FIN30021 Fixed Income and Debt Markets Topic 7 Suggested Solutions Question 7.13 1. "The strongest argument for investing in nondollar bonds is that there are diversification benefits." Explain why you agree or disagree with this statement. In general, you can agree with this statement (that diversification is the strongest argument for investing in nondollar bonds) with the strongest argument being theoretical. However, there are mixed empirical findings for agreeing with the statement with the most recent research indicating disagreement. The details are supplied below. Several reasons have been offered for why U.S. investors should allocate a portion of their fixed income portfolio to nondollar bonds. First, there is a theoretical argument which states that diversifying bond investments across countries- particularly with the currency hedged-reduces risk. This is generally demonstrated using modern portfolio theory by showing that investors can realize a higher expected return for a given level of risk (as measured by the standard deviation of return) by adding nondollar bonds in a portfolio containing U.S. bonds. Second, researchers have offered evidence that diversification in nondollar bonds can lead to an optimal choice. However, this evidence comes from earlier studies in the 1980s and early 1990s. Recent research suggests that the reduction in risk may not be that great to offset lower portfolio returns. There is another reason for investing in nondollar bonds that competes with diversification. For example, a study by Litterman (1992) suggests that while the diversification benefits may not be that great, a powerful reason for a U.S. investor to invest in nondollar bonds is "the increased opportunities to find value that multiple markets provide." However, it is hard to quantify such a benefit because it depends on the investor's talents. That is, nondollar bond investments-with the currency hedged-permits investment strategies based on interest rate changes in various countries. This provides additional dimensions to the actual investment decision or a broader range of investment choices. A final reason given for nondollar bond investing is that the decision not to hedge the currency component can then be regarded as an active currency play. 2. What arguments are offered for investing in nondollar bonds? Module 7 Solutions Page 1
FIN30021 Fixed Income and Debt Markets There are three reasons given for investing in nondollar bonds. These are described below. A first reason for investing in nondollar bonds concerns the notion that diversification maximizes return for a given level of risk. Modern portfolio theory states that the most efficient portfolio, the market or world portfolio, contains all assets and is perfectly diversified. This portfolio is risky but generates the highest possible return for its risk level. If investors want to achieve higher returns they must invest in this portfolio. If their preference is to receive higher returns then they must allocate a portion of their total investments to purchasing this risky world portfolio, which includes nondollar bonds. A second reason (offered for a U.S. investor to invest in nondollar bonds) is the increased opportunities to find value that multiple markets