Transcript Lectures 24 & 25: Portfolio Risk • Lecture 24: Risk Premium & Portfolio Diversification • Bias in the forward exchange market as a.

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 1: Intervention in the FX Market
• Lecture 25: Sovereign Risk
• Sovereign spreads
•
Appendix 2: Greece & the euro’s debt crisis
• Appendix 3: Procyclical fiscal policy
ITF220 - Prof.J.Frankel
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?
ITF220 - Prof.J.Frankel
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.
ITF220 - Prof.J.Frankel
What makes a currency risky to a portfolio investor?
• If uncertainty regarding the value of the currency
(variance) is high.
• If he already holds a lot of assets in that currency.
• If currency is highly correlated with other assets he holds.
What matters is how much risk the currency
adds to your overall portfolio.
ITF220 - Prof.J.Frankel
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.
ITF220 - Prof.J.Frankel
What portfolio allocation minimizes risk?
• Assume 2 assets (e.g., domestic & foreign),
– each with probability ½ of earning -1, ½ of earning +1.
– Variance of overall portfolio ≡ E (overall return)2
– Assume uncorrelated.
• If entire portfolio allocated to 1st asset,
– Variance = ½ (-1)2 + ½ (+1)2 = 1.
• If entire portfolio allocated to 2nd asset,
– Variance = ½ (-1)2 + ½ (+1)2 = 1.
• If portfolio is allocated half to 1st asset & half to 2nd,
– Variance = ¼(-1)2 + (½)(0)2 + ¼ (+1)2 = ½ .
– That’s minimum-variance. Maximum diversification.
ITF220 - Prof.J.Frankel
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.
ITF220 - Prof.J.Frankel
Investors want to minimize risk
and maximize expected return.
• To get them to hold assets that add risk
to the portfolio, you have to offer them
a higher expected return.
• That is why stocks pay a higher expected return
than treasury bills.
• Do foreign assets pay a higher expected return
than domestic assets?
ITF220 - Prof.J.Frankel
↑
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 →
ITF220 - Prof.J.Frankel
↑
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 →
ITF220 - Prof.J.Frankel
The 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.
ITF220 - Prof.J.Frankel
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 moved back into that situation.
– Investors may start to see US debt as carrying sovereign risk too.
ITF220 - Prof.J.Frankel
Sovereign spreads depend on general sensitivity to risk,
as reflected in the VIX (option-implied volatility of US stock market)
ITF220 -Michelle
Prof.J.Frankel
Laura Jaramillo & Catalina
Tejada, IMF Working Paper, March 2011
Capital Flows to Emerging Markets
and Risk/Uncertainty as measured by VIX
1990-2013
Private Capital Flows to EMs as % of GDP (left axis)
Volatility Index (right axis)
Source: Kristin Forbes, 2014
10
4
20
Volatilty Index
Capital Flows to EMs as % of GDP
5
3
2
30
1
0
40
Notes:
1990
1995
2000
2005
2010
2015
Data on private capital flows from IMF's IFS database, Dec. 2013. Capital flows are private financial flows to emerging markets & developing economies.
More importantly, sovereign spreads depend on
country-specific characteristics,
• including: 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).
ITF220 - Prof.J.Frankel
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
ITF220 - Prof.J.Frankel
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
ITF220 - Prof.J.Frankel
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.
ITF220 - Prof.J.Frankel
Market Nighshift Nov. 16, 2011
APPENDICES
2. Greece & the € crisis
1. FX intervention 3. Pro-cyclical fiscal policy
ITF220 - Prof.J.Frankel
APPENDIX 1:
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,
ITF220 - Prof.J.Frankel
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.
ITF220 - Prof.J.Frankel
APPENDIX 2:
Greece & the Euro Crisis
Based on presentation in Academic Consultants Meeting, May 2013,
to the Board of Governors of the Federal Reserve System, Washington DC
ITF220 - Prof.J.Frankel
Three structural drawbacks are built into the monetary union:
• (I) The competitiveness problem,
– which arises from the inability of members to devalue (& loosen money),
– thoroughly anticipated by “Optimum Currency Area” warnings.
– A case of the OCA problem: Euro periphery needed tighter monetary policy
than the ECB’s during 1999-2007, and needs looser today.
