Journal of Applied Research in Finance: summer 2010 issue

JARF Summer 2010 Issue (pdf file)

Anand BANSAL, J.S. PASRICHA

Impact of Foreign Capital on Economic Growth in India: 1992 – 2009 … 9

Gustavo FERRO

Insurance Regulation and the Credit Crisis. What’s New? … 14

Francesco GUIDI

Modelling and Forecasting Volatility of East Asian Newly Industrialized Countries

and Japan Stock Markets with Non-Linear Models … 27

Drama Bedi Guy HERVE, Yao SHEN, Amzath AMED

The Effects of Real Exchange Rate on Trade Balance in Cote D’ivoire:

Evidence from the Cointegration Analysis and Error-Correction Models … 44

Taisei KAIZOJI

Modelling of Stock Return Volatility … 61

Nader NAIFAR

Does the Subprime Crisis affect Credit Default Swap Markets? … 68

Nobuyoshi YAMORI, Yoshihiro ASAI

Did Market Reform make Risk Evaluation on Japanese Firms Easier?:

An Evidence from Credit Ratings … 74

Xiaolou YANG

The Effect Of Annual Earnings Announcement Delay On Stock Returns … 84

New issue of JAES

Volume V of the Journal of Applied Economic Sciences has been issued. I am proud to co-author one of the papers.

Alessio Emanuele BIONDO, Growth Rate for a Sustainable Economy … 7

Maria BOBROVA, Arndt KÜMPEL, Reasoning on Evolution of Culture and Structure

… 21

A.B. BONACHE, J. MAURICE, K. MORIS, A Best Evidence Synthesis on the Link between Budgetary Participation and Managerial Performance … 34

Ginters BUSS, Forecasts with Single-Equation Markov-Switching Model: An Application to the Gross Domestic Product of Latvia … 48

Lisi GAETANO, The Unemployment Volatility Puzzle: The Role of the Underground Economy … 59

Giuseppe GAROFALO, Patrizio MIRGANTI, The Financing of R&D Investments: Effects on Growth and Financial Structure … 70

Ivan O. KITOV, Oleg I. KITOV, Dynamics of Unemployment and Inflation in Western Europe: Solution by the 1-D Boundary Elements Method … 94

Abstract

Using an analog of the boundary elements method in engineering and science, we analyze and model unemployment rate in Austria, Italy, the Netherlands, Sweden, Switzerland, and the United States as a function of inflation and the change in labor force. Originally, the model linking unemployment to inflation and labor force was developed and successfully tested for Austria, Canada, France, Germany, Japan, and the United States. Autoregressive properties of neither of these variables are used to predict their evolution. In this sense, the model is a self-consistent and completely deterministic one without any stochastic component (external shocks) except that associated with measurement errors and changes in measurement units. Nevertheless, the model explains between ~65% and ~95% of the variability in unemployment and inflation. For Italy, the rate of unemployment is predicted at a time horizon of nine (!) years with pseudo out-of-sample root-mean-square forecasting error of 0.55% for the period between 1973 and 2006. One can expect that the unemployment will be growing since 2008 and will reach ~11.4% [0.6 %] near 2012. After 2012, unemployment in Italy will start to descend.

Evgenia MOTCHENKOVA, Daniel LELIEFELD, Adverse Effects of Corporate Leniency Programs in View of Industry Asymmetry … 114

Rajesh K. PILLANIA, Indo-China Trade: Trends, Composition and Future … 129

Georg QUAAS, Was the Worldwide Asymmetry in Current Accounts Caused by the Macroeconomic Policy of the Global Economy’s Leader? … 138

Is your breakfast getting cheaper?

The study of consumer price index sometimes gives more fun than regular research. This morning is formulated a question: Is my breakfast getting cheaper? In addition to the general knowledge of the CPI behavior, which is always good, and the quality of food, which is beyond the CPI coverage, one can enjoy the thought that every morning the meal costs less and less. Because the presence of price inflation is a part of our wisdom, the cost is assumed in relative terms, i.e. with the overall CPI as a reference.

The approach is straightforward:

1. To calculate the overall price inflation, p. We prefer monthly estimates taken on year to year basis. So, we calculate the relative increase in corresponding price index during the past 12 months:

p(t)= [P(t)-P(t-12)]/P(t-12),
where P(t) is the consumer price index, t is time in months.

