FIN3IFM Midsemester Exam Preparation
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Why is it important to study international financial management?
We are now living in a world where all the major economic functions, i.e. consumption, production, and investment, are highly globalised. It is thus essential for financial managers to fully understand vital international dimensions of financial management. This global shift is in marked contrast to a situation that existed only a few decades ago, when much of financial education ignored the international aspects, a practice that has become untenable since then.
How is international financial management different from domestic financial management?
International financial management possesses three traits that domestic financial management does not: foreign exchange risk (exists whenever you have to deal with more than one currency) and political risk (when your capital is tied up in a foreign country you are at the mercy of the political situation in the foreign country), market imperfections (When governments impose import and export tariffs, differential tax treatments etc, the free market is constrained) and an expanded opportunity set (provides additional opportunities for investors to diversify, including the ability to diversify away specific country risk).
Discuss the three major trends that have prevailed in international business during the last two decades..
There has been the emergence of globalised financial markets, brought about through the deregulation of financial markets, advances in technology and financial innovations. There has also been the emergence of the euro as a global currency, which was a momentous event in the history of world financial systems. There has been a trend in the changing attitudes of many of the world’s governments, to one have has abandoned mercantilist views and embraced the power of free trade to ensure prosperity for their nations. This has resulted in the General Agreement on Tariffs and Trade (GATT), one of many examples of the liberalisation of protectionist legislation which has reduced many barriers to trade. Finally, a major trend of the last two decades has been increasing rate at which state-owned businesses are being privatised, particularly due to the fall of communism.
In 1995, a working group of French chief executive officers was set up by the Confederation of French Industry (CNPF) and the French Association of Private Companies (AFEP) to study the French corporate governance structure. The group reported the following, among other things “The board of directors should not simply aim at maximizing share values as in the U.K. and the U.S. Rather, its goal should be to serve the company, whose interests should be clearly distinguished from those of its shareholders, employees, creditors, suppliers and clients but still equated with their general common interest, which is to safeguard the prosperity and continuity of the company”. Evaluate the above recommendation of the working group.
- These things are all interlinked, which is not acknowledged by the working group. If the board of directors did aim to maximise share values, they would need to ensure the prosperity and continuity of the company, as the share value is only the value of expected future returns (thereby implying expected future prosperity and continuity).
- The recommendations of the French working group clearly show that shareholder wealth maximization is not a universally accepted goal of corporate management, especially outside the United States and possibly a few other Anglo-Saxon countries including the United Kingdom and Canada. To some extent, this may reflect the fact that share ownership is not wide spread in most other countries. In France, about 15% of households own shares.
How does the instantaneous access to information via the internet affect the nature and workings of financial markets?
Ready access to international information helps integrate financial markets, dismantling barriers to international invetment and financing. Integration, however, may help a financial shock in one market to be transmitted to other markets.
Explain the mechanism which restores the balance of payments equilibrium when it is disturbed under the gold standard.
- The adjustment mechanism under the gold standard is regerred to as the price-specie-flow mechanism, expounded by David Hume. Under the gold standard, a balance of payment disequilibrium will be correct by a counter-flow of gold.
- Suppose that the US imports more from the UK that it exports (net flow of imports). Under the classical gold standard, gold, which is the only means of international payments, will flow from the US to the UK. As a result, the US will experience a decrease in money supply, and the UK will experience an increase. This means that the price level will tend to fall in the US and rise in the UK. Consequently, the US products become more competitive in the export market, while IK products become less competitive. This change will improve US balance of payments and at the same time hurt the UK balance of payments, eventually eliminating the initial balance of payments disequilibrium.
Supppose that the pound is pegged to gold at 6 pounds per ounce, whereas the franc is pegged to gold at 12 francs per ounce. This, of course, implies that the equilibrium exhcnage rate should be two francs per pound. If the current market exchange rate is 2.2 francs per pound, how would you take advantage of this situation? What would be the effect of shipping costs?
Suppose that you need to by 6 pounds using French francs. If you buy 6 pounds directly in the foreign exchange market, it will cost you 13.2 francs. Alternatively, you can first buy an ounce of fold for 12 francs in France and then ship it to England and sell it for 6 pounds. In this case, it only costs you 12 francs to buy 6 pounds. It is thus beneficial to ship gold due to the overpricing of the pound. Of course, you can make an arbitrage profit by selling 6 pounds for 13.2 francs in the foreign exchange market. The arbitrage profit will be 1.2 francs. So far, we have assumed that shipping costs do not exist. If it costs more than 1.2 francs to ship an ounce of gold, there will be no arbitrage profit.
Discuss the advantages and disadvantages of the gold standard.
- The advantages include:
- Limits on inflation (stopping it from getting very high), since the supply of gold is restricted.