• (II) The fiscal problem, in particular, moral hazard,
– which arises from keeping fiscal policy primarily at the national level.
– It was well-anticipated by architects of Maastricht.
• Pushed by German taxpayers afraid they’d have to bail out Club Med,
• they produced Maastricht criteria, No Bailout Clause, SGP, & successors.
• All failed, from day 1.
– Greece was the worst example.
• (III) The banking problem,
– which arises from keeping bank supervision at the national level.
– It received very little discussion at Maastricht.
– Example: Ireland’s bank credit was excessive. Bank crisis became debt crisis.
23
Overviews: Shambaugh (2012) “The Euro’s Three Crises” & Lane (2012) "The European Sovereign Debt Crisis"
(I) THE COMPETITIVENESS PROBLEM
During the euro’s first decade, wages & ULCs
rose faster in the periphery than in Germany.
During
2008-11 (only) a fraction of the
wage gap was reversed.
Figure 3:
Figure 4:
Source, IMF/ECB via M.Wolf, FT 10/10/12
24
Huge current account deficits in periphery countries
up to 2007 were seen as benign reflections of
optimizing capital flows, instead of warning signals.
Figure 5:
Figure 6:
25
Source: World Bank, PREM, 2012. Data from IMF WEO Database
Source: Krugman. “Which Way to the Exit?” Brussels, 2012
(II) THE FISCAL MORAL HAZARD PROBLEM
Periphery-countries’ interest rates
converged to Germany’s after they joined the euro
=> investors perceived no default risk.
Figure 1
Given the high debts, the ECB must have been seen as standing behind them.
26
The Greek budget deficit in truth had never
come below the 3% of GDP ceiling. Nor did the debt/GDP ratio
(≈100%) ever decline in the direction of the 60% limit.
27
Although many Emerging Market countries learned
lessons from the sovereign debt crises
of the 1980s & 1990s, e.g., how to run
countercyclical fiscal policy,
leaders in euroland failed to do so.
• They thought a sovereign debt crisis
could never happen to them.
– even after the periphery countries
violated the deficit & debt ceilings
of Maastricht and the SGP.
But Reinhart & Rogoff remind us: sovereign default
is an old story, including among advanced countries –
This Time is Different, updated in “From Financial Crash to Debt Crisis,” 2010
Sovereign External Debt: 1800-2009.
Percent of Countries in Default or Restructuring
50%-
1830s
1870s
1930s
1980s
Sources:
Lindert & Morton (1989), Macdonald (2003), Purcell & Kaufman (1993), Reinhart, Rogoff & Savastano (2003), Suter (1992), and Standard & Poor’s (various years).
Notes: Sample size includes all countries, out of a total of sixty six listed in Table 1, that were independent states in the given year
“What changes would be required for a more stable currency union?”
Possible paths forward in the 3 areas of crisis
• (I) The competitiveness problem:
– Bleak: The periphery must tough out internal devaluations.
• (II) The fiscal problem:
– Germany is right about moral hazard (in LR),
but wrong about “expansionary fiscal austerity” (in SR).
• (III) The banking problem:
– Encouraging moves in 2012, toward a banking union.
• Unlike fiscal union, one can imagine Europeans having moved
to supra-national supervision even if not part of monetary union.
30
Pro-cyclical fiscal policy in Greece:
expansion in 2000-08, contraction in 2010-12
Source:
IMF, 2011.
I. Diwan,
PED401,
Oct. 2011
31
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 % !
ITF220 - Prof.J.Frankel
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.
ITF220 - Prof.J.Frankel
As one could have predicted, fiscal contraction is contractionary
Source: P.Krugman, 10 May 2012, via R.Portes, May 2013.
Austerity doesn’t even achieve sustainable debt:
Debt/GDP ratios have been rising sharply,
as high interest rates & declining GDP overpower
progress on reduction of primary budget deficits.
Via: World Bank, PREM, 2012
35
Question: “Are comparisons with the United States useful?”
Yes. The US is a successful monetary union.
• (I) Regarding loss of monetary independence:
– Prospective € members did not satisfy OCA criteria
among themselves as well as the 50 American states do:
• trade, symmetry of shocks, labor mobility, market flexibility,
& countercyclical cross-state fiscal transfers.
