The Influence of the Exchange Rate of US Dollars on the Efficiency of Mutual Funds in China - Part 3


2.3 The Relation between the Yuan – Dollar Exchange Rate and the Mutual Funds in China

China invests in the U.S. public debts, holding long-term treasury, agency, corporate, equity and short-term debts. This makes China the biggest holder of U.S. securities, summing up a total of $ 1,6 trillion (Morrison and Labonte, 2011, p. i). These impressive shares that China owns in the U.S. debts create not only an advantage for China, as it has become a real economic threat to U.S., because it can sell its debts at any time, for whatever value it considers. The two economies are tight together. If one falls, the other one follows, as Morrison and Labonte observe. This relation is possible because China’s currency is pegged against the U.S. dollar (2011, p. i).

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First, if the dollar destabilizes than the yuan also decreases in value. Next, China is dependent of United States in its economic trades, mostly in what concerns the exports. Hence, the decline of the American dollar and of the American economy would hit the Chinese export, which represents, as seen, a significant aspect of the Chinese economy (Harvey and Bansal, 1995, p.32).

Selling its dollars would mean that Chinese products that are exported to U.S.A (from the automotive industry, mobile, consuming goods, etc.) will be sold at a higher price and this would seriously affect its overall economy. The only solution for China to sell its dollars without damaging its own economy would be to find a new marketplace, as profitable and as stable as U.S. However, giving the actual economic context, its imbalances and instability, China cannot jeopardize by taking such an action. Nevertheless, other potential marketplaces, such as the European or the Japanese ones are not sufficient or liquid enough to absorb China’s investments (Barboza, “China’s Treasury Holdings”, 2011).

Therefore, while the mutual funds in China orient towards security investments, in this case U.S. government debts, this creates an advantage for the Chinese economy, giving it the authority to coordinate the economic games with United States. Yes, China is dependent by the U.S. market, as a solid and stable marketplace and as a real economic international partner. However, holding such an impressive U.S. capital (under the form of the debts, mostly), China can take advantage by its position to decide the stability of its nominal exchange rate, while the real exchange rate can develop under its own inflationist trend.

Financial analysts consider this economic situation a cold war between China and U.S.A. wherein both sides fear the risks of a mutual destruction (Barboza, “China’s Treasury Holdings”, 2011). While U.S. dollar would collapse if China would start to sell its debts (because this would naturally determine other countries to sell their U.S. debts), China’s economy would be damaged because it would not benefit from the same economic conditions that it now has with the United States.

2.4. The Performances of Mutual Funds

2.4.1 The Modern Portfolio Theory

The Modern Portfolio Theory and the Post Modern Portfolio Theory provides besides methods of assets allocation also performance assessment methods for the financial assets (Rom, Brian & Ferguson, 1994, pp. 11-17). Over the recent years a series of measures were developed based on these methods, but also some that are empirical, derived from the practical experience of financial market analysts. The current conditions of the capital market from developed countries, have imposed a systematic approach to performance evaluation methods because of pressure created by the existence of a down market ("bear market"), and due to the frequently made criticisms of the Modern Portfolio Theory that until recently was considered the basis for performance measurement methods in the capital markets, and that nowadays become a generator of conventional and unclear systems considering the new market conditions, and the emergence of new financial products (Mercer, 2003, p.9).

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For a performance measurement system to be effective, i.e. to generate a true picture of the financial assets, it must meet the following conditions:

  • Adequacy: that is to capturethe fundamental elements of the distributionfor a minimum riskand a higherprofitability
  • Rationale: themeasuremust bebased oneconomictheoryor beaccepted as astandardon the market
  • Clarity:The modelmust beeasilyexplainedandunderstoodby investorsevenif they are nottrainedandfamiliarwiththe technical termsofmarketanalysis
  • Consistentwith therisk-profitability frontierfor the assetsallocationanalysis
  • Internationalcomparability – the measurementsystemmust reflect the internationaldifferencesbased onthe specificity of the national markets

The performances of the financial assets portfolios (like mutual funds) are determined based on ratability and risk (Dowd, 1999, p.62). For quantifying the risk, usually specialists use the standard deviation of ratability or the Sharpe indicator and the covariance between the portfolio’s ratability (the Treynor and the Jensen indicator).

