Question

Explain this relationship Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + DVar

Explain this relationship

Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + DVar

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Answer #1

The risk for a U.S. resident investing in a foreign market will depend not only on the risk in the foreign market but also on the risk in the exchange rate between the U.S. dollar and the foreign currency.

Equation Var(Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + DVar

The above equation demonstrates that exchange rate fluctuations contribute to the risk of foreign investment through three channels:

Through their own volatility Var(Ri)

Covariance with local market returns (Cov(Ri, ei))

Contribution of cross product term, Riei, to the risk of foreign investment (DVar)

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