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Currency
TA B L E 21.14 EAFE Return on Appreciation Manager™s Manager™s
Example of Weight Equity Index E1/E0 1 Weight Return
performance
attribution: Europe 0.30 10% 10% 0.35 8%
international Australia 0.10 5 10 0.10 7
Far East 0.60 15 30 0.55 18
Overall performance (dollar return return on index currency appreciation)
EAFE: .30(10 10) .10(5 10) .60(15 30) 32.5%
Manager: .35(8 10) .10(7 10) .55(18 30) 32.4%
Loss of .10% relative to EAFE
Currency selection
EAFE: (0.30 10%) (0.10 ( 10%)) (0.60 30%) 20% appreciation
Manager: (0.35 10%) (0.10 ( 10%)) (0.55 30%) 19% appreciation
Loss of 1% relative to EAFE
Country selection
EAFE: (0.30 10%) (0.10 5%) (0.60 15%) 12.5%
Manager: (0.35 10%) (0.10 5%) (0.55 15%) 12.25%
Loss of 0.25% relative to EAFE
Stock selection
(8% 10%)0.35 (7% 5%)0.10 (18% 15%)0.55 1.15%
Contribution of 1.15% relative to EAFE
Sum of attributions (equal to overall performance)
Currency ( 1%) country ( .25%) selection (1.15%) .10%



4. Cash/bond selection may be measured as the excess return derived from weighting
cash/bond
bonds and bills differently from some benchmark weights.
selection
Choice between Table 21.14 gives an example of how to measure the contribution of the decisions an inter-
money market versus
national portfolio manager might make.
longer-term bonds.



>
4. Using the data in Table 21.14, compute the manager™s country and currency se-
Concept
lection if portfolio weights had been 40% in Europe, 20% in Australia, and 40% in
CHECK the Far East.
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition




EXCE L Applications www.mhhe.com/bkm


> International Portfolios


This Excel model provides an efficient frontier analysis similar to that in Chapter 6. In Chapter 6
the frontier was based on individual securities, whereas this model examines the returns on inter-
national exchange traded funds. Using the model with return data enables us to analyze the bene-
fits of international diversification.

A B C D E F G H I J
58 Bordered Covariance Matrix for Target Return Portfolio
EWD EWH EWI EWJ EWL EWP EWW SP 500
59
60 Weights 0.00 0.00 0.08 0.38 0.02 0.00 0.00 0.52
61 0.0000 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
62 0.0000 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
63 0.0826 0.00 0.00 4.63 3.21 0.55 0.00 0.00 7.69
64 0.3805 0.00 0.00 3.21 98.41 1.82 0.00 0.00 53.79
65 0.0171 0.00 0.00 0.55 1.82 0.14 0.00 0.00 2.09
66 0.0000 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
67 0.0000 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
68 0.5198 0.00 0.00 7.69 53.79 2.09 0.00 0.00 79.90
69 1.0000 0.00 0.00 16.07 157.23 4.59 0.00 0.00 143.47
70
71 Port Via 321.36
72 Port S.D. 17.93
73 Port Mean 12.00
74
75
76 Weights
EWD EWH EWI EWJ EWL EWP EWW SP 500
77 Mean St. Dev
78 6 21.89 0.02 0.00 0.00 0.71 0.00 0.02 0.00 0.26
79 9 19.66 0.02 0.00 0.02 0.53 0.02 0.00 0.00 0.41
80 12 17.93 0.00 0.00 0.08 0.38 0.02 0.00 0.00 0.52
81 15 16.81 0.00 0.00 0.14 0.22 0.02 0.00 0.00 0.62
82 18 16.46 0.00 0.00 0.19 0.07 0.02 0.00 0.00 0.73
83 21 17.37 0.00 0.00 0.40 0.00 0.00 0.00 0.00 0.60
84 24 21.19 0.00 0.00 0.72 0.00 0.00 0.00 0.00 0.28
85 27 26.05 0.00 0.00 1.00 0.00 0.00 0.00 0.00 0.00
86
87




SUMMARY
• U.S. assets are only a part of the world portfolio. International capital markets offer
important opportunities for portfolio diversification with enhanced risk-return
characteristics.
• Exchange rate risk imparts an extra source of uncertainty to investments denominated in
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foreign currencies. Much of that risk can be hedged in foreign exchange futures or forward
markets, but a perfect hedge is not feasible unless the foreign currency rate of return is
known.
• Several world market indexes can form a basis for passive international investing. Active
international management can be partitioned into currency selection, country selection,
stock selection, and cash/bond selection.