The most known formula used for the measurement of the performance of portfolios of financial assets is known as the Sharpe ratio - introduced in 1966 by CAPM - and has the following expression:

 , where,

the numerator is the difference between the average return rate, or the estimated rate of return of the financial asset and the risk-free asset ratio or the excess return of the asset, compared to the rate of the asset without risk (Grootveld & Hallerbach, 1999, pp. 304-309). The denominator is the standard deviation or the square root of the variant and is the measurement of the associated risk of the financial asset portfolio.

The Treynor ratio is also the called the reward rate of volatility. Treynor introduced it as a performance measurement tool in 1965.

 (Mercer, 2003, p.32)

The formula is similar to the Sharpe ratio but measures the excess profitability of the assets with risks in comparison with the one with no risk for the volatility unit; the beta coefficient is a measure of the volatility of the return rates of the assets to the market (Sharpe, 1964).

 (Mercer, 2003, p.34)

The higher the Treynor ratio estimates a greater return value the fund realizes a higher return per risk unit.

The Jensen indicator is derived mainly from the single index model of Sharpe (1964) and it was introduced in the scientific circuit in 1972 by the author as a tool to measure performance on the capital market. The only change from the basic model is that rates of return have no absolute value but are in the form of the risk premium, i.e. the relative value to the point of comparison that is risk-free interest rate in the regression equation. Typically, this indicator is measured for longer periods of time: 3 years or more. The average excess return on the of risk-free rate assets is:

Jensen's alpha = Portfolio Return − [Risk Free Rate + Portfolio Beta * (Market Return − Risk Free Rate)] (Mercer, 2003, p.12)

2.4.2 Risk Management

The prediction of the future has always been a quest of people throughout the ages. Although various methods have been tried some of them very exotic and some very analytic, 100% accuracy in predicting future events is an impossibility and so the future will always be a generator of various risks.

The word “risk” even nowadays it is utilized inconsistent and ambiguous, fact that generates a wide range of criticism for all the methods developed in order to help risk management take on the challenges of predicting the future. (Hubbard, 2009)

Risk Management is the name given to a logical and systematic method of identifying, analyzing, treating and monitoring the risks involved in any activity or process. Risk Management is a methodology that helps managers make the best use of their available resources.

The international Standard Organization (ISO) in its ISO 31000 standards defines risk as: “the effect of uncertainty on objectives”. The definition includes events and information in both their forms. Events may happen or not and information can be acquired or not.

Risk has in the past been regarded as a negative concept that companies should try to avoid and transfer to others. However, it is now recognized that risk is simply a fact of life that cannot be avoided and denied. If we understand risk and how it is caused and influenced, we can change it, so that we are more likely to achieve our objectives and might even perform faster, more efficiently, or with improved results (Wellington Meeting, 2009).

Risk management as defined by the Business Dictionary represents the totality of policies, procedures, and practices involved in the identification, analysis, control and avoidance, minimization or elimination of unacceptable risks. “A firm may use risk assumption, risk avoidance, risk transfer or any other strategy (or combination of strategies) in proper management of future events”. (

Risk is implicit in all decisions we make: how we make those decisions will effect how successful we are in achieving our objectives. Decision-making is, in turn, an integral part of day-to-day existence and nowhere more prominent in an organization that at times of change and when responding to external developments. This is why risk management is so closely linked to the management of chance and to decision-making.

At present, no specific indicators exist, widely accepted, to valuate directly the performance of risk management or other relevant issues that reflect what we want to measure as risk management. Some initiatives have been taken at the regional and national levels [Mitchell, 2003]. However, in all cases this type of measure has been considered subjective and arbitrary due to their normative character. One of the principle efforts at defining those aspects that define risk management has been made within the action framework led by the ISDR [2003] where in draft form various thematic areas, components and possible performance evaluation criteria are proposed [Cardona et al. 2003a,b]. In any case it is necessary to evaluate the variables in a qualitative way, using a scale that may run from 1 to 5 or from 1 to 7 (Benson, 2003; Briguglio, 2003a, b; Mitchell, 2003) or using linguistic qualifications (Davis, 2003; Masure, 2003).

