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					                                      Introduction
Project Hypothesis

This project is intended to develop a top-down allocation model for Latin American
countries that will out-perform a Latin American benchmark. Latin America was chosen
specifically because it is an emerging market with a history of being quite volatile. The
particular countries that were used within our model were Mexico, Chile, Venezuela,
Brazil, and Argentina. Our intention is to capitalize on the volatility of these countries by
using our model to identify money-making opportunities as well as hedge against any
negative market movements. Our interest in this project arose from the recent Brazilian
currency crisis and the possible application of a top-down model to protect portfolios
against possible future devaluation.

Latin America Benchmarks

The benchmarks used for Latin America were the:

   International Finance Corporation Latin America U.S. Dollar Price Index, and
   MSCI Latin America U.S. Dollar Price Index

These files provided the best data of Latin American returns in which our top-down
allocation model could be tested.

Out of Sample Testing
We purposely did not include the monthly data from 1999 so that we could use this data
to perform an out-of-sample test of our model.
                                        Project Details
Country Information

The countries of Mexico, Venezuela, Chile, Brazil, and Argentina were selected to
represent Latin America in the top-down allocation model. The following is a snapshot of
each country:


INSERT COUNTRY SPECIFIC INFO HERE


Country Correlation Matrix

                     Mexican_Stocks Brazilian Stocks   Chilean_Stocks    Argentina_Stocks Venezuela_Stocks
  Mexican_Stocks                  1
  Brazilian Stocks      0.483757418                1
  Chilean_Stocks         0.43796651    0.507936581                   1
  Argentina_Stocks      0.681842787    0.543798432         0.566596254                  1
  Venezuela_Stocks      0.191924169    0.241733625         0.261842118        0.245392718                1


The correlation matrix shows a significant relationship of each country to the other. As a
result, each country can be used to hedge against the other by exploiting the high
correlation to reduce the portfolio risk and receive a return premium.

Selection of Economic Variables/ Comments on Coefficient Signs

Asset Class               Variables/Economic Reasoning Behind Selection
Chile Equities            One month lagged variation of International Reserves for Chile-
                          The International Reserves of Chile represent the money held by the
                          government to support the economic transactions of the country
                          including the financial obligations to other countries. The stock
                          returns tend to fluctuate with the supply of international reserves;
                          hence, this variable is positively correlated with the stock returns.

                          Two month lagged variations on Unemployment-
                          The variations on unemployment are an indicator of the expected
                          economic activity within Chile. As the economy improves and the
                          stock market rises, as it has been doing, unemployment falls. As a
                          result, this variable is negatively correlated with the stock returns.

                          We use a 2 month lag structure for this variable because of the
                          government‟s timing for announcing the number. For instance,
                          January oil exports are announced on February 29th, thus impacting
                          March stock returns.

                          One month lagged variations on Mexico’s Returns-
                          The variations on Mexico‟s returns act as an indicator of the economy
                          of Chile. As the Mexican economy thrives, the economy in Chile
                          booms as well. This is due to the fact that a free trade agreement
                          exists between Mexico and Chile, and Mexico is considered the
                     „gateway‟ country into Latin America. In other words, as international
                     activity is initiated in Latin America, Mexico is usually the first country
                     entered. After Mexico, international activity reaches out to other Latin
                     American countries, which includes Chile. Due to this relationship,
                     this variable is positively correlated with the stock returns of Chile.

Venezuela Equities   One month lagged variations on Exchange Rates-
                     This exchange rate represents bolivars to dollars. When the
                     percentage change in exchange rates is negative on a month to
                     month basis, this indicates that the bolivar has appreciated against
                     the dollar. As the bolivar appreciates, the stock returns grow
                     positively. This variable is indicated by a negative coefficient, which
                     represents the relationship between the change in exchange rates
                     and the stock returns.