2. To calculate individual price inflation, p_i, for given subcategory of the CPI. Without loss of generality, I have chosen eggs, butter, juice, and coffee. (The index of bread was started only in 2005 and thus omitted.) It is also instructive to estimate the price inflation of food.

3. To calculate the relative price inflation, i.e. subtract the p(t) from all p_i(t).

Figure 1 displays the differences between individual rates of price inflation and the overall inflation. In 2010, all prices, except that for butter, have been growing at a lower rate than the overall price index. In relative terms, each breakfast is getting cheaper, if you do not eat butter.
A researcher and likely investor may have additional fun from Figure 2, where the relative inflation of food and juice is shown. Since 2005, both curves are similar in timing of main peaks and through and their amplitudes. I would say that juice price has been chasing the overall price.


Figure 1. Relative price inflation of food, eggs, coffee, juice, and butter. Since the beginning of 2010, all prices have been growing at a lower rate than the CPI, except that of butter.


Figure 2. Same as in Figure 1 for food and juice

Real GDP in Ireland

Four years ago I published a paper [1] introducing the concept of constant annual increment in real GDP per capita, G, as observed in developed countries. In the long run, the GDP growth as a linear function of time:

G(t-t₀)= G₀+B(t-t₀)

where G₀ is the initial level of GDP per capita at time t₀ in a given country, B is the country dependent increment measured in dollars. Therefore, the rate of growth of real GDP per capita, dG/G, has a decelerating trend:

dG/G = B/G

This assumption gives excellent statistical results and explains the evolution of real GDP per capita in developed countries, as also was confirmed in our 2008 paper [2].

In 2004, when the first results were obtained, there were few countries which demonstrated lager deviations from the constant increment model. The worst example was Ireland, which had demonstrated an outstanding performance in the 1990s and the beginning of the 2000s. Five years ago, I wrote

An opposite example of an excellent recovery gives Ireland with corresponding results displayed in Figure 11. A slow start was quickly compensated and the last twenty years of an extremely fast growth resulted in the leading position in the world economy with the mean increment $678. There are some doubts, however, that future will be so successful. Such a long and quick growth always ends up in a depression. This was observed in Japan and is related to the long-term decrease in the number of the specific age population [Kitov, 2005a]. Ireland has managed to increase birth rate for a very long period and has an age structure similar to that observed in Japan 20 years ago. The population distribution is currently peaked near 20 years with the defining age of 18 years. The years to come will demonstrate only decrease in the defining age population.

Fig. 11. Same as in Figure 4 for Ireland. The mean value is $678. The growth of the real GDP per capita is outstanding during the last twenty years. There is a downward tendency during the last four years, however.

So, we put the progress of the Irish economy under doubt. The reason was its similarity to the Japanese case and the underlying model of real GDP growth, which includes population of a country specific age. Neglecting fluctuations induced by the population change, we now depict the same Figure with six new readings between 2004 and 2009.

Figure. The increment of real GDP per capita vs. real GDP per capita in Ireland. As before, all data are borrowed from the Conference Board data base (http://www.conference-board.org/economics/database.cfm).

The slope of +0.06, observed between 1950 and 2003, now has reduced to 0.027, i.e. by a factor of 2. The near future of the Irish GDP per capita is under question as well: it will likely to decrease as in 2008 and 2009. We will keep reporting on the case of Ireland, but is does not represent an exclusion to our approach with constant increment. Ireland provides a higher volatility in the GDP growth, which is driven by the weird population pyramids with a strong peak at one age. Same shape is observed in Japan, but the peak age is 25 years larger.

References

[1] Kitov, I., (2006). Real GDP per capita in developed countries, MPRA Paper 2738, University Library of Munich, Germany, http://ideas.repec.org/p/pra/mprapa/2738.html

http://mpra.ub.uni-muenchen.de/2738/01/MPRA_paper_2738.pdf

[2] Kitov, I., (2009). The Evolution of Real GDP Per Capita in Developed Countries, Journal of Applied Economic Sciences, Spiru Haret University, Faculty of Financial Management and Accounting Craiova, vol. IV(1(8)_ Summ), pp. 221-234.