The attempt to measure risk management, when confronted with phenomena of a natural form, using indicators is a major challenge from the conceptual, scholastic, technical, and mathematical perspectives. Indicators must be transparent, robust, representative and easily understood by public policy makers at national, sub-national and urban level. It is important that evaluation methodology have easy application to be used periodically, facilitating management risk aggregation and comparison between countries, cities or regions, or any other territorial level (Roy, 1952, pp.431-449). Also, the methodology should be easy to apply in different time periods, in order to analyze its evolution. In risk management assessment, necessary involving data with incommensurable units or information only can be valuated using linguistic estimates.

However, there are some methods that are used in a certain degree of accuracy. One of the most common ones is the GAP analysis. The GAP interval model focuses on the management of the net interest income on the short term.

2.4.3 Main Evaluation Methods in China

The most common approaches towards the evaluation of the mutual funds in China are the Morningstar and Value.

Morningstar is published weekly and ranks all the mutual funds that are based in China. Morningstar does not offer a classification of the close – end funds, but it gives a classification of the open-end funds. The Chinese specialists classify the open-end mutual funds based on the proportion of their investments on different assets so that the rating is only held among the same kind of mutual fund. It is important to note that the fund classification of Morningstar is usually based on the fund’s prospectus (Jorion, 1997). However, in some cases, Morningstar may define a fund type differently from that implied by the fund’s name or by the fund’s prospectus if Morningstar figures out that the fund invests in a way that is different from the meaning of its prospectus.

In the ranking of Morningstar, the return measure is represented by the total return; for the measurement of risk, it is used the standard deviation and Morningstar risk; for measuring the fund’s performance it is used the Sharpe ratio (Shen & Xingluan, 2001). When calculate the returns of the mutual fund, Morningstar uses the monthly total return to measure the return of the mutual fund. The assumption is that the dividends will be reinvested and the tax and transaction fee are not taken into account (Treynor, 1965, pp. 63-75). Morningstar ranks the fund from high return to low return. Standard deviation reflects the fluctuations of the returns. If the standard deviation is high, the investment is also risky. Morningstar risk measures the downside risk of some funds. If Morningstar risk is high, it also indicates the funds are risky. Sharpe ratio shows the excess returns of taking unit risk. The funds with high Sharpe ratio indicate the funds have better performance. Morningstar gives the funds a quartile ranking according to the standard deviation, Morningstar risk and Sharpe ratio respectively (Treynor, 1965, pp. 63-75).

There are many different funds in the market, such as stock funds, bond funds etc. It is unfair to just compare the returns of all the funds since different portfolios have different risks. For example, money market funds have a very low risk, while the expected return is also relatively low; though the expected return of the stock funds are high, the risk are also high. So Value also firstly classifies the mutual funds. According to the different portfolios of the mutual funds and the investment preference, they classify the mutual funds: Stock funds, balanced funds, bonds funds, preserve principal funds, money market funds, index funds. Moreover, they use different benchmarks to the different types of mutual funds. (

Value Rating uses the excess rate of return over the benchmark as the rate of return. The risk is measured by the fluctuations of the excess rate of return. We can also call it standard deviation of the excess rate of return (Jorion, 1997). For the comprehensive rating, Value Rating uses the Information ratio to rank the mutual funds. It depicts the excess return of unit risk. It is easy to tell that the higher Information ratio, the better performance the mutual funds have. Similar to Morningstar, Value rating also uses star rating service to rank the mutual fund. If the fund lies in the top 10% of the investment category, it gets a rating of five stars; if the fund falls in the next 25%, it receives four stars; if it is in the middle 30%, it gets three stars; if it lies in the next 25%, the fund receives two stars and if it is in the last 10%, it receives only one star (Campbell, 1995, p.23).

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2.5. Conclusion of the Chapter

The present chapter presented some of the most important theoretical frameworks regarding mutual fund as a whole and mutual funds in China, along with theoretical presentations of the relations between the exchange rates of the US dollar versus the yuan and the mutual funds of China. Also, there were presented the main methods of determining the performances of the mutual funds. The preset chapter will help underline the methodologies used further in presenting the data and the data analysis of the exchange rate versus the performances of the mutual funds.

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