You work for Golden Mountains Ltd., an investment fund that specialises in equity investment. Your fund currently holds an international portfolio of equities including US, European, and Japanese stocks. The fund management is considering a further diversification of the fund portfolio and contemplates the possibility of investing in some emerging markets (in South Asia, Eastern Europe, and Latin America). You are asked to analyse the optimality of such a diversification in the mean-variance framework. Your manager requires you to write a report that should summarise and critically discuss your empirical findings, as well as provide a recommendation about the inclusion of emerging market stocks in the portfolio of your fund. Your manager sets very high standards and expects a professional (yet concise) report that he can present to the funds clients.

Detailed problem description

1. Why might the fund management be interested in diversification into emerging markets? Are they right to recommend such a diversification?

Answer these questions citing some empirical evidence.

1. Obtain six Morgan Stanley Capital International (MSCI) monthly total return indexes data for equity markets in the different regions, in US dollar terms, for the last 5-year period (the names of the corresponding indices provided in the spreadsheet), e.g. US (MSCI USA) , Europe (MSCI EUROPE U$), etc.

Compute monthly returns for each series. Obtain the current US risk-free rate of interest (You can use the data on the interest rate of the US 3-month Treasury Bills to compute such a rate). Compute the mean and standard deviation of each series and the variance-covariance matrix. Obtain monthly total return index for the US dollar-based MSCI World equity index (MSCI WORLD U$) and compute its returns.

2. In order to estimate expected returns, you decide to use the CAPM. Estimate the beta of the six indices listed above with respect to the MSCI All Country index. Use these estimates of beta in order to compute the CAPM expected return of these six indices. (For estimates of the equity risk premium, see for example, Jorion and Goetzmann, 1999).

3. Compute the efficient frontier for (i) the three markets (i.e. US, Europe, Japan) and (ii) all the six markets considered. Assume that investors can borrow and lend at the risk-free rate of interest and that they are able to take short positions. How does diversification into emerging markets affect the efficient set?

4. In the light of existing empirical evidence and your own findings, what are your recommendations?

5. Suppose that your fund is not allowed to take short positions in any of the markets. How would such a restriction affect the conclusion you have drawn in Questions 4 and 5?

6. What, if any, are the limitations of your analysis?

Excel Sheet

136613	MSCI ASIA APEX 50 PRICE RETURN INDEX IN US DOLLAR CURRENCY	Reuters	RealTime	STRD	USD	.ASIAAPEX
136613	MSCI ASIA APEX 50 in USD currency	Reuters	RealTime	GRTR	USD	.ASIAAPEXG
136613	MSCI ASIA APEX 50 in USD currency	Reuters	RealTime	NETR	USD	.ASIAAPEXN
700004	MSCI ASIA APEX MID 50 PRICE RETURN INDEX IN USD CURRENCY	Reuters	RealTime	STRD	USD	.ASIAMCAPEX
700004	MSCI ASIA APEX MID CAP 50 in USD currency	Reuters	RealTime	GRTR	USD	.ASIAMCAPEXG
700004	MSCI ASIA APEX MID CAP 50 in USD currency	Reuters	RealTime	NETR	USD	.ASIAMCAPEXN