23 August 2005

Out & About

!!!On Holidays!!!

The Blog would be up and running again by the 1st January 2006.

Trading Costs

The cost associated with trading securities can have a non-negligible impact on portfolio return. Trading costs include the following:
  • Explicit costs - commissions, fees, and taxes.
  • Market maker spread - difference between the bid and ask prices that the specialist sets for a stock; the specialist keeps the difference as compensation for providing immediacy. For less liquid stocks, the specialist has greater exposure to adverse price movements and likely will make the spread larger.
  • Market impact - results when high volume trades influence the market price. Market impact can be broken into two components - a temporary one and a permanent one. The temporary component is due to the need for liquidity to fill the order. The permanent impact is due to the change in the market's perception of the security as a result of the block trade.
  • Opportunity cost - the effective cost of price movements that occur before the trade executes.
NYSE specialists sometimes may appear to have a monopoly on trading their respective securities, creating a larger than necessary spread between bid and ask. However, there is more competition than is initially obvious. First, there is competition for the specialist positions, providing the specialist incentive to price fairly. Furthermore, there are other specialists on the floor who may be willing to trade within the spread if it is too wide.

The total trading cost of a buy transaction is calculated by taking the percentage increase of the average purchase price as compared to the price when the buy decision was made, and adding the commissions, fees, and taxes as a percentage of the price when the buy decision was made.

Active portfolio managers attempt to outperform passive benchmarks, but trading costs reduce any realized advantages. Typical trading commissions run 0.20% of the transaction amount, and the typical cost due to bid-ask spread and market impact is 0.55%. The total cost of a trade then is 0.75% of the trade amount. If a fund has a portfolio turnover rate of 80%, and for every sell transaction the stock is replaced via a buy transaction, a total of 160% of the portfolio value will be transacted each year. For trading costs of 0.75% per transaction, the annual trading costs amount to (1.6)(0.75%) = 1.20% of the portfolio value. If one adds a 0.3% management fee to this amount, the total becomes 1.50%.

Reducing Trading Costs: Passively Traded Funds

Passive portfolios have lower transaction costs and overall trading costs. The transaction cost is typically 0.25% of the transaction value, since a passive portfolio does not have to trade as quickly and can be more patient with each transaction. A typical turnover rate for a passive portfolio is about 4% per year, and assuming replacement 8% of the portfolio value will be transacted each year for annual trading costs of only (0.08)(0.25%) = 0.02% of the portfolio value. Passive portfolios have lower management fees, for example, 0.10%, so the total of trading costs and management fees is only 0.12%, compared to 1.50% for a typical actively managed fund.

Passively managed funds that track an index often have returns less than that of the index because of trading costs, especially for small-cap indices in which the securities are less liquid. These trading costs can be reduced if the weights of the securities in the fund are allowed to deviate somewhat from the index, since both trading volume and the need for immediacy are reduced. The correlation with the index still can remain quite high under the relaxed weights.

In 1982 Dimensional Fund Advisors (DFA) introduced a passive small-cap "9-10" fund composed of the lower two deciles of NYSE market capitalization. The fund sacrificed tracking accuracy by allowing the weights to deviate in order to minimize trading costs. The result was higher performance than other small-cap funds. The 9-10 fund even outperformed the stocks in the lower two market capitalization deciles of the NYSE, partly due to the following strategies:
  1. The 8th decile is treated as a hold range, not a sell range,
  2. The DFA waits a minimum of one year before buying IPO's,
  3. The fund does not buy stocks selling for less than $2 or having less than $10 million in market capitalization,
  4. The fund does not buy NASDAQ stocks having fewer than four market makers,
  5. The fund does not buy bankrupt stocks, and
  6. The fund is passive, not rigidly indexed.
Note that using the 8th decile as a hold range effectively increases the average market cap of the portfolio and increases returns in periods in which large caps outperform small caps, such as in the 1980's.

