A practical example of a weighted index is the U.S. Dollar Index, traded on the New York Futures Exchange. In order of greatest weighting, the 10 currency components are the Deutschemark 20.8%, Japanese yen 13.6%, French franc 13.1%, British pound 11.9%, Canadian dollar 9.1%, Italian lira 9.0%, Netherlands guilder 8.3%, Belgian franc 6.4%, Swedish kroner 4.2%, and the Swiss franc 3.6%. This puts a total weight of 75.5% in European currencies with only the Japanese yen representing Asia, not a practical mix for a world economy that has become dependent on Far Eastern trade. Within Europe, however, allocations seem to be proportional to the relative size of the economies.
The Dollar Index rises when the U.S. dollar rises. Quotes are in foreign exchange notation, where there are 1.25 Swiss francs per U.S. dollar, instead of .80 dollars per franc as quoted on the Chicago Mercantile Exchange’s IMM. For example, when the Swiss franc moves from 1.25 to 1.30 per dollar, there are more Swiss francs per dollar; therefore, each Swiss franc is worth less.
In the daily calculation of the Dollar Index, each price change is represented as a percent. If, in our previous example, the Swiss franc rises .05 points, the change is 5/12 5 04; this is multiplied by its weighting factor .208 and contributes +. 00832 to the Index.
U.S. Dollar Index
December 7th, 2009Compensation and management incentives
December 6th, 2009The compensation of managers can be structured to bring the interests of managers more into harmony with those of shareholders. Corporations usually tie the compensation of managers to the market success of the business. The salary increases and bonuses of most high-level managers are directly related to the firm’s profitability and the price of its shares. How important are these incentives? In recent years, salaries have constituted only about 10 percent of the compensation of chief executive officers (CEOs). The other 90 percent has been in the form of bonuses, often stock awards and stock options (the right to buy shares at a certain price). Both forms of payment have a “vesting period,” which means they will be granted only if the CEO stays with the firm for a certain amount of time and meets specific goals. Policies like these encourage corporate managers to maximize the the firm’s profits – and, not coincidentally, the value – of its shares both strongly in the interest of shareholders. Managers who develop a good track record of adding value to the firm gain not only more pay and greater job security, but also better job offers should they later decide to switch firms.
Incentive pay brings with it another unwanted incentive for managers, though: the incentive to gain personally by manipulating the firm’s accounting records to make its financial performance look better than it really is. However, stockholders and portfolio managers, and especially investors who specialize in selling stocks short when they think the firm is overvalued, will be scrutinizing the records to detect phony accounting designed to mislead investors.
THE INDEX
December 3rd, 2009The purpose of an average is to transform individuality into classification. When done properly, there is useful information to be gained. Indices have gained popularity in the futures markets recently; the stock market indices are now second to the financial markets in trading volume. These contracts allow both individual and institutional participants to invest in the overall market movement rather than take the higher risk of selecting individual securities. Furthermore, investors can hedge their current market position by taking a short position in the futures market against a long position in the stock market.
A less general index, the Dow Jones Industrials, or a grain or livestock index can help the trader take advantage of a more specific price without having to decide which products are more likely to do best. An index simplifies the decision-making process for trading. if an index does not exist, it can be constructed to satisfy most purposes.
If it’s worth doing..
November 28th, 2009Eliminating pollution. Earning straight As. Being completely organized Cleaning your apartment until it sparkles. Making automobiles completely safe. Making airplanes fully secure against terrorist attacks. All of these are worthwhile goals, right? Well, they are until you consider the costs of actually achieving them. The heading for this post is of course, a play on the old saying, “If it’s worth doing, it’s worth doing to the best of your ability.” Economics suggests, however, that this is not a sensible guideline At some point. the gains from doing something even better will not be worth the cost It will make more sense to stop short of perfection.
As more resources are dedicated to an activity, the marginal improvements (benefits) will become smaller and smaller, while the marginal costs will rise. The optimal time and effort put into the activity will be achieved at Q2, and this will nearly always be well below one’s best effort. Note that inef-ficiency results when either too little (for example, Q,) or too much (for example, Q,) time and effort are put into the activity.
