Lucía Álvarez and Ana Acatrinei

Group 45 (International Studies and Political Science)

12. 09. 2022

Unit 1: Introduction
1. Go to the WTO’s website at www.wto.org/ and identify four goods or services that
have been the sources of trade disputes between countries in the last three years.
The WTO has a dispute settlement organ that receives complaints from the delegations of
countries against other members for not complying with the WTO laws. These are some
disputes over different goods that began in the last year and are still taking place. Even if the
disputes take place mainly between two countries, there’s always third parties involved.
Dispute between India and guatemala: Measures Concerning Sugar and Sugarcane. This
complaint was put up by Guatemala against India. Guatemala argues that India supports sugar
producers with different types of subsidies including a subsidy to export the product that
Guatemala considers unlawful. (Source: WTO | dispute settlement - the disputes - DS581)
Dispute between Peru and Argentina: Antidumping and countervailing measures on biodiesel
from Argentina. This complaint was put up by Argentina against Perú regarding biodiesel.
Argentina exports biodiesel to Peru but Peru has deemed these exports unlawful under
peruvian anti-dumping laws. Argentina recurs to the WTO to defend that the exports are
lawful under WTO jurisdiction. (Source: WTO | dispute settlement - the disputes - DS614:
Peru – Antidumping and countervailing measures on biodiesel from Argentina)
Dispute between US and China: domestic support for producers of wheat, Indica rice,
Japonica rice, and corn. This is a complaint put up by the US against China. The US argues
that the domestic support that the Chinese government offers to wheat, Indica rice, Japonica
rice, and corn farmers is inconsistent with the WTO agreements on agricultural products.
(Source: WTO | dispute settlement - the disputes - DS511)
Dispute between Indonesia and Brazil: Measures Concerning the Importation of Bovine
Meat. Brazil put up this complaint against Indonesia. Brazil argues that Brazilian firms have
been trying to access the Indonesian market of bovine meat and Indonesia prohibits their
entrance to the market through unjustified laws. (Source: WTO | dispute settlement - the
disputes - DS506)

2. The current price of a Bernt Oil barrel is $70. An American oil company is evaluating
the possibility of drilling a new oil well. It has been estimated that the well could
produce 25000 barrels per year during 3 years before becoming exhausted. The costs
of drilling the new well, starting today, would amount to $3 million and construction
would be completed in one year’s time. Once construction is completed, the running
costs would be of $200000 per year and, once the well is exhausted, the costs of
closing it are estimated at $500000. The company is assuming the price of oil will
remain stable for the next four years and a required discount rate of 8% per year
during the life of the project.
a. Which is the NPV of the project?
 (Net discounted cash flow)

we need to take into account 2 important things:

- we are working with estimations
- events are happening at different point in time

b. What does this mean in terms of the risk-return profile of the project?
The Net Present Value is positive, which means that the investment is liable i. e.: the
minimum return one should expect from this project is 8% (discount rate required, signaling
the risk tolerance profile of the investor // uncertainty-riskiness of the cash flows), and given
that in this case it will be above that, they should make the investment.

c. If there are many oil companies that have unused drilling opportunities, how is
the assumption of stable oil prices affected? And the expected NPV?
The fact that many companies have the opportunity to drill but do not do it may indicate that
the main assumption in our prediction, the price of the barrel, doesn’t hold. If the assumption
that the barrel will remain at a price of 70USD doesn’t hold and the price went down, the
revenue from the sales would be affected and it could eventually result in a negative NPV.
This must be taken into account because if the companies that have the opportunity of drilling
start doing it the supply will increase and the price of the barrel will go down.

3. Consider an efficient stock market where we can invest €100,000 in the shares of four
different companies with the following data.

variance as a measure for how strong do returns fluctuate (how reliable in terms of stability
are the returns going to be in the future too)

( )
r x+ t−E (r ) 2
N ❑

∑ ¿
N
=Var (r )
t =i
 *we need the equation to be squared, as there might be positive as well as negative
years, which might cancel each other out, therefore messing everything up

σ (r )=√❑
σ (st.dev) as a measure of volatility

a. Which company has more/less total risk?

