==============CHAPTER 15======================================
SUGGESTED ANSWERS TO CHAPTER 15 QUESTIONS
l.As seen in Exhibit 15.2, Hong Kong stocks are over twice as volatile as U.S. stocks. Does that mean that risk-averse American investors should avoid Hong Kong equities? Explain.
ANSWER. No. Although Hong Stock stocks are much more volatile /than U.S. stocks, their systematic component of risk is relatively low because of the low correlation with the U.S.
market. The net result is that the systematic risk (beta) of the average Hong Kong stock from a U.S. perspective is only 0.85, compared with a beta of 1.0 for the average U.S. stock. In
other words, diversifying into Hong Kong stocks will reduce the riskiness of a portfolio currently concentrated in U.S. stocks.
2. What characteristics of foreign securities lead to diversification benefits for American investors?
ANSWER. The two basic characteristics are:
a)Many foreign securities are issued by companies that produce goods and services not available from U.S. companies.
b)All U.S. companies are more or less subject to the same cyclical economic fluctuations. Foreign securities by contrast involve claims on economies whose cycles are not perfectly in
phase with the U.S. economic cycle. Thus, just as movements in different stocks partially offset one another in an all-U.S. portfolio, so also movements in U.S. and non-U.S. stocks
cancel out each other somewhat.
3. Will increasing integration of national capital markets reduce the benefits of international diversifications?
ANSWER. Despite increasing integration of national capital markets, they still don’t march in lock step. Some economies and, hence, their markets will do befter than others at any given
time, so having stakes in several countries still spreads risks. Nonetheless, increasing integration could lead to more comovement in common risk factors (e.g., real interest rate changes).
If so, this will increase the correlation of national markets and decrease the risk-reducing benefits of diversifying internationally. Ultimately, it’s an empirical issue, and one that should be
ANSWER. Domestic stocks are more highly correlated because they are all subject in one way or another to the state of the domestic economy. The lower correlations between
domestic and foreign stocks reflect the lower correlations between the domestic and foreign economies. These lower correlations also imply that international investing is likely to lead to
greater diversification than just investing across industries within a country. As the text shows, these lower correlations appear to be persisting despite the greater integration of the global
economy.
5. Who is likely to gain more from investing overseas, a resident of the United States or of Mexico? Explain.
ANSWER. Mexican investors will gain much more from international investing. The size of the U.S. economy is such that the U.S. and world stock markets are highly correlated whereas
the Mexican stock market, being much smaller, shows a much lower correlation with the world stock market. The result is greater diversification (and, I hence, risk reduction) benefits for
the Mexican investor than for the U.S. investor. In addition, the U.S. has a much greater range of industries than does Mexico, giving much more scope for industry diversification outside
Mexico than would be true for a U.S. investor who has access to such a broad range of industries already.
6-Suppose that Mexican bonds are yielding more than 100% annually. Does this high yield make them suitable for American investors looking to raise the return on their portfolios?
Explain.
ANSWER. These returns are denominated in nominal peso terms, subjecting them to currency risk. Nonetheless, holding a small percentage of your portfolio in Mexican bonds will
reduce its risk, without sacrificing expected return. This is because arbitrage will equilibrate expected returns across countries at the same time that the actual returns from the Mexican
peso bonds are relatively uncorrelated with returns on the U.S. stock market. Hence, the primary reason for holding Mexican bonds is to reduce risk, not raise expected return.
7. According to one investment advisor, UJ feel more comfortable investing in Western Europe or Canada. I would not invest in South America or other regions with a record of debt
defaults and restructuring. The underwriters of large new issues of ADRs of companies from these areas assure us that things are different now. Maybe, but who can say that a
government that has defaulted on debt won’t change the rules again?” Comment on this statement.
ANSWER, it’s true. A nation that has already defaulted on its debt is less trustworthy than one that never has. However, this possibility has already been factored into the prices of that
nation’s bonds and stocks in the form of a large discount to what they would sell for absent that past experience. The real--and important--question is whether the discount is high enough
to provide an expected return high enough to compensate for those risks. If so, then Latin American stocks and bonds would be a reasonable investment since they would provide
additional A diversification benefits.
