Financial issues

Historical International Investment Performance

admin — Tue, 13 Oct 2009 21:02:32 +0000

So, how did investment into the stock markets of different countries perform historically? Table I.2 describes the performance of various MSCI stock market returns over the last 35 years and over the last 20 years. It also shows the performance of two more global indexes, one being the equal-weighted index of the preceding 14 countries in the table, and the other being the MSCI World index.
Reward Even though the last three decades were terriﬁc years for the U.S. stock market, it appears that foreign stock markets performed almost as well, if not better. (An important factor is, of course, that the dollar generally depreciated over these years.) Scandinavia and Hong Kong beat the U.S. market handily. Not all countries did, however—Canada, Singapore, and Japan beat the United States only over the full 35 years, not over the last 20 years.
Risk Contribution All foreign stock markets had betas with respect to the U.S. stock market below 1. Austria and Japan were particularly helpful in diversifying U.S. market risk; Canada, Hong Kong and Singapore less so.
Over the full 35 years, the equal weighted index of the countries also performed better than the U.S. stock market, although with equal volatility. The MSCI world index was safer than the U.S. stock market, although it sacriﬁced a tiny 3 basis points per month performance. In the second half, both world indexes had lower risk, but only the equal-weighted portfolio outperformed the U.S. stock market.
Risk Contribution vs. Reward Relation Would investing in these countries’ stock market portfolios have offered U.S. investors a high enough rate of return to make at least a small investment of international investing worthwhile? To answer this question, we use a U.S. CAPM formula. The market-beta of each country’s stock market with respect to a U.S. stock market index is the measure of how much reward our foreign stock market has to offer for its risk contribution/diversiﬁcation. Alas, to use a CAPM formula, we need an estimate for the appropriate risk-free rate in U.S. dollars. Reasonable choices would be about 0.4% per month (5% per annum) over the last 35 years, and 0.3% per month (4% per annum) over the last 20 years. Therefore, the ex-post CAPM in the United States was something like 1970 − 2005 : E ( ˜ ri ) ≈ 0.4% + (0.95% − 0.4%) · βi,M 1986 − 2005 : E ( ˜ ri ) ≈ 0.3% + (1.07% − 0.3%) · βi,M (I.4)
So, against these formulas, how did our speciﬁc countries perform for a U.S. investor?
The majority outperformed! For example, according to a U.S. CAPM, Austria should have earned about 0.3% + (1.07% − 0.3%) · βaut = 0.55% per month in the most recent 20 years. Instead, it offered about twice this average return. Only Canada and Singapore did not outperform. Even Japan, which had the lowest average stock market returns, still outperformed, because its U.S. beta was low.
Of course, when it comes to data, you must always be cautious: being ex-post actual data, these are only approximate relationships, not even historical expected relationships—and much of the strong historical performance of foreign markets was due to the weakening of the dollar, which is not necessarily expected to repeat. Furthermore, it could also matter what speciﬁc stock market index and risk-free rate we are using for each country, just as it matters which exact sample period and foreign stock market indexes we choose, and that we have ignored taxes and transaction costs. Moreover, although the sample suggests that international diversiﬁcation has worked quite well and that the OECD country indexes had low betas with respect to the U.S. stock market, this empirical relationship seems to have changed in recent years. The OECD countries’ stock indexes seem to now be covarying more strongly with the U.S. stock market—perhaps a sign of increasing ﬁnancial integration. Nevertheless, even if international diversiﬁcation no longer works as well as it has historically, chances are that it is still a good ﬁnancial choice.
In sum, the evidence suggests that investing in OECD countries offers decent diversiﬁcation beneﬁts. And fortunately, widely available international mutual funds have made it very easy to obtain these modest diversiﬁcation beneﬁts. But many investors do not take advantage of them.
The jury is still out on the diversiﬁcation beneﬁts and expected rates of return from investments in “emerging markets” (developing countries). Many of these emerging markets did not exist or were not easy to access for U.S. investors just twenty years ago, but have only recently come online in a form that a typical U.S. retail investor can take advantage of (i.e., with country-speciﬁc mutual funds).

