Tuesday, March 31, 2009

the international Bond market (Debt securities)(1)

Beside international bank lending,increasingly sizable activity has been taking place in the last several decades in the international bond market.the issuance of bonds by governments and corporation represents borrowing by issuing entities ,and the time period of the loan is generally longer than one year .within the general bond category,a distinction is often made between notes,which have a maturity of less than 10 years ,and bonds,which have a maturity of 10 years or longer.we will generally use the term bonds to refer to both of these types of debt instruments.Bonds have a face value or maturity value (for example,$1000) which indicates the amount that will be paid back to the lender at the end of the life of the bond ,and interest payments (or coupon payments ) are usually made each year (for example ,60$ per year or a 6 percent (=$60/$1000)coupon rate).

advantages of a currency board

four major advantages are usually cited when comparing a currency board arrangement with a central bank with discretionary control of the money supply.
1- A currency board ensures convertibility .the maintenance of a 100 percent reserve system makes it certain that assets are available to cover any demand for conversion into foreign currency .
2- a currency board instills macroeconomic discipline .because the currency board is prohibited from buying domestic assets,it cannot finance a fiscal deficit .the government is forced to borrow from the public at home or aboard or maintain a balanced budget.in other words ,the government cannot simply "print money" to finance a government budget deficit since the money supply is strictly tied to the quantity of foreign exchange held by the currency board .it is hence also argued that a currency board will secure discipline over inflation .the process of tying the local currency to a reserve (and presumably low inflation) currency at a fixed exchange rate enhances price stability.
3- A guaranteed payment adjustment mechanism is provided. The payment adjustment mechanism is simply the gold-standard adjustment mechanism that is actually aversion of David Hume is price-specie-flow mechanism .these three advantages combine to create greater confidence in the system.
4- the increased confidence leads to the promotion of higher rates of trade ,investment ,and growth.

Do Fixed or flexible Exchange rates provide for greater "discipline" on the part of policymakers?(4)

On the other hand ,if a country has a Bop surplus,there is upward pressure on the price level because of the expanding money supply .while this could potentially be helpful from the standpoint of employment and growth,it will aggravate internal performance with respect to the goal of price stability.for example ,Germany has often had a Bop surplus but at the same time did not want its inflation rate to rise .thus,whether a country is in Bop deficit or surplus,the attainment of some internal goal will be frustrated because of the fixed rate system. the resolution of the question of whether discipline and hence price stability is more prevalent with fixed rates than with flexible rates requires extensive empirical research .it can be noted that world inflation was more rapid in the floating-rate period of the 1970s than in the pegged rate period of the 1960s,but events occurring independently of the exchange rate system-such as the behavior of OPEC-undoubtedly played a role in generating this difference in world inflation .

Do Fixed or flexible Exchange rates provide for greater "discipline" on the part of policymakers?(3)

Two major replies can be made to these points .first,with respect to the vicious circle hypothesis ,flexible-rate advocates think that the depreciation that was a response to the inflation and that is alleged to cause further inflation can actually be clear signal to the authorities that monetary restraint is needed .This signal can therefore lead to the quick instigation of anti-inflationary policies.thus,in this view,the danger of inflation is no greater under flexible than under fixed rates.
In response to the alleged discipline in necessarily always desirable .Countries also have other domestic goals besides maintenance of the fixed exchange rate and price stability,such as the generation of high levels of employment and of reasonably rapid economic growth .A BOP deficit implies that,whether the adjustment is accomplished trough the automatic reduction of the money supply or through contractionary tedencies will serve to worsen the internal situation.the united states faced this dilemma in a number of years in the 1960s.

Do Fixed or flexible Exchange rates provide for greater "discipline" on the part of policymakers?(2)

Note that the result in the preceding discussion is a tendecy for deflation in the deficit country and inflation in the surplus country .Therefore ,if prices are flexible in bot directions ,it is likely that prices will be relatively stable in the world as a whole .IN practice ,the world could have some inflation if prices are less flexible downward than upward.however,the inflation will probably not be as rapid as it would be if the discipline of fixed rates did not exist .
In addition to this emphasis on the discipline of fixed exchange rates ,proponents of such a system stress that flexible rates could actually aggravate inflationary tendencies in a country .the point is made that,under flexible rates ,inflation in a country becomes self perpetuating ;this argument is sometimes called the vicious circle hypothesis.Suppose that a country is undergoing rapid inflation because of an excess supply of money and excess demand in the economy.The inflation will cause the country is currency to depreciate in the exchange markets ,which will add to aggregate demand in the economy and generate further inflationary pressure.in addition ,the rise in prices will lead to correspondingly higher money wages,which also induces more inflation .thus ,inflation will cause depreciation, but the depreciation itself will cause further inflation .this sequence of events continues until the monetary authorities put a stop to the monetary expansion.

Do Fixed or flexible Exchange rates provide for greater "discipline" on the part of policymakers?(1)

A point made in favor of fixed exchange rates is that such a system provides for the "discipline" needed in economic policy to prevent continuing inflation.that is ,in a fixed-rate system,there should be no tendency for greater inflation to occur in one country than in the world as a whole .Consider a country with a balance -payment (BOP) deficit .if the cause of the deficit is a more rapid inflation than that in trading partners,then the country is authorities will need to apply anti-inflationary policy to protect the country is international reserve position .the fixed-rate system virtual forces this type of policy action ,because failure to do so will lead to eventual elimination of the country is international reserves if the automatic adjustment mechanism takes considerable time . what about the situation in BOP surplus country? given the objective of a fixed exchange rate , the forces working in the opposite direction from that for a deficit country are set into motion .Accumulation of foreign exchange reserves (which may be difficult to sterilize )will expand the money supply.This enhancement of the money supply will drive the interest rate downward ,increase aggregate demand and prices,increase private purchases of goods and foreign financial assets,and thus eliminate the surplus.

Monday, March 30, 2009

reasons for international Movements of capital (4)

7-firms also argue that they need to invest abroad for defensive purposes to protect market share.firm A,for example ,reasons that it needs to begin production in the foreign market location in order to preserve its competitive position because its competitors are establishing plants in the foreign market currently served by A is exports or because firms in the host country are producing in larger volume and competing with A is goods.
8- Finally ,foreign firms may find investment in a host country to be profitable because of some firm-specific knowledge or asset that enable the foreign firm to outperform the host country is domestic firms .Superior management skills or an important patent might be involved .At any rate,the opportunity to generate a profit by exploiting this advantage in new setting in a new setting entices the foreign firm to make the investment .
A considerable amount of further empirical research is needed in order to determine the most important causes of international capital mobility ,and different reasons will apply to different industries ,different periods,and different investors .for examples of econometric work that has been done on the causes of foreign direct investment.

reasons for international Movements of capital (3)

5- tariffs and nontariff barriers in the host country also can induce an inflow of foreign direct investment .if trade restrictions make it difficult for the foreign firm to sell in the host country market,then an alternative strategy for the firm is to " get behind the tariff wall" and produce within the host country itself.IT as been argued that U.S companies built such Tariff factories in Europe in the 1960s,shortly after the European Economic community (common market) was formed ,with its common external tariff on imports from the outside world .such U.S investment continued in the 1990s as Europe pressed for even closer economic integration and adopt a common currency for 11 countries in 1999.
6-A foreign firm may consider investment in a host country if there are low relative wages in the host country,although studies indicate that low wages per se are not as much an enticement for FDI as envisioned by the general public .Clearly,the existence of low wages because of relative labor abundance in the recipient country is an attraction when the production process is labor intensive.in fact ,the production process often can be broken up so that capital-intensive or technology-intensive production of components takes place within developed countries while labor-intensive assembly operations that use the components take place in developing countries .this division of labor is facilitated by offshore assembly provisions in the tariff schedules of developed countries.

reasons for international Movements of capital (2)

2- similarly ,because manufacturing and services production in developed countries is catering increasingly to high-income tastes and wants ,it can be hypothesized that developed-country firms will invest overseas if the recipient country has a high per capita income . This suggestion leads us to expect that there would be little manufacturing investment flowing from developed countries to developing countries.However,per capita income must be kept distinct from total income (GDP),since firms in developed countries are eager to move into China because of its sheer market size and despite its relatively low per capita income.
3- Anoter reason for direct investment in a country is that the foreign firm can secure access to mineral or row material deposits located there and can then process the raw materials and sell them in more finished from.Examples would be FDI in petroleum and copper.
4- It has also been suggested that firms may want to invest abroad as a means of risk diversification .Just as investors prefer to have a diversified financial portfolio instead of holding their assets in the stock of a single company ,so firms may wish to distribute their real investment assets across industries or countries.if a recession or downturn occurs in one market or industry,it will be beneficial for a firm not to have all its eggs in one basket.some of the firm is investment in other industries or countries may not experience the downturn or may at least experince it wit reduced severity.

reasons for international Movements of capital (1)

It should be clear that there is considerable mobility of capital across borders in the world economy today.we cannot make a full examination of the reasons for this mobility,but brief mention can be made of possible causes .above all ,economists view the movement of capital between countries as fundamentally no different from movement between regions of a country (or between industries) ,because the capital is moved in response to the expectation of a higher rate of return in the new location than it earned in the old location . Economic agents seek to maximize their well-being .Although many additional reasons for capital movements have been suggested,all imply the seeking of higher rate of return on capital over time .We list and comment briefly on several hypotheses ,many of which have found empirical support.
1- Firms will in invest abroad in response to large and rapidly growing markets for their products.Empirical studies have attempted to support this general hypothesis at the aggregative level by seeking a positive correlation between the gross domestic (and its rate of growth) of a recipient country and the amount of foreign direct investment flowing into that country .

