1.
Ethical Standards
a. Can a multinational firm adopt varying ethical standards [such as with regard to product safety (Pinto), employee benefits (Nike) and “kickbacks” to win business (HP)] in its global operations? Why or Why Not? Discuss in depth based on the goals of multinational corporations? b. How do corporate governance and financial management differ for US based corporations and global multinational corporations? Answer 1 (a) With the emergence of a global economy, MNCs are forced to adopt more specific ethical codes as part of their long-term corporate strategy. . Market globalization and trade bloc formation are two powerful concerns that forced MNCs to sign agreements on social responsibility. MNCs are also likely to adopt ethical standards as a response to the growing threat poised by an increasingly vocal consumer base who demand that corporations promote sustainable development strategies without sacrificing product and service quality.
A Multinational corporation (MNC) is a business firm that is incorporated in one country and has its operations, production and sales in other countries. The main goal of a multinational organisation is the same as that of any other organisation and that is to create the maximum value that can be created for the shareholders. This can be done by following practices that could enable sales growth or market share growth, growth in the operating profit margin, lowering the cash tax rate, incremental expenditure in capital expenditure that would reap benefits in future, optimizing the investment in working capital, exploit the time period to gain competitive advantage and finally lowering the cost of capital by optimizing the debt to equity ratio. A firm has many stakeholders that are both internal as well as external to the organisation. The internal stakeholders includes shareholders, employees of the organisation, debt holders, the management including the board of directors and the external stakeholders include customers, debt holders, community, suppliers, government etc. All the stakeholders are aligned to the business operations in one way or the other and to maximise the value a firm can generate, it needs to look into the interest of each of its shareholders. For example employees, suppliers, government agencies, and customers represent a major part of the value of the company. In order to motivate employees to work hard for a company, a level of trust must be built. Such trust can only grow from the perceived security that the interests of all individual stakeholders are taken into account Multinational corporations as mentioned above have operations in various countries and each country follows different laws with respect to corporate governance and business ethics. Each organisation in pursuit to maximise profits and value for the shareholders should not forget the applicable laws that are in place. It is not only important for corporations to comply with applicable laws but also adhere to the social responsible behaviour that includes preservation of human capital, the environment and the relationship with the stakeholders. Social responsibility should not be limited to countries where there are strict laws to
protect against bribery, child labour, environmental protection, and the like. In the age of the Internet, information flows very rapidly across the world and sooner or later people from around the world will find out about inappropriate behaviour of corporations and hence would affect the operations in other countries as well. Hence MNCs should generally adopt the same ethical standards on their subsidiaries as on their home operations. An economic rationale for a multinational's (MNC) imposing universal ethical standards can be based on the following argument: 1. Certain ethical commitments are believed by the management of a MNC to provide the MNC with a competitive advantage. 2. These ethical commitments which provide a durable competitive advantage abroad tend to be knowledge-based, to be embodied in individual employees or firm routines, and to be characterized by high asset specificity. 3. Highly specific assets, for example ethical commitments, associated with high return should not be diluted. 4. If ethical commitments vary among subsidiaries, these assets will be diluted due to the phenomenon of cognitive dissonance. 5. Therefore, a MNC should have common ethical commitments in all its subsidiaries. Generally followed ethical standards can solve agency problems, lower transaction costs, and increase trust both within the organization and between organizations engaged in partnerships or strategic alliances. If a MNC has one set of ethical standards in the home country and different ethical commitments in host countries, cognitive dissonance will be created. Corporate stakeholders will not know which values, beliefs, and behaviours really represent the MNC. The ethical climate of the MNC will become confused and the ethical climate which had been an asset that provided competitive advantage will be diluted. To prevent the negative consequences of cognitive dissonance, the moral climate of the MNC should include standards that are applied universally, i.e., in both the home country and in host country subsidiaries. Thus if the MNC exceeds the legal requirements with respect of the environment at home, it should do the same abroad. Suppose the home country norms vary widely from host country norms. Customers may not buy their product. When such situations occur the MNC must consider how important its ethical climate asset really is. If that asset truly is important, then it would be better for the MNC not to do business in that country than to dilute its ethical climate asset. For example: Conventional wisdom might consider the action of the Levi Strauss Company to exit China and Burma because of human rights violations there to be extremely foolish. After all they are leaving one of the major markets in the world. Levi Strauss recognizes that it cannot maintain a commitment to basic human rights and thereby to its basic moral integrity while simultaneously done business in a country that commits human rights violations. Levi Strauss places a high value on its reputation as a socially responsible MNC. This argument, however, does not apply to a MNC that does not consider being seen as socially responsible to be an asset.
