Problem:
An international investment bank oversees a USA investment portfolio with total assets of $25billion. The portfolio has 15% of total assets allocated to foreign investments, which include both International stocks and bonds.
The investment bank has adopted a position that the domestic markets are efficient and, thus, has indexed the domestic portion of the portfolio. Each unique asset class in the domestic portfolio has been benchmarked individually but the bank believes that foreign markets are less efficient and utilizes active managers for this asset class. The foreign allocation is 60% stocks and 40% bonds and the bank has divided the foreign stock portfolio equally among three different investment managers by reviewing their portfolio betas (current betas of these three portfolios are as follows: 1.1, 0.95, and 1.3).
Examine the strategy of international diversification and the application of the international capital asset pricing model (ICAPM);
Evaluate whether to invest the entire foreign bond allocation in euro-denominated bonds or reallocate the money to US bonds over the next year on the assumption that Euro-denominated bonds are paying a 4.5% interest rate versus USD denominated bonds with a 2.9% rate. The 1-year forward exchange rate is $1.5 per euro, whilst the current exchange rate is at $1.4 per euro. Show your calculation of the US dollar return on the euro-denominated bonds.