- Correction of balance of payments disequilibrium though cross-border flows of gold.
- The disadvantages include:
- Potential for deflationary pressure on the world economy due to the restricted supply of gold.
- No mechanism of the gold standard to 'enforce the rules of the game', so countries may pursue economic policies (like de-monetisation of gold) that are incompatible with the gold standard.
What were the main objectives of the Bretton Woods system?
It was designed to maintain stable exchange rates and economise on gold, and resulted in the creation of the IMF and the World Bank.
Explain the arrangements and workings of the European Monetary System (EMS)
- EMS was launched in 1979 in order to
- 1) Establish a zone of monetary stability in Europe
- 2) Coordinate exchange rate policies against the non-EMS currencies, and
- 3) Pave the way for the eventual European monetary union.
- The main instruments of EMS are the European Currency Unit (ECU) and the Exchange Rate Mechanism (ERM):
- Like SDR, the ECU is a basket currency constructed as a weighted average of currencies of EU member countries. The ECU works as the accounting unit of EMS and plays an important role in the workings of the ERM. The ERM is the procedure by which EMS member countries manage their exchange rates. The ERM is based on a parity grid system, with parity grids first computed by defining the par values of EMS currencies in terms of the ECU. If a country’s ECU market exchange rate diverges from the central rate by as much as the maximum allowable deviation, the country has to adjust its policies to maintain its par values relative to other currencies. EMS achieved a complete monetary union in 1999 when the common European currency, the euro, was adopted.
In an integrated world financial market, a financial crisis in a country can be quickly transmitted to other countries, causing a global crisis. Wat kind of measures would you propose to prevent the recurrance of an Asia-type crisis?
- 1) Countries must first strengthen their domestic financial system before liberalising their financial markets. This may involve strengthening the countries financial sector regulation and supervision. Countries should depend more on domestic savings and long-foreign invetments, rather than short-term portfolio capital.Banks should be encouraged to lend solely on economic merit rather than political considerations.
- 2) There should be a multinational safety net to safeguard the world financial system from the Asia-type crisis
- 3) International institutions like the IMF and the World Bank should monitor problematic countries more closely and provide timely advice to those countries. Countries should be required to fully disclose the economic and financial information so that devaluation surprises can be prevented.
Define balance of payments
The balance of payments can be defined as the statistical record of a country's international transactions over a certain period of time presented in the form of double-entry bookkeeping. Any transaction resulting in a receipt from foreigners is recorded as a credit, with a positive sign, whereas any transaction resulting in a payment to foreigners is recorded as a debit, with a minus sign.
The United States has experienced continuous current account deficits since the early 1980s. What do you think are the main causes for the deficits? What would be the consequences of continuous US current account deficits?
- The current account deficits of the US may be attributable to:
- The strong dollar and undervalued currencies of trading partners such as China
- High consumption and lwo savings in the US and
- Weak competitiveness of US industries.
- If US deficits continue, the dollar may eventually depreciate substantially and the confidence in the dollar may suffer.
In contrast to the United States, Japan has realised continuous current account surpluses.What could be the main causes for these surpluses? Is it desirable to have continuous current account surpluses?
- Japan's continuous current account surpluses may have reflected a weak Yen and high competitiveness of Japanese industries. Massive capital exports by Japan prevented the Yen from appreciatingmore than it did. At the same time, foreigners' exports to Japan were hampered by the closed nature of Japanese markets.
- Continuous current account surpluses disrupt free trade by promoting protectionist sentiment in the deficit country. It is not desirable especially when it is brought about by the mercantilist policies.
Explain how a country can run an overall balance of payments deficit or surplus
A country can run an overall balance of payments deficit or surplus by engaging in the official researve transactions. For example, an overall balance of payments deficit can be supported by drawing down the central bank's reserve holdings. Likewise, and overall balance of payments surplus can be absorbed by adding to the central bank's reserve holdings.
Explain how to compute the overall balance and discuss its significance
The overall balance is determined by computing the cumulative balance of payments including the current account, capital account, and the statistical discrepancies. The overall balance is significant becaise it indicates a country's international payment gap that must be financed by the government's official reserve transactions.
Since the early 1980s, foreign portfolio investors have purchased a significiant portion of US treasury bond issues. Discuss the short-term and long-term effects of foreigners' portfolio investment on the US balance of payments.
As foreigners purhcase US Treasury bonds, US balance of payments will improve in the short run. But in the long run, US balance of payments may deteriorate because the US should pay interests and principals to foreigners. If foreign funds are used productively and contributes to the competitiveness of US industries, however, US balance of payments may improve in the long run.
Describe the balance of payments identity and discuss its implications under the fixed and flexible exchange rate regimes.