the Effects of factor Growth (2)

The matter is more complex if one of the factors grows and the other does not .Suppose that the capital stock increases but the size of the labor force remains constant .how will the production-possibilities frontier change ? In answering this question ,remember the production assumptions from neoclassical theory and the Heckscher-Ohlin analysis.Assume that cutlery is capital intensive and cheese is labor intensive .if the capital stock grows ,it has the greatest relative impact on the capital-intensive product .If all the country is resources are devoted to the production of cutlery ,the expansion of the capital stock permits the country to reach ahigher output level (higher isoquant)than that reached prior to the growth of capital.the growth in capital also permits a larger amount of cheese to be produced for any level of cutlery because capital can be substituted to some degree for labor .however ,because cheese is the labor-intensive good,the potential impact on production is less than it is for the capital-intensive good.Consequently ,the PPF shifts outward asymmetrically in the direction of the capital-intensive good.this shift is demonstrated in panel.an analogous argument can be made for growth in labor when the capital stock is held constant .Then the production-possibilities frontier shifts outward in an asymmetrical manner ,with the labor-intensive product showing a greater relative response.the effect of growth in the labor force is demonstrated .

the Effects of factor Growth (1)

The second source of economic growth is increased availability of the factor of production .we consider the impact of factor growth in terms of two homogeneous inputs ,capital and labor.in the real world ,there are other primary inputs such as natural resources ,land and human capital ,and factor do not tend to be homogeneous .Labor and capital remain ,however ,two of the imports inputs ,and the insights gained from examining K and L can be extended to the more general case .Estimates for the growth in capital and labor for selected countries for 1966-2001 are presented .
An increase in factor abundance can take place trough increases in capital stock of country ,increase in the labor force ,or both .the capital stock of a country grows as domestic and foreign investment occurs in the country .the labor force expands through increase in population (including immigration) ,increase in the labor force participation rate ,or both .if both labor and capital grow at the same rate,the PPF will sift out proportionally ,as in the case of commodity-neutral technological change . this factor-neutral growth effect in demonstrated in panel in figure 6 with the new PPf that is farther out than the old.

Sunday, March 29, 2009

Economic of scale (2)

While the gains from trade are clearly a result of the cost reductions that come from specialization that exploit the economies of scale,there are a number of uncertainties in this model.first,there is no way to know which country will specialize in each good .Second,something unusual is needed to jolt production away from the autarky point ,but there is no way to predict the cause of the shock.in spite of these uncertainties ,the analysis opens up new possibilities for gains that do not exist in traditional models .Whether the introduction of increasing returns is more realistic than the constant-returns assumption is a debated question,but increasingly ,economists do think that scale economies can be important .

economic of scale (1)

some alternative trade theories are based upon the existence of scale.in these models ,the economies of scale are external economics pertaining to the industry rather than the firm .In these industries ,as output increases firms experience cost reductions per unit of output because,for example ,the industry growth is attracting a pool of qualified labor. In two-country world where the countries have identical PPFs and demand conditions ,there is normally no incentive to trade. if the two industries experience economies of scale , the model generates a potentially new reason for trade .in spite of the fact that both countries begin with identical autarky positions , a shock that results in each country moving to specialization in different goods and trading would lead both countries to experience gains from trade.See Appendix A for The complete development of this model .

Commodity Factor Intensity and Heckscher-Ohlin

A commodity is said to be factor-x-intensive whenever the ratio of factor x to a second factory is larger when compared with a similar ratio of factor usage of a second commodity.For example ,steel is said to be capital intensive Compared with cloth if the K/L ratio in steel production is larger than the K/L ratio in cloth production .H-o assumes not only that the difference holds for all possible factor price ratios in both countries .This means that at all possible factor prices,the isoquants reflecting the technology used in stell production are more oriented toward the capital axis ,compared with the isoquants reflecting cloth production,so that the capital/labor ratio for steel will always be larger than that for cloth .it is important to note that this assumption does not preclude substituting labor for capital if capital becomes relatively more expensive ,or substituting capital for labor if the relative price of labor rises .while such price changes would indeed change the capital/labor ratios in both commodities,they would never cause cloth to use more capital relative to labor compared with steel.This is a strong assumption and it is critical to the H-O analysis .we will later examine some possible conditions when it would not hold and the resulting implications for international trade.

full employment of factors of production (2)

Of course ,the real world does not always reach full employment.the assumption of full employment is not made to ignore real-world problems,however ,but to separate conceptually the problem of efficiency and welfare from that of idle capacity.the internal problem of unemployment may not present itself any differently when the country is in autarky then in a trading situation ;policies that are not necessarily "international" in dimension can be used in either case.By moving to a higher indifference curve ,there are gains from trade even if the country has unemployment ;the opening of the country to trade will lead to different prices facing consumers and producers than was the case with autarky .gains from exchange and specialization still occur .

Full Employment of factors of production (1)

This assumption is related to the problem of adjustment ,but it merits separate treatment because of its application to a more general context.The assumption that all of country is factors of production are fully employed (or experience a given level of unemployment owing to institutional characteristics,for example,"natural level of unemployment"),combined with their efficient use in the competitive market ,means that the country is operating on the PPF.thus,because of this assumption ,we have not previously analyzed situations where trade moved the country from somewhere inside the PPE to a point on the ppf.
The "full -employment " assumption is a general one in microeconomic theory as will as in trade theory.In micro ,it is assumed that the macroeconomic question of unemployment has been solved .the solution to the problem of unemployment might lie ,for example ,with effective monetary and fiscal policies.Given this solution ,the subject of microeconmics looks at questions of efficiency and welfare.

the Effect of wage Rate Changes

Expanding the number of commodities is useful extension of the basic Classical model because it permits an analysis of the effect of exogenous changes in relative wages or the exchange rate on the pattern of trade (In the two-country,two-commodity model,sufficiently large wage or exchange rate movements can remove the basis for trade,but if trade takes place ,it is always the same trade pattern) To drive This point home,suppose that an increased preference for leisure causes the U.K.this shift in relative wages means that Spain will now export cheese and hardware ,instead of importing them from the United kingdom .the pattern of trade has shifted markedly because the united kingdom is cost advantage has been eroded by increase in its wage rate ,which has eliminated its ability to export two products .if trade tasks place ,however ,cloth will always be exported by Spain and cutlery by the united kingdom.

Saturday, March 28, 2009

the Effect of Exchange Rate Changes (2)

As John Stuart Mill(1848) pointed out ,the equilibrium terms of trade will reflect the size and elasticity of determined by the resource endowments and technology.appropriate adjustment to demand conditions is provided in the classical model by the price-specie-flow mechanism if trade is not balanced between the two trading partners . the equilibrium terms of trade are thus realized by adjustments in the relative wage rates because of the movement of gold between the two countries . a country with a trade surplus will find gold flowing in,resulting in an increase in prices and wages.This will continue until wages have risen sufficiently to reduce its exports and increase its imports and trade is balanced between the two countries. the reverse will occur in the deficit country,The mechanism ensures that each country will export at least one good .
the general equilibrium nature of the Classical approach is formally presented in a well-known model by Rudiger Dornbusch,Stanley Fischer ,and Paul Samuelson (1977). they construct a multicommodity model between two countries that captures the relative supply conditions between the two countries and incorporates total (both countries) relative demand for the commodities under consideration.This enables them to demonstrate the simultaneously-determined links relative wage rates ,prices ,and exchange rates and to show clearly that wages and prices are jointly determined with trade when balanced trade between countries is achieved . the original model also incorporated transportation costs , traffic ,and nontraded goods .

the Effect of Exchange Rate Changes (1)

changes in the exchange rate also can alter a country is trade pattern.A shift in tastes and preferences toward foreign goods,which leads to an increase in the domestic price of foreign currency ,will make domestic products cheaper when measured in that foreign currency ,thereby increasing the competitiveness of a country in terms of exports. A decrease in the domestic cost of foreign currency will make foreign goods cheaper and act as a stimulus to imports .In the classical model ,this means that changes in the exchange rate can cause goods not at endpoint of the spectrum to change from exports to imports. A decrease in the pound\euro rate would have the opposite effect ,potentially increasing Spain is exports and reducing its imports.
what determines the equilibrium relative wage ratio in in this two-country,multiple-commodity analysis? In this single-factor approach ,the relative size of the labor force will clearly be critical from the supply perspective .Holding other considerations constant ,the larger the lobar force in one country ,the smaller is its relative wage rate and,other things being equal ,the larger the number of goods it will export .Reciprocal demand will also play a role in determining the ultimate relative wage rate in equilibrium.

Friday, March 27, 2009

Adam smith and the invisible hand (4)

.that gains from trade can occur over a wide range of barter price.smith,argument was especially significant at the time because it indicated that both countries could benefit from trade and that trade was not a zero-sum game as the mercantilists had believed.the fact that trade was mutually beneficial and was a positive -sum game was a powerful argument for expanding trade and reducing the many trade controls that characterized the mercantilist period .smith saw the source of these absolute advantages as the unique set of natural resources (including climate ) and abilities that characterized a particular nation .he also recognized that certain advantages could be acquired through the accumulation transfer ,and adaption of skills and technology .
smith is ideas were crucial for the early development of Classical thought and for altering the view of the potential gains from international trade .David Ricardo then expanded upon Smith is concepts and demonstrated that the potential gains from trade were far greater than Adam smith had envisioned in his concept of absolute advantage .

