Professional Documents
Culture Documents
Global Investments
As of 1 November 2009
P. 539. 1st full paragraph, last sentence Columns 5-7 should be Columns 5-6
P. 540, 1st full paragraph Note that in Exhibit 12.4 reference should be Exhibit 12.5
6089_SOLN_ch12_p523-580.qxd 12/19/07 1:48 PM Page 534
practice is five years) are required to obtain statistically significant estimates of an
overall funds volatility, and this assumes stationary currency and market returns
over that period, as well as a constant risk objective on the part of the manager.
These assumptions are risky (especially for currencies) in light of the marked insta-
bility that many financial markets have displayed over time.
534 Chapter 12. Global Performance Evaluation
Base Base
Local Currency Local Currency
Dec. 31 Mar. 31 Currency (dollar) Currency (dollar)
Japanese Stocks
Sony 400 10,000 11,000 4,000,000 40,000 4,400,000 41,905
European Stocks
BMW 100 600 600 60,000 60,000 60,000 61,224
Total 100,000 103,129
International index
benchmark ($) 100 98.47
Japanese index () 100 105
European index (:) 100 95
Yen per dollar ($ : ) 100 105
Euro per dollar ($ : :) 1 0.98
SOLUTION
On March 31, her portfolio has gained 3.13 percent ((103,129 - 100,000)/
100,000), while the benchmark (international index) has lost 1.53 percent in
dollars ((98.47 - 100)/100). The performance of the portfolio relative to the
benchmark is therefore a positive 4.66 percent. Of course, she will want to know
why her portfolio had such a good performance over the quarter.
indicated with superscripts, and specific portfolio segments are indicated with
subscripts. We now present the rate of return calculations for a specific segment,
both in its local currency and in the investors base currency.
Return in Base Currency The base currency rate of return is easily derived by
translating all prices10 into the base currency 0 at exchange rate S j :
V jtS jt + D jt S jt - V jt - 1S jt - 1
rj 0 =
V jt - 1S jt - 1
where rj 0 is the segment return in base currency 0, while rj is the segment return in
its local currency and sj is the number of units of currency 0 per unit of currency j.
After some algebraic reshuffling, this may be written as
rj 0 = pj + dj + s j(1 + p j + d j), or
rj 0 pj dj cj (12.9)
10
For simplicity, assume that the dividend is paid at the exchange rate prevailing at the end of the period.
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Total-Return Decomposition
The first objective of GPE is to decompose the portfolios total return, measured in
base currency, into the three main sources of return:
I Capital gain (in local currency)
I Yield
I Currency
EXHIBIT 12.3
Market and Currency Gains
Final 11,000
value
Value of investment in pounds
B C
Initial
value 10,000
A D
2 2.1
0
Initial Final
value value
The total return is simply the weighted average of the returns on all segments. Over
period t, the total portfolios return r is computed in the base currency as follows:
r = a wj rj 0 = a wj(pj + d j + cj)
j j
where wj represents the percentage of segment j in the total portfolio at the start of
the period, and the sign g means that we sum over all segments j. The various
j
sources of return may be regrouped into three components:
r = a wj pj + a wj dj + a wj c j (12.10)
j j j
Capital gain Yield Currency
+ +
component component component
Example 12.7 is an important example to demonstrate total return decomposition.
Lets now return to the sample international portfolio and its international
benchmark. Decompose the total return into capital gain, yield, and currency
components. Perform a similar calculation for the benchmark.
SOLUTION
There is no yield, so we will focus on the other components of return. The
Japanese shares went up by 10 percent in the first quarter (from 10,000 per
share to 11,000). The rate of return in yen on the Japanese equity segment is
10 percent (from 4 million to 4.4 million). When translated into dollars, the
rate of return of the Japanese equity segment becomes 4.76 percent (from
$40,000 to $41,905). The difference between 4.76 percent and 10 percent is
due to the currency contribution (-5.24%), caused by a drop in the value of
the yen relative to the dollar. Note that this figure is not exactly equal to the
percentage currency loss on the yen, which dropped from 100 = $1 to 100 =
$0.9524. As mentioned, the currency contribution is equal to the currency loss
applied to the original investment plus the capital gain.
These results are reproduced in the first four columns of Exhibit 12.4. The
first column gives the weights in the portfolio, as of December 31. The second
column gives the rates of return in the base currency (dollar) for each seg-
ment. The last line gives the weighted average return for the total portfolio,
using the portfolio weights given in the first column. Note that the weighted
average return in dollars is indeed 3.13 percent, which is consistent with the
total portfolio appreciation reported in Exhibit 12.2. The third and fourth
columns give the return in local currency and the currency contribution for
each segment, as well as for the total portfolio (by taking the weighted average
for each segment). For example, the total currency contribution of -0.87
percent is equal to the currency contribution for Japanese equity (-5.24%)
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EXHIBIT 12.4
International Portfolio: Total Return Decomposition
(1) (2) (3) (4) = (2) - (3) (5) (6) = (3) - (5)
Rate of Rate of
Portfolio Return Return in Currency Market Security
Weights in $ Local Currency Contribution Index Selection
multiplied by the weight of Japanese equity in the total portfolio (40%), plus
the currency contribution of European equity (2.04%) multiplied by the
weight of European equity in the total portfolio (60%).
In the end, the total portfolio return of 3.13 percent can be decomposed
as a nice capital gain in local currency of 4.00 percent, minus a currency loss of
-0.87 percent. Note that columns 3 and 4 add up to column 2. Columns 57
are discussed in Example 12.8.
The Japanese index gained 5 percent from 100 to 105 yen, but the yen
depreciated from $: = 100 to $: = 105. The dollar return on the Japanese
index is calculated by simply dividing the index by the $: exchange rate. The
Japanese index in dollar terms was unity on December 31 (100/100) and
remains unity on March 31 (105/105). Hence, the dollar return on the
Japanese market equals 0 percent (constant index in dollars). Similarly, the
European index return is -5 percent in euros, but the euro strengthened from
$:: = 1 to $:: = 0.98. So the European index return is -3.06 percent in dollars,
and the currency contribution is +1.94% = -3.06% - (-5%). To get the return
decomposition for the international benchmark, we simply take the weighted
average of the return decomposition for the Japanese and European market
indexes as shown in Exhibit 12.5. We verify that the benchmark return in dol-
lars is a loss of 1.53 percent. The benchmarks total return all comes from
EXHIBIT 12.5
International Benchmark: Total-Return Decomposition
(1) (2) (3) (4)
Rate of Return
Benchmark Rate of in Local Currency
Weights Return in $ Currency Contribution
Performance Attribution
A managers relative performance may be measured by making several comparisons.
The basic idea is to provide a comparison with some passive benchmarks for all
major investment decisions. Active management decisions will induce deviations
from the benchmarks returns. Some of the many management decisions that are
commonly analyzed are discussed next.
r a wj I j a wj (pj - Ij ) a wj dj a wj cj (12.11)
Market Security
Yield Currency
return selection
component component
component contribution
The first term on the right-hand side of Equation 12.11 measures the perfor-
mance that would have been achieved had the manager invested in a local market
index instead of individual securities. This contribution is calculated net of cur-
rency movements, which are picked up by the last term in the formula. The second
term measures the contribution made by the managers individual security selec-
tion. It is simply the weighted average of the security selection on each segment.