International Money And Capital Markets

International Money And Capital Marketsm31513the Intended Learning Out

Using the following information about US and UK market returns and beginning of period $/£ exchange rates: Period US Return UK Return $/£ Exchange Rate % 6% $2.. – – 1.90

(a) Compute the average return in each market from the standpoint of a US investor and from the perspective of a UK investor.

(b) What is the covariance of the domestic market and exchange rate returns from the standpoint of each investor?

(c) What is the standard deviation of return for each market from the standpoint of each investor?

Write notes on the following returns techniques available for assessing portfolio performance and explain how they are used.

(a) Sharpe’s measure

(b) Treynor’s measure

(c) Jensen’s alpha measure

(d) Why is Jensen’s alpha generally preferred over the other alternative measures of Sharpe and Treynor for assessing portfolio performance? Explain in detail.

How is value-at-risk (VAR) used to measure portfolio performance? Is this concept useful in the approach to portfolio risk assessment?

The risk management team of Planet Capital believe that the firm’s €100,000,000 stock portfolio will have a 10 per cent return standard deviation during the coming week and that its portfolio’s return is normally distributed.

(a) What is the probability of Planet Capital losing €10,000,000 or more?

(b) What is the euro loss expected with a 5 per cent probability?

(c) What is the euro loss expected with a 1 per cent probability?

Explain why it is important to have an understanding not only of the market forces driving observed nominal interest rates but also the characterisation of the random nature of interest rates. (Hint: explain the stochastic process as defined in interest rate models)

The following spot interest rates for maturities of one, two, three, and four years are currently observable in the market: r₁ = 4.3%, r₂ = 4.9%, r₃ = 5.6%, r₄ = 6.4%. Compute the forward rates for f₁,₁, f₁,₂, and f₁,₃, where f₁,n refers to a forward rate for the period beginning in one year and extending for n years.

Based on the spot rates in 4(a), and assuming a constant real interest rate of 2 per cent, what are the expected inflation rates for the next four years?

Paper For Above instruction

The analysis of international money and capital markets involves understanding various key concepts that influence global investment decisions, portfolio performance evaluation, risk measurement, and interest rate modeling. This paper synthesizes these core themes, emphasizing their relevance, methodologies, and applications within the context of international finance.

Introduction

International financial markets play a crucial role in facilitating cross-border investment and economic integration. Understanding the dynamics of these markets includes examining returns across different countries, evaluating portfolio performance through various metrics, assessing risk via tools like Value-at-Risk (VaR), and analyzing the term structure of interest rates. These elements collectively enable investors and financial managers to optimize investment strategies, manage risks effectively, and understand the underlying economic variables influencing interest rates and inflation expectations.

Market Returns and Exchange Rate Analysis

The calculation of average returns from both US and UK investor perspectives offers insights into the comparative performance of domestic and international investments. Given the data, the US investor perceives market return primarily in USD, while the UK investor evaluates returns in GBP, adjusted for currency movements. The average return can be derived by considering the respective period returns and adjusting for currency fluctuations, which significantly impact international investing outcomes. This comparative analysis underscores the importance of currency risk management in diversification strategies.

The covariance between market returns and exchange rate movements measures the degree of co-movement and helps assess the extent to which currency risk is systematic or diversifiable. Higher covariance indicates that currency movements and market returns tend to move together, affecting portfolio risk profiles from the perspective of each investor. These calculations are integral in constructing hedged or unhedged international portfolios.

Standard deviation, representing return volatility, is crucial in understanding the risk associated with market investments. A comprehensive analysis involves computing these deviations from the mean, helping investors gauge the potential fluctuations in returns. Comparing these metrics across markets and currencies aids in identifying relative risks and benefits of international diversification.

Portfolio Performance Evaluation Techniques

Various metrics exist to evaluate portfolio performance, each with unique attributes and relevance. Sharpe's measure evaluates excess return per unit of total risk, helping investors understand risk-adjusted performance. Treynor's measure emphasizes systematic risk, assessing returns relative to beta, which measures sensitivity to market movements. Jensen’s alpha measures abnormal return beyond what is predicted by the Capital Asset Pricing Model (CAPM), indicating the skill of portfolio managers.

Jensen’s alpha is generally favored because it isolates the manager’s ability to generate returns above the expected market performance, adjusting for systematic risk. Unlike Sharpe and Treynor, which depend on total and systematic risks respectively, Jensen's alpha directly measures performance relative to a benchmark, providing a clearer indication of active management skill.

Value-at-Risk (VaR) and Portfolio Risk Measures

VaR quantifies the maximum expected loss over a specified time horizon at a given confidence level, serving as a vital tool in risk management. It enables portfolio managers to assess potential downside risk quantitatively, facilitating strategic decision-making. For example, calculating the probability of loss beyond a certain threshold helps allocate capital and set risk limits.

In the case of Planet Capital's portfolio, assuming a normal distribution of returns with a standard deviation of 10%, probabilistic assessments can estimate potential losses. The probability of experiencing losses exceeding €10 million involves calculating the z-score corresponding to the loss threshold. The expected losses at different confidence levels (5%, 1%) are derived from the inverse cumulative distribution function of the normal distribution, providing insights into risk exposure.

Interest Rate Dynamics and Stochastic Modeling

Understanding not just the determinants of nominal interest rates but also their stochastic nature is vital for accurate forecasting and risk assessment. Interest rates are influenced by macroeconomic factors, monetary policies, and market expectations, all contributing to their randomness modeled through stochastic processes such as the Vasicek or Cox-Ingersoll-Ross models.

A stochastic process characterizes interest rate movements as probabilistic, incorporating mean reversion, volatility, and drift components. This mathematical representation is essential for pricing interest rate derivatives, managing duration and convexity risk, and developing hedging strategies. It recognizes that interest rates evolve unpredictably but within probabilistic bounds, shaping effective risk management and investment decisions.

Term Structure of Interest Rates and Inflation Expectations

The current spot interest rates facilitate the calculation of forward rates, which encode market expectations of future rates. Forward rate computations involve extrapolating the implied future interest rates based on the current term structure, revealing market sentiments about economic outlooks.

Using the given spot rates, forward rates for periods starting one year from now are derived through arbitrage-free conditions. Additionally, assuming a constant real rate of 2%, the expected inflation rate over the subsequent years can be estimated. This approach isolates the real interest rate component from the nominal rate, allowing for forecasts of inflation based on the Fisher equation. These projections are instrumental for policymakers and investors to formulate strategies aligned with anticipated economic conditions.

Conclusion

Effective management of international investments hinges on a thorough understanding of return dynamics, risk measurement, interest rate modeling, and inflation expectations. The integration of these analytical tools supports robust portfolio strategies, risk mitigation, and economic forecasting. As global markets continue to evolve, proficiency in these areas remains essential for financial professionals seeking to maximize returns while controlling risk in an uncertain environment.

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