Adam smith and the invisible hand (3)

in this situation,with a labor of theory of value,1 barrel of wine will exchange for 4 yards of cloth in England;on the other hand,1barrel of wine will exchange for 1 1\2 yards of cloth in portugal.these exchange ratios reflect the relative quantities of labor required to produce the goods in the countries and can be viewed as opportunity costs.these opportunity costs are commonly referred to as the price ratios in autarky;England has an absolute advantage in the production of cloth and portugal has an absolute advantage in the production of wine because less labor time is required to to produce cloth in England and wine in portugal.according to smith,these is a basis for trade because both bations are clearly better off specializing in their low-cost commodity and importing the commodity that can be produced more cheaply abroad. for purposes of illustrating the gains from trade,assume that the two countries,rather than producing each good for themselves,exchange goods at a rate of1 barrel of wine for3yards of cloth.for england this means obtaining wine in portugal for only3yards of cloth per barrel instead of4yards at home.similarly,portugal benefits from acquiring cloth for acost of only 1\3barrel of wine instead of2\3barrel of wine at home.it is important to note

Adam smith and the invisible hand (2)

in the wealth of nations,smith explained not only the critical role the market played in the accumulation of a nation,s wealth but also the nature of the social order that it achieved and helped to maintain. smith applied his ideas about economic activity within a country to specialization and exchange between countries.he concluded that countries should specialize in and export those commodities in which they had an absolute advantage and should import those commodities in which the trading partner had an absolute advantage.each country should export those commodities it produced more efficiently because the absolute labor required per unit was less than that of the prospective trading partner.consider the two-country,two-commodity framework shown in table 1.assume that a labor theory of value is employed.

Adam smith and the invisible hand (1)

A second assault on mercantilist ideas came in the writing of a dam smith .smith perceived that nation is wealth was reflected in it productive capacity not in its holdings of precious metals .Attention thus turned from acquiring specie to enlarging the production of goods and services.smith believed that growth in productive capacity was fostered best in an environment where people were free to pursue their own interests.self-interest would lead individuals to specialize in and exchange goods and services based on their own special abilities.the natural tendency "to truck,barter ,and exchange" goods and services would generate productivity gains through the increased division and specialization of labor.self-interest was the catalyst and competition was the automatic regulation mechanism .smith saw little need for government control of the economy .he stressed that a government policy of laissez faire (allowing individuals to pursue their own activities within the bounds of law and order and respect for property rights) would best provide the environment for increasing a nation is wealth .the proper role of government was to see that the market was free to function in an unconstrained manner by removing the barriers to effective operation of the "invisible hand" of the market

David Hume-The price-specie-flow mechanism (3)

3- prefect competition in both product and factor markets is assumed in order to establish the necessary link between price behavior and wage behavior ,as well as to guarantee that prices and wages are flexible in both an upward and a downward direction .
4- Finally ,it is assumed that a gold standard exists .Under such a system ,all currencies are pegged to gold and hence to each other,all currencies are freely convertible into gold ,gold can be bought and sold at will ,and governments do not offset the impact of the gold flows by other activities to influence the money supply .This is sufficient to establish the link between movements of specie and changes in a nation is money supply .
If all these assumptions are satisfied,the automatic adjustment mechanism will ,allowing time for responses to occur ,restore balanced trade any time it is disrupted .Balance-of-payments adjustment mechanisms and the gold standard are still prominent in discussions of international monetary economics .

david Hume-The price-specie-flow mechanism (2)

1- There must be some formal link between money and prices ,such as that provided in the quantity theory of money when full employment is assumed:
Ms v = p y
where: Ms=the supply of money
v= the velocity of money ,or the rate at which money changes hands
p= the price level
Y= the level of real output
if one assumes that the velocity of money is fixed by tradition and institutional arrangements and that Y is fixed at the level of full employment,then any change in the supply of money is accompanied by a proportional change in the level of prices.
2- Demand for traded goods is price elastic .this is necessary to ensure that an increase in price will lead to a decrease in total expenditures for the traded goods in question and that a price decrease will have the opposite effect.if demand is price inelastic ,the price-specie-flow mechanism will tent to worsen the disequilibrium in the trade balance . however,demand elasticities tent to be greater in the long run than in the short run as consumers gradually adjust their behavior in response to price changes .Hence,even though the price-specie-flow mechanism may be "perverse" in the short run,Hume is result is likely to occur as time passes

Thursday, March 26, 2009

David Hume-the price-Specie-flow mechanism (1)

One of the first attacks on mercantilist tough was raised by David Hume (in this political Discourses 1752) with his development of the price-specie-flow mechanism.Hume challenged the mercantilist view that a nation could continue to accumulate specie without any repercussions to its international competitive position .he argued that the accumulation of gold by means of a trade surplus would lead to an increase in the money supply and therefore to an increase in prices and wages. the increases would reduce the competitiveness of the country with a surplus.note that Hume is assuming that changes in the money supply would have an impact on prices rather than on output and employment.at the same time,the loss of gold in the deficit country would reduce its money supply,price,and wages,and increase its competitiveness . thus,it is not possible for a nation to continue to maintain appositive balance of trade indefinitely.a trade surplus automatically produces internal repercussions that work to remove that surplus.the movement of specie between countries serves as an automatic adjustment mechanism that always seeks to equalize value of exports and imports.
today the classical price -specie-flow mechanism is seen as resting on several assumptions.

mercantilism and Domestic Economic policy (2)

mercantilist economic policies resulted from the view of the world prominent at that time time.the identification of wealth with holdings of precious metals instead of a nation is productive capacity and the static view of world resources were crucial to the policies that were pursued .while these doctrines seem naive today ,they undoubtedly seemed logical in the period from 1500to 1750 .Frequent warfare lent credibility to maintaining a powerful army and merchant marine .the legitimization of and growing importance of saving by the merchant class could easily be extended to behavior by the state,making the accumulation of precious metals seem equally reasonable .however ,the pursuit of power by the state at the expense of other goals and the supreme importance assigned to the accumulation of precious metals led to an obvious paradox:rich nations in the mercantilist sense would comprise large numbers of very poor people .Specie was accumulated at the expense of current consumption .At the same time,the rich nations found themselves expending large amounts of their holdings of precious metals to protect themselves against other nations attempting to acquire wealth by force .

mercantilism and domestic economic policy(1)

The regulation of economic activity also was pursued within the country trough the control of industry and lobar.Comprehensive systems of regulations were put into effect utilizing exclusive product charters such as those granted to the royal manufacturers in France and England ,tax exemption ,subsidies,and the granting of special privileges .In addition to the close regulation of production ,labor was subject to various controls through craft guilds.Mercantilists argued that these regulations contributed to the quality of both skilled labor and the manufactures such labor helped produce -quality that enhanced the ability to export and increased the wealth of the country.
finally,the mercantilists pursued policies that kept wages low.Because labor was the critical factor of production,low wages meant that production costs would be low and a country is products would be more competitive in world markets.It was widely held that the lower classes must be kept poor in order to be industrious and that increased wages would lead to reduced productivity.Not that ,in this period,wages were not market determined but were set institutionally to provide workers with incomes consistent with their traditional position in the social order .however,because labor was viewed as vital to the state ,a growing population was crucial to growth in production . thus,governments stimulated population growth by encouraging large families,giving subsidies for children ,and providing financial incentives for marriage .

Wednesday, March 25, 2009

The mercantilist Economic System (2)

Mercantilists saw the economic system as consisting of three components: a manufacturing sector ,a rural sector (domestic hinterland).and the foreign colonies (foreign hin -terland).They viewed the merchant class as the group most critical to the successful functioning of the economic system,and labor as the most critical among the basic factors of production. the mercantilists,as did the classical writers who followed ,employed a labor theory of value, that is, commodities were valued relatively in terms of their relative labor content.Not surprisingly,most Writers and policy makers during this period subscribed to the doctrine that economic activity should be regulated and not left to individual prerogative.Uncontrolled individual decision making was viewed as inconsistent with the goals of the nation-state,inparticular,the acquisition of precious metal .Finally ,te mercantilists stressed the need to maintain an excess of exports over imports ,that is,a favorable balance of trade or positive trade balance. this doctrine resulted from viewing wealth as synonymous with the accumulation of precious metals (specie) and the need to maintain a sizable war chest to finance the military precious required of a wealthy country .the inflow of specie came from foreigners who paid for the excess purchases from the home country with gold and silver.this inflow was an important source of money to countries constrained by a shortage in coinage . crucial to this view was the implicit mercantilist belief that the economy was operating at less than full employment ;therefore ,the increase in the money supply stimulated the economy ,resulting in growth of output and employment and not simply in inflation .hence ,the attainment of a positive trade balance could be economically beneficial to the country.Obviously ,an excess of imports over exports_an unfavorable balance of trade or a negative trade balance_ would have the opposite implications.

the mercantilist Economic system (1)

central to mercantilist thinking was the view that national wealth was reflected in a country try is holdings of precious metals .In addition ,one of the most important pillars of mercantilist thought was the static view of world resources .Economic activity in this setting can be viewed as a zero-sum game in which one country is economic gain was at the expense another. (A zero -sum game such as poker where one person is winning are matched by the losses of the other players.)Acquisition of precious metal thus became the means for increasing wealth and well-being and the focus of the emerging European nation states .In a hostile world ,the enhancement of state power was critical to the growth process,and this was another important mercantilist doctrine.A strong army ,strong navy and merchant marine ,and productive economy were critical to maintaining and increased the power of a nation-state.

