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Thursday, June 23, 2011

The Risks Of Sovereign Bonds

Sovereign debt is one of the oldest investment asset classes in the world, as national governments have been issuing bonds for centuries. Today, sovereign debt forms an important cornerstone of many institutional investment portfolios, and is becoming increasingly popular with many individual investors. This article will examine the sovereign debt market, and explain techniques investors can use to safely invest in this market. (For more, see How Countries Deal With Debt.)

TUTORIAL: Advanced Bond Concepts

What is Sovereign Debt?
Sovereign debt can be broken down into two broad categories. Bonds issued by large, developed economies (such as Germany, Switzerland or Canada) usually carry very high credit ratings, are considered extremely safe and offer relatively low yields. The second broad category of sovereign debt encompasses bonds issued by developing countries - often referred to as emerging market bonds. These bonds often carry lower credit ratings than developed nation sovereigns, and may actually be rated as junk. Because they are perceived as being more risky, emerging market bonds often provide higher yields. U.S. treasuries are technically a sovereign bond, but this article will focus on evaluating sovereign bonds from issuers other than the United States; in other words, international government bonds from the perspective of a U.S.-based investor. (For more, see Investing In Emerging Market Debt.)

Why Invest in Sovereign Debt
Because they are issued by national governments, sovereign bonds are generally among the safest investments in most countries (although, this is all relative – sovereign bonds issued by Venezuela may be safer than Venezuelan stocks, but this does not necessarily make them safe). This makes sense for several reasons:

1. Countries want to be able to continue borrowing, so they generally make a high priority of paying back debt.

2. Even if countries are not particularly credit worthy, their sovereign bonds are usually safer than other domestic alternatives. In a scenario where the government is defaulting on its debt, it is unlikely that the country's other stocks, bonds or currency markets are doing well. (For more, see Playing It Safe In Foreign Stock Markets.)

In addition to being relatively safe, sovereign debt can also produce impressive returns. In the case of high-quality developed market bonds, relatively low yields during normal times can turn into very high returns during times of market stress, when these bonds usually perform well in a "flight to quality." Because they are generally riskier, emerging market sovereign bonds often offer higher returns than developed nation bonds. In fact, emerging market sovereign bonds have produced equity-like returns at times in the past (with commensurately high volatility, of course).

One final benefit U.S.-based investors will find with sovereign bonds is that adding them to a diversified portfolio will help add international exposure and diversify a portfolio away from the United States. Thus, investors can benefit (or lose) in two ways from sovereign bonds: interest and capital gains (or losses) from the bond itself, and currency movements relative to the U.S. dollar. (For more, see Protect Your Foreign Investments From Currency Risk.)

Risks from Sovereign Debt
A government's ability to pay is a function of its economic position. A country with a strong economy, manageable debt burden, stable currency, strong tax collection and positive demographics will likely have the ability to pay back its debt. This ability will usually be reflected in a strong credit rating by the major ratings agencies. On the other hand, a country with a weak economy, high debt burden, weak or volatile currency, little ability to collect taxes and poor demographics may find itself in a position where it is unable to pay back its debt. (For more, see Broadening The Borders Of Your Portfolio.)

A government's willingness to pay back its debt often is a function of its political system or government leadership. A government may decide not to pay back its debt, even if it has the ability to do so. This usually occurs following a change of government or in countries with unstable governments. This makes political risk analysis an important component of investing in sovereign bonds. Importantly, ratings agencies take into account willingness to pay as well as ability to pay when evaluating sovereign credits. (For related reading see Evaluating Country Risk For International Investing.)

Negative Credit Events for Sovereign Investors
There are several types of negative credit events that investors should be aware of, up to and including a debt default. A debt default occurs when a borrower (in this case, a government) can't (or won't) pay back its debt. In this case, bondholders no longer receive their scheduled interest payments, nor do they receive their principal on maturity. Bondholders will often negotiate with a government to receive some value for their bonds, but this is usually cents on the dollar, and rarely approaches 100% of the initial investment. (For related reading, see How To Create A Modern Fixed-Income Portfolio.)

A debt restructuring occurs when a government anticipates difficulty in repaying its debt as planned, and therefore comes to an agreement with bondholders in order to renegotiate the terms of the bonds. These changes can include a lower rate of interest, longer term to maturity or reduced principal amount. These restructurings are done to benefit the bond issuer and are almost always negative for bondholders (except to the degree that they prevent a default.)

A final negative development for bondholders is inflation. Because it is not technically a default or other credit event, issuers that can't (or won't) pay back their scheduled debts sometimes prefer to inflate their way out of the problem. From a bondholder's perspective though, high inflation results in principal and interest payments that carry less value (from a purchasing power perspective) than they initially planned for. (For more, see 6 Biggest Bond Risks.)

Ways to Protect Against Sovereign Risk
There are several tools that an investor can use to protect against sovereign credit risk. The first is research. By carefully analyzing a country's ability to pay and determining if it is likely to have the willingness to pay, an investor can properly analyze whether the expected return is in line with the risk being taken. Investors might also examine credit ratings for a country, as well as 3rd-party research tools, such as the Economist Intelligence Unit or CIA World Factbook, for more information about some issuers.

Diversification is the other primary tool for protecting against sovereign credit risk. By owning bonds issued by a variety of governments in different regions of the world, an investor can cushion his portfolio against the impact that a negative credit event by any single government might have. Investors can also diversify their currency exposure by owning a variety of bond issues denominated in several different currencies. (For more, see An Introduction To Emerging Market Bonds.)

Bottom Line
Depending upon the issuer, sovereign debt can provide safety, relatively high returns or a combination of both. However, investors need to be aware that governments sometimes lack the ability or willingness to pay back their debts as scheduled, making research and diversification extremely important for international debt investors. Because it might be difficult for many individual investors to conduct in-depth research on a variety of sovereign credits and construct a large enough portfolio to achieve proper diversification, mutual funds and exchange traded funds are attractive options for investing in sovereign debt. (For related reading, see Spice Up Your Portfolio With International Bonds.)

by Brian Perry

Brian Perry is the author of From Piggybank to Portfolio: A Financial Roadmap for New Investors (2011) and also serves as a portfolio manager/strategist at an asset management firm. Brian has contributed numerous articles to investment industry publications, is a frequent speaker at investment conferences and charity events, and has appeared on NBC news to discuss the financial markets. Brian previously worked as a fixed income trader for an investment bank, where he was responsible for trading government, corporate and emerging market securities. Brian has a bachelor’s degree in finance from Villanova University, an MBA in international business from National University, and a master’s degree in international affairs from the Fletcher School at Tufts University. He also holds the designation of Chartered Financial Analyst (CFA).

Financial Physics: "Natural" Market Laws

Math is at the heart of markets and economies, whether it is a simple budget or the rate calculation for a credit default swap. Physics has used math to make fundamental laws that help inform us about our universe and explain what we see around us. When one of these discoveries is important enough, it becomes a law. In this article, we'll look at what laws we can use to explain our financial universe.

All Measurements Are Relative
Measurements only matter in reference to other events. A mutual fund returning 16% sounds good, but what if that year the market crawled up 14% normally? Earnings can fall 3% below analysts' expectations but still represent a 5% increase, or even exceed expectations simply by posting a lower-than-expected loss of 10%. (Learn how this key metric is calculated and how it is used to judge market performance Earnings Forecasts: A Primer.)