                     Two month lagged variations on International Lliquidity-
                     International liquidity is a measure relating to the country‟s liability
                     and also to their monetary reserves. As the economy experiences
                     positive growth, the country becomes more liquid; therefore, this
                     variable produces a positive coefficient.

                     We use a 2 month lag structure for this variable because of the
                     government‟s timing for announcing the number.

                     Two month lagged variations on Oil Exports-
                     The exportation of oil is a huge factor in Venezuela. As oil
                     exportation increases, the growth in the economy of Venezuela also
                     increases. For this reason, the country‟s stock returns are positively
                     tied to the exportation of oil.

                     We use a 2 month lag structure for this variable because of the
                     government‟s timing for announcing the number.

                     One month lagged variations on Price Earnings-
                     The alterations in P/E ratios can bring investors attention to the
                     market showing over or under estimations of the current prices. As
                     the P/E ratios increase, the country believes the economy is growing
                     strong due in part to oil exports; therefore, they are more willing to put
                     funds into Venezuela‟s stock market.

                     One month lagged variations on U.S. Risk Free Rates-
                     The variations on US risk free rates are an indicator of expected
                     economic activity and inflation on US. As the rates in the U.S.
                     increase, Venezuela receives a monetary boost from their exports,
                     which in turn helps the economy to grow. As the economy grows, the
                     stock market benefits; hence, there is a positive correlation between
                     Venezuela‟s equity returns and the U.S. risk free rates.

Mexico Equities      One month lagged variations on International Investor Credit
                     Rating-
                  The international investor credit rating is a measure of one country
                  versus another in terms of riskiness. The higher the credit rating, the
                  more willing investors are to add a particular country to their portfolio.
                  In Mexico, as the credit rating improves, the investors pour more
                  money into the country. As a result, the country‟s stock returns grow
                  positively. Therefore, this variable is represented by a positive
                  coefficient.

                  One month lagged variations on Price Earnings-
                  The alterations in P/E ratios can bring investors attention to the
                  market showing over or under estimations of the current prices.
                  As the P/E in Mexico increases, investors become wary and believe
                  the stock market is overvalued; therefore, investors start to pull out of
                  the market, and Mexico‟s stock returns drop. This relationship is
                  represented by a negative coefficient.

                  One month lagged variations on Exchange Rate-
                  This exchange rate represents pesos to dollars. When the
                  percentage change in exchange rates is negative on a month to
                  month basis, this indicates that the peso has appreciated against the
                  dollar. As the peso appreciates, the stock returns grow positively.
                  This variable is indicated by a negative coefficient, which represents
                  the relationship between the change in exchange rates and the stock
                  returns.

                  One month lagged variations on Mexico’s Interest Rates-
                  The variations of interest rate on last month contain expectations of
                  future inflation, and are an element of purchase decisions. It is
                  believed that the positive correlation of a rise in interest rates with a
                  rise in the stock market returns is due to the fact that the Government
                  has successfully contained inflation in the past. Therefore, as the
                  government raises rates in an effort to curtail on-coming inflation, the
                  market reacts positively and shows increased returns.

                  One month lagged variations on Price/Book Value-
                  This variable is used as a measure of the overall “value” or
                  “expensiveness” of the Mexican market. We believe this variable is
                  actively used by portfolio managers around the world in making asset
                  allocation decisions amongst countries. Therefore, we expect the
                  variable to have some predictive power in estimating future inflows
                  and outflows of capital to the Mexican market.

                  As the price to book value ratio increases, investors believe that the
                  market may be overvalued and not an attractive investment.
                  Investors start to pull out of the market, and Mexico‟s stock returns
                  drop. This relationship is represented by a negative coefficient.

Brazil Equities   One month lagged variations on Brazil Price/Book Value divided
                  by Latin America Price/Book Value-
                  This variable is used as a measure of the overall “value” or
                     “expensiveness” of the Brazilian market. We believe this variable is
                     actively used by portfolio managers around the world in making asset
                     allocation decisions amongst countries. Therefore, we expect the
                     variable to have some predictive power in estimating future inflows
                     and outflows of capital to the Brazilian market.