Does crude drive the price index of steel and iron?

In September 2009, we reported that the price index of crude oil had been likely evolving in sync with that of iron and steel, but with a lag of two months. In order to present both indices in a comparable form, the difference between a given index, iPPI, and the overall PPI was normalized to the PPI: (iPPI(t)-PPI(t))/PPI(t). The normalized differences represent the evolution of the rate of deviation from the PPI over years.

Figure 1 depicts corresponding time histories of the normalized deviations from the PPI. Simple visual inspection reveals the following feature: the (normalized deviation from the PPI of the) index of iron and steel lags by two months behind the (normalized) index of crude oil.

Figure 1. The deviation of the iron and steel price index and the index of crude oil from the PPI, normalized to the PPI.

In order to reduce both deviations to the same scale we additionally normalized the curves in Figure 1 to their peak values between 2005 and 2009:

(iPPI(t)-PPI(t))/[PPI(t)*max{iPPI-PPI)}]

This scaling allows a direct comparison of corresponding shapes. In Figure 2, we display the normalized index of iron and steel shifted by two months ahead to synchronize its peak with that observed in the normalized index for crude petroleum. The scaled index of crude demonstrates just minor discrepancies from the index of iron and steel in the overall shape and timing of the peak and trough. Simple smoothing with MA(3) makes the curves resemblance even better. As an invaluable benefit of the resemblance, one can use the two-month lag to predict the future of the iron and steel price index.

Figure 2. Deviation of the iron and steel price index from the PPI, normalized to the PPI and the peak value after 2005 as compared to the deviations of the index for crude petroleum normalized in the same way. The normalized index for iron and steel is shifted two months ahead.

Conclusion

Between 2006 and 2010, the deviation of the price index of iron and steel from the PPI in the USA repeats the trajectory of the deviation of the index of crude petroleum (domestic production) with a two-month lag. Therefore, the prediction of iron and steel price for at this horizon is a straightforward one. It is likely that in 2010 the index of iron and steel will approach closely the level attained in August 2008. From this level, it will be declining in the long run following the new trend of oil price, as shown in our previous post.

References

Kitov, I., Kitov, O., (2009). Sustainable trends in producer price indices, Journal of Applied Research in Finance, Spiru Haret University, Faculty of Financial Management and Accounting Craiova, vol. I(1(1)_ Summ), pp. 43-51

Copper ores and grains. A year after

About a year ago we published a prediction for copper and grain:

Therefore, copper price will likely not be growing to its peak in April 2008 (491.7), but will likely return to heights around 350.

In the short-run, the index for copper will be growing at least till the end of 2009. The index for grains will continue its decline relative to the PPI. As a consequence, one can expect that the index for food will be also decreasing and this decline will stretch into the 2010s.

Figure 1 compares the prediction and actual behavior for the producer price index of copper ores relative to the overall PPI. All in all, the prediction was right: by the end of 20009 the price index of copper has reached the level of 350 (375) and even higher in the beginning of 2010 (443 in April). However, it has not reached the 2008 level. It is difficult to foresee further evolution, but one cannot exclude the price to grow beyond that in 2008.

Figure 2 illustrates the accuracy of our prediction of the index of grains. The index has been falling relative to the PPI and the trajectory actually repeats that observed 142 months before, as explained the previous post:

It is instructive to compare two major spikes in the grains index in 1996 and 2008 relative to the PPI. In order to avoid comparing absolute values, which undergo secular growth, the evolution of the difference between the PPI and the price index of grains normalized to the PPI. Figure 3 presents the normalized curves. The left panel shows that the spike in the grains PPI in July 1996 is similar in relative terms to that observed in 2008. The right panel tests this hypothesis: the spikes are synchronized - for the black line is shifted forward by 142 months. From this comparison, it is likely that decline in the grains index relative to the PPI will extend into the 2010s.

Figure 1. Evolution of the price index of copper ores relative to the PPI. Upper panel: September 2009. Lower panel: April 2010.

Figure 2. Evolution of the difference between the PPI and the price index of grains normalized to the PPI. Left panel: September 2009. Right panel: April 2010.