Tuesday, March 24, 2009

the role of government (2)

governments attempted to control international trade with specific policies to maximize the likelihood of a positive trade balance and the resulting inflow of specie.Exports were subsidized and quotas and high tariffs were placed on imports of consumption goods .Tariffs on imports of raw materials that could be transformed by domestic labor into exportable were ,however ,low or nonexistent,since the raw materials imports could be "worked up" domestically and exported as high-value manufactured goods .Trade was fostered with the colonies,which were seen as low-cost sources of raw materials and agricultural products and as potential markets for exports of manufactures from the parent country .Navigation polices aimed to control international trade and to maximize the inflow(minimize the outflow) of specie for shipping services .the British navigation acts ,for example ,excluded foreign ships from engaging in coastal trade and from carrying merchandise to Britain or its colonies.(such policies have not disappeared-even today non-us .ships are prevented by law from carrying goods between U.S.ports.) Trade policy was consistently directed toward controlling the flow of commodities between countries and toward maximizing the inflow of specie that resulted from international trade.

the role of government (1)

The economic policies pursued by the mercantilism followed from these basic doctrine governments controlled the use and exchange of precious metals,what is often referred to as bullion ism .In particular ,countries attempted to prohibit the export of gold ,silver ,and other precious metals by individuals ,and rulers let specie leave the country only out of necessity .Individuals caught smuggling specie were subject to swift punishment ,often death.government also gave exclusive trading rights for certain routes or areas to specific companies. trade monopolies fostered the generation of the higher profits contributed both directly and indirectly to a positive trade balance and to the wealth of the rulers who shared the profits of this activity .The Hudson Bay Company and the dutch East India Trading company are familiar examples of trade monopolies ,some of which continued well into the nineteenth century.

the world of international economics (3)

The study of international economics ,like all branches of economics,concerns decision making with respect to the use of scarce resources to meet desired economic objectives .it examines how international transaction influence such things as social welfare,income distribution ,employment,growth,and price stability and the possible ways public policy can effect the outcomes.in the study of international trade ,we ask ,for example :what determines the basis for trade?what factors impede trade flows? what is the impact of public policy that attempts to alter the pattern of trade? in the study of international monetary economics we address question such as :what is meant by a country is balance of payments ?how are exchange rates determined ? how does trade affect the economy at the macro level? Why does financial capital flow rapidly and sizabley across country border? should several countries adopt a common currency? how do international transactions affect the use of monetary and fiscal policy to pursue domestic targets?

the world of international Economics (2)

This Increased internationalization of economic life made even more complicated by foreign-owned assets.More and more companies in many countries are owned partially or totally by foreigner .Further,in the 1990s ,foreigners purchased U.S government bonds and corporate stocks in record number ,partly fueling the stock market boom of those years .The overall heightened presence of foreign goods ,foreign producers ,and foreign owned assets causes many to question the impact and desirability of international transaction .it is our hope that after reading this text you will be better able to understand how international trade and payments effect a country and that you will Know how to evaluate the implication of government policies that are undertaken to influene the level and direction of international transaction .
you will be studying one of the oldest branches of economics.people have been concerned about the goods and services crossing their borders for as long as nation-states or city-states have existed .some of the earliest economic data relate to international trade ,and early economic thinking often centered on the implications of international trade for the well-being of a politically defined area.Although similar to regional trade for the well-being of apolitically defined area .Although similar to regional economics in many respects,international economics has traditionally been treated as a special branch of the discipline.this is not terribly surprising when one consider that economic transactions between politically distinct areas are often associated with many differences that influence the nature of exchange between them rather than transactions within them.For example,the degree of factor mobility between countries often differs from that within countries .countries can have different forms of government ,different cultures,different institutions ,and different arrays of products .

the world of international Economics (1)

welcome to the study of international economics . no doubt you have become increasingly aware of the importance of international transaction in daily economic life .when people say that "the world is getting smaller every day" they are referring not only not only to the increased speed and ease of transportation and communications but also to the increased use of international markets to buy and sell goods ,services,and financial assets.this is not a new phenomenon ,of course :In ancient times international trade was important for the Egyptians ,the the Greeks ,the Romans ,the Phoenicians ,and later for Spain ,Portugal,Holland,and Britain.it can be said that all the great nations of the past that were influential world leaders were also important World traders.Nevertheless ,the importance of international trade and finance to the economic health and overall standard of living of a country has never been as clear as it is today .
signs of these international transactions are all around us.the clothes we wear come from production sources all over the world :the united states to the pacific Rim to Europe to central and south America .The automobiles we drive are produced not only in the United states,when you call an 800 number about a product or service,you may be talking to someone in India .Further ,products manufactured in the United states often use important parts produced in other countries .At the same time ,many U.S imports are manufactured with important U.S.-made components.

Monday, March 23, 2009

currency options

A major disadvantage of forward contracts from a customer is point of view is that , while the fixed exchange rate guards against adverse currency movements ,the customer is not able to take advantage of favorable movements .A currency option contract ,however,allow this .
The holder of an option contract has the right ,but not the obligation,to buy or sell a specified a mount of currency at an agreed rate within a specified period .A fee is paid for this right.

DOCUMENTARY CREDITS

by issuing an irrevocable letter of credit ,a bank is conditionally guaranteeing a customer is trade debt .The letter of credit represent an obligation to pay,providing that the overseas supplier meets the terms of the credit ,including the provision of the documents of tide to the goods being shipped .
The lender must be satisfied of the buyer is ability to meet the liability on the due date and if any doubts persist about this ,than full or partial cash cover should be taken from the buyer at the times the letter of credit is issued .IT must be understand that once an irrevocable letter of credit is in existence ,all the overseas supplier has to do is meet its terms and conditions ,and the lender will be obliged to pay .

credit insurance

The availability of good credit insurance for the debts will,of course,greatly improve the prospects of payment .provided the bills are drawn for terms not more than 180 days ,the exporter can obtain 90% cover on the net invoice value of each transaction under an ECGD comprehensive short-term policy . An assignment of this policy can br taken to boost the lender is security position .This does not make the facility fully secured however ,because the lender is still dependent Upon the exporter observing the terms and conditions of the credit insurance policy.

some types of operating lease

- contract hire - used widely in the supply of company vehicle fleets.The lessor takes some responsibility for the management and maintenance of the asset at an agreed level
- fleet management - this goes beyond simple contract hire and includes elements such as accident management ,so that everything to do with the vehicle is outsourced to the lessor .
- spot hire -short-term hire of an asset as practised by car rental companies and plant hirers .
- dry lease- this is the term for when an asset is leased without operators, the most common from of operating lease .
- wet lease - this is where the lessor also provides some or all of the services to operate the equipment .A common example would be vending machines that are maintained by the lessor , who will usually also supply the stock to be dispensed.

residual value risk (2)

All these things have to be predicted in advance along with specific issues relating to the individual asset. A conservative approach that looks at an absolutely worst-case evaluation may lose the deal ,but getting the residual value wrong could cause a capital loss of significant proportions and cause a less on a deal for an entirely creditworthy customer.
The best type of residual value setter is someone steeped in the second hand market for assets ;someone who will have a good idea of who will be in the market for such an asset and how much they are likely to pay .such a person is not a traditional lender or credit risk assessor .IT is interesting to note that some of the world is most successful operating lessors have a background in manufacturing or dealing in assets rather than originally being financial institutions . this is a business where understanding the assets is the difficult part and assessing the credit risk the easy part.
Just as portfolio control is an important element of taking credit risk,it is also a key element of taking residual value risk.The operating lessor will not want to be over-exposed to taking residual value risk . The operating lessor will not want to be over-exposed to a particular type of asset and will want a balanced portfolio to avoid being caught out if something happens to effect the value of an asset category. There is also a "sanity check " inherent in achieving a well spread portfolio - if you are consistently winning deals by having the lowest rentals for a specific type of asset ,maybe your residual values are too generous;certainly the rest of the market seems to think so.

residual value risk (1)

with an ordinary loan or finance lease ,the size of repayments \rentals is determined by a mixture of the capital amount\cost of the asset and funding cost/credit risk margin .With an operating lease there is an additional variable ,the residual value .The rental in an operating lease takes account of the funding cost and credit risk margin but the cost of the asset ,or capital amount to be "repaid" (in reality the extent to which the depreciation in the value of the asset has to be covered in the rental) is reduced by the assumed residual value of the asset at the end of the lease period .The higher the assumed residual value ,the lower the capital element and the lower the rental .
In a competitive scenario ,this means that there is pressure to set aggressive residual values in order to win business .setting residual values is not a simple task anyway-looking forward two ,three,five or perhaps more years and predicting the second hand value of apiece of equipment is a difficult Job .some of the generic factors that have to be taken into account are :
- the likely rate of inflation ;
- likely exchange rate movements if the asset is sourced from overseas;
- how specialized the asset is-how limited a market will it be sold into;
- the rate of technological change - computers that are state of the art now soon become entirely obsolete if they cannot be upgraded ;
- how will the asset be used ? an asset that is run into the ground will not be an attractive sale proposition ;
- potential for legislative or regulatory changes that would impact on the asset-change to environmental standard could make a non-compliant asset unsaleable .

