Lecture IV
Questions from last lecture
Review questions:
• What are economic problems posed by bankruptcy?
• What are economic advantages/ benefits of bankruptcy laws?
• What are short-comings of Paris and London Club? When do they
arise?
• What are problems with IMF’s SDRM approach?
Some types of flows are too persistent
Foreign Debt
$800
$700
$600
Africa
Cen Eur
L Am
Asia
$500
$400
$300
$200
$100
2002
2000
1998
1996
1994
Total foreign indebtedness in billions of US$
1992
1990
1988
1986
1984
1982
1980
$0
Persistent debt and its legacy
Foreign Debt Service Payments
$180
$160
$140
$120
$100
Africa
Cen Eur
L Am
Asia
$80
$60
$40
$20
$0
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
Principle and interest payments on total foreign indebtedness in billions of US$
Lecture IV
Local Currency Debt
• Major part of problem as been dollar denomination of developing country
debt.
• How did this come about?
Dodd (1989) – banks and other lenders did not want currency risk –
would not lend other terms that included local currency denomination.
• Hausmann, et al – due to Original Sin
Not the fault of LDCs, not a result of their errors
- not bad fiscal policy
- not bad monetary policy
- not foreign exchange volatility or inflation volatility
- not history of default
Instead it is the result of a sort of “Original Sin”
Original Sin caused by problems with 1) size and 2)
timing
•
Large countries more apt to borrow internationally in their own currency. FX
Traders more likely to make market in currency from large country. (But Switzerland
is certainly an exception.)
Other countries who issue debt in their own currency had the advantage of coming
first. Given that there can only be a few major currencies, there is significant benefit
from being first. Late-comers suffer.
•
SOLUTION
Housmann approach is too, far too complicated and expensive
The EM Index would be created by the IMF – no one wants them involved
Index would still leave each developing country with currency exposure but to the
index instead of dollar, etc.
What should the US issue debt in the index?
Portfolio Approach to Salvation
•
Dodd-Spiegel
- Market was using wrong approach
- Diversification of credit risk is NOT effective
- Avoided FX risk which is easier of two risks to manage
1.
DC government borrowers are much less credit risk in their own
currency than in dollars or hard currency
FX risk in any one currency is indeed substantial
FX risk is largely independent – one currency to the next – or has
low levels of correlation
Large potential benefits from diversification
Encourage foreign investors to invest through deversified portfolio
of developing country currency debt
DC need to improve their local currency debt market infrastructure
and regulation
More active, deeper markets will improve pricing efficiency
Current misspricing leaves too much excessive gains for foreign
investors, efficient pricing would allow DC to borrow more cheaply
2.
3.
4.
5.
6.
7.
8.
Primer on Volatility and Portfolio Variance
•
•
•
•
The value of financial assets is generally uncertain. Economic models usually have to
assume a risk-free or risk-less asset, and then approximate it with some short-term
government security such as the U.S Treasury bill.
Policy analysis needs to be as practical as possible and so the actual uncertainty of
financial assets is something that must be dealt with. One practical was of
conceptualizing this uncertainty in order to make it intellectually tractable is to focus on
the distribution of the uncertain events. Knowing something about the distribution of the
returns on financial assets allows us to act rationally in making individual as well as
policy decisions. In this way, economic policies about how to deal with uncertain future
events can be developed, studied and compared to other plans. Although rational it is
not exact and not a perfect substitute for certainty, but is the best known way to operate
in a world that is appropriately described by the great wit and sage Yogi Berra's remark,
"It's tough to make predictions, especially about the future."
Risky securities can be combined into a portfolio so that their combined volatility is lower
than that of any of the securities. This allows an investor to combine different securities
in order to produce a risk-return trade-off that is better than that on any one of the
individual securities.
This key to taking advantage of the combination of risky securities is known as
diversification. In order to benefit from diversification, the returns must be independent
or sufficiently uncorrelated or negatively correlated in order to generate this benefit.
108
Constant STDEV = 2.05
106
+/-2%
Grow th
Spike
104
102
100
98
96
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
5 Independently Distributed Random Series
2
1.5
1
0.5
0
-0.5
-1
-1.5
-2
-2.5
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20
In order to explain the concepts of negative correlation and independence, it helps to
visual what this means. Figure 1.A below illustrates a portfolio of two securities whose
returns vary between 20% and 0%. The fact that one is always high when the other is
low, or is equal to zero when the other is equal to zero, means that the combination of
the two is constant at 10% (in bold).
25
Perfect Negative Correlation
20
15
10
5
0
1
5
9
13
17
21
25
29
33
37
41
45
49
Of course find two such perfectly and negatively correlated assets is unlikely (one exception would be
short and long derivatives positions, but the combined return would be zero). Consider a slightly more
complicated portfolio of four securities that are two pairs of perfectly negatively correlated securities
but the two pairs are not perfectly correlated. This is illustrated by Figure 2.A below. Note that one
pair has a greater volatility than the other pair (this is illustrated by the high amplitudes (both positive
and negative) of the waves of returns).
Correlation & Variance
25
20
15
10
5
0
-5
1
5
9
13
17
21
25
29
33
37
41
45
49
Of course it is even more unlikely to find two pairs of perfectly negatively
correlated securities. The point here is to illustrate the potential of
combining different securities, and larger number of different securities,
into a portfolio so as to reduce overall risk or volatility.
The next point to consider is independence. In order to illustrate this point,
Figure 3.A below shows a portfolio of hypothetical returns created by a
random number generator. Each security is not perfectly independent but
is sufficiently independent that the portfolio variance, represented by the
dark bold line, exhibits substantially less volatility than any of the individual
securities.
Diversification & Portfolio Variance
3.0
2.0
1.0
0.0
-1.0
-2.0
-3.0
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20
Figure above shows that a portfolio of securities that are each very volatile
can be combined into a portfolio whose volatility is much less variable.
A concluding word of caution. The past distribution is not a guarantee of
future distribution. The world, as Heraclitus pointed out some time ago, is
constantly changing. And that applies also to the distribution of changing or
uncertain things. This point was illustrated graphically but tragically when
Long Term Capital Management collapsed when they investment strategy
ran into uncharacteristic distribution of interest rates. Perhaps an easier
way to remember this caveat is to recall again the words of the great wit
and sage Yogi Berra who said, "The future is not what it used to be.“