• Endogenous change in these parameters has been insufficient.
• (II) Regarding moral hazard from states’ fiscal policy:
– The US federal government has bailed out no state since 1790
– and nobody expects it to do so now.
– How did the US vanquish state-level moral hazard?
36
The secret US ingredient is especially relevant
for Merkel’s recent reforms to give enforceability
& credibility to the eurozone targets for deficits & debt,
after the repeated earlier failures of the SGP.
• The Fiscal Compact is technically in effect, as of 2013.
• It sets deficit targets stricter than the SGP,
• though at least they are specified in cyclically adjusted terms.
• Countries must put the euro-wide targets into their national laws.
• As rationale, some point to fiscal rules among the 50 states.
– Do they explain the absence of moral hazard in the US?
– Or is it the way spreads on the debts of spendthrift states rise,
• long before debt/income ratios reach anything like European levels?
– The fundamental explanation: The decision to let 8 states default
in 1841-42 rather than bail them out was a critical precedent.
37
The EU leaders should have reacted to the Greek debt crisis
as Washington reacted to the southern states’ crisis in 1841.
• When the crisis erupted in Athens in late 2009,
Frankfurt & Brussels should have seen it
as a golden opportunity.
• They already knew their attempted
fiscal constraints had failed.
– So even the leaders must have known that sometime
during the euro’s life it would be challenged
by debt troubles among one or more members.
– It was important to get the first case right,
to set the correct precedent.
38
Frankel, “The Greek debt crisis: The ECB’s three big mistakes,” VoxEU, May 16, 2011.
The EU should have reacted to the Greek crisis as Washington reacted in 1841.
•
• Greece was the ideal test case, for two reasons:
– 1) Unlike Ireland or Spain, it was egregiously at fault,
• a natural place to draw a line,
its creditors the natural ones to suffer losses.
– 2) Unlike Italy, it was small enough that other
governments and systemically important banks could
have been protected from the consequences of a default,
• at a fraction of the cost of the EFSF, ESM, etc.
• In early 2010 the EC & ECB should have urged Greece
to go to the IMF and, if necessary, to restructure its debts,
– rather than calling this course “unthinkable.”
– The odds of containing the fire would have been far better than later.
39
Frankel, “The Greek debt crisis: The ECB’s three big mistakes,” VoxEU, May 16, 2011.
Question: “In the current environment,
how should monetary policy operate…?”
• The ECB should ease monetary policy
• => higher inflation rates & depreciation.
• Will help Club Med improve its relative price competitiveness.
• German horror is understandable;
– they are entitled to their “morality tale.”
• But if the euro is to survive, the Germans must give way on some
things that they very deliberately did not sign up for at the start.
– They especially must give way on the absurd premise that
austerity is expansionary, as if we learned nothing from the 1930s.
• The ECB has already moved in the right direction under Draghi,
– LTROs & OMTs.
– QE: If the ECB can’t legally do it by buying euro govt. bonds
– it should do it by buying US bonds (which is fx intervention).
40
Question: “Can the monetary union be achieved in the long run
without a significant increase in fiscal unity?”
No. “More Europe” is now inescapable.
In the medium run, debt/GDP ratios
must be put back on a sustainable path
through write-downs of “legacy debt,” “re-profiling,”
financial repression, bank bailouts, EFSF, ESM, ECB, etc.
Question: “Is fiscal unity politically possible?”
Full fiscal union? No.
The German taxpayers who were afraid that the euro would
lead to a fiscal bailout were proven right
(and the elites proven wrong). Why should they believe
that there will be no future bailouts?
41
The financial situation has improved since Nov. 2011,
when Mario Draghi became ECB President.
LTROs
-- Dec.2011 & Feb.2012
“Within our mandate, the ECB is
ready to do whatever it takes
to preserve the euro.
And believe me, it will be
enough.” -- July 2012
OMTs -- Aug.2012
42
APPENDIX 3:
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.
ITF220 - Prof.J.Frankel
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.
ITF220 - Prf.J.Frankel
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.
ITF220 - Prof.J.Frankel
45
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.
ITF220 - Prof.J.Frankel
46
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 some 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.
ITF220 - Prof.J.Frankel