Operating leases

If a finance lease has an element of 'fiction' about it and is really a quasi-loan device to enable the financier to get access to tax allowances ,operating leasing is 'true' leasing and in fact s called by this term in some parts of the world .
it is sometimes said that a taxi ride is the simplest illustration of an operating lease- the hirer of a taxi ride (the lessee) has its use for a limited period in return for paying the fare (the rental) and never takes any of the risk or benefits n owning it,which remain with the taxi owner (the lessor).however,if it seems that it should be a straightforward matter to give a simple definition of an operating lease ,this is not so in accounting terms .Both SSAp 21 and IAS 17 ,rather unhelpfully ,define an operating lease as 'a lease other than a finance lease'.A more helpful way of looking at an operating lease is that it is an arrangement where the lessee requires the asset for a period shorter than its useful life . The lessor retains a significant interest in the end value (commonly known as the 'residual value') of the equipment at the conclusion of the lease period because the asset is returned to him or her and he or she will have to realize its value by selling it into the second-hand market to recover costs and make an adequate return .

Rental patterns

Leasing companies are able to provide a wide range of option when It comes to rental payment profiles and generally are more willing to adapt 'repayment' to the profile of a company is cash flow than traditional lenders.
- Rentals in advance - because a lease has to cover the full cost of an asset, the option available to a bank lender of only advancing a proportion of the asset value is not readily available to lessor . however ,it is possible to overcome this problem through charging rentals in advance and a common arrangement would be to charge six month 'rental in advance .
- seasonal - in seasonal businesses such as farming or tourism ,rentals can be tailored to be higher in the summer and lower in the winter .
- Escalating - rentals can be tailored to reflect the increasing cash generating capacity of an asset over its life.
- Deferred - a deferred profile will mean that payments will not have to begin until the asset starts to generate cash .while traditional lenders will often agree a capital repayment holiday ,they are very rarely prepared to agree a total finance charge moratorium to include interest ,which is what happens with a deferred rental arrangement .
- Balloon-for an asset where , despite the apparent depreciation profile ,the asset will have a significant value at the end may be appropriate to reflect the cash flow available from the disposal of the asset . IF a serious balloon profile is needed ,however ,an operating lease is probably the answer .

Sunday, March 22, 2009

finance leases and covenants

one advantage of leasing to a lessee is that medium term quasi-borrowing can be taken outside borrowing covenants agreed with lenders .Rentals are not interest and will not be covered by standard interest cover covenants .
on the other hand ,finance leases do appear on balance sheet and are relatively easy to include in gearing covenants if broadly defined.
The fundamental point is that lease rentals are an important element in overall debt service and will have to be met if assets potentially crucial to a business is operations are to be retained.lenders need to ensure that their covenants are sufficiently widely drawn to encompass leasing obligations as well as normal borrowing.this should be relatively easy for finance lease obligations but is more difficult for operating leases as will be seen below.

features of finance lease

In general , UK finance leases contain the following features :
- the asset is selected by lessee and usually supplied by a third party ;
- the lessor negotiates with the supplier the terms of warranties, maintenance agreements ,delivery , installation and the price ;
- the losser retains ownership and claims the capital allowances;
- the lessee carries the risk of obsolescence and has exclusive right to use the asset ,subject to the terms of the lease ,which will include a requirement to keep it in good working order;
- the lease is,nominally , over anon-cancellable period covering the asset is working life,with rentals to cover the capital outlay of the lessor.finance leases are sometimes called 'full pay-out leases ' ,reflecting this ;
- the lease agreement will probably contain a provision to ensure the lossor suffers no loss in the event of early termination;
- at the end of the lease the lessee may continue to lease the asset at a nominal 'secondary' rental or arrange , as agent for the lessor for the equipment to be sold or scrapped. A finance lease in the UK allows for most of any profit on disposal to be returned to the lessee as a rebate of the sale proceeds.
finance leases are reported 'on balance sheet',whereas operating leases are not.In distinguishing a finance lease from an operating lease,Uk accounting practice uses an 'ownership' test based on the risks and rewards of ownership being 90% of the fair market value of the leased asset start of the lease agreement . so ,in UK accounting terms ,a finance lease is one where the net present value of the rentals exceeds 90% of the capital cost of the asset . however ,as will be seen later ,this test is not the issue in differentiating between operating leases and finance leases.

finance leases

both the current Uk statement of standard Accounting practice (SSAp 21)and the standard published by the international accounting standards committee (IAS 17)classify a finance lease as being one where substantially all the risks and rewards of ownership of the asset are transferred from the lessor to the lessee.In other words ,the leasing arrangement is a kind of fiction because the apparent owner,the lessor,does not suffer or benefit from changes in the asset is value ,while the user ,the lessee ,does .
However,this fiction is crucially important from a tax point of view as the capital allowances for an asset funded by a finance lease without an option to purchase accrue to the lessor and not the lessee.
In other words the capital allowances accrue to 'the lender' (lessor) and not 'the borrower ' (lessee).where a potential borrower is insufficiently profitable ,or can ameliorate tax liabilities in other ways,acquiring an asset through leasing will be Avery favorable option because the lessor will pass on the value of the tax allowances the lessee will be unable to take full advantage of him\herself via lease rentals that are less than the equivalent interest and capital repayment on a loan .

lease purchase

this type of leasing is more commonly known as 'hire purchase' in the UK.It is essentially a finance lease with a nominal purchase option built into the agreement that can , and normally always is , exercised at the end of the lease period . under UK tax rules , where such an option to purchase exists , it is the lessee, not the lessor , who can claim any available capital Allowances .SO For Tax Purposes The Treatment OF The Asset IS The same as if it was acquired by simple loan and the accounting treatment regards the asset to all intents and purposes as being owned by the lessee,with the asset appearing on the lessee is balance sheet.

computer-generated management reports

different banks have different computer systems and produce different printouts. however,all of them have the capacity to supply historical information on the trend on individual customer accounts . when looking at this information the main questions that should be asked are :
- what is the worst balance trend? Are there excesses over the limit?
- what is the best balance trend ? Is there any evidence of a hard core developing?
- is the average balance figure worsening ?
- is the Turnover through the account out of line with what might have been expected ?
- has there been a change in the run of the account compared to previous periods?
an adverse trend in just one of these need not be a cause for concern , but when a deterioration is evident in more than one ,Then some action may be necessary , even if this is limited to keeping the account ,under more regular review.

credit standards (4)

banks face a genuine dilemma. If they ignore the market and apply standards rigidly they will avoid credit losses but lose the good business and market share they need to meet shareholder aspirations . while models of risk-adjusted capital are widely used and returns related to them , shareholders contribute actual real money capital and want returns on that.it is hard of banks to sit with a lot of real capital and keep ignoring the demand to leverage it .
A strong credit culture can help achieve the right balance. If the bank genuinely understands its customers and has the right sort of relationship with team,it can choose when to bend standard a little and when to adhere to them . It is possible , in the context of a strong customer relationship to persuade even the most macho of customers to see the bank is point of view.
Relationship banking is a two way street and customers will expect support when they need it.But where transactional banking is the norm,the risks are greater in boom times when the marketeers are driving and reasonable protections are being sacrificed to 'market conditions' .if you want to get something outside the market in the good times , you need to be prepared to give something back when the customer is in a less strong position.
relationship banking is not a complete panacea against bad debts , but it is likely to make losses less in recession , albeit at the price of not doing as much business in the boom times as some more aggressive transaction getter in other banks .

credit standards (3)

however ,this is this time when banks are at their most defensive , chastened by their own losses and more likely to be risk averse as opposed to risk aware . This is when the loan conditions are tightened beyond what is reasonable or the banks simply refuse to lend .sometimes they almost actually add to losses by refusing to support battered but fundamentally sound companies that could recover if only they had sufficient finance . it is difficult ,but necessary,to remain objective.
In the past,lending skills were regarded as essential for all bankers and and the most senior members of a bank is management would have them. Times have changed and the credit function within banks is usually one of the less glamorous places to work lending is often regarded as 'value destroying' because of the amount of scarce capital it uses and business that generates fees and other non-interest income is seen as more attractive .The problem with this is that customers have a need to borrow . maybe the bigger ones can access capital markets direct through bond issues or commercial paper , but there is a lot of research to show that the service that most customers-especially business ones - most value from their banker is the willingness to grant credit.

