International trade and Portfolio

Diversification

SUBMITTED BY:
KITTY SINGLA
MBA 4503/10
DEEPSHIKHAR
MBA 4547/10

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International Trade

Introduction

International trade uses a variety of currencies, the most important of which

are held as foreign reserves by governments and central banks. Here the
percentage of global cumulative reserves held for each currency between
1995 and 2005 are shown: the US dollar is the most sought-after currency,
with the Euro in strong demand as well.

What is International Trade?

International trade is exchange of capital, goods, and services across
international borders or territories. In most countries, it represents a
significant share of gross domestic product (GDP). While international trade
has been present throughout much of history, its economic, social, and
political importance has been on the rise in recent centuries.

Industrialization, advanced transportation, globalization, multinational

corporations, and outsourcing are all having a major impact on the
international trade system. Increasing international trade is crucial to the
continuance of globalization. Without international trade, nations would be
limited to the goods and services produced within their own borders.

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Difference between international trade and domestic
trade:

The main difference is that international trade is typically more costly than
domestic trade. The reason is that a border typically imposes additional costs
such as tariffs, time costs due to border delays and costs associated with
country differences such as language, the legal system or culture.

• Another difference between domestic and international trade is that

factors of production such as capital and labour are typically more
mobile within a country than across countries. Thus international trade
is mostly restricted to trade in goods and services, and only to a lesser
extent to trade in capital, labor or other factors of production. Then
trade in goods and services can serve as a substitute for trade in
factors of production.

Instead of importing a factor of production, a country can import goods that

make intensive use of the factor of production and are thus embodying the
respective factor. An example is the import of labor-intensive goods by the
United States from China. Instead of importing Chinese labor the United
States is importing goods from China that were produced with Chinese
labor.

Top trading nations

Rank Country Exports + Date of

Imports information
European Union (Extra-
- $3,197,000,000,000 2009 est.
EU27)
1 United States $3,173,000,000,000 2010 est.
2 People's Republic of $2,813,000,000,000 2010 est.

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 China
3 Germany $2,457,000,000,000 2010 est.
4 Japan $1,402,000,000,000 2010 est.
5 France $1,086,400,000,000 2010 est.
6 United Kingdom $952,100,000,000 2010 est.
7 Italy $918,100,000,000 2010 est.
8 South Korea $884,200,000,000 2010 est.
9 Netherlands $859,700,000,000 2010 est.
10 Canada $813,200,000,000 2010 est.
- Hong Kong $795,600,000,000 2010 est.
11 Singapore $666,800,000,000 2010 est.
12 Russia $614,000,000,000 2010 est.
13 Mexico $609,000,000,000 2010 est.
14 Spain $592,900,000,000 2010 est.
15 Belgium $560,900,000,000 2010 est.
16 India $528,000,000,000 2010 est.
Taiwan (Republic of
17 $524,800,000,000 2010 est.
China)
18 Switzerland $453,000,000,000 2010 est.
19 Australia $411,100,000,000 2010 est.
20 Brazil $387,400,000,000 2010 est.

Source : Exports. Imports. The World Factbook.

Top traded commodities (exports)

Rank Commodity Value in US$ Date of

('000) information
Mineral fuels, oils, distillation
1 $1,658,851,456 2009
products, etc
2 Electrical, electronic equipment $1,605,700,864 2009
Machinery, nuclear reactors,
3 $1,520,199,680 2009
boilers, etc
Vehicles other than railway,
4 $841,412,992 2009
tramway
5 Pharmaceutical products $416,039,840 2009
6 Optical, photo, technical, $396,337,696 2009

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 medical, etc apparatus
7 Plastics and articles there of $386,628,064 2009
Pearls, precious stones, metals,
8 $320,174,080 2009
coins, etc
9 Organic chemicals $310,106,432 2009
10 Iron and steel $273,024,416 2009

Regulation of international trade

Traditionally trade was regulated through bilateral treaties between two

nations. For centuries under the belief in mercantilism most nations had high
tariffs and many restrictions on international trade. In the 19th century,
especially in the United Kingdom, a belief in free trade became paramount.
This belief became the dominant thinking among western nations since then.
In the years since the Second World War, controversial multilateral treaties
like the General Agreement on Tariffs and Trade (GATT) and World Trade
Organization have attempted to promote free trade while creating a globally
regulated trade structure. These trade agreements have often resulted in
discontent and protest with claims of unfair trade that is not beneficial to
developing countries.

