each country’s stocks compared to the country’s bonds on the basis of current risk
premiums and economic variables. They define the risk premium as the difference in
expected return between common equity and bonds. They measure expected return on
bonds by using the yield to maturity. They measure expected return on equity by cal-
culating the earnings divided by price. Comparing this measure with the valuation
model just presented shows that growth should be added and differences in payout
taken into account. These differences, as well as differences in accounting conven-
tions across countries and the impact of this on earnings, could affect risk premium
comparisons across countries. They recognize these influences and instead of using
risk premiums directly, they use current risk premiums relative to past risk premiums.
Their forecast equation states that future performance is related to current risk premi-
ums divided by average risk premiums in the past. In equation form this is
Future returns on equities relative to debt
ConstantConstant (Current risk premium/average risk premium prior two years)
They find for many countries that this equation is a useful predictor and that for some
countries it can be improved by adding other macroeconomic variables, such as pre-
diction of trade and production statistics. This model could be used to estimate which
countries have higher expected future returns on equities by using current bond yields
as expected returns for bonds, and the preceding equation to estimate the difference
between bond and equity returns. Clearly, further testing of all of these models is nec-
essary. However, they are suggestive of the type of analysis that can be done in active
international asset allocation.
The second new consideration that international investment introduces is ex-
change risk. As discussed earlier, entering into futures contracts can reduce the vari-
ability because of the exchange risk. Considering only risk, this is generally useful.
Entering into futures contracts can also affect expected return; however, entering into
a futures contract could lower expected returns. Furthermore, the investor may have
some beliefs about changes in exchange rates different from those contained in mar-
ket prices.^14 In this case the sacrifice in expected return may lead the investor to
choose not to eliminate exchange risk.
Finally, Black (1989) has shown that taking some exchange risk can increase ex-
pected return. Thus exchange rate exposure involves a risk return tradeoff.
Risk-free interest rates differ from country to country. For example, the interest
rate on six-month government issues could be 7% in England and 4% in the United
States. The expected return for a U.S. investor buying an English bond would be the
expected return to a British investor plus the exchange gains and losses.
Theory says the exchange gain or loss should be related to the interest rate differ-
ential. Thus the U.S. investor should expect to lose about 3% in exchange rate changes
by buying the British bond. However, empirical evidence does not support the claim
that exchange rate changes have a close relationship to interest rate differentials.
The empirical evidence strongly supports that investment in the high interest rate
country gives the higher return.^15 Three explanations have been suggested: a peso ex-
11 • 24 INTERNATIONAL DIVERSIFICATION(^14) Levich (1970 and 1979) has shown that some forecasters are able to predict exchange rate movements.
(^15) For example, Cumby (1990) finds on average that exchange rate changes increase the return of buy-
ing the higher interest rate counting (e.g., British bonds would be expected to return more than 7%).