planation, extra risk, and an investment opportunity. The peso explanation is named
after the investors who invested their money in Mexican government bonds. For a
number of years they earned a return greater than they would have earned in the
United States. When the devaluation occurred, however, it more than eliminated all
past gains. The peso argument is that although the empirical evidence suggests gains
by investing in the higher interest rate countries, some future devaluation will elimi-
nate all gains. The return gains have been so persistent that the size of a devaluation
necessary to eliminate past gains seems too large to be plausible. Thus, most analysts
reject this explanation.
The second explanation is that the extra return is simply compensation for risk. Al-
though some of the extra return may be compensation for risk, studies to date do not
support this as a complete explanation. Thus, there seems to be an investment op-
portunity and there are a number of funds that follow the strategy of investing in the
higher-yielding country (Cho, Eun, and Senbet (1986).^16
11.10 CONCLUSION. In this chapter we have discussed the evidence in support of
international diversification. The evidence that international diversification reduces
risk is uniform and extensive. Given the low risk, international diversification is jus-
tified even if expected returns are less internationally than domestically. Unless there
are mechanisms such as taxes or currency restrictions that substantially reduce the re-
turn on foreign investment relative to domestic investment, international diversifica-
tion has to be profitable for investors of some countries, and possibly all.
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Adler, Michael. “The Cost of Capital and Valuation of a Two-Country Firm.”Journal of Fi-
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Adler, Michael, and Reuven Horesh. “The Relationship Among Equity Markets: Comment on
[3].”Journal of Finance, XXIX, No. 4, September 1974, pp. 1131–1317.
Adler, Michael, and Bernard Dumas. “International Portfolio Choice and Corporate Finance:
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SOURCES AND SUGGESTED REFERENCES 11 • 25(^16) There is a variation in this strategy that some funds follow. Assume we observe the following in-
terest rates on six-month government debt:
In this scenario, one investment strategy is to buy English bonds and hedge exchange risk by buying a
futures contract of Deutsche marks for dollars. The investor will lose 1% on the futures contract since
there is a 1% difference in T-bill rates and empirical evidence supports that the interest rate differential
is reflected in the futures contract. If the English-deutsche mark exchange rate stays constant, the investor
will earn 7% on the bond less 1% on the futures contract or 6%, which is superior to the return on U.S.
bills.
German rate 5%
English rate 7%
U.S. rate4%