national diversification. The low correlation suggests that international diversifica-
tion could reduce the risk on an investor’s portfolio.
Risk depends not only on correlation coefficients but also on the standard devia-
tion of return. Exhibits 11.6 through 11.8 show the standard deviation of return for
an investment in the common equity indexes, the long-term bond indexes, and the
short-term bond indexes discussed earlier. It should be emphasized once again that
the standard deviation is calculated on market indexes and is therefore a measure of
risk for a well-diversified portfolio, consisting only of securities traded within the
country under examination.
As shown in the last section, there are two sources of risks. The return on an in-
vestment in foreign securities varies because of variation of security prices within the
securities home market and because of exchange gains and losses. Note that in some
cases the total risk is less than the domestic risk. The reduction in correlation when
exchange rates are taken into account comes about because for these countries in this
period exchange fluctuations were negatively correlated with movements in the local
market.
The column headed “Domestic Risk” in Exhibits 11.6 through 11.8 shows the stan-
dard deviation of return when returns are calculated in the indexes’ own currency.
Thus the standard deviation of 20.41 for Germany is the standard deviation when re-
turns on German stocks are calculated in marks. The second source of risk is exchange
risk. Exchange risk arises because the exchange rate between the mark and dollar
11 • 8 INTERNATIONAL DIVERSIFICATIONCanada France Germany Japan Netherlands Switzerland U.K.Canada
France 0.191
Germany 0.157 0.910
Japan 0.112 0.391 0.495
Netherlands 0.217 0.917 0.960 0.408
Switzerland 0.076 0.697 0.803 0.540 0.751
U.K. 0.433 0.599 0.580 0.314 0.614 0.467
United States 0.567 0.456 0.357 0.177 0.430 0.257 0.478
Exhibit 11.4. Correlations Among Bond Indexes Measured in U.S. Dollars.
United
Canada France Germany Japan Netherlands Switzerland KingdomCanada
France –0.178
Germany –0.163 0.978
Japan –0.015 0.393 0.426
Netherlands –0.167 0.983 0.998 0.422
Switzerland –0.146 0.915 0.933 0.477 0.931
United Kingdom –0.006 0.696 0.697 0.282 0.695 0.660
United States 0.097 –0.073 –0.073 0.113 –0.068 –0.060 –0.106
Exhibit 11.5. Correlations for Three-Month Bond Indexes Measured in U.S. Dollars.