or Norwegian point of view, the “Exchange Rate Expected Return” and “Risk”
columns would be different, because they would contain results as if all currencies
were converted to francs (for the French investor) or kroner (for the Norwegian in-
vestor). Because francs and kroner have not fluctuated perfectly with the dollar, these
columns would be different. Thus, the country of domicile affects the expected returns
and risk (including correlation coefficients) from international diversification.
Exhibit 11.12 illustrates this by computing expected return and risk from the U.S.
investor’s point of view (which is a repeat of prior exhibits) and from the French
point of view. The numbers are clearly quite different. It is possible to protect par-
tially against exchange rate fluctuations. An investor can enter into a contract for fu-
ture delivery of a currency at a price that is fixed now. For example, an American in-
vestor purchasing German securities could simultaneously agree to convert marks
into dollars at a future date and at a known rate. If the investor knew exactly what the
security would be worth at the end of the period, he or she would be completely pro-
tected against rate fluctuations by agreeing to switch an amount of marks exactly
equal to the value of the investment. However, given that, in general, the end of pe-
riod value of the investment is random, the best the investor can do is protect against
a particular outcome (e.g., its expected value).^6
As shown earlier, the standard deviation of foreign investments generally in-
creases as a result of exchange risk. If exchange risk was completely hedged, then the
“Domestic Risk” column in Exhibits 11.6 through 11.8 would be the relevant column
used to measure risk.
When examining risk for common stocks in most periods, total risk is higher for
most countries. However, in the period of the 1990s, this was not true. Therefore, in
the 1990s, hedging increased risk for many countries. The increase in risk due to ex-
11 • 14 INTERNATIONAL DIVERSIFICATIONMean Return VarianceCountry In Francs In Dollars In Francs In Dollars
Australia 9.15 7.69 21.58 17.92
Austria 2.29 0.82 25.62 24.50
Belgium 11.92 10.46 16.77 15.86
Canada 12.70 11.24 21.73 17.13
France 14.78 13.37 18.87 17.76
Germany 13.79 12.32 21.02 20.13
Hong Kong 18.38 16.92 32.72 29.79
Italy 9.68 8.22 27.91 25.29
Japan –0.86 –2.32 26.67 25.70
Netherlands 17.29 15.83 16.44 15.50
Spain 13.42 11.96 25.08 23.27
Sweden 19.28 17.81 26.37 24.21
Switzerland 16.84 15.38 18.67 17.65
United Kingdom 13.74 12.28 17.03 15.59
United States 17.63 16.17 18.45 13.59
Exhibit 11.12. The Effect of Country of Domicile on Mean Return and Risk.
(^6) Procedures exist for changing the hedge through time in order to eliminate most of the exchange risk.
See Kaplanis and Schaefer.