FINS3616 International Business Finance

Week 5 Lecture Topic: International Capital Market Equilibrium

TutorialQuestions

1.IsthevolatilityofthedollarreturntoaninvestmentintheJapaneseequitymarketthesumofthe
volatilityoftheJapaneseequitymarketreturninyenplusthevolatilityofyen/dollarexchangerate
changes?Whyorwhynot?
2.HowcanyouincreasetheSharperatioofaportfolio?Whattypeofstockswouldyouhavetoaddtoitin
ordertodoso?
3.WhatisthepredictionoftheCAPMwithrespecttooptimalportfoliochoice?
4.WhatisitpredictionoftheCAPMwithrespecttotheexpectedreturnonanysecurity?
5.Whatdoesitmeanforanequitymarkettobeintegratedorsegmentedfromtheworldcapitalmarket?
6.TheChinesestockmarketstradesharesissuedbythesamecompanyfornativeChineseandanother
shareforforeigninvestors.WhattypeofstockmarketwouldtheChinesemarketsbeanexampleof,a
segmentedoranintegratedequitymarkets.Why?
7.Whataresomebenefitsofaportfoliothatisinternationallydiversified?
8.Whatwouldyouexpecttohappentotheriskfreerateandequityreturnswhenasegmentedcountry
opensitscapitalmarketstoforeigninvestment?
9.SupposeFordMotorsmanagerswouldliketoinvestinanewproductionlineandmustdetermineacost
ofcapitalfortheinvestment.ThebetaforFordis1.185,thebetafortheautomobileindustryis0.97,the
equitypremiumontheworldmarketisassumedtobe6%,andtheriskfreerateis3%.Proposearangeof
costofcapitalestimatestoconsiderintheanalysis.

Problems:
1.TheEAFEistheinternationalindexcomprisingmarketsinEurope,Australia,andtheFarEast.Consider
thefollowingannualizedstockreturndata:
AverageU.S.indexreturn: 14%
AverageEAFEindexreturn: 13%
VolatilityoftheU.S.return: 15.5%
VolatilityoftheEAFEreturn: 16.5%
CorrelationofU.S.returnandEAFEreturn: 0.45

a.WhatwouldbethereturnandriskofaportfolioinvestedhalfintheEAFEandhalfintheU.S.market?
b.MarketwatchershavenoticedslowlyincreasingcorrelationsbetweentheUnitedStatesandtheEAFE
index,whichsomeascribetotheincreasingintegrationofmarkets.Giventhatthevolatilitiesremain
unchanged,isitpossiblethatthevolatilityofaportfoliothatisequallyweightedbetweenthetwoindexes
hashighervolatilitythantheU.S.market?

2.ThomYorkeisatypicalmeanvarianceinvestor,currentlyinvested100%inadiversifiedU.S.equity
portfoliowithexpectedreturnof12.46%andvolatilityof15.76%.ThomisconsideringaddingtheSTCMM
fundtohisportfolio.STCMMinvestsinU.S.smallcapitalization,hightechnologyfirmsandhasanexpected
of14.69%andavolatilityof32.5%.Thomhasdetermineditscorrelationwithhiscurrentportfoliotobe
0.7274.HeisalsointriguedbytheLYMFfund,whichinvestsinseveralemergingmarkets.Theexpected
returnonthefundisonly12%;ithas35%volatilityandacorrelationof0.2withhisportfolio.The
correlationoftheLYMFfundwiththeSTCMMfundis0.15.Assumethattheriskfreerateis5%.

a.IfThomisinterestedinimprovingtheSharperatioofhisportfolio,willheinvestapositiveamountinone
ofthefunds?Whichone?Carefullyexplainyourreasoning.
b.SupposeThomismoreriskaversethanhisfriend,NickCave.Bothcannotshortsellsecurities,andboth
arethinkingofsplittingtheirentireportfoliobetweentheU.S.portfoliothatThomiscurrentlyholding,the
STCMMfund,andtheLYMFfund.Theyalsodonotinvestintheriskfreeassetanddonotconsiderlevering
upriskyportfolios.Comparethetwoinvestorsoptimalholdings.WhowillinvestmoreintheLYMFfund,
andwhowillinvestmoreintheSTCMMfund?Why?