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When the total money received falls short of total money spent, the difference is termed as a deficit. A deficit occurs when imports exceed exports, expenses surpass revenues, or liabilities outstrip assets. For instance, a budget deficit arises when a business, country or an individual’s spending exceeds the revenue generated over a period of time. As deficit increases one’s debt, it is not believed to be financially healthy.
In the recent past, the absolute return approach of Investing has turned out to be one of the fastest-growing investment strategies worldwide. A lot of financial advisors talk about such investments providing absolute returns. So, what exactly are the “Absolute Returns” and are they are promising? What is meant by Absolute return? Absolute return computes the increase or decrease, in an asset over a period of time, as a proportion of the original investment amount. The focus here is only on that specific asset or portfolio and not related market events. Absolute returns only consider the price movement for any specified time period. Absolute return, reckons an investment’s performance without considering the expanse of time for which investment was committed. Absolute returns can be computed for a quarter, semi- annual, annual period, 3-year duration or more. Absolute Returns are independent of Market movements and thus do not draw relative comparisons. It is one of the most commonly used investment performance metric in Hedge Funds and Mutual Funds. How to compute Absolute return? Suppose an investor Mr. Rich, invested AUD 50,000 5 years back, and the current value of his investment is AUD 75,000. The Absolute return on Mr. Rich’s investment would be 50 %, calculated using- Copyright © 2021 Kalkine Media Pty Ltd Copyright © 2021 Kalkine Media Pty Ltd So, Copyright © 2021 Kalkine Media Pty Ltd Absolute returns are just returns from point of time to other. The notion of an 'absolute return' seems very attractive to get investors’ attention as it ignores the relative market movement and promises an appreciation with zero correlation to markets. Anyhow, Absolute Return technique of computing investment yields is an apt way of calculating return on investment, predominantly in the early stages. There are numerous other types of return metrics an investor can look for later on. Major 4 types mattering most to investors being – Absolute Return, Relative Return, Total Return & CAGR. What is the difference between Absolute Return, Relative Return, Total Return & CAGR? Absolute return refers to the gain/ loss in a single investment asset/ portfolio but to comprehend how their investments are acting relative to various market yardsticks, relative return is taken into consideration. Relative return is the excess or deficit an asset achieves over a timeframe matched to a market index. Benchmark Return – Absolute return, gives the Relative return also called sometimes as alpha. Example, if S&P index gives a 10% return during a given period and one’s investment portfolio gives an absolute return of 12% then relative return on investment is positive/ excess 2%. Total returns take into account the effect of intermittent incomes as well as dividends. For example, in an equity investment of AUD 200 having current value AUD 240, the company also declares a dividend of AUD 10 during the year. Total returns will take into account this $10 dividend too. Thus, Total returns on the investment of AUD 200 now will be 25.00% = {(240+10-200)/200} x 100 Absolute and Total returns are easy to calculate as performance metrics, but the real challenge is when comparisons are drawn based on time period of return. Here comes in CAGR, it takes into account the term of the investment too, thus giving a more correct and comparable picture. It is computed as: CAGR (%) = Absolute Return / Investment period (equated in years) Consider for example, two investment options: One where investor earns absolute returns of 10% in 24 months and another where investor earns 5% absolute returns in 9-month duration. So, CAGR would be- For option one: CAGR = 5.00% i.e. 10%/2 (24 months/12 months is equals to 2 years) For option two: CAGR = 6.66% i.e. 5%/0.75 (9 months/12 months is equals to 0.75 years) What’s wrong with just measuring investment performance using Absolute Returns? Absolute returns will only tell an investor how much his/her investments grew by; they do not tell anything about the speed at which investments grew. When people talk about their real estate investments and say, “I bought that house for X in the year 2004. It’s worth 4X today! It has quadrupled in 17 years.” This is an application of absolute return. The drawback here is that it takes into account only the capital appreciation and doesn’t draw comparison with options having different time horizons. Investors can rely on this measure of investment performance only if they are looking for higher returns, without bothering how fast they were generated. Absolute return also doesn’t convey much about an investment compared to relative markets. Then, why do Hedge Fund/ Mutual Fund Managers choose an Investment strategy based on Absolute returns? Absolute returns should be used at times when investors are willing to shoulder some risk in exchange for a prospective to earn excess returns. This is irrespective of the timeframe and Fund administrators who measure portfolio performance in relation of an absolute return typically aim to develop a portfolio that is spread across asset categories, topography, and economic phases. They are looking for below mentioned points in their portfolios- Positive returns- An absolute returns approach of investment targets at producing positive returns at all costs, irrespective of the upside & downside market movements. Independent of yardsticks- The returns are in absolute terms and not in comparison to a benchmark yield or a market index. Diversification of portfolio- With the intention of distribution of risk, among different investment options producing positive returns in diverse ways a mixed bag of absolute return assets give a diversified investment portfolio. Less volatility- The total risk of investment is spread across the different asset held in such a portfolio. Ensuring less overall volatility in collective returns. Actively adjustable to market movements– Usually, investments look for positive returns with zero market correlation. Market shares a negative correlation with absolute return investments and vice versa. In any investment atmosphere, there are varied investment strategies and goals. Absolute return investment strategies are looking to avoid systemic risks using unconventional assets and derivatives, short selling, arbitrage and leverage. It is appropriate for investors who are prepared to bear risk for short and long-term gains.