Company A has less risk because its volatility is the smallest (5%) while company D is more
risky because its volatility is the highest (10%). A smaller volatility indicates that the revenue
will be more stable and predictable (certainty equals safety).

b. Explain the difference between company specific (i.e. diversifiable risk) and
economy wide risk (i.e. systemic or undiversifiable risk).
Company specific risk (σ) is a type of risk that depends on the company. Hence, it can be
reduced if the company took different decisions that increased their success. For instance, by
diversifying the assets they decide to invest in. Economy wide risk is a risk that pertains to
the product itself or to the way the market is structured. Therein, there is little that can be
done by individual companies to reduce that risk as it depends on macroeconomic trends. The
only way out for investors in this dimension, on the other hand, is to invest in companies
whose risk is less correlated with the economy-wide success (beta in the CAPM).

c. In your opinion, which company has more /less systemic risk ( E( r i))?
The video games developer company (D). Both a retailer and an electrical company have less
systemic risk. company specific risk. That is, they can diversify investment to reduce their
company specific risk (i.e. producing mini-shorts and scarfs, solar panels and oil-well
drilling). As for the pharmaceutical, it may be more difficult to diversify given that its
products are heavily regulated and approval of new medicines takes a longer time, might not
always be obtained and the investments in research are not always profitable. However, it is
still a less risky company than a video games company, given that pharmaceutical products
are always needed. For this reason we believe that company D is the most risky, given that it
has a high undiversifiable risk and we have no means of knowing when something is going to
work very well in the market or fail terribly (there is low certainty on which video games
might be successful in the market or not, and this escapes the control of the company).
“in equilibrium, an asset's expected return exactly and only compensates for the asset
systemic risk"

d. Is it true for these four assets that higher return implies higher risk?
No. In the case of these four companies it is quite the opposite: those with the highest
(expected) return [ E ¿] have the lowest risk σ (r ) (fashion retailer and electric company).
(Further explanation) The market only offers higher return for higher systemic risk, [not
company risk] market risk ( E ¿), not systemic risk. For the statement to be true, it should be
“higher (market / non-diversifiable) risk implies higher return”. Diversifiable risks implies
lower returns as a whole.
 e. Compute the expected return and volatility (i.e. standard deviation of returns)
of a portfolio that invests 50% of the money in A and 50% in B with a
portfolio that invests 25% in each of the four companies.
Hint: For a portfolio P with N assets that invests a fraction wi in asset i (with
i=1,2,...N) we can compute the expected return and the variance of returns as
follows:

EXPECTED RETURN OF THE PORTFOLIO

N
E [ r p ] =∑ wi∗E [ r i ]
i=1

Variance of the portfolio is the weighted average return of all the assets included there.
Variation of the portfolio does not only depend on the variations among the assets but
also the covariances (correlations between them) between them.
COVARIANCE
N
[ r X +t , A −E(r A ) ][ r X +t ,B −E(r B )]
Cov (r A , r B )=∑ ¿
t =1 N
w A=weight of A
Variance-covariance matrix (the results for Cov (w A , w A )=var (r A ))

VARIANCE OF THE PORTFOLIO

w A w A Cov (w A , w A )+ w A w B Cov(w A , w B )+w B w A Cov (w B , w A )+ wB wB Cov (w B , wB )

Square-root of 0,003 = 5.7%, which is the volatility for the first portfolio. Wa and Wb is
0,5 because that is the percentage invested in each of the two assets part of this portfolio.
That is multiplying the expected returns of each company it is investing in. Then, for the
variance, we take the covariance and variance from the table.
In the second portfolio, we invest 25% in each of the four assets so now we have 0,25 times
the expected return of A, plus 0,25 times the expected returns of B, plus 0,25 times the
expected returns of C, plus 0,25 times the expected returns of D (weights). The expected
return of the second portfolio is 6,4% Since the variance Var(rp2)=0.002, we do the same
thing as in the first portfolio, finding the square-root and we have the volatility of the second
portfolio, which is 4,9%
 f. Comparing these results with the expected return and volatility of investing all
the money in only one of the companies, what is the impact of diversifying
across the companies? Can you explain why this happens?
The conclusion of comparing the results is that diversifying reduces the risk of an investment.

4. The following graph reflects the investment opportunities in risky financial assets (all
assets and possible portfolios of assets) for a given population (consider a closed
economy). Assuming all these investment opportunities have zero NPV.

- Explain the choice between assets A and B

As Er refers to the expected return and σ r to volatility (in other words, all things equal and
stable, risk), this graph would allow us to identify which assets are considered to be more
risky against others. In this case, asset A is thought to be less risky than asset B as they share
the same expected return but asset A has a lower volatility. Because of the NPV rule stating
that investing projects should only be engaged in if they demonstrate a positive Net Present
Value, we would choose here to invest in asset A because it is less risky and the expected
return would cover for the risk involved to a higher extent that the risk of asset B.

