Robert Merton (2004) - How to Focus on Comparative Advantage while Efficiently Diversifying Economic Risks: An Application of Modern Financial Technology

My remarks are divided into three parts, three points. First modern contracting technology as exemplified by the SWAP contract is a powerful tool for innovation because it combines the benefits of customisation with the simplicity of cost benefits of standardisation. Second point: Modern financial technology permits the separation of risk exposure selection and management from physical and capital expenditure. Whether for firms or countries risk exposures can be radically changed without affecting capital, trade or income flows or even the traditional balance sheet. Market accepted financial technology exists, it makes it possible to do so in much larger size and at much lower cost than in the not too distant past. Thus is a practical matter risk is now a separable dimension of management decisions. Third point, innovations using existing market proven technology, financial contracting technology offer the prospect to eliminate or greatly reduce the economic trade-off between pursuing comparative advantage and pursuing the efficient risk diversification. This applies whether at the level of the individual, household, firm, financial institution or again an entire country. I will illustrate using a specific example from managing country risk in the public sector. If time permits, and I doubt it, I will happily discuss other examples from financial institutions or non-financial corporate sector or even for households. I did allude to households in my round table discussion yesterday. Now, I want to consider applying this in the case of managing a whole country. So we went from a banker for twenty years to managing a country which to my knowledge has really not been done except in some very sporadic ways. But what I will describe is something that is entirely feasible to do today. I want you to consider two countries, say Taiwan - I pick Taiwan because it has a very important part of its economy is concentrated in computer chips, that's the nature of it. You take Chile and Chile's concentration is forestry and mining. Taiwan has neither forestry or mining, commercially, and Chile doesn't do chips. So they are both relatively diversified, more concentrated than you will find. Now, suppose you analyse the risk of these countries, the policy makers decided that they would like to spread out the risk, not have such concentrated risk as they have right now, single industries. In the old, old days, the solution might be in industrial policy in which you develop a second industry, even if it's not the best industry because in the name of risk diversification you may develop an industry that otherwise is not as competitive as the best of its kind out there. But you may do it if it's the only way to diversify risk. What we could do here, instead of building an industry and going through all that process and expense, you could just enter into a SWAP contract. What SWAP contracting you might try? Look at it from the point of view of Taiwan, Taiwan can enter into a SWAP on which say on 10 billion dollars, it's a notional amount. The contract says: We, Taiwan, will pay to our counterpart whatever the total return, meaning dividends plus capital gains or losses, total return on a portfolio, world portfolio of chip stocks. Intel, AMD and so forth, Bill Sharpe can put it together for us, and have it validated, this is indeed a world portfolio for chip stocks. At the end of each period it could be 90 days, six months or one year, you set the terms, you would look at that total return on that portfolio. And whatever that number is, 10%, 12%, would be applied to 10 billion dollars and that's what Taiwan would have to pay to its counterpart. The other part of the contract says that the counterpart in return would pay to Taiwan the total return earned on a world portfolio of say mining stocks. Again with Bill's aid. So the effect of this is the following: At the end of each period you look at the total return on the chips stock, the total return on the mining stock, if the chips stocks were 12% and the mining stocks were 8%, Taiwan would have to pay 12 and receive back 8, the net of that is Taiwan would have to pay 4% to the counterpart. If on the other hand however chips stocks had earned 8% and mining stocks 12%, Taiwan would receive 4% of 10 billion dollars or 400 million dollars. So that's how the SWAP contracts work. Let's look at the economics of what is done by entering into such contracts. In effect Taiwan has transferred 10 billion dollars worth of risk of investment in world chips exposure. And received in return 10 billion dollars worth of world mining exposure. It's no different than if they really had sold and done all that sort of thing. And by attaching it to the securities, total returns rather than the dividends growth or earnings growth, you really are hedging your risk because it's the value of the whole stream, not one period stream. So it's a very simple transaction, however what we've done is we have now got Taiwan more diversified by reducing its chip exposure and increasing its exposure to other things. And we've also made Chile more diversified by giving it exposure to chips without Chile having to go into the computer chip business. Now you can substitute, instead of bilateral chips or mining, you can have everyone of them go in directly to the world portfolio. One of the natural places where this might get implemented and has been in one country that I'm aware of is to the extent that countries have pension funds. It's very common in those countries for the rules to say pension funds all the assets or most of the assets have to be invested locally. So in Canada I don't know whether it's 70%, now it used to be 90%. In Canada 90% of all pension funds had to be invested locally. And I don't need to explain to this group what's the rational for that. Whether it's right or wrong, but you can see, they want to the funds to stay