Reducing Trading Costs: Electronic Trading

Electronic crossing networks have lower trading costs than do exchanges because of lower commissions, no bid-ask spread, and elimination of market impact. By matching the natural buyers and sellers of a security at some predetermined price, for example, the NYSE closing price, electronic crossing networks eliminate the need for a market maker to provide liquidity. However, crossing networks require buyers and sellers to participate in order for there to be liquidity. Furthermore, there are the disadvantages of potentially limited liquidity and no inherent price discovery mechanism.

Electronic communications networks are computerized bulletin boards for matching trades. Because the traders can remain anonymous, price impact is diminished.

Another electronic trading mechanism is the single-price call auction in which buyers and sellers simply place limit orders. The market clearing price is set at the intersection of the supply and demand curves.

19 August 2005

Your Views?

* What effect is technology having on education?

* What role would technology play in education in the years to come?

Dont hesitate to express your views!

18 August 2005

Is Trade Good for Poor Countries?

Robert Hunter-Wade writes in the Financial Times:

Even the World Bank estimates that removing rich countries’ barriers to developing country exports would generate only very small income gains for the latter... many would actually lose from rich country trade liberalisation in key sectors. The ending of the multi-fibre agreement early this year, for example, has hurt textile exporters across the developing world as super-efficient producers in China gobble up the market.

Wade goes on to suggest other higher priorities (including reform of the WTO's intellectual property rules and the international monetary system).

But why have poor countries sometimes struggled to benefit from trade liberalisation? This paper from Bolaky and Freund provides evidence for an answer that is obvious in retrospect: countries with rigid labor laws or other excessive red tape cannot seize opportunities. Their entrepreneurs have to struggle against bureaucratic obstacles to respond to changes in the price of imports and exports.

Originally posted on PSD Blog by Tim Harford.

Competitiveness Partnerships

Governments that listen to the private sector are more likely to design credible and workable reforms, while entrepreneurs who understand what their government is trying to achieve with a program of reforms are more likely to accept and support them.

Benjamin Herzberg and Andrew Wright offer a practitioner's guide to setting up discussion between entrepreneurs and governments, with the aim of cutting red tape or otherwise improving the business environment.

Originally posted on PSD Blog by Tim Harford.

Joseph Stiglitz on Intellectual Property

Formerly Chief Economist at the Bank, the Nobel Laureate wrote a short piece on intellectual property in the Daily Times of Pakistan:

Without intellectual property protection, incentives to engage in certain types of creative endeavors would be weakened. But there are high costs associated with intellectual property. Ideas are the most important input into research, and if intellectual property slows down the ability to use others’ ideas, then scientific and technological progress will suffer. In fact, many of the most important ideas – for example, the mathematics that underlies the modern computer or the theories behind atomic energy or lasers – are not protected by intellectual property.

To read the article please click here.

16 August 2005

Financial Ratios

A firm's performance can be evaluated using financial ratios. Referencing these ratios to those of other firms allows a comparison to be made. The following is a listing of some useful ratios.

Leverage : Assets / Shareholder's Equity

Gross Margin = Gross Profit / Sales
Gross margin measures the profitability considering only variable costs and is a measure of the percentage of revenue that goes to fixed costs and profit.

Net Profit Margin = Net Income / Sales

Total Asset Turnover = defined as Sales / Total Assets

Return on Assets (ROA) = Net Income / Assets
ROA is a measure of the return on money provided by both owners and creditors, and is a measure of how efficiently all resources are managed.

Return on Equity (ROE) = defined as Net Income / Equity
Where the equity value is the shareholder's equity at the end of the period in which the income was earned. ROE is a measure of the return on money provided by the firm's owners.

ROE can be calculated indirectly as:

ROE = ( Net Income / Total Assets ) ( Total Assets / Equity )

ROE also can be calculated using DuPont analysis:

ROE = (Net Income / Sales)(Sales / Total Assets)(Total Assets / Equity)

This states that ROE is determined by multiplication of three levers:

ROE = (net profit margin) (total asset turnover) (leverage)

These levers are readily viewed on the company's financial statements. While ROE's may be similar among firms, the levers may differ significantly.


The term working capital is used to describe the current items of the balance sheet. Working capital includes current assets such as cash, accounts receivable, and inventory, and current liabilities such as accounts payable and other short term liabilities. Net working capital is defined as non-cash current operating assets minus non-debt current operating liabilities. Cash, short-term debt, and current portion of long-term debt are excluded from the net working capital calculation because they are related to financing and not to operations.

