Suppose you are a financial adviser and your client, who is currently investing only in the U.S. stock market, is considering diversifying into the U.K. stock market. At the moment, there are neither particular barriers nor restrictions on investing in the U.K. stock market. Your client would like to know what kinds of benefits can be expected from doing so. Using the data provided in problem 6, solve the following problems:
1. Graphically illustrate various combinations of portfolio risk and return that can be generated by investing in the U.S. and U.K. stock markets with different proportions. Two extreme proportions are (a) investing 100 percent in the United States with no position in the U.K. market, and (b) investing 100 percent in the U. K. market with no position in the U.5. market.
2. Solve for the optimal international portfolio comprising the U.S. and U.K. markets. Assume that the monthly risk-free interest rate is 0.5 percent and that investors can take a short (negative) position in either market. This problem can be solved using the spreadsheet MPTSolver.xls.
3. What is the extra return that U.S. investors can expect to capture at the U.S. equivalent risk level? Also trace out the efficient set. Appendix 15.B provides an example.