Choice Multiple Questions 1. Shares of several foreign firms are traded in the U.S. markets in the form of A) ADRs B) ECUs C) single-country funds D) all of the above E) none of the above Answer: A Difficulty: Easy Rationale: American Depository Receipts (ADRs) allow U. S. investors to invest in foreign stocks via transactions on the U.S. stock exchanges. 2. __________ refers to the possibility of expropriation of assets, changes in tax policy, and the possibility of restrictions on foreign exchange transactions. A) default risk B) foreign exchange risk C) market risk D) political risk E) none of the above Answer: D Difficulty: Easy Rationale: All of the above factors are political in nature, and thus are examples of political risk. 3. __________ are mutual funds that invest in one country only. A) ADRs B) ECUs C) single-country funds D) all of the above E) none of the above Answer: C Difficulty: Easy Rationale: Mutual funds that invest in the stocks of one country only are called singlecountry funds.
4. The performance of an internationally diversified portfolio may be affected by A) country selection B) currency selection C) stock selection D) all of the above E) none of the above Answer: D Difficulty: Easy Rationale: All of the above factors may affect the performance of an international portfolio. 5. Over the period 2001-2005, most correlations between the U.S. stock index and stockindex portfolios of other countries were A) negative B) positive but less than .9 C) approximately zero D) .9 or above E) none of the above Answer: B Difficulty: Moderate Rationale: Correlation coefficients were typically below .9, while correlations between well-diversified U. S. market portfolios were typically above .9. See Table 25.10. 6. The __________ index is a widely used index of non-U.S. stocks. A) CBOE B) Dow Jones C) EAFE D) all of the above E) none of the above Answer: C Difficulty: Easy Rationale: The Europe, Australia, Far East (EAFE) index computed by Morgan Stanley is a widely used index of non-U.S. stocks.
Chapter 25 International Diversification
7. The __________ equity market had the highest average local currency return between 2001 and 2005. A) Russian B) Norwegian C) U.K. D) U.S. E) none of the above Answer: A Difficulty: Moderate Rationale: See Table 25.9. 8. The __________ equity market had the highest average U.S. dollar return between 2001 and 2005. A) Russian B) Finnish C) Columbian D) U.S. E) none of the above Answer: C Difficulty: Moderate Rationale: See Table 25.9. 9. The __________ equity market had the highest average U.S. dollar standard deviation between 2001 and 2005. A) Turkish B) Finnish C) Indonesian D) U.S. E) none of the above Answer: A Difficulty: Moderate Rationale: See Table 25.9. 10. The __________ equity market had the highest average local currency standard deviation between 2001 and 2005. A) Turkish B) Finnish C) Indonesian D) U.S. E) none of the above Answer: A Difficulty: Moderate Rationale: See Table 25.9.
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11. In 2005, the U.S. equity market represented __________ of the world equity market. A) 19% B) 60% C) 43% D) 39% E) none of the above Answer: D Difficulty: Moderate Rationale: See Table 25.1. 12. The straightforward generalization of the simple CAPM to international stocks is problematic because __________. A) inflation risk perceptions by different investors in different countries will differ as consumption baskets differ B) investors in different countries view exchange rate risk from the perspective of different domestic currencies C) taxes, transaction costs and capital barriers across countries make it difficult for investor to hold a world index portfolio D) all of the above E) none of the above. Answer: D Difficulty: Moderate Rationale: All of the above factors make a broad generalization of the CAPM to international stocks problematic. 13. The yield on a 1-year bill in the U.K. is 8% and the present exchange rate is 1 pound = U. S. $1.60. If you expect the exchange rate to be 1 pound - U. S. $1.50 a year from now, the return a U. S. investor can expect to earn by investing in U.K. bills is A) -6.7% B) 0% C) 8% D) 1.25% E) none of the above Answer: D Difficulty: Moderate Rationale: r(US) = [1 + r(UK)]F0/E0 - 1; [1.08][1.50/1.60] - 1 = 1.25%.
