Topic of the Week - Dutch Disease

Dutch disease is an economic concept that tries to explain the seeming relationship between the exploitation of natural resources and a decline in the manufacturing sector. The theory is that an increase in revenues from natural resources will de-industrialize a nation's economy by raising the exchange rate, which makes the manufacturing sector less competitive. However, it is extremely difficult to definitively say that Dutch disease is the cause of the decreasing manufacturing sector, since there are many other factors at play in the economy. While it most often refers to natural resource discovery, it can also refer to "any development that results in a large inflow of foreign currency, including a sharp surge in natural resource prices, foreign assistance, and foreign direct investment."

The term was coined in 1977 by The Economist to describe the decline of the manufacturing sector in the Netherlands after the discovery of natural gas in the 1960s.

The "Core Model"

The classic economic model describing Dutch Disease was developed by the economists W. Max Corden and J. Peter Neary in 1982. In the model, there is the non-traded good sector (this includes services) and two traded good sectors: the booming sector, and the lagging sector, also called the non-booming tradable sector. The booming sector is usually the extraction of oil or natural gas, but can also be the mining of gold, copper, diamonds or bauxite, or the production of crops, such as coffee or cocoa. The lagging sector generally refers to manufacturing, but can also be agriculture; there can be de-agriculturalisation in addition to de-industrialization.

A resource boom will affect this economy in two ways. In the resource movement effect, the resource boom will increase the demand for labor, which will cause production to shift toward the booming sector, away from the lagging sector. This shift in labor from the lagging sector to the booming sector is called direct-deindustrialisation. However, this effect can be negligible, since the hydrocarbon and mineral sectors generally employ few people. The spending effect occurs as a result of the extra revenue brought in by the resource boom. It increases the demand for labor in the non-tradable, shifting labor away from the lagging sector. This shift from the lagging sector to the non-tradable sector is called indirect-deindustrialisation. As a result of the increased demand for non-traded goods, the price of these goods will increase. However, prices in the traded good sector are set internationally, so they cannot change. This is an increase of the real exchange rate.

Cool Dude - Benjamin Graham

Benjamin Graham (May 8, 1894 – September 21, 1976) was an influential economist and professional investor who is today often called the "Father of Value Investing" and the "Dean of Wall Street." He is perhaps best known today from frequent references made to him by billionaire investor Warren Buffett, who studied under Graham at Columbia University, and was his only pupil to receive an A+. Other well known students of Graham include William J. Ruane, Irving Kahn, Walter J. Schloss, and Charles Brandes. Buffett, who credits Graham as grounding him with a sound intellectual investment framework, described him as the second most influential person in his life after his own father. In fact, Graham had such an overwhelming influence on his students that two of them, Buffett and Kahn, named their sons after him.

His book, Security Analysis, (with David Dodd), was published in 1934 and has been considered a bible for serious investors since it was written. It and The Intelligent Investor published in 1949 (4th revision, with Jason Zweig, 2003), are his two most widely acclaimed books. Warren Buffett describes The Intelligent Investor as "the best book on investing ever written."

Graham exhorted the stock market participant to first draw a fundamental distinction between investment and speculation. In Security Analysis, he proposed a clear definition of investment that was distinguished from speculation. It read, "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

For his biography please visit : http://www.buffettsecrets.com/benjamin-graham-biography.htm

Topic of the Week - Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is used in finance to determine a theoretically appropriate required rate of return (and thus the price if expected cash flows can be estimated) of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. The CAPM formula takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), in a number often referred to as beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset.

The model was introduced by Jack Treynor, William Sharpe, John Lintner and Jan Mossin independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. Sharpe received the Nobel Prize in Economics (jointly with Harry Markowitz and Merton Miller) for this contribution to the field of financial economics.

The formula

The CAPM is a model for pricing an individual security (asset) or a portfolio. For individual security perspective, we made use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:

,

The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).

Where:

• is the expected return on the capital asset
• is the risk-free rate of return
• (the beta coefficient) the sensitivity of the asset returns to market returns, or also ,
• is the expected return of the market
• is sometimes known as the market premium or risk premium (the difference between the expected market rate of return and the risk-free rate of return). Note 1: the expected market rate of return is usually measured by looking at the arithmetic average of the historical returns on a market portfolio (i.e. S&P 500). Note 2: the risk free rate of return used for determining the risk premium is usually the arithmetic average of historical risk free rates of return and not the current risk free rate of return.

Topic of the Week : Sharpe Ratio

The Sharpe ratio or Sharpe index or Sharpe measure or reward-to-variability ratio is a measure of the mean excess return per unit of risk in an investment asset or a trading strategy. Since its revision by the original author made in 1994, it is defined as:

,

where R is the asset return, R_f is the return on a benchmark asset, such as the risk free rate return, E[R − R_f] is the expected value the excess of the asset return over the benchmark return, and σ is the standard deviation the excess return (Sharpe 1994).

Note, if R_f is a constant risk free return throughout the period, . Sharpe's 1994 revision acknowledged that the risk free rate changes with time, prior to this revision the definition was assuming a constant R_f.

The Sharpe ratio is used to characterize how well the return of an asset compensates the investor for the risk taken. When comparing two assets each with the expected return E[R] against the same benchmark with return R_f, the asset with the higher Sharpe ratio gives more return for the same risk. Investors are often advised to pick investments with high Sharpe ratios.

Sharpe ratios, along with Treynor ratios and Jensen's alphas, are often used to rank the performance of portfolio or mutual fund managers.

This ratio was developed by William Forsyth Sharpe in 1966. Sharpe originally called it the "reward-to-variability" ratio in before it began being called the Sharpe Ratio by later academics and financial professionals. Recently, the (original) Sharpe ratio has often been challenged with regard to its appropriateness as a fund performance measure during evaluation periods of declining markets (Scholz 2007).