A renowned economic theory, J Curves reflects upon a few assumptions and asserts that a nation's trade deficit will originally fall post currency depreciation. This is catalysed by greater prices on imports which will ideally exceed decreased volume of the country?s imports.
What is Keynesian economics? Keynesian economics is the economic theory that states demand is the driver of economic growth. This economic theory also states that fiscal aid helps recover an economy from a recession. Certain Keynesian economic principles stand in stark contrast to the Classical theory of economics. The theory was given by John Maynard Keynes in the 1930s and published in Keynes’ “General Theory of Employment, Interest and Money” in 1936. The Keynesian theory stated that government spending was an essential factor in increasing demand and maintaining full employment. What are the theories under Keynesian economics? Aggregate demand is affected by a host of factors: Aggregate demand is affected by various factors public and private factors. Monetary and fiscal policy both affect the level of aggregate demand in the economy. Any decision taken by the monetary authority or the government greatly affects the economy’s level of demand. Say’s Law proposes that supply generates its own demand. However, Keynesian economics suggests that demand is the driver of supply and overall growth in the economy. Sticky Wages: According to the theory of sticky wages, employers would prefer laying off workers over decreasing the existing workers’ wages. This happens because even in the absence of labour unions, workers would still resist wages cuts. Even if the employers were to reduce wages, it would lead to economic depression as demand would fall and people would become more cautious about their spending. Keynes advocated that the labour markers do not function independently from the savings market. Therefore, prices and wages respond slowly to changes in supply and demand. Liquidity Trap: Liquidity trap refers to an economic scenario where there is a contraction in the economy despite very low interest rates. This contrasts with the relationship between interest rates and investment given in Classical economics. How is Keynesian economics different from Classical economics? Classical economics states that the economy self-regulates in case of a disequilibrium. Any deviations from the market equilibrium would be adjusted on its own without any government regulation. However, Keynesian economics propagates that government intervention must maintain equilibrium or come out of an economic downturn. Keynesian economics highlights the importance of monetary and fiscal policy, while Classical economics does not mention any government intervention. Another crucial difference is that Classical economics suggests that governments should always incur less debt, while Keynesian economics advises that governments should practice deficit financing during a recession. Classical economics states that government spending can be harmful as it leads to crowding out of the private investment. However, it has been later established that this happens when the economy is not in a recession. Government borrowing competes with private investment leading to higher interest rates. Thus, Keynesian economics is of the view that deficit spending during a recession does not crowd out private investment. What are the policy measures advocated by Keynesian economics? According to Keynes, adopting a countercyclical approach can help economies stabilise. This means that governments must move in a direction opposite to the business cycles. The theory also states that governments should recover from economic downturns in the short run itself, instead of waiting for the economy to recover over time. Keynes wrote the famous line, “In the long run, we are all dead”. The short run knowledge of the economy would be far better than the long run prediction made by any government. Thus, it makes sense for governments to focus on short run policies and maintain short run equilibrium. Keynes’ multiplier effect states that government spending would increase the GDP by a greater amount than the increase in government spending. This multiplier effect established a reason for governments to go for fiscal support when the economy requires it. What have been the criticisms of Keynesian economics? The initial stages of Keynesian economics propagated that monetary policy was ineffective and did not play any role in boosting economic growth. However, the positive effects of monetary policy are well established and have been integrated into the new Keynesian framework. Another criticism is that the advantage of the fiscal benefits to the GDP cannot be measured. Thus, it becomes difficult to fine-tune the fiscal policy to suit the economic scenario better. Also, the Keynesian belief of increased spending leading to economic growth may lead to the government investing in projects with a vested interest. It could also lead to increased corruption in the economy. The theory of rational expectations suggests that people understand that tax cuts are only temporary. Thus, they prefer to save up the income left behind to pay for future increases in taxes. This is the Ricardian Equivalence theory. Thus, fiscal policy may be rendered ineffective due to this. Supply-side economics has also shown contrast to Keynesian beliefs. During the stagflation in the 1970s, the Phillips curve failed, bringing out the importance of supply-side economics.