Saturday, March 21, 2009

credit standards (2)

standards need to be sustained across the economic cycle . They should not be relaxed in good times or over-tightened in bad .In general ,companies look better at the top of the cycle and weaker at the bottom than they realy are. Therefore,logically ,monitoring needs to be most strictly applied as the cycle reaches its peak;but this is Just the time when companies are tending to seek to drop or weaken covenants as they flex their muscles in the more competitive market place as far as lenders are concerned.The temptation for banks to look at the favourable surface factors and ignore the longer-term risks is greatest, as is the pressure not to lose 'good business' To succumb to this pressure -as banks historically have- is to sow the seeds of losses in the next recession . the losses in recession reflect the mistakes banks make during booms.
conversely , at the bottom of a recession,survival can be the best proof of management quality and the ultimate robustness of a business that there is.companies are likely to be at their most chastened by their recent experience and unlikely to be going for over-expansive and risky plans .Even if they do ,they have several years of improved economic conditions a heat of them in which they can pay off their borrowings and get away with all but damaging mistakes.

credit standards (1)

credit standards convert the culture into action .They must take account of the nature of the bank is business , its structure and the quality and training of staff involved in credit decisions.
standards include factors such as :
- the depth of analysis and how far this is adapted to the needs of the borrower. There is a trade off to be made between a wish to understand all aspects of a proposition and cost ;
- how far facilities are to be standardized and how far they are to be tailored to customers individual needs;
- structuring facilities to protect the bank which should be done in a way that as far as possible also benefits the customer .A repayment schedule for a term loan should match customer cash flow ,not Just meet some predetermined arbitrary benchmark;
- recognizing how far customer sensibilities are going to be balanced against the bank is need to protect itself against loss. for example ,when a customer is resistance to giving or improving security , or providing information is going to be allowed;
- education of customer and the capacity to be able to explain decisions .A banker who can only defend a particular decision by reference to head office rules is hardly an impressive professional;
- the inclusion of a proper degree of monitoring and control . The point of monitoring is to identify deterioration as soon as possible and to take constructive remedial action . its effectiveness depends not only on the ability to spot adeterioration ,but also the quality of the reaction. It is as important to avoid a panic reaction as a complacent one.

credit culture (2)

- cover the type of risk the bank is prepared to take and the reward it expect to earn for given levels of risk , both at the individual lending and portfolio level ;
- establish the relative status and authority of the credit risk function in the bank.There must be clarity over the extent that credit has a veto over the activities of the business developers .The support of top management in maintaining the agreed authority is essential;
- be willing to pay the cost of maintaining the culture.This includes training analysis , monitoring,the quality of decision-takers,computer systems and other elements. But cost here cannot simply be calculated in cash terms ; it also covers willingness to overcome and customer as to the benefits of a sound credit structure and ultimately to lose business if the customer proves uneducable ;
- be robust enough not to be effected by economic cycles . A culture that changes in response to different economic cycles . A culture that changes in response to different conditions is a weak one .

credit culture (1)

this can be defined as abank is attitude to all matters relating to its management of credit risk . If it is produce a sound credit risk portfolio it must :
- Fit with the overall business and organization of the bank. The culture must be capable of delivering the service the bank requires to meet the needs of its customers. It can only do this if it is compatible with the overall business strategy of the bank;
- be championed by top management of the bank . because the credit culture must be a balance between taking new risks and also limiting the amount of risk, it is bound to run into opposition of various types, Top management is the only source that can ensure that the culture supports appropriate credit standards,but also is commercial enough not to cost the bank good business, which in hindsight would have been good . but at the time of the decision 20\20 hindsight is not available . There must be agreement throughout the bank that there is some business it is willing to lose and a consensus as to the criteria to be used in deciding which . This policy has to be laid down by top management;

Friday, March 20, 2009

portfolio management (4)

the key to understanding unexpected loss is to understand the correlation of assets in the portfolio. correlation arises through linkages ,usually indirect,which result in more than one lending defaulting together.A well-spread portfolio,such as one consisting of a large number of personal loans is likely to be less volatile than a narrow portfolio of property advances that have a high risk of defaulting together in recessionary conditions . Banks need to hold sufficient capital to cover the volatility in their loan portfolio. The greater the volatility ,the greater the capital need . This can be developed into the concept of achieving a risk-adjusted return ( to cover expected loss ) on risk-adjusted capital (to cover unexpected loss). Extra capital need produces a greater cost in relation to more volatile portfolios and this needs to be factored into pricing decisions.
portfolio management enables the optimization of risk and reward . A bank will want to maximize the returns to its shareholders for any given level of risk , or minimize the risk for whatever level of returns is available . Active management of the composition of the bank is loan portfolio is key ,Active management can entail directing business development efforts into acquiring different type of loan assets or taking a conscious effort to exit certain type of business . it can also encompass securitization of parts of the loan portfolio and the use of credit derivatives , for example ,to swap portfolios with other institutions .

portfolio management (3)

Establishing the likely loss in a portfolio can also be used to price risk . Eash new loan has a potential loss built into it and this 'expected loss' can be derived from the calculation explained in this section . To make a satisfactory return , a lender needs to cover the expected loss in the portfolio-which is acost of lending- plus make an additional margen to satisfy shareholders .
Expected loss gives an average level of loss over an economic cycle. however ,in any individual year, actual losses can vary from the annual average . actual losses are likely to be cyclical ,with a disproportionate number of defaults occurring in periods of recession. The likelihood is that in most years the actual losses seen will be below the average projected by expected loss, with short periods with losses significantly above the average . Unexpected loss theory recognizes this and attempts to measure how actual losses will differ from average losses . It deals with volatility around the expected level of loss .Volatility produces greater risk; the greater the volatility in a portfolio,In an extreme scenario ,the risk is that losses at a particular point could be so great as to threaten the bank is solvency .

portfolio management (2)

once the likelihood of default is established ,It needs to be applied to probable loan amount outstanding at the time of default as the first stage of calculating the extent of the future loss associated with it. The balance outstanding at the time of default is difficult to predict with any accuracy , but it can probably be safely assumed that overdrafts will be in the upper range of their limits and most banks use the customer lending limuts as the basis for this calculation.
The final element in the calculation of the likely or expected loss on a loan is the extent to which loss can be mitigated by the realization of collateral security. Unsecured loans are likely to produce greater losses than secured ones when default has occurred . At the portfolio level ,the model has to factor in broad assessments of the realization value of different types of security based on general past experience. again , as with grading of the likelihood of default , a generalized assessment linked to portfolio performance is being made ,not aspecific individual credit assessment.
historically banks carried out credit risk analysis on an individual credit basis with little or no regard for the overall balance of assets in the portfolio . This produced big swings in provisions and profitability. portfolio management enables diversification of risks because concentrations of risk can be readily identified. A balanced portfolio needs to avoid lots of loans that will default together.

Thursday, March 19, 2009

portfolio management (1)

The biggest change we have seen in credit risk management over recent years is in the use of portfolio management techniques . Traditional lending assessment looks at a loan and considers whether it will default or not. portfolio management seeks to understand the probability of default of a loan with certain characteristics . This enables a lending institution to build a a model of the overall risk in its portfolio of each new loan is given a grade based on its probability of defaulting . The measurement of this probability is based on a number of characteristics that are associated with default . The underlying grading model uses a set format to ensure consistency and comparability. There is a temptation to look at the grades generated as a 'quick fix' from of credit assessment but the number of characteristics considered in necessarily limited and model does not seek to identify which loans will default but is aimed primarily at establishing the risk of loss in the portfolio of loans . any grade of borrower can and will default and any grade of borrower can repay satisfactorily.

intelligent Knowledge based system (3)

Third, a company is position in its market place and how it relates to external factors is a key factor in assessing its future . The analysis of such issues cannot be totally objective and three has to be a large element of subjective judgment in what is fed into the computer model.
similarly ,management quality cannot be assessed quantitatively and subjective judgments have to be used in the computer modelling .
so where does this leave expert systems? they are here to stay .But their weaknesses must be more widely appreciated .They do not produce as objective an assessment as many of their proponents would profess . There is a wish to try to use them more mechanistically as a way of saving cost in credit assessment but this is likely to be dangerous given the inherent weaknesses and the introduction of extra systemic risk this would entail . it is going to be hard to eliminate traditional skills completely .

intelligent Knowledge based system (2)

There are also some inherent analytical weaknesses, which cannot easily be eliminated from expert systems.They are at their strongest When they are looking at numerical data .so they are good at analyzing balance sheets and other historical financial data;at their best with quantitative opposed to qualitative analysis .The areas where they are particularly vulnerable are :
- relying on extrapolation techniques ;
- the impact of creative accounting ;
- weak on assessing business risks ;
- weak on assessing management quality.
the first problem arises because in testing future projections ,expert systems essentially extrapolate trends from the past .Of course,the past is probably the best guide to the future there is ,but there are clear risks in extrapolating it without question .
The second point relates to the fact that ,to save costs ,financial data is input into the model by Junior and relatively unsophisticated staff,who do not have the capacity to understand the important nuances of balance sheet from the back forwards so that you can understand how the figures have been arrived at .the staff inputting figures , often simply by rote or in accordance with simple instruction, cannot be expected to understand the impact of subtle accounting policy changes and the numbers may not represent the true financial situation of the business.

intelligent Knowledge based system (1)

If the large corporates are increasingly being credit assessed by rating agencies on behalf of landers and smaller lending s are being handled by credit scoring systems,the remaining home for traditional credit assessment techniques would seem to be in the small and middle corporate market .Even here science increasingly impinges with the growing widespread use of intelligent knowledge based systems :commonly Known as 'expert systems ' .
the idea behind expert systems is to multiply the experience of experts by feeding the rules and observations developed from their working lives into a computer model lenders have quickly become comfortable with the way expert systems credit assess lending s, because they mirror their own mind's work when evaluating a lending proposition .
however ,there are dangers with expert system . As previously indicated with regard to credit scoring system , the use of any sort of system produces systemic risk.The main use of expert systems has developed only since the last major period of recessionary economic conditions; expert systems for credit assessment have not yet been 'stress tested' in the most demanding conditions.

