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# bkmsol_ch25 - CHAPTER 25 INTERNATIONAL DIVERSIFICATION 1 d...

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CHAPTER 25: INTERNATIONAL DIVERSIFICATION 1. d. Initial investment = 2,000 × \$1.50 = \$3,000 Final value = 2,400 × \$1.75 = \$4,200 Rate of return = (\$4,200/\$3,000) - 1 = 0.40 = 40% 2. a. 3. c. 4. a.\$10,000/2 = £5,000 £5,000/£40 = 125 shares b. To fill in the table, we use the relation: 1 + r(US) = [(1 + r f (UK)] 0 1 E E Price per Pound-Denominated Dollar-Denominated Return (%) for Year End Exchange Rate Share (£) Return (%) \$1.80/£ \$2.00/£ \$2.20/£ £35 -12.5% -21.25% -12.5% -3.75% £40 0.0% -10.00% 0.0% 10.00% £45 12.5% 1.25% 12.5% 23.75% c.The dollar-denominated return equals the pound-denominated return when the exchange rate is unchanged over the year. 5. The standard deviation of the pound-denominated return (using 3 degrees of freedom) is 10.21%. The dollar-denominated return has a standard deviation of 13.10% (using 9 degrees of freedom), greater than the pound-denominated standard deviation. This is due to the addition of exchange rate risk. 25-1

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6. First we calculate the dollar value of the 125 shares of stock in each scenario. Then we add the profits from the forward contract in each scenario. Price per Dollar Value of Stock at Given Exchange Rate Share (£) Exchange Rate: \$1.80/£ \$2.00/£ \$2.20/£ £35 7,875 8,750 9,625 £40 9,000 10,000 11,000 £45 10,125 11,250 12,375 Profits on Forward Exchange: [ = 5000(2.10 – E 1 )] 1,500 500 -500 Price per Total Dollar Proceeds at Given Exchange Rate Share (£) Exchange Rate: \$1.80/£ \$2.00/£ \$2.20/£ £35 9,375 9,250 9,125 £40 10,500 10,500 10,500 £45 11,625 11,750 11,875 Finally, calculate the dollar-denominated rate of return, recalling that the initial investment was \$10,000: Price per Rate of return (%) at Given Exchange Rate Share (£) Exchange Rate: \$1.80/£ \$2.00/£ \$2.20/£ £35 -6.25% -7.50% -8.75% £40 5.00% 5.00% 5.00% £45 16.25% 17.50% 18.75% b. The standard deviation is now 10.24%. This is lower than the unhedged dollar-denominated standard deviation, and is only slightly higher than the standard deviation of the pound-denominated return. 7. Currency Selection EAFE: [0.30 × (–10%)] + (0.10 × 0%) + (0.60 × 10%) = 3.0% Manager: [0.35 × (–10%)] + (0.15 × 0%) + (0.50 × 10%) = 1.5% Loss of 1.5% relative to EAFE. Country Selection EAFE: (0.30 × 20%) + (0.10 × 15%) + (0.60 × 25%) = 22.50% Manager: (0.35 × 20%) + (0.15 × 15%) + (0.50 × 25%) = 21.75% Loss of 0.75% relative to EAFE. Stock Selection [(18% – 20%) × 0.35] + [(20% – 15%) × 0.15] + [(20% – 25%) × 0.50] = – 2.45% Loss of 2.45% relative to EAFE. 25-2
8. 1 + r(US) = [1 + r f (UK)] × (F 0 /E 0 ) = 1.08 × (1.85/1.75) = 1.1417 r(US) = 14.17% 9. You can now purchase: \$10,000/\$1.75 = £5,714.29 This will grow with 8% interest to £6,171.43. Therefore, to lock in your return, you would sell forward £6,171.43 at the forward exchange rate. 10. a. The primary rationale is the opportunity for diversification. Factors that contribute to low correlations of stock returns across national boundaries are: i. imperfect correlation of business cycles ii. imperfect correlation of interest rates iii. imperfect correlation of inflation rates iv. exchange rate volatility b. Obstacles to international investing are: i. Availability of information , including insufficient data on which to base investment decisions.

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