Reading 45: The Case for Inter....Diversification－LOS j investing, emerging

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 17: Portfolio Management in a Global Context
Reading 45: The Case for International Diversification
LOS j: Summarize the basic case for investing in emerging markets as well as the risks and restrictions often associated with such investments.

tycoon

Which of the following best describes investing in emerging markets?

A) 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.

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

D) Emerging markets have high stand alone risk and a high correlation with developed world markets. Their higher return, however, makes them an attractive addition to a portfolio.

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Answer and Explanation

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.

tycoon

Which of the following best describes investing in emerging markets?

A) Emerging markets are segmented from 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 standard deviation.

C) Emerging markets are integrated with developed world markets. They are priced according to their standard deviation.

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

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Answer and Explanation

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.

tycoon

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) Germany and Chile.

B) Germany and France.

C) Great Britain and France.

D) Italy and France.

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Answer and Explanation

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.

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

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

B) negligible.

C) still predominant in a large portfolio.

D) measured by the beta or covariance measure.

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Answer and Explanation

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. Note that beta is a measure of systematic, not unsystematic risk.