The errata listed below should be taken into account for this particular reading:

Global Investments
As of 1 November 2009

P. 539. 1st full paragraph, last sentence Columns 5-7 should be Columns 5-6

P. 540, 1st full paragraph Note that in Exhibit 12.4 reference should be Exhibit 12.5
6089_SOLN_ch12_p523-580.qxd 12/19/07 1:48 PM Page 534
practice is five years) are required to obtain statistically significant estimates of an
overall funds volatility, and this assumes stationary currency and market returns
over that period, as well as a constant risk objective on the part of the manager.
These assumptions are risky (especially for currencies) in light of the marked insta-
bility that many financial markets have displayed over time.
534 Chapter 12. Global Performance Evaluation

Performance Attribution in Global

Performance Evaluation

The exact measurement of returns is an important task in a domestic as well as

global performance evaluation. Performance attribution is more difficult in a GPE
because a portfolio can be invested in many different national markets and because
prices are quoted in different currencies on these markets.
To conduct a detailed global performance attribution, a portfolio is broken
down into various segments according to type of asset and currency. Each homoge-
neous segment (say, Japanese stocks) is valued separately in its local currency as
well as in the base currency of the portfolio. Thus, Japanese stocks are valued in yen
as well as in the investors base currency.
In Example 12.6, we introduce a sample international portfolio designed to
assist the reader in understanding the concepts and performing attribution and
calculations in a practical and intuitive manner.
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Performance Attribution in Global Performance Evaluation 535

EXAMPLE 12.6 INTERNATIONAL PORTFOLIO : TOTAL RETURN

A U.S. investor has invested $100,000 in an international equity portfolio

(which we will call the international portfolio) made up of Asian and European
stocks. On December 31, the portfolio is invested in 400 Sony shares listed in
Tokyo and 100 BMW shares listed in Frankfurt. She wants to beat some interna-
tional index used as benchmark. This benchmark has an equal weight in the
Japanese stock index and in the European stock index. She uses the U.S. dollar
as the base currency. All necessary data are given in Exhibit 12.2. There were
no cash flows in the portfolio, nor were any dividends paid. No dividends were
paid on the market indexes either. What is the total return on the international
portfolio in dollars, and how does it compare to the benchmark return?
EXHIBIT 12.2
International Portfolio: Composition and Market Data
Number Price (in local Portfolio Value Portfolio Value
Portfolio of Shares currency) on Dec. 31 on Mar. 31

Base Base
Local Currency Local Currency
Dec. 31 Mar. 31 Currency (dollar) Currency (dollar)

Japanese Stocks
Sony 400 10,000 11,000 4,000,000 40,000 4,400,000 41,905
European Stocks
BMW 100 600 600 60,000 60,000 60,000 61,224
Total 100,000 103,129

Market Data Dec. 31 Mar. 31

International index
benchmark ($) 100 98.47
Japanese index () 100 105
European index (:) 100 95
Yen per dollar ($ : ) 100 105
Euro per dollar ($ : :) 1 0.98

SOLUTION
On March 31, her portfolio has gained 3.13 percent ((103,129 - 100,000)/
100,000), while the benchmark (international index) has lost 1.53 percent in
dollars ((98.47 - 100)/100). The performance of the portfolio relative to the
benchmark is therefore a positive 4.66 percent. Of course, she will want to know
why her portfolio had such a good performance over the quarter.

The Mathematics of Multicurrency Returns

The basic unit of measurement is the rate of return on each segment before any
cash movement between segments. To avoid a notational crisis, all time indexes are
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536 Chapter 12. Global Performance Evaluation

indicated with superscripts, and specific portfolio segments are indicated with
subscripts. We now present the rate of return calculations for a specific segment,
both in its local currency and in the investors base currency.

Return in Local Currency If we call Vj the value of one segment j, in local

currency, the rate of return in local currency for period t is given by
V jt - V jt - 1 + D jt V jt - V jt - 1 D jt
rj = = + = pj + d j (12.7)
V jt - 1 V jt - 1 V jt - 1
where
Dj is the amount of dividends or coupons paid during the period
pj is the capital gain(price appreciation) in percent
dj is the yield in percent
Further precision is needed for fixed-income segments. In most countries, as
well as on the Eurobond market, accrued interest A is computed and quoted sepa-
rately from the quoted price of a bond P. An investor must pay both the price and
accrued interest to the seller. Therefore, the total value of the bond is V = P + A.
The rate of return on the bond segment is given by
V jt - V jt - 1 + D jt P jt - P jt - 1 Atj - Atj - 1 + D jt
rj = = + = pj + d j (12.8)
V jt - 1 P jt - 1 + Atj - 1 P jt - 1 + Atj - 1