Do you make decisions this way? Last time you cleaned your car or apartment, why did you decide to leave some things undone? Once the most important areas were clean, you likely began to slup over other areas (like on top of the refrigerator or under the bed), figuring that the benefits of cleaning these areas were not worth the cost. Very few people live in a perfectly organized and clean house, wash their hands enough to prevent all colds, brush their teeth long enough to prevent all cavities, or make their home as Fort Knox. They recognize that the benefit of perfection in these, and many other areas, is simply not worth the cost.
Economics is about trade-offs; it is possible to pursue even worthy activities beyond the level that is consistent with economic efficiency. People seem to be more aware of this in their personal decision making than when evaluating public policy. It is not uncommon to hear people say things like, “We ought to eliminate all pollution” or “No price is too high to save a life.”
Incentives, cooperation and the nature of the firm (2)
November 22nd, 2009The firm can reduce many of the transaction costs associated with contracting by using team production. Team production, however, comes with another set of problems. Team members – the employees working for the firm. – must be monitored and given incentives to avoid shirking, or working at less than the expected rate of productivity. Taking long work breaks, paying more attention to their own convenience than to work results, and wasting time when diligence is called for are examples of shirking. A worker will shirk more when the costs of doing so are shifted to other team members, including the owners of the firm. Hired managers, even including those at the top, must be monitored and given incentives to avoid shirking.
Imperfect monitoring and imperfect incentives are a problem with team production. It is part of a larger class of what economists call principal-agent problems. A person taking a car to an auto mechanic confronts this problem. The mechanic wants to get the job done quickly and make as much money on it as possible. The car owner wants to get the job done quickly also, but wants the problem fixed in a lasting way, at the lowest possible cost. Because the mechanic typically knows far more about the job than the customer, it is hard for the customer to monitor the mechanic’s work. There is a possibility, therefore, that the mechanic may charge a large amount for a “quick fix” that will not last.
The owner of a firm is in a similar situation. It is often difficult to monitor the performance of individual employees and motivate them in a way that will encourage high productivity. Nonetheless, the ability of the firm to use resources effectively and succeed in a competitive market depends crucially upon resolving these problems. To keep costs low and the value of output high, a firm must discover and use an incentive structure that motivates managers and workers, and discourage5 shirking. The problem extends all the way to the top.
Even top-level executives hired to manage a firm do not have the same objectives as owners – who care mainly about profit maximization – unless, of course, the managers are the owners. So the judgments of executives, too, are influenced by what is in their personal best interests. They want perks, personal job security, and other benefits that may not be consistent with profit maximization for the firm. The problem becomes more serious as firms grow larger and acquire more managers and employees. Ultimately, it is the job of the owners, as residual claimants, to develop an incentive structure to minimize the principal-agent problem. For the owner, the saying “the buck stops here” always applies.
Incentives, cooperation and the nature of the firm (1)
November 18th, 2009In capitalist countries, most firms are privately owned. Owners risk their wealth on the success of the business. If the firm is successful and earns profits, these financial gains go to the owners. Conversely, if the firm suffers losses, the owners must bear the consequences. Because the owners receive what remains after the revenue of the firm is used to pay the contractual costs, they are called residual amiantus.
In a market economy, the property right of owners to the residual income of the firm plays a very important role: it provides owners with a strong incentive to organize and structure their business in a manner that will keep the cost of producing output low (relative to its value). The wealth of these residual claimants is directly influenced by the success or failure of the firm. Thus, they have both the authority and a strong incentive to see that resources under their direction are used efficiently and directed toward production do goods that are valued more highly than their costs.
In principle, all production could be accomplished solely through contracting. For example, a builder might have a house built by contracting with one person to pour the concrete, another to construct the wooden part of the house, a third to install the roofing, a fourth to do the electrical wiring, and so on. No employees would have to be involved in such a project. More commonly though, goods and services are produced with some combination of contracting and the use of team production by employees of a firm.
Why do firms use team production? If contracting alone is used to produce some- thing, the producer must, for each project, (1) determine what needs to be produced and how, given the circumstances, current technology, and prices, (2) search out reliable suppliers, and (3) negotiate and enforce the contracts. The entrepreneur who wants to produce by this method must have specialized knowledge in a variety of areas and must devote a great deal of time and effort to the planning and contracting processes. Not many people have the expertise or the time to perform all these tasks by themselves except on a small scale. Team production for certain tasks can be more practical and less costly.
Accordingly, a builder with multiple projects is likely to hire knowledgeable, experienced workers to plan the construction process, purchase materials, and build the structures. The builder will then contract with others to obtain materials and more specialized labor services.
