International Diversification

I suggested in a recent email message that you avoid reading Chapter 13 in Bekaert and Hodrick. This chapter is tedious and its main points can made in a much briefer manner. Serendipitously, an article from today's WSJ titled "Swimming with the Currency " is very helpful. The article touches upon several points

First, when investing in a foreign investment, the rate of return in terms of the domestic currency (say USD) is affected by both the performance of the investment in the foreign asset (stock or bond) and the performance of the foreign currency itself (see my December 17 email message). Let me pick an example from this article relating to results of investing in the Brazilian stock market (the Bovespa index). During 2008 the Bovespa declined 41% in local prices and the Brazilian real lost 55% of its value against the USD. This means a total loss of 73.45% (compute!!!)

The second important point in this article is what it calls geographical diversification. Modern portfolio theory tells us that the more assets you include in your portfolio, the better are the risk-return opportunities. If you remember the mean-standard deviation capital market line, this means that the slope of this line is steeper when more assets are included. In short, don't attempt to outperform your domestic market by investing in foreign stocks. Do so in order to mitigate domestic market's variability. Hopefully, when your domestic market performs badly, foreign ones might mitigate this loss.
A few additional observations about international diversification:
1. The lower the correlation between the rates of return between the domestic and foreign markets, the better are the diversification opportunities. See page 465 for a tabulation of the historical correlations between various economies (Exhibit 13.5). Which countries seem to be good vehicles for international diversification?
2. Although you can't see it from Exhibit 13.5, these correlations tighten over time. Because we live in a global economy, all local economies are interrelated and are becoming more so with time.
3. What is the meaning of a "foreign" company anyhow? Is Toyota a foreign company? a huge part of its production and sales take place in the U.S.

The third important concept in this article is called translation exposure which is completely ignored by Bekaert and Hodrick. Here is the gist of this concept. According to GAAP (Generally Accepted Accounting Principles) U.S. corporation should consolidate the financial results of their subsidiaries --including foreign subsidiaries). When a the currency of the foreign subsidiary appreciates against the domestic currency, the subsidiary's assets appreciate. This appreciation enhances the parent corporation's income for the year. Obviously, the opposite might happen and profits could be dampened.

Money supply and the Fed's Actions

Many of you elected to use the December 18 article titled "Japan Looks Set to Follow U.S. Rate Cut". Several of you had difficulty conceptualizing the mechanism of the money supply. As stated by a class participant:

The article mentions that as part of the “quantitative easing” approach, the Fed may consider buying U.S. Treasuries to create funding for new programs. I am not clear how the U.S. federal government purchasing its own securities provides additional funding in a real sense.

To clarify this issue I will guide you through the following steps:
1. Economic activity is promoted by banks extending credit
2. When credit is granted by a bank, it create a "deposit" available to the borrower for check writing.
3. Banks are limited by reserve requirements (stipulated by the Fed) as to how much credit they can extend. Currently, for every 10 dollars in deposits the bank must hold a reserve of one dollar. The more the reserves available to a bank the more deposits (and hence credit) it can create.
4. When the Fed buys securities from dealers, it pays them money that is automatically deposited in their bank accounts.
5. This extra money constitutes new (and therefore additional)reserves that enable banks to lend more (see point 3 above) by creating new loans (deposits).
6. Because bank deposits constitute a component of the money supply, we say that by purchasing securities the Fed helps increase the money supply or the quantity of money.
7. Note that if banks refuse to use the new reserves to grant new loans (as they currently do) , the money supply may not grow.

Newspaper Article

There are two interesting articles that appeared in the press in the last couple of days. Friday's New York Times article titled "Chinese Savings Helped Inflate American Bubble" is long but instructive. It demonstrates how all nations are linked to each other in this global economy. Yesterday' Wall Street Journal included a major long article titled "The Isle That Rattled the World ". Please make sure to read at least one of these articles.

Not Quite Global Finance

Some years ago I was frequently hosting in my office a representative of one of the largest textbook publishers. The guy is no longer with this company and, yet, he felt compelled to write me for advice regarding the situation in capital markets. Here is his message:


It has been a long time. I hope you and your loved ones are doing well. I was just contemplating the repercussions of an over supply of T bills and thought you might explain what the treasury and fed can do to counter this serious problem. I thought at first the fed could print more money which may result later in hyper inflation, but I still need your opinion. Please see the Bloomberg article below:

http://www.bloomberg.com/apps/news?pid=20601087&sid=aiw3cE2FfsLU&refer=home

Thanks for taking the time to respond.


