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Portfolio Management and Wealth Planning【Reading 22】

Which of the following arguments makes the case for international diversification?
A)
The presence of increased Sharpe ratios with international investing.
B)
Correlations are said to have increased over time.
C)
Corporations are becoming more global in their orientation.



Higher Sharpe ratios imply a higher excess return per level of risk. If correlations have increased over time, 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.

Which of the following would benefit an investor who is considering foreign markets?
A)
Depreciating foreign currencies.
B)
Withholding taxes on foreign investments.
C)
Lower correlations between international assets.



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. A depreciating foreign currency would lower the dollar denominated return to a U.S. investor who invests globally.

TOP

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)
Appreciating foreign currencies.



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.

TOP

A domestic stock has an expected return of 12% and a standard deviation of 18%. A foreign stock has an expected return of 25% and a standard deviation of 33%. An investor has 60% of the domestic stock in their portfolio and 40% in the foreign stock. If the correlation between the stocks is 0.70, what is the portfolio’s standard deviation?
A)
24.00%.
B)
22.15%.
C)
17.20%.



The standard deviation of the portfolio will be a function of the weights in the assets, their risk, and the correlation between them. It is calculated as:

TOP

A British investor holds assets denominated in euros. A 5% decrease in the value of the assets in euros and a 5% increase in the ₤/€ exchange rate will lead to what total return to the British investor in terms of pounds?
A)
0.00%.
B)
-0.25%.
C)
-0.50%.



-0.05 + 0.05 + (-0.05)(0.05) = -0.0025 or -0.25%.

TOP

A French investor earned a 12% return, in terms of Euros, on an investment in dollar assets in the U.S. If the return on the investment in dollars was 6%, then the change in the exchange rate:
A)
must have been greater than 6%.
B)
must have been equal to 6%.
C)
must have been less than 6%.



The equation for total return in euros = ($ return) + (change in exchange rate) + ($ return)(change in exchange rate).
Thus,
0.12 = 0.06 + (change in exchange rate) + (0.06)(change in exchange rate),
0.12 - 0.06 = (change in exchange rate) + (0.06)(change in exchange rate)
0.06 = (1.06)(change in exchange rate)
0.06/1.06 = change in exchange rate = 0.0566 or 5.66% < 6%.

TOP

A U.S. investor holds assets denominated in British pounds. A 10% increase in the value of the assets in pounds and a 5% increase in the $/₤ exchange rate will lead to what total return to the U.S. investor in terms of dollars?
A)
4.5%.
B)
5.5%.
C)
15.5%.



Since the $/₤ exchange rate increased, the value of the pound assets increased with respect to dollars. The total return is 0.10 + 0.05 + (0.05)(0.10) = 0.155 or 15.5%.

TOP

The following data applies to a foreign stock investment:

  • The gain on the stock in foreign currency terms was 22%.

  • The foreign currency has appreciated by 7%.

  • The standard deviation of stock returns was 38% and the standard deviation of the foreign currency was 24%.

  • The correlation between the stock returns and the currency is 0.10.
What is the contribution of currency risk?
A)
46.93%.
B)
8.93%.
C)
22.02%.



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$2 = 0.382 + 0.242 + 2(0.38)(0.24)(0.1) = 0.2202
σ$ = √0.2202 = 0.4693 = 46.93%
Contribution of Currency = 46.93% - 38.00% = 8.93%

TOP

Which of the following statements regarding foreign currency risk is least accurate? Foreign currency risk:
A)
is about twice that of foreign bond risk.
B)
is about twice that of foreign stock risk.
C)
is often diversified away in a portfolio of foreign assets.



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.

TOP

Which of the following with respect to correlations of international security markets is least accurate?
A)
Greater capital mobility leads to increased correlations.
B)
Low correlations have been especially valuable to the international investor during times of crisis.
C)
Trade agreements lead to increased correlations.



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.

TOP

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