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management judgment?”
c. “Our common stock performance was especially poor for the five-year period.”
d. “Why bother to compare your returns to the return from Treasury bills and the
actuarial assumption rate? What your competition could have earned for us or how
we would have fared if invested in a passive index (which doesn™t charge a fee) are
the only relevant measures of performance.”
e. “Who cares about time-weighted return? If it can™t pay pensions, what good is it!”
Appraise the merits of each of these statements and give counterarguments that Mr. Karl
can use.
12. Historical data suggest the standard deviation of an all-equity strategy is about 5.5% per
month. Suppose the risk-free rate is now 1% per month and market volatility is at its
historical level. What would be a fair monthly fee to a perfect market timer, according
to the Black-Scholes formula?
13. A fund manager scrutinizing the record of two market timers comes up with this
information:

Number of months that rM rf 135
Correctly predicted by timer A 78
Correctly predicted by timer B 86
Number of months that rM rf 92
Correctly predicted by timer A 57
Correctly predicted by timer B 50


a. What are the conditional probabilities, P1 and P2, and the total ability parameters for
www.mhhe.com/bkm




timers A and B?
b. Using the historical data of problem 12, what is a fair monthly fee for the two
timers?
14. A portfolio manager summarizes the input from the macro and micro forecasts in the
following table:
Bodie’Kane’Marcus: VI. Active Investment 20. Performance Evaluation © The McGraw’Hill
Essentials of Investments, Management and Active Portfolio Companies, 2003
Fifth Edition Management




717
20 Performance Evaluation and Active Portfolio Management


Micro Forecasts

Residual Standard
Asset Expected Return (%) Beta Deviation (%)
Stock A 20 1.3 58
Stock B 18 1.8 71
Stock C 17 0.7 60
Stock D 12 1.0 55

Macro Forecasts

Asset Expected Return (%) Standard Deviation (%)
T-bills 8 0
Passive equity portfolio 16 23


a. Calculate expected excess returns, alpha values, and residual variances for these
stocks.
b. Construct the optimal risky portfolio.
c. What is Sharpe™s measure for the optimal portfolio and how much of it is contributed
by the active portfolio? What is the M 2?



WEBMA STER
Analyzing Performance
Go to http://www.morningstar.com/Cover/Funds.html to access the Morningstar Fund
Quick Rank program.
Using this screening program, get a listing of funds that are ranked the highest in
both 5- and 10-year returns. From those lists, select the highest-ranking fund that ap-
pears on both lists. Once you have identified the fund, click on its ticker to get a Morn-
ingstar Quicktake report. Using that report, answer the following questions:
1. What is the fund™s Sharpe ratio?
2. What are the beta and alpha coefficients for both the S&P 500 and the Russell
2000 Index?
3. What are the top three investment sectors in the fund? www.mhhe.com/bkm




SOLUTIONS TO
1. Sharpe: (¯ rf )/

SP (35 6)/42 0.69
< Concept
SM (28 6)/30 0.733
Jensen: r [¯f
¯ r (¯M rf )]
r ¯ CHECKS
35 [6 1.2(28 6)] 2.6%
P
0
M
Treynor: (¯ rf)/

TP (35 6)/1.2 24.2
TM (28 6)/1.0 22
Bodie’Kane’Marcus: VI. Active Investment 20. Performance Evaluation © The McGraw’Hill
Essentials of Investments, Management and Active Portfolio Companies, 2003
Fifth Edition Management




718 Part SIX Active Investment Management


2. Performance attribution
First compute the new bogey performance as
(0.70 5.81) (0.25 1.45) (0.05 0.48) 4.45%
a. Contribution of asset allocation to performance