Short term prediction

In the short-run, the index for copper will NOT be growing too long, at least NOT till the end of 2010. The index for grains will continue its decline relative to the PPI. As a consequence, one can expect that the index for food will be also decreasing and this decline will stretch into the 2011.

We can also repeat the conclusion from the post one year ago

In the long run, the producer price index for copper and that of grains both demonstrate practically unpredictable behavior with unclear future. This observation only emphasizes the importance of sustainable trends observed for other commodities. In the US economy, as in many natural systems, there exist trend components, oscillating components, and random components.

PPI of metals: annual revision

About a year ago we revised the evolution of several price indices of metals. Our general approach is based on the presence of long-term sustainable trends in the evolution of the CPI and PPI in the United States. The difference between various components of these indices is not a random but rather a predetermined process, as shown in a series of papers we published in 2008-2009 [1-4]. Using these trends, one can predict consumer and producer price indices for select goods, services and commodities [5-7]. We have summarized these papers and some more studies in a monograph “Deterministic mechanics of pricing” published by LAP [8].

In this post, we revisit the trends in the PPI of three commodities related to metals: steel iron, nonferrous metals, and metal containers. Originally, these items were studied in our article [4]. This is a regular revision with the next scheduled to the end of 2010.

1. Figure 1 compares the original (upper panel), revised (middle panel) and the newly updated differences. According to [4]:
“the normalized difference between the PPI and the index for iron and steel (101) is characterized by the presence of a sharp decline between 2001 and 2008: from +0.2 to -0.4. Between 1980 and 2000, the curve fluctuates around the zero line, i.e. there was no linear trend in the absolute difference. One could expect the negative trend is now transforming into a positive one.“

A year ago we wrote:
“Between March and June 2009, the difference continued to increase, and likely reached its peak in June (Figure 2). In July or August 2009, the difference will stall around its peak value and then will start to decrease. As a result, the index for iron and steel will be growing faster than the PPI. In the short run, one can expect a fast recovery of iron and steel prices to the level observed in January-March 2008, i.e. the index will reach the level 210 to 220. However, this recovery will not stretch into 2011, and the index of iron and steel will be declining in the long run to the level of 2001, as depicted in Figure 3. In other words, the period between 2008 and 2010 is characterized by very high volatility, which will fade away after 2011. “

This prediction was right, as Figures 2 and 3 in this post demonstrate.

2. According to [4]:
“the index for non-ferrous metals (102) shows an example of the absence of sustainable trends in the normalized difference. The curve is rather a comb with teeth of varying width. Although varying, the distance between consecutive troughs is several years at least. Therefore, one should not expect a quick recovery in the price for nonferrous metals”.

A year ago we wrote:
Figure 4 displays the original and updated predictions. There is almost nothing to add to the previous statement. The recovery in March-June 2009 is likely only a short-term one, as the past experience shows.

We also display in Figure 4 the newly updated trajectory. As forecasted, the producer price index of nonferrous metals has regained its price setting power, and the March-June 2009 excursion in the difference was only temporary. It should not last long, however.


3. It was stated in [4] that,
“the index for metal containers (103) provides an excellent example of linear trends in the normalized difference. There are two distinct periods between 1960 and 2008 with a turning point in 1987. A sudden drop in the difference in the end of 2008 may symbolize the start of transition to a new period with a negative trend. Then the price for metal containers will be increasing at an elevated rate, i.e. the index will get back its price setting power.”

A year ago we wrote:
Figure 5 presents the original and updated versions of the difference between the PPI and the index of metal containers. The negative overshoot in the difference reached its peak in March and currently the difference started to increase. One can not exclude short-period oscillations in the near future. The future of the index for metal containers is vague.

The difference was on an upward trend since June 2009 with a short-period fluctuation, as expected. The evolution along the positive trend should continue into 2011, i.e. the price index of metal containers will be losing its pricing power relative to the overall PPI.


Conclusion
Our simple predictions were good enough and validate the general concept of the sustainable trends in the CPI and PPI differences. Will keep reporting on the further developments.




