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Term Paper: An Investor’s Guide to Measuring Risk

Country: Bahrain

Sample paper attached

OBJECTIVE

Whether you are a portfolio manager investing internationally in stocks and bonds or working for a business seeking to develop a multinational presence through foreign direct investment or greater diversification of revenue sources, business decision making in the 21st century requires an understanding of the risks associated with deploying funds abroad. In this project, you will assess international risk by choosing a particular country to follow throughout the quarter and developing a dossier on that country. Your dossier will include an assessment of the macroeconomic environment and policies related to exchange rates and capital flows, a discussion of institutional factors (legal, political, cultural, and social structures) that might influence decisions to invest capital in this country, and an assessment of how current news (that occurring over the next 10 weeks) affects your risk assessment. In choosing a country to study, you might consider one that, a priori, has some elevated level of risk for investors. If you need help thinking about this criterion, please see me in office hours or look ahead to Part IIA of the exercise and use the information on crises to help you select a country that has experienced financial and economic turmoil (although most do!). Please read all parts of this assignment for two reasons: (1) as described in part II, you will need to begin collecting any news articles that might change your assessment of risk and (2) you will need to manage your time wisely to meet the deadlines.

Part I: Assessing the Macroeconomic Environment (Due October 3th)

(40% of paper’s grade)

(Upload via Blackboard)

A. Data Collection and Interpretation

Go to the OECD’s World Economic Data base:

https://www.imf.org/external/pubs/ft/weo/2019/01/weodata/index.aspx

Choose your country from the database and proceed to select the indicators described in the next sentence by for the period 2005 – 2019 as well as future projections (some may go through 2023 or 2024). Find, or in some cases, tabulate the percentage change in real GDP, the inflation rate, the output gap, the unemployment rate, the structural budget deficit or surplus as a percent of GDP, and the current account balance as a percent of GDP. To help you interpret the data, which you will write about below, create bar diagrams or time-series plots of these measures, and include them at the back of your dossier (refer to them in the text by providing each figure with a number, i.e. Figure 1).

In section I of your dossier, entitled “Current Economic Trends,” describe the trends – past, present, and (plausible) future – of these key variables. What do you observe in the data? Are the measures rising or falling? Based on your understanding of macroeconomics, what do these suggest to you about the fiscal health of the country, the growth prospects, etc. Make sure to provide some analysis along these lines based on the indicators you have chosen. If any data were missing for your particular country, make sure to include a footnote indicating this.

Now visit Oanda’s website and use their currency graphing tool at http://www.oanda.com/currency/graph or FRED at https://fred.stlouisfed.org

to plot the exchange rate vis-à-vis the dollar for the last two years and add this picture to your dossier (take a screen shot or make a pdf of this and import it into your report as a figure attached to the back of the paper). Make a judgment as to whether this currency is fixed (peg or band) or floating based on what you observe. Do you detect any trend relative to the dollar? Now play around with longer periods. Do you see any trends? If so, create another plot and describe it. Has the degree of fixity changed over longer time periods? Now visit the IMF’s website https://www.imf.org/external/pubs/nft/2013/areaers/ar2013.pdf and locate the latest classification (2013) of the de facto exchange regimes in all countries around the world. Does your regime assessment agree with theirs for the period in which you plotted the most recent data? Discuss. If your country is listed in the Big Mac Index, http://www.economist.com/content/big-mac-index what does it tell you about whether your currency is under or overvalued in the long run? Label this section of your discussion “Exchange Rate Dynamics.”

See what you can find out about the major imports and exports of this economy by going to the homepage of the International Trade Center and selecting your country: http://www.intracen.org/itc/market-info-tools/trade-statistics/ Make a bar graph showing the shares (percentages) of the 10 leading imports and exports for this economy. Are there any changes in the global prices of the goods in which they export or import that might affect your assessment of risk? Based on these data, describe what kinds of shocks to trade might hurt this country’s current account? Can you find out anything about trends in tariff rates or other forms of non-tariff protection? You may have to dig more broadly online for this, and perhaps visit the website of the WTO (World Trade Organization). Is your country a member of WTO? Using other data available on this site for FDI (foreign direct investment), calculate the share of FDI as a percent of GDP (where the correct nominal GDP data will come from the IMF website you visited earlier). What are the major categories of FDI for this country? Write a description of the trends in FDI. Can you find out any information about short-term capital flows? Are they denominated in foreign or domestic currency? How big are they relative to the size of all capital flows, FDI, or GDP? Label this discussion “Balance of Payments.”

Finally, discuss how you might improve your ability to assess risk for this country based on this information. That is, is there anything else the assignment could have asked to allow you to understand whether this would be a risky country in which to transact?