(1) (2) (3) (4) (5) (3) (4)
Actual Benchmark Index Contribution to
Weight Weight Excess Return Performance
Market in Market in Market Weight (%) (%)
Equity 0.70 0.70 0.00 5.81 0.000
Fixed-income 0.07 0.25 0.18 1.45 .261
Cash 0.23 0.05 0.18 0.48 .086
Contribution of asset allocation .175


b. Contribution of selection to total performance

(1) (2) (3) (4) (5) (3) (4)
Portfolio Index Excess
Performance Performance Performance Portfolio Contribution
Market (%) (%) (%) Weight (%)
Equity 7.28 5.00 2.28 0.70 1.60
Fixed-income 1.89 1.45 0.44 0.07 0.03
Contribution of selection within markets 1.63


3. Beginning-of-period fund: F0 $1
End-of-period fund for each strategy:
16.98 Strategy Bills only
c 1,987.01 Strategy
F1 Market only
115,233.89 Strategy Perfect timing
Number of periods: N 76 years
Annual compounded rate:
F1
rA)N
(1
F0
F1 1/N
¢¤
rA 1
F0
3.80% Strategy Bills only
www.mhhe.com/bkm




c10.51% Strategy
rA Market only
16.57% Strategy Perfect timing
4. The timer will guess bear or bull markets randomly. One-half of all bull markets will be preceded
by a correct forecast, and similarly, one-half of all bear markets will be preceded by a correct
forecast. Hence, P1 P2 1 1/2 1/2 1 0.
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition




21
INTERNATIONAL
INVESTING


AFTER STUDYING THIS CHAPTER
YOU SHOULD BE ABLE TO:


> Demonstrate the advantages of international diversification.


> Formulate hedge strategies to offset the currency risk
involved in international investments.

> Understand international investment strategies.


> Decompose investment returns into contributing factors
such as country, currency, and stock selection.




720
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition




Related Websites http://www.momingstar.com
This site provides information on international, regional,
http://www.adrbny.com
and country funds.
This site includes information on American Depository
http://www.imf.org
Receipts.
This site provides information on international
http://www.site-by-site.com
economics and performance in regions.
The site above has information on all aspects of
http://www.ishares.com
international investing.
This site offers information on international index
http://www.cefa.com
securities that can be used to secure portfolio
This site gives information on international closed-end
diversification.
investment funds.




lthough we in the United States customarily treat the S&P 500 as the market

A index portfolio, this practice is increasingly inappropriate. Equities represent
less than 25% of total U.S. wealth and a much smaller proportion than that of
world wealth. In this chapter, we look beyond domestic markets to survey issues of ex-
tended diversification.
In one sense, international investing may be viewed as no more than a straight-
forward generalization of our earlier treatment of portfolio selection with a larger
menu of assets from which to construct a portfolio. One faces similar issues of diver-
sification, security analysis, security selection, and asset allocation. On the other
hand, international investments pose some problems not encountered in domestic
markets. Among these are the presence of exchange rate risk, restrictions on capital
flows across national boundaries, an added dimension of political risk and country-
specific regulations, and differing accounting practices in different countries.
We begin by looking at market capitalization of stock exchanges around the
world and its relation to the home country GDP Next, we examine exchange rate risk
.
and how such risk can be mitigated by using foreign exchange futures and forward
contracts. We also introduce political and country-specific risk that must be consid-
ered in the overall risk assessment of international investments. We then examine cor-
relation across country portfolios with and without hedging foreign exchange risk.
Based on these insights, we assess the efficacy of investing globally in the context of
equilibrium in international capital markets. Finally, we show how performance attri-
bution procedures can be adapted to an international setting.
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition




722 Part SIX Active Investment Management


21.1 GLOBAL MARKETS FOR EQUITIES
Developed Countries
To appreciate the myopia of an exclusive investment focus on U.S. stocks and bonds, consider
the data in Table 21.1. Developed (high-income) countries are defined as those with per capita
income exceeding $9,300 (in 2000), and their broad stock indexes are generally less risky than
those of emerging markets. The World Bank listed 52 developed countries in 2000, many of
them with very small exchanges. Our list includes 25 countries with the largest equity capi-

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