LOS j: Summarize the basic case for investing in emerging markets, as well as the risks and restrictions often associated with such investments.

Q1. Nancy Sims and Janice Davis are investment analysts for Platinum Investment Advisors. Platinum provides investment advice regarding U.S. and non-U.S. market assets for U.S. investors. They attempt to exploit foreign asset and currency misvaluations whenever possible. Sims specializes in advising on tactical asset allocations and Davis specializes in strategic asset allocations. They analyze both developed and emerging market investments.

Davis is considering adding a portfolio of Korean stocks to a portfolio of U.S. stocks. She gathers the following information on the expected returns, standard deviations, correlations of the current U.S. portfolio and the Korean portfolio. The returns for the Korean portfolio are in U.S. dollar terms. She is considering weighting the overall portfolio so that 70 percent of its assets are in the U.S. and 30 percent are in Korea .

Sims is considering adding a Japanese stock to a portfolio of U.S. stocks. She is concerned, however, as to what the effect would be on the portfolio’s return from changes in the value of the yen. She gathered the following figures for both the asset and currency for the Japanese investment.

Another area of interest for Platinum is the Taiwan market. As part of their investigation into the attractiveness of these markets, Sims has been asked to evaluate Taiwanese stocks and the effect of currency risk on the risk of these investments. The standard deviation of the Taiwanese stocks in Taiwanese dollars (TWD) terms is 20 percent. The standard deviation of the U.S. dollar/TWD exchange rate is 15 percent. The correlation between the exchange rate and Taiwanese stock portfolio is 0.4.

In response to an advertisement that Platinum posted on a well-know financial news website, Sims has been contacted by a potential client, Louis Baldi. Baldi would like to know why he should diversify internationally when the U.S. markets have had higher returns than other markets over the past decade. Sims answers that it is difficult to predict the future, and that just because a market has outperformed in the past does not mean that it will outperform in the future. Sims adds that Baldi’s argument against international diversification, known as the “country-specific out-performance” argument was especially popular during the 1990s when the U.S. markets had an extremely long bull run. Davis adds that Baldi needs to diversify across not only countries, but also industries.

What is the expected return on the portfolio of U.S. and Korean assets that Davis is considering?

A)   8.8%.

B)   9.2%.

C)   10.0%.

Q2. What is the standard deviation of the portfolio of U.S. and Korean assets that Davis is considering?

A)   5.0%.

B)   22.5%.

C)   27.0%.

Q3. What is the expected return on the Japanese stock that Sims is considering?

A)   39.2%.

B)   -7.2%.

C)   45.0%.

Q4. What is the contribution of currency risk for the Taiwanese stocks that Sims is considering?

A)   9.4%.

B)   5.0%.

C)   8.7%.

Q5. When investing in foreign markets Sims and Davis should be aware of the correlation between the asset and currency. In developed and emerging markets, what is the typical correlation between the asset and currency?

Developed                   Emerging

A)  Positive                      Negative

B)  Positive                      Positive

C)  Negative                    Positive

Q6. With respect to Sims’ and Davis’ responses to Baldi’s comments:

A)   Sims is correct; Davis is incorrect.

B)   Sims is correct; Davis is correct.

C)   Sims is incorrect; Davis is correct.

Q7. Which of the following best describes investing in emerging markets?

A)   Emerging markets are integrated with developed world markets. They are priced according to their contribution to portfolio risk.

B)   Emerging markets are segmented from developed world markets. They are priced according to their contribution to portfolio risk.

C)   Emerging markets are segmented from developed world markets. They are priced according to their standard deviation.

Q8. Which of the following best describes investing in emerging markets?

A)   Emerging markets have low stand alone risk and low correlation with developed world markets. This makes them an attractive addition to a portfolio.

B)   Emerging markets have high stand alone risk and a high correlation with developed world markets. Their risk does not justify their addition to a portfolio.

C)   Emerging markets have high stand alone risk but have a low correlation with developed world markets. This makes them an attractive addition to a portfolio.

Q9. Which of the following statements regarding the unsystematic risk of investing in emerging markets is TRUE? It is:

A)   negligible.