Following is my response:
Hi:
Good hearing from you. I believe the Treasury is in a bind. Currently, it is able to sell a bunch of T-bills because of the flight-to-safety effect; investors, motivated by anxiety regarding capital markets, are more than glad to lend their money to the Treasury at practically zero interest. Should the Treasury be successful in comforting investors, interest rates will go up as they will require higher rates. At some point, to avoid too high of interest rates, the Fed will have to interfere by printing money. High inflation might follow. I was aware of this possibility in September when I moved a bunch of money into TIPS (Treasury Inflation Protected Securities) and promptly lost 7%.Markets' fear of deflation pushed down the value of such inflation-linked securities (they pay less interest when the CPI declines though their face value cannot sink below 100%). Markets have reversed themselves to a large extent. My current loss on such TIPS has declined to just 1.2%.
At my stage of life, my goal is to guard the purchasing power of my savings. I was not hyperventilating over the 7% loss because, had deflation taken place, my consumption would have cost less. In this sense, I was hedged. Since you are far from retirement and you might need the money for your daughters' education, I am not sure that long-term TIPS are for you. You may want to consider I-Bond sold directly to the public by the Federal Reserve Bank (of Richmond, given your Roanoke domicile). I believe that currently, you can do so up to $10,000 per year (down from $30,000 a couple of years ago). Your wife can purchase a similar amount.

I Hope all is well with you.

Happy New Year.

A concluding remark: my students too are invited to write me in the future when they encounter a work or personal life financial dilemmas. I am proud for granting my students five-year warranty on they finance education.

Vareity of WSJ Articles

There are several good articles that you should read in today's Wall Street Journal. Even before you get to the Money and Investments section, you should find in page A12 an article describing (for the n-th time) what the carry trade is all about (I intend to write a special entry on this). The second paragraph refers to the "policy rate". This is no other than the federal funds rate. You might recall how the FRB controls this rate (not always successfully) by lending and borrowing Treasury securities through repurchase agreements (see previous posting on repos). A similar reference to the federal funds rate can be found in page C2 ("For Dollar, December Blues").

Let's move to the Market Place section. The main item is titled: "Siemens to Pay Huge Fine in Bribery Inquiry". Corruption is a major problem in international trade. The book (Bekaert and Hodrick (p. 510) provides a short analysis of this issue. The book mentioned the Transparency International Index. Table 14.1 provides a table of Legal Systems Quality. I fail to see why these measures convey any information. For example, is the U.S. legal system more efficient than Germany because it evicts tenants faster (40 vs. 331 days) or is this a reflection of the fact that capital has more say in our country?
At any rate: The book refers to the Transparency International corruption index. In its 2008, this organization ranked Germany as number 14 in the world in terms of transparency while Argentina is 109. Is a country "transparent" because it gives rather than takes bribes? Another good source is the Global Integrity organization reporting that The wealthier G8 (Investigate!!!)countries suffer from similar corruption challenges as developing countries.
And then there is the Journal Report section whose subject today is Business Insights. Why don't you look into the Global Business article titled: "In Emerging Markets, Know What Your Partner Expects". All of these expectations have something to do with thuggery. The "pleasures" of doing business in emerging markets: first you have to look for a partner who will help you with bribery and then you are pursued by the SEC for paying bribes. Usually the "partner" is the ruler's cousin (as is often the case in Saudi Arabia) isn't that some type of bribery?

Sovereign Risk

Bekaert and Hodrick (p. 508) define sovereign risk as the risk of a government defaulting on its bonds payments (this is different from what appears on Investopedia and YourDictionary). You should read an article in today's Washington post titled:"Calling Foreign Debt 'Immoral' Leader Allows Ecuador to Default". Yesterday's Wall Street Journal also had an auricle on this subject that you might (or not) want to use for your next submission. I am using the Post's article because it relates a comment from a Moody's senior analyst. Well, less than a month ago,Moody's has downgraded Ecuador's sovereign debt but gently: it moved it to Caa1. It was only last April that Moody's still rated Ecuador as B3. At any rate, as you can read in the Post's article, investors have already taken this into consideration and traded this debt at a very deep discount (though not as bad a discount as Moody's stock which lost 75% of its value in the last two years.

The relevant chapter to read is: Chapter 14. BUT: please skip all sections that contain formulas Such as 14.2.

No Extraordinary News

I have not found something of value in today's press. I suggest you watch the Short View from yesterday about the end of the dollar rally.
In a different vein (it has nothing to do with Global Finance)read the press today about the Adventures of Mr. Madoff. The guy stole $50 billion from his customers. These customers included some of the biggest finance brains on Wall Street and, yet, they believed his record of 1.00% to 1.20% (per month ) month after month for years. This is the equivalent of offering the Brooklyn Bridge at a discount