                     As the price to book value ratio increases as a percentage of the
                     Latin America price/book value, investors believe that the market may
                     be overvalued and not an attractive investment. Investors start to pull
                     out of the market, and Brazil‟s stock returns drop. This relationship is
                     represented by a negative coefficient.

                     One month lagged variations on Brazil Price/Earnings divided by
                     Latin America Price/Earnings-
                     The alterations in P/E ratios can bring investors attention to the
                     market showing over or under estimations of the current prices.
                     Although a positive correlation is counter-intuitive to what we would
                     expect given the negative correlation of the above price/book value
                     ratio as a percentage of Latin America‟s price/book value ratio, we
                     believe that as the price/earning ratio of Brazil increases as a
                     percentage of Latin America, investors see this as a positive sign of
                     growth. Therefore, more funds enter into Brazil, and as a result the
                     stock markets returns increase.

                     One month lagged variations on Exchange Rates-
                     This exchange rate represents reals to dollars. When the percentage
                     change in exchange rates is negative on a month to month basis, this
                     indicates that the real has appreciated against the dollar. As the real
                     appreciates, the stock returns grow positively. This variable is
                     indicated by a negative coefficient, which represents the relationship
                     between the change in exchange rates and the stock returns.

                     One month lagged variations on Price Earnings-
                     The alterations in P/E ratios can bring investors attention to the
                     market showing over or under estimations of the current prices.
                     As the P/E in Brazil increases, investors become wary and believe
                     the stock market is overvalued; therefore, investors start to pull out of
                     the market, and Brazil‟s stock returns drop. This relationship is
                     represented by a negative coefficient.

Argentina Equities   One month lagged variations on Bond Yield-
                     Bond yields movements are equivalent to the movement in interest
                     rates. As the interest rates are falling, investors see this as a positive
                     sign to enter the stock market. Hence, there is a negative correlation
                     between the bond yields and stock market returns.

                     One month lagged variations on Inflation Rates-
                     Inflation is an indicator of the robustness of economic activity.
                     Normally, we would expect a negative correlation between a rise in
                     inflation rates and the returns on a stock market; however, Argentina
                                      is experiencing a positive correlation. We believe this is due to the
                                      fact that as inflation increases, the prices on the stock market follow
                                      suit by increasing as well. This is reflected by positive returns on the
                                      stock market. Over time, as Argentina becomes more developed, we
                                      would expect this trend to reverse and the coefficient to become
                                      negatively correlated with the stock market. This is due to the fact
                                      that the Argentina government will eventually gain credibility in its
                                      ability to control inflation.

                                      One month lagged variations on Brazil Equity Returns-
                                      The variations on Brazil‟s returns act as an indicator of the economy
                                      of Argentina. As the Brazilian economy thrives, the economy in
                                      Argentina should boom as well, which should be reflected in with a
                                      positive coefficient. This is due to the fact that Brazil is considered
                                      the „gateway‟ country (with Mexico) into Latin America. In other
                                      words, as international activity is initiated in Latin America, Brazil and
                                      Mexico are usually the first countries entered. After Brazil,
                                      international activity reaches out to other Latin American countries,
                                      which includes Argentina. However, our results indicate a negative
                                      correlation between the lagged returns in Brazil and the returns in
                                      Argentina. The economic reasons for this negative correlation is
                                      beyond our knowledge, and further investigation into this result
                                      should be conducted.