When the balance-of-payments accounts are recorded correctly, the balance of payments identity is BCA (balance on the current account) + BKA (balance on the capital account) +BRA (balance on the reserves account) = 0. The equation indicates that a country can run a balance-of-payments surplus or deficit by increasing or decreasing its official reserves. Under the fixed exchange rate regime, countries maintain official reserves that allow them to have balance-of-payments disequilibrium, that is where BCA + BKA does not equal 0, without adjusting the exchange rate. Under the fixed exchange rate regime, the combined balance on the current and capital accounts will be equal in size, but opposite in sign, to the change in the office reserves (BCA + BKA = -BRA). For example, if a country runs a deficit on the overall balance, that is, BCA + BKA is negative, the central bank of the country can supply foreign exchanges out of its reserve holdings. But if the deficit persists, the central bank will eventually run out of its reserves, and the country may be forced to devaluate its currency.
A CD/$ bank trader is currently quoting a small figure bid-ask of 35-40, when the rest of the market is trading at CD1.3436-CD1.3441. What is implied about the trader's beliefs by his prices?
The trader must think the Canadian dollar is going to appreciate against the U.S. dollar and therefore he is trying to increase his inventory of Canadian dollars by discouraging purchases of U.S. dollars by standing willing to buy $ at only CD1.3435/$1.00 (As a client, you will choose to sell $ to the rest of the market for a higher price) and offering to sell from inventory at the slightly lower than market price of CD1.3440/$1.00 (As a client, you are attracted to the lower buying price offered by this trader. As a result, you buy $ from this trader using the CD; the trader ends up with more CD). The future appreciation of the CD will provide an opportunity to make profit on the CD inventory.
Over the past five years, the exchange rate between the British pound and the US dollar, $/£, has changed from about 1.90 to about 1.45. Would you agree that over this five-year period that British goods have become cheaper for buyers in the US?
The value of the British pound in US dollars has gone from about 1.90 to about 1.45. The British pound has depreciated relative to the dollar.Therefore, the dollar has appreciated relative to the British pound, and the dollars needed by Americans to purchase British goods have decreased. Thus, the statement is correct.
What is meant by a currency trading at a discount or at a premium in the forward market?
The forward market involves contracting today for the future purchase or sale of foreign exchange. The forward price may be the same as the spot price, but usually it is higher (at a premium) or lower (at a discount) than the spot price.
Give a full definition of arbitrage
Arbitrage can be defined as the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits.
Discuss the implications of the interest rate parity for the exchange rate determination.
Assuming that the forward exchange rate is roughly an unbiased predictor of the future spot rate, IRP can be written as S = [(1 + I£)/(1 + I$)]E[St+1|It]. The exchange rate is thus determined by the relative interest rates, and teh expected future spot rate, conditional on all the available information, It, as of the present time. One can thus say that expectation is self-fulfilling. Since the information set will be continuously updated as news hits the market, the exchange rate will exhibit a highly dynamic, random behaviour.
Explain the conditions under which the forward excange rate will be an unbiased predictor of the future spot exchange rate.
- The forward exchange rate will be an unbiased predictor of the future spot rate if:
- The risk premium is insignificant and
- Foreign exchange markets are informationally efficient.
Discuss the implications of the deviations from the purchasing power parity for countries competitive positions in the world market.
If exchange rate changes satisfy purchasing power parity, competitive positions of countries will remain unaffected following exchange rate chages. Otherwise, exchange rate changes will affecte relative competitiveness of countries. If a country's currency appreciates by more than is warranted by purchasing power parity, that will hurt the country's competitive position in the world market. It the currency depreciates, the country's position will stengthen.
Researchers found that it is very difficult to forecast the future exchange rates more accurately than the forward exchange rate or the current spot exchange rate. How would you interpret this finding?
This implies that exchange markets are informationally efficient. Thus, unless one has private information that is not yet reflected in teh current market rates, it would be difficult to beat the market.
Explain the following conepts of purchasing power parity:
The law of one price
Absolute purchasing power parity
Relative purchasing power parity
- The law of one price: refers to the international arbitrage condition for the standard consumption basket. The law of one price requires that the consumption basket should be selling for the same price in a given currency across countries.
- Absolute purchasing power parity: holds that the price level in a country is equal to the price level in another country times the excange rate between the two countries.
- Relative purchasing power parity: holds that the rate of exchange rate change between a pair of countries is about equal to the difference in inflation rates of the two countries.
A country with a current account surplus:
A) acquires IOUs from foreigners, thereby increasing its net foreign wealth.
B) must borrow from foreigners or draw down on its previously accumulated foreign wealth.
C) will experience a reduction in the country's net foreign wealth.
D) both B and C
The dollar-euro exchange rate is $1.25=€1.00 and the dollar-yen exchange rate is ¥100=$1.00. What is the euro-yen cross rate?
D) None of the above
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