With the increasing tendency of Wall Street and the financial media to bombard investors with figures and attention-grabbing headlines like "XYZ smashes analysts expectations" or "ZYX tanks with a weak fourth quarter," it is important to realize that these figures may mean nothing for you. If an investor is happy with a company's fundamentals, then a quarterly loss or weak gain is just a small bump in a long road - it might even present a buying opportunity. (Learn more in What Are Fundamentals?)

In this same way, no benchmark is a universal measure, but is only useful in relation to what you're measuring. There is no point in measuring an aggressively managed fund against the S&P 500, because an aggressive fund should outpace the S&P in bull markets and underperform in bear markets. Instead, investors have to measure such things with benchmarks that are highly correlated – measuring an aggressive fund against all other aggressive funds – to get any meaningful information.
The Future Is Unknowable
Analysts, market pundits and investors are firmly focused on the future. This is how we end up with companies trading at ridiculous multiples of their earnings – investors aren't paying for the company as it is, but as they see it performing in the future. Unfortunately, the future is unknowable and it gets increasingly so the farther ahead you try and look. This has three practical applications to the market:
- Your Portfolio
  Sometimes value investors are given to hyperbole, suggesting that a good company can be bought, put in a drawer and forgotten for 20 years. While this may turn out to be true, it adds unnecessary risk to your portfolio. Because the future is uncertain, investors should check their holdings annually to see if there is any indication that the companies they own are changing for the worse. Black swan events that drain a portfolio can't always be avoided, but the long-term decline of a company shows up in the financials year-to-year. You can't predict the future, but you can look at the company you own now and decide whether you still want to own it next year. (Learn more in our Stock Picking Strategies Tutorial.)
- Analysts
  Take analyst expectations with a large grain of salt. Following May Day, the business models for most brokerages changed from a focus on commissions to institutional banking services. This means that the age of the independent analyst is over. Instead, you have analysts writing reports for companies who are clients of their brokerage house, setting up a sizable conflict of interest. Analysts can be encouraged to predict a rosy future for a client even if their research suggests otherwise. This doesn't mean all analyst research is useless, but the recommendation pages with lofty predictions should be torn out before reading.
- Shooting Stars
  Think hard before buying high P/E multiples. When companies start getting into the high 20s in P/E multiples it's essentially saying it will take two decades for you to make back your initial investment – that's if the company continues on exactly as it is. When investors buy into high multiples, they believe the company will continue to improve, paying back the investment and more in a much shorter time.
  
  The odds are stacked against this as companies, even companies with a hot new product, generally follow a growth cycle where the fast-growth phase is only a small part. Even the most revolutionary products saturate the available market over time and profit growth slows. So, think twice before buying a company trading a 30 times earnings that might keep you waiting throughout your old age for the payout. It's fine to put risk capital on a few potential future giants, but you shouldn't leverage your whole portfolio on the future path of shooting stars. (Do you have the best mix of investments? Find out how to make sure, check out Major Blunders In Portfolio Construction and How Risky Is Your Portfolio?)
All Economies and Markets Are in Relative Motion
Einstein and others gave us a universe where galaxies are moving while also exerting forces on each other. In the financial universe, we have the economies of different countries expanding and contracting, and influencing the economies around them. Although we can say one economy is up compared to another, it's difficult to isolate one from the others. The amount of short-term capital in the world is relatively finite, and if one economy is seeing an increase, another economy will be experiencing a comparative lack.

The best part of this global market is that there will always be investment opportunities in some parts of the world, even if your domestic market is overvalued. Unfortunately, there is a downside to the mesh of forces making up global trade. If a speculative bubble dangerously accelerates certain parts of the global market, then the whole economic fabric can be warped. When the bubble bursts it leaves a black hole of destroyed capital like the mortgage meltdown or the crash of 1929. That said, the interaction of economies has brought far more prosperity than harm over thousands of years of trade. (For more, see 4 Factors That Shape Market Trends.)

Breaking the Laws of Physics
Although physics and economics both speak the language of math, there is one irreconcilable difference – human behavior can alter market laws, whereas we still haven't found a way to break the laws of physics. This means that observations, trading strategies and market theories may hold up for a long time and then suddenly fail. There are numerous incidents where groups, governments and even individuals have warped or suspended the natural functions of the market. This chaotic element of human behavior is what creates the risk and rewards that make investing as exciting as the black holes, particle smashers and quantum theories of physics.

by Andrew Beattie

Andrew Beattie is a managing editor and contributor at Investopedia.com. He operates the Wandering Wordsmith blog, and can be reached there.

Research Report Red Flags For Brokers

Registered representatives are inherently in a tough situation when left to choose between selling a stock in a company for which their firm has done underwriting, and doing what is ultimately best for the client. In many cases, however, this decision is mutually exclusive. Therefore, when it comes to researching stocks, brokers must pay close attention when reading a research report, rather than just relying on the ratings their firms provide. In this article, we'll provide a breakdown of what brokers should look for and give you the tools you'll need to separate the wheat from the chaff to get the best stocks for your clients.

The Temptation
Oftentimes, firms that have underwritten a particular security will look favorably on sales managers or brokers who sell these shares to their clients. In such cases, brokers may face pressure to push these shares as a result of, say, a sales contest rewarding the broker who unloads the most shares, the possibility of getting a better office in the branch or some other perk.

This is where a smart broker can step in and head off any problems that may arise with the client by conducting his or her own independent research.

Key Warning Signs
Savvy brokers (and investors) should look for several key items in a research report to gauge whether or not the stock has the potential to be a winner. These items include:

1. Excessive Rationalization and Qualifications: By definition, research reports need to show balance, which means they should disclose both the good and the bad points about a company. The methods an analyst uses to extrapolate his or her findings and generate a conclusion about a company can help readers determine whether or not that analyst's thought process was logical.
If an analyst describes a situation in a report and then comes up with a long, drawn out reason why it must be a positive for the company, this excessive rationalization should set off alarm bells in a broker's mind.
If the analyst qualifies every statement with a disclaimer, this could be a sign that the fundamental outlook is not as clear as the analyst is suggesting.
Again, a research report should be fair and balanced, but the future prospects for the company also should be obvious to the reader at first blush. Put another way, neither clients nor brokers should have to read between the lines.

2. Growth Inconsistent With Industry Averages: Logically speaking, faster growing companies should enjoy more popularity and a higher stock price than those with slower growth. To that end, brokers should take their analysts' prognostications lightly when they claim that a given stock will appreciate in parity or faster than its peers when its anticipated earnings growth rate actually is slower then the industry average.

Smart brokers should always look at how fast the analyst expects the company's earnings to grow over the next year - and the next five years - and then compare those with industry averages in Standard & Poor's or FactSet reports. This will help the broker to get a better sense of whether the stock is truly a buy, or will merely be a mediocre performer. (For related reading, see Earnings Forecasts: A Primer and Surprising Earnings Results.)

3. Questionable "Buy" Ratings: In spite of the SEC's focus on bringing some accountability to research departments and making certain that reports contain all of the information investors and advisors need to make good investment decisions, in many cases, rating systems remain antiquated.