Chapter 25 International Diversification
14. Suppose the 1-year risk-free rate of return in the U. S. is 5%. The current exchange rate is 1 pound = U. S. $1.60. The 1-year forward rate is 1 pound = $1.57. What is the minimum yield on a 1-year risk-free security in Britain that would induce a U. S. investor to invest in the British security? A) 2.44% B) 2.50% C) 7.00% D) 7.62% E) none of the above Answer: C Difficulty: Moderate Rationale: 1.05 = (1 + r) X [1.57/1.60] - 1; r = 7.0%. 15. The interest rate on a 1-year Canadian security is 8%. The current exchange rate is C$ = US $0.78. The 1-year forward rate is C$ = US $0.76. The return (denominated in U.S. $) that a U.S. investor can earn by investing in the Canadian security is __________. A) 3.59% B) 4.00% C) 5.23% D) 8.46% E) none of the above Answer: C Difficulty: Moderate Rationale: 1.08[0.76/0.78] = x - 1; x = 5.23%. 16. Suppose the 1-year risk-free rate of return in the U.S. is 4% and the 1-year risk-free rate of return in Britain is 7%. The current exchange rate is 1 pound = U.S. $1.65. A 1-year future exchange rate of __________ for the pound would make a U. S. investor indifferent between investing in the U. S. security and investing the British security. A) 1.6037 B) 2.0411 C) 1.7500 D) 2.3369 E) none of the above Answer: A Difficulty: Moderate Rationale: 1.04/1.07 = x/1.65; x = 1.6037.
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17. The present exchange rate is C$ = U. S. $0.78. The one year future rate is C$ = U. S. $0.76. The yield on a 1-year U.S. bill is 4%. A yield of __________ on a 1-year __________ Canadian bill will make investor indifferent between investing in the U.S. bill and the Canadian bill. A) 2.4% B) 1.3% C) 6.4% D) 6.7% E) none of the above Answer: D Difficulty: Moderate Rationale: 1.04 = [($0.76/$0.78)(1 + r)] - 1; r = 6.7%. Use the following to answer questions 18-19: Assume there is a fixed exchange rate between the Canadian and U.S. dollar. The expected return and standard deviation of return on the U.S. stock market are 18% and 15%, respectively. The expected return and standard deviation on the Canadian stock market are 13% and 20%, respectively. The covariance of returns between the U.S. and Canadian stock markets is 1.5%. 18. If you invested 50% of your money in the Canadian stock market and 50% in the U.S. stock market, the expected return on your portfolio would be __________. A) 12.0% B) 12.5% C) 13.0% D) 15.5% E) none of the above Answer: D Difficulty: Moderate Rationale: 18% (0.5) + 13%(0.5) = 15.5%. 19. If you invested 50% of your money in the Canadian stock market and 50% in the U.S. stock market, the standard deviation of return of your portfolio would be __________. A) 12.53% B) 15.21% C) 17.50% D) 18.75% E) none of the above Answer: A Difficulty: Difficult Rationale: sP = [(0.5)2(15%)2 + (0.5)2(20%)2 + 2(0.5)(0.5)(1.5)]1/2 = 12.53%.
Chapter 25 International Diversification
20. The major concern that has been raised with respect to the weighting of countries within the EAFE index is A) currency volatilities are not considered in the weighting. B) cross-correlations are not considered in the weighting. C) inflation is not represented in the weighting. D) the weights are not proportional to the asset bases of the respective countries. E) none of the above Answer: D Difficulty: Moderate Rationale: Some argue that countries should be weighted in proportion to their GDP to properly adjust for the true size of their corporate sectors, since many firms are not publicly traded. 21. You are a U. S. investor who purchased British securities for 2,000 pounds one year ago when the British pound cost $1.50. No dividends were paid on the British securities in the past year. Your total return based on U. S. dollars was __________ if the value of the securities is now 2,400 pounds and the pound is worth $1.60. A) 16.7% B) 20.0% C) 28.0% D) 40.0% E) none of the above Answer: C Difficulty: Moderate Rationale: ($3,840 - $3,000)/$3,000 = 0.28, or 28.0%. 22. U.S. investors A) can trade derivative securities based on prices in foreign security markets. B) cannot trade foreign derivative securities. C) can trade options and futures on the Nikkei stock index of 225 stocks traded on the Tokyo stock exchange and on FTSE (Financial Times Share Exchange) indexes of U.K. and European stocks. D) A and C. E) none of the above. Answer: D Difficulty: Moderate Rationale: U. S. investors can invest as indicated in A, examples of which are given in C.