Local vs. Foreign Returns and Home Bias

admin — Sat, 10 Oct 2009 21:00:46 +0000

An important conceptual issue to keep in mind is that the CAPM suggests that investors hold the (value-weighted) market portfolio. This portfolio should considers all investable assets, domestic and foreign. Consequently, investors should invest not just in the U.S. market, but also in all foreign markets. Of course, even if the CAPM does not hold, thinking about diversiﬁcation across all possible dimensions—including international—is a good idea.
However, the empirical evidence suggests that investors tend to have strong home bias: U.S. investors tend to overweight U.S. stocks, European investors tend to overweight European stocks, Japanese investors tend to overweight Japanese stocks, and so on. In fact, many investors hold nothing but domestic securities. This home bias holds up even after we adjust for differential transaction costs—and currency.
Currency matters because investment rates of return themselves depend on the currency in which they are earned. For example, Volkswagen AG started 2002 with a price of €52.30 and ended 2002 with a price of €34.50. Therefore, its local currency rate of return was €34.50/€52.30 − 1 ≈ −34% (incorrectly ignoring dividends). But the euro started 2002 at 0.90 $/€ and ended 2002 at 1.05 $/€, a 16.7% appreciation of the euro against the dollar. The Volkswagen shares therefore cost €52.30 · 0.90$/€ ≈ $47.07 and returned €34.50 · 1.05 ≈ $36.23 for a Volkswagen dollar rate of return of −23%. Most U.S. investors in Volkswagen are more concerned with the dollar rate of return; most German investors in Volkswagen are more concerned with their local currency rate of return.

Purchasing Power Parity

admin — Sat, 03 Oct 2009 20:59:01 +0000

Forward exchange rates are exactly determined by interest rates through an arbitrage condition. But there is a deeper question here: why is the interest rate in euros higher than the interest rate in U.S. dollars?
Economists are not sure, and here is why. The most important question is whether purchasing power parity (PPP) holds. The PPP theory of exchange rates posits that prices of identical goods should be the same in all countries, differing only in the costs of transport and duties. But does PPP hold? Do $108.86 dollars buy the same amount of goods—say apples—that €100 buy? If an apple costs $1.0886 in the United States, and €1.00 in Europe, then PPP holds. What if it does not hold? What if, for example, an apple costs $1.00 in the United States and €1.00 in Europe? Then we should export cheaper U.S. apples to Europe, sell them for €1, and earn a proﬁt of $0.08/apple. Transport costs and import/export barriers (such as tariffs) are probably too high to permit an apple arbitrage, but there are other, more easily transportable commodities, ranging from diamonds, to gold, to gasoline. As economists, we expect prices for easily exportable and tradeable commodities to obey PPP. But other goods need not obey PPP: Land in France is not the same as land in Manhattan and it cannot be exported. Concrete is too costly to transport, because shipping costs are too high. Raspberries spoil too easily to transport long distances. Maple syrup has little demand in Europe, and is not easy to resell. A work hour by a Czech hair stylist is not same as a work hour by an American hair stylist. And so on. Indeed, PPP does not even hold inside one country: apartments and plumbers cost more in Manhattan than in New Jersey. Gas costs more in San Francisco (CA) than in San Antonio (TX). The reasons why PPP does not hold inside a country are the same as why PPP does not hold across countries. But, if after taking transport costs into account, gas is too expensive in San Francisco relative to San Antonio, someone will start shipping it from San Antonio to San Francisco sooner rather than later.
Still, let us assume for a moment that PPP does hold—that is, that goods in Europe and goods in the United States are worth the same—and that PPP will also hold in the future. This will allow us to determine relative inﬂation rates. For example, an apple that costs $1.0886 in the United States today costs €1 in Europe today. If the U.S. dollar inﬂation rate is 2%, then the apple will cost $1.0886 · 1.02 = $1.1104 next year. We can lock in a future exchange rate of 1.0783 $/€, which means that next year’s U.S. apple will be worth $1.1104/1.0783 = €1.0297. In sum, a Euro-apple, costing €1 today will cost €1.0297 next year, which means that the euro inﬂation rate is 2.97%.
Another way to state this is that purchasing power parity implies that real interest rates must be equal. After all, a real interest rate is just an inﬂation-adjusted nominal interest rate. (You can think of money here as a good like apples, but one which increases not only through inﬂation, but also through interest earnings.)

