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Friday, February 25, 2011

On oil

According to Deutsche Bank, a $10 increase in oil prices translates into roughly a 25 cent increase in retail gasoline prices.

That is about how much oil went up this week.

Is the sky falling? The following chart showing the S&P500 (GSPC), Brazilian Bovespa (BVSP) and oil returns (USO) certainly suggests so. We shoulc be buying oil!

However, if we take a longer view, perhaps a 5-year view, the picture looks much different...

Even after the financial crisis, Brazil and the S&P 500 overperformed oil.

Thursday, February 24, 2011

Can the war on drugs be won?

I keep reading articles about the violence in Mexico. I read about outrage in the US. I read about efforts to fight the cartels and the North to South weapons traffic. I read nothing about consumption. I have come to conclude that to fight drugs could be as dangerous as to consume it. Think about this: in 2010 in Mexico alone a study reports that over 15,000 people were killed because of the war on drugs. To this number we should add the hard to quantify figures of drug related homicides in the US. As for the harm… in the US, about 16,000 people die for illegal drug usage.
Compare these figures to those of the legal drugs, 430,000 deaths for tobacco or 110,000 for alcohol.
The war is useless unless consumption decreases. A victory by Mexico, (imagine drug trafficking comes down to zero) would only imply an increase in prices in the streets of US cities. Very quickly, the same market forces that moved textile factories to Asia will move drug trafficking to the next country, say Costa Rica or Canada, soon supply will increase again, prices drop, everyone happy.
This is what happened when Colombia defeated (or controlled) the FARCs.
In an agency world where politicians care only about their gains, the Mexican government should simply help cartels in their move to another country. Instead of fighting them, help them. Up to 2009 the war was costing Mexico 0.3% of its GDP or 2.6 billion per year. Why not create an annuity and make annual payments to cartels contingent on them moving operations to another country? The government could even tax them on that money.
Could cartels be trusted?

Saturday, February 19, 2011

Some perspective on China’s impact on US

Let’s think of the following scenario… CNY goes up by 20% (similar to the 2007 move) and that inflation pressures in wages and commodities make up for another 10% increase in total costs of manufacturing in China… what would happen in the US? A sure catastrophe?
Let’s look…
The GDP of the US is about $15 trillion. Every year we import goods worth about USD2 trillion, so imports are only 14% of our economy. In other words, despite the rhetoric, our country is a relatively closed economy.  Compare this figure to 48% in Denmark, 41% in Germany or 89% in Ireland. Which countries are more likely to suffer from Currency wars?
You may think that everything we buy comes from China, but in 2010 we imported only (I guess this is a relative word) 365 billion. So imports from China represent around 2.5% of GDP. 
A 30% increase in costs from China would surely impact us. However, if this increase is limited to China alone, MNCs will likely shift manufacturing to other low cost locations such as Vietnam, Thailand or Malaysia, or even Africa or Latin America.

Friday, February 18, 2011

China's buying spree, the answer to the CNY?

Latin trade pubished a series of articles on Chinas recent interest in the region.

Foreign Direct investment in developing countries would be a good use of the currency reserves that the People's Bank of China holds. It will be interesting to see how and if any of these partnerships could provide an escape valve for the CNY.

Currently 67% of FDI goes to Asian countries and 25% to Latin America

The problem is that China has too much free cash flow and I believe the agency costs will start to kick in...

China’s Buying Spree: Chile – In Search of a Strategy for Emerging Trade Behemoth

Thursday, February 17, 2011

Why inflation is not a big deal yet

At least in developed countries...
Did you know that if wheat prices go up 100%, this will only translate into a 30% increase in the price of flour and a much lower 10% increase in the price of bread...


100 / 30 / 10

Wednesday, February 16, 2011

A rational incentive to do the wrong thing

Politiians now have evidence to back their mishandling of fiscal policy.

A new study made by Joachim Voth an economist at Chile's Central Bank shows evidence of something that we all have assumed. There is a positive significant correlation between tightening fiscal policy and civil unrest...
At least in Latin America

On how FX quotes work for real

Students get frustrated when they attempt to go from the book to the real world.