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23. Exchange rate risk A) results from changes in the exchange rates in the currencies of the investor and the country in which the investment is made. B) can be hedged by using a forward or futures contract in foreign exchange. C) cannot be eliminated. D) A and C. E) A and B. Answer: E Difficulty: Moderate Rationale: Although international investing involves risk resulting from the changing exchange rates between currencies, this risk can be hedged by using a forward or futures contract in foreign exchange. 24. International investing A) cannot be measured against a passive benchmark, such as the S&P 500. B) can be measured against a widely used index of non-U. S. stocks, the EAFE index (Europe, Australia, Far East). C) can be measured against international indexes computed by Morgan Stanley, Salomon Brothers, First Boston and Goldman, Sachs, among others. D) B and C. E) none of the above. Answer: D Difficulty: Moderate Rationale: International investments can be evaluated against an international index, such as EAFE, created by Morgan Stanley, and others that have become available in recent years. 25. Investors looking for effective international diversification should A) invest about 60% of money their in foreign stocks. B) invest the same percentage of their money in foreign stocks that foreign equities represent in the world equity market. C) frequently hedge currency exposure. D) both A and B. E) none of the above. Answer: E Difficulty: Moderate
Chapter 25 International Diversification
Use the following to answer questions 26-28: The manager of Quantitative International Fund uses EAFE as a benchmark. Last year's performance for the fund and the benchmark were as follows:
26. Calculate Quantitative's currency selection return contribution. A) +20% B) -5% C) +15% D) +5% E) -10% Answer: B Difficulty: Difficult Rationale: EAFE: (.30)(10%) + (.10)(-10%) + (.60)(30%) = 20% appreciation; Diversified: (.25)(10%) + (.25)(-10%) + (.50)(30%) = 15% appreciation; Loss of 5% relative to EAFE. 27. Calculate Quantitative's country selection return contribution. A) 12.5% B) -12.5% C) 11.25% D) -1.25% E) 1.25% Answer: D Difficulty: Difficult Rationale: EAFE: (.30)(10%) + (.10)(5%) + (.60)(15%) = 12.5%; Diversified: (.25)(10%) + (.25)(5%) + (.50)(15%) = 11.25%; Loss of 1.25% relative to EAFE.
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28. Calculate Quantitative's stock selection return contribution. A) 1.0% B) -1.0% C) 3.0% D) 0.25% E) none of the above. Answer: A Difficulty: Moderate Rationale: (9% - 10%).25 + (8% - 5%).25 + (16% - 15%).50 = 1.00% 29. Using the S&P500 portfolio as a proxy of the market portfolio A) is appropriate because U.S. securities represent more than 60% of world equities. B) is appropriate because most U.S. investors are primarily interested in U.S. securities. C) is appropriate because most U.S. and non-U.S. investors are primarily interested in U.S. securities. D) is inappropriate because U.S. securities make up less than 40% of world equities. E) is inappropriate because the average U.S. investor has less than 20% of her portfolio in non-U.S. equities. Answer: D Difficulty: Easy Rationale: It is important to take a global perspective when making investment decisions. The S&P500 is increasingly inappropriate. 30. The average country equity market share is A) less than 2% B) between 3% and 4% C) between 5% and 7% D) between 7% and 8% E) greater than 8% Answer: A Difficulty: Moderate Rationale: This is stated in the text and confirmed by Table 25.1.
Chapter 25 International Diversification
31. When an investor adds international stocks to her portfolio A) it will raise her risk relative to the risk she would face just holding U.S. stocks. B) she can reduce its risk relative to the risk she would face just holding U.S. stocks. C) she will increase her expected return, but must also take on more risk. D) it will have no significant impact on either the risk or the return of her portfolio. E) she needs to seek professional management because she doesn't have access to international stocks on her own. Answer: B Difficulty: Easy Rationale: See Figure 25.1. 32. Which of the following countries has an equity index that lies on the efficient frontier generated by allowing international diversification? A) the United States B) the United Kingdom C) Japan D) Norway E) none of the above--each of these countries' indexes fall inside the efficient frontier. Answer: E Difficulty: Moderate Rationale: See Figure 25.8. To get to the efficient frontier you would need to combine the countries' indexes. 33. ADRs stands for ___________ and WEBS stands for ____________. A) Additional Dollar Returns; Weekly Equity and Bond Survey B) Additional Daily Returns; World Equity and Bond Survey C) American Dollar Returns; World Equity and Bond Statistics D) American Depository Receipts; World Equity Benchmark Shares E) Adjusted Dollar Returns; Weighted Equity Benchmark Shares Answer: D Difficulty: Easy Rationale: The student should be familiar with these basic terms that relate to international investing.
