Week 10 - International asset allocation

Question 1

Which 2 factors does the return of a foreign security/strategy depend on?

Answer 1

1. Return in foreign exchange rate
2. Return on foreign investment strategy itself

Question 2

Expected dollar return on a foreign asset (formula)

Answer 2

E[r_t] = E[r_t] + E[s_t] + E[r_t s_t]

where r and r* are domestic and foreign returns (need not be risk-free), and s_t is the % change in S_t

Question 3

Dollar variance {of return on a foreign asset} formula

Answer 3

Var[r_t]
= Var[r_t* + s_t + r_t* s_t]
= Var[r_t*] + Var[s_t] + INTERACTION TERMS

What fraction of the return variance is attributed to the…
+ VARIABILITY of the asset return
+ variability of the exchange rate
+ variability of the interaction terms?

Question 4

What is the takeaway from the variance of dollar return on FOREIGN STOCKS & FOREIGN BONDS?

Answer 4

Stock markets across countries are more connected to each other; Bond markets are more separate

• most variability in the return on foreign stocks is explained by ASSET RETURN VARIABILITY, Var(r_t) and not the exchange rate
• dominant risk in foreign bond markets is EXCHANGE RATE VARIABILITY, Var(s_t)

^interaction terms are CLOSE TO ZERO for both foreign stocks & foreign bonds

Question 5

FX risk hedging strategy

*rmb that hedging = minimising risk, NOT maximising returns

Answer 5

1. Sell forward the EXPECTED PAYOFF from the foreign asset at forward price F
2. UNEXPECTED PAYOFF is converted at the SPOT RATE, S_t

[see slides for equation]
» if Expectations Theory is true, FP_t = 0

> > return on hedged portfolio primarily takes into account return on portfolio and not the exchange rate → less risk

Question 6

International asset pricing - Asset prices depend on the level of Market segmentation. What are the 2 types of financial markets?

Answer 6

1. INTEGRATED financial markets
   - no barriers to financial flows
   - asset prices in different countries are determined jointly
2. SEGMENTED financial markets
   - there are various barriers to trade and capital
   - prices are set independent in each national market

• reality is somewhere between these 2 extremes

Question 7

International CAPM (I-CAPM)

What to consider in the case of frictions and PPP violations?

Answer 7

1. explicitly recognises that investors care about returns in their own local currency
2. this implies that the US T-bond is riskless for US investors, but not for German/Japanese {ie. foreign} investors
   -> the new source of risk is the exchange rate risk
3. In the case of frictions and PPP violations, various CURRENCY RISK PREMIA should be added
   » country K relative to UK, eg.
   » [see slides for formula]

Question 8

International diversification benefits - Can we reduce risk?

Answer 8

Yes, portfolios that are diversified internationally tend to have substantially lower standard deviations (reduce total risk of portfolio).

1. Foreign stock markets are imperfectly correlated, implying possible gains from international diversification
2. The LOWER the CORRELATION COEFFICIENT between investments, the greater the benefit of diversification
3. It is possible to expand the EFFICIENT FRONTIER above the domestic only frontier
4. It is possible to reduce the SYSTEMATIC RISK level below the domestic only level

Question 9

What is home bias in investors’ portfolios?
4 potential explanations

[2019, 3m]
[2022, 4m]

Answer 9

Home bias: despite the potential benefits of international portfolio diversification, most
investors tilt their portfolios towards domestic securities
1. Domestic assets used as a hedge against domestic risk.
- Domestic stocks can hedge domestic inflation risk
- banks and insurance companies with domestic liabilities have an incentive to hedge with domestic assets.
2. Market frictions.
- Government controls: limitations on foreign ownership of domestic assets intended to keep capital at home.
- Taxes on cross-border transactions (capital gains, etc.).
- Transaction costs influence informational and allocational efficiency.
3. Unequal access to information due to, eg. time difference, language barrier, etc.
- Difficult to get and interpret information from distant markets
- once invested, it is difficult to monitor the
actions of distant managers.
4. Investor irrationality.
- Individuals prefer investments that are culturally similar and geographically nearby.