Some brokerage houses parse their words by having several tiers of bullish ratings including "accumulate", "overweight", "buy" and "strong buy". This leaves brokers - and their clients - confused about the analyst's true sentiment. (For more insight, see Analyst Recommendations: Do Sell Ratings Exist?, Stock Rating: The Good, The Bad And The Ugly and Why There Are Few Sell Ratings On Wall Street.)

For this reason, brokers must read all research reports thoroughly to get a grasp on the fundamental outlook before entering any orders for their clients. Far too often, brokers enter a buy order for a given stock for a client just because the firm rates it as a "buy", or gives it some other bullish sounding title. In many cases, these brokers have not read the report in detail, and aren't really aware of the stock's outlook.

The fact is, investment banks use the word "buy" or similar sounding words on their clients' research reports because it looks good. Big banks don't want to cannibalize their underwriting business, so they give the shares the highest rating possible and then hedge their statements in the body of the report. This is a tricky business, but it's the broker's responsibility to pick up on this and to make sure that his or her clients don't get duped.

4. Key Statistics Analysis: It is highly unlikely that all metrics in a given company analysis are going to be bullish. However, brokers should give greater credence to certain factors over others.

Insiders: Ideally, brokers want to look for companies in which insiders - such as company executives - are buying the stock. It's usually a great sign that the stock is headed higher if those running the company are buying into it. Most research reports will touch on recent insider activity - if they don't, services such as Bloomberg, ILX and/or SEC filings will detail insider buys and sells. (For related reading ,see Uncovering Insider Trading and When Insiders Buy, Should Investors Join Them?)
Gross Profit: Brokers should look favorably on companies with growing gross profits (calculated as sales minus cost of goods sold). The reason for this is simple. It shows whether the company is growing its sales, as well as if it is sourcing materials for its goods effectively. Shrinking gross profits are more likely to lead to lower earnings. Conversely, a company that is showing an increase in gross profit is more likely to show a corresponding increase in earnings.

Conclusion
The bottom line is that brokers shouldn't take their analysts' recommendations at face value. They have a fiduciary responsibility to do their own homework and to make certain that an investment is viable in order to avoid conflict with their clients.

by Glenn Curtis

Glenn Curtis started his career as an equity analyst at Cantone Research, a New Jersey-based regional brokerage firm. He has since worked as an equity analyst and a financial writer at a number of print/web publications and brokerage firms including Registered Representative Magazine, Advanced Trading Magazine, Worldlyinvestor.com, RealMoney.com, TheStreet.com and Prudential Securities. Curtis has also held Series 6,7,24 and 63 securities licenses.

Cyclical Versus Non-Cyclical Stocks

Investors cannot control the cycles of the economy, but they can adjust their investing practices with its ebbs and flows. Adjusting to economic transitions requires an understanding of how industries are characterized by their relationship to the economy. It's important for you to know the fundamental difference between cyclical and non-cyclical companies so that you can distinguish between sectors that are affected by economic changes and those that are more immune. Here we look at the industries that reside within these categories, and identify where it's best to put your money when the economy starts to decline.

What Does Cyclical and Non-Cyclical Mean?
These terms, cyclical and non-cyclical, refer to how highly correlated a company's share price is to economic fluctuations. Non-cyclical stocks repeatedly outperform the market when economic growth slows, while cyclical companies are highly correlated to the economy. The non-cyclical securities, also called defensive stocks, experience profit regardless of economic gyrations because they produce or distribute goods and services we always need: food, power, water and gas. The sales of companies with cyclical stocks, on the other hand, depend on whether or not the economy is strong; sales will thrive when people have extra income to spend on luxuries, and they'll decline when the economy slumps.

The Concept
The difference between cyclical and non-cyclical industries is simply the difference between necessity and luxury. There are certain items we can't live without and won't likely cut back on even when times are tough. The stocks of companies producing these things are non-cyclical and are "defended" against the effects of economic downturn, providing great places to invest when the economic outlook is sour. For example, household non-durable goods - a fancy term for the things you use up quickly around the house - such as toothpaste, soap, shampoo and dish detergent may not seem like essentials, but you can't really sacrifice them. Most people don't feel they can wait until next year to lather up with soap in the shower.

Contrast this to the new car you've had your eye on. Although it's more exciting to buy a new car than soap, you are more likely to postpone the car for a year or two if your finances feel the effects of an economic slump. Another good example of a cyclical industry is fine dining. When things are good people are more inclined to take the family out for an expensive meal; macaroni and cheese, on the other hand, has to suffice when finances are depressed. Other examples of cyclical industries are manufacturing, the steel industry, travel and construction - the sectors that produce things we can live without when money is tight. These are exactly the types of industries you want to avoid when the economy turns sour.

Charting a Cyclical vs. Non-Cyclical Company
Below is a chart showing the performance of a highly cyclical company, the Ford Motor Co. (blue line), and a classic non-cyclical company, Florida Public Utilities Co. (red line). This chart clearly demonstrates how each company's share price reacts to downturns in the economy.

Notice that the downturn in the economy from 2000 to 2002 drastically reduced Ford's share price, whereas the growth of Florida Public Utilities' share price hardly batted an eye at the slowdown.

Non-Cyclical Industries - Safety in Turbulent Times
Let's look more closely at examples of non-cyclical industries so that you know where to start looking when a recession is on the horizon.

Utilities
An excellent example of a non-cyclical industry is utilities, which can help investors avoid losses when highly cyclical companies are suffering. For instance, selling your Caterpillar stock and buying a share in, say, Minnesota Power Inc. is a type of maneuver that investors have used for years during economic downturns. If times become tough, there's not much money for building projects, so construction companies are less likely to purchase heavy machinery. But, no matter what, people's top priority will always be to have power and heat for themselves and their families. By providing a service that is consistently used, utility companies grow conservatively and do not fluctuate dramatically - these companies provide safety, but this also means they are not going to skyrocket when the economy experiences growth.

Household Non-Durables
As we mentioned before, people will always need certain essentials around the house. From deodorant to bleach, we can't really sacrifice the things that keep us and our living spaces clean. For this reason, companies such as Procter & Gamble, Colgate-Palmolive and the Gillette Co. are all attractive investment choices when the economy is in the dumps.

Tobacco
It is easy to see why tobacco companies are considered non-cyclical: it's hard for smokers to stop smoking, even during a recession. So a company such as British American Tobacco will exhibit more stability during these times. Even though tobacco is considered a "sin" industry and may be unethical for some investors, it does have the characteristics of a non-cyclical sector.

Conclusion
Learning how to predict economic cycles is not within the scope of this article, but simply realizing that different industries respond differently to economic fluctuations can help keep your money safe. When the economy cools off, the cyclical companies will be hit the hardest, so seek out stable companies that produce things you can't live without.

by Investopedia Staff

Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including thousands of original and objective articles and tutorials on a wide variety of financial topics.

What Is The World Bank?

The World Bank Group (WBG) was established in 1944 to rebuild post-World War II Europe under the International Bank for Reconstruction and Development (IBRD). Today, the World Bank functions as an international organization that fights poverty by offering developmental assistance to middle-income and low-income countries. By giving loans and offering advice and training in both the private and public sectors, the World Bank aims to eliminate poverty by helping people help themselves. Under the World Bank Group, there are complimentary institutions which aid in its goals to provide assistance.