(b) The corporate governance laws are different in different countries and hence have different legislations and needs to be dealt accordingly. After the Enron scandal and other scandal, the US laws have become really strict by the introduction of Sarbanes
Oxley act and the latest being the Dodd Frank act that was bought into practice after the 2008 economic crises. Most organisations face the agency problems where the owners and managers(including the board of directors) have different interest and the managers try to enhance their returns sometime at the expense of the shareholders. Sometime managers also enter into unethical practices as well; one fine example of the same was Enron. The structure of the corporate boards, the way the board is elected is different in different countries and companies have to work accordingly. In the U.S., shareholders have the right to elect the board of directors. If the board remains independent of management, it can serve as an effective mechanism for curbing the agency problem. In Germany however the board is not legally charged with representing the interests of shareholders, but is instead charged with representing the interests of stakeholders. In England, the majority of public companies voluntarily abide by the Code of Best Practice on corporate governance. It recommends that there should be at least three outside directors and that the board chairman and the CEO should be different individuals. In Japan, most corporate boards are insider-dominated and primarily concerned with the welfare of the keiretsu to which the company belongs. In the United States and the United Kingdom, concentrated ownership is relatively rare. Elsewhere in the world, however, concentrated ownership is the norm. So companies for example that are listed in the US stock exchange have to follow certain laws and a structure in a way the board is selected, compliance with the Sarbanes Oxley etc. The advantage multinational organizations that have practices in large companies can become listed in the other countries stock exchange that has less strict laws. For example a company got it self-listed in the UK stock exchange because it wanted to evade the troublesome compliance to the Sarbanes Oxley act. 2.
Global Pricing Strategy
With the emergence of the Internet as a dominant influence in global markets, many anticipated that the “Law of One Price” for all products would evolve. However that did not materialize. . What is “Law of One Price”?. When would that exist globally? A. Identify the major pricing strategies/ methodologies of corporations in pricing products and services. B. Discuss the impact of the Internet on “Global Pricing Strategies” of firms with specific reference to ‘Internet Pricing’ and ‘Brick and Mortar pricing’. A: The theory that the price of a given security, commodity or asset will have the same price when exchange rates are taken into consideration. The law of one price is another way of stating the concept of purchasing power parity. The law of one price exists due to arbitrage opportunities. If the price of a security, commodity or asset is different in two different markets, then an arbitrageur will purchase the asset in the cheaper market and sell it where
prices are higher. When the purchasing power parity doesn't hold, arbitrage profits will persist until the price converges across markets. For example, an ounce of gold should cost the same on commodity exchanges in two different countries. If the gold costs more on one exchange, then traders would have incentive to purchase the gold on one exchange and sell it at the other one. They would do what is called an arbitrage. However, this law does not always hold in practice. The reason is mostly transaction costs and trade barriers. There may be limits on how much gold one can export or import out of the country. It costs something to buy gold in one country and have it shipped to another. B. Identify the major pricing strategies/ methodologies of corporations in pricing products and services. A: There are many strategies organisations may use in pricing their products. Competitive pricing strategy
[Bottled Water, Pizzas]
‘Skimming the cream’ pricing strategy *High Technology, Plasma TVs+
Penetration pricing strategy [ Limit Pricing: PCs; Cosmetics or Colas in Emerging Markets] Keep out pricing strategy [Predatory Pricing: Internet firm Webvan] - a pricing practice, common in oligopolistic market situations, in which the large companies maintain very low prices to discourage smaller competitors and thus protect their own market shares Mark-up pricing strategy [Retailers, Walmart, K-mart] - widely used in retailing, where the retailer wants to know with some certainty what the gross profit margin of each sale will be. An advantage of this approach is that the business will know that its costs are being covered
Target-return pricing strategy [Utilities, Auto Dealers?] - Pricing method whereby the selling price of a product is calculated to produce a particular rate of return on investment for a specific volume of production. The target pricing method is used most often by public utilities, like electric and gas companies, and companies whose capital investment is high, like automobile manufacturers.