Two commonly used liquidity ratios are the current ratio and the quick ratio.

Current Ratio : defined as Current Assets / Current Liabilities.
The current ratio is a measure of the firm's ability to pay off current liabilities as they become due.

Quick Ratio : defined as Quick Assets / Current Liabilities.
The quick ratio also is known as the acid test. Quick assets are defined as cash, accounts receivable, and notes receivable - essentially current assets minus inventory.

14 August 2005

SWOT Analysis

A scan of the internal and external environment is an important part of the strategic planning process. Environmental factors internal to the firm usually can be classified as strengths (S) or weaknesses (W), and those external to the firm can be classified as opportunities (O) or threats (T). Such an analysis of the strategic environment is referred to as a SWOT analysis.

The SWOT analysis provides information that is helpful in matching the firm's resources and capabilities to the competitive environment in which it operates. As such, it is instrumental in strategy formulation and selection.


A firm's strengths are its resources and capabilities that can be used as a basis for developing a competitive advantage. Examples of such strengths include:

* patents
* strong brand names
* good reputation among customers
* cost advantages from proprietary know-how
* exclusive access to high grade natural resources
* favorable access to distribution networks


The absence of certain strengths may be viewed as a weakness. For example, each of the following may be considered weaknesses:

* lack of patent protection
* a weak brand name
* poor reputation among customers
* high cost structure
* lack of access to the best natural resources
* lack of access to key distribution channels

In some cases, a weakness may be the flip side of a strength. Take the case in which a firm has a large amount of manufacturing capacity. While this capacity may be considered a strength that competitors do not share, it also may be a considered a weakness if the large investment in manufacturing capacity prevents the firm from reacting quickly to changes in the strategic environment.


The external environmental analysis may reveal certain new opportunities for profit and growth. Some examples of such opportunities include:

* an unfulfilled customer need
* arrival of new technologies
* loosening of regulations
* removal of international trade barriers


Changes in the external environmental also may present threats to the firm. Some examples of such threats include:

* shifts in consumer tastes away from the firm's products
* emergence of substitute products
* new regulations
* increased trade barriers

PEST Analysis

A scan of the external macro-environment in which the firm operates can be expressed in terms of the following factors:

* Political
* Economic
* Social
* Technological

The acronym PEST (or sometimes rearranged as "STEP") is used to describe a framework for the analysis of these macroenvironmental factors.

Political Factors

Political factors include government regulations and legal issues and define both formal and informal rules under which the firm must operate. Some examples include:

* tax policy
* employment laws
* environmental regulations
* trade restrictions and tariffs
* political stability

Economic Factors

Economic factors affect the purchasing power of potential customers and the firm's cost of capital. The following are examples of factors in the macroeconomy:

* economic growth
* interest rates
* exchange rates
* inflation rate

Social Factors

Social factors include the demographic and cultural aspects of the external macroenvironment. These factors affect customer needs and the size of potential markets. Some social factors include:

* health consciousness
* population growth rate
* age distribution
* career attitudes
* emphasis on safety

Technological Factors

Technological factors can lower barriers to entry, reduce minimum efficient production levels, and influence outsourcing decisions. Some technological factors include:

* R&D activity
* automation
* technology incentives
* rate of technological change

External Opportunities and Threats

The PEST factors combined with external microenvironmental factors can be classified as opportunities and threats in a SWOT analysis.

10 August 2005

Antidumping law: protecting special interests

The current issue of Foreign Affairs has an excellent article debunking the idea that America's antidumping policies are good for America. The essay, Antidumping: The Third Rail of Trade Policy, is written by N. Gregory Mankiw and Phillip L. Swagel. They say that antidumping law has become just a way for vested interests to protect themselves at the expense of American consumers (especially harming the poorest Americans) and at the expensive of companies that benefit from cheap inputs.

