Refer to Table 15.2 in the textbook. Choose two markets and refer to the table for the correlation between those two markets. Do you think the correlation is high or low? Why is the correlation between these two countries high or low in your opinion?

CHAPTER 15 INTERNATIONAL PORTFOLIO INVESTMENT 367 EXHIBIT 15.2 Correlations among International Stock Returns* (in U.S. dollars) Stock Market AU FR GM JP NL SW UK US Australia (AU) 0.586 France (FR) 0.286 0.576 Germany (GM) 0.183 0.312 0.653 Japan (JP) 0.152 0.238 0.300 Netherlands (NL) 0.241 0.344 0.416 0.509 0.358 0.282 Switzerland (SW) 0.368 0.624 0.475 0.315 0.281 United Kingdom (UK) 0.378 0.517 0.664 0.299 0.304 0.209 0.393 0.698 United States (US) 0.431 0.225 0.170 0.137 0.271 0.272 0.279 0.439 "The exhibit provides the average pairwise correlations of individual stock returns within each country in the diagonal cells and the average pairwise correlations between countries in the off-diagonal cells. The correlations were computed using the weekly returns from the period 1973-1982 Source: C. Eun and B. Resnick, "Estimating the Correlation Structure of International Share Prices," Journal of Finance, December 1984, p. 1314. Exhibit 15.2 provides historical data on the international correlation structure. Specifically, the table provides the average pairwise correlations of individual stock returns within each country in the diagonal entries, and the average pairwise correla- tions of stock mourns between countries in the off-diagonal entries. The correlations are in terms of U.S. dollars and computed using the weekly return data from the period 1973-1982. As can be seen from the table, the average intracountry correlation is 0.653 for Germany, 0.416 for Japan, 0.698 for the United Kingdom, and 0.439 for the United States. In contrast, the average intercountry correlation of the United States is 0.170 with Germany, 0.137 with Japan, and 0.279 with the United Kingdom. The average correlation of the United Kingdom, on the other hand, is 0.299 with Germany and 0.209 with Japan. Clearly, stock returns tend to be much less correlated between countries than within a country. The international correlation structure documented in Exhibit 15.2 suggests that international diversification can sharply reduce risk. According to Solnik (1974), that is indeed the case. Exhibit 15.3, adopted from the Solnik study, first shows that as the portfolio holds more and more stocks, the risk of the portfolio steadily declines, and eventually converges to the systematic (or nondiversifiable) risk. Systematic