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P = (CovPM /VarM)
2
Total Risk
80
Diversifiable Risk
(unsystematic)
Market Risk
(systematic)
60
Portfolio of
U.S. stocks
40
27%
Total
risk
20
Systematic
risk
10
20
30
40
50
E(Rp)
Capital Market
Line (Domestic)
DP
R DP
MRD
Rf
Domestic portfolio
opportunity set
DP
Expected Risk
10
Optimal
international
portfolio
IP
Capital Market
Line (International)
Capital Market
Line (Domestic)
DP
Internationally diversified
portfolio opportunity set
Rf
Domestic portfolio
opportunity set
IP
DP
Risk reduction of
optimal portfolio
Expected
Risk, P
13
18
17
Minimum risk
combination
(70% US &
30% GER)
16
15
Maximum
return &
Initial portfolio
(40% US & 60% GER) maximum risk
(100% GER)
14
13
12
P
0
11
12
13
14
15
16
17
18
19
20
15
16
Segmented markets
Lack of liquidity
Exchange rate controls
Underdeveloped capital markets
Exchange rate risk
Lack of information
a) not readily accessible
b) data is not comparable
17
rp
= a rUS + ( 1 - a) rrw
= 0.65(0.05) + 0.35(0.10)
= 6.75%
where
US2
rw2
Portfolio Risk
What is the risk of a portfolio with 35% invested in
Japan with a standard deviation of 6% and a
standard deviation of 8% in the U.S. and a
correlation coefficient of 0.7?
1/ 2
P a (1 a) 2a(1 a) US rw
2
2
US
2
rw
B(1) B(0) C
1 R$ 1
(1 g )
B(0)
P(1) P(0) D
1 R$ 1
(1 g )
P(0)
P(1) P(0) D
1 R$ 1
(1 g )
P
(0)
where
R$ = dollar return
P(0) = foreign currency stock
price at time 0
P(1) = foreign currency stock
price at time 1
D
= foreign currency annual
dividend
23
P(0)
48 50 1 .20 .2105
1
1
1
50
.2105
R$ 6.9%
24