Other Taxes

admin — Fri, 25 Sep 2009 20:57:12 +0000

In addition to federal income taxes, there are a plethora of other taxes. Most states impose their own income tax. This typically adds another tax rate of between 0% and 10%, depending on state and income. Worse, each state has its own idea not only of what its tax rate and tax brackets should be, but even how taxable income should be computed. Thus, you need to learn not only the federal tax code, but also your state’s tax code. For example, California has the highest marginal state income tax bracket that is not federal deductible: 9.3%. Montana has the highest marginal state income tax bracket that is tax deductible on your federal income tax: 11%. Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming levy no state income tax, and New Hampshire and Tennessee tax only interest and dividend income.
Many counties pay for school education with property tax rates. In the richer counties of southwest Connecticut, the tax is about 1% of the value of the house, but it can reach about 4% in the poorer urban counties. In Maine (the second-highest property tax collector in the nation), residents pay 5.5% of their income in property tax. Many states also levy a sales tax. Tennessee and Louisiana have a sales tax of 8.35%; Alaska, Delaware, Montana, New Hampshire, and Oregon levy no sales tax. (A nice summary can be found at www.retirementliving.com/RLtaxes.html. It also includes a ranking of the tax burdens by state—Alaska [with 6% of total income], New Hampshire, Delaware, and Tennessee have the lowest; New York [with 12.9% of total income], Maine, Ohio, and Hawaii have the highest.)
If you have to ﬁle in multiple states or even in multiple countries—although there are rules that Complex Complexity. try to avoid double taxation—the details can be hair-raisingly complex. If you ﬁnd yourself in such a situation, may the force be with you!
Finally, there are social security and medicare contributions. Although these are supposedly insurance premia, any money taken in today is immediately spent by the government on the elderly today. Thus, anyone young today is unlikely to receive much in return from the government in 20 to 30 years—when there will be fewer young people around to pay their retirement beneﬁts. Thus, many ﬁnancial economists consider social taxes to be as much a form of income tax as the statutory income tax.
This blog also ignores many other non-income taxes. For some taxes, such as the sales tax, it is not clear how to use expertise in ﬁnance to lower them. For other taxes, such as the estate tax, you need extremely specialized ﬁnancial vehicles to avoid or reduce them.

Before-Tax vs. After-Tax Expenses

admin — Thu, 17 Sep 2009 20:54:15 +0000

It is important for you to understand the difference between before-tax expenses and after-tax expenses. Before-tax expenses reduce the income before taxable income is computed. After- tax expenses have no effect on tax computations. Everything else being equal, if the IRS allows you to designate a payment to be a before-tax expense, it is more favorable to you, because it reduces your tax burden. For example, if you earn $100,000 and there were only one 40% bracket, a $50,000 before-tax expense leaves you ($100, 000 − $50, 000) · (1 − 40%) = $30, 000 , Before-Tax Net Return · (1 − Tax Rate) = After-Tax Net Return while the same $50,000 expense if post-tax leaves you only with $100, 000 · (1 − 40%) − $50, 000 = $10, 000.
We have already discussed the most important tax-shelter: both corporations and individuals can and often reduce their income tax by paying interest expenses, although individuals can do so only for mortgages.
However, even the interest tax deduction has an opportunity cost, the oversight of which is a common and costly mistake. Many home owners believe that the deductibility of mortgage interest means that they should keep a mortgage on the house under all circumstances. It is not rare to ﬁnd a home owner with both a 6% per year mortgage and a savings account (or government bonds) paying 5% per year. Yes, the 6% mortgage payment is tax deductible, and effectively represents an after-tax interest cost of 4% per year for a tax payer in the 33% marginal tax bracket. But, the savings bonds pay 5% per year, which are equally taxed at 33%, leaving only an after-tax interest rate of 3.3% per year. Therefore, for each $100,000 in mortgage and savings bonds, the house owner throws away $667 in before-tax money (equivalent to $444 in after-tax money).

