Question

The expected returns in the U.S. are 7% and 10% in Indonesia. The historical standard deviation of the U.S. market is 5%, and the historical standard deviation of the Indonesian market is 11%. The covariance between the US and the Indonesian market is .002. What is the correlation between the US and the Indonesian markets? What are your expected returns and standard deviations if you diversify your US portfolio by moving 20% into Indonesia? What are the advantages and disadvantages to this strategy?

Answer 1

	Expected return	Standard deviation	Variance= (SD)^2
US	7	5	25
Indonesia	10	11	121
Covariance= 0.002
Correlation= Covariance/(SD of US*SD of Indonesia)
	0.002/(0.05*0.11)
	0.364
Expected return= Weighted average
	(0.80*7)+(0.20*10)
	7.60%
Standard deviation= Sq Root of ((Weight of US)^2*(Variance of US)+(Weight of Indonesia)^2*(Variance of Indonesia)+2*Weight of US*Weight of Indonesia*Covariance)
	Sq root((0.80)^2*(25)+(0.20)^2*121+2*0.8*0.2*0.002)
	Sq root(16+4.84+0.00064)
	Sq root (20.84064)
	4.57%
The advantages of diversification is risk reduction (as is evident from the solution above) and increased exposure to different securities and market whereas disadvantages of diversification is that it reduces quality and is complicated (as investment In one security is way more simpler than diversifying it with multiple securities)