local. You are also worried that if you've too much foreign ownership, you lose governance control of your local industries. So those are two reasons you might want to keep. One reason I don't think for having that policy is to force on the pensioners either in Canada or anywhere else a concentrated risk that, while Canada is a great country and has wonderful industries, it's nevertheless pretty concentrated relative to the world portfolio. And you've imposed on the pensioners a concentrated exposure when there's no particular reason. So what we do here and what's actually done in Canadian pension funds is they actually do hold the assets in Canada following the rules, but then they swap out the returns for a diversified set of equity returns. By the way I should underscore this is fully understood by the Canadian government, so this is not subverting, this is not an attempt to get around regulation. What it's attempting to do is to allow the positive parts of policy that were the wonderfully intended purpose of setting these rules to continue. While eliminating the so-called side effects. This chart which you probably can't see in brilliant colours, but this is some work done by my colleague at Harvard Business School, André Perold, he analysed the total returns of the last 30 years of the 20th century. He presented these in pictures in a class for Bill Sharpe and Harry Markowitz. Expected or average return is at the ordinate and risk measured by volatility, standard deviation is measured along here. So risk is in this direction and expected return is this direction. And the plot is the exposed 30 year returns variation and average for the world portfolio, market portfolio, US equities, developed equities, Japanese equities, UK equities, European equities, German equities, French, US bonds, developed market bonds etc. But in particular emerging market bonds and emerging market equity. All done in dollar terms. And we just plotted all these points here, which you can't see. First thing I want to point out, which is not related to my lecture but it is a tribute to Bill Sharpe, there was no guarantee this would happen... but if you look at the trade-off of risk return you can achieve any point between the risk free which is about 6% and any other point here by just levering up and down. So any point is achievable, you can draw a line between any two points ... Clearly the higher the slope the better for the investor because you are getting more return for each unit of risk. So the steepest slope - by the way that slope is the Sharpe ratio - the steeper the slope the better. The more efficient in terms of risk return. This white box up here is the world market portfolio, at least of stocks and bonds. And it turned out exposed to be the most efficient. No guarantee of that. But what I will show you, since you can't see it probably, see this point here, that's the 30 years for investing in a portfolio of emerging market equity. The risk of that is 22% annual standard deviation. We expect average return if you went across is about 9%. If you were willing to take the same 22% risk but instead of concentrating that risk in a portfolio of emerging market equity, but put it in the world portfolio, following Sharpe's advice, you could go straight north feasibly from this point to that black line. Because that black line represents the menu of investments you could make by mixing the world market portfolio with the risk of the asset. Just levering it up and down. If you make that point going up, you will discover the intersection is something over 16%, 15.5%. The point as I mentioned yesterday, as a crude number, had this developed portfolio of nations interacting, they had instead been able to diversify and you will see pursuing comparative advantage, not diversified by trying to build mini-worlds in their countries, which is totally unfeasible and economically flawed. But if they had transformed the risk in that direction, if they had been able to go all the way that would have been approximately 600 basis points. As I mentioned yesterday, if you apply that to 30 years, that's a multiple of five to six times wealth. So the message here is: You can diversify risk while maintaining, whether it's Taiwan and chips or Chile and forestry, you can maintain focus on your comparative advantage and at the same time use contracting in a real way to get rid of the risk. Thank you very much.

Robert Merton (2004)

How to Focus on Comparative Advantage while Efficiently Diversifying Economic Risks: An Application of Modern Financial Technology

Robert Merton (2004)

How to Focus on Comparative Advantage while Efficiently Diversifying Economic Risks: An Application of Modern Financial Technology

Abstract

One of the classic economic tradeoffs is between following the fundamental dictum to pursue comparative advantage which generally requires focus on a few related activities and implementing the equally fundamental dictum of efficient risk diversification which requires engagement in many, relatively unrelated activities. Modern financial technology makes it possible to separate risk-exposure selection and management from the choice of physical and capital expenditure plans. It is now feasible to radically change risk exposures without affecting capital, trade or income flows or the stock of assets or liabilities. Market-accepted financial technology exists that makes it possible to do so in much larger size and at much lower cost than in the not-too-distant past. Thus, as a practical matter, risk is now a separable dimension of management desicions.

In my remarks, I will develop and illustrate the idea of using financial technology to greatly reduce or even eliminate altogether this classic tradeoff in a series of examples at the levels of the firm, the financial institution, and the entire country. I close with some observations on implications of these new technologies for private-sector management and implementing public-sector economic policies.

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