The Basics of (Federal) Income Taxes

admin — Wed, 09 Sep 2009 20:52:38 +0000

With the exception of tax-exempt institutions, such as charitable institutions and pension funds (which suffer no taxes), individuals and corporations in the United States are taxed in a similar fashion, so we can combine our discussion of the two. The name of the Internal Revenue Service (IRS) tax form that individuals have to ﬁle is feared by every U.S. tax payer: it is the infamous Form 1040.
Earned income or ordinary income is subject to both federal income taxes and state income taxes. There are, however, some deductions that taxpayers can take to result in lower taxable income. Most prominently, in the United States, individuals who itemize their deductions can reduce their taxable income through mortgage interest payments. (This does not extend to other kind of interest payments, so mortgage borrowing—rather than, say, car loan borrowing—is often the best choice in terms of after-tax effective interest costs for many individuals.) Further, with some restrictions, individuals may deduct other expenses, such as some educational expenses and certain retirement savings (speciﬁcally, through contribution to an individual retirement account, such as an ordinary I.R.A. or a 401-K). (These are only tax-advantaged, not tax-exempt. Most contributions are income-tax exempt, but the IRS will collect taxes when the money is withdrawn in the future.) Individuals can also carry forward losses or deductions that they could not legally deduct in the current year into future years.
Corporations are treated similarly, but often more generously by the tax code: they are generally allowed to deduct all interest, not just mortgage interest, and many corporations enjoy a plethora of preferential tax exemptions and loopholes, too numerous to list in just one book and ever-changing. Unlike individuals, corporations that have losses or extra deductions can even receive a refund for taxes paid in the most recent three years. This is not necessarily unfair—after all, corporations are just entities owned by individuals. Just as your car is not paying the car tax the DMV imposes—you, the owner, are paying the car tax —taxing corporations is just a different mechanism of taxing the individuals who own the corporation.
After you have computed your taxable income, you must apply the appropriate income tax rates. Income tax rates for individuals depend on your marital status and are usually progressive—that is, not only do you have to pay higher taxes when making more money, you have to pay increasingly higher taxes when making more money. (They are roughly progressive for corporations, but not perfectly so.)
If you are an individual in the 28% tax bracket, it means that you have taxable earnings between $70,350 and $146,750. Again, as with the computation of the taxable income, be warned that this particular tax rate table also contains many simpliﬁcations. (For example, there is also an Alternative Minimum Tax (A.M.T.) that nowadays applies to many taxpayers.)

Liquidity

admin — Mon, 31 Aug 2009 20:50:16 +0000

Things get even more interesting when transaction costs inﬂuence your upfront willingness to purchase assets. You might not want to purchase a house even if you expect to recoup your transaction cost, because you dislike the fact that you do not know whether it will be easy or hard to resell. After all, if you purchase a stock or bond instead, you know you can resell without much transaction cost whenever you want.
So, why would you want to take the risk of sitting on a house for months without being able to sell it? To get you to purchase a house would require the seller to compensate you. The seller would have to offer you a liquidity premium—an extra expected rate of return—to induce you to purchase the house. The liquidity analogy comes from physics. The same way that physical movement is impeded by physical friction, economic transactions are impeded by transaction costs. Financial markets are often considered low-friction, or even close to frictionless. And when the amount of trading activity subsides, pros would even say that “the market has dried up.”
Housing may be an extreme example, but liquidity effects seem to be everywhere and important— and even in ﬁnancial markets with their low transaction costs. A well-known and startling example is Treasury bonds. One bond is designated to be on-the-run, which means that everyone who wants to trade a bond with roughly this maturity (and the ﬁnancial press) focuses on this particular bond. This makes it easier to buy and sell the on-the-run bond than a similar but not identical off-the-run bond. For example, in November 2000, the 10-year on-the-run Treasury bond traded for a yield-to-maturity of 5.6% per annum, while a bond that was just a couple of days off in terms of its maturity (and thus practically identical) traded at 5.75% per annum. In other words, you would have been able to purchase the off-the-run bond at a much lower price than the on-the-run bond. The reason why you might want to purchase the on-the-run bond, even though it had a higher price, would be that you could resell it much more quickly and easily than the equivalent off-the-run bond. Of course, as the date approaches when this 10-year bond is about to lose its on-the-run designation and another bond is about to become the on-the-run 10-year bond, the old on-the-run bond drops in value and the new on-the-run bond increases in value.
The provision of liquidity in markets of any kind is a common business. For example, you can think of antique stores or second-hand car dealerships as liquidity providers that try to buy cheap (being a standby buyer), and try to sell expensive (being a standby seller). Being a liquidity provider can require big risks and capital outlays. If it was easy, everyone could do it–and then there would be no more money in liquidity provision!