Floria Scarpia believes that many of her clients could benefits from using international investments to diversify their portfolios but many are reluctant to invest abroad -especially since they many be unfamiliar all suggestions to diversify internationally have met resistance. At best, clients have been willing to invest in U.S firms with international operations such as Coca-Cola or IBM
To overcome this reluctance Scarpia has decided to demonstrate the reduction in portfolio risk from foreign investments. For the demonstration she has selected a single country fund to illustrate the variability of returns from combining a country fund with an index fund based on the S&P 500 stock index. The S&P 500 has averaged a return of 10 percent with a standard deviation of 10 percent. The country fund specializes in Japanese stocks and has a beta of 1.0 when compared to the return on the Japanese market. The return has average 10 percent with standard deviation of 14 percent. The fund has no investments in U.S stocks and historically the correlation coefficients rating the returns on the fund to the S&P 500 stock index have been 0.4.to isolate the impact of selecting the fund for diversification , Scarpia assumes that the return on the fund and on the S&P 500 stock index will continue to be 10percent so that the investor can anticipate earning 10 percent regardless of which choice is made. the only consideration will be the reduction in the variability of the returns. ( i.e., the reduction in risk as measured by the standard deviation).to show the reduction , compute the standard deviation of the return when combining the U.S index fund with the Japanese fund for each of the following investment proportions:
Proportion invested in the U.S fund proportion in the foreign fund
1) What happens to the portfolio standard deviations as the investor substitutes the foreign securities for the U.S securities? What combination of U.S and Japanese stock minimizes risk?
2) Repeat the analysis but assume that the correlation coefficient is -0.2 instead of 0.4
3) Should a Japanese investor who owns only Japanese stock acquire U.S stocks?
4) How would each of the following affect a U.S investor's willingness to acquire foreign stocks?
a) The dollar is expected to strengthen
b) Globalization of financial markets should accelerate.