Membership
There are 184 member countries that are shareholders in the IBRD, which is the primary arm of the WBG. To become a member, however, a country must first join the International Monetary Fund (IMF). The size of the Bank's shareholders, like that of the IMF's shareholders, depends on the size of a country's economy. Thus, the cost of a subscription to the Bank is a factor of the quota paid to the IMF. There is an obligatory subscription fee, which is equivalent to 88.29% of the quota that a country has to pay to the Fund. In addition, a country is obligated to buy 195 Bank shares (USD 120,635 per share, reflecting a capital increase made in 1988). Of these 195 shares, 0.60% must be paid in cash in U.S. dollars while 5.40% can be paid in a country's local currency, in U.S. dollars, or in non-negotiable non-interest bearing notes. The balance of the 195 shares is left as "callable capital", meaning the Bank reserves the right to ask for the monetary value of these shares when and if necessary. A country can subscribe a further 250 shares, which do not require payment at the time of membership but are left as "callable capital".

The president of the Bank comes from the largest shareholder, which is the United States, and members are represented by a Board of Governors. Throughout the year, however, powers are delegated to a board of 24 Executive Directors (ED). The five largest shareholders - the U.S., U.K., France, Germany and Japan - each have an individual ED, and the additional 19 EDs represent the rest of the member states as groups of constituencies. Of these 19, however, China, Russia and Saudi Arabia have opted to be single country constituencies, which means that they each have one representative within the 19 EDs. This decision is based on the fact that these countries have large, influential economies, which requires that their interests be voiced individually rather than diluted within a group. The World Bank gets its funding from rich countries as well as from the issuance of bonds on the world's capital markets.

The Parts That Make Up the Whole
The IBRD offers assistance to middle income and poor but credit worthy countries, and it also works as an umbrella for more specialized bodies under the Bank. The IBRD was the original arm of the Bank which was responsible for the reconstruction of post-war Europe. Before gaining membership in the WBG's affiliates (the International Finance Corporation, the Multilateral Investment Guarantee Agency and the International Center For Settlement of Investment Disputes), a country must be a member of the IBRD.

The International Development Association offers loans to the world's poorest countries. These loans come in the form of "credits", and are essentially interest-free. They offer a 10-year grace period and hold a maturity of 35 years to 40 years.

The International Finance Corporation (IFC) works to promote private sector investments by both foreign and local investors. It provides advice to investors and businesses, and it offers normalized financial market information through its publications, which can be used to compare across markets. The IFC also acts as an investor in capital markets and will help governments privatize inefficient public enterprises.

The Multilateral Investment Guarantee Agency (MIGA) supports direct foreign investment into a country by offering security against the investment in the event of political turmoil. These guarantees come in the form of political risk insurance, meaning that MIGA offers insurance against the political risk that an investment in a developing country may bear.

Finally, the International Center for Settlement of Investment Dispute facilitates and works towards a settlement in the event of a dispute between a foreign investor and a local country.

Adapting to the Times
As I mentioned earlier, the main function of the WBG is to eliminate poverty and to provide assistance to the poor by offering loans, policy advice and technical assistance. As such, the countries receiving aid are learning new ways to function. Over time, however, it has been realized that sometimes as a nation develops, it requires more aid to work its way through the development process. This has resulted in some countries accumulating so much debt and debt service that payments become impossible to meet. Many of the poorest countries can receive accelerated debt relief through the Heavily Indebted Poor Countries scheme, which reduces debt and debt service payments while encouraging social expenditure.

Another issue on which the Bank has recently been focusing has presented itself as an endangerment to a country's livelihood: support programs for HIV/AIDS. The WBG has also been focusing on reducing the risk of projects by means of better appraisal and supervision mechanisms as well as a multidimensional approach to overall development. (This includes not only lending but also support for legal reform, educational programs, environmental safety, anti-corruption measures and other types of social development.)

The Bank encourages all of its clients, which number over 100, to implement policies that promote sustainable growth, health, education, social development programs focusing on governance and poverty reduction mechanisms, the environment, private business and macroeconomic reform.

Opposition to the Bank
While the WBG strives to create a poverty-free world, there are groups that are passionately opposed to the international patron. The opponents believe that, due to the fundamental structure of the Bank, the already existing imbalance between the world's rich and poor is only exacerbated. The system allows the largest shareholders to dominate the vote, resulting in WBG policies being decided by the rich but implemented by the poor. This can result in policies that are not in the best interests of the developing country in question, whose political, social and economic policies will often have to be molded around WBG resolutions.

Moreover, even though the Bank provides training, assistance, information and other means that may lead to sustainable development, opponents have observed that developing countries often have to put health, education and other social programs on hold in order to pay back their loans.

Opposition groups have protested by boycotting World Bank bonds. These are the bonds that the WBG sells on global capital markets to raise money for some of its activities. These opposition groups also call for an end to all practices that require a country to implement structural adjustment programs - including privatization and government austerity measures - an end to debt owed by the poorest of the poor, and an end to environmentally damaging projects such as mining or the building of dams.

Conclusion
It is not surprising that there is a clash of opinion over how aid is given. Indeed, those that offer assistance are going to want to have a say in how the loans are used and what kind of economic policies are fostered in a country's developmental process. Many developing and poor nations, however, are stuck in a quagmire of debt and impoverishment, no matter how much assistance they receive. Given this, we may need to remember that the process of aid is also a developing state, in which both the giver and the receiver should be helping each other reach a poverty-free world.

by Reem Heakal

What Are Economies Of Scale?

When more units of a good or a service can be produced on a larger scale, yet with (on average) less input costs, economies of scale (ES) are said to be achieved. Alternatively, this means that as a company grows and production units increase, a company will have a better chance to decrease its costs. According to theory, economic growth may be achieved when economies of scale are realized.

Adam Smith identified the division of labor and specialization as the two key means to achieve a larger return on production. Through these two techniques, employees would not only be able to concentrate on a specific task, but with time, improve the skills necessary to perform their jobs. The tasks could then be performed better and faster. Hence, through such efficiency, time and money could be saved while production levels increased.

Just like there are economies of scale, diseconomies of scale (DS) also exist. This occurs when production is less than in proportion to inputs. What this means is that there are inefficiencies within the firm or industry resulting in rising average costs.

Internal and External Economies of Scale
Alfred Marshall made a distinction between internal and external economies of scale. When a company reduces costs and increases production, internal economies of scale have been achieved. External economies of scale occur outside of a firm, within an industry. Thus, when an industry's scope of operations expands due to, for example, the creation of a better transportation network, resulting in a subsequent decrease in cost for a company working within that industry, external economies of scale are said to have been achieved. With external ES, all firms within the industry will benefit.

Where Are Economies of Scale?
In addition to specialization and the division of labor, within any company there are various inputs that may result in the production of a good and/or service.

Lower input costs: When a company buys inputs in bulk - for example, potatoes used to make French fries at a fast food chain - it can take advantage of volume discounts. (In turn, the farmer who sold the potatoes could also be achieving ES if the farm has lowered its average input costs through, for example, buying fertilizer in bulk at a volume discount.)
Costly inputs: Some inputs, such as research and development, advertising, managerial expertise and skilled labor are expensive, but because of the possibility of increased efficiency with such inputs, they can lead to a decrease in the average cost of production and selling. If a company is able to spread the cost of such inputs over an increase in its production units, ES can be realized. Thus, if the fast food chain chooses to spend more money on technology to eventually increase efficiency by lowering the average cost of hamburger assembly, it would also have to increase the number of hamburgers it produces a year in order to cover the increased technology expenditure.