Differntiated/dual product pricing strategy [Quaker Oats, Proctor and Gamble] -
Differential pricing is the strategy of selling the same product to different customers at different prices Dual - The practice of setting prices at different levels depending on the currency used to make the purchase. Dual pricing may be used to accomplish a variety of goals, such as to gain entry into a foreign market by offering unusually low prices to buyers using the foreign currency, or as a method of price discrimination.
Pricing methods
Cost orientated
Demand orientated
Cost-plus pricing Contribution pricing Target (ROI) pricing Price-minus pricing Return on costs
Marginal analysis Trial and error pricing Intuitive pricing Market pricing Monopsonistic pricing
Competition
Product analysis pricing Value pricing Pricing leadership/ followership Competitive parity pricing
Pricing policy, objectives and methods
To ensure survival,
To achieve a target rate of return,
To maintain or improve market share, and
To meet or prevent competition.
C.
Discuss the impact of the Internet on “Global Pricing Strategies” of firms with specific reference to ‘Internet Pricing’ and ‘Brick and Mortar pricing’.
A: The Internet makes global price differences obvious. There are certainly pros and cons to both business models. Online retailers like Amazon have low cost structures and can maintain larger inventories making it difficult for brick and mortar retailers like WalMart to compete on price and product selection. On the other hand, brick and mortar retailers offer real people to talk to, don't require credit cards, and can provide unique services that require the consumer to be in the store. Take GameStop (GME) for example, which interestingly enough,was sold off by Barnes & Noble in 2004. GameStop purchases used games in exchange for in-store credit; one reason this service can't be completed online is because the purchaser has to confirm the game works before payment. Internet pricing has also led to “showrooming” — consumers visiting brick and mortar stores to see and touch products before returning to the Internet to make their online purchases. Many brick and mortar retailers are feeling the pinch of showrooming and are taking steps to convert online buyers to in-store customers. Graphics producers who specialize in creating environments and branding products can help retailers hold market share at their brick and mortar stores. There are several changes taking place in the strategies of the retail community that are intended to help big-box stores better compete with online retailers:
Manufacturers of items like TVs and appliances are trying to achieve unilateral pricing by removing or reducing online discounting. Apple is a master at managing
unilateral pricing. When the price in the store and the price online are the same, there is no need to shop twice. Brick and mortar stores are strengthening the value of onsite customer support and benefiting from instant availability. We’re also seeing stores offer selected products only through brick and mortar channels. Some brick and mortar retailers are using targeted coupons and special offers, delivered electronically to potential customers when they are in the vicinity of the store. And, near and dear to our imaging hearts, retailers are improving the onsite buying experience with improved shopping environments and exciting in-store branding.
However internet pricing doesn’t always affect the pricing strategies of brick and mortar stores. Luxury brands such as Gucci and Louis Vuitton are among the retailers least affected by showrooming. Not coincidentally, they are obsessive about their store environments. Their products carry a premium price and they know their customers are interested in the total buying experience, as well as the product. The elaborate store environment and instore promotions contribute to the exclusivity of the brand. They are trend-setters in the use of environmental enhancement designed to contribute to the sale. Luxury brands are great clients for environmental graphic producers and the retail community can learn from their business practices.
3. A. What does Securitization of assets mean? B. What are its costs and benefits for financial institutions? C. Why has this market experienced such a tremendous growth in prior decades? D. Why did it cause a global crisis? A. The pooling, and packaging of asset backed loans [began with mortgages] into marketable securities It is also known as Asset-Backed lending. More advanced and complex developments are now called Structured Finance. The marketable securities are sold to government agencies or to private investors. The proceeds enable banks to make new loans. Securitization is an off-balance-sheet transaction that allows a bank to increase net income, because the originating institution [bank] can continue to service the loans, in return for the ‘residual interest income’ and ‘servicing fees’. The interest and principal payments generated by the loan package are passed on to the investors who purchase the securities.
Bank loans on balance sheets.
Some loans are removed from bank balance sheets, pooled, and placed under control of a separate special
Securities are issued against the pool of loans and sold to
Funds from the sale flow back allowing it to make new loans and investments.
