Download foreign exchange risk and diversification

Lectures 24 & 25: Portfolio Risk
• Lecture 24: Risk Premium & Portfolio Diversification
• Bias in the forward exchange market
as a predictor of the future spot exchange rate
• What makes a currency risky?
• The gains from international diversification
• The portfolio balance model
• Appendix: Intervention in the Foreign Exchange Market
• Lecture 25: Sovereign Risk
• Sovereign spreads
• Procyclical fiscal policy
• Appendices: (1) Car crash analogy (2) Greece & the euro’s debt crisis
Does the Forward Market Offer an Unbiased
Predictor of the Future Spot Exchange Rate?
• More particularly, does the forward discount equal the
mathematically expected percentage change in the spot rate:
(fd)t = Et Δst+1 ?
• Given Covered Interest Parity, it is the same as the question
whether the interest differential is an unbiased predictor:
(i-i*)t = Et Δst+1 ?
• So then, does the interest differential equal the
mathematically expected percentage change in the spot rate?
Is the interest differential an unbiased predictor
of the future spot exchange rate?
• Usual finding:
Bias is statistically significant:
.
No.
(i-i*)t ≠ Et Δst+1 .
– In fact, Et Δst+1 is much closer to zero (a random walk).
– The bias is known in the markets as the “carry trade”:
One can make money, on average, going short in a low-i currency
and long in a high-i currency.
• How can this be?
– One interpretation: Rational expectations fails, Δste ≠ EtΔst+1
– Another: Uncovered interest parity fails, i-i*t ≠ Δste
A risk premium separates (i-i*)t from Δste .
In this case, riskier currencies should be the ones to pay higher returns
What makes a currency risky to a portfolio investor?
• If uncertainty regarding the value of the currency
(variance) is high.
• If you already hold a lot of assets in that currency.
• If currency is highly correlated with other assets you hold.
What matters is how much risk the currency
adds to your overall portfolio.
The gains from international diversification
• James Tobin: The theory of
optimal portfolio diversification
• “Don’t put all your eggs in one basket.”
• The theory was worked out for stocks
in the Capital Asset Pricing Model (CAPM).
• Applies to all assets: bonds, equities;
domestic, foreign.
• International markets offer a particular
opportunity for diversification,
because they move independently to some extent.
Standard
deviation
of return
to portfolio
Diversification lowers risk to the overall portfolio.
The investor can achieve a lower level of risk
by diversifying internationally.
↑
Return
Assets with high individual uncertainty don’t
necessarily pay higher returns on average.
Not if the risk is diversifiable. Only the risk
that an asset contributes to the uncertainty
of the aggregate portfolio merits an extra
average rate of return (risk premium).
Risk →
↑
Return
Medium riskaversion
Low riskaversion
High riskaversion
Placing 20% of your portfolio abroad reduces risk (diversification).
After that point, the motive for going abroad is higher expected return;
investors who are more risk averse won’t go much further.
Purely US
Risk →
↑
Return
Similarly, putting 25%
of the global portfolio
in emerging markets
gives diversification.
After that, the gain
in expected return
comes at the expense
of higher risk.
Risk →
PORTFOLIO BALANCE MODEL
• Portfolio investors should allocate shares in their portfolios
to countries’ assets as:
- a decreasing function of the asset’s risk, and
- an increasing function of its expected rate of return (risk premium).
• Valuation effect: a 1% increase in supply of $ assets
(whether in the form of money or not) can be offset by a 1% depreciation,
-- so that portfolio share is unchanged, and
-- therefore no need to increase expected return to attract demand.
• One implication: As its debt grows, a deficit country
will eventually experience depreciation of its currency,
or its interest rate will be forced up, or both.
• Another implication:
=> FX intervention can have an effect even if sterilized.
Appendix:
Intervention in the $ foreign exchange market
• was effective in 1985, to bring down the $,
represented by the G-5 agreement at the Plaza Hotel;
• and to have been effective at times subsequently
(though not always).
• Since 2001, the ECB, Fed, & BoJ have intervened very little;
• But other floaters intervene more often,
– e.g., major emerging market countries,
1985-1999
US FX intervention, even though sterilized, can sometimes be effective:
The Plaza Accord of 1985 brought the dollar down,
and the G-7 meeting of 1995 brought it up.
Sovereign Risk
• In the past, sovereign risk (i.e, risk of default by governments)
was normally assumed zero for major borrowers
• such as the US, Japan, Euroland.
– Then bonds are identified only by currency of denomination,
• and “risk” was just exchange risk.
• But default risk was always an issue for developing countries.
• Assets are identified not just by currency, but also by the issuer;
• risk also includes default risk, requiring its own risk premium
– “sovereign spreads.”
• Recently
– Most European countries are now back in that situation.
– Investors may start to see US debt as carrying sovereign risk too.
