Innocents Abroad

Calculate the stock market returns for the different countries, in both the local currency and in USD and the standard deviations of the average monthly returns. In order to answer this question we took into account the method Meyer used to calculate the returns and standard deviation which means that we calculated the stock market returns for the different countries, in both local currency and in USD and the standard deviations of the average monthly returns using first a period from 1981 to 2003 and then we divided this time period into two separate periods: from 1981 to 1991 and from 1992 to 2003.

In order to calculate the stock market returns for the different countries in their local currency we calculated the returns for each month using the regular formula and then we calculated the geometric average of these returns which yielded the following results. These values are all in monthly rates and the calculations for turning these rates into annual rates are pretty straight forward, we just use . These results are available in annex 1. Now we have to calculate the stock market returns for each country in USD, obviously because the U. S. returns are already in USD we don't calculate the U.

S. returns again. In order to do this we first divide each country's monthly index value by the corresponding monthly exchange rate which gives us the index value for each country in USD. After that we have to calculate the returns which we calculate in the same manner as before and then we calculate the geometric average of each country's monthly return so, we get the following monthly returns in USD. Once again, these results are in monthly rate, however, we applied the same formula as before to these values and the annual rates are available in annex.

Also, obviously the U. S. stock market return is not included in this table because the previous values were already in USD seeing as that is the U. S. 's currency. Just like before, we calculated the annual standard deviation of the monthly returns but this time we just multiplied the value by the square root of 12. These results are also available in annex. We have calculated these values but we believe that in order for this question to be complete we should, at least, make a small analysis of our results.

If we take a look at the two different time blocks we can see that the stock market returns were higher during the period from 1981 to 1991 than in the period from 1992 to 2003 in every country except for Canada where the returns were higher during the 1992-2003 period. Also, as we can see, the difference in returns in Japan from one period to the next was very high, especially if we take into account that from 1992 to 2003 the stock market return was negative.

When it comes to exchange rates the results are very different, in Australia, Canada, Hong Kong and the U. K. the exchange rates were higher from 1992 to 2003 than from 1981 to 1991, however, in the U. K. 's case the exchange rates are very similar for both time periods. In the remaining countries (France, Germany and Japan) we have the opposite situation; the average exchange rate was higher from 1981 to 1991 than from 1992 to 2003.

Finally, the standard deviation of monthly returns was higher in the first time period everywhere except for Germany where the standard deviation of monthly returns is slightly higher in the second time period than in the first. Calculate the correlation coefficients between the different stock markets. Much like in the previous question we calculated the correlation coefficients between the different stock markets for the whole period (1981-2003) and then divided it into two different time periods (1981-1991 and 1992-2003) both for each country's currency and for USD.

It is easy to see that correlations are higher in the second time period pretty much across the board, with only two or three exceptions and this could be explained by the globalization effect which gained force during the 90's, the fact that economies are increasingly more in contact and dependent of each other is one of the reasons that the correlation between countries is higher in this time period than before.

Also, all the correlations are higher than zero and lower than 1 which means that all these country's stock market returns are positively correlated and this result is easily explainable if we once again take into account the fact that globalization makes every country more dependent and in contact with each other and, therefore, the stock markets of each country are somewhat dependent of every other country's stock market, hence the positive correlation between the stock markets available for analysis. Identify the costs and benefits of international investing through portfolio formation.

Investing in several different countries allows for a better diversification, since the systematic risk in each market is different. This is, the correlation among markets is not perfect and, therefore, investing in several different markets allows for better diversification effects. Though, such correlations tend not to be far away from one within the developed countries. The economic globalization has turned a domestic country's economic problem into a worldwide one, since all the countries rely heavily on international trade, being a high domestic product component.

A crisis in one of its main "customers" will damage the country's export companies' performance and, consequently, the countries' overall output, which, finally, will hurt domestic companies. This "spreading mechanism" has turned international diversification among developed and open countries harder to achieve, leading to a search for new underdeveloped countries where such benefits may be reached. Even so, despite the strong correlations, some diversification effects among developed countries are possible.

Taking the current crisis as an example, we may expect U. S. companies to overperform European ones, since the U. S. 's economy is much more flexible than the European. Despite the hard hit on the U. S. it is expected that its economic recovery will happen much faster than in most European countries, though, we are actually observing a very close performance between the U. S. financial market and the European ones. Since March, the S&P 500 has surged about 30 per cent, the pan-European FTSE Eurofirst 300 has jumped 26 per cent and the Nikkei 225 has risen 25%.

Such data shows us how close the performance of these countries' financial markets is. The easiness of capital flows within developed countries is another factor that helped prompt such close performances. The highest diversification effects may be achieved through investments in underdeveloped countries. Taking for instance China's financial market, whose correlation with the US's is 0. 19 (in dollar terms). Though, these underdeveloped markets carry huge risks that must be taken into account when investing.

