Suppose you are a financial advisor 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 kind of benefits can be expected from doing so. Using the data provided in the above problem (i.e., problem 12), solve the following problems:
(a) 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 (I) investing 100% in the U.S. with no position in the U.K. market, and (ii) investing 100% in the U.K. market with no position in the U.S. market.
(b) Solve for the ‘optimal' international portfolio comprised of the U.S. and U.K. markets. Assume that the monthly risk-free interest rate is 0.5% and that investors can take a short (negative) position in either market.
(c) 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.