B)   largely diversified away due to low correlations with developed world markets.

C)   still predominant in a large portfolio.

Q10. A U.S. investor wants to invest internationally to reduce risk and seek higher returns. Which pair of countries’ stock markets would provide the best opportunity to do so?

A)   Great Britain and France.

B)   Germany and France.

C)   Germany and Chile.

LOS j: Summarize the basic case for investing in emerging markets, as well as the risks and restrictions often associated with such investments. fficeffice" />

Q1. Nancy Sims and Janice Davis are investment analysts for Platinum Investment Advisors. Platinum provides investment advice regarding ffice:smarttags" />U.S. and non-U.S. market assets for U.S. investors. They attempt to exploit foreign asset and currency misvaluations whenever possible. Sims specializes in advising on tactical asset allocations and Davis specializes in strategic asset allocations. They analyze both developed and emerging market investments.

Davis is considering adding a portfolio of Korean stocks to a portfolio of U.S. stocks. She gathers the following information on the expected returns, standard deviations, correlations of the current U.S. portfolio and the Korean portfolio. The returns for the Korean portfolio are in U.S. dollar terms. She is considering weighting the overall portfolio so that 70 percent of its assets are in the U.S. and 30 percent are in Korea .

	U.S. portfolio	Korean portfolio
Expected Return	8.00%	12.00%
Standard Deviation	22.00%	32.00%
Correlation	0.60

Sims is considering adding a Japanese stock to a portfolio of U.S. stocks. She is concerned, however, as to what the effect would be on the portfolio’s return from changes in the value of the yen. She gathered the following figures for both the asset and currency for the Japanese investment.

Return on Japanese stock in yen	16%
Beginning spot rate (yen/$)	100
Ending spot rate (yen/$)	125

Another area of interest for Platinum is the Taiwan market. As part of their investigation into the attractiveness of these markets, Sims has been asked to evaluate Taiwanese stocks and the effect of currency risk on the risk of these investments. The standard deviation of the Taiwanese stocks in Taiwanese dollars (TWD) terms is 20 percent. The standard deviation of the U.S. dollar/TWD exchange rate is 15 percent. The correlation between the exchange rate and Taiwanese stock portfolio is 0.4.

In response to an advertisement that Platinum posted on a well-know financial news website, Sims has been contacted by a potential client, Louis Baldi. Baldi would like to know why he should diversify internationally when the U.S. markets have had higher returns than other markets over the past decade. Sims answers that it is difficult to predict the future, and that just because a market has outperformed in the past does not mean that it will outperform in the future. Sims adds that Baldi’s argument against international diversification, known as the “country-specific out-performance” argument was especially popular during the 1990s when the U.S. markets had an extremely long bull run. Davis adds that Baldi needs to diversify across not only countries, but also industries.

What is the expected return on the portfolio of U.S. and Korean assets that Davis is considering?

A)   8.8%.

B)   9.2%.

C)   10.0%.

Correct answer is B)

The expected return of the portfolio is a weighted average of the asset returns: (0.70 × 8%) + (0.30 × 12%) = 9.2%.

Q2. What is the standard deviation of the portfolio of U.S. and Korean assets that Davis is considering?

A)   5.0%.

B)   22.5%.

C)   27.0%.

Correct answer is B)

To calculate the standard deviation of the portfolio, use both the individual stocks risk as well as the correlation between them in the following formula for portfolio variance: (0.702 × 0.222) + (0.302 × 0.322) + (2 × 0.70 × 0.30 × 0.22 × 0.32 × 0.6) = 0.0237 + 0.0092 + 0.0177 = 0.0507. We then take the square root of 0.0507 to obtain the standard deviation of 22.5%. Notice that this is much less than the standard deviation of 32% on the Korean asset.

Q3. What is the expected return on the Japanese stock that Sims is considering?

A)   39.2%.

B)   -7.2%.

C)   45.0%.

Correct answer is B)

The expected return on the Japanese stock in U.S. dollar terms must consider both the return on the asset in yen terms and the change in the value of the yen. The change in the value of the yen is calculated as follows: ((1/125) – (1/100)) / (1/100) = -20%. The return in U.S. dollar terms is then: (1.16)(1-.20)-1 = -7.20%.

