding only developed market equities, the existence of stable emerging market currencies is one of several preconditions necessary for that investor to realize strong
emerging market performance.”

Answer 42

False

Question 43

True or False:

“Local currency depreciation against the dollar has been a frequent occurrence for U.S. investors in emerging markets. U.S. investors have consistently seen large percentages of their
returns erased by currency depreciation. This is true even for long-term investors.”

Answer 43

True

Question 44

True or False:

“Historically, the addition of emerging market stocks to a U.S. equity portfolio such as the S&P 500 index has reduced volatility; volatility has also been reduced when emerging market stocks are combined with an international portfolio such as the MSCI EAFE
index.”

Answer 44

True

Question 45

True or False:

“Although correlations among emerging markets can change over the short term, such correlations show evidence of stability over the long term. Thus, an emerging markets portfolio that
lies on the efficient frontier in one period tends to remain close to the frontier in subsequent
periods.”

Answer 45

False