Sovereign spreads depend on general sensitivity to risk,
as reflected in the VIX (option-implied volatility of US stock market)
Laura Jaramillo & Catalina Michelle Tejada, IMF Working Paper, March 2011
More importantly, sovereign spreads depend
on country-specific characteristics,
• especially: the country’s debt/GDP ratio,
• whether the ratio is expected to come down in the future
(the definition of sustainability),
• whether the country has a past reputation for defaulting
(“debt intolerance”),
• and whether somebody is expected to bail it out
(moral hazard).
After joining the euro, Greece never got its budget deficit
below the 3% of GDP limit of the Stability & Growth Pact,
nor did the debt ever decline toward the 60% limit
16
Spreads for Greece, Portugal & other Mediterranean members
of the € were near zero, 2001-07, until they shot up in 2008-11
under fears of sovereign default risk.
17
Country creditworthiness is now inter-shuffled
“Advanced” countries
AAA Germany, UK
AA+ US, France
AA
Belgium
AA- Japan
A+
A
Spain
ABBB+ Italy
BBB- Iceland, Ireland
BB+
BB
Portugal
B
CC
Greece
(Formerly) “Developing” countries
Singapore
Chile
China
Korea
Malaysia, South Africa
Brazil, Thailand, Botswana
Colombia
India
Indonesia, Philippines
Costa Rica, Jordan
Burkina Faso
S&P ratings, Feb.2012 domestic curren
The historic role reversal
• Some emerging markets have earned credit ratings
higher than some so-called advanced countries.
• Over the last decade some emerging market countries
finally developed countercyclical fiscal policies:
• They took advantage of the boom years 2003-2008
– to run budget primary surpluses.
– By 2007, Latin America had reduced its debt to 33% of GDP,
• as compared to 63 % in the United States.
– So they were able to respond to 2008-09 recession by fiscal expansion.
• Debt levels among top-20 rich countries (debt/GDP ratios ≈ 80%)
are now > twice those of the top-20 emerging markets
..
19
Ratio of public debt to GDP among advanced countries
is the highest since the end of WW II
Source: Carlo Cotarelli “Making Goldilocks Happy,” IMF, Apr. 20, 2012
Pro-cyclical fiscal policy
THESE 3 PAGES WERE IN L3 APP. IN 2010
• In the textbook approach, benevolent governments
are supposed use discretionary fiscal (& monetary)
policy to dampen cyclical fluctuations.
• expanding at times of excess supply, and
• contracting at times of excess demand.
• In practice, policy has often been procyclical,
i.e., destabilizing, in developing countries.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Political economy explanations
for destabilizing fiscal policy
• #1 : Political Budget Cycles
– Politicians expand just before elections, so that
rapid growth will buy votes; the cost comes later
(debt, inflation, reserve loss, devaluation)
– Example: The Mexican sexenio (until 2000)
– Do politicians really fool voters this way? Yes, for awhile.
• #2: Procyclical government spending
– Due, e.g., to commodity cycle
• Dutch Disease in commodity booms,
• and the need to retrench in downturns.
– Bias toward optimism in official forecasts.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Historic role reversal in the cyclicality of fiscal
policy in industrialized vs. developing countries
Previously, fiscal policy was procyclical
in developing countries:
• Governments would raise spending in booms;
• and then be forced to cut back in downturns.
• Especially Latin American commodity-producers.
23
Correlations between Gov.t Spending & GDP
1960-1999
Adapted from Kaminsky, Reinhart & Vegh, 2004, “When It Rains It Pours”
procyclical
Pro-cyclical spending
countercyclicall
Countercyclical
spending
G always used to be pro-cyclical
for most developing countries.
The procyclicality of fiscal policy, cont.
• An important development -some developing countries, were able to break
the historic pattern in the most recent decade:
– taking advantage of the boom of 2002-2008
• to run budget surpluses & build up reserves,
– thereby earning the ability to expand
fiscally in the 2008-09 global recession.
25
Correlations between Government spending & GDP
2000-2009
procyclical
Frankel, Vegh & Vuletin (2011)
countercyclical
In the last decade,
about 1/3 developing countries
switched to countercyclical fiscal policy:
Negative correlation of G & GDP.
What determines countries’ fiscal performance?
– Fundamentally: Quality of institutions.
– This does not mean “tough” rules, if they lack enforceability –
like SGP, debt ceiling or Balanced Budget Amendment.
– Better would be structural budget targets (Swiss)
with forecasts from independent experts (Chile).
– Since 2000, while many developing countries have graduated
from pro-cyclical spending to countercyclical,
– the US, UK & euro countries have seemingly forgotten
how to run countercyclical fiscal policy.
• They instead enacted higher spending & tax cuts
in the expansion & contraction after the recession hit.
