Reading 45: The Case for International Diversification－LO return, between, security, currency

tycoon

The following data applies to a foreign stock investment:

• The gain on the stock in foreign currency terms was 15 percent.

• The foreign currency has depreciated by 8 percent.

• The standard deviation of stock returns was 35 percent and the standard deviation of the foreign currency was 11 percent.

• The correlation between the stock returns and the currency is 0.10.

What is the contribution of currency risk?

A) 2.72%.

B) 11.00%.

C) 37.72%.

D) 14.23%.

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Answer and Explanation

The contribution of currency risk measures the risk incremental to foreign asset risk from currency risk and is the difference between the asset risk in domestic currency terms and the risk of the foreign asset in foreign currency terms. To obtain the contribution of currency risk, we must first calculate the risk of the asset in domestic currency terms. To obtain the risk of the asset in domestic currency terms, we use the formula for portfolio risk that considers the risk of the asset in foreign currency terms, the risk of the foreign currency, and the correlation between the two:

σ_$² = 0.35² + 0.11² + 2(0.35)(0.11)(0.1) = 0.1423

σ_$ = √0.1423 = 0.3772 = 37.72%

Contribution of Currency = 37.72% - 35.00% = 2.72%

The contribution of currency risk measures the risk incremental to foreign asset risk from currency risk and is the difference between the asset risk in domestic currency terms and the risk of the foreign asset in foreign currency terms. To obtain the contribution of currency risk, we must first calculate the risk of the asset in domestic currency terms. To obtain the risk of the asset in domestic currency terms, we use the formula for portfolio risk that considers the risk of the asset in foreign currency terms, the risk of the foreign currency, and the correlation between the two:

σ_$² = 0.35² + 0.11² + 2(0.35)(0.11)(0.1) = 0.1423

σ_$ = √0.1423 = 0.3772 = 37.72%

Contribution of Currency = 37.72% - 35.00% = 2.72%

tycoon

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 b: Distinguish between the asset return and currency return for an international security.

tycoon

Which of the following statements concerning currency risk is most accurate? Currency risk:

A) slightly magnifies the risk of foreign investments.

B) greatly magnifies the risk of foreign investments.

C) slightly reduces the risk of foreign investments through diversification of the asset risk.

D) greatly reduces the risk of foreign investments through diversification of the asset risk.

Answer and Explanation

Currency risk only slightly magnifies the risk of foreign investments because it is only about half that of foreign stock risk on average and much of it can be diversified away in a portfolio of currencies. Also foreign currency risk and foreign asset risk are not additive due to correlations between them of less than one.

tycoon

Which of the following statements regarding foreign currency risk is FALSE? Foreign currency risk:

A) is about twice that of foreign bond risk.

B) can be hedged with futures and options.

C) is about twice that of foreign stock risk.

D) is often diversified away in a portfolio of foreign assets.

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Answer and Explanation

Foreign currency risk is only about half that of foreign stock risk on average. It is about twice that of foreign bond risk however. Much of it can be diversified away in a portfolio of currencies and can be hedged with derivative instruments.

tycoon

Which of the following with respect to correlations of international security markets is FALSE?

A) Low correlations have been especially valuable to the international investor during times of crisis.

B) Greater capital mobility leads to increased correlations.

C) Trade agreements lead to increased correlations.

D) Cross-border mergers lead to higher correlations.

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Answer and Explanation

During times of crisis, international correlations are usually higher, and offer the investor less diversification benefit. Trade agreements and increased capital mobility increase correlations as capital flows across borders. Cross-border mergers result in more globally oriented corporations and higher correlations.

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