Political risk is probably the highest one. We have seen in Venezuela the nationalization fever held some years ago, with the economic crisis' impact, such measures may spread all over the less developed economies. But the crisis may also lead to revolutionary movements willing to take down current governments, leaving the country's economic systems on hold until peace is re-taken. Another risk that ought to be taken into account when investing in underdeveloped countries is the information/asymmetry risk.

Such countries usually lack proper information systems, leading to high flows of private information that put outside investors in disadvantage. Several other risks, like corruption risk, military conflict eminence and so on, must also be properly weighted before the decision of investing on underdeveloped countries is done. When investing in countries, regardless of their political risk, other risky variables must be analyzed. The most important one is the currency risk. Variations in exchange rates have an immediate and significant impact in the returns.

For example, a North American who had invested on France T-bonds on April 2006 (EUR/USD=1. 21) and sold his position on April 2008 (EUR/USD=1. 56), would have had a positive return of close to 30% only due to exchange rate effects. Obviously, such an investment cannot be considered a risk free investment. In fact, the exchange rate market is the most liquid market in the world (around 3. 2 trillion USD per day are traded). Many variables must be taken into account to manage such risk, like inflation, budget balance, current account balance, foreign debt and GDP per capita being the main ones.

Summing up, investing abroad carries many risks that ought to be properly weighted before making the investment decision. Exchange rate risk is by far the most important one when investing in developed countries, but when investing in underdeveloped countries, political risks play a huge role alongside with currency risks. If correctly managed, international investments may output excellent diversification effects, overperforming domestic-based investments. Evaluate the impact of currencies on investment portfolios. The risk caused by currencies effect is denominated by the exchange rate risk.

Exchange rate risk is defined by the uncertainty of returns to an investor who acquires securities denominated in a currency different from his or her own (Investment Analysis and Portfolio Management 7th Edition). The probability of incurring in this risk becomes greater as investors buy and sell assets around the world, as opposed to assets in their own country. In addition to the foreign firm's business and financial risk and the security's liquidity risk, the CapGlobal Advisors, must consider the additional uncertainty of the return on the currency of the firm they invested.

The more volatile the exchange rate between two countries, the less certain you would be regarding the exchange rate, the greater the exchange rate risk, and the larger the exchange rate risk premium you would require1. The degree of hedging against currency risk in international portfolios is a question of active debate. In academic literature there are two opposite views: the optimal asset pricing (IAPM) and optimal hedging in the futures market. In the Solnik's (1974) IAPM, investors are rational mean-variance optimizers that hold a combination of the domestic risk-free asset and a portfolio composed by stocks and bills.

This portfolio is the logarithmic utility function of each investor. The main conclusion of this model is that all investors should hold the same portfolio of risky assets, which are optimally "hedged" against currency risk through the inclusion of forward contracts. Black (1990) added specific assumptions, creating a "global" hedge ratio that is optimal for all the investors. The hedge ratio arises from the IAPM includes both: risk minimization and speculation motives. With a low risk tolerance, the hedge ratio will be close to unity, which corresponds to the pure minimization. The hedge ratio for a logarithmic investor is zero.

For less risk-averse investors, the hedge ratio is even negative. In the case-study analyzed, Henry Boss expressed his worry about the "unnecessary currency risks", ignoring in total return, the split between the stock and currency returns. Sandra Mayer created a diversification effect, combining equity stocks with currencies. In the paper, the most currency exchanged currency is the dollar (taking a short position). According to John J. Murphy in Intermarket Technical Analysis, there is a negative correlation between Gold and Dollar and the changes occur at the same time, which can be analyzed in exhibit 1

Exhibit 1 – Gold and U. S. Dollar Index price (1985-1989) In this line of though when a U. S. fund or an individual investor, takes a short position in dollar (a long position in a foreign currency), he is indirectly taking a long position in gold. Empirical studies prove there is a negative correlation between the evolution between the price of gold and the equity stock prices. We can conclude, the fund invested in a short position of U. S dollar (long position of foreign currencies) because there is a positive correlation between the price of dollar and the price of equity stocks.

Construct portfolios with different mixes of foreign and U. S. equities and identify efficient portfolios. In order to construct portfolios with different mixes of foreign and U. S. equities we must first calculate the returns of the S&P 500 Composite, EAFE and EAFE $. Afterwards we have to calculate the monthly return of these three composites for the three different periods we have been considering throughout this report: 1981-2003, 1981-1991 and 1992-2003. We calculate the monthly return using a geometric average and then we annualized the results using .