Chapter 9 – Replacement problems:

1.The annualized performance, in U.S. dollars, of the United States and EAFE stock indices are:
ReturnUS  12% US  15.5%
ReturnEAFE  14.6% EAFE  18.2%
Correlation  0.47
a. What would be the return and risk of a portfolio invested half in the U.S. market and half in the
EAFE index?
b. What if the correlation increases to 0.6?

2. The annualized performance, in U.S. dollars, of the U.S. and European stock indices are:
ReturnUS  10% US  16%
Returneurope  11% europe 18%
Correlation  0.60

. What would be the return and risk of a portfolio invested half in the U.S. market and half in the
European index?
b. What if the correlation increases to 0.8?
3. Here are the expected returns and risks of two assets:
E(R1)  10% 1  16%
E(R2)  14% 2  16%
a. Assume a correlation of 0.5 and draw all the portfolios made up of the two assets in an Expected
Return/Risk graph.
b. Same question assuming successively a correlation of 1, 0, and 1.
c. Looking at the four graphs, what do you conclude about the importance of correlation in
risk-reduction?
4.The French stock market has a sigma of 20%, when computed in euros. The U.S. stock market has a
sigma of 16% in US$ and the €/US$ exchange rate has a sigma of 6%.
a. Assuming that the correlation between stock market and currency movements is zero, what is
the sigma of the U.S. stock market when expressed in €.
b. Using this number, calculate the sigma, in €, of a portfolio made up of 50% of French stocks and
50% of U.S. stocks (zero-correlation between the two markets).

5.Assume that the domestic and foreign assets have standard deviations of d  16% and f  19%,
respectively, with a correlation of df  0.6. The risk-free rate is equal to 5% in both countries.
a. The expected returns of the domestic and foreign assets are both equal to 10%, E(Rd)  E(Rf ) 
10%. Calculate the Sharpe ratios for the domestic asset, the foreign asset, and an internationally-
diversified portfolio equally invested in the domestic and foreign assets. What do you conclude?
b. Assume now that the expected return on the foreign asset is higher than on the domestic asset,
E(Rd)  10% but E(Rf) 12%. Calculate the Sharpe ratio for an internationally diversified
portfolio equally invested in the domestic and foreign assets, and compare your findings to those
in Question (a).