Lectures 24 & 25: Portfolio Risk• Lecture 24: Risk Premium & Portfolio Diversification

• Bias in the forward exchange marketas 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?

ITF220 - Prof.J.Frankel

• 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 math-ematically expected percentage change in the spot rate?

Is the interest differential an unbiased predictor of the future spot exchange rate?

• Usual finding: No. Bias is statistically significant: (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

ITF220 - Prof.J.Frankel

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 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

Diversification lowers risk to the overall portfolio.

The investor can achieve a lower level of risk by diversifying internationally.

Standarddeviationof return to portfolio

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Investors want to minimize riskand 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

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.

Risk →

↑ Return

Medium risk- aversion

High risk-aversion

Low risk- aversion

Purely US

ITF220 - Prof.J.Frankel

Similarly, putting 25%of the global portfolio in emerging markets gives diversification.

Risk →

↑ Return

After that, the gainin expected return

comes at the expenseof higher 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.

• Another implication: => FX intervention can have an effect even if sterilized.

• 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.

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

ITF220 - Prof.J.Frankel

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

Capital Flows to Emerging Marketsand Risk/Uncertainty as measured by VIX

1990-2013

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

20082009

20102011

20122013

20142015

0

1

2

3

4

5 10

20

30

40

Private Capital Flows to EMs as % of GDP (left axis) Volatility Index (right axis)

Capi

tal F

low

s to

EM

s as

% o

f GD

P

Vola

tilty

Inde

x

Notes: Data on private capital flows from IMF's IFS database, Dec. 2013. Capital flows are private financial flows to emerging markets & developing economies. Volatility index measured by the Chicago Board's VIX or VXO at end of period. 2013 data are estimates.

Source: Kristin Forbes, 2014

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).

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Ratio of public debt to GDP among advanced countriesis the highest since the end of WW II

Source: Carlo Cotarelli “Making Goldilocks Happy,” IMF, Apr. 20, 2012

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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

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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.FrankelMarket Nighshift Nov. 16, 2011

ITF220 - Prof.J.Frankel

APPENDICES1. FX intervention

2. Greece & the € crisis3. Pro-cyclical fiscal policy

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,

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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.

1985-1999

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APPENDIX 2: Greece & the Euro Crisis

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Based on presentation in Academic Consultants Meeting, May 2013, to the Board of Governors of the Federal Reserve System, Washington DC

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.Overviews: Shambaugh (2012) “The Euro’s Three Crises” & Lane (2012) "The European Sovereign Debt Crisis" 

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(I) THE COMPETITIVENESS PROBLEM

During the euro’s first decade, wages & ULCs rose faster in the periphery than in Germany.

Source, IMF/ECB via M.Wolf, FT 10/10/12

Figure 3: Figure 4:

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During 2008-11 (only) a fraction of the wage gap was reversed.

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:

Source: World Bank, PREM, 2012. Data from IMF WEO Database Source: Krugman. “Which Way to the Exit?” Brussels, 2012

Figure 6:

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(II) THE FISCAL MORAL HAZARD PROBLEM

Given the high debts, the ECB must have been seen as standing behind them.

Figure 1

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Periphery-countries’ interest rates converged to Germany’s after they joined the euro

=> investors perceived no default risk.

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 countriesviolated 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%-

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

1980s1930s1870s1830s

“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.

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Pro-cyclical fiscal policy in Greece:expansion in 2000-08, contraction in 2010-12

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Source: IMF, 2011.I. Diwan, PED401, Oct. 2011

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?”

• (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

Yes. The US is a successful monetary union.

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.

39Frankel, “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?”

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

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?”

42

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

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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.

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• #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.

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.

45ITF220 - Prof.J.Frankel

Historic role reversal in the cyclicality of fiscal policy in industrialized vs. developing countries

Previously, fiscal policy was procyclicalin developing countries:

• Governments would raise spending in booms;• and then be forced to cut back in downturns.

• Especially Latin American commodity-producers.

46ITF220 - Prof.J.Frankel

• 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.

The procyclicality of fiscal policy, cont.

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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.