Competition among firms for investment funds and customers
November 13th, 2009Even without direct control of their corporation, stockholders (and the investment advisers, pension fund managers, and others hired to help them) have an incentive to monitor the corporation’s management in order to anticipate problems and search for constructive changes. Investors who are the first to spot a profitable new management strategy can buy stock early, before others realize the opportunity, and bid the price up. A rising stock price is both a signal of approval to good managers and an incentive to manage the corporation well. Conversely, when managers’ decisions are contrary to the interests of stockholders, the opposite occurs: the stock price will fall. Knowing that stock prices can plummet motivates stockholders (along with professional managers of stock holdings) to be the first to spot a problem with the company. This way they can dump their stock before everyone else does, and thus prior to the share price falling. Some investment firms even specialize in selling shares “short” (writing contracts to deliver shares of the stock later, when they expect the stock price to be lower than its current level) if they believe a company is overvalued on the market. So managers get constant feedback via stock price changes, which can be just as important as current profits to stockholders and boards of directors.
Similarly, consumers have an incentive to monitor the quality and price of the firm’s output. No one forces them to buy the corporation’s product, so if other firms supply superior products or offer lower prices, consumers can take their business elsewhere. Because investors are free to buy and sell the company’s shares and customers to buy its products or those of other firms, the ability of managers to benefit personally at the expense of either customers or stockholders is limited. While some managers are still able to enrich themselves at stockholders’ expense, at least temporarily, the recent cases of corporations like Tyco and Enron show that their actions tend to catch up with them.
The cost of government subsidy programs
November 10th, 2009Policy makers and citizens alike often complain that the cost of government subsidy programs almost invariably exceeds initial projections. One reason for this is the increase in the quantity of the good purchased resulting from the subsidy. Prior to the enactment of the textbook subsidy, 100 million textbooks were sold annually. With a subsidy of $20 per textbook, one might be inclined to think that the annual cost of the program will be $2 billion ($20 X 100 million). This figure, however, will underestimate the true cost. Once the subsidy is in place, textbook sales will increase to 110 million, driving the overall cost of the program up to $2.2billion ($20X 110million).
Furthermore, the expenditures on the subsidies will understate their total costs. To finance the subsidies, the government will have to raise the funds through taxation. A subsidy granted in one market will require taxation in other markets. As we have previously discussed, the taxes will generate a deadweight loss over and above the revenues transferred to the government. This excess burden is also a cost of the subsidy payments.
Offset foreclosure costs
November 7th, 2009The buffer also provides a margin to cover professional foreclosure costs. Many legal systems, particularly in developing markets, are biased against creditors. Banks are often better placed than other creditors but there are still significant legal and professional costs associated with foreclosure.
Building a Model
November 6th, 2009A model can be created to explain or forecast price changes. Most models explain rather than forecast. Explanatory models analyze sets of data at concurrent times, that is, they look for relationships between multiple factors and their effect on price at the same moment in time. They can also look for causal, or lagged relationships, in which prices respond to other factors after one or more days. It is possible to use the explanatory model to determine the normal price at a particular moment. Although not considered forecasting, any variation in the actual market price from the normal or expected price could present trading opportunities.
Methods of selecting the best forecasting model can affect its credibility An analytic approach selects the factors and specifies the relationships in advance. Tests are then performed on the data to verify the premise. Many models, though, are refined by fitting the data, using regression analysis or shotgun testing, which applies a broad selection of variables and weighting to find the best fit. These models do not necessarily forecast but are definitely using perfect hindsight. Even an analytic approach that is subsequently finetuned could be in danger of losing its forecasting qualities.
The factors that comprise a model can be both numerous and difficult to obtain. The change in value of the U.S. dollar and the volatility of interest rates have had far greater influence on price than normal fundamental factors for many commodities.
Models that explain price movements must be constructed from the primary factors of supply and demand. A simple example for estimating the price of fall potatoes’ is where P is the average price of fall potatoes received by farmers; PPI is the Producer Price Index; S is the apparent domestic free supply (production less exports and diversions); D is the estimated deliverable supply; and a, b, and c are constants determined by regression analysis.
This model implies that consumption must be constant (i.e., inelastic demand); demand factors are only implicitly included in the estimated deliverable supply Exports and diversion represent a small part of the total production. The use of the PPI gives the results in relative terms based on whether the index was used as an inflator or defiator of price.