Abstract
The issue of economic diversification is considered from a portfolio perspective, and the chapter begins by describing a simple mean-variance optimization process for a financial portfolio. Considering an economy to be a portfolio of economic sectors, a brief empirical illustration is provided. This is done to assess the prospect of such an algorithm in providing diversification guidelines for policymakers. For this purpose, quarterly revenue data from June 1991 to June 2016 are used from the energy and non-energy sectors of Trinidad and Tobago. The empirical exercise provides important pointers for the administration, in terms of attention allocation to energy and non-energy sectors in Trinidad and Tobago.
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Notes
- 1.
Several countries such as the United Arab Emirates (UAE), Botswana, and Kazakhstan improved their citizens’ standard of living by exploiting rich natural resources during favourable economic times. Trinidad and Tobago (TT) is not an exception to this.
- 2.
Many international forums like Small Island Developing States Accelerated Modalities of Action, the Vienna Programme of Action for Landlocked Developing Countries for the decade 2004–2014, and the 2030 Agenda for Sustainable Development recognize the importance of diversification (Freire 2017).
- 3.
- 4.
This is with the exception of countries in autarky such as North Korea and Bhutan.
- 5.
Figure 2.1 shows the risk reduction as the investment is spread over a number of assets. While some part of the risk is not asset specific and must be tolerated, the idiosyncratic risk can be reduced through diversification.
- 6.
Short-selling refers to selling an asset that an investor does not own, by borrowing it from a third party. She does that in the expectation that asset price will fall in future, at which time she can cover her position by purchasing the asset at a now cheaper price and returning it to the lender for a profit. Clearly, a State cannot short-sell a sector.
- 7.
For ease of exposition, we assume that the total the portfolio consists of two assets. However, Eq. (2.2) is a more generalized form and the assumption becomes less restrictive in the sense that we now assume that any number of assets can form a portfolio and capital proportions allocated to them must add up to unity.
- 8.
Covariance between returns of assets 1 and 2 can also be written as: σ12 = σ1σ2ρ12, where ρ12 is the correlation coefficient between the returns of assets 1 and 2.
- 9.
Sharpe’s ratio (Sharpe 1966) gives us the reward-to-variability ratio, where the reward is the excess return over the risk-free rate or a benchmark rate. In such a case, Sharpe’s ratio is specified as:
\( {S}_P=\frac{E\left({r}_P\right)-{r}_f}{\sigma_P} \), where, rf is the risk-free rate or a benchmark rate of return.
- 10.
Matrix notation is not presented due to space limitation.
- 11.
The choice is strictly financial though we recognize that the gamut of reasons for a State to embark on a diversification drive can be fairly broad, including but not limited to, tackling low growth rates, providing public and private motivations for building human capital, increasing competitiveness of other sectors like manufacturing, providing a cushion against shocks and spillovers from other economies (El-Kharouf et al. 2010).
- 12.
In case there is a perfect positive correlation between asset returns and \( {\sigma}_1^2\ne {\sigma}_2^2 \), it is possible to arrive at a minimum risk portfolio with zero risk, for which shorting is required. w1 will be negative if σ1 > σ2, and w2 will be negative if σ1 < σ2.
- 13.
In general, the optimum weights for risk minimization when the correlation coefficient is −1, are: \( {w}_1=\frac{\sigma_2}{\sigma_1+{\sigma}_2}\ and\ {w}_2=1-{w}_1. \)
We can quickly check this by using the values from Panel B of Table 2.2 as follows: \( {\displaystyle \begin{array}{l}{w}_E=\frac{2466.57}{3614.18+2466.57}=\frac{2466.57}{6080.75}=0.41\kern0.5em and\kern0.5em {w}_{NE}=1-{w}_E\\ {}\kern1.75em =1-0.41=0.59.\end{array}} \)
- 14.
Ignoring transaction costs like bid-ask spread and brokerage fee.
- 15.
Investors can be motivated to short-sell for speculative and hedging purposes also.
- 16.
Such a signal can be perceived even if a regime does not permit short-selling on its capital market. The recommendation to short-sell, and not the actual short-sale, is the signal.
- 17.
Not reported here due to space constraints but are available with the authors.
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Bhatnagar, C.S., Arjoon, V., Ramlakhan, P. (2019). The Diversified Economy: Possibilities from Modern Portfolio Management. In: Bissessar, A. (eds) Development, Political, and Economic Difficulties in the Caribbean. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-02994-4_2
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