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58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
A
B
C
D
E
F
G
H
I
J
Bordered Covariance Matrix for Target Return Portfolio
EWD
EWH
EWI
EWJ
EWL
EWP
EWW
SP 500
Weights
0.00
0.00
0.08
0.38
0.02
0.00
0.00
0.52
0.0000
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.0000
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.0826
0.00
0.00
4.63
3.21
0.55
0.00
0.00
7.69
0.3805
0.00
0.00
3.21
98.41
1.82
0.00
0.00
53.79
0.0171
0.00
0.00
0.55
1.82
0.14
0.00
0.00
2.09
0.0000
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.0000
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.5198
0.00
0.00
7.69
53.79
2.09
0.00
0.00
79.90
1.0000
0.00
0.00
16.07
157.23
4.59
0.00
0.00
143.47
Port Via
321.36
Port S.D.
17.93
Port Mean
12.00
Weights
Mean
St. Dev
EWD
EWH
EWI
EWJ
EWL
EWP
EWW
SP 500
6
21.89
0.02
0.00
0.00
0.71
0.00
0.02
0.00
0.26
9
19.66
0.02
0.00
0.02
0.53
0.02
0.00
0.00
0.41
12
17.93
0.00
0.00
0.08
0.38
0.02
0.00
0.00
0.52
15
16.81
0.00
0.00
0.14
0.22
0.02
0.00
0.00
0.62
18
16.46
0.00
0.00
0.19
0.07
0.02
0.00
0.00
0.73
21
17.37
0.00
0.00
0.40
0.00
0.00
0.00
0.00
0.60
24
21.19
0.00
0.00
0.72
0.00
0.00
0.00
0.00
0.28
27
26.05
0.00
0.00
1.00
0.00
0.00
0.00
0.00
0.00
919
2. Country selection measures the contribution to performance attributable to invest-
ing in the better-performing stock markets of the world. It 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. We use index returns to abstract
from the effect of security selection within countries. To measure a manager’s
contribution relative to a passive strategy, we might compare country selection to
the weighted average across countries of equity index returns using as weights the
share of the EAFE portfolio in each country.
3. Stock selection ability may, as in Chapter 24, be measured as the weighted aver-
age of equity returns in excess of the equity index in each country. Here, we would
use local currency returns and use as weights the
investments in each country.
4. Cash/bond selection may be measured as the
excess return derived from weighting bonds and
bills differently from some benchmark weights.
Table 25.13 gives an example of how to measure the
contribution of the decisions an international portfolio
manager might make.
Using the data in Table 25.13 , compute the man-
ager’s country and currency selection if portfo-
lio weights had been 40% in Europe, 20% in
Australia, and 40% in the Far East.
CONCEPT CHECK
25.3
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920
P A R T V I I
Applied Portfolio Management
EAFE
Weight
Return on
Equity Index
Currency
Appreciation
E
1
/E
0
2 1
Manager’s
Weight
Manager’s
Return
Europe
0.30
10%
10%
0.35
8%
Australia
0.10
5
2
10
0.10
7
Far East
0.60
15
30
0.55
18
Overall performance (dollar return 5 return on index 1 currency appreciation)
EAFE: .30(10 1 10) 1 .10(5 2 10) 1 .60(15 1 30) 5 32.5%
Manager: .35(8 1 10) 1 .10(7 2 10) 1 .55(18 1 30) 5 32.4%
Loss of .10% relative to EAFE
Currency selection
EAFE:
(0.30 3 10%) 1 (0.10 3 (210%)) 1 (0.60 3 30%) 5 20% appreciation
Manager: (0.35 3 10%) 1 (0.10 3 (210%)) 1 (0.55 3 30%) 5 19% appreciation
Loss of 1% relative to EAFE
Country selection
EAFE:
(0.30 3 10%) 1 (0.10 3 5%) 1 (0.60 3 15%) 5 12.5%
Manager: (0.35 3 10%) 1 (0.10 3 5%) 1 (0.55 3 15%) 5 12.25%
Loss of 0.25% relative to EAFE
Stock selection
(8% 2 10%)0.35 1 (7% 2 5%)0.10 1 (18% 2 15%)0.55 5 1.15%
Contribution of 1.15% relative to EAFE
Sum of attributions (equal to overall performance)
Currency (21%) 1 country (2.25%) 1 selection (1.15%) 5 2.10%
Table 25.13
Example of
performance attribu-
tion: international
1. U.S. assets are only a part of the world portfolio. International capital markets offer important
opportunities for portfolio diversification with enhanced risk–return characteristics.
2. Exchange rate risk imparts an extra source of uncertainty to investments denominated in foreign
currencies. Much of that risk can be hedged in foreign exchange futures or forward markets, but
a perfect hedge is not feasible unless the foreign currency rate of return is known.
3. Several world market indexes can form a basis for passive international investing. Active inter-
national management can be partitioned into currency selection, country selection, stock selec-
tion, and cash/bond selection.
SUMMARY
exchange rate risk
interest rate parity relationship
covered interest arbitrage
relationship
political risk
Europe, Australasia, Far East
(EAFE) index
currency selection
country selection
stock selection
cash/bond selection
KEY TERMS
Related Web sites
for this chapter are
available at www.
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C H A P T E R
2 5
International Diversification
921
Interest rate parity (covered interest arbitrage) for direct ($/foreign currency) exchange rates:
F
0
5 E
0
1
1 r
f
(U.S.)
1
1 r
f
(foreign)
Interest rate parity for indirect (foreign currency/$) exchange rates:
F
0
5 E
0
1
1 r
f
(foreign)
1
1 r
f
(U.S.)
KEY EQUATIONS
1. Return to the box “International Investing Raises Questions” on page 918. The article was writ-
ten several years ago. Do you agree with its response to the question, “Can U.S. companies with
global operations give you international diversification?”
2. I n Figure 25.2 , we provide stock market returns in both local and dollar-denominated terms.
Which of these is more relevant? What does this have to do with whether the foreign exchange
risk of an investment has been hedged?
3. S uppose a U.S. investor wishes to invest in a British firm currently selling for £40 per share. The
investor has $10,000 to invest, and the current exchange rate is $2/£.
a. How many shares can the investor purchase?
b. Fill in the table below for rates of return after 1 year in each of the nine scenarios (three pos-
sible prices per share in pounds times three possible exchange rates).
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