Specialized inputs: As the scale of production of a company increases, a company can employ the use of specialized labor and machinery resulting in greater efficiency. This is because workers would be better qualified for a specific job - for example, someone who only makes French fries - and would no longer be spending extra time learning to do work not within their specialization (making hamburgers or taking a customer's order). Machinery, such as a dedicated French fry maker, would also have a longer life as it would not have to be over and/or improperly used.
Techniques and Organizational inputs: With a larger scale of production, a company may also apply better organizational skills to its resources, such as a clear-cut chain of command, while improving its techniques for production and distribution. Thus, behind the counter employees at the fast food chain may be organized according to those taking in-house orders and those dedicated to drive-thru customers.
Learning inputs: Similar to improved organization and technique, with time, the learning processes related to production, selling and distribution can result in improved efficiency - practice makes perfect!

External economies of scale can also be realized from the above-mentioned inputs as a result of the company's geographical location. Thus all fast food chains located in the same area of a certain city could benefit from lower transportation costs and a skilled labor force. Moreover, support industries may then begin to develop, such as dedicated fast food potato and/or cattle breeding farms.

External economies of scale can also be reaped if the industry lessens the burdens of costly inputs, by sharing technology or managerial expertise, for example. This spillover effect can lead to the creation of standards within an industry.

But Diseconomies Can Also Occur…
As we mentioned before, diseconomies may also occur. They could stem from inefficient managerial or labor policies, over-hiring or deteriorating transportation networks (external DS). Furthermore, as a company's scope increases, it may have to distribute its goods and services in progressively more dispersed areas. This can actually increase average costs resulting in diseconomies of scale.

Some efficiencies and inefficiencies are more location specific, while others are not affected by area. If a company has many plants throughout the country, they can all benefit from costly inputs such as advertising. However, efficiencies and inefficiencies can alternatively stem from a particular location, such as a good or bad climate for farming. When ES or DS are location specific, trade is used in order to gain access to the efficiencies.

Is Bigger Really Better?
There is a worldwide debate about the effects of expanded business seeking economies of scale, and consequently, international trade and the globalization of the economy. Those who oppose this globalization, as seen in the demonstrations held outside World Trade Organization (WTO) meetings, have claimed that not only will small business become extinct with the advent of the transnational corporation, the environment will be negatively affected, developing nations will not grow and the consumer and workforce will become increasingly less visible. As businesses get bigger, the balance of power between demand and supply could become weaker, thus putting the company out of touch with the needs of its consumers. Moreover, it is feared that competition could virtually disappear as large companies begin to integrate and the monopolies created focus on making a buck rather than thinking of the consumer when determining price. The debate and protests continue.

Conclusion
The key to understanding ES and DS is that the sources vary. A company needs to determine the net effect of its decisions affecting its efficiency, and not just focus on one particular source. Thus, while a decision to increase its scale of operations may result in decreasing the average cost of inputs (volume discounts), it could also give rise to diseconomies of scale if its subsequently widened distribution network is inefficient because not enough transport trucks were invested in as well. Thus, when making a strategic decision to expand, companies need to balance the effects of different sources of ES and DS so that the average cost of all decisions made is lower, resulting in greater efficiency all around.

by Reem Heakal

Dragons, Samurai Warriors And Sushi On Wall Street Read more: http://www.investopedia.com/articles/03/062503.asp#ixzz1Q9ap6UAr

Since China first emerged as a less restricted market, the West has been taking a serious look at how Asian refinements of American business practices have allowed the East to catch up with the West so rapidly. Additionally, despite current economic bumps and bruises, Japan still holds the record for the fastest economic regrouping and industrialization following a military defeat (World War II). Therefore, it's not surprising that we find the wisdom and the mystery of "the Orient" seeping steadily into our investing terminology. Here we look at a few key terms with an Eastern flavor.

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Sushi Bond
Japan, by virtue of being an island, learned early in its development that seafood was going to be a big part of the Japanese menu. Rather than going through the unnecessary steps of battering and broiling and slathering and frying seafood like other countries, the Japanese decided to skip the cooking altogether. Despite, however, the initial reluctance some people may experience when first trying raw fish, sushi is now enjoyed around the world; first it was a delicacy and now it's common fare in most major cities.

Becoming an international food rather than one firmly rooted in a single country, sushi appropriately lends its namesake to the sushi bond, which is a eurobond issued by a Japanese company. What is a eurobond? It's a bond that is not within the jurisdiction of any one country and, consequently, is offered to investors in many countries. The advantage to the Japanese issuing company is that sushi bonds don't count against the Japanese institutional limit on foreign holdings. The aforementioned flexibility is the reason sushi bonds have gained the same international appeal as the food after which they are named. (For more insight, read The Ins And Outs Of Corporate Eurobonds.)

Chinese Wall
The ancient emperor of China, Qin Shi Huangdi, wasn't a fan of the Mongol hordes who were persistently ravaging the land and slaying his subjects. His simple solution was to unite the walls that had been built by various warlords to protect their borders. After 10 years and the labor of over 800,000 soldiers and peasants, China had a wall stretching more than 3,000 miles. It wasn't absolutely foolproof, but it did cut down the number of visits from marauders on the other side of the wall. Despite some notable threats, one being Genghis Khan (who generally defeated everyone), the Great Wall of China has stood as a symbol of power, permanence and protection.

The investing world's pared down version of the Great Wall refers to the division in a brokerage firm that hinders the flow of insider information. At first glance, insider trading doesn't look as bad as having a Mongol horde trample and maim you, but it is actually very damaging to the market, which can operate properly only if investors have equal access to information for making investment decisions.

The U.S. government faced its own version of the Mongol army with the crash of 1929, to which insider trading contributed. Like the early emperors of China, the government wanted to protect its people, so it created a "Chinese Wall" between professionals and the opportunity to exploit their privileged access to information. Legal (and ethical) barriers deterred people from engaging in insider trading and punished people who cross the line. (Learn more about the Chinese Wall in Brokerage "Chinese Wall" Protects Against Conflicts Of Interest.)

The later gangs of inside traders were comprised of analysts and investment bankers who would manipulate and control information to guarantee the successful IPOs of some companies. Under the increasing pressure to find the "next big thing", the analysts and brokerages faced the lure to break the rules. In the short lived dotcom craze, for example, the next big thing was nicknamed the "new paradigm" or the "new economy". As we now know, the "new economy" was built upon a "new paradigm" that turned out to be baseless. Regardless of the cautions from respected investors (like Warren Buffett), many people followed the herd into a market that the analysts had hyped out of nothing. Unfortunately, no wall, no matter how great, is impenetrable, so industry insiders have continued to slip over the Chinese Wall just like Genghis Khan did almost 800 years ago. (To learn more, check out Why did dotcom companies crash so drastically?)

