1. Lectures 24 & 25: The 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 For Ex Market Appendix 2: Default Risk

2. Is the Interest Differential an Unbiased as a Predictor of the Future Spot Exchange Rate? Usual finding: No. Bias is significant: (i-i*) t ≠ E t Δs t+1 –It 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. –One interpretation: Rational expectations fails, Δs t e ≠ E t Δs t+1 –Another: A risk premium separates (i-i*) t from Δs t e. Given Covered Interest Parity, it is the same as the question whether the forward market offers an unbiased predictor.

3. What makes a currency risky to a portfolio investor ? If uncertainty regarding the value of the currency ( e.g., 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.

4. 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. International markets offer a particular opportunity for diversification, because they move independently to some extent.

5. Assets with high individual uncertainty don’t necessarily pay higher returns on average. Not if that 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

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

7. 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

8. Similarly, putting 25% of the global portfolio in emerging markets gives diversification. Risk → ↑ Return After that, the gain in expected return comes at the expense of higher risk.

9. 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 rates 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. An implication: As its debt grows, eventually a deficit country will experience depreciation of its currency, or its interest rate will be forced up, or both.

11. Appendix 1: Intervention in the $ foreign exchange market appears to have been 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.

12. 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

13. Appendix 2: Default risk The Portfolio Balance model shows how investors diversify their portfolios among various assets, depending on expected returns and risk. –In the past, for major borrowers such as the United States, default risk is normally assumed zero. Then the bonds are identified just by currency of denomination ($), and “risk” is just exchange risk. –But, especially for developing countries, assets are identified also by who is issuing them and risk also includes default risk. Greece is back in that situation. Maybe investors will start to view US debt as carrying default risk.