749
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition




750 Part SIX Active Investment Management


KEY cash/bond selection, 748 currency selection, 746 interest rate parity
TERMS country selection, 746 European, Australian, Far relationship, 729
covered interest arbitrage East (EAFE) index, 745 political risk, 731
relationship, 729 exchange rate risk, 727 stock selection, 747
PROBLEM 1. Suppose a U.S. investor wishes to invest in a British firm currently selling for £40 per
SETS share. The investor has $10,000 to invest, and the current exchange rate is $2/£.
a. How many shares can the investor purchase?
b. Fill in the table below for rates of return after one year in each of the nine scenarios
(three possible prices per share in pounds times three possible exchange rates).

Dollar-Denominated Return
for Year-End Exchange Rate

Price per Pound-Denominated
Share (£) Return (%) $1.80/£ $2/£ $2.20/£
£35
£40
£45


c. When is the dollar-denominated return equal to the pound-denominated return?
2. If each of the nine outcomes in problem 1 is equally likely, find the standard deviation
of both the pound- and dollar-denominated rates of return.
3. Now suppose the investor in problem 1 also sells forward £5,000 at a forward exchange
rate of $2.10/£.
a. Recalculate the dollar-denominated returns for each scenario.
b. What happens to the standard deviation of the dollar-denominated return? Compare
it to both its old value and the standard deviation of the pound-denominated return.
4. Calculate the contribution to total performance from currency, country, and stock
selection for the manager in the example below. All exchange rates are expressed as
units of foreign currency that can be purchased with one U.S. dollar.

EAFE Return on Manager™s Manager™s
Weight Equity Index E1/E0 Weight Return
Europe 0.30 20% 0.9 0.35 18%
Australia 0.10 15 1.0 0.15 20
Far East 0.60 25 1.1 0.50 20


5. If the current exchange rate is $1.75/£, the one-year forward exchange rate is $1.85/£,
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and the interest rate on British government bills is 8% per year, what risk-free dollar-
denominated return can be locked in by investing in the British bills?
6. If you were to invest $10,000 in the British bills of problem 5, how would you lock in
the dollar-denominated return?
7. Ren©e Michaels, CFA, plans to invest $1 million in U.S. government cash equivalents
for the next 90 days. Michaels™s client has authorized her to use non-U.S. government
cash equivalents, but only if the currency risk is hedged to U.S. dollars by using forward
currency contracts.
a. Calculate the U.S. dollar value of the hedged investment at the end of 90 days for
each of the two cash equivalents in the table below. Show all calculations.
b. Briefly explain the theory that best accounts for your results.
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition




751
21 International Investing


c. Based upon this theory, estimate the implied interest rate for a 90-day U.S.
government cash equivalent.

Interest Rates
90-Day Cash Equivalents

Japanese government 7.6%
Swiss government 8.6


Exchange Rates
Currency Units per U.S. Dollar
Spot 90-Day Forward
Japanese yen 133.05 133.47
Swiss franc 1.5260 1.5348


8. Suppose that the spot price of the Euro is currently 90 cents. The 1-year futures price is
95 cents. Is the U.S. interest rate higher than the Euro rate?
9. a. The spot price of the British pound is currently $1.50. If the risk-free interest rate
on one-year government bonds is 4% in the United States and 3% in the
United Kingdom, what must the forward price of the pound be for delivery one year
from now?
b. How could an investor make risk-free arbitrage profits if the forward price were
higher than the price you gave in answer to (a)? Give a numerical example.
10. Consider the following information:
rUS 5%
rUK 7%
E0 2.0 dollars per pound
F0 $1.97/£ (one-year delivery)
where the interest rates are annual yields on U.S. or U.K. bills. Given this information:
a. Where would you lend?
b. Where would you borrow?
c. How could you arbitrage?
11. John Irish, CFA, is an independent investment adviser who is assisting Alfred Darwin,
the head of the Investment Committee of General Technology Corporation, to establish
a new pension fund. Darwin asks Irish about international equities and whether the
Investment Committee should consider them as an additional asset for the pension fund.
a. Explain the rationale for including international equities in General™s equity
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portfolio. Identify and describe three relevant considerations in formulating your
answer.
b. List three possible arguments against international equity investment and briefly
discuss the significance of each.
c. To illustrate several aspects of the performance of international securities over time,
Irish shows Darwin the accompanying graph of investment results experienced by a
U.S. pension fund in the recent past. Compare the performance of the U.S. dollar and
non-U.S. dollar equity and fixed-income asset categories, and explain the
significance of the result of the account performance index relative to the results of
the four individual asset class indexes.
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition




752 Part SIX Active Investment Management


Real returns (%)
6

5

4 Account performance index
EAFE index
Non-U.S. $bonds
3
U.S. $bonds
S&P index
2

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