SUGGESTED SOLUTIONS TO CHAPTER 15 PROBLEMS

1. During the year the price of British gilts (government bonds) went from 102 to 106, while paying a coupon of 9. At the same time, the exchange rate went from 1:$1.76 to 1:$1.62. What was the total dollar return, in percent, on gilts for the year?

ANSWER. Rewriting Equation 15.4, the one-period total dollar return on a foreign bond investment r$ can be calculated as follows:

Dollar return

Local currency return

Currency gain (loss)

B(1) B(0) + C 1 + r $ = 1 + (1 + g) B(0)

where B(t) = local currency bond price at time t C = local currency coupon income G = percent change in dollar value of LC With an initial bond price of 102, coupon income of 9, end-of-period bond price of 106, and pound depreciation of (1.62 - 1.76)/1.76 = -7.95%, the total dollar return is 3.79%: r$ = [1 + (106 - 102 + 9)/102](1 - .0795) - 1= (1.1275)(0.9205) - 1= 3.79% 2. During a recent six-month period, Swiss government bonds yielded a local-currency return of -1.6 percent. However, the Swiss franc rose by 8 percent against the dollar over this six-month period. Corresponding figures for France were 1.8 percent and 2.6 percent. Which bond earned the higher U.S. dollar return? What was the return?

ANSWER. The dollar return on Swiss bonds equaled (1 - .016)(1 + 0.08) - 1 = 6.27%. The return on French bonds was lower at (1.018)(1.026) - 1 = 4.45%. In this case, Swiss franc appreciation more than offset the lower local currency return on Swiss bonds. 3. During the year Toyota Motor Company shares went from 9,000 to 11,200, while paying a dividend of 60. At the same time, the exchange rate went from $1 = 145 to $1 = 120. What was the total dollar return, in percent, on Toyota stock for the year?

ANSWER. Rewriting Equation 15.5, the one-period total dollar return on a foreign stock investment R$ can be calculated as follows:

Dollar return

Local currency Currency x return gain(loss

P(1) P(0) + DIV 1 + R$ = 1 + (1 + g) P(0)

where

P(t) = local currency stock price at time t DIV = local currency dividend income

Substituting in the numbers yields a total dollar return on Toyota stock for the year of 51.17%: R$ = [1 + (11,200 - 9,000 + 60)/9,000](1+.2083) - 1 = (1.2511)(1.2083) - 1 = 51.17% Note that yen appreciation during the year was (145 - 120)/120 = 20.83%. 4. During 1989, the Mexican stock market climbed 112 percent in peso terms while the peso depreciated by 28.6 percent against the U.S. dollar. What was the dollar return on the Mexican stock market during the year?

ANSWER. According to these data, the dollar return on the Mexican stock market during 1989 was 51.37%: R$ = (1 + 1.12)(1 - 0.286) - 1 = 51.37% 5a. In 1992, the Brazilian market rose by 1,117 percent in cruzeiro terms, while the cruzeiro fell by 91.4 percent in dollar terms. Meanwhile, the U.S. market rose by 8.5 percent. Which market did better? ANSWER. The dollar return on the Brazilian market can be calculated using Equation 15.5: R$ = (1 + 11.17)(1 - 0.914) - 1 = 4.66% The numbers reflect the fact that a return of 1,127% is equivalent to receiving an additional Cr11.17 for each Cr1 invested. Based on these figures, the U.S. market return of 8.5% bested the dollar return on the Brazilian market by almost 4 percentage points. b. In 1993, the Brazilian market rose by 4,190 percent in cruzeiro terms, while the cruzeiro fell by 95.9 percent in dollar terms. Did the Brazilian market do better in dollar terms in 1992 or in 1993?

ANSWER. Redoing the numbers in the answer to part a, we see that the Brazilian market did far better in 1993 than in 1992: R$ = (1 + 41.90)(1 - 0.959) - 1 = 75.89% In this case, the extraordinarily large local currency return more than offset the dramatic devaluation of the cruzeiro. 6. Suppose that the dollar is now worth 1.1372. If one-year German bunds are yielding 9.8 percent and one-year U.S. Treasury bonds are yielding 6.5 percent, at what end-of-year exchange rate will the dollar returns on the two bonds be equal? What amount of euro appreciation or depreciation does this equilibrating exchange rate represent?

ANSWER. To begin, given that German bunds are yielding more than U.S. Treasuries, it is clear that for dollar returns on these two securities to equilibrate, the euro must depreciate against the dollar by about the interest differential, which is 3.3%. Using Equation 15.4, the expected dollar return on investing $1 in a bund (after first converting it into 1.1372) for a year can be found as 1.1372(1.098)e1 = 1.2486e1 where e1 is the unknown end-of-year exchange rate ($/). Note that ex ante, one cannot anticipate any capital gains or losses on investing. Setting this figure equal to the $1.065 expected dollar return from investing one dollar in a Treasury bond yields the solution e1 = $0.8529, which converts into a direct quote for the dollar of 1.1724. This exchange rate entails a euro depreciation of (1.1372 - 1.1724)/1.1724 = -3.01% against the dollar. Alternatively, the dollar has appreciated against the euro by (1.1724 - 1.1372)/1.1372 = 3.10%. 7. In 1990, Matsushita bought MCA Inc. for $6.1 billion. At the time of the purchase, the exchange rate was about 145/$. By the time that Matsushita sold an 80% stake in MCA to Seagram for $5.7 billion in 1995, the yen had appreciated to a rate of about 97/$.

a.

Ignoring the time value of money, what was Matsushita's dollar gain or loss on its investment in MCA?

