Lesson 6 of 8 · All lessons in this module
  1. Asset classes: return, risk and other characteristics
  2. Risk aversion and utilityVideo lesson
  3. Indifference curves and the capital allocation lineVideo lesson
  4. Measuring asset and portfolio riskVideo lesson
  5. Correlation and the power of diversificationVideo lesson
  6. Integrated cases: a foreign bond with currency, and pairs from a scenario table
  7. Minimum-variance and efficient frontiersVideo lesson
  8. Optimal risky portfolio and the optimal investor portfolioVideo lesson

Lesson 6 of 8 · 16 min

Integrated cases: a foreign bond with currency, and pairs from a scenario table

Two exam set-ups in one place: a portfolio whose third 'asset' is a currency, and a scenario table in which the pair that diversifies best can be spotted before any formula is used.

In short

  • A foreign asset in a domestic portfolio is three positions: domestic equity, the foreign asset's local return and the exchange-rate return. The currency carries the same weight as the foreign asset.
  • Expected return: compound the local and currency returns, then take the weighted average. Risk: the three-asset variance formula with every pair's correlation.
  • A bond that looks safer in its own currency can still raise portfolio risk once currency is added, especially when the currency moves with equities.
  • Scenario table: a pair's return in each scenario is the weighted average of that row. If the pair's return never changes, the two assets are perfectly negatively correlated.
  • Equal weights remove all risk from a ρ=−1\rho = -1 pair only if the two standard deviations are equal; otherwise solve w1σ1=w2σ2w_1\sigma_1 = w_2\sigma_2.

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