- Explain the choice between assets B and C

In this case, we would opt for investing in asset C as it has a higher expected return than asset
B given that they involve the same amount of risk. Here the higher expected return would
cover for the involved risk with higher margins than for asset B. In other words, the expected
returns in the future overcompensate for the risks undergone.
 - Assuming investors try to maximize return and minimize risk (as proposed by Nobel
Prize winner Harry Markowitz in 1952), can you identify the assets in the investment
opportunity set that (i) will never be selected by any investor, (ii) may be selected by
investors with high risk tolerance, and (iii) may be selected by investors with low risk
tolerance?
i) Assets F, J, D, B (dominated cases // Er does not compensate for risk)
ii) Assets A, G
iii) Assets C, E, K

5. The following graph is the same as in the previous exercise but we have added a risk-
free asset (zero volatility and zero covariance of returns with the rest of the assets).
This risk free asset can be combined with any of the risky assets investing a fraction w
in the risky asset and a fraction (1-w) in the safe asset to produce new combinations of
risk and return.

- Represent graphically all the portfolios (for w going from 0 to 1) that you can build by
combining the risk free asset with risky asset B and do the same for the combinations
between the risk-free asset and risky asset C. Is it better to combine the risk-free asset
with B or with C? (hint: start by plotting the portfolios with w=0 and w=1 and notice
that because the risk free asset has no risk, both the return and the volatility of the
portfolio will increase linearly with w. Check that this is true using the formulas
provided in exercise 3.)

It is better to combine the risk free asset with asset C, as the reduction in compound risk is
higher and we still retain the benefits of having the higher expected return of asset C.
Additionally, as we can see in the graph, this opportunity of combining the risk free asset and
asset C gives us the chance “to stop” at the optimal point for us where we feel comfortable
enough with the level of risk due to a positive (that optimal/equilibrium point would be a zero
percent value) NPV for us as subjects. This would mean that the expected return would be
equal to the individual volatility “preferences” for asset C.

EXPECTED RETURN OF THE PORTFOLIO

N
E [ r p ] =∑ wi∗E [ r i ]
i=1

E [ r 1 ] =w1∗E [ r 1 ] +(1−w 1)∗E [ r free ]

VARIANCE (volatility) OF THE PORTFOLIO

σ p 1=w σ k

*investment of w 1>1 in the risky asset by having a short-selling in the risk-free asset [pure
arbitrage situation where you are making money without an initial investment and at 0 risk]

*market portfolio [approximation through the most diversified portfolio, all investment
assets available in the market (highest returns in the line between the risk-free asset and
the asset / steepest slope available → in our example it would be with asset E!)]
index funds form a portfolio equivalent to an index (then, investors are able to
purchase that fund as they optimize risk-opportunities by diversifying among
different assets → you get higher returns with lower risk)
best way to invest if you consider that you do not better than the market!!
The risk free asset is considered to be the fixed income asset (bond) with the shortest
maturity issued by the issuer with the highest credit rating (most trusted issuer / lowest
possibility of default) (1y Bundesbank-Bond) in the monetary zone [avoiding currency risks]

6. In 1964 Nobel Prize winner William Sharpe proposed the Capital Asset Pricing
Model (CAPM). The model assigns an expected return to each financial asset
depending on three variables: (i) the return on the risk-free asset, (ii) the expected
return on the market portfolio and (iii) a variable called beta which takes different
values for each asset.

E [ r i ] −r free =β i∗[ E [ r M ]−r f ]

market risk premium

- Using the data from exercise 3 and knowing that rf=1% and E[rM]=8% and the betas
of assets A,B,C and D are respectively 1.2, 1, 0.5 and 0.4. Is the CAPM model
satisfied for the assets in that exercise?
ASSET A → 9.4 - 1= 1.2 * (8 - 1)
8.4 = 8.4 The model is satisfied
ASSET B → 8 - 1= 1 * (8 - 1)
7 = 7 The model is satisfied
ASSET C → 4.5 - 1= 0.5 * (8 - 1)
3.5 = 3.5 The model is satisfied
ASSET D → 3.8 - 1= 0.4 * (8 - 1)
2.8 = 2.8 The model is satisfied

- Beta is a measure of the riskiness of each asset, but it is different from the volatility.
Compare the volatility and the betas of assets A, B, C and D. Which type of risk do
you think that beta is capturing?
ASSET A has a volatility of 5%, ASSET B has a volatility of 6%, ASSET C has a volatility
of 7%, ASSET D has a volatility of 10%
Beta captures how correlated the volatility of the asset is correlated with the overall volatility
of the whole economy. [market risk]

- Why do you think the beta (rather than the volatility of the asset) is the relevant
variable to determine expected returns according to CAPM?
Because, so long as we cannot predict the future of the economy as unpredictable events
might occur such as droughts, wars, political instability, etc., we prefer to know “how
resistant/ confiable” our assets are in case of economic recession. As individuals are
considered to be risk averse, according to CAMP the safest option would be to go for the
asset that is less correlated with the overall economic welfare. Thus, in case of an overall bad
economic situation, we could still be making some profit as the sector where we invested is
more or less isolated from that back down.