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Which of the following statements with respect to international bonds is CORRECT? The correlations between international bond markets are:
 A) quite low, but the returns to bonds are too low to warrant their inclusion in an international portfolio.
 B) often quite low, suggesting that international bonds should be a component of an international portfolio.
 C) high, but the returns to bonds are sufficient to warrant their inclusion in an international portfolio.

The correlations between international bond markets are quite low and the inclusion of international bonds in an international portfolio will result in higher returns for a given amount of risk.
Adding international bonds to an international stock portfolio has the potential for:
 A) higher returns but also higher risk.
 B) lower returns for the same amount of risk.
 C) higher returns for the same amount of risk.

Plotting the risk return profile for international portfolios, the portfolio that includes international bonds in addition to international stocks will have higher returns for a given amount of risk.
Joe Murad, a U.S. investor, invested in foreign securities. The following data is available:

• The return on stock in foreign currency terms was 14%.

• The foreign currency depreciated by 5%.

• The standard deviation of stock returns was 30%.

• The standard deviation of the foreign currency was 10%.

• The correlation between the stock return and the currency was 0.30.
Murad’s return on his foreign securities investment is:
 A) 9.70%.
 B) 9.00%.
 C) 8.30%.

Use the following formula to compute the return in dollars:
R\$ = RLC + S + (RLC)(S)
R\$ = return on the foreign asset in U.S. dollar terms
RLC = return on the foreign asset in local currency terms
S = percentage change in the foreign currency
Return = 0.14 + (-0.05) + (0.14) (-0.05) = 8.30%

The risk of the portfolio in U.S. dollar terms as measured by its standard deviation is:
 A) 34.35%.
 B) 11.80%.
 C) 36.75%.

The formula used below considers the risk of the asset in foreign currency terms, the risk of the foreign currency, and the correlation between the two:
σ2\$ = σ2LC + σ2S + 2σLCσSρLC,S
where:
σ2\$ = variance of the returns on the foreign asset in U.S. dollar terms
σ2LC, σLC = variance and standard deviation of the foreign asset in local currency terms
σ2S, σS = variance and standard deviation of foreign currency
ρLC,S = correlation between returns for the foreign asset in local currency terms and movements in the foreign currency.

Variance = (0.30)2 + (0.10)2 + 2(0.3)(0.1)(0.3) = 0.118
Standard deviation = √(0.118) = 34.35%

The contribution of currency risk to the risk of the portfolio is closest to:
 A) 4.00%.
 B) 4.35%.
 C) 5.00%.

The contribution of the currency risk is the difference between the asset risk in domestic currency terms less the risk of the foreign asset in foreign currency terms.
Contribution of currency risk = σ\$ - σLC
Contribution of currency risk = 34.35% - 30.00% = 4.35%
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 expected return of the portfolio?
 A) 13.46%.
 B) 30.54%.
 C) 29.00%.

To obtain the return in domestic currency terms use the following formula that considers the return in local currency terms as well as the exchange rate change:

22% + 7% + (22% × 7%) = 30.54%
The following data applies to a foreign stock investment:

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

• The foreign currency has depreciated by 8%.

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

• The correlation between the stock returns and the currency is 0.10.
What is the expected return of the portfolio?
 A) 24.20%.
 B) 7.00%.
 C) 5.80%.

To obtain the return in domestic currency terms use the following formula that considers the return in local currency terms as well as the exchange rate change:
15% - 8% + (15% × - 8%) = 5.80%
Which of the following statements regarding international diversification is least accurate?
 A) Foreign currency risk will diversify the risk from domestic government monetary and fiscal policies.
 B) Foreign currency risk and foreign asset risk are not additive.
 C) A depreciating foreign currency benefits the international investor.

A depreciating foreign currency harms the international investor by resulting in a lower home currency return. Foreign currency risk and foreign asset risk are not additive because the correlations between them are usually quite low, and sometimes negative. Foreign currency risk also helps diversify domestic fiscal and monetary policies.
Which of the following best describes the properties of the correlation statistic? If a sample of returns is split in half, the high return half will have:
 A) higher correlations than the low return half. The true correlation is best measured by the whole sample correlation.
 B) lower correlations than the low return half. The true correlation is best measured by the whole sample correlation.
 C) higher correlations than the low return half. The true correlation is best measured by the low return half correlation.

If the sample of returns between two markets is split in half, the high return and higher volatility half will have a higher correlation than the low return half when in fact the true correlation is best measured by the whole sample correlation. This is due to the econometrics of the correlation measure and illustrates the pitfalls of estimating the correlation statistic during periods of increased market volatility. To determine whether markets really have increased their comovement during periods of increased volatility, the analyst should measure the dispersion (standard deviation) of country portfolios.
Due to estimation error, the analyst should be aware that estimating correlations during volatile periods results in:
 A) higher correlations.
 B) lower correlations.
 C) correlations that must be adjusted for serial correlation.

During periods of increased volatility, correlations will be estimated higher due to estimation error, even if correlations have not actually increased.
In order to estimate whether correlations have increased during volatile periods, the analyst should calculate the:
 A) autoregressive conditional heteroskedasticity.
 B) standard deviation of an international portfolio.
 C) correlation between markets.

During volatile periods, the correlation will appear to increase, even if it hasn’t, due to the econometrics of the correlation measure. The analyst should examine the standard deviation through time to see if it has increased.
Which of the following countries is most likely to offer the lowest correlation with other capital markets? A country with:
 A) few multinational corporations and low tariffs.
 B) many multinational corporations and low tariffs.
 C) few multinational corporations and high tariffs.

Countries with few multinational corporations and high tariffs will have segmented capital markets and will be less correlated with other country markets. The higher the proportion of multinational corporations and the more open the capital markets, the more integrated the capital market and the higher the correlation with other country markets.
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