The authors point out that antidumping law's use in practice is very different from its purpose. It was introduced to act "when a foreign company uses temporary low prices to drive its competitors out of the market and then raises prices, a practice known as 'predatory pricing'." The idea was that consumers lose out in the long run because foreign producers are able to raises prices having put the competition out of practice. But even that might be a weak reason for the an antidumping law. As the authors point out: "On the other hand, if the price war lasts long enough or if the would-be predator is unable to raise prices in the end because of the entrance of new competitors, consumers are net winners. The possibility of new firms entering a market is thus a crucial constrain on anticompetitive behavior."

Moreover, predatory pricing isn't what the law is used for: "the American companies who petition for antidumping tariffs... use them to thwart foreign competition. In essence, 'antidumping' means little more than 'antibargain'."

The biggest user of antidumping procedures is the steel industry: "nearly half of antidumping tariffs imposed since 1970 have been on steel imports, and 158 of the 294 antidumping orders in force as of April 2005 were on steel products." The result, according to one study, is that for each job saved by steel tariffs, three jobs are lost in steel-using industries.

Sometimes antidumping rows are resolved by "suspension agreements" where foreign companies agree to minimum prices for their exports. But the authors point out: "It is no small irony that the [US] Department of Commerce sets prices in this fashion for steel plates imported into the United States from the former Soviet Union."

Originally published on the Globalization Institute Blog byAlex Singleton

09 August 2005

What Happened When Two Countries Liberalized Trade? Pain, Then Gain

"ECONOMISTS argue for free trade. They have two centuries of theory and experience to back them up. And they have recent empirical studies of how the liberalization of trade has increased productivity in less-developed countries like Chile and India. Lowering trade barriers, they maintain, not only cuts costs for consumers but aids economic growth and makes the general public better off."

To read this excellent article by Virginia Postrel please click here.

07 August 2005

A Definition of Entrepreneurship

The concept of entrepreneurship has a wide range of meanings. On the one extreme an entrepreneur is a person of very high aptitude who pioneers change, possessing characteristics found in only a very small fraction of the population. On the other extreme of definitions, anyone who wants to work for himself or herself is considered to be an entrepreneur.

The word entrepreneur originates from the French word, entreprendre, which means "to undertake." In a business context, it means to start a business. The Merriam-Webster Dictionary presents the definition of an entrepreneur as one who organizes, manages, and assumes the risks of a business or enterprise.

Schumpeter's View of Entrepreneurship

Austrian economist Joseph Schumpeter 's definition of entrepreneurship placed an emphasis on innovation, such as:

* new products
* new production methods
* new markets
* new forms of organization

Wealth is created when such innovation results in new demand. From this viewpoint, one can define the function of the entrepreneur as one of combining various input factors in an innovative manner to generate value to the customer with the hope that this value will exceed the cost of the input factors, thus generating superior returns that result in the creation of wealth.

Entrepreneurship vs. Small Business

Many people use the terms "entrepreneur" and "small business owner" synonymously. While they may have much in common, there are significant differences between the entrepreneurial venture and the small business. Entrepreneurial ventures differ from small businesses in these ways:

1. Amount of wealth creation - rather than simply generating an income stream that replaces traditional employment, a successful entrepreneurial venture creates substantial wealth, typically in excess of several million dollars of profit.

2. Speed of wealth creation - while a successful small business can generate several million dollars of profit over a lifetime, entrepreneurial wealth creation often is rapid; for example, within 5 years.

3. Risk - the risk of an entrepreneurial venture must be high; otherwise, with the incentive of sure profits many entrepreneurs would be pursuing the idea and the opportunity no longer would exist.

4. Innovation - entrepreneurship often involves substantial innovation beyond what a small business might exhibit. This innovation gives the venture the competitive advantage that results in wealth creation. The innovation may be in the product or service itself, or in the business processes used to deliver it.

A Race to the Top

"It was extremely revealing traveling from Europe to India as French voters (and now Dutch ones) were rejecting the E.U. constitution - in one giant snub to President Jacques Chirac, European integration, immigration, Turkish membership in the E.U. and all the forces of globalization eating away at Europe's welfare states. It is interesting because French voters are trying to preserve a 35-hour work week in a world where Indian engineers are ready to work a 35-hour day. Good luck."