Samurai Bond
Samurai were the warrior caste of ancient Japan. A samurai would pledge himself to the service of his lord until death or dishonor. Sadly, peace and the evolution of weaponry rendered these warriors obsolete. The samurai way of life ended when Saigo Takamori, upset with the imperial order that soldiers could not carry swords, led an army of samurai wielding the traditional katana against an imperial army carrying Dutch firearms. The new Japanese warrior, who was of the Imperial Army, would march into the 20th century using the weapons of foreigners.

A samurai bond is only related to the traditional samurai in a minor way. Samurai bonds are bonds issued in Japan (on the Tokyo Stock Exchange) and in Japanese currency (yen), but the issuer is non-Japanese. So, the neo-samurai (the Imperial Army) were supported by foreign weapons in the same manner that samurai bonds, while foreign, are purchased with Japanese yen.

Ichimoku, Keiretsu, Japan Inc, etc.
From 1960 to 1980, Japan went from a nation characterized by mass production of unreliable products to one on the cutting edge of technology, business and global economics. Skyscrapers rocketed up all over Tokyo, and Japanese companies began to take advantage of their $30 billion trade surplus with the U.S., purchasing American assets like the Rockefeller Center. For the first time in history, industrialized countries were coming to Japan to learn. This had two very interesting effects:

A massive industry based on "pleasing" visiting businessmen with large expense accounts sprung up. In Japan, five-star dining and hotels materialized as quickly as the skyscrapers.
The businessmen, exhausted by the indulgences of Japan and needing to justify the enormous expenses, used as many Japanese words possible in introducing "new management techniques" ("new paradigms?") to curious bosses. For the most part, the cultural gap between North America and Asia prevented the techniques from having a positive impact, but the love of Japanese words in business has continued unabated.

The first such term we find in the investing world is "ichimoku", which translates into "one look". So, an ichimoku chart is simply a one-look chart - that is, a chart from which the pertinent information can be gleaned at a glance. Plotting historical highs and lows, the ichimoku chart provides the equilibrium prices of a specified security. Also in the world of charting stocks are "harami" and "doji", which are Japanese terms heard in technical analysis. Both describe the appearance that a stock price takes in candlestick charting. Harami in Japanese means "pregnant", so it refers to the large middle of the candlestick that was named after it. Doji means little boy, and the candlestick to which it refers is, not surprisingly, relatively small in size. (To get a sense of how these charts are used, check out An Introduction To Ichimoku Charts In Forex Trading.)

The term Japan Inc. was coined by North Americans to refer to the huge amount of collusion between the Japanese government and private businesses. Politics and business became so entangled that corruption ran amok. In Japan the government would change laws to make businesses happy, raising tariffs on imports and loosening environmental laws. Many of Japan's economic problems originated in the days of Japan Inc., including pollution, corporate crime and a general lack of competition in some business sectors.

"Keiretsu" describes the good things about Japan Inc. It has no direct English equivalent: the closest we have is the verb "to link together", but we must add the phrase "without becoming entangled" to translate accurately the term's connotation. Keiretsu is one of the only two Japanese words to have made it into the "Oxford English Dictionary" (the other is "karoshi", or "death by overwork"). In a business/management sense, keiretsu refers to a loose conglomeration of firms that are held together by a robust corporate structure (by cross-holding shares or contractual agreements), but the companies don't necessarily need to own equity in each other. One of the premier advantages to keiretsu strategies is that they toughen the conglomerate against takeovers and drastic losses.

The Dragon Bond and Asian Options
Dragons have roots in all countries and cultures, but the dragon is ingrained too deeply in the Asian consciousness to be scrubbed out by any cynicism of the modern world. China and Japan have dragons for everything: seasons, weather, luck, knowledge, lakes, astrology, and so forth. The dragons of Asia also act as both the grantors of life ("celestial breath") and the ushers of dead souls into heaven. Despite having a nature that encompasses the good and bad of any given characteristic, the dragon represents a force of stability that continues to anchor Asian culture.

Dragon bonds act as a force of stability in the Asian market. They are, however, denominated in U.S. dollars, which has proved to be one of the most stable currencies in the world, a fact that the issuers hope will attract more foreign investors.

Another Asian investment opportunity that exudes the stability of the Orient is the Asian option, whose payout depends on the average price of the underlying asset over the life of the option rather than the price at maturity. This is in stark contrast to a European option, which can be exercised only at the end of its life, meaning that the payout depends completely on the price of the underlying on the day of maturity. An Asian option protects you from the volatility risk that comes with the market.

Asian dragons and Asian options share a trait: they both have handy tails that help them out of trouble. The tail of the Asian option kicks in if the option price falls below a specified average. Once the tail is activated, the option's strike price becomes a reference (set) price to save the investor from an asset that may continue to fall in value. (Learn about how to trade these options in Exotic Options: A Getaway From Ordinary Trading.)

The Bottom Line
Well, that's our look at how the mysteries and intrigues of the Orient have invaded Wall Street terminology. We hope you find more time in your life for the finer things these countries have brought us as well, such as sushi and sake.

by Andrew Beattie

Andrew Beattie is a managing editor and contributor at Investopedia.com. He operates the Wandering Wordsmith blog, and can be reached there.

Five Things To Know About Asset Allocation

With literally thousands of stocks, bonds and mutual funds to choose from, picking the right investments can confuse even the most seasoned investor. However, starting to build a portfolio with stock picking might be the wrong approach. Instead, you should start by deciding what mix of stocks, bonds and mutual funds you want to hold - this is referred to as your asset allocation.

What is Asset Allocation?
Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as cash, bonds, stocks, real estate and derivatives. Each asset class has different levels of return and risk, so each will behave differently over time. For instance, while one asset category increases in value, another may be decreasing or not increasing as much. Some critics see this balance as a settlement for mediocrity, but for most investors it's the best protection against major loss should things ever go amiss in one investment class or sub-class.

The consensus among most financial professionals is that asset allocation is one of the most important decisions that investors make. In other words, your selection of stocks or bonds is secondary to the way you allocate your assets to high and low-risk stocks, to short and long-term bonds, and to cash on the sidelines.

We must emphasize that there is no simple formula that can find the right asset allocation for every individual - if there were, we certainly wouldn't be able to explain it in one article. We can, however, outline five points that we feel are important when thinking about asset allocation:

Risk vs. Return
The risk-return tradeoff is at the core of what asset allocation is all about. It's easy for everyone to say that they want the highest possible return, but simply choosing the assets with the highest "potential" (stocks and derivatives) isn't the answer. The crashes of 1929, 1981, 1987, and the more recent declines of 2000-2002 are all examples of times when investing in only stocks with the highest potential return was not the most prudent plan of action. It's time to face the truth: every year your returns are going to be beaten by another investor, mutual fund, pension plan, etc. What separates greedy and return-hungry investors from successful ones is the ability to weigh the difference between risk and return. Yes, investors with a higher risk tolerance should allocate more money into stocks. But if you can't keep invested through the short-term fluctuations of a bear market, you should cut your exposure to equities. (To learn more about bond investing, see Bond Basics Tutorial.

Don't Rely Solely on Financial Software or Planner Sheets
Financial planning software and survey sheets designed by financial advisors or investment firms can be beneficial, but never rely solely on software or some pre-determined plan. For example, one rule of thumb that many advisors use to determine the proportion a person should allocate to stocks is to subtract the person's age from 100. In other words, if you're 35, you should put 65% of your money into stock and the remaining 35% into bonds, real estate and cash.