Stakeholders/ Players in Securitization Originating Institution [Bank (SunTrust), Savings and Loans (Countrywide)] o
Special purpose Entity [ SPE also, SP Vehicle or SP Trust or SP Corporation] o
Acquires assets from the originator
o
Sells them as securities to investors
Investors [Pension Funds, Mutual Funds, Hedge Funds] o
Buyer of securities; main attraction: High Rates backed by Secured Assets
Loan Processing / Service Institution (normally the originating institution) o
Originates a cash generating asset
Manages / administers the collection of Proceeds
Credit Enhancer [s] [Prudential, AIG] o
Provides credit support for improving credit rating; insure risks for a fee.
Rating Agency [S & P, Moody’s+
Assesses credit risk profile of underlying asset/enhancements and rates it
Mortgage Backed Securities (MBS, Residential [RMBS], Commercial [CMBS]) Collateralized Debt Obligations [CDO, Collateralized Loan Obligations CLO, Collateralized Bond Obligations CBO] Asset Backed Commercial Paper [ABCP] Asset Backed Securities [ABS] Securitization Process- Transfer, Enhance, Rate, Issue , Manage [TERIM}
B. Advantages of Securitization 1. To Originators [Banks] o
Liquidity: Ability to sell asset readily
o
Profitability: Income on Sales
o
Solvency: More efficient use of capital; reduce regulatory capital
o
Potential Service Income
o
Diversified source of funds (regional, national, global)
2. To Investors [Mutual, Pension, Hedge Funds] a. High yields on enhanced and rated collateralized securities b. Greater Liquidity due to enhanced secondary markets c. Enhanced diversification d. Potential Trading profits 3. To Consumers & Borrowers:
Lower cost of funds
Increased selection of credit forms
Competitive rates and terms nationally and locally
Consistent availability of funds
4. To Investment Banks [Bear Stearns, Lehman]
New product lines
Continuous flow of originations and fees
Trading volume and profits
Potential for Innovation and market expansion
5.
To Rating Agencies *S & P, Moody’s+
New product lines;
3 Times fee income in rating ABS versus Bonds
6. Many other financial institutions, banks and non-banks, Brokers are now active in Securitization; Provides Liquidity, and active secondary market for Underlying Loans 6. Increases funding sources 7. Avoid risk associated with deposit funding 8. Helps Profitability and Solvency Ratios 9. Better Monitor/ Control of Institution LIMITATIONS Risk Enhancement due to Leverage: Other asset-backed securities are riskier than the real estate backed mortgage security. They have less secure collateral [Car/computer loans, a depreciating asset], or, in the case of credit cards, maybe none at all. They do not have the insurance or guarantee of the government as FNMA, GNMA loans have. Securitization Structure and Guarantee Risk: While securitizations enables banks to raise non-deposit funds and increase earnings, depending on the structure of securitization [pass through, ABS, pay through], The bank may guarantee the loans they securitize. While this protects the investor, it seriously undermines the security of the bank’s stockholders and depositors and FDIC. This is because the bank’s required capital reserves are lower than they would be if these loans were carried on the balance sheet.
Moral Hazard: Window Dressing: The Off- balance sheet structure is a way for the banks to hide and unload risky loans that, perhaps, should never have been made, and for which they may still be liable in the event of default. [ENRON] If institutions is not expected to hold Loans in books, may create Lemon Loans. Poor Operational Performance: Enhanced Risk taking while it increases bank earnings, may hide poor performance in other operations. C. This growth has been encouraged by the benefits that securitisation of financial assets brings to both issuers and investors. For issuers it offers cheaper and more efficient funding for operations combined with greater balance sheet flexibility. For investors, securitisation provides a broad selection of fixed income investment alternatives, most with higher credit ratings, less downgrade risk than corporate bonds and, more stable cash flows than other fixed income securities.
4. Financial Institutions Muti-goal Optimization Strategy: a.
Identify the major ‘objectives’ and ‘problems’ in the management of financial institutions globally. What strategies do institutions use to meet these challenges?
b.
How do regulators evaluate the financial institutions?
c.
Why did ‘Virtual Banks’ fail? Discuss in depth. Based on this, What are the prospects for Mobile Banking worldwide in the forthcoming decade?