"Yes, this is a bad time for France and friends to lose their appetite for hard work - just when India, China and Poland are rediscovering theirs."

Article published by Thomas L. Friedman can be read here.

Web Globalization

Earlier this week John Yunker spotted a job advert. This job advert gave him an excuse to link back to a piece he did last December in which he said that 2005 would be the year when Web Globalization Goes Mainstream. Web designers are now being asked if they are also "web globalizers". Can they, that is to say, design websites that reach out successfully beyond their linguistic base, with well placed "change the language" buttons, which route viewers to their local supplier of the global goods or services in question?

One of the most portentous questions about cheap global electronic communication generally, and about the internet in particular, concerns whether these technologies will unite mankind, regardless of race, colour, creed, or language, or whether, by making global communication far easier between all those who share the same beliefs, cultures or languages, it will merely allow mankind to remain as divided and quarrelsome as ever.

But this latter tendency may only be the first consequence of the new technology.

Throughout the history of communications technology you get these first-this-then-that stories. Printing began with Latin Bibles, which seemed capable of uniting all of Christendom. But soon, printing presses were the basis of different, nationally distinct, church systems, each with their own particular Bibles, like the Church of England. Printing turned out to be divisive and nationalistic.

Our current electronic communications devices, when they first got started in the 1840s, when the Morse Code was first devised, seemed at first to hold out the promise of global unification. Yet the electric telegraph fed nationally selected news to national newspapers distributed on national railway systems which were themselves only made manageable by telegraph wires besides the railway lines. And when the nationalism thus democratised and inflamed culminated in the First World War, telephones enabled a new sort of twentieth century warlord to supervise battles that stretched over hundreds of miles and thus killed soldiers in unprecedented numbers.

In short, these things can be very hard to predict.

The tendency that John Yunker has noted suggests that the internet may now be engaged in yet another of these communications technology about-faces. Yes, the internet, during its first few years, has allowed people to concentrate on the easy stuff, of talking only to ideological allies, of uniting only those most easily united, of selling products only to those who already understand your language and already love your sales patter, needing only to hear it. But once that is accomplished, the balance of reward shifts, towards those who are able to reach out beyond the confines of shared belief, shared culture, or shared language. Selling across language barriers, with effective multi-lingual websites, is all part of this latter process.

Originally published on the Globalization Institute Blog by Brian Micklethwait.

06 August 2005

Made in China

Britain's tabloid Sun newspaper had an superb article on Friday on the effect of globalization on China. Oliver Harvey, writing from Shenzhen in China, pointed out that only 25 years ago Shenzhen was a...

...sleepy, impoverished, fishing village. Workers in blue Mao tunics cycled to work for a pittance in the bleak paddy fields on Communist farms. Today, the city is the heartbeat of the new China - a throbbing metropolis of soaring skyscrapers and ten million soulds that has become the workshop of the world.

The paper illustrated how China is cutting the cost of clothing with a picture of a man and woman with each bit of clothing priced. The article also explained that Chinese success does not mean we in Britain will lose out jobs-wise. It concluded with a Factfile:

China's economy is growing three times faster than America. It uses 40 per cent of the world's concrete and 25 per cent of its steel. Produces 16billion pairs of socks a year. Is currently building 200 airports. Built more power stations last year than exist in Britain. Makes 40 per cent of the world's microwaves, 30 per cent of our TVs, one in four washing machines.

All this is excellent news in the fight against poverty - and China's integration into the world economy should be welcomed too from the perspective of promoting peace and stability around the globe.

Originally published on the Globalization Institute Blog by Penelope Hawthorne.

Banana Wars

Some people still don't quite seem to get this free trade idea. I refer, of course, to Peter Mandelson's minions in Brussels who have once again been found to be in the wrong by the World Trade Organization.

Brussels suffered a blow in its latest trade war yesterday after the World Trade Organization ruled against its plans to triple import duties on bananas imported from the Americas.

They have managed to understand one small piece of the puzzle, that tariffs are at least better, less distorting, than quotas:

The "banana wars" go back to at least the 1990s when the EU agreed to dismantle its complex quota system and replace it with tariffs.

