of the purchaser’s home country. Thus the return on a foreign investment can be quite
different than simply the return in the asset’s own market and can differ according to
the domicile of the purchaser. From the viewpoint of an American investor, it is con-
venient to express foreign currency as costing so many dollars.^2 Thus it is convenient
to express an exchange rate of 2 marks to the dollar, or the cost of 1 mark is $0.50.
Assume the following information:
12
——— ——————–
Cost of Value of Value in
Time 1 Mark German Shares Dollars (1 2)
0 $0.50 40 DM 0.50 40 $20
1 $0.40 45 DM 0.40 45 $18Furthermore assume that there are no dividends paid on the German shares. In this
case the return to the German investor expressed in the home currency (marks) is
However, the return to the U.S. investor is
The German investor received a positive return, whereas the U.S. investor lost
money because marks were worth less at time one than at time zero. It is convenient to
divide the return to the American investor into a component due to return in the home
or German market and the return due to exchange gains or losses. Letting Rxbe the ex-
change return we have
Thus the 12 % gain on the German investment was more than offset by the 20%
loss on the change in the value of the mark. Restating the preceding equation
11 RUS 2 11 Rx 211 RH 2(^1)
2
11 RUS 2 11 0.20 211 0.125 2 1 0.10 or RUS0.10
1 RH
45
40
1 0.125 or RH0.125
1 Rx
0.40
0.50
1 0.20 or Rx0.20
11 RUS 2 11 Rx 211 RH 2
11 RUS 2
0.40 45
0.50 40
18
20
or RUS0.10 or 10%
11 RH 2
45
40
or RH0.125 or 12.5%
11 • 4 INTERNATIONAL DIVERSIFICATION
(^2) Foreign currency exchange rates can be quoted in two ways. If an exchange rate is stated as the
amount of dollars per unit of foreign currency, the exchange rate is quoted in direct (or American) terms.
If the exchange rate is given as the amount of foreign currency per dollar, the quote is in indirect (or for-
eign) terms. The form of quotes differs across markets. In the interbank market indirect quotes are used,
whereas direct quotes are the norm in futures and options markets.