Traditional Questions for Domestic Firms RISK MANAGEMENT What domestic Operations and Instruments we should immunize? FINANCING DECISIONS How Should we finance ourselves? CASH MANAGEMENT How Should we return Cash to Shareholders? INVESTMENT / CAPITAL BUDGETING DECISIONS How Should we analyze Investment Opportunities? SIGNALLING / COMMUNICATION How Should we communicate information to Shareholders and Lenders? CAPITAL STRUCTURE DECISIONS How Should our ownership structure influence operations?
New and Additional Questions for Global Firms What Global Operations and Instruments we should use for immunization? How should we finance our Subsidiaries? How should we get money out of Subsidiaries? How should we analyze the same investment opportunities in different countries? How Should we communicate financial information inside the Firm? How Should we decide what to own and with Whom?
The regulators evaluate and rate an institution’s financial condition, operational controls and compliance in six areas:
Capital Adequacy: Evaluating and planning for an institution’s capital needs is a major responsibility for directors. To carry out this responsibility, directors must monitor their institution’s capital position on an ongoing basis and identify factors that may influence the adequacy of this position over time. It also requires the directors to work with management to develop strategies to meet identified needs. Asset Quality: Directors are responsible for asset quality and for ensuring their institution maintains an adequate reserve to absorb loan losses. This has been the main reason in financial institution failures. Board members should establish a policy to guide the institution’s lending activities. Additionally, there should be in place policies and processes to determine probable loss in the loan portfolio and to maintain an adequate reserve to cover these losses. Monitoring asset quality and the adequacy of the reserve to ensure that policies in place are operationally effective is essential in preserving an institution’s asset quality and protection from foreseeable losses. Management: The Board plays a key role in an institution’s governance process and success. Directors work for the shareholders in overseeing the operation of the institution. Directors set the course and direction of the institution via its strategic planning, policies and procedures. Management works for the directors in running the institution on a day-to-day basis, implementing its policies and procedures consistent with the strategic plan. Directors monitor management’s performance through the various reports it receives. Together, directors and management identify, measure, control and monitor the institution’s risks. Given this, it is of prime importance that the Board does its job well. Earnings: In monitoring an institution’s earnings, directors should receive reports that allow them to compare actual results to budgeted projections and assess the quality, or sustainability, of earnings. Earnings quality refers to the composition, level, trend and stability of institution earnings. For directors and management, earnings quality is a financial report card. It tells how the institution has managed its risk exposure. Where risk management is good, earnings will be consistently strong and earnings quality will be good. Where risk management is poor, the opposite will be the result. In such cases, dissecting earnings into its component parts provides insights regarding areas needing attention. Liquidity: Planning and managing liquidity are important aspects of an institution’s governance. Institutions need to plan for depositor and borrower demands so that funds are readily accessible at a reasonable cost. This planning is guided by policies adopted by the board of directors that set liquidity and interest rate risk tolerances, identify appropriate institution products, and provide a liquidity contingency plan in the event of significant, unforeseen circumstances. Sensitivity to Market Risk: Steering an institution through different interest rate environments is an important task, guided by the policies set by the board of directors. These include a funds management or asset liability management policy, which includes risk tolerances that maintain earnings and protect capital as interest rates change. The policies should also include a reporting mechanism for the directors, so that the board may monitor the institution’s sensitivity to market risk and compliance with established policy.