Figure 1. Upper panel: The evolution of the difference between the PPI and the price index of iron and steel between July 1985 and March 2009 (borrowed from [4]). Middle panel: Same for the period between 1985 and June 2009. Red and blue lines highlight segments between 1988 and 2001, and from 2001 to 2008, respectively. Green line predicts the evolution of the difference after 2008, as a mirror reflection of the linear trend between 2001 and 2008. Lower panel: The difference updated for the period between June 2009 and April 2010. As expected, the difference has been decreasing during the reported period and sank below the new trend (green). The trajectory has to turn up in the near future and reach the new trend by July 2011. This means that the price index for iron and steel will be growing at a lower rate than the overall PPI.



Figure 2. Upper panel: The evolution of the difference between the PPI and the price index of iron and steel between January 2005 and June 2009. Red line predicts the evolution of the difference after 2008. Red circles represent the difference between April and June 2009. We expect the difference will start growing in August-September 2009. Lower panel: The newly updated trajectory. The difference precisely obeyed our prediction a year ago and sank below the green line (new trend).



Figure 3. Upper panel: The evolution of the PPI, the index for iron and steel, and their difference in the long-run between 2009 and 2016. The index for iron and steel is predicted to decrease from the level of 220, which it will reach by the end of 2009, to ~185 in 2016. Accordingly, the difference will be growing as shown in Figure 1. The PPI will be also slowly growing. Lower panel: The newly updated trajectory.






Figure 4. Upper panel: The evolution of the difference between the PPI and the index of nonferrous metals from 1960 to March 2009 (borrowed from [4]). Middle panel: Same as in the upper panel for the period between 1985 and June 2009. There are no linear trends in the difference, but its behavior demonstrates a clear periodic structure with relatively deep but short troughs, which reflect the fast growth in the PPI for nonferrous metals. The last excursion ended in 2009. A period of hovering near the zero line is expected. Lower panel: The newly updated trajectory. As forecasted, the producer price index of nonferrous metals has regained its price setting power, and the March-June 2009 excursion in the difference was only temporary. It should not last long, however.




Figure 5. Upper panel: The evolution of the difference between the PPI and the index of metal containers from 1960 to March 2009 (borrowed from [4]). Middle panel: Same as in the upper panel for the period between 1985 and June 2009. There are distinct linear trends in the difference. One can not exclude that the fall in the difference is a start of the transition to a new trend. Lower panel: The newly updated trajectory.


References

1. Kitov, I., Kitov, O., (2008). Long-Term Linear Trends In Consumer Price Indices, Journal of Applied Economic Sciences, Spiru Haret University, Faculty of Financial Management and Accounting Craiova, vol. 3(2(4)_Summ), pp. 101-112.
2. Kitov, I., (2009). Apples and oranges: relative growth rate of consumer price indices, MPRA Paper 13587, University Library of Munich, Germany.
3. Kitov, I., Kitov, O., (2009). A fair price for motor fuel in the United States, MPRA Paper 15039, University Library of Munich, Germany,
4. Kitov, I., Kitov, O., (2009). Sustainable trends in producer price indices, Journal of Applied Research in Finance, v. 1, issue 1.
5. Kitov, I., Kitov, O., (2009). PPI of durable and nondurable goods: 1985-2016, MPRA Paper 15874, University Library of Munich, Germany
6. Kitov, I., (2009). Predicting gold ores price, MPRA Paper 15873, University Library of Munich, Germany
7. Kitov, I., (2009). Predicting the price index for jewelry and jewelry products: 2009-2016, MPRA Paper 15875, University Library of Munich, Germany
8. Kitov, I. (2010). Deterministic mechanics of pricing. LAP Academic Publishing, Saarbrucken, Germany.

CPI and core CPI. Two years later

Two years ago we published a paper on the presence of long-term sustainable trends in the differences between various components of the CPI in the USA. We started with the difference between core CPI (i.e. CPI less food and energy) and overall CPI. Two Figures below are borrowed from the paper Figure 1. Linear regression of the difference between the core CPI and CPI for the period from 1981 to 1999. The goodness-of-fit is 0.96, and the slope is 0.67.

Figure 2. Linear regression of the difference between the core CPI and CPI after 2002. The goodness-of-fit is 0.86, and the tangent is -1.57. An elevated volatility has been observed from 2005.

We also suggested in this and later papers on the sustainable trends in the CPI and PPI (see here) that the negative trend shown in Figure 2 should reach some bottom point and turn to a positive trend. It was also mentioned that such processes in the past had been accompanied by an elevated volatility in the difference, i.e. high amplitude fluctuations.

