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0 10 20 30 40 deviation)
Annualized historical performance data

International Diversification
Should U.S. Investors Hold Foreign Stocks? This question has been debated by invest-
ment advisers and investors alike. In theory, an investor should be able to reduce risk
as long as the investments aren™t perfectly correlated. In a recent article that was pub-
lished by the Federal Reserve Bank of New York, Asani Sarkar and Kai Li investigated
the benefits of international diversification. The article can be found on the bank™s web-
site at http://www.newyorkfed.org/rmaghome/curr_iss/ci8-3.html
After reading this article, address the following questions:
1. What two measures did the authors use to examine the potential benefits of
international diversification?
2. Compare the deletions of stock returns for G7 countries with emerging market
countries. What should that imply about benefits of diversification? Were the
benefits associated with diversification solely due to the ability to short sell? What
is the potential impact of global market integration on diversification benefits?
3. How did the authors investigate the impact of global market integration?

SOLUTIONS TO 1. 1 r (US) [(1 rf (UK)] (E1/E0)

a. 1 r(US) 1.1 1.0 1.10. Therefore, r(US) 10%.

Concept b. 1 r(US) 1.1 1.1 1.21. Therefore, r(US) 21%.
CHECKS 2. According to interest rate parity, F0 should be $1.93. As the futures price is too high, we should
reverse the arbitrage strategy just considered.
Bodie’Kane’Marcus: VI. Active Investment 21. International Investing © The McGraw’Hill
Essentials of Investments, Management Companies, 2003
Fifth Edition

21 International Investing

Cash Flow Cash Flow in
Action Now ($) One Year ($)
Borrow $2 in the United States. $ 2.00 $ 2.00(1.0615)
Convert the borrowed dollars to pounds,
and lend in the United Kingdom at a 10%
interest rate. 2.00 1.10E1
Enter a contract to sell 1.10 pounds at a
E1 )
futures price of $1.95/£. 0.00 1.10(1.95
Total $ 0.00 $0.022

3. You must sell forward the number of pounds you will end up with at the end of the year. This value
cannot be known with certainty, however, unless the rate of return of the pound-denominated
investment is known.
a. 10,000 1.20 12,000 pounds
b. 10,000 1.30 13,000 pounds
4. Country selection:
(0.40 10%) (0.20 5%) (0.40 15%) 11%

This is a loss of 1.5% (11% versus 12.5%) relative to the EAFE passive benchmark.
Currency selection:
(0.40 10%) (0.20 ( 10%)) (0.40 30%) 14%

This is a loss of 6% (14% versus 20%) relative to the EAFE benchmark.

Bodie’Kane’Marcus: Appendixes A. References © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

Appendix A


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