Question

Countries around the world historically used the Gold standard (1890-1914), which, however, was changed to fixed exchange rate system through Bretton Woods since the WWII. The Bretton Woods System collapsed and most countries around the world today use either a clean float or dirty float as an exchange rate system. While removing FX controls and increasing economic integration enable investors to roam around the world, this also means that investors and countries face diverse challenges, risks and uncertainties, which they have to manage through different tools (e.g., measuring country risk and using debt management strategies such as Paris and London Club, debt-for-debt swap and debt-for-equity swap). Generating profits from investments is becoming increasingly challenging even from international diversification. Hence, some investors prefer to tilt towards their home assets (home bias). Highlight the key differences between the following terms:

i)       Gold standard vs Bretton Woods

ii)      Clean float vs dirty float

iii)     Paris vs London Club

iv)     International diversification vs home bias

Answer 1

(I)

Before Bretton Woods, most countries followed the gold standard. 5 That meant each country guaranteed that it would redeem its currency for its value in gold. After Bretton Woods, each member agreed to redeem its currency for U.S. dollars, not gold. The dollar had now become a substitute for gold.

(ii)

A clean float, also known as a pure exchange rate, occurs when the value of a currency, or its exchange rate, is determined purely by supply and demand in the market. A clean float is the opposite of a dirty float, which occurs when government rules or laws affect the pricing of currency.

(iii)

The London Club is an informal group of private creditors on the international stage, and is similar to the Paris Club of public lenders. The London Club is not the only informal group of private payables. The first meeting of the London Club took place in 1976 in response to Zaire's debt payment problems.

The Paris Club treats debts due by governments of debtor countries and certain private sector entities as guaranteed by the public sector to Paris Club members. A similar process occurs for public debt held by private creditors in the London Club, which was organized in 1970 on the model of the Paris Club

(IV)

Home bias is the tendency for investors to invest the majority of their portfolio in domestic equities, ignoring the benefits of diversifying into foreign equities. This bias was originally believed to have arisen as a result of the extra difficulties associated with investing in foreign equities, such as legal restrictions and additional transaction costs. Other investors may simply exhibit home bias due to a preference for investing in what they are already familiar with rather than moving into the unknown.

Diversification reduces risk by allocating investments among various asset types, geographic regions and industries. It aims to maximize returns by investing across different areas to lessen the chance that a market event can have a debilitating effect on an entire portfolio. By not investing beyond one's particular country or region, investors can become too concentrated in the movements of their domestic market and economy, increasing the volatility risk level to the portfolio. When an investor is not properly globally diversified, they may miss opportunities to invest in faster-growing markets.