Now, two years later, we plot the difference again and are happy to conclude that our prediction has realized in practice. We announce the beginning of the positive trend, as Figure 3 shows. The trend should be observed at least five to eight years and will be characterized by a faster growth in prices of goods and services not associated with food and energy. We will keep posting on the difference.

Same pivot is observed in many other, but not all(!), differences mentioned in the original paper.

Figure 3. A positive trend has been emerging since December 2010. The differnce will likely grow from 3 in the beginning of 2010 to 11 in 2016. Accordingly, energy and food will lose their pricing power relative to the core CPI goods and services.

Crude price in August 2010

A month ago we presented a forecast for oil price. It’s time to revisit the price. All our estimates are based on the existence of long-term sustainable trends in the differences between various subcategories of the producer price index (PPI). The concept and numerous forecasts is published in this paper. The dry residual is that the producer price indices evolve along straight lines, with all deviations from the trend cancelling themselves out over relatively short periods of several months.

Figure 1 present the case of crude petroleum (domestic production) for the period between 2007 and 2012. We have predicted that the difference between the overall PPI and the index for oil will be on a upward trend since 2009. This means than the PPI will grow faster than the index of oil, the latter likely to fall into 2016 down to the level of ~75.

In March and April 2010, the index of crude petroleum had a bigger deviation out of the trend in Figure 1. Therefore, the most likely next movement in the price will be the return to the trend. Moreover, the difference will likely to break the trend line and go into the other side for several months. This would mean the price of oil falling in May 2010 and during the summer months, as shown in Figure 1 by red circles. Tentatively, we put the index at the level between 160 and 180 in August 2010. Relevant crude oil price will be between $62 and $70 per barrel.

Figure 1. The difference between the overall PPI and the index for crude petroleum. The new predicted trend is shown by dashed line. In May and likely in summer 2010, the index for oil will be decreasing. The difference will be growing as shown by red circles.

P.S. Apparently, oil price lost several dollars in May 2010, and one could say that this post is a bit late and just declares known facts. This is the Bureau of Labor Statistics who reports the PPI and its components in the middle of the next month. Our concept would fail to predict that this is exactly May 2010 when oil price should stop to grow. However, the currently observed level of price is not viable. The price must fall at some point, the larger is the deviation the faster and more violent is the recovery.

S&P 500 in June 2010

As has already been discussed many times since March 2009 and also documeted in a working paper (S&P 500 returns revisited), we expect the S&P 500 stock market index to be gradually decreasing at an avearge rate of 46 points per month. In this post on S&P 500 (01/05/2010), we put the closing level of S&P 500 in May 2010 at 1132 (miscalculation, should be 1142). The actual closing level was 1090 (-97 relative to April 2010), i.e. 42 points below the predicted one. One could expect that kind dynamic "overshoot" in the beginning of a new trend. Same purely emotional effect was observed in March (+69) and April 2009 (+74), when the S&P 500 was increasing much faster than the average rate for the whole period of the rally between March 2009 and April 2010.

So, one might not exclude that the panic of May 2010 will last another month and the closing level of S&P 500 in June will be below 1095, as would be predicted by the rate of -46 points per month starting with 1187 in April 2010. By the end of the summer, the fall will likely decelerate. But the overall downward trend will continue and extend into 2011.

Russian language

Russian was a popular language a century ago. All in all, it was due to great writers and revolutionary movements. Now it loses its popularity worldwide. The reason is obvious - there is nothing interesting Russia can offer to the broader international community. No intellectual breakthrough or/and social process of importance for people as a solution to their own problems.
So, the portion of the world's population speaking or understanding Russian decreases over time. After the disintegration of the Soviet Union - at a dramatically high rate. The question is : What to do?
There are two points of potential improvement. We need to make ourselves to be interested in ... ourselves focusing on the fact that, with all these external changes, we retain the core of our souls, which was inherited from the generations before us. At the same time, the transition to the new social construction allowed us to aquire in a very short time what other nations have been accruing during the past century. As a benefit, we could avoid all mistakes already made.
Such an analysis would be instructive for everybidy.