Why is the hurdle rate in Section 13.2 lower for Japan than for Canada? Should U.S. investors still invest in Canada?

Question

What will be an ideal response?

Answer 1

From the formula in the answer to Question 3, we see that the two main drivers of the hurdle rates are the correlations between Canadian and U.S. returns and between Japanese and U.S. returns (reported in Exhibit 13.6), and the volatilities of Canadian and Japanese returns (reported in Exhibit 13.1). The most important number is the correlation. Of the G7 countries, the Canadian returns have the highest correlation with U.S. returns, whereas the Japanese returns have the lowest correlation. It is this difference that makes Japan have the lowest hurdle rate and Canada the highest. Whether U.S. investors should still invest in Canada depends on their opportunity set. The hurdle rate for Canada, reported in Exhibit 13.7, suggests that even if the expected return on Canadian stock is only a bit lower than that of the U.S., it is still a valuable investment that increases the Sharpe ratio. However, if the U.S. investor can invest in Japanese securities first, the Canadian hurdle rate will increase considerably, because the U.S.-Japan diversified portfolio has a high Sharpe ratio. In that case, it may not be optimal to go long Canadian securities unless you really believe the Canadian stock market will have an expected return higher than the hurdle rate, and thus likely far higher than the U.S.-Japan portfolio's expected return. Note that this answer depends on the historical numbers reported in the Exhibits. Some theories of portfolio choice (such as the CAPM) postulate that investors should hold portfolios that are well diversified and include all securities in line with their market capitalizations.