Finance textbooks tend to use fraction notations for a direct quotation like USD/JPY = 0.0120 to imply the number of USD to buy 1 JPY. It takes less than a little over a penny to buy a yen.

Students are then faced with quotes from financial websites where USD/JPY=83.4250 to imply that it takes more than 83 yen to buy one US dollar.

The trading logic is as follows
The currency listed first in the pair is referred to as the base currency. The second one is called quote or trade currency. This means the trader currently holds the base (USD) and he or she is using it to buy the quote currency (JPY). After looking at the quote the trader knows she will get 83.425 yens for every 1 dollar she trades.

The following chart explains it all.

Forward rate quotations

You are not alone if puzzled about how forward FX rates are quoted.  The mystery is very simple, they are expressed in points or pips

Given that exchange rates change by the second, It would be impractical to quote them in terms of currency prices. Forward prices are usually quoted as the difference in pips—forward points—from the current exchange rate. Since currency in the country with the higher interest rate will grow faster and because IRP (interest rate parity) must hold, it follows that the currency with a higher interest rate will trade at a discount in the FX forward market, and vice versa. So if the currency is at a discount in the forward market, then you subtract the quoted forward points in pips; otherwise the currency is trading at a premium in the forward market, so you add them.

How to solve triangular arbitrage problems

Once students learn that arbitrage in the wrong direction end in a riskless loss, they often ask how do we know which direction to take?
Assume the following information:

                             Quoted Prices from different banks
              Bank 1) Value of 1 CAD in USD= USD 0.90
              Bank 2) Value of 1 NZD in USD= USD 0.30
              Bank 3) Value of 1 CAD in NZD= NZD 3.02
              Given this information, is triangular arbitrage possible?  If so, explain the steps that would reflect triangular arbitrage, and compute the profit from this strategy if you had $1,000,000 to use.
The first step is to determine if there is an arbitrage opportunity. Start calculating the “implied” cross rate from Banks 1 and 2.
(USD/CAD) 0.9 / (USD/NZD) 0.3 = NZD/CAD 3
Given that Bank 3 offers more NZD per CAD, there is an imbalance, we can arbitrage the difference.
We would like to buy CADs for 3 NZDs sell CADs for 3.02 NZDs. Since we cannot directly buy CAD for @ NZD at the implied rate, we need to sell CADs to Bank 3)… In order to sell CADs we need to buy them from somewhere.  The problem tells us that we have USD and therefore we have to get the CADs from bank 1. Once we get them we can sell them to Bank 3 in exchange for NZD, which we then sell in Bank 2 for USD.
[$1,000,000/$.90 = C$1,111,111 × 3.02 = NZ$3,355,556 × $.30 = $1,006,667]

Friday, February 11, 2011

What makes a PIGS?

Much has been said about the PIGS (Portugal, Ireland, Greece and Spain).

One of the alleged characteristics is that these countries have high debt to GDP ratios. Indeed these countries sit high in ranking available in wikipedia. In fact Greece is N.5 with 144%, Ireland is ranked 11th with 98%, Portugal ranks 15th 83% and Spain ranks 27th in the world with a ratio of 63%. However, little is said about Japan, Belgium and Singapore which rank 2, 8 and 9 respectively. Brazil and India, shining stars of the BRIC are not too far ranking 31and 42

Another argument could be related to the 2008 financial crisis. If we look at the soundness of banks (as per the World Economic Forum in 2009) in different countries we can see that while is true that Irish banks rank at the bottom, Spanish banks are ranked 25th in the world with Greek and Portuguese banks coming in 45 and 62 respectively.

Another characteristic of PIGS is their high sovereign spreads or low ratings. An inspection of the sovereign ratings according to the Economist Intelligence Unit reveals that PIGS are no different from BRIC.

From these points of view, PIGS and BRIC are not so far apart...

There is however one difference between PIGS and BRICs...
Portugal 39.7                   Brazil 28.9
Ireland 35.4                     Russia 38.5
Greece 42.2                     India 25.9
Spain 41.5                       China 35.2

Which countries have more growth potential?