Return in Base Currency The base currency rate of return is easily derived by
translating all prices10 into the base currency 0 at exchange rate S j :
V jtS jt + D jt S jt - V jt - 1S jt - 1
rj 0 =
V jt - 1S jt - 1

where rj 0 is the segment return in base currency 0, while rj is the segment return in
its local currency and sj is the number of units of currency 0 per unit of currency j.
After some algebraic reshuffling, this may be written as
rj 0 = pj + dj + s j(1 + p j + d j), or
rj 0  pj  dj  cj (12.9)

Total return Capital

Yield Currency
in  gain  
component component
base currency component
where s j denotes the percentage exchange rate movement, and cj denotes the influ-
ence of the exchange rate movement on the estimated return in the base currency.
Note that the currency component cj is equal to zero if the exchange rate movement
s j is zero. If s j is not zero, c j differs slightly from sj because of the cross-product terms.

10
For simplicity, assume that the dividend is paid at the exchange rate prevailing at the end of the period.
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Performance Attribution in Global Performance Evaluation 537

The compounding of currency and market movements on a foreign security is

illustrated in Exhibit 12.3. The value of a foreign investment is represented as a rec-
tangle, where the horizontal axis represents the exchange rate and the vertical axis
represents the value of the investment in local currency. As an illustration, consider a
U.S. investor holding 10,000 of British assets with an exchange rate of $/ = 2. The
dollar value of the assets is represented by area A, or $20,000. Later, the British assets
have gone up by 10 percent to 11,000, and the pound has appreciated by 5 percent
to $/ = 2.10. The total dollar value is now 23,100, or a gain of 15.5 percent. The dol-
lar gain, if the currency had not moved, is represented by area B (10 percent of initial
value). Because of the currency movement, this gain is transformed to a total gain of
15.5 percent, equal to the sum of areas B, C, and D. Area C plus D is the currency com-
ponent of the total return. Note that it can be seen as a pure exchange rate movement
(area D) and a cross-currency market term (area C). It is equal to the exchange rate
movement applied to the final pound value of the investment, not its initial value.

Total-Return Decomposition
The first objective of GPE is to decompose the portfolios total return, measured in
base currency, into the three main sources of return:
I Capital gain (in local currency)
I Yield
I Currency

EXHIBIT 12.3
Market and Currency Gains

Final 11,000
value
Value of investment in pounds

B C
Initial
value 10,000

A D

2 2.1
0
Initial Final
value value

Exchange rate in dollars per pound

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538 Chapter 12. Global Performance Evaluation

The total return is simply the weighted average of the returns on all segments. Over
period t, the total portfolios return r is computed in the base currency as follows:

r = a wj rj 0 = a wj(pj + d j + cj)
j j

where wj represents the percentage of segment j in the total portfolio at the start of
the period, and the sign g means that we sum over all segments j. The various
j
sources of return may be regrouped into three components:
r = a wj pj + a wj dj + a wj c j (12.10)
j j j
Capital gain Yield Currency
+ +
component component component
Example 12.7 is an important example to demonstrate total return decomposition.

EXAMPLE 12.7 INTERNATIONAL PORTFOLIO : TOTAL RETURN DECOMPOSITION

Lets now return to the sample international portfolio and its international
benchmark. Decompose the total return into capital gain, yield, and currency
components. Perform a similar calculation for the benchmark.

SOLUTION
There is no yield, so we will focus on the other components of return. The
Japanese shares went up by 10 percent in the first quarter (from 10,000 per
share to 11,000). The rate of return in yen on the Japanese equity segment is
10 percent (from 4 million to 4.4 million). When translated into dollars, the
rate of return of the Japanese equity segment becomes 4.76 percent (from
$40,000 to $41,905). The difference between 4.76 percent and 10 percent is
due to the currency contribution (-5.24%), caused by a drop in the value of
the yen relative to the dollar. Note that this figure is not exactly equal to the
percentage currency loss on the yen, which dropped from 100 = $1 to 100 =
$0.9524. As mentioned, the currency contribution is equal to the currency loss
applied to the original investment plus the capital gain.
These results are reproduced in the first four columns of Exhibit 12.4. The
first column gives the weights in the portfolio, as of December 31. The second
column gives the rates of return in the base currency (dollar) for each seg-
ment. The last line gives the weighted average return for the total portfolio,
using the portfolio weights given in the first column. Note that the weighted
average return in dollars is indeed 3.13 percent, which is consistent with the
total portfolio appreciation reported in Exhibit 12.2. The third and fourth
columns give the return in local currency and the currency contribution for
each segment, as well as for the total portfolio (by taking the weighted average
for each segment). For example, the total currency contribution of -0.87
percent is equal to the currency contribution for Japanese equity (-5.24%)
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Performance Attribution in Global Performance Evaluation 539