ANSWER. If an 80% stake in MCA was worth $5.7 billion, then the entire firm was worth $7.125 billion. Based on this valuation, Matsushita actually made $1.025 billion on its purchase of MCA. That is, by buying MCA at a price of $6.1 billion and selling it for a price that valued the business at $7.125 billion, Matsushita made $1.025 billion. b. What was Matsushita's yen gain or loss on the sale?

ANSWER. Taking into account the differences in exchange rates, Matshushita paid 884,500,000,000 (6,100,000,000 x 145) for MCA in 1990 and sold MCA in 1995 for a price that valued it at 691,125,000,000 (7,125,000,000 x 97). The net result was a loss for Matsushita of 193,375,000,000 on its purchase of MCA. c. What did Matsushita's yen gain or loss translate into in terms of dollars? What accounts for the difference between this figure and your answer to part a?

ANSWER. Matsushita's yen loss converts into a dollar loss of $1,993,556,701 (193,375,000,000/97). This figure differs from the answer in part a because it takes into account the change in exchange rates between 1990 and 1995. In effect, it asks what would have happened if Matsushita had held onto its yen instead of converting them into a dollar asset that didn't appreciate in line with the yen's appreciation. In other words, this computed dollar loss represents an opportunity cost. 8. Suppose that the standard deviations of the British and U.S. stock markets have risen to 38 percent and 22 percent, respectively, while the correlation between the U.S. and British markets has risen to 0.67. What is the new beta of the British market from a U.S. perspective?

Standard deviation British market Correlation with of British market = x beta U.S. market Standard deviation of U.S. market
ANSWER. Using the following formula to calculate the beta of the British market we can calculate the new British market beta from the perspective of a U.S. investor to be 0.67 x 38/22 = 1.16. 9. A portfolio manager is considering the benefits of increasing his diversification by investing overseas. He can purchase shares in individual country funds with the following characteristics: U.S. (%) Expected return Standard deviation of return Correlation with U.S. a. 15 10 1.0 U.K. (%) 12 9 0.33 Spain (%) 5 4 0.06

What is the expected return and standard deviation of return of a portfolio with 25 percent invested in the United Kingdom and 75 percent in the United States?

ANSWER. Use the formulas rp = w1r1 + w2r2 and p2 = w1212 + w2222 + 2w1w2r1212 to calculate the means and standard deviations of the portfolios. % US %UK 75 50 25 Expected Return 12.75 13.50 14.25 Standard Deviation 7.93 7.75 8.51

25 50 75

b.

What is the expected return and standard deviation of return of a portfolio with 25 percent invested in Spain and 75 percent in the United States?

ANSWER. Using the same formulas as in the answer to part a, we can calculate the means and standard deviations of the various portfolios as follows: %US %Spain Expected Return Standard Deviation

c.

25 75 7.50 4.02 10.00 5.50 50 50 75 25 12.50 7.63 Calculate the expected return and standard deviation of return of a portfolio with 50 percent invested in the United States and 50 percent in the United Kingdom. With 50 percent invested in the United States and 50 percent invested in Spain. Calculate the expected return and standard deviation of return of a portfolio with 25 percent invested in the United States and 75 percent in the United Kingdom. With 25 percent invested in the United States and 75 percent invested in Spain.

d.

ANSWER. The answers to items a and b contain the answers to items c and d. e. Plot these two sets of risk-return combinations (a) through (d) as in Exhibit 15.5. Which leads to a better set of risk-return choices, Spain or the United Kingdom?

ANSWER. As the following diagram shows, Spain offers better diversification opportunities because its fund returns are less correlated with the U.S. market (corr. = 0.06) than U.K. funds (corr. = 0.33). However, it also obvious that investors are sacrificing a significant amount of expected return by choosing to add Spanish stocks to their portfolios.

Ri sk -R e tur n C om b in a ti o ns fo r U .S ., Sp ai n, a n d th e U .K .

15 % 14 % n r u t e r d e t c e p x E 13 % 12 % 11 % 10 % 9% 8% 7% 6% 3% 4% 5% 6% S tanda rd de viation 7% 8% 9%
Po rtfo lio C om b in ati on s o f U .S. an d S p an is h F un ds

Po rtfo lio C om b in ati on s o f U .S. an d U.K. F un ds

f.

How can you achieve an even better risk-return combination?

ANSWER. An investor can improve on the risk-return combination selected in the answer to part d by including the U.K. fund in the portfolio. You can never do worse by expanding the set of portfolio assets. The appropriate percent to invest in the U.K. fund depends on the correlation between the U.K. fund and the Spain fund, which we don't know. 10. Suppose that the standard deviation of the return on Nestl, a Swiss firm, in terms of Swiss francs is 19 percent and the standard deviation of the rate of change in the dollar-franc exchange rate is 15 percent. In addition, the estimated correlation between the Swiss franc return on Nestl and the rate of change in the exchange rate is 0.17. Given these figures, what is the standard deviation of the dollar rate of return on investing in Nestl stock?

ANSWER. According to Equation 15.8 in the text, we can write the standard deviation of the dollar return, $, as $ = [f2 + g2 + 2fgf,g] where f2 = the variance (the standard deviation squared) of the foreign currency return g2 = the variance of the change in the exchange rate f,g = the correlation between the foreign currency return and the exchange rate change

Applying this equation, the standard deviation of the dollar rate of return on investing in Nestl stock is 27.33%:

$ (Nestle) = (0.19 2 + 0.152 + 2 x .19 x .15 x .17) = 0.2733

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