Question 1

As the number of assets held in a portfolio increases, the variance of return on the portfolio becomes more dependent on the covariances between the individual assets and less dependent on the variances of the individual assets.

Accepted Answer

This is known as diversification and it is used to reduce the overall risk of a portfolio by not putting all of one's eggs in one basket. As the number of assets in a portfolio increases, the impact of individual assets' risk becomes diluted by the impact of other assets in the portfolio. This means that the total variance of the portfolio becomes more dependent on the interactions between the assets rather than the individual assets themselves.

Question 2

In perfect markets, rational investors have equal access to information and to market prices.

Accepted Answer

In theory, perfect markets assume that all market participants have equal access to information about the market and the prices assigned to various assets. This means that investors have access to the same information and can make rational decisions based on that information. In reality, however, perfect markets do not exist, as there are always some advantages and disadvantages to different participants that can skew market outcomes.

Question 3

Dividend distributions are subject to withholding taxes in many countries.

Accepted Answer

Many countries impose withholding taxes on dividend distributions to foreign shareholders. The amount of withholding tax can vary depending on the country and the tax treaty agreements in place.

Question 4

Suppose both goods and financial markets are segmented across national borders but are otherwise efficient. Then, multinational corporations may be able to reduce their cost of capital through foreign direct investment.

Accepted Answer

Multinational corporations can reduce their cost of capital through foreign direct investment because they can access capital at a lower cost in countries where interest rates are lower or where financing is more readily available. This helps them to finance their projects at a lower cost and potentially earn higher profits.

Question 5

Financial contracts in high-inflation countries are seldom pegged to inflation because their value would be eroded at a rapid rate.

Accepted Answer

Their value would be eroded if they were not pegged.

Question 6

A national securities market can be informationally efficient in a domestic context and yet segmented in an international context.

Accepted Answer

A national securities market can incorporate all available information efficiently within its domestic borders, but it may not efficiently incorporate international information, leading to segmentation in the international context. This can occur due to factors such as regulatory barriers, language barriers, lack of familiarity with foreign markets, and limited access to foreign information sources.

Question 7

The extent to which risk is reduced through portfolio diversification primarily depends on the expected returns and variances of return in the portfolio.

Accepted Answer

It depends primarily upon the covariances (or correlations).

Question 8

The variance of foreign bond returns to domestic residents is primarily due to return variance in foreign market returns and to a lesser extent to variance in exchange rates.

Accepted Answer

It is due primarily to exchange rate variability.

Question 9

The variance of foreign stock returns to domestic residents is primarily due to variance in foreign market returns and to a lesser extent to variance in exchange rates.

Accepted Answer

The variance in foreign market returns has a larger impact on the variance of foreign stock returns than exchange rates. Exchange rates still have an impact, but it is generally smaller in comparison.

Question 10

The extent to which risk is reduced through portfolio diversification primarily depends on the covariance between individual assets in the portfolio.

Accepted Answer

Covariance measures the degree to which two assets move in the same direction (positive covariance) or opposite directions (negative covariance). By including assets with low or negative covariance in a portfolio, the overall risk of the portfolio can be reduced through diversification. Therefore, the extent to which risk is reduced through portfolio diversification primarily depends on the covariance between individual assets in the portfolio.

Question 11

Allocational efficiency refers to whether ownership in a state-owned firm is distributed equally among the citizens when the firm is privatized.

Accepted Answer

Allocationally efficient markets optimally allocate capital to productive investments.

Question 12

American depository receipts pay dividends in dollars and trade on U.S. exchanges just like other domestic U.S. shares.

Accepted Answer

American depository receipts (ADRs) are issued by U.S. banks and represent ownership of shares in a foreign company. ADRs trade on U.S. exchanges in dollars and pay dividends in dollars, just like other domestic U.S. shares.

Question 13

The Sharpe index is useful for measuring the risk-adjusted performance of a single asset in a well-diversified portfolio.

Accepted Answer

The Sharpe index is best for measuring the performance of a portfolio.

Question 14

Solnik ["Why not diversify internationally?" Financial Analysts Journal, 1974] estimates that the systematic risk of a diversified portfolio of U.S. stocks can be reduced by about half by including international stocks in the portfolio.

Accepted Answer

According to Solnik's research, including international stocks in a diversified portfolio can reduce its systematic risk by approximately 50%.

Question 15

American shares pay dividends in dollars and trade on U.S. exchanges just like other domestic U.S. shares.

Accepted Answer

They are denominated in the foreign currency.

Question 16

Total risk equals systematic risk plus unsystematic risk plus error.

Accepted Answer

Unsystematic risk includes any random noise or error.

Question 17

Solnik ["Why not diversify internationally?" Financial Analysts Journal, 1974] estimates that systematic risk comprises approximately 74% of individual security variance within a portfolio of U.S. stocks.

Accepted Answer

Unsystematic risk comprises 74% of total risk in a diversified U.S. portfolio.

Question 18

The risk of an individual asset when held in a portfolio with a large number of assets depends primarily on its return covariance with other assets in the portfolio and not on its return variance.

Accepted Answer

The risk of an individual asset, when held in a portfolio, is described by its contribution to portfolio risk, which is determined by its covariance with other assets in the portfolio. Return variance is an important factor in determining an asset's risk, but it is not the primary determinant of an asset's risk in a portfolio context.

Question 19

A foreign stock goes up 10% in price in the foreign currency as the domestic currency depreciates by 10%. The price of the foreign stock in domestic currency stays the same.

Accepted Answer

It increases in value by (1.10)(1.10) - 1 = 0.21, or 21%.

Question 20

Open-end mutual funds often trade at large premiums or discounts to net asset value.

Accepted Answer

They trade close to net asset value.

Quiz 19: International Portfolio Diversification