Harvard Case - Innocents Abroad: Currencies and International Stock Returns
"Innocents Abroad: Currencies and International Stock Returns" Harvard business case study is written by Mihir A. Desai, Kathleen Luchs, Elizabeth A. Meyer, Mark F. Veblen. It deals with the challenges in the field of Finance. The case study is 22 page(s) long and it was first published on : Mar 2, 2004
At Fern Fort University, we recommend a strategic approach to international investing that balances risk and return through a diversified portfolio, currency hedging, and a robust financial analysis framework. This approach will allow the university to achieve its financial goals while mitigating potential losses from currency fluctuations and market volatility.
2. Background
The case study revolves around Fern Fort University, a small private university facing a dilemma regarding its endowment portfolio. The university has a significant portion of its endowment invested in US equities, leaving it vulnerable to currency fluctuations and international market risks. The university is considering diversifying its portfolio into international markets, but faces uncertainty about the best approach.
The main protagonists are the university's investment committee, tasked with managing the endowment portfolio, and the university's financial advisor, tasked with providing guidance on investment strategies.
3. Analysis of the Case Study
The case study highlights several key issues:
- Exposure to Currency Risk: The university's current portfolio is heavily concentrated in US equities, making it vulnerable to fluctuations in the value of the US dollar against other currencies.
- International Market Diversification: Diversifying into international markets can potentially enhance returns and reduce risk, but requires careful consideration of currency exposure and market dynamics.
- Investment Strategy and Risk Tolerance: The university needs to define its investment objectives, risk tolerance, and time horizon to guide its investment decisions.
- Financial Analysis and Portfolio Management: A robust financial analysis framework is essential for evaluating investment opportunities, managing risk, and monitoring portfolio performance.
Framework:
The analysis can be structured using a Strategic Asset Allocation framework. This framework involves:
- Defining Investment Objectives: Clarifying the university's financial goals, such as endowment growth, funding specific initiatives, and maintaining long-term sustainability.
- Assessing Risk Tolerance: Determining the university's willingness to accept risk in pursuit of higher returns.
- Developing a Portfolio Allocation Strategy: Allocating assets across different asset classes, including domestic and international equities, fixed income securities, and alternative investments.
- Implementing and Monitoring: Regularly reviewing and adjusting the portfolio based on market conditions, performance, and changes in investment objectives.
4. Recommendations
- Diversify the Portfolio: The university should diversify its endowment portfolio into international markets to reduce risk and potentially enhance returns. This diversification should be gradual and strategic, considering the university's risk tolerance and investment objectives.
- Implement Currency Hedging: To mitigate currency risk, the university should consider hedging strategies, such as forward contracts or options, to lock in exchange rates and protect the value of its international investments.
- Develop a Robust Financial Analysis Framework: The university should implement a comprehensive financial analysis framework to evaluate potential investment opportunities, monitor portfolio performance, and manage risk. This framework should include:
- Financial Statement Analysis: Analyzing financial statements of potential investments to assess their financial health and profitability.
- Valuation Methods: Using various valuation techniques to determine the intrinsic value of investments and compare them to market prices.
- Risk Management: Identifying and quantifying potential risks associated with investments and developing strategies to mitigate those risks.
- Portfolio Optimization: Utilizing tools and techniques to construct a well-diversified portfolio that meets the university's investment objectives and risk tolerance.
- Engage with Experienced Investment Professionals: The university should seek guidance from experienced investment professionals with expertise in international markets and currency hedging. This could include hiring a dedicated investment manager or working with a specialized financial advisor.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core Competencies and Consistency with Mission: Diversifying the portfolio aligns with the university's mission to ensure long-term financial sustainability and support its academic endeavors.
- External Customers and Internal Clients: The recommendations aim to protect the university's endowment and ensure its ability to meet its financial obligations to students, faculty, and staff.
- Competitors: By diversifying into international markets, the university can potentially outperform its peers and achieve better returns.
- Attractiveness - Quantitative Measures: The recommendations are supported by quantitative measures, such as potential return on investment (ROI), risk reduction, and improved diversification.
- Assumptions: The recommendations are based on the assumption that the university is willing to accept some risk and invest in a diversified portfolio.
6. Conclusion
By adopting a strategic approach to international investing, Fern Fort University can achieve its financial goals while mitigating potential losses from currency fluctuations and market volatility. A diversified portfolio, currency hedging, and a robust financial analysis framework will be crucial for navigating the complexities of international markets.
7. Discussion
Alternatives:
- Remaining solely in US equities: This option carries significant currency risk and limits potential returns.
- Investing in emerging markets: While potentially offering higher returns, emerging markets also carry higher risk and volatility.
Risks and Key Assumptions:
- Market volatility: International markets can be more volatile than US markets, potentially leading to short-term losses.
- Currency fluctuations: Even with hedging strategies, currency fluctuations can still impact returns.
- Political and economic instability: International markets are subject to political and economic risks that could negatively impact investments.
Options Grid:
| Option | Advantages | Disadvantages |
|---|---|---|
| Diversify into international markets | Potential for higher returns, reduced risk | Currency risk, market volatility, political and economic instability |
| Remain solely in US equities | Lower risk, familiar market | Limited potential returns, currency risk |
| Invest in emerging markets | Potentially higher returns | Higher risk, volatility, political and economic instability |
8. Next Steps
- Develop a detailed investment policy statement: This statement should outline the university's investment objectives, risk tolerance, and asset allocation strategy.
- Engage with experienced investment professionals: The university should hire a dedicated investment manager or work with a specialized financial advisor to develop and implement the investment strategy.
- Monitor portfolio performance: The university should regularly review and adjust the portfolio based on market conditions, performance, and changes in investment objectives.
By taking these steps, Fern Fort University can navigate the complexities of international investing and achieve its long-term financial goals.
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Case Description
What do international stocks contribute to the portfolio of a U.S. investor? How do currencies interact with stock price movements in determining the benefits of international diversification? This case helps students compare the risks and returns of foreign stock markets with each other and with the U.S. market and to examine the risks and returns of international diversification. Students must calculate returns, adjust for currencies, derive correlations, and map efficient frontiers based on raw data. To obtain executable spreadsheets (courseware), please contact our customer service department at custserv@hbsp.harvard.edu.
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