8-Investors should avoid Hong Kong, given its problematic outlook now that Britain has surrendered the colony to China. Comment.
ANSWER. The problematic outlook for Hong Kong now that it is a special province of China is already reflected in the price of Hong Kong assets (in the form of discounted prices).
Thus, the expected risk-adjusted return on Hong Kong assets is the same as that on assets elsewhere. It is precisely these different risks, which are uncoordinated with risks elsewhere
that give rise to the benefits of international diversification.
ANSWER. Note that the same argument could be made as to why non Japanese investors should also invest all their money in Japan. Implicit in this argument is the expectation that
historically high returns will persist into the future. Such an expectation is an unreasonable one in efficient markets. Thus, unless one unrealistically expects these superior returns to persist
into the future, diversification would make sense for both Japanese and non Japanese investors. The benefits of this diversification were pointed out in 1990, when the Tokyo Stock
Exchange fell 35% in dollar terms (39% in yen), while the Morgan Stanley Capital International World Index fell by “just” 18.6% in dollar terms.
b. What arguments would you use to persuade a Japanese investor to invest overseas?
ANSWER. Here are two arguments. First, you can’t expect stock markets to keep going up in a straight line. All markets entail risk, and one way to counter that risk is through
diversification. This argument should by now be bolstered by the crash of the Japanese stock market in 1990. Second, to the extent that the Japanese investor consumes foreign goods
and services, international investing can reduce the risk associated with the investor’s consumption stream by matching foreign currency inflows with foreign currency outflows. For
example, if the yen depreciates, the higher yen cost of buying foreign goods and services will be offset by the higher yen value of foreign assets.
c. Why might Japanese (and other) investors still prefer to invest in domestic securities despite the potential gains from international diversification?
ANSWER. If investors buy mostly domestic goods and services (or at least goods and services priced in a domestic context), investing overseas will expose them to currency risk that is
not offset by gains on the consumption side. For example, if the yen appreciates, the yen value of dollar assets will decline. If the Japanese  investor is not consuming much in the way of
U.S. goods and services, the reduction in consumption costs will not offset the investment losses.
10. Because ADRs are denominated in dollars and are traded in the United States, they present less foreign exchange risk to U.S. investors than do the underlying foreign shares of stock.
Comment.
ANSWER. ‘the answer to this question depends on the distinction between the currency of denomination and the currency of determination. Although the ADR currency of denomination
is the dollar, the currency of determination is the local currency (or whatever currency determines the cash flows of the stock). More specifically, the price of an ADR is the price of the
share of stock in its foreign currency multiplied by the spot dollar value of the foreign currency. As the spot exchange rate changes, the dollar price of the ADR will also change (unless the
foreign currency value of the stock changes in inverse proportion to the change in the spot price, an unlikely scenario). Hence, ADRs are as subject to exchange risk as the underlying
shares of foreign stock.
SUGGESTED SOLUTIONS TO CHAPTER 15 PROBLEMS
1. ANSWER.  3.79%
2. The dollar return on Swiss bonds equaled (1 - .016)(1 + 0.08) - 1 = 6.27%. The return on French bonds was lower at (1.018)(1.026) - 1 = 4.45%. In this case, Swiss franc
appreciation more than offset the lower local currency return on Swiss bonds.
3.Substituting in the numbers yields a total dollar return on Toyota stock for the year of 51.17%:
Note that yen appreciation during the year was (145 - 120) = 20.83%.
4. During 1989, the Mexican stock market climbed 112% in peso terms while the peso depreciated by 28.6% against the U.S. dollar. What was the dollar return on the Mexican stock
market during the year?