A: Virtual bank is a financial institution that does not have physical branches or location but operate over the World Wide Web using Internet technology. BUSINESS MODEL: Profitability of a virtual bank can be explained by the equation: NI = (NII-burden-PLL) (1-t) Where, NI = Net Income NII = Net Interest Income Burden = (Non Interest Expense – Non Interest Income) PLL = Provision for Loan Loss t = Bank’s Tax Rate 1. For a virtual bank to be profitable, the revenue has to exceed the cost of maintaining their presence over the Internet. 2. Cost of designing a non-interactive, static Internet site ranges from $5,000 to $50,000. Dynamic, interactive Internet channel ranges from $300,000 to $500,000 for community banks, in 2005. The cost of initiating a full-fledged virtual banking bank is over $2 Million, in 2005. In 2012, It is estimated to be over $5 M. 3. A Bank’s net income depends on several factors. Two most crucial ones are: a. Net interest income from deployment of assets & liabilities, and b. Burden, the Excess of non-interest expenses over non-interest revenue. 4. Theoretically, the comparative advantage for a virtual bank is lower operating costs and hence lower burden. It was estimated in the early 2000s that, the Operating cost for a brick-mortar-bank: 60% of revenue; and for a virtual bank: 10% of revenue. 5. However, intense competition forced changes in their business models. a. Heavy expenditure of web advertising to establish brand name; b. Lack of name recognition; forced to pay higher Deposit rates, increasing cost. c. Lack of established lending relationships forced them to invest in lower-yielding secondary margin securities and loans. 6. Virtual operations could not achieve economies of scale and scope; 7. Banking Customers wanted multi channel access, such as branches, ATMS, and kiosks, in addition to Internet banking. 8. Competition from other wannabe virtual banks created downward pricing pressures. 9. Superior Infrastructure alone does not guarantee profitability; Citibank’s Citifi. 10. All the above mentioned factors eroded Virtual banks profitability; under these circumstances established brick-and-mortar banks had a comparative cost advantage. For future prospects for Mobile Banking – Read Lecture 2 Module E – Slides 2,13,14,15,16,17,18
MOBILE BANKING: Mobile banking transactions to excess US$860 billion by 2013. Informa Telecoms & Media forecasts that in 2013 almost 300 billion transactions, worth more than US$860 billion, will be conducted using a mobile phone Remote mobile payments Local mobile payments Mobile banking Mobile money transfer (MMT). Mobile phone and network technologies are now more sophisticated and more mature than ever before and, and thanks to industry initiatives, more coordinated and standardized agencies to take a more ‘enlightened’ approach to this market. In developing markets it is recognized that mobile banking and mobile money transfer services can facilitate and encourage economic growth in the poorest and most deprived regions Yet these new technologies and service opportunities do offer the potential to make real cost reductions, attract and retain customers and potentially drive new revenue growth and profit opportunities for mobile operators, banks and credit card companies. Once the full ‘leather wallet’ analogy is achieved by the mobile wallet – with the mobile phone holding multiple ‘virtual’ accounts or cards, including loyalty cards as well as ad-hoc discounts (vouchers), and other applications such as ‘mTickets’ and ‘mAccess control’ – mobile payments and mobile banking will become fully integrated in the consumer’s lifestyle. In the developing world, the behavioral change amongst consumers has already begun; mobile payments and mobile banking are already the natural and only financial services to millions of previously unbanked consumers– it will lead the world in the use of mobile payments and banking. Mobile phone will inevitably become embedded in the financials services’ infrastructure and be accepted as a natural means of payment. Will not happen overnight, and that it will not happen in isolation. Will require unprecedented levels of collaboration and coordination between two very different industries. There is a strong appetite for these new business opportunities but the key players – mobile operators, banks and credit card companies – must acknowledge and take advantage of each others respective strengths, and work together to overcome the remaining barriers rather that attempt to control everything on their own.” THREATS Mobile attack. Mobile phones today can be as smart as a small computer, but they typically do not have anti-virus programs installed, meaning they are more vulnerable to attack. Next generation backing. Hackers today carry out targeted attacks and have the clear objective of gathering money. The victims are typically executive or celebrity targets, which hackers can search information about using search engines such as google.com or bing.com, together with “intelligent data gathering” from the databases of social networks. Inside threats or organized crime. More than 50 percent of cyber security threats are caused by internal figures or disgruntled employees.