Wednesday, March 18, 2009

neural networks

the use of neural networks for credit assessment is still relatively in its infancy and the purpose of this short section is mainly to record that they exist and have great potential to bring effective use of technology to judgmental credit decisions.
A neural network is a computer program that can learn from its experience.unlike credit scoring and expert system ,which have their rules set for them , neural networks are self-training that can take experiences and derive new rules from them. They do not function in the same way as human brains but they are more like brains than most computer. they can learn from experience by following set procedural principle. some models can do pattern matching and they can also take on board contextual differences . for example ,they can tell the difference between a painting of a human and one of apple in a still life . Instead of proceeding by hard and fast logical rules , they deal with information by a process that is roughly similar to what we call associative or analogical thinking .
The potential power of a computer that can learn is obvious ;watch this space .

credit scoring (4)

credit scoring is cost effective because it establishes a system to take repetitive credit decisions.but systems create systemic risk.If the system or the assumptions on which it is based malfunction ,wrong decisions are magnified across the whole of the borrower population being managed with potentially horrendous consequences.subjective judgment is still needed in establishing the parameters of the system and deciding when they need to be revised .circumstances in the world change and so does borrower behaviour. credit scoring does have abase in subjective judgment . Decisions are merely taken in another place from individual assessment of borrowers and involve different risks .

credit scoring (3)

there is a general wish to try to extend credit scoring into the small business market . This is mainly on grounds of reducing the cost of processing large volumes of small borrowing requests .plenty small business credit scoring models exist,but it is questionable how successful they are.The problem is that small businesses with apparently similar characteristics in one area,for example,turnover size,have very different characteristics in other areas, ie aretail shop is different to a self employed plumber, as a doctor is different to a lawyer .
it is also the case that characteristics built into a model are most valuable when they are entirely objective . it would be thought conceptually,that for a personal borrower, the most valuable indicator of repayment would be disposable income .however,this has not proved to be the case.The data has to be captured on a simple application from and borrowers interpret the term 'disposable income' differently and subjectively .Than can also lie easily! so it is not a good objective indicator .on the other hand ,having a fixed line telephone is objective .It is factual and can be checked easily.It is evidence of relatively permanent residence as well as regular payment of a financial obligation in the form of telephone bills.Having a fixed line telephone has proved a good indicator for credit scoring models.

credit scoring (2)

credit scoring models make assumptions about how common characteristics in statistical populations affect likely borrower behaviour.but any change in potential borrower behaviour that is not picked up quickly can make the base assumptions invalid and allow large numbers of inappropriate borrowings to be approved.IN the US,what had happened was that there had been a major shift in the attitude of individual Americans towards bankruptcy .Historically this had carried agreat social stigma that people wanted to avoid .Quite suddenly a different attitude became fashionable ;the stigma was removed ,and borrowers began to see bankruptcy as merely a sensible piece of financial planning . personal bankruptcy rates soared , hitting credit card companies very heavily with the consequent losses.
credit scoring models need a homogenous statistical base to work effectively ; in other words ,lots of borrowers with similar characteristics who can be readily compared to one anther and for which common conclusions can be deduced .Homogenous populations are available where personal borrowers are concerned but things immediately become more difficult where business borrowers are concerned

Tuesday, March 17, 2009

CREDIT SCORING (1)

Actuarially based credit techniques have become increasingly popular and credit scoring systems now dominate the personal lending market .The principles underlying credit scoring are not new . insurance companies have been estimating likely death rates on an actuarial basis for centuries to establish insurance premiums. well-managed and policed credit scoring systems have been accurate mechanisms for predicting default and a highly cost effective method of taking large volumes of credit risk decisions .
but credit is not a risk-free panacea.The most mature market for credit scoring techniques is the US in 1997 to the extent that the office of the comptroller of the currency ,one of the principle US bank regulators,felt obliged to issue a circular to banks warning of the dangers inherent in relying on credit scoring systems . Eugene Ludwig ,the comptroller,said,like all tools,credit scoring models can be used well or badly. because they are so powerful,their potential for good or ill is magnified.

rating agencies (3)

A further potential problem with rating agency judgments has developed as a result of the complete dependence of some lenders on their assessments .This has resulted in the maintenance of specified minimum credit rating being included as covenant in medium term loan agreements .This means that the rating agency itself can trigger a loan default by changing it is credit rating of the borrower. There have been suggestions that the rating agencies have come under pressure from lending institutions and/or investors not to precipitate such developments thereby bringing their objectivity into question .
it is apparent that rating agencies do not always have superior knowledge . where lending institutions abdicate responsibility for credit assessment to some third party ,they lose control and take a different kind of risk.The underlying principle has to be that if you relinquish the task of credit assessment and rely on someone else,You had better be sure that that party does indeed have better Knowledge and judgment than you yourself could apply.

rating agencies (2)

so relying on rating agency judgments has a logic to it , but banks abdicate responsibility for credit assessment -their single most important risk-at their peril.an editorial in the financial times in December 1997,under the banner :'overrated Agencies ' commenting on the then current Emerging markets crisis said :
-what is becoming clear is that something rotten in us markets is helping make it worse ,namely the absurd reliance of investors on questionable judgments by credit rating agencies .
- in the past couple of days moody is and standard & poors have between them downgraded the long-term sovereign debt of south Korea to junk status .... no doubt there are risks -but if so ,why did the credit rating agencies wait until now to advice Their clients ? .
- this is not the first time that the rating agencies ,who are accountable to no one but wield enormous power in the credit markets , have come up with half-backed Judgments .

rating agencies (1)

the role of external rating agencies ,such as Standard &poors and moody is ,has become increasingly and steadily more important to banks in their evaluation of larger corporate credits . the original role of the rating agencies role of the rating agencies was to provide credit assessment for individual investors in commercial paper and corporate bonds issued BY LARGE CORPORATIONS .such investors lacked the banks knOWLEDGE AND SKILL IN CREDIT ASSSESSMENT AND NEEDED OBJECTIVE and professional credit analysis af the risks in volved in these financial instruments ,which were aimed at replacing bank lending as part of the process of disintermediation through which large corporates sought to reduce their borrowing costs .
many senior bankers,despite the capacity of their highly professional credit risk evaluators ,favour the Judgments of the rating agencies where the assessment of large corporates is concerned .the reason for this is that the rating agencies are perceived to be able to obtain asuperiorlevel of information than any single lender because they get privileged access to corporates . large companies have to satisfy if they want to achieve ahigh rating and thereby lower borrowing costs . they are , therefore, under more pressure to co-operate with them than they might with individual banks that can be played off against one another in the limiting of information availability .

Monday, March 16, 2009

environmental risk (2)

3- INDIRECT risk : if aborrower engage in an activity that damages the environment ,then it is profitability and hence it is capacity to repay could be weakened .such borrowers face :
- increasing costs of complying with ever-tightening environmental regulations ;
- fines for non-compliance with legislation ;
- costs for cleaning up apolluted site (and even where asite has been sold ,liability can flow back to the polluter under the legal principle of 'polluter pay s ) ;
- third party common law claims for contamination of nearby properties or water resource ;
- contingent liabilities from environmental warranties or indemnities given on the sale or purchase of land or abusiness ;
- managers being distracted ,production disrupted or the companies sales being damaged through apoor public image as aresult of polluting activities.
alander can gain adegree of protection from including environmental clauses in loan documentation ,Appropriate conditions precedent ,representations and warranties , covenants and events of default can alert lenders to problems at an early stage and trigger the capacity to seek early repayment .Obtaining insurance against clean up costs is another option but it be expensive and hard to find .

environmental risk (1)

most businesses incur some risk of their activties polluting the environment in some way. This risk impacts on lenders in three main ways-direct,reputational and indirect.
1- direct risk :in some countries alender may incur direct lagal liability for cleaning up contamination that has been caused by an insolvent borrower.In the UK ,for example ,the Environment ACT 1995 imposes aduty on local authorities to identify contaminated land and to serve upon the 'appropriate person' a'remediation notic' secifying the work that is required to clean up the contamination .if the lender has taken possession of the land through enforcement of security ,responsibility can fall on the mortgagee in possession . lenders need to evaluate the environmental risk before lending or taking possession of security .
2- reputational risk : lenders are increasingly wary about being associated with projects that might be deemed environmentally damaging .projects like new dams or nuclear power stations may well be capable of being financed by banks within the law and without legal liability for environmental damage ,but they carry other penalties for lenders in terms of bad publicity ,potential customer boycotts and being shunned by 'etical investors'.

Sunday, March 15, 2009

country risk

country risk ,also called transfer risk or country transfer risk ,arises where an bligation is not in the domestic currency of the country where it occurs .
it is traditionally thought of as arising in asituation where alending is made cross border and the risk is that acountry may be unwilling or unable to meet it is foreign currency obligations .it is separate from the credit risk of the borrower .the borrower can be solvent and able to repay the dept but is prevented from remitting hard currency outside the country because of the imposition of exchange control or the country simply running out of foreign exchange ,an example would be a US dollar lending acompany in adeveloping country . if that country ran short of us dollars ,the company would not be able to find the hard currency to meet the obligation .
Although country risk is commonly thought of as being across border risk , it can also arise in some demestic situations involving foreign currency lending .for example .abank in adeveloping country might run US dollar deposit accounts for that country is residents .it might lend those us dollars to businesses wanting to take advantage of lower US dollar interest rates than exist for the domestic currency ,the imposition of exchange control result in the state taking full control of all hard currency balance and incoming hard currency from exports .IN such circumstances ,the borrower may not be able to access the US dollars needed to meet the obligation .