ANSWER. According to these data, the dollar return on the Mexican stock market during 1989 was 51.37%:
it = (1 ÷ 1.12)0 - 0.286) - I = 51.37%
5a. in 1992, the Brazilian market rose by 1,117% in cruzeiro terms, while the cruzeiro fell by 91.4% in dollar terms. Meanwhile, the U.S. market rose by 8 which market did better?
ANSWER. The dollar return on the Brazilian market can be calculated as 4.66%
The numbers reflect the fact that a return of 1,127% is equivalent to receiving an additional Cr11.17 for each Cr1 invested. Based on these figures, the U.S. market return of 8.5% bested
the dollar return on the Brazilian market by almost 4 percentage points.
b. In 1993, the Brazilian market rose by 4,190% in cruzeiro terms, while the cruzeiro fell by 95.9% in dollar terms. Did the Brazilian market do better in dollar temis in 1992 or in 1993?
ANSWER. Redoing the numbers in the answer to part a, we see that the Brazilian market did far better in 1993 than in 1992:
= (1 + 41.90)0 - 0.959) - 1 = 75.89%
In this case, the extraordinarily large local currency return more than offset the dramatic devaluation of the cruzeiro.
6. Suppose that the dollar is now worth _l.1372. If one-year German bunds are yielding 9.8% and one-year U.S. Treasury bonds are yielding 6.5%, at what end-of-year exchange rate
will the dollar returns on the two bonds be equal? What amount of euro appreciation or depreciation does this equilibrating exchange rate represent?
ANSWER. To begin, given that German bunds are yielding more than U.S. Treasuries, it is clear that for dollar returns on these two securities to equilibrate, the euro must depreciate
against the dollar by about the interest differential, which is 3.3%. Using Equation 15.4, the expected dollar return on investing $1 in a bund (after first converting it into _1.1372) for a
year can be found as
1.l372(l.098)e1 = 1.2486e1 where e is the unknown end-of-year exchange rate ($/J. Note that ex ante, one cannot anticipate any capital gains or losses on investing. Setting this figure
equal to the $1 .065 expected dollar return from investing one dollar in a Treasury bond yields the solution e = $0.8529, which converts into a direct quote for the dollar of _1.1724. This
exchange rate entails a euro depreciation of (1.1372 - 1.1724)/1.1724 = -3.01% against the dollar. Alternatively, the dollar has appreciated against the euro by (1.1724 - 1 = 3.10%.
7. In 1990, Matsushita bought MCA Inc. for $6.1 billion. At the time of the purchase, the exchange rate was about Y1451$. By the time that Matsushita sold an 80% stake in MCA to
Seagram for $5.7 billion in 1995, the yen had appreciated to a rate of about Y971$.
a. Ignoring the time value of money, what was Matsushita’s dollar gain or loss on its investment in MCA?
ANSWER. If an 80% stake in MCA was worth $5.7 billion, then the entire firm was worth $7.125 billion. Based on this valuation, Matsushita actually made $1 .025 billion on its
purchase of MCA. That is, by buying MCA at a price of $6.1 billion and selling it for a price that valued the business at $7. 125 billion, Matsushita made $1 .025 billion.
b. What was Matsushita’s yen gain or loss on the sale?
ANSWER. Taking into account the differences in exchange rates, Matshushita paid Y884,500,000,000 (6,100,000,000 x 145) for MCA in 1990 and sold MCA in 1995 for a price
that valued it at Y691,125,000,000 (7,125,000,000 x 97). The net result was a loss for Matsushita of  Y193,375,000,000 on its purchase of MCA.
c. What did Matsushita’s yen gain or loss translate into in terms of dollars? What accounts for the difference between this figure and your answer to part a?
ANSWER. Matsushita’s yen loss converts into a dollar loss of $1,993,556,701 (193,375,000,000/97). This figure differs from the answer in part a because it takes into account the
change in exchange rates between 1990 and 1995. In effect, it asks what would have happened if Matsushita had held onto its yen instead of converting them into a dollar asset that
didn’t appreciate in line with the yen’s appreciation. In other words, this computed dollar loss represents an opportunity cost