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34. WEBS portfolios A) are passively managed. B) are shares that can be sold by investors. C) are free from brokerage commissions. D) A and B E) A, B, and C Answer: D Difficulty: Moderate Rationale: They are passively managed and when holders want to divest their shares they sell them rather than redeeming them with the company that issued them. There are brokerage commissions, however. 35. The EAFE is A) the East Asia Foreign Equity index. B) the Economic Advisor's Foreign Estimator index. C) the European and Asian Foreign Equity index. D) The European, Asian, French Equity index. E) the European, Australian, Far East index. Answer: E Difficulty: Easy Rationale: The index is one of several world equity indices that exist. It is computed by Morgan Stanley. 36. Home bias refers to A) the tendency to vacation in your home country instead of traveling abroad. B) the tendency to believe that your home country is better than other countries. C) the tendency to give preferential treatment to people from your home country. D) the tendency to overweight investments in your home country. E) none of the above. Answer: D
Chapter 25 International Diversification
Essay Questions 37. Discuss performance evaluation of international portfolio managers in terms of potential sources of abnormal returns. Difficulty: Moderate Answer: The following factors may be measured to determine the performance of an international portfolio manager. A) Currency selection: a benchmark might be the weighted average of the currency appreciation of the currencies represented in the EAFE portfolio. B) Country selection measures the contribution to performance attributable to investing in the better-performing stock markets of the world. Country selection can be measured as the weighted average of the equity index returns of each country using as weights the share of the manager's portfolio in each country. C) Stock selection ability may be measured as the weighted average of equity returns in excess of the equity index in each country. D) Cash/bond selection may be measured as the excess return derived from weighting bonds and bills differently from some benchmark weights. The rationale for this question is to determine the student's understanding of evaluating the various components of potential abnormal returns resulting from actively managing an international portfolio. 38. Discuss some of the factors that might be included in a multifactor model of security returns in an international application of arbitrage pricing theory (APT). Difficulty: Moderate Answer: Some of the factors that might be considered in a multifactor international APT model are: A) A world stock index B) A national (domestic) stock index C) Industrial/sector indexes D) Currency movements. Studies have indicated that domestic factors appear to be the dominant influence on stock returns. However, there is clear evidence of a world market factor during the market crash of October 1987. The rationale for this question is to determine the student's understanding of the possible effects of various factors on an international portfolio.
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39. Marla holds her portfolio 100% in U.S. securities. She tells you that she believes foreign investing can be extremely hazardous to her portfolio. She's not sure about the details, but has heard some things. Discuss this idea with Marla by listing three objections you have heard from your clients who have similar fears. Explain each of the objections is subject to faulty reasoning. Difficulty: Moderate Answer: A few of the factors students may mention are Client: The U.S. markets have done extremely well in the past few years, so I should stay 100% invested in them. Your Reply: You can explain that there are other times when foreign markets have beat the U.S. substantially in performance. You can't tell easily beforehand what markets will do the best. It is important to consider that there are many times when countries' markets move in different directions and you can buffer your risk to some extent by investing globally. Client: You should keep your money at home. Your Reply: Don't confuse familiarity with good portfolio management. Even though there is a lot of information available on U.S. companies, it can be difficult to use the information to make good forecasts. Most professional managers aren't even good at this. Client: There's too much currency risk. Your Reply: It is true that there may be times when both a security's value in its own currency and the currency exchange rate may lead to poor returns. But the opposite is also true. And there are cases when security price movements and currency movements will have opposite impacts on your portfolio's return. This may have a smoothing effect on your portfolio. Client: Invest with the best. Your Reply: Even if U.S. markets have been the best performers in recent periods there is no guarantee that things will stay that way. If you diversify internationally you will benefit when other markets take the lead.
Chapter 25 International Diversification
40. You are managing a portfolio that consists of U.S. equities. You have prepared a presentation to use when you discuss the possibility of adding international stocks to your client's portfolio. Draw a graph that shows the risk of the portfolio relative to the number of stocks held in the portfolio. When your client arrives, he is surprised at your suggestion that he add international stocks, but is willing to listen to your statements to justify your recommendations. State two reasons why he should consider the international stocks and briefly explain each. Difficulty: Moderate Answer: The graph should look like the one that is shown in figure 25.7. Two important reasons for adding international securities are the favorable diversification effects due to the less than perfect positive correlations among countries' returns and the possible benefit from currency risk. This question tests the student's knowledge of the basic ideas behind investing in international stocks and other classes of equities.
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