B. Assessment

After collecting this information and writing up your results, submit your paper to Blackboard by the due date mentioned above. Once all papers are submitted, you will be assigned a classmate for peer assessment. Your job is now to analyze the report and assess its strengths and weaknesses, following a rubric. Please make general comments about where the analysis needs clarification or correction. After you have examined your peer’s dossier, write a paragraph describing (1) what you learned from reading it and (2) what you feel you would like more information in order to form a judgment about risk (this will help your peer with part 2). Finally, if you feel there are any, describe any trends or make any relevant observations that were not spotted by the author.

Part II: Institutions and Political Risk

(60% of paper’s grade)

(Uploaded via Blackboard)

As we will discuss in class, foreign exchange traders try to forecast the exchange rate. In this project, we are, in part, exploring how this is done. We are also learning how markets assess country-specific risk and use it to price assets, like bonds issued by governments (i.e., sovereign bonds) and corporations.

Objective:

Thus far, we have focused on developing an overview of the macroeconomic environment to think about “fundamentals.” Changes in GDP, interest rates, and inflation rates are key components of many bond traders and FX traders’ forecasts. In this section, we begin to explore other factors, some of which create an “environment” for investment; that is, they help foreign investors understand how difficult it is to set up a company or carry out portfolio investment. Included in the investment environment are political factors, such as governmental stability, protection of property rights, corruption, etc. Factors that influence this “political risk” or “country-specific risk” can vary enormously across countries and over time, and thus account for much of the cross-country variation we see in interest rates by borrowers in different countries. In this part of your dossier, you will gather information about some of the most widely tracked political and institutional factors.

A. Historical Information

We begin with an exploration of a country’s borrowing history. The past can give us insight into how credible political regimes are in keeping their promises. We would like to learn whether a country has experienced any severe crises, be they domestic-debt crises, sovereign-debt crises, high-inflation episodes, or banking crises. Use the text and data tables found in Reinhart and Rogoff, (especially tables 3-7, 9, 11-13 A2, and A3) as a starting point to identify crisis episodes: http://www.nber.org/papers/w13882.pdf

You can also visit their database: http://www.reinhartandrogoff.com/data/

Create a data table (if there are multiple crises), listing the chronology and types of crises and discuss how the episodes might influence investors’ decisions to invest. If the crisis episodes for your country are discussed therein, then include some insights (citing references appropriately). If not, then use the web to find out more about the particular episodes now that you have identified the dates. Please use the following questions to help you write up this part of your risk assessment:

1. Has the monetary policy of the country been run in a credible fashion? That is, do they print too much money; do politicians fire their central bankers often or are they insulated from this?
2. Has the fiscal policy been carried out in a sustainable fashion?
3. Are there any characteristics, institutional or otherwise, that seem to make this country crisis prone or more “immune” to crises?
4. What is the history of repayment of debt? What do you think the likelihood of reneging on a promise to pay is in the future?

B. Quality of Institutions

We next consider the institutional environment of conducting business or investing in a country. Use the World Bank’s “doing business survey” found at: http://www.doingbusiness.org/rankings

1. What variables make up these rankings? How are they determined? You will need to look at the methodology link to answer this?
2. How would investors use them to assess risk?
3. How does your country perform? Does it score high in some areas and low in others?
4. Have its values changed recently?
5. What do you take away from this if you were assessing risk?

Now examine the World Bank’s Governance Indicators data set listed here (click on Excel download for rankings file).

http://info.worldbank.org/governance/wgi/index.aspx#home

1. How are the rankings determined? You may need to read some about the methodology to adequately carry this out. (Please consult the referenced working paper on the website.)
2. There are six measures (rule of law, voice and accountability, etc.) Plot these six measures on a single graph since 2000 and describe any trends you see for your country. How stable are they?
3. What do you think these variables tell us about a country and investor risk? Explain why or why not they contribute to an environment that contributes to long-term investment in a country.
4. How might changes in current geopolitics influence some of these rankings, if any?

C. Contemporary Affairs

From now, until the last week of class, collect news articles that tell us about the current political and economic environment of the country. Summarize your findings and relate them to risk assessment, drawing on the following questions to frame your thinking:

1. What are the main factors presently affecting the outlook of this country? What does the news tell you about the political situation, the economic situation, etc.?
2. Has the political regime changed recently? Does it change frequently? How would these changes affect investor sentiment?
3. Are there any global changes in politics or economics that are particularly important for us to understand the environment for risk.
4. Make sure to provide proper citations in your references list or in footnotes.

III. Overall Assessment

(Included as part of Part II’s 60%)

Based on your understanding of the history, institutions, macroeconomic environment, and recent news of your country, form an assessment of how exchange rates and country risk on foreign-denominated debt issued by this country will move in the near future. Support your analysis with the information you have obtained in Parts 1 & 2 of this project. That is, you should use this section to pull together the main “drivers” of risk based on your understanding. You ought to leave yourself sufficient time to do so by developing Section II information in advance of the last two weeks of the class.

In your final document or dossier, make sure to include your original macro assessment. This should be updated to take into account any feedback you received from your peer review. All parts of your final analysis should be labeled appropriately so what you turn in is easy to follow.

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