Financial Environment: FN6411 Summer 2004 Sris Chatterjee

From WSJ, 30 April 2004

The Financial Environment Interest Rates Inflation Stock and Bond Returns Volatility Currency Exchange Rates Investors

Questions What does Mr. Greenspan “cut” when he is “cutting” rates ? And how does he “cut” it ? What is the discount rate ?

Questions What is the yield to maturity or YTM ? What is coupon yield ? What do bond ratings signify ? How does inflation affect the rates ? What factors are important ?

Source: Roll, ”Empirical TIPS “ Financial Analysts Journal, Jan/Feb 2004 P. 39 Theoretical Yield-Curve Movements

Theories of Term Structure Pure Expectations Theory Liquidity Theory Preferred Habitat Theory Market Segmentation Theory

Source: Jones and Wilson,”The Changing Nature of Stock and Bond Volatility, “ Financial Analysts Journal, Jan/Feb 2004 P. 102 Nominal and Inflation-Adjusted Annualized Monthly Geometric Mean Returns for Stocks and- Bonds,

Source: Jones and Wilson,”The Changing Nature of Stock and Bond Volatility, “ Financial Analysts Journal, Jan/Feb 2004 P. 106 Geometric and Logarithmic Means and Standard Deviations for Nominal and Inflation- Adjusted Stock and Bond Annual Returns,

Source: Jones and Wilson,”The Changing Nature of Stock and Bond Volatility, “ Financial Analysts Journal, Jan/Feb 2004 P. 107 Variances, Covariances, and Correlations for Nominal and Inflation-Adjusted Stock and Bond Annual Returns,

Source: Jones and Wilson,”The Changing Nature of Stock and Bond Volatility, “ Financial Analysts Journal, Jan/Feb 2004 P. 107 Nominal and Inflation-Adjusted Compound Returns and Standard Deviations for Various Portfolios of Stocks and Bonds,

Source: Chan and Lakonishok, ”Value and Growth Investing: Review and Update “ Financial Analysts Journal, Jan/Feb 2004 P. 77 Returns, Risk, and Past Performance for Value and Glamour Portfolios, May 1968-April 1990

Source: Kothari and Shanken, ”Asset Allocation with Inflation-Protected Bonds “ Financial Analysts Journal, Jan/Feb 2004 P. 59 Descriptive Statistics for Indexed and Nonindexed Bond Returns

Source: Kothari and Shanken, ”Asset Allocation with Inflation-Protected Bonds “ Financial Analysts Journal, Jan/Feb 2004 P. 62 Correlation between Real and Nominal Stock and Bond Returns

Source: Kothari and Shanken, ”Asset Allocation with Inflation-Protected Bonds “ Financial Analysts Journal, Jan/Feb 2004 P. 67 Optimal Portfolios of Indexed Bonds, Nonindexed Bonds, and Stocks Based on Nominal Monthly Returns,

Source: Roll, ”Empirical TIPS “ Financial Analysts Journal, Jan/Feb 2004 P. 33 Daily Returns: Means and Standard Deviations

Source: Roll, ”Empirical TIPS “ Financial Analysts Journal, Jan/Feb 2004 P. 49 Efficient Frontier with Two TIPS, Two (Nominal) T-Bonds, and the CRSP Value-Weighted Index

Flow of Goods and Services:  The net exports of any country are the value of a country’s exports minus the value of its imports.  Net exports are also known as the trade balance.  If net exports are negative, then we talk about a trade deficit.  If net exports are positive, then we talk about a trade surplus.  In the case of the value of imports being equal to the value of exports, we say that a country has balanced trade. Flow of Capital:  Net foreign investment refers to the purchase of foreign assets by do-mestic residents minus the purchase of domestic assets by foreigners. Net foreign investment (NFI) must always equal net exports (NX): NFI = NX

 A nation’s savings and investment are related to the international flow of goods and services, and of capital. This can be shown formally as follows…  Net exports (NX) can be found in the components of Gross Domestic Product (GDP): Y = C + I + G + (X – M), where X is the value of goods exported and M is the value of goods imported. In other words, (X–M) is equal to net exports (NX).  Re-arranged, this equation can be written as Y – C – G = I + NX  As national savings (S) are equal to the national income that is left after consumption (C) and government expenditure (G), we can also write the following: S = I + NX (orS – I = NX)  We know that net exports are equal to net foreign investment. Therefore S = I + NFI

 The equation S = I + NFI shows us that a nation’s savings must equal its domestic investment plus its net foreign investment. In other words, when Spanish citizens, for instance, save one Euro of their income for the future, this money can be used to finance Spanish investments (I) or it can be used to finance the purchase of capital abroad (NFI).  We can also use the saving-investment equation to explain the fallacy of a trade deficit being a sign of a lack of competitiveness. Looking at the equation S = I + NX, we can state that a trade deficit (NX then being negative) is not a problem in itself but is more a symptom of a problem, namely low national savings.  To be more explicit, the reason for trade deficits lie in the extent to which national savings are not able to cover domestic investments.

Purchasing Power Parity – How Good is the Data?  The Economist conducts a yearly analysis of PPP. It is known as the Big Mac index and compares the price of Big Macs, with each local price being converted to US dollars.  If PPP holds, then the converted US dollar price should be the same as the price that exists in the US.  The table, using data from July 2001 taken from the website bigmac/bigmac.shtml, shows that PPP does not always hold. In this case, we talk of either an overvaluation or an undervaluation.  For Switzerland, this index shows that a Big Mac costs 41% more in dollar terms in Switzerland than it does in the US. Hence, the Swiss franc is said to be overvalued by 41%. data from July 2001 Purchasing Power Price: local price divided by price in United States.

Purchasing Power Parity and the EUR|CHF Rate EUR|CHF PPP EUR|CHF Source: Warburg Economic Research Switzerland