Asset Class Regressions

Summary of Predictive Regressions
   Asset Class                     Variable                  Lag (Mths)   Coefficient   T-Ratio   Regression Period   Adjusted R^2   D-W
  Chile Equities
                            Variation of Reserves                1          0.278        1.616       3/90-12/98          0.066       1.813
                               Unemployment                      2          -0.154      -1.407
                              Mexico Returns                     1          0.184        2.497
  Brazil Equities
                       Brazil P/BV / Latin America P/B           1          -0.560      -3.725       5/90-12/98          0.092       1.854
                       Brazil P/E / Latin America P/E            1          0.030        1.850
                               Exchange Rates                    1          -0.163      -1.856
                            Brazil Price Earnings                1          -0.001      -1.911
 Mexico Equities
                     International Investor Country Rating       1          0.031        3.480       1/90-12/98          0.201       1.994
                                 Price Earnings                  1          -0.001      -2.432
                                Exchange Rates                   1          -0.385      -2.509
                            Interest Rates Variation             1          6.775        2.826
                               Price/Book Value                  1          -0.052      -2.625
Venezuela Equities
                               Exchange Rates                    1          -0.163      -1.251       6/92-12/98          0.140       2.332
                            International Liquidity              2           0.428       2.879
                                  Oil Exports                    2           0.410       2.696
                                Price Earnings                   1           0.053       1.234
                                 US Risk Free                    1          22.634       1.281
Argentina Equities
                                  Bond Yield                     1          -0.492      -3.974       6/91-12/98          0.192       2.002
                                Inflation Rates                  1          3.778        2.526
                                Brazil Returns                   1          -0.226      -2.226



Variable Correlation Matrices

Chile Correlation Matrix
Variable                                      Chile Equity Return                              Variation of Reserves               Mexico Equity Return                     Unemployment
Chile Equity Return                                                                  1.000
Variation of Reserves                                                                0.153                                 1.000
Mexico Equity Return                                                                 0.227                                -0.004                                 1.000
Unemployment                                                                        -0.119                                -0.009                                 0.063                       1.000


Mexico Correlation Matrix
Variable                        Int'l Investor Credit Rating      Price Earnings               Exchange Rate            Interest Rates       Price/Book Value               Mexico Equity Returns
Int'l Investor Credit Rating                                1.000
Price Earnings                                              0.018                      1.000
Exchange Rate                                              -0.116                     -0.101                    1.000
Interest Rates                                             -0.295                      0.394                    0.213                1.000
Price/Book Value                                           -0.082                      0.101                    0.023                0.007                          1.000
Mexico Equity Returns                                       0.275                     -0.118                   -0.183                0.054                         -0.283                          1.000




Brazil Correlation Matrix
Variable                             Brazil P/BV / Latin Amer. P/B Brazil P/E / Latin Amer. P/EBrazil Equity Returns     Exchange Rates    Price Earnings
Brazil P/BV / Latin Amer. P/B                                  1.000
Brazil P/E / Latin Amer. P/E                                  -0.003                     1.000
Brazil Equity Returns                                         -0.255                    -0.033                     1.000
Exchange Rates                                                -0.484                    -0.009                    -0.026             1.000
Price Earnings                                                -0.055                     0.991                    -0.041             0.014                                                     1.000



Argentina Correlation Matrix

 Variable                                       Argentina Equity Returns                         Brazil Equity Returns      Inflation Rate                                    Bond Yield
 Argentina Equity Returns                                                              1.000                         -0.115                                        0.233                      -0.036
 Brazil Equity Returns                                                                -0.115                          1.000                                        0.144                      -0.018
 Inflation Rate                                                                        0.233                          0.144                                        1.000                      -0.059
 Bond Yield                                                                           -0.359                         -0.175                                       -0.059                       1.000


Venezuela Correlation Matrix

 Variable                        Exchange Rates                     International Liquidity      Oil Exports             Price Earnings          Venezuela Equity Return      US Risk Free Rates
 Exchange Rates                                             1.000
 International Liquidity                                    0.019                        1.000
 Oil Exports                                                0.061                        0.023                   1.000
 Price Earnings                                             0.054                        0.012                  -0.145                   1.000
 Venezuela Equity Return                                   -0.090                        0.284                   0.265                   0.089                        1.000
 US Risk Free Rates                                         0.082                       -0.242                  -0.017                   0.018                        0.050                         1.000

				
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posted:9/5/2011
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