International Financial Markets Assignment-
Q(1) You have 100% of your wealth in the U.S. stock market. You learned in MBA 796 that international diversifications often lead to a portfolio with better risk-return characteristics. Consider the following information about the U.S. market and the MSCI Latin America Indexes.
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U.S. Stocks
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MSCI Latin America (un hedged)
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MSCI Latin America (hedged)
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Expected return
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12%
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11%
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11%
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Standard deviation of return
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20%
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30%
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25%
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U.S. risk-free rate
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6%
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Correlation with U.S. stocks
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1.00
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0.40
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0.70
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a. What is the expected return and standard deviation of a portfolio with 90% in U.S. stocks and 10% in un-hedged Latin American stocks?
b. Is the Sharpe Ratio of the portfolio in (a) higher or lower than the Sharpe Ratio of a portfolio with 100% in U.S. stocks?
c. Should you diversify into Latin American stocks? If so, should you hedge your currency risk?
d. Is the correlation between U.S. stocks and Latin American currencies positive?
Q(2) You work for a boutique investment bank specializing in helping foreign firms issue ADRs in the United States. You are considering approaching one of the following two candidates: (i) Super Honest, Inc. headquartered in Switzerland, and (ii) Giant Mining, PLC headquartered in Ivory Coast (a small country in Africa). Assuming that both prospective customers can meet all the requirements for listing in the U.S., who is likely to:
a. Experience a greater reduction in cost of capital?
b. Benefit more from an access to capital in the U.S.?
c. Pay higher explicit and implicit costs to meet the relevant SEC regulations?
Q(3) In this exercise, I'd like you to try estimating a stock's CAPM "beta" by linear regression. The monthly risk premiums for Petrobras, MSCI Brazil Index, and the MSCI World Index are in the spreadsheet "Problem Set 2.xlsx." These premiums are in terms of BRL, net of the BRL risk-free rate.
E(rPETR) - rf = βPETR,M(E(rM) - rf)
where "PETR" denotes Petrobras and "M" denotes the market portfolio. If you use Excel, regressing PETR risk premium on the market risk premium means that Y = PETR risk premium, X = market risk premium, and βPETR,M is the coefficient of X. Please allow the intercept term in your regression.
a. Use a "domestic" CAPM. Regress the risk premium of Petrobras on the risk premium of MSCI Brazil Index. That is, take MSCI Brazil Index as the market return in the above equation. What is the estimate of domestic CAPM beta for Petrobras (βPETR,brazil)?
b. Use a "world" CAPM. Regress the risk premium of Petrobras on the risk premium of MSCI World Index. That is, take MSCI World Index as the market return in the above equation. What is the estimate of world CAPM beta for Petrobras (βPETR,World)?
c. Now, estimate the beta for Brazil as a portfolio by regressing the risk premium of MSCI Brazil Index on the risk premium of MSCI World Index. What is the estimate of world CAPM beta for Brazil (βBrazil,World)?
d. Brazil in an open country; so, in general, you should use a world CAPM. If you happened to wrongly use a domestic CAPM, your estimated cost of capital would be wrong. How wrong? The error is equal to:
(βPETR,brazil βBrazil,World - βPETR,World)[E(rworld) - rf]
Suppose that [E(rworld) - rf) is 6% per annum. What is the error from using the wrong version of CAPM (i.e., using the domestic CAPM as opposed to the world CAPM)?