MARKET RISK

when financial institutions talk about market risk ,it is generally in the context of assessing their exposure in commodities , securities or foreign exchange markets.market risk is the risk to an institution is financial position resulting from adverse movements in the level or volatility of market prices .market risk is measured by the practice of 'marking to market' .this machanism uses current market prices to calculate the profit or loss that has been made from price movements since the last valuation of the institution is assets and liabilities .the net value of essets and obligations is thereby known and controlled .
but lenders are exposed to market risk in more familiar situations than securities trading .lenders often rely on the value of essets to repay aborrowing .this most crucially arises when aloan has become doubtful and the lender looks to the asale of assets pledged as collateral to repay the debt .The practicality and cost of regular marking to market of assets held as security can be problematical ,but some from of systematic revaluation of assets that from asource of repayment ,even if it is only contingent ,has to be undertaken to ensure that value assumptions are correct .

interest rate risk

Most borrowing is undertaken on variable interest rate terms . borrowers will have made assumptions about the intersert rate that they will be charged in their plans to repay the borrowing . they are therefore exposed to the risk that their interest rate assumptions turn out be too optimistic.this could have asignificant effect on the borrower is capacity to repay.
fixing the interest rate in advance produces more certainty for both the borrower and the lender .if this is not possiple ,or the fixed rate is thought to be too unattractive hedging through instruments such as interest rate swaps ,forward rate agreements,interest rate caps ,floor and collars can be considered.
An interest rate swap is an exchange of interest paymet obligations between two parties without an exchange of the underlying principle repayment obligations .fixed interest obligations can be swapped for floating and vice versa.
A forward rate agreement (FRA) enables the customer to protect itself against adverse interest rate movements when there is aknown interest -related requirement at aKnown future data .THIS Is Achieved without incurring any commitment to take up the loan or place the deposit involved through the mechanism of agreeing with the bank afuture interest rate and then paying or receiving the interest differential between the rate agreed and the market rate on the agread settlement data .
interest rate caps ,floors and collars are all forms of interest rate option contracts that enable interest costs to be managed within arange agreed in return for afee .the customer does not have to exercise the option if it is not in his interests to do so .

currency risk

also Known as exchange risk,currency risk arises when an obligation has to be settled in acurrency other than your 'domestic' currency . Exchange rates move all the time and the mount of domestic currency that can be expected to be received for agiven amount of foreign currency will moves as aconsequence.
movements can be favourable , resulting in windfall gains they can equally easily be unfavourable .businesses that operate on tight profit margins can ill afford to have their expected income reduced ,or their costs increased , through unfavourable exchange rate movements . such businesses should either invoice in domestic currency when selling aboard ,or insist in paying in domestic currency for imports-in other words ,pass on the exchange risk to the buyer of goods when selling and/or to the seller of goods when buying .if this is not possible ,fixing the domestic currency amount to be received or paid through ahedging mechanism,such as aforward exchange contract,is advisable.
lenders are sometimes asked to lend in foreign currency .this is usually the case when there is tract record of interest rates for that currency being generally lower than for domestic currency borrowing.whilst this can be superficially attractive ,it can be highly dangerous with the borrower being exposed to adverse exchange rate movements.currency borrowing only usually makes sense where the borrower has areasonably certain cash inflow in that currency from , say , export sales , to meet the loan repayment and interest servicing requirements

Saturday, March 14, 2009

operational risk

In an ideal world , everything always goes according to plan .system always work and do the jobs they were designed for .documentations is always alegally watertinght and is properly completed .frauds are perpetrated on other people and are readily identifiesd before they can effect you .
murphy is law says that if something can go wrong , it will . systems can fail and vital information lost if not properly backed up . afire could destroy important security documentation if it is not properly protected .There is arisk involved simply in trying to ensure that things happen in the way they are intended to this is known as operational risk .
errors or omissions in documents can prove very costly . An assumption that a contract is legally enforceable underpins many credit decisions . But what if there is amisunderstanding or ignorance as to the meaning or significance of aclause or adocument? the whole basis of alending judgment can be proved wrong . failure of security documentation to prove enforceable when it is needed is abig cause of loss to lenders . these losses appear as credit losses in the bank is bad debt figures but are realy the result of operational failures .
It is the lucky lender who has avoided coming into contact with aborrower who has fraud in mind . borrowing money with the intention of running off with it and no thought of repaying is awell-established way of stealing relatively large sums .
fraudsters will target inexperienced lenders and use lies and misrepresentations to create an apparently viable lending proposition If alender parts with money without making the necessary level of enquiry into the borrower is bona fides and without controlling the lending with asufficient degree of diligence , then large losses will result .

the main type of ricks

the main type of ricks :
- operational risk
- currency risk
-interest rate risk
- market risk
- country risk
- environmental risk
- credit risk

Friday, March 13, 2009

measuring inflation

inflation can be measured by measuring the changes in the prices of goods and services . the trouble is that there are thousands of shops and millions of transaction each week.we cannot record each one centrally ! so,the government organizes certain samples in order to publish arrange of statistics called index numbers,in which the prices of (say ) food and housing are more important than the prices of clothing and perfume .there are several indices :
1- General Index of Retail prices (Known as the headling RPI) which uses January 1987 as its base or starting point.it is calculated once amonth and published on atuesday in the middle of the following month.
2- underlying inflation (called RPIX),which is headline RPI excluding interest paid on mortgages . this is the measure which is targeted by the government to be 2.5% pa in about two years time .
3- tax and price index ,also monthly ,which seeks to take in to consideration the changes in take-home pay caused by income tax and national insurance contributions . it tries to measure the purchasing power not of money but of take-home pay .
4- index numbers of producer prices :(a) materials and fuel purchased ,(b) output .these indices seek to measure changes in prices of items long before they reach the shops or are exported
5- average earnings index ,which is usually published about three or four days before the RPI.our earnings are important for two reasons -we spend them and so influence prices ;our employers pay them and so will try to raise prices in order to recoup their extra costs when earnings rise .

causes of inflation

inflation has many causes and economists often disagree as to which are the more important at any one time in aparticular country .however ,three main causes can be outlined :
1- demand-pull inflation ,where buyers bid up the prices of goods and services .
2- cost-push inflation ,where sellers have to increase prices because their costs -wages ,raw materials and fuel (especially oil)-have risen.
3- structural inflation,where acountry is wage bargaining and price determination are so organized that an easy solution to problems is to raise prices.

government borrowing and debt repayment

when the government spends more than it raises in taxation ,it has to find the money from somewhere . it borrows it ,from those pepole who buy national savings certificates or premium bonds or put money in the National savings bank , and also from pension funds and life assurance companies that buy government securities-called 'gilts - on the stock exchange ' gilts is short for gilt -edged meaning they are of the highest quality ,with no risk of interest not being paid or of default on repayment of the original loan . let us see what happens when somebody buys $100 of premium bonds , or apension fund buys $10 of gilt-edged securities from the govrenment.
the purchaser of the premium bonds pays $100 in cash or by cheque over the counter of apost office . his or her bank deposits fall by $100 -as does the money supply - and the government is holding of money (which are excluded from the money supply ) rise by $100. so ,money supply has fallen .
it is much the same with apension fund ,only the amounts involved are far larger . the pension fund buys the gilts from the government with a$10m cheque drawn on its bank account ;it is credit balance falls , as does the money supply . the government is balance at the bank of england rises by $10m , but the money supply does not increase ,because of the definition stated above .
therefore ,we can say that if the government borrows money from the general public , businesses and financial institutions ,this has acontractionary effect on the money supply ,in the same way as when taxes are collected .

Thursday, March 12, 2009

taxation and spending

whenever we pay our taxes ,such as VAT on goods we buy ,the money leaves our wallets ,purses or bank accounts and eventually reaches the bank accounts of the government at the bank of england .these taxes , when received by the government ,are excluded from the money supply.so,when people pay taxes ,the money supply falls.
but the government does not sit on this money paid in taxes -it spends it .when pensioners ,teachers,soldiers,students ,etc receive this money ,their cash or bank deposits rise ,and those of the government fall . it is the reverse of tax collecting ,so the money supply rises .
Now comes abig 'if',If the mount raised in taxation and the mount spent by the government are exactly equal,then the combined effect of taxation and spending is nil, because the increase in one cancels out the increase in the other .Money supply is unchanged.
If you say 'Nonsense ' they are never equal,because the government is always spending more than it raises in taxes ,then,surprisingly,you are only half right .let us see.

the banking system

You may be thinking 'what happens if there are three or four banks in the town? Not all the gold Withdrawn by borrowers Will return to our banker-perhaps only afifthَ well, you are right ,because if one bank 'goes it alone ' and lends , it is loans will end up as deposits with rival banks .
however, if the example were to refer to abanking system , ie all the banks in acountry , in wich all the banks expand their lending at roughly the same rate ,then the same thing might still happen.
most of the lending will return to the banks ,with only afraction being hald elsewhere in cash - perhaps in people is mattersses !-or being paid to the government ,eg in tax or to people overseas.Do not forget that money held by the government,and by banks and foreigners is not included in the m measures of the quantity of money .
so ,he banking system is asort of 'closed ciruit' with entry only from banks , the government and from overseas.which brings us to the role of the government .

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