APPENDIX 1: FINANCIAL CRISES
& THE CAR CRASH ANALOGY
Sudden stops:
“It’s not the speed that kills, it’s the sudden stops”
– Dornbusch
Superhighways:
Modern financial markets get you where you want to go fast,
but accidents are bigger, and so more care is required.
– Merton
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Is it the road or the driver? Even when many countries
have accidents in the same stretch of road (Stiglitz), their own
policies are also important determinants; it’s not determined
just by the system.
– Summers
Contagion is also a contributor to multi-car pile-ups.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
THE CAR CRASH ANALOGY
Moral hazard -- G7/IMF bailouts that reduce the impact of a
given crisis, in the LR undermine the incentive for investors
and borrowers to be careful. Like air bags and ambulances.
But to claim that moral hazard means we should abolish the
IMF would be like claiming that drivers would be safer with a
spike in the center of the steering wheel column. – Mussa
Correlation does not imply causation: That the IMF
(doctors) are often found at the scene of fatal accidents
(crises) does not mean that they cause them.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Reaction time: How the driver reacts in the short
interval between appearance of the hazard and the
moment of impact (speculative attack) influences
the outcome. Adjust, rather than procrastinating
(by using up reserves and switching to short-term
$ debt) – J Frankel
Optimal sequence: A highway off-ramp should
not dump high-speed traffic into the center of a
village before streets are paved, intersections
regulated, and pedestrians learn not to walk in the
streets. So a country with a primitive domestic
financial system should not necessarily be opened
to the full force of international capital flows
before domestic reforms & prudential regulation.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
APPENDIX 2:
The Euro Crisis & Greece
• Looking back: 6 mistakes made by
euroland’s leaders regarding Greece
34
6 mistakes made by euro leaders
• Admitting Greece to the € in the first place,
– a country that was not yet ready.
• Pretending to enforce the fiscal criteria:
• BD < 3% of GDP & Debt < 60% of GDP.
• Allowing Mediterranean countries’ bonds spreads near 0
– helped by investors’ under-perception of risk (2003-07)
– and artificial high credit ratings. But also
– ECB acceptance of Greek bonds as collateral.
When the crisis hit, the leaders buried their heads in the sand:
• 2 years ago, sending Greece to the IMF was “unthinkable.”
• 1 year ago, restructuring of the debt was “unthinkable.”
• The current strategy: austerity and the Fiscal Compact.
35
The Treaty of Maastricht (1991) surprised many
economists by emphasizing fiscal criteria
BD < 3% & Debt < 60% of GDP, as qualifications for membership.
The motivation for the Maastricht fiscal criteria:
• Skeptical German taxpayers believed that,
before the € was done, they would be asked
to bail out profligate Mediterranean countries.
• European elites adopted the fiscal rules
to demonstrate that these fears were groundless.
• The motivation
• was the same for the No Bailout Clause
• and the subsequent Stability & Growth Pact (1997)
36
After the euro came into existence
• it became clear the German taxpayers had been right
– and the European elites were wrong.
• E.g., Greece persistently violated the 3% deficit rule.
• The large countries violated the rule too.
• SGP targets were “met” by overly optimistic forecasts.
• SGP threats of penalty had zero credibility.
• Yet each year the ostrich elites stuck
their heads deeper & deeper into the sands.
37
When PASOK leader George Papandreou
became PM in Oct. 2009,
• he announced
– that “foul play” had misstated the fiscal statistics
under the previous government:
– the 2009 budget deficit ≠ 3.7%,
as previously claimed,
but > 12.7 % !
38
Missed opportunity
• The EMU elites had to know that someday
a member country would face a debt crisis.
• In early 2010 they should have viewed Greece as a good
opportunity to set a precedent for moral hazard:
– The fault egregiously lay with Greece itself.
• Unlike Ireland or Spain, which had done much right.
– It is small enough that the damage from debt restructuring could
have been contained at that time.
• They should have applied the familiar IMF formula:
serious bailout, but only conditional on serious
policy reforms & serious Private Sector Involvement.
39
• But the ostriches
stuck their heads
ever further
down in the sand.
• There is even less reason now to think
Brussels can impose fiscal constraints on
borrowers or ask unlimited transfers from
creditor country taxpayers than before.
40
Any solution to the euro crisis must include a
way to prevent repeats in the long term.
• As the Maastricht architects knew all along,
this means a way of preventing fiscal moral hazard:
– preventing individual countries from running big deficits &
debts, expecting to be bailed out in the event of a crisis.
– The German taxpayers are no more
supportive of a “transfer union” than ever.
• Merkel’s “fiscal compact” is the 6th mistake:
– yet another declaration of determination
to strengthen the SGP,
– incl., via budget limits in national laws/constitutions.
– One SR problem: Europeans think austerity is expansionary.
• Another explanation for pro-cyclical fiscal policy.