But standard worksheets sometimes don't take into account other important information such as whether or not you are a parent, retiree or spouse. Other times, these worksheets are based on a set of simple questions that don't capture your financial goals. Remember, financial institutions love to peg you into a standard plan not because it's best for you, but because it's easy for them. Rules of thumb and planner sheets can give people a rough guideline, but don't get boxed into what they tell you.

Determine your Long and Short-Term Goals
We all have our goals. Whether you aspire to own a yacht or vacation home, to pay for your child's education, or simply to save up for a new car, you should consider it in your asset allocation plan. All of these goals need to be considered when determining the right mix.

For example, if you're planning to own a retirement condo on the beach in 20 years, you need not worry about short-term fluctuations in the stock market. But if you have a child who will be entering college in five to six years, you may need to tilt your asset allocation to safer fixed-income investments.

Time is your Best Friend
The U.S. Department of Labor has said that for every 10 years you delay saving for retirement (or some other long-term goal), you will have to save three times as much each month to catch up. Having time not only allows you to take advantage of compounding and the time value of money, it also means you can put more of your portfolio into higher risk/return investments, namely stocks. A bad couple of years in the stock market will likely show up as nothing more than an insignificant blip 30 years from now.

Just Do It!
Once you've determined the right mix of stocks, bonds and other investments, it's time to implement it. The first step is to find out how your current portfolio breaks down. It's fairly straightforward to see the percentage of assets in stocks vs. bonds, but don't forget to categorize what type of stocks you own (small, mid, or large cap). You should also categorize your bonds according to their maturity (short, mid, long-term). Mutual funds can be more problematic. Fund names don't always tell the entire story. You have to dig deeper in the prospectus to figure out where fund assets are invested.

There is no one standardized solution for allocating your assets. Individual investors require individual solutions. Furthermore, if a long-term horizon is something you don't have, don't worry. It's never too late to get started. It's also never too late to give your existing portfolio a face-lift: asset allocation is not a one-time event, it's a life-long process of progression and fine-tuning.

by Investopedia Staff

How Equities Affect The FX Market

Foreign exchange (forex) traders are always looking for trends and economic outlooks to predict the potential movement in a currency. Some look at economic reports or GDP, or trade relations, but you might be able to predict these reports using the equity markets. Equity markets have thousands of firms around the world producing hundreds of reports every day that can be a useful source of information for currency traders. (To learn more about forex trading, check out How To Become A Successful Forex Trader.)

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The Fundamental Issue
Ultimately, a currency fluctuates based on supply and demand characteristics. When more investors demand a currency, it will likely strengthen relative to other currencies. When there is excess supply, the opposite is true. This fundamental principle, however, is influenced by a many factors that lead to constant currency fluctuations each and every day. It is beyond the scope of this article to discuss many of these factors. The focus will be on how equity markets can provide an insight into the foreign exchange markets.

A Global Game
The foreign exchange markets are truly a global market, bigger than any other securities market. So when thinking about equities and their influence on forex markets, you truly have to think globally. The best companies to consider are naturally the ones with international operations that transact in various currencies. For example, as the biggest retailer on the planet, Wal-Mart deals with foreign exchange issues just as much as any other company you could think of. Another great name is Coca-Cola. These global consumer stocks transact with consumers all over the world and provide the best corporate glimpse into the forex market.

The commodities market can also be useful with respect to the forex market. Consider the main global commodity, crude oil. Global oil prices are denominated in U.S. dollars. As an example, the price of oil can spike because the value of the U.S. dollar declines relative to major global currencies. So the price of oil has to go up in order to equalize the price that other foreign countries buy in their home currencies. While other global commodities – sugar, corn, and wheat – offer similar insights, oil is the most significant commodity that relates to the foreign exchange markets.

A major equity market can also influence forex markets in another way. A weak currency favors exporters in that particular country. When your domestic currency is weak, exports are cheaper abroad. That helps fuel growth and profits of those exporters. When earnings are growing, equity markets tend to do well. Of course, the situation is most likely to occur in equity markets backed by the major global currencies – the U.S. dollar, the yen, the euro, the British pound, etc. (To learn more about commodities prices can affect global currency, read Commodity Prices And Currency Movements.)

Looking Forward
Because foreign exchange markets are dynamic and fluctuate very quickly, most industries serve as lagging indicators for the direction of forex markets. It's not until a company reports its earnings that one begins to know the effect of currency movements. Often, the company's results will be vastly different than analysts' estimates when forex has played a major role. It is at that point that investors can analyze the comments from management with regards to the future outlook of currency fluctuations. Things to look for are any indications of hedging strategies that a company will take going forward.

Trying to differentiate what types of assets – hard or soft – best identify forex movements is meaningless. Rather, what is important is the necessity of the asset. Things like food, gasoline, and medicine would be more useful than clothing or jewelry. A company like Kraft, which sells food on all over the world would be more useful than Tiffany's, the iconic jewelry store retailer.

Government Involvement
One would think that global financial institutions would serve a meaningful purpose in forex markets. They do in the sense that they help facilitate forex markets. But in terms of identifying direction, remember that the value of their main material – money – is influenced by government policy.

Unfortunately, equities don't provide any meaningful leading indicators. The value of money is determined by its supply and demand, which is generally determined by government via interest rate changes or other policy movements. Trying to use equities as a leading indicator would not be wise when governments can influence movements at will.

The reality is that equities alone are not a prudent way to predict the direction of currencies. Government balance sheets, monetary policy and interest rates play a major role in forex markets. Recent U.S. history serves as an important example. As a response to the 2007-2009 financial crisis, the Federal Reserve significantly increased the money supply by buying over a trillion dollars in bonds. While this program - commonly known as quantitative easing - helped the economy out of the worst recession since the Great Depression, the dollar weakened significantly against a basket of global currencies. This dollar weakening occurred even as U.S. equity prices surged from 2009 to 2011. (To read more on the financial crisis, see The 2007-08 Financial Crisis In Review.)

Thinking Outside of the United States
Nevertheless, investors can look for patterns among these global companies.

In fact there has been one major pattern that has emerged over the years. Many global businesses have been focusing growth efforts outside the U.S. For example, in the late 2000s, coffee giant Starbucks outlined a plan to fuel future growth by expanding overseas. The company outlined plans to close 800 locations, most located in the U.S. Starbucks' focus on growing stores internationally worked out, and the company grew sales and profits, and rewarded shareholders with a higher stock price.

But Starbucks isn't the only company that saw the writing on the wall: the best growth is coming from emerging and developing markets. Nearly all global companies have focused significant growth efforts in developing and emerging parts of the world.

The viewpoint of growth from abroad has coincided with a weaker dollar at the expense of other currencies. While it is no guarantee, strong economies are usually supported by strong currencies over the long run. Investors should clearly understand that short-term fluctuations are the rule not the exception when it comes to foreign exchange markets. Of course it's far from 100% accurate that a strong economy belies a strong currency. During the financial crisis in the U.S., the Japanese yen continued to strengthen relative to the U.S. dollar, even though Japan's economy had been in a funk for decades. But that was the yen versus the dollar and the U.S. economy at the time was falling faster than Japan. (To learn more about the correlation between the economy and currency, see Economic Factors That Affect The Forex Market.)

