Quiz 20: Financial Globalization: Opportunity and Crisis
A diversified portfolio is the one that contains investments in different sectors that are either unrelated or inversely related. For example, stocks of Steel Company and an Auto company (Ford)are directly related, this is because demand of cars influences the demand for steel; on the other hand, stocks of Auto Company and Beverage Company like coke are unrelated, because prices of demand of cars do not influence either demand or price of coke. In case of Dental Supply Company and Candy Company, the stocks are directly related because higher consumption of candy may lead to dental problem making the consumer to visit a dentist. Thus, stocks of candy and dental supply are related making the risk undiversified. On the other hand, stocks of Dental Supply Company and Diary Company are unrelated because the demand of one product might not affect the demand for the other product; hence, considered as a better-diversified portfolio.
The exchange rate is an important asset price. Variations in asset prices are largely dependent upon the type of exchange rate system a country follows. Countries with fixed exchange rate have lower exchange rate volatility than countries that float. Since under fixed exchange rate system, the central bank has the responsibility to maintain the exchange rate stability through foreign exchange market interventions, a change in monetary policy is less effective. Therefore, any change in monetary policy brings less volatility in the asset prices, more specifically, international asset price. Under floating exchange rate system, the role of monetary policy is more dominant. A change in the monetary policy will affect the asset prices more directly as the exchange rate system is left to market forces. As a result, any unexpected positive shifts in the monetary policies increases the gains from international asset trade.
The covered interest parity condition explains the relationship between the forward exchange rate between two currencies say euro and dollar, their spot exchange rate and interest rate on deposits of those currencies. The covered exchange rate principal is best explained as the covering of the exchange rate risks in the future. For example if one wants to buy euro deposits with dollars but wants to make sure that he receives a certain amount in the future, he may sell the dollars in terms of the principal and interest forward. But this covered interest parity works efficiently well only when the different foreign currency deposits are issued by the same financial center. This is mainly because deviations in covered interest parity will occur if the deposits are compared across financial centers of different countries. This will occur when the asset holders who are buying the deposits tend to compare and fear that the governments of other countries might impose regulations (political risk)which might hinder the free movements of foreign deposits between countries. One another fear that the banks of other countries might fail also leads to the inefficient functioning of the covered interest parity.