Why is it that they actually want to have tariffs at all? The European Union (small volumes from the Azores and Canaries aside) is not known as a producer of bananas so there is no domestic industry to protect (not that that would be a good reason even if there were).

The EU wants to give privileged access to its markets to African, Caribbean and Pacific region countries - many of which are former colonies. It had planned to lift tariffs on Latin American bananas from €75 (£52) a ton to €230 from the beginning of next year.

This shows up two points. Firstly, that organizations like the WTO are essential to keep those who sign agreements to the terms of those very agreements they have signed. Without a complaints procedure ("Teacher! He did it first!") whatever was actually down there on the piece of paper would be ignored in a welter of recriminations.

The second is that the Brussels mandarins seem not to have grasped the important point about free trade. If we wish to aid banana growers who are woefully uncompetitive in the world market (as, for example, many of the Caribbean ones are) we would be best served by aiding them directly, perhaps by helping to upgrade their production or by assisting their move into the production of other items.

Forcing every mother on the continent to pay more for the mashed banana she forces down her little one's throat is a grossly inefficient way of perpetuating those poor countries' dependency.

Far better to have free trade, zero tariffs and quotas, and then deal with the displaced and losers from the change directly.

Originally published on the Globalization Institute Blog by Tim Worstall.

03 August 2005

Market Share

Sales figures do not necessarily indicate how a firm is performing relative to its competitors. Rather, changes in sales simply may reflect changes in the market size or changes in economic conditions.

The firm's performance relative to competitors can be measured by the proportion of the market that the firm is able to capture. This proportion is referred to as the firm's market share and is calculated as follows:

Market Share = Firm's Sales / Total Market Sales

Sales may be determined on a value basis (sales price multiplied by volume) or on a unit basis (number of units shipped or number of customers served).

While the firm's own sales figures are readily available, total market sales are more difficult to determine. Usually, this information is available from trade associations and market research firms.

Reasons to Increase Market Share

Market share often is associated with profitability and thus many firms seek to increase their sales relative to competitors. Here are some specific reasons that a firm may seek to increase its market share:
  • Economies of scale - higher volume can be instrumental in developing a cost advantage.
  • Sales growth in a stagnant industry - when the industry is not growing, the firm still can grow its sales by increasing its market share.
  • Reputation - market leaders have clout that they can use to their advantage.
  • Increased bargaining power - a larger player has an advantage in negotiations with suppliers and channel members.
Ways to Increase Market Share

The market share of a product can be modeled as:

Share of Market = Share of Preference x Share of Voice x Share of Distribution

According to this model, there are three drivers of market share:
  • Share of preference - can be increased through product, pricing, and promotional changes.
  • Share of voice - the firm's proportion of total promotional expenditures in the market. Thus, share of voice can be increased by increasing advertising expenditures.
  • Share of distribution - can be increased through more intensive distribution.
From these drivers we see that market share can be increased by changing the variables of the marketing mix.
  • Product - the product attributes can be changed to provide more value to the customer, for example, by improving product quality.
  • Price - if the price elasticity of demand is elastic (that is, > 1), a decrease in price will increase sales revenue. This tactic may not succeed if competitors are willing and able to meet any price cuts.
  • Distribution - add new distribution channels or increase the intensity of distribution in each channel.
  • Promotion - increasing advertising expenditures can increase market share, unless competitors respond with similar increases.
Reasons Not to Increase Market Share

An increase in market share is not always desirable. For example:
  • If the firm is near its production capacity, an increase in market share might necessitate investment in additional capacity. If this capacity is underutilized, higher costs will result.
  • Overall profits may decline if market share is gained by increasing promotional expenditures or by decreasing prices.
  • A price war might be provoked if competitors attempt to regain their share by lowering prices.
  • A small niche player may be tolerated if it captures only a small share of the market. If that share increases, a larger, more capable competitor may decide to enter the niche.
  • Antitrust issues may arise if a firm dominates its market.
In some cases it may be advantageous to decrease market share. For example, if a firm is able to identify certain customers that are unprofitable, it may drop those customers and lose market share while improving profitability.