Hedging Currency Risks at Aifs Case Questions

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Session 4 CASE Questions

Innocents Abroad: Currencies and International Stock Returns

The goal of this case is to help Sandra Meyer develop a presentation to address Henry Bosse’s concerns about international investments. The general idea is to demonstrate to Henry the benefits of international diversification, if any. To achieve this goal, you need to have a view on 1) the impact of foreign exchange (FX) rates on the return and risk of international investments, and 2) the impact of having more assets on the return and risk of the investment portfolio To form views on these two points, answer the following questions: I. The impact of FX rates on the risk and return of foreign investments 1a) Using data in Appendix A, calculate the expected return and variance of each of the eight country indices in their respective local currencies. Calculate the equal-weighted index of these returns, and its expected return and variance. 1b) Convert each of the local-currency index values to US$ using the exchange rates provided. Calculate the expected return and variance for each of the resulting return series. Calculate the equal-weighted index of these returns, and its expected return and variance. 1c) Compare results from 1a and 1b. For a US investor (such as Mr. Bosse), does FX exposure increase or decrease his total return on foreign investments? Does FX exposure increase or decrease the overall risk of his investment? Does FX exposure increase or decrease the Sharpe Ratios of his investment? 1d) For each of the eight countries, decompose the variance of its US$-return into the following three components: - due to return in the underlying local index

- due to FX rate - due to the correlation between the two How much does FX exposure contribute to the overall risk? (It’s useful to come up with some representative numbers, such as 15% for example). Now repeat the analysis for the equal-weighted index. Can currency risk be diversified away? Note: One can decompose...
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