EXHIBIT 12.4
International Portfolio: Total Return Decomposition

(1) (2) (3) (4) = (2) - (3) (5) (6) = (3) - (5)

Rate of Rate of
Portfolio Return Return in Currency Market Security
Weights in $ Local Currency Contribution Index Selection

Japanese Stocks 40% 4.76% 10.00% -5.24% 5.00% 5.00%

European Stocks 60% 2.04% 0.00% 2.04% -5.00% 5.00%
Total Portfolio 100% 3.13% 4.00% -0.87% -1.00% 5.00%

multiplied by the weight of Japanese equity in the total portfolio (40%), plus
the currency contribution of European equity (2.04%) multiplied by the
weight of European equity in the total portfolio (60%).
In the end, the total portfolio return of 3.13 percent can be decomposed
as a nice capital gain in local currency of 4.00 percent, minus a currency loss of
-0.87 percent. Note that columns 3 and 4 add up to column 2. Columns 57
are discussed in Example 12.8.
The Japanese index gained 5 percent from 100 to 105 yen, but the yen
depreciated from $: = 100 to $: = 105. The dollar return on the Japanese
index is calculated by simply dividing the index by the $: exchange rate. The
Japanese index in dollar terms was unity on December 31 (100/100) and
remains unity on March 31 (105/105). Hence, the dollar return on the
Japanese market equals 0 percent (constant index in dollars). Similarly, the
European index return is -5 percent in euros, but the euro strengthened from
$:: = 1 to $:: = 0.98. So the European index return is -3.06 percent in dollars,
and the currency contribution is +1.94% = -3.06% - (-5%). To get the return
decomposition for the international benchmark, we simply take the weighted
average of the return decomposition for the Japanese and European market
indexes as shown in Exhibit 12.5. We verify that the benchmark return in dol-
lars is a loss of 1.53 percent. The benchmarks total return all comes from

EXHIBIT 12.5
International Benchmark: Total-Return Decomposition
(1) (2) (3) (4)

Rate of Return
Benchmark Rate of in Local Currency
Weights Return in $ Currency Contribution

Japanese Index 50% 0.00% 5.00% -5.00%

European Index 50% -3.06% -5.00% 1.94%
Benchmark 100% -1.53% 0.00% -1.53%
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540 Chapter 12. Global Performance Evaluation

an average currency contribution of -1.53 percent. The local currency returns

of the Japanese and European market indexes offset each other.
Note that in Exhibit 12.4 we calculated the currency contributions on the
Japanese index as -5 percent and on the European index as +1.94 percent.
The currency contributions for the Japanese and European segments of the
international portfolio shown in Exhibit 12.4 are slightly different (-5.24% and
2.04%). This is because the currency loss applies both to the original principal
and also to the capital gain. Because the Japanese portfolio had a better capital
appreciation (10%) than the Japanese index (5%), it has more currency expo-
sure to the yen and therefore lost more. Similarly, the European portfolio had
a slightly better currency gain.

Performance Attribution
A managers relative performance may be measured by making several comparisons.
The basic idea is to provide a comparison with some passive benchmarks for all
major investment decisions. Active management decisions will induce deviations
from the benchmarks returns. Some of the many management decisions that are
commonly analyzed are discussed next.

Security Selection A managers security selection ability is determined by

isolating the local market return of the various segments. Lets call Ij the return, in
local currency, of the market index corresponding to segment j (e.g., the Tokyo
Stock Exchange index). Remember that market indexes are usually price-only
indexes (do not reflect dividends). Assuming a portfolio has market-index-average
risk, the return derived from security selection is simply pj - Ij. The rate of return
on segment j ( Japanese stocks) may be broken down into the following
components:
rj 0 = Ij + (pj - Ij) + dj + cj
The total portfolio return may be written as

r a wj I j  a wj (pj - Ij )  a wj dj  a wj cj (12.11)
Market Security
Yield Currency
return  selection  
component component
component contribution
The first term on the right-hand side of Equation 12.11 measures the perfor-
mance that would have been achieved had the manager invested in a local market
index instead of individual securities. This contribution is calculated net of cur-
rency movements, which are picked up by the last term in the formula. The second
term measures the contribution made by the managers individual security selec-
tion. It is simply the weighted average of the security selection on each segment.