Free trade is usually most strongly supported by the most economically

powerful nations, though they often engage in selective protectionism for
those industries which are strategically important such as the protective
tariffs applied to agriculture by the United States and Europe. The
Netherlands and the United Kingdom were both strong advocates of free
trade when they were economically dominant, today the United States, the
United Kingdom, Australia and Japan are its greatest proponents. However,
many other countries (such as India, China and Russia) are increasingly
becoming advocates of free trade as they become more economically

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powerful themselves. As tariff levels fall there is also an increasing
willingness to negotiate non tariff measures, including foreign direct
investment, procurement and trade facilitation. The latter looks at the
transaction cost associated with meeting trade and customs procedures.

Traditionally agricultural interests are usually in favour of free trade while

manufacturing sectors often support protectionism This has changed
somewhat in recent years, however. In fact, agricultural lobbies, particularly
in the United States, Europe and Japan, are chiefly responsible for particular
rules in the major international trade treaties which allow for more
protectionist measures in agriculture than for most other goods and services.

During recessions there is often strong domestic pressure to increase tariffs

to protect domestic industries. This occurred around the world during the
Great Depression. Many economists have attempted to portray tariffs as the
underlining reason behind the collapse in world trade that many believe
seriously deepened the depression.

The regulation of international trade is done through the World Trade

Organization at the global level, and through several other regional
arrangements such as MERCOSUR in South America, the North American
Free Trade Agreement (NAFTA) between the United States, Canada and
Mexico, and the European Union between 27 independent states. The 2005
Buenos Aires talks on the planned establishment of the Free Trade Area of
the Americas (FTAA) failed largely because of opposition from the
populations of Latin American nations. Similar agreements such as the
Multilateral Agreement on Investment (MAI) have also failed in recent
years.

Risk in international trade

Companies doing business across international borders face many of the
same risks as would normally be evident in strictly domestic transactions.
For example,

• Buyer insolvency (purchaser cannot pay);

• Non-acceptance (buyer rejects goods as different from the agreed
upon specifications);
• Credit risk (allowing the buyer to take possession of goods prior to
payment);

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 • Regulatory risk (e.g., a change in rules that prevents the transaction);
• Intervention (governmental action to prevent a transaction being
completed);
• Political risk (change in leadership interfering with transactions or
prices); and
• War and other uncontrollable events.

In addition, international trade also faces the risk of unfavorable exchange

rate movements (and, the potential benefit of favorable movements).

Gallery

Globalisation: Peugeot in Jakarta, Indonesia. International trade

coincides with the expansion of multinational corporations.

Triangle trade: Slaves being sold from Africa to The Caribbean, sugar
from South America to New England, and Rum and other goods from
North America back to Africa.

Some people do not see international trade favourably: here a child

protests against the WTO in Jakarta.

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Portfolio Diversification:
First of all we would discuss what is portfolio and then diversification, and
after that both ….

What is portfolio?
In finance, a portfolio is a collection of investments held by an institution or
an individual.

Holding a portfolio is a part of an investment and risk-limiting strategy

called diversification. By owning several assets, certain types of risk (in
particular specific risk) can be reduced. The assets in the portfolio could
include bank accounts, stocks, bonds, options, warrants, gold certificates,
real estate, futures contracts, production facilities, or any other item that is
expected to retain its value.

In building up an investment portfolio a financial institution will typically

conduct its own investment analysis, while a private individual may make
use of the services of a financial advisor or a financial institution which
offers portfolio management services.

Portfolio management involves deciding what assets to include in the

portfolio, given the goals and risk tolerance of the portfolio owner. Selection
involves deciding which assets to acquire/divest, how many to
acquire/divest, and when to acquire/divest them. These decisions always
involve some sort of performance measurement, most typically the expected
return on the portfolio, and the risk associated with this return.

What is diversification?

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A risk management technique that mixes a wide variety of investments
within a portfolio. The rationale behind this technique contends that a
portfolio of different kinds of investments will, on average, yield higher
returns and pose a lower risk than any individual investment found within
the portfolio.
In finance, diversification means reducing risk by investing in a variety of
assets. If the asset values do not move up and down in perfect synchrony, a
diversified portfolio will have less risk than the weighted average risk of its
constituent assets, and often less risk than the least risky of its constituents.
[1]
. Therefore, any risk-averse investor will diversify to at least some extent,
with more risk-averse investors diversifying more completely than less risk-
averse investors.

It is important to remember that diversification only works because

investment in each individual asset is reduced. If someone starts with
$10,000 in one stock and then puts $10,000 in another stock, they would
have more risk, not less. Diversification would require the sale of $5,000 of
the first stock to be put into the second. There would then be less risk.

The risk reduction from diversification does not mean anyone else has to
take more risk. If person A owns $10,000 of one stock and person B owns
$10,000 of another, both A and B will reduce their risk if they exchange
$5,000 of the two stocks, so each now has a more diversified portfolio

Examples
The simplest example of diversification is provided by the proverb "don't put
all your eggs in one basket". Dropping the basket will break all the eggs.
Placing each egg in a different basket is more diversified. There is more risk
of losing one egg, but less risk of losing all of them. In finance, an example
of an undiversified portfolio is to hold only one stock. This is risky; it is not
unusual for a single stock to go down 50% in one year. It is much less
common for a portfolio of 20 stocks to go down that much, even if they are
selected at random. If the stocks are selected from a variety of industries,
company sizes and types (such as some growth stocks and some value
stocks) it is still less likely.

Further diversification can be obtained by investing in stocks from different

countries, and in different asset classes such as bonds, real estate and
commodities like heating oil or gold

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Diversifiable and non-diversifiable risk ••

The Capital Asset Pricing Model introduced the concepts of diversifiable

and non-diversifiable risk. Synonyms for diversifiable risk are idiosyncratic
risk and security-specific risk. Synonyms for non-diversifiable risk are
systematic risk, beta risk.

If one buys all the stocks in the S&P 500 one is obviously exposed only to
movements in that index. If one buys a single stock in the S&P 500, one is
exposed both to index movements and movements in the stock relative to the
index. The first risk is called “non-diversifiable,” because it exists however
many S&P 500 stocks are bought. The second risk is called “diversifiable,”
because it can be reduced it by diversifying among stocks, and it can be
eliminated completely by buying all the stocks in the index.

Corporate diversification strategies

In corporate portfolio models, diversification is thought of as being vertical
or horizontal. Horizontal diversification is thought of as expanding a product
line or acquiring related companies. Vertical diversification is synonymous
with integrating the supply chain or amalgamating distributions channels.

Portfolio Diversification and Risk Management

Portfolio diversification can be a valuable stock investing concept for every

investor whose ultimate goal is to maximize profit and minimize risk. The
principle of maximizing profits and minimizing risks is so simple, yet its
practice is seemingly an impossible task. While the best investment advice

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abounds throughout investment circles, any wise and mature approach to
investing is the same. Your best protection against risk is portfolio
diversification; investing in multiple investment options instead of choosing
to place all of your investments in only one area. one can, for example, use
the stability of cash investments like CDs and money market funds to
diversify your portfolio and offset the liability of stocks, futures, options and
stock or bond mutual funds. Picking stocks of riskier small growth
companies while also investing in the traditional blue chippers, which are
the stocks of large, well-established companies allows for a structured
stability that will translate to the bottoms line of an investor’s portfolio. In
other words, when the return is down in one area, it’s usually balanced by a
positive performance in another. In the simplest terms, portfolio
diversification is an excellent hedge against stock volatility and the ups and
downs of investing.

As with any stock trading plan, it is imperative to evaluate assets and realign
the investment mix from time to time. For example, as the value of a stock
increases, it consumes a larger percentage of the total, thus affecting the total
diversification of the portfolio. In an effort to maintain a healthy balance, it
may be necessary to decrease the holding in that particular stock and
increase in a different area, such as bond or cash holdings. Such decisions
require not only experience but the benefit of a method such as candlestick
chart analysis.

In all likelihood, a well-diversified portfolio will contain most, or all, of the

following: stocks, bonds, mutual funds, cash equivalents like Treasury bills
or money funds, as well as other types of investments. Being able to
diversify over a broad range of investment options can help minimize many
of the dramatic ups and downs in investing. It has been shown through
research that, over extended periods of time, investors are actually able to
reduce the level of stock volatility in their portfolios (by diversifying)
without sacrificing much in the way of profit at the bottom line. Establishing
a well diversified portfolio is crucial, and it is dependent on available assets,
money management, risk tolerance, and long term investing goals.

Simply stated, asset allocation is diversifying an investment portfolio among

various categories, also know as asset classes. A typical allocation, for
example, would put 60% of the available capital in stocks, 30% in bonds,
and the other 10% in cash.

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What is an asset class?
It to say that asset classes are significantly different investments. Here are
some examples:

• Stocks, bonds, real estate, commodities, precious metals and

collectibles. But here the classes are already starting to blur, as many
investments in real estate, commodities and precious metals are in the
form of common stock.
• Market capitalization: micro-, small-, mid- and large-cap.
• Style: Value, growth, aggressive growth, blend, and growth and
income.
• A combination of market capitalization and style: small-cap value,
large-cap growth, etc.
• Market sectors or industries.
• Industry groupings such as consumer staples and consumer durables.
• Geography and type of security: Domestic stock, international stock,
emerging markets debt, etc.

A Well-Diversified Portfolio
The definition is highly dependent upon factors that are unique to each
investor. Those factors include: risk tolerance, targeted terminal wealth,
investment horizon (planned holding period) and the universe an individual
is willing to accept as the pool from which they will select their assets.

Well-conceived portfolio diversification will result in the construction a

well-diversified portfolio that will serve you well in achieving long-term
investment goals.

Diversified portfolios may produce combinations of risk and return that

dominate non-diversified portfolios.

Table 2: Combinations of risk and return

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Consider part (i) of the table. In this case both assets have the same expected
return (20 per cent) and the same degree of risk. (The possible range of
outcomes is between 10 and 30 per cent on each asset.) If all that mattered in
investment decisions were the risk and return of individual shares, the
investor would be indifferent between assets A and B. Indeed, if the choice
were between holding only A or only B, all investors should be indifferent
(whether they were risk-averse, risk-neutral, or risk-loving) because the risk
and expected return are identical for both assets. However, this is not the end
of the story, because the returns on these assets are not independent. Indeed,
there is a perfect negative correlation between them: when one is high the
other is low, and vice versa.

. Let the investor decide to hold half his wealth in asset A and half in asset
B. His risk will then be reduced to zero, since his return will be 20 per cent
whichever situation arises. This diversified portfolio will clearly be preferred
to either asset alone by risk-averse investors. The risk-neutral investor is
indifferent to all combinations of A and B because they all have the same
expected return, but the risk-lover may prefer not to diversify. This is
because, by picking one asset alone, the risk-lover still has a chance of
getting a 30 per cent return and the extra risk gives positive pleasure.

Risk-averse investors will choose the diversified portfolio, which gives

them the lowest risk for a given expected rate of return, or the highest
expected return for a given level of risk.

International Trade and portfolio diversification

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The relationship between international trade and portfolio
diversification is related to the portfolio diversification in terms of
export and import goods.
Our study is based on:
• How the country diversify their export and import portfolio.
• Why there is need to diversify export and import activity

Export diversification i.e. diversification of export goods

Exports are important for growth and development; developing Countries
have been struggling with the challenge of expanding and
diversifying their export baskets beyond their primary product bases for a
long time. It is now well established that, openness to trade and integration
into Global markets is a central element of successful growth strategies;
and higher and sustained economic growth is associated with export
growth.

Why Exports matter?

Export growth, defined as the expansion of exports in volume and
value, as critical for any country for a variety of macro and microeconomic
reasons including the:
(i) need to generate foreign exchange vital to finance imports;
(ii) Need to exploit larger scale economies that can be achieved by
producing for export markets, given the small size of many developing
countries and their negligible purchasing power; and
(iii) Potential contribution to employment and growth of national product.

Export diversification aims at moving away from a limited basket of

exports in order to mitigate economic and political risks of dependence
upon a few primary commodity exports. Export diversification is widely
seen as a positive trade objective in sustaining economic growth.

When export is concentrated in a few primary commodities, there

can be serious economic and political risks.
• Economic risks include:

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 In the short term, volatility and instability in foreign exchange earning
which have adverse macroeconomic effect (on growth, employment,
investment planning, import and export capacity, foreign exchange cash
flow, inflation, capital flight and undersupply of investments by
risk averse investors, debt repayment); and
In the long term, secular and unpredictable declining terms of trade
trends which exacerbate short run effects.
• Political risks include :
Worsened governance and risk of civil war in fragile states and the
risk of conflict is strongly related to the level and growth of income, as well
as its structure as reflected in the dependence upon a few primary
Commodity exports. Heavy dependence on a small number of primary
commodities products exposes a country to the negative effects of
unfavorable characteristics of world demand and negative supply side
features of these primary products.

On the demand side, the low income elasticity of world demand of primary
commodities can lead to falling export revenues which can be exacerbated
by historically downward trends in primary commodities relative to
manufactures. Although, according to Cashin and Mc.Dermott (2002), real
commodity prices have declined by about 1% per year over the last
140 years, volatility and persistence of commodity price shocks can have
more dramatic consequences than the long term downward trend of
commodity prices.

On the supply side, the combined effect of lower skills and technology
content of commodity production and its negligible backward and forward
linkages with the rest of the economy usually lead to negative growth
spillovers.

Benefits of export diversification

A diversified portfolio could help

• minimize volatility in export earnings
• boost overall growth by replacing primary commodities with positive
price trends products and
• Adding value through additional processing or marketing.
• makes countries less vulnerable to adverse terms of trade shocks by
stabilizing export revenues ,

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 • makes it easier to channel positive terms of trade shocks into growth,
• knowledge spillovers and increasing returns to scale,
• creates learning opportunities that lead to new forms of comparative
advantage.
As traditional exports are particularly vulnerable to exogenous shocks
and face limited demand due to their low income elasticity and declining
terms of trade, diversifying away from traditional exports is expected to
raise growth rates and lower their variability. Hence, export
diversification can also aim at improving backward and forward linkages
to domestic inputs and services, and expanding opportunities for export
in existing or new markets. Reducing dependence upon one or a limited
number of geographical destinations or origins can also be a major
objective for export diversification.

Free access to imported inputs to exporting firms, subsidies and various

other complementary measures formed the basis of the standard
permissive and positive policies used to accelerate export growth and
diversification.

Export Diversification: A Policy Portfolio Approach

In particular diversification can also take the form of :
(i) Diversifying the range of markets into which existing products are sold
(geographic diversification);
(ii) Upgrading the quality of existing products, including agricultural
exports diversifying the range of markets into which existing exports are
sold; and
(iii) Taking advantage of opportunities to expand exports of services.

We therefore argue for a portfolio of policies – with emphasis tailored to a

country’s niche in the global market.

Elements that helps the country to compete in

international markets:

• The incentives regime. A key challenge for policy makers is to ensure that
domestic resources are channeled to their most productive activities. If
private investors can make more money by investing in highly protected

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local markets, they will do so, and opportunities to invest in markets abroad
will be lost. Creating a modern incentive framework that spurs national
competitiveness requires careful analysis to ensure that land, labor, capital
and technology are moving to :

(a) Sectors in which the country has a long-term capacity to compete and
(b) to the most productive firms within sectors.
This necessitates a clear understanding of how trade, tax, the business
environment and labor market policies interact to affect investment, output
and trade decisions. In many small, low income countries the economy tends
to be dominated by a small number of sectors, so that many of the key issues
regarding the allocation of resources can be unearthed by analyses that focus
on these sectors.
• Lowering the costs of backbone services and, generally, of doing business.
• Pro-active policies to support trade. Both market and government
failures tend to afflict low-income countries as they seek to expand exports
and growth. Laissez faire policies cum low-tariffs are rarely sufficiently to
prompt dynamic export drives or overcome obstacles in other areas. In
many cases these constraints to competitiveness require specific
interventions and institutions.

 In identifying the role of product deaths and weak performance in the

index of export market penetration, this study underscores the
importance of export promotion agencies – and even economic
officers in foreign embassies – in overcoming informational
asymmetries. This is particularly important for overcoming
impediments to gaining information for the private sector in search
for third markets. Of similar importance are likely to be investment
promotion agencies, standards bodies, customs and agencies to
support innovation and clustering, export processing zones and duty
refund schemes.
 In tackling government and market failures, trade ministries are
typically weak and their policy purview limited to border barriers.
Large domains of policy that affect competitiveness reside outside
the normal trade minister’s ambit – for example, investment policies,
services and transport, to name a few. It is important that these
Initiatives are brought together within strategy for competitiveness
rather than as a series of ad hoc interventions. In isolation these
agencies tend to focus on narrow objectives, some of which
may even be inconsistent with a broader competitiveness strategy.

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 Incorporating competitiveness broadly into the national development
strategies may require more effective mechanisms to review and
coordinate policies. One option is to create an inter-ministerial council on
competitiveness with the mandate of undertaking analysis of the
existing policy framework and for reviewing policies before they are
put in place.

 In addition to the incentive framework and costs of doing

business competitiveness diagnostics can highlight whether
binding constraints to export performance reside in low
discovery, low geographic diversification low product quality
and and/or low services exports. Each may have slightly
different policy remedies.

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