Insecure infrastructure and insecure outsourcing. As many organizations are likely to outsource at least some of their IT operations or infrastructure to third parties, many will use a managed security provider (MSSP) for log and security management. Misunderstanding about GRC/increase in regulatory compliance. Top management executives don’t know or understand the concept of GRC (governance, Risk Management, Compliance) for IT governance, information security government and corporate governance. Increasing incidence of espionage and corporate fraud. Enemy countries have often engaged in espionage missions to each other. Cyber security threats at international level are called “Cyber Welfare” and have been carried out with the objective of gaining strategic advantage in political disputes, Cyber warfare techniques include Information Operation (IO), Information Assurance (IA) and Computer Network Operations (CNO). 5. Theoretical Relationship 1: Relationship between Money Supply and Inflation; Monetary Equation a. What Causes Inflation? Discuss. b. What is the ‘Monetary Equation’. Why is it important to the financial manager? c. What are the implications of this for the ‘foreign exchange market’? Inflation is the rate at which the general level of prices for goods and services is rising. The purchasing power of the monetary unit such as dollar is declines when inflation is present. Causes: Long Term: Inflation occurs when the rate of growth of money supply consistently exceeds the growth rate of output. When the money supply grows too quickly than the output of goods and services inflation is high. When it grows only slightly faster than the output inflation is low and when it consistently decreases in relation to output there is deflation i.e. price level falls. Think how economy responds to increase in money supply. Firms do not immediately increase their prices. Because of this lag, there is increase in the real money supply and this decreases the price of money we call ‘interest rate’. Lower interest rates stimulates borrowing and spending by the firms and consumers, leading to the expansion of the economy. Firms react to booming economy by raising prices until they match the increase in the money supply. This pushes back the real money supply. If money supply increases 10% faster than output every year, prices must rise eventually 10% per year. The gap between the average rate of money growth and average growth rate of output determines the average inflation. In theory difference in the inflation between different countries or time periods could be explained by difference in money growth or output, however in practice the most important factor is money growth. It varies from near zero in some countries to 100% in other countries. Variation in output growth is smaller and thus a secondary factor in explaining difference in gap in money growth and output growth. Why is money growth excessive? The answer depends on the type of the economy. Many countries with high level of government spending are unable to politically match the spending by tax revenue and finance the spending by creating new money. This produces high inflation (e.g. Israel and South American countries in past decade) In USA and many European economies
government spending is financed primarily by borrowing and not by printing money. Federal Reserve contributes less than 1% of total revenue by creating new money. Short Term: Demand shock and Supply shock are major sources of short run changes in inflation. Demand shock is sudden shift in aggregate demand (i.e. desired spending by government, businesses and consumers). As the demand rises the economy expands, firms increase production and unemployment decreases. This leads to higher wages and prices, inflation rises. Fall in aggregate demand causes recession. Supply shock is sharp increase in the price of particular goods or decrease in availability of these goods. Bad weather, OPEC Cartel, War, Terrorist attack are some examples that causes disruption of supply. The inflationary effects of price shocks can be explained by 1) inertia in prices and 2) magnitude of the rise and fall of relative prices. Firms do not instantly adjust the prices to every change. They only change if the desired price change is large enough to justify the cost of adjustment. This implies that large shocks have larger effects on prices and adjust to them quickly while makes smaller shock adjustment slowly.
Theoretical Relationship Number 1 - Money Supply and Inflation(Milton Friedman_ MS=K Yo P o Where: Ms = Money Supply K = [1 / Velocity of Money Supply] Yo = Amount of Goods and Services Produced in the Economy or GNP Po = the respective prices of Goods and Services in the Economy. In the short run, If Money Supply is increased by say 10%, in the RHS equation, K a constant does not change, Yo The GNP of a nation which increases 2% or 3% in a year does not change, hence to balance out Ms increase leads to a 10% increase in Prices or Inflation. If MS increases by 10%, then P increases by 10% If MS decreases by 5% , then P decreases by 5% Why is it important to the financial manager? One of the responsibilities of a finance manager in a corporation can be international trade in the global market. He has to deal with foreign exchange in the import export of products and services. The inflation and currency exchange rate are the most important determinants of a corporation’s relative level of economic health. Inflation is one of the determinants of exchange rate. A higher currency makes a company’s exports more expensive (Japanese pay higher price ¥110 instead of ¥100 for $1 item) and imports cheaper (US pays less for Japanese goods); a lower currency makes a company's exports cheaper and its imports more expensive in foreign markets. The Central Bank controls Money Supply in Four Major Ways: 1. Printing Of Money 2. Open market operations 3. Federal Discount Rate mechanism 4. Setting Bank Reserve Requirements
6.Trade Policy and Offshoring Strategy: a. Why do nations trade with one another? Explain in your own words. (Ricardo’s Comparative advantage Chapter 1 Appendix: Economics and Efficiency) b. What is Dynamic Comparative Advantage? What are the implications of this for the current debate on “Outsourcing” