Chapter 25 - International Diversification

Chapter 25
International Diversification
Multiple Choice Questions
1. Shares of several foreign firms are traded in the U.S. markets in the form of
A. ADRs
B. ECUs
C. single-country funds
D. all of the above
E. none of the above
American Depository Receipts (ADRs) allow U.S. investors to invest in foreign stocks via
transactions on the U.S. stock exchanges.

Difficulty: Easy

2. __________ refers to the possibility of expropriation of assets, changes in tax policy, and
the possibility of restrictions on foreign exchange transactions.
A. default risk
B. foreign exchange risk
C. market risk
D. political risk
E. none of the above
All of the above factors are political in nature, and thus are examples of political risk.

Difficulty: Easy

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3. __________ are mutual funds that invest in one country only.

A. ADRs
B. ECUs
C. single-country funds
D. all of the above
E. none of the above
Mutual funds that invest in the stocks of one country only are called single-country funds.

Difficulty: Easy

4. The performance of an internationally diversified portfolio may be affected by

A. country selection
B. currency selection
C. stock selection
D. all of the above
E. none of the above
All of the above factors may affect the performance of an international portfolio.

Difficulty: Easy

5. Over the period 2001-2005, most correlations between the U.S. stock index and stock-index
portfolios of other countries were
A. negative
B. positive but less than .9
C. approximately zero
D. .9 or above
E. none of the above
Correlation coefficients were typically below .9, while correlations between well-diversified
U.S. market portfolios were typically above .9. See Table 25.10.

Difficulty: Moderate

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6. The __________ index is a widely used index of non-U.S. stocks.

A. CBOE
B. Dow Jones
C. EAFE
D. all of the above
E. none of the above
The Europe, Australia, Far East (EAFE) index computed by Morgan Stanley is a widely used
index of non-U.S. stocks.

Difficulty: Easy

7. The __________ equity market had the highest average local currency return between 2001
and 2005.
A. Columbian
B. Norwegian
C. U.K.
D. U.S.
E. none of the above
See Table 25.9.

Difficulty: Moderate

8. The developed country with the highest average local-currency equity-market return
between 2001 and 2005 is
A. Japan
B. Korea
C. U.K.
D. U.S.
E. none of the above
See Table 25.9.

Difficulty: Moderate

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9. The emerging market country with the highest average local-currency equity-market return
between 2001 and 2005 is
A. China
B. Columbia
C. Poland.
D. Turkey
E. none of the above
See Table 25.9.

Difficulty: Moderate

10. The __________ equity market had the highest average U.S. dollar return between 2001
and 2005.
A. Russian
B. Finnish
C. Columbian
D. U.S.
E. none of the above
See Table 25.9.

Difficulty: Moderate

11. The developed country with the highest average U.S. dollar equity-market return between
2001 and 2005 is
A. Japan
B. Korea
C. Austria.
D. U.S.
E. none of the above
See Table 25.9.

Difficulty: Moderate

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12. The emerging market country with the highest average U.S. dollar equity-market return
between 2001 and 2005 is
A. China
B. Russia
C. Poland.
D. Turkey
E. none of the above
See Table 25.9.

Difficulty: Moderate

13. The __________ equity market had the lowest average local currency return between
2001 and 2005.
A. Columbian
B. China
C. U.K.
D. U.S.
E. none of the above
See Table 25.9.

Difficulty: Moderate

14. The developed country with the lowest average local-currency equity-market return
between 2001 and 2005 is
A. Finland
B. Korea
C. U.K.
D. U.S.
E. none of the above
See Table 25.9.

Difficulty: Moderate

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15. The emerging market country with the lowest average local-currency equity-market return
between 2001 and 2005 is
A. China
B. Columbia
C. Poland.
D. Turkey
E. none of the above
See Table 25.9.

Difficulty: Moderate

16. The __________ equity market had the lowest average U.S. dollar return between 2001
and 2005.
A. Russian
B. Finnish
C. Columbian
D. U.S.
E. none of the above
See Table 25.9.

Difficulty: Moderate

17. The developed country with the lowest average U.S. dollar equity-market return between
2001 and 2005 is
A. Japan
B. Korea
C. Austria.
D. U.S.
E. none of the above
See Table 25.9.

Difficulty: Moderate

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18. The emerging market country with the lowest average U.S. dollar equity-market return
between 2001 and 2005 is
A. China
B. Russia
C. Poland.
D. Argentina
E. none of the above
See Table 25.9.

Difficulty: Moderate

19. The __________ equity market had the highest average U.S. dollar standard deviation
between 2001 and 2005.
A. Turkish
B. Finnish
C. Indonesian
D. U.S.
E. none of the above
See Table 25.9.

Difficulty: Moderate

20. The __________ equity market had the lowest average U.S. dollar standard deviation
between 2001 and 2005.
A. Turkish
B. U.S.
C. Indonesian
D. U.K.
E. none of the above
See Table 25.9.

Difficulty: Moderate

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21. The __________ equity market had the highest average local currency standard deviation
between 2001 and 2005.
A. Turkish
B. Finnish
C. Indonesian
D. U.S.
E. none of the above
See Table 25.9.

Difficulty: Moderate

22. The __________ equity market had the lowest average local currency standard deviation
between 2001 and 2005.
A. Turkish
B. Finnish
C. Indonesian
D. Australia
E. none of the above
See Table 25.9.

Difficulty: Moderate

23. In 2005, the U.S. equity market represented __________ of the world equity market.
A. 19%
B. 60%
C. 43%
D. 39%
E. none of the above
See Table 25.1.

Difficulty: Moderate

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24. The straightforward generalization of the simple CAPM to international stocks is

problematic because __________.
A. inflation risk perceptions by different investors in different countries will differ as
consumption baskets differ
B. investors in different countries view exchange rate risk from the perspective of different
domestic currencies
C. taxes, transaction costs and capital barriers across countries make it difficult for investor to
hold a world index portfolio
D. all of the above
E. none of the above.
All of the above factors make a broad generalization of the CAPM to international stocks
problematic.

Difficulty: Moderate

25. The yield on a 1-year bill in the U.K. is 8% and the present exchange rate is 1 pound =
U.S. $1.60. If you expect the exchange rate to be 1 pound - U.S. $1.50 a year from now, the
return a U.S. investor can expect to earn by investing in U.K. bills is
A. -6.7%
B. 0%
C. 8%
D. 1.25%
E. none of the above
r(US) = [1 + r(UK)]F0/E0 - 1; [1.08][1.50/1.60] - 1 = 1.25%.

Difficulty: Moderate

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26. Suppose the 1-year risk-free rate of return in the U.S. is 5%. The current exchange rate is
1 pound = U.S. $1.60. The 1-year forward rate is 1 pound = $1.57. What is the minimum yield
on a 1-year risk-free security in Britain that would induce a U.S. investor to invest in the
British security?
A. 2.44%
B. 2.50%
C. 7.00%
D. 7.62%
E. none of the above
1.05 = (1 + r) X [1.57/1.60] - 1; r = 7.0%.

Difficulty: Moderate

27. The interest rate on a 1-year Canadian security is 8%. The current exchange rate is C$ =
US $0.78. The 1-year forward rate is C$ = US $0.76. The return (denominated in U.S. $) that
a U.S. investor can earn by investing in the Canadian security is __________.
A. 3.59%
B. 4.00%
C. 5.23%
D. 8.46%
E. none of the above
1.08[0.76/0.78] = x - 1; x = 5.23%.

Difficulty: Moderate

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28. Suppose the 1-year risk-free rate of return in the U.S. is 4% and the 1-year risk-free rate of
return in Britain is 7%. The current exchange rate is 1 pound = U.S. $1.65. A 1-year future
exchange rate of __________ for the pound would make a U.S. investor indifferent between
investing in the U.S. security and investing the British security.
A. 1.6037
B. 2.0411
C. 1.7500
D. 2.3369
E. none of the above
1.04/1.07 = x/1.65; x = 1.6037.

Difficulty: Moderate

29. The present exchange rate is C$ = U.S. $0.78. The one year future rate is C$ = U.S. $0.76.
The yield on a 1-year U.S. bill is 4%. A yield of __________ on a 1-year __________
Canadian bill will make investor indifferent between investing in the U.S. bill and the
Canadian bill.
A. 2.4%
B. 1.3%
C. 6.4%
D. 6.7%
E. none of the above
1.04 = [($0.76/$0.78)(1 + r)] - 1; r = 6.7%.

Difficulty: Moderate

Assume there is a fixed exchange rate between the Canadian and U.S. dollar. The expected
return and standard deviation of return on the U.S. stock market are 18% and 15%,
respectively. The expected return and standard deviation on the Canadian stock market are
13% and 20%, respectively. The covariance of returns between the U.S. and Canadian stock
markets is 1.5%.

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30. If you invested 50% of your money in the Canadian stock market and 50% in the U.S.
stock market, the expected return on your portfolio would be __________.
A. 12.0%
B. 12.5%
C. 13.0%
D. 15.5%
E. none of the above
18% (0.5) + 13%(0.5) = 15.5%.

Difficulty: Moderate

31. If you invested 50% of your money in the Canadian stock market and 50% in the U.S.
stock market, the standard deviation of return of your portfolio would be __________.
A. 12.53%
B. 15.21%
C. 17.50%
D. 18.75%
E. none of the above
sP = [(0.5)2(15%)2 + (0.5)2(20%)2 + 2(0.5)(0.5)(1.5)]1/2 = 12.53%.

Difficulty: Difficult

32. The major concern that has been raised with respect to the weighting of countries within
the EAFE index is
A. currency volatilities are not considered in the weighting.
B. cross-correlations are not considered in the weighting.
C. inflation is not represented in the weighting.
D. the weights are not proportional to the asset bases of the respective countries.
E. none of the above
Some argue that countries should be weighted in proportion to their GDP to properly adjust
for the true size of their corporate sectors, since many firms are not publicly traded.

Difficulty: Moderate

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33. You are a U.S. investor who purchased British securities for 2,000 pounds one year ago
when the British pound cost $1.50. No dividends were paid on the British securities in the
past year. Your total return based on U.S. dollars was __________ if the value of the securities
is now 2,400 pounds and the pound is worth $1.60.
A. 16.7%
B. 20.0%
C. 28.0%
D. 40.0%
E. none of the above
($3,840 - $3,000)/$3,000 = 0.28, or 28.0%.

Difficulty: Moderate

34. U.S. investors

A. can trade derivative securities based on prices in foreign security markets.
B. cannot trade foreign derivative securities.
C. can trade options and futures on the Nikkei stock index of 225 stocks traded on the Tokyo
stock exchange and on FTSE (Financial Times Share Exchange) indexes of U.K. and
European stocks.
D. A and C.
E. none of the above.
U.S. investors can invest as indicated in A, examples of which are given in C.

Difficulty: Moderate

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35. Exchange rate risk

A. results from changes in the exchange rates in the currencies of the investor and the country
in which the investment is made.
B. can be hedged by using a forward or futures contract in foreign exchange.
C. cannot be eliminated.
D. A and C.
E. A and B.
Although international investing involves risk resulting from the changing exchange rates
between currencies, this risk can be hedged by using a forward or futures contract in foreign
exchange.

Difficulty: Moderate

36. International investing

A. cannot be measured against a passive benchmark, such as the S&P 500.
B. can be measured against a widely used index of non-U.S. stocks, the EAFE index (Europe,
Australia, Far East).
C. can be measured against international indexes computed by Morgan Stanley, Salomon
Brothers, First Boston and Goldman, Sachs, among others.
D. B and C.
E. none of the above.
International investments can be evaluated against an international index, such as EAFE,
created by Morgan Stanley, and others that have become available in recent years.

Difficulty: Moderate

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37. Investors looking for effective international diversification should

A. invest about 60% of their money in foreign stocks.
B. invest the same percentage of their money in foreign stocks that foreign equities represent
in the world equity market.
C. frequently hedge currency exposure.
D. both A and B.
E. none of the above.
None of the above are correct.

Difficulty: Moderate

The manager of Quantitative International Fund uses EAFE as a benchmark. Last year's
performance for the fund and the benchmark were as follows:

38. Calculate Quantitative's currency selection return contribution.

A. +20%
B. -5%
C. +15%
D. +5%
E. -10%
EAFE: (.30)(10%) + (.10)(-10%) + (.60)(30%) = 20% appreciation; Diversified: (.25)(10%) +
(.25)(-10%) + (.50)(30%) = 15% appreciation; Loss of 5% relative to EAFE.

Difficulty: Difficult

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39. Calculate Quantitative's country selection return contribution.

A. 12.5%
B. -12.5%
C. 11.25%
D. -1.25%
E. 1.25%
EAFE: (.30)(10%) + (.10)(5%) + (.60)(15%) = 12.5%; Diversified: (.25)(10%) + (.25)(5%) +
(.50)(15%) = 11.25%; Loss of 1.25% relative to EAFE.

Difficulty: Difficult

40. Calculate Quantitative's stock selection return contribution.

A. 1.0%
B. -1.0%
C. 3.0%
D. 0.25%
E. none of the above.
(9% - 10%).25 + (8% - 5%).25 + (16% - 15%).50 = 1.00%

Difficulty: Moderate

41. Using the S&P500 portfolio as a proxy of the market portfolio

A. is appropriate because U.S. securities represent more than 60% of world equities.
B. is appropriate because most U.S. investors are primarily interested in U.S. securities.
C. is appropriate because most U.S. and non-U.S. investors are primarily interested in U.S.
securities.
D. is inappropriate because U.S. securities make up less than 40% of world equities.
E. is inappropriate because the average U.S. investor has less than 20% of her portfolio in
non-U.S. equities.
It is important to take a global perspective when making investment decisions. The S&P500 is
increasingly inappropriate.

Difficulty: Easy

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42. The average country equity market share is

A. less than 2%
B. between 3% and 4%
C. between 5% and 7%
D. between 7% and 8%
E. greater than 8%
This is stated in the text and confirmed by Table 25.1.

Difficulty: Moderate

43. When an investor adds international stocks to her portfolio

A. it will raise her risk relative to the risk she would face just holding U.S. stocks.
B. she can reduce its risk relative to the risk she would face just holding U.S. stocks.
C. she will increase her expected return, but must also take on more risk.
D. it will have no significant impact on either the risk or the return of her portfolio.
E. she needs to seek professional management because she doesn't have access to
international stocks on her own.
See Figure 25.1.

Difficulty: Easy

44. Which of the following countries has an equity index that lies on the efficient frontier
generated by allowing international diversification?
A. the United States
B. the United Kingdom
C. Japan
D. Norway
E. none of the above - each of these countries' indexes fall inside the efficient frontier.
See Figure 25.8. To get to the efficient frontier you would need to combine the countries'
indexes.

Difficulty: Moderate

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45. "ADRs" stands for ___________ and "WEBS" stands for ____________.
A. Additional Dollar Returns; Weekly Equity and Bond Survey
B. Additional Daily Returns; World Equity and Bond Survey
C. American Dollar Returns; World Equity and Bond Statistics
D. American Depository Receipts; World Equity Benchmark Shares
E. Adjusted Dollar Returns; Weighted Equity Benchmark Shares
The student should be familiar with these basic terms that relate to international investing.

Difficulty: Easy

46. WEBS portfolios

A. are passively managed.
B. are shares that can be sold by investors.
C. are free from brokerage commissions.
D. A and B
E. A, B, and C
They are passively managed and when holders want to divest their shares they sell them rather
than redeeming them with the company that issued them. There are brokerage commissions,
however.

Difficulty: Moderate

47. The EAFE is

A. the East Asia Foreign Equity index.
B. the Economic Advisor's Foreign Estimator index.
C. the European and Asian Foreign Equity index.
D. The European, Asian, French Equity index.
E. the European, Australian, Far East index.
The index is one of several world equity indices that exist. It is computed by Morgan Stanley.

Difficulty: Easy

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48. Home bias refers to

A. the tendency to vacation in your home country instead of traveling abroad.
B. the tendency to believe that your home country is better than other countries.
C. the tendency to give preferential treatment to people from your home country.
D. the tendency to overweight investments in your home country.
E. none of the above.
Home bias refers to the tendency to overweight investments in your home country.

Difficulty: Easy

Short Answer Questions

49. Discuss performance evaluation of international portfolio managers in terms of potential
sources of abnormal returns.
The following factors may be measured to determine the performance of an international
portfolio manager.
(A) Currency selection: a benchmark might be the weighted average of the currency
appreciation of the currencies represented in the EAFE portfolio.
(B) Country selection measures the contribution to performance attributable to investing in
the better-performing stock markets of the world. Country selection can be measured as the
weighted average of the equity index returns of each country using as weights the share of the
manager's portfolio in each country.
(C) Stock selection ability may be measured as the weighted average of equity returns in
excess of the equity index in each country.
(D) Cash/bond selection may be measured as the excess return derived from weighting bonds
and bills differently from some benchmark weights.
Feedback: The rationale for this question is to determine the student's understanding of
evaluating the various components of potential abnormal returns resulting from actively
managing an international portfolio.

Difficulty: Moderate

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50. Discuss some of the factors that might be included in a multifactor model of security
returns in an international application of arbitrage pricing theory (APT).
Some of the factors that might be considered in a multifactor international APT model are:
(A) A world stock index
(B) A national (domestic) stock index
(C) Industrial/sector indexes
(D) Currency movements.
Studies have indicated that domestic factors appear to be the dominant influence on stock
returns. However, there is clear evidence of a world market factor during the market crash of
October 1987.
Feedback: The rationale for this question is to determine the student's understanding of the
possible effects of various factors on an international portfolio.

Difficulty: Moderate

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51. Marla holds her portfolio 100% in U.S. securities. She tells you that she believes foreign
investing can be extremely hazardous to her portfolio. She's not sure about the details, but has
"heard some things". Discuss this idea with Marla by listing three objections you have heard
from your clients who have similar fears. Explain each of the objections is subject to faulty
reasoning.
A few of the factors students may mention are
- Client: "The U.S. markets have done extremely well in the past few years, so I should stay
100% invested in them." Your Reply: You can explain that there are other times when foreign
markets have beat the U.S. substantially in performance. You can't tell easily beforehand what
markets will do the best. It is important to consider that there are many times when countries'
markets move in different directions and you can buffer your risk to some extent by investing
globally.
- Client: "You should keep your money at home." Your Reply: Don't confuse familiarity with
good portfolio management. Even though there is a lot of information available on U.S.
companies, it can be difficult to use the information to make good forecasts. Most
professional managers aren't even good at this.
- Client: "There's too much currency risk." Your Reply: It is true that there may be times when
both a security's value in its own currency and the currency exchange rate may lead to poor
returns. But the opposite is also true. And there are cases when security price movements and
currency movements will have opposite impacts on your portfolio's return. This may have a
smoothing effect on your portfolio.
- Client: "Invest with the best." Your Reply: Even if U.S. markets have been the best
performers in recent periods there is no guarantee that things will stay that way. If you
diversify internationally you will benefit when other markets take the lead.
Feedback: This question tests the student's knowledge of the importance of international
deversification.

Difficulty: Moderate

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52. You are managing a portfolio that consists of U.S. equities. You have prepared a
presentation to use when you discuss the possibility of adding international stocks to your
client's portfolio.
- Draw a graph that shows the risk of the portfolio relative to the number of stocks held in the
portfolio.
- When your client arrives, he is surprised at your suggestion that he add international stocks,
but is willing to listen to your statements to justify your recommendations. State two reasons
why he should consider the international stocks and briefly explain each.
The graph should look like the one that is shown in figure 25.7.
- Two important reasons for adding international securities are the favorable diversification
effects due to the less than perfect positive correlations among countries' returns and the
possible benefit from currency risk.
Feedback: This question tests the student's knowledge of the basic ideas behind investing in
international stocks and other classes of equities.

Difficulty: Moderate

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