Q4. What is the contribution of currency risk for the Taiwanese stocks that Sims is considering?

A)   9.4%.

B)   5.0%.

C)   8.7%.

Correct answer is A)

The risk of the Taiwanese stocks in U.S. dollar terms must consider both the risk of the TWD and the correlation between the TWD and the Taiwanese stocks. The variance of these investments in U.S. dollar terms is: 0.202 + 0.152 + (2 × 0.20 × 0.15 × 0.4) = 0.0865. The standard deviation in U.S. dollar terms is then the square root of the variance: 0.08651/2 = 29.41%. The contribution of currency risk is then: 29.4% - 20.0% = 9.4%. Note that this is much less than the 15% that might otherwise be expected as being the risk of the TWD.

Q5. When investing in foreign markets Sims and Davis should be aware of the correlation between the asset and currency. In developed and emerging markets, what is the typical correlation between the asset and currency?

Developed                   Emerging

A)  Positive                      Negative

B)  Positive                      Positive

C)  Negative                    Positive

Correct answer is C)

In developed markets, the typical correlation between the asset and currency is negative, with the logic being that when the currency depreciates, the firms in those markets can export more and their stock rises. In emerging markets though, currency devaluations are often accompanied by a lack of confidence in the stock markets, so the correlation is positive. This suggests that currency risk is a greater concern in emerging markets.

Q6. With respect to Sims’ and Davis’ responses to Baldi’s comments:

A)   Sims is correct; Davis is incorrect.

B)   Sims is correct; Davis is correct.

C)   Sims is incorrect; Davis is correct.

Correct answer is B)

Sims is correct. Although the “country-specific out-performance” argument appears attractive when the investor’s home market is doing quite well, past performance is no guarantee of future results. Davis is also correct. An investor needs to diversify across borders and industries. As the world economy and stock markets have become more interconnected, simply diversifying across borders is not as effective as it once was. Increasingly stock returns are determined by the industry the firm is in. Therefore the investor should also diversify across industries. This form of diversification is termed “global” diversification, as opposed to “international” diversification that only diversifies across borders.

Q7. Which of the following best describes investing in emerging markets?

A)   Emerging markets are integrated with developed world markets. They are priced according to their contribution to portfolio risk.

B)   Emerging markets are segmented from developed world markets. They are priced according to their contribution to portfolio risk.

C)   Emerging markets are segmented from developed world markets. They are priced according to their standard deviation.

Correct answer is C)

Emerging markets are segmented from developed world markets. Due to this segmentation, they have a low correlation with developed world markets. They should be priced according to their contribution to portfolio risk, but instead are priced according to their standard deviation (stand alone risk). This results in them having high expected returns.

Q8. Which of the following best describes investing in emerging markets?

A)   Emerging markets have low stand alone risk and low correlation with developed world markets. This makes them an attractive addition to a portfolio.

B)   Emerging markets have high stand alone risk and a high correlation with developed world markets. Their risk does not justify their addition to a portfolio.

C)   Emerging markets have high stand alone risk but have a low correlation with developed world markets. This makes them an attractive addition to a portfolio.

Correct answer is C)

Emerging markets have high stand alone risk but have a low correlation with developed world markets. Their contribution to portfolio risk is not as much as commonly expected. They also have high expected returns. This makes them an attractive addition to a portfolio.

Q9. Which of the following statements regarding the unsystematic risk of investing in emerging markets is TRUE? It is:

A)   negligible.

B)   largely diversified away due to low correlations with developed world markets.

C)   still predominant in a large portfolio.

Correct answer is B)         

The unsystematic risk arising from emerging markets is largely diversified away in a portfolio of international assets due to low correlations with the developed world.

Q10. A U.S. investor wants to invest internationally to reduce risk and seek higher returns. Which pair of countries’ stock markets would provide the best opportunity to do so?

A)   Great Britain and France.

B)   Germany and France.

C)   Germany and Chile.

Correct answer is C)

As Chile is an emerging country, it will have low correlations and potentially higher returns with Germany and the U.S., compared to the other pairs of developed world markets.

thanks.