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Assignment Guide

International Financial Management (FINA862)

 Assignment Task

You work for a global investment firm and is in charge of providing international investment advice to a group of clients. In particular, one client is seeking your advice on allocating assets internationally. The client is a local state pension fund from                     .

(You will be randomly assigned one home country and three foreign countries to invest in your client’s portfolio from the following list of countries, please see attached spreadsheet (country allocation) on the canvas course page under assignments tab->assessment. The countries will be from the following list: Argentina, Australia, Belgium, Brazil, Canada, Chile, China, Colombia, Denmark, Finland, France, Germany, Greece, India, Indonesia, Ireland, Japan, South Korea, Luxembourg, Mexico, Netherlands, New Zealand, Russia, South Africa, Spain, Switzerland, Taiwan, Turkey, the United Kingdom and the United States.)

The client is questioning their international portfolio allocation in light of the underperformance of major developed countries’ equities and the high volatility of emerging market equities. The client had expressed scepticism that an international strategy might not add much value to their overall portfolios and in fact might create unnecessary currency risks.

You are tasked with explaining the fundamentals of global markets to the client and with justifying your investment strategy. Your mission is to educate the client on:

(i) the benefits of international diversification

(ii) the impact of currency movements on returns of global portfolios

(iii) the drivers and consequences of correlations among global equity markets

(iv) the risks and limitations of international investing.

You understand perfectly well that the past does not predict the future. Nevertheless, you rely on the data for past returns to get a feel for the return and volatility characteristics of various markets. You need to develop international asset allocation strategies by examining individual foreign markets and measuring the returns and standard deviations of those markets both in local currency and in the home currency of the client. You will need to examine the performance of international equities over a considerable period of time, from 2000 to 2018, and also for short periods within this time frame (sub-periods). You will be assigned three equity markets out of the above countries list. In addition, your analysis will include the home equity market of your client. You are given total return stock market indices which include dividends (see provided spreadsheet).

You prepare a report for the client, addressing the following questions:

1. Returns and standard deviations (8 marks)

You need to provide the client with information on the returns and standard deviations of foreign equity markets and compare these markets with each other and with the client’s home equity market. Specifically, you should:

· Using the total return stock markets indices data, calculate the monthly returns for different markets in local currency.

· Calculate the average monthly return and standard deviation of each stock market for the total period and for shorter sub-periods.

· Calculate the returns of the various markets in terms of the client’s home currency. In order to do this, you will need to convert each of the indices to the client’s home currency using exchange rates in the provided spreadsheet.

· Annualize the average monthly return and the standard deviations in order to demonstrate the differences across markets and over different time periods to the client. (The standard deviation of the monthly returns can be annualized by multiplying the monthly standard deviation with the square root of 12.)

· Compare Sharpe ratios for different countries, both in local currency and in the home currency of the client. Discuss your findings.

2. Market correlations (8 marks)

In addition to charting the risk and return characteristics of the various markets, you need to show the client the correlations of the different country markets with each other.

· Calculate the correlations of the returns for the full period and for sub-periods, first based on the local currency and then based on the client’s home currency. Discuss your findings.

· What are the possible causes for convergences and divergences between markets?

3. Disentangling currency effects from international portfolio returns (12 marks)

You recognise that investors ultimately care about the return in their home currency and, therefore, you need to clarify the impact of currency movements on those returns. Show the client, year by year, what portion of international market returns was accounted for by equity performance and what portion resulted from currency movements. Most of the clients are mainly interested in whether international equities performed better or worse than the home market equities over a given period. In other words, it is the performance of international stocks relative to the home market stocks that is important to clients.

· In order to demonstrate the performance of international equities relative to the home market equities and to clarify the impact of currency movements on returns, you need to analyse the historical data on the performance of a domestic index, various foreign market indices and an international index, which you need to calculate for the chosen foreign markets as a market value weighted index using return data and market capitalization data (see provided spreadsheet).

· To show the performance of foreign equities relative to the home market equities, compare the returns on the home currency based indices with those of the home market index from year to year.

· Demonstrate how local equity returns and currency movements each contributed to the returns to the home market investors. To demonstrate these effects, use data on home market and foreign markets returns, both in local currency and the home currency.

4. Synthesizing the results (14 marks)

You will need to synthesize the data you have analysed in a risk-return framework so you can show how international diversification enhances the returns of domestic investors. Using this framework you can explain why the benefits existed and what could cause them to increase and decrease.

· Using the monthly index values for the home market index and for various foreign markets, calculate the monthly returns on the indices and use these data to construct a series of portfolios, starting with a 100% allocation to the home market index, then calculating the returns of different portfolios with increasing shares of foreign equities. Work through different portfolio mixes, ending with a 100% allocation to foreign equities.

· Analyse the full period as well as sub-periods.

· Use the home currency-based indices for these calculations.

· Use monthly returns for the analysis, however, for the client report and presentation, annualize the average monthly returns and the standard deviations.

· Compare the Sharpe ratios of various portfolios.

· Use the results to map the efficient frontier in a typical mean-variance graph to demonstrate how different international allocations in a portfolio affect the portfolio’s risk-return characteristics. Explain your findings to the client.

5. Globalization of financial markets and benefits of international diversification (8 marks)

In the client report, to prevent questions from the client, you need to discuss to what extent the principles of international portfolio diversification are still applicable, given the globalization of financial markets. In addition to your own findings, you may cite empirical evidence from financial research studies published in academic journal articles (particularly, Journal of Finance, Journal of Financial Economics, Journal of Financial and Quantitative Analysis, Review of Financial Studies, Financial Analysts Journal, Journal of Banking and Finance).

In addition, the client has asked you to present your main points to the fund’s executives. You should address the client’s questions effectively and support your investment recommendations with facts. Your boss urge you to make a convincing case to this important client for your firm.