Where global companies invest is often a leading sign that those companies see strong economic growth. Where there is strong economic growth, there is usually greater demand for the currency. More importantly a strong economy often suggests a solid government balance sheet that helps support currency prices. When a nation is heavily indebted or has to continue issuing currency, the long-term effects on that currency are not favorable.

The Bottom Line
Forex markets are complex dynamic markets. Using one data point – such as equities – to forecast future forex directions can be a limiting exercise. Equities can be useful indicators, but investors should be aware that equities alone may not be sufficient to provide an accurate assessment.

by Sham Gad

Tuesday, July 20, 2010

Trading The MACD Divergence

by Boris Schlossberg,
FREE Forex Report The 5 Things That Move The Market (Contact Author | Biography)

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Filed Under: Forex

Moving average convergence divergence (MACD), invented in 1979 by Gerald Appeal, is one of the most popular technical indicators in trading. MACD is appreciated by traders the world over for its simplicity and flexibility because it can be used either as a trend or momentum indicator.

Trading divergence is a popular way to use MACD histogram (which we explain below), but, unfortunately, the divergence trade is not very accurate - it fails more than it succeeds. To explore what may be a more logical method of trading MACD divergence, we look at using the MACD histogram for both trade entry and trade exit signals (instead of only entry), and how currency traders are uniquely positioned to take advantage of such a strategy.

MACD: An Overview
The concept behind MACD is fairly straightforward. Essentially, it calculates the difference between an instrument's 26-day and 12-day exponential moving averages (EMA). Of the two moving averages that make up MACD, the 12-day EMA, is obviously the faster one, while the 26-day is slower. In the calculation of their values, both moving averages use the closing prices of whatever period is measured. On the MACD chart, a nine-day EMA of MACD itself is plotted as well, and it acts as a trigger for buy and sell decisions. MACD generates a bullish signal when it moves above its own nine-day EMA, and it sends a sell sign when it moves below its nine-day EMA.

The MACD histogram is an elegant visual representation of the difference between MACD and its nine-day EMA. The histogram is positive when MACD is above its nine-day EMA and negative when MACD is below its nine-day EMA. If prices are rising, the histogram grows larger as the speed of the price movement accelerates, and contracts as price movement decelerates. The same principle works in reverse as prices are falling. See Figure 1 for a good example of a MACD histogram in action.

Figure 1: MACD histogram. As price action (top part of the screen) accelerates to the downside, the MACD histogram (in the lower part of the screen) makes new lows

Source: FXTrek Intellicharts

The MACD histogram is the main reason why so many traders rely on this indicator to measure momentum, because it responds to the speed of price movement. Indeed, most traders use the MACD indicator more frequently to gauge the strength of the price move than to determine the direction of a trend.

Trading Divergence
As we mentioned earlier, trading divergence is a classic way in which the MACD histogram is used. One of the most common setups is to find chart points at which price makes a new swing high or a new swing low but the MACD histogram does not, indicating a divergence between price and momentum. Figure 2 illustrates a typical divergence trade.

Figure 2: a typical (negative) divergence trade using a MACD histogram. At the right-hand circle on the price chart, the price movements make a new swing high, but at the corresponding circled point on the MACD histogram, the MACD histogram is unable to exceed its previous high of 0.3307. (The histogram reached this high at the point indicated by the lower left-hand circle.) The divergence is a signal that the price is about to reverse at the new high, and as such, it is a signal for the trader to enter into a short position.

Source: Source: FXTrek Intellicharts

Unfortunately, the divergence trade is not very accurate - it fails more times than it succeeds. Prices frequently have several final bursts up or down that trigger stops and force traders out of position just before the move actually makes a sustained turn and the trade becomes profitable. Figure 3 demonstrates a typical divergence fakeout, which has frustrated scores of traders over the years.

Figure 3: A typical divergence fakeout. Strong divergence is illustrated by the right circle (at the bottom of the chart) by the vertical line, but traders who set their stops at swing highs would have been taken out of the trade before it turned in their direction.

Source: Source: FXTrek Intellicharts

One of the reasons that traders often lose with this set up is they enter a trade on a signal from the MACD indicator but exit it based on the move in price. Since the MACD histogram is a derivative of price and is not price itself, this approach is, in effect, the trading version of mixing apples and oranges.

Using the MACD Histogram for Both Entry and Exit
To resolve the inconsistency between entry and exit, a trader can use the MACD histogram for both trade entry and trade exit signals. To do so, the trader trading the negative divergence takes a partial short position at the initial point of divergence, but instead of setting the stop at the nearest swing high based on price, he or she instead stops out the trade only if the high of the MACD histogram exceeds its previous swing high, indicating that momentum is actually accelerating and the trader is truly wrong on the trade. If, on the other hand, the MACD histogram does not generate a new swing high, the trader then adds to his or her initial position, continually achieving a higher average price for the short.

Currency traders are uniquely positioned to take advantage of this strategy because with this strategy, the larger the position, the larger potential gains once the price reverses - and in FX, you can implement this strategy with any size of position and not have to worry about influencing price. (Traders can execute transactions as large as 100,000 units or as little as 1,000 units for the same typical spread of three to five points in the major pairs.)

In effect, this strategy requires the trader to average up as prices temporarily move against him or her. This, however, is typically not considered a good strategy. Many trading books have derisively dubbed such a technique as "adding to your losers". However, in this case the trader has a logical reason for doing so - the MACD histogram has shown divergence, which indicates that momentum is waning and price may soon turn. In effect, the trader is trying to call the bluff between the seeming strength of immediate price action and MACD readings that hint at weakness ahead. Still, a well-prepared trader using the advantages of fixed costs in FX, by properly averaging up the trade, can withstand the temporary drawdowns until price turns in his or her favor. Figure 4 illustrates this strategy in action.

Figure 4: The chart indicates where price makes successive highs but the MACD histogram does not - foreshadowing the decline that eventually comes. By averaging up his or her short, the trader eventually earns a handsome profit as we see the price making a sustained reversal after the final point of divergence.

Source: Source: FXTrek Intellicharts

Conclusion
Like life, trading is rarely black and white. Some rules that traders agree on blindly, such as never adding to a loser, can be successfully broken to achieve extraordinary profits. However, a logical, methodical approach for violating these important money management rules needs to be established before attempting to capture gains. In the case of the MACD histogram, trading the indicator instead of the price offers a new way to trade an old idea - divergence. Applying this method to the FX market, which allows effortless scaling up of positions, makes this idea even more intriguing to day traders and position traders alike.

by Boris Schlossberg (Contact Author | Biography)

Boris Schlossberg serves as director of currency research at GFT Forex. He is a weekly contributor to CNBC's Squawk Box and a regular commentator for Bloomberg radio and television. His daily currency research is widely quoted by Reuters, Dow Jones and Agence France Presse newswires and appears in numerous newspapers worldwide. Schlossberg has written for publications like SFO magazine, Active Trader and Technical Analysis of Stocks and Commodities. He is also the author of "Technical Analysis of the Currency Market" and the co-author of "Millionaire Traders" with Kathy Lien.

Filed Under: Forex

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Trading The MACD Divergence