Reading 45: The Case for International Diversification－LO across, equity, domestic

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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 a: Evaluate the implications of international diversification for domestic equity and fixed income portfolios, based on the traditional assumptions of low correlations across international markets.

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Which of the following arguments makes the case for international diversification?

A) Correlations are said to have increased over time.

B) The presence of increased Sharpe ratios with international investing.

C) Correlations purportedly increase during times of crisis.

D) Corporations are becoming more global in their orientation.

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Answer and Explanation

Higher Sharpe ratios imply a higher excess return per level of risk. If correlations have increased over time or increase during times of crisis, then the risk reduction benefit of international diversification is curtailed. If corporations become more global, it would also imply higher correlations, thus diversifying across borders becomes a less effective method of decreasing portfolio risk.

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Which of the following is NOT a reason why investors should consider constructing global portfolios?

A) Increasingly integrated global capital markets.

B) Lower correlations between international assets.

C) Higher stock returns.

D) Appreciating foreign currencies.

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Answer and Explanation

Global diversification is attractive because foreign markets offer lower correlations and the opportunity for higher return. If the foreign currency appreciates, the domestic investor will also benefit. Increasingly integrated global capital markets would actually harm the investor because correlations would increase.

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Which of the following would benefit an investor who is considering foreign markets?

A) Lower correlations between international assets.

B) Withholding taxes on foreign investments.

C) Government control of currency convertibility.

D) Depreciating foreign currencies.

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Answer and Explanation

Lower correlations would result in reduced portfolio risk for the global investor. The other answer choices would actually be a detriment for an investor considering foreign markets. Foreign governments sometimes tax the interest and dividends earned by investors, thereby reducing investment return. Governments can also suspend currency convertibility, especially in times of crisis. A depreciating foreign currency would lower the dollar denominated return to a U.S. investor who invests globally.