Question

Consider an MNC has two choices on investment. One of them is to invest the project in Taiwan only. The other is to invest 75% funds in Taiwan and 25% in Singapore. Both investments give the same return. The standard deviation of exchange movements is 7% for Taiwan dollars and 5% for Singapore dollars. The correlation coefficient between movements in the value of the Taiwan dollar and the Singapore dollar is .7. Based on this information, which investment should the MNC chose? Show the calculations

Answer 1

Return on both investments is the same hence we will choose the investment on the basis of standard deviation.

Lower the standard deviation lower the risk

Taiwan Project:

Standard Deviation for Taiwan Project = 7%

75% Taiwan and 25% Singapore:

The standard deviation of this investment = ((Wa * standard deviation of A)^2 + (Wb * standard deviation of B)^2 +2*Wa*Wb *standard deviation of A * standard deviation of B * correlation) ^0.5

Wa = 0.75

Wb = 0.25

Standard deviation of A = 0.07

Standard deviation of B = 0.05

Correlation = 0.7

The standard deviation of this investment ={ (0.75*0.07)^2 + (0.25*0.05)^2 + 2*0.75*0.25*0.07*0.05*0.7 }^0.5

The standard deviation of this investment = 6.19% Answer

The second option has lower standard deviation and the same return. Hence, MNC should opt for the second option ( 75% funds in Taiwan and 25% in Singapore).

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