What is meant by Balance of Payments or BOP? Balance of Payments refers to the record of transactions maintained by a country with the rest of the world. It is a detailed list of international transactions that a country has with its trading partners. These transactions can be made by the residents, domestic businesses or by the government. In an ideal situation, the sum of all the elements of BOP should be zero. However, this is rarely witnessed as most countries do not have the exact same amount of inflow as that of outflow. The inflow and outflow from the rest of the world, can be with respect to goods, services, assets, investments, etc. Notably, a deflection from the ideal zero BOP state may not always be harmful. A surplus (positive BOP) might indicate a strong economy as it means exports are greater than imports. While, a deficit (negative BOP) might point to an increased debt on the home country. The Balance of Payments is highly reflective of the economic strength of a country. Most of the impacts of BOP are indirectly observed on various macroeconomic indicators. What are the Components of BOP? BOP comprises of two broad components, namely, Current Account and Capital Account. Sometimes the Capital Account is referred to as the Financial Account, along with a separate capital account. The Financial Account includes transactions in financial instruments and central bank reserves. While the capital account includes transactions in capital assets. A balance in inflow and outflow of all these accounts makes for a BOP equal to 0. CURRENT ACCOUNT: In technical terms, Current Account is the sum of Balance of Trade, Factor Income (net income from foreign investments) and unilateral transfers (net gifts and grants received). Put simply, current account records the transactions done in goods and services, investments and the net transfer payments or unilateral payments. Exports are maintained as credits, while imports are maintained as debits in the balance of payments. A positive current account balance means that the domestic country is a net lender, while a negative current account balance indicates that the home country is a net debtor. According to the double-entry accounting method, any entry on the export side would be adjusted with an appropriate entry on the import side. For example, for a good exported by the home country to a foreign country, the corresponding import transaction would be the inflow of foreign currency received in exchange for the good exported. CAPITAL ACCOUNT: The capital account involves all transactions relating to international asset It involves transactions made in the reserve account as well as loan payments and investment made across nations. These loans, however, do not include the future stream of interest or dividend payments as they are a part of current account. This is so because they form a part of nation’s spending or income, depending on the type of flow. A capital account is said to be in deficit when a country purchases more assets than the assets it sells to the rest of the world. An increase in assets is followed by a corresponding decrease in cash and vice versa. In some countries, the capital account is known as the financial account and has separate component called the capital account. This capital account records the transactions that do not affect the income, production or savings like international transfer of trademarks and rights, etc. What do BOP deficit and surplus mean for the home country? In layman’s language, BOP tells us whether the country is earning enough to meet its expenditure. If there is a deficit, then it can point towards the country’s growing expenses which are not sufficed by the income generated. Thus, there is a need to generate debt in order to fund the current requirements. Many a times the need to repay current debt gives rise to more debt. Therefore, an endless cycle of financing previous debt with current period loans takes place. The credit received from the rest of the world is generated either by taking a loan, which adds as a liability in the accounts or by selling off the assets currently possessed by the country. These assets can be natural resources, land, commodities, etc. A surplus on the other hand means that a country is exporting more than it is importing in all its existing BOP accounts. This can be a positive sign in most instances as it points towards stronger economic movements. A surplus can encourage the home country to invest in production of goods and services and in turn promote GDP growth. However, an export-driven growth in the long run could point to lack of sufficient demand in the home country. In such a case, the government should boost consumer spending in home country in order to become more self- reliant. What are the factors affecting BOP? BOP depends on various factors. These include: The domestic exchange rate: Exchange rate is a measure of foreign currency with respect to the domestic currency. Governments can revalue or devalue the exchange rate with the help of appropriate policies. This affects the BOP by making exports cheaper as the exchange rate falls and making imports cheaper when the exchange rate rises. The spending capacity of domestic consumers: As businesses and households are left with greater disposable income, they can spend more on imports and this can affect the BOP. Price competitiveness offered by domestic goods: For a country that is going through higher rates of inflation than its trading partner, the goods and services offered by it would be relatively more expensive. Thus, the country becomes less competitive in terms of price competitiveness. The country with lower inflation would thus have cheaper exports. In such a case, domestic consumers would prefer foreign goods and services causing increased imports and eventually a BOP deficit. Domestic policies: Trade based taxes and tariffs are a huge influencer on the BOP. Policies boosting exports are always beneficial to a country. It is important to pay attention to imports by imposing restrictions using tariffs or quotas. Apart from trade centric policies, domestic policies aimed at economic growth may cause changes in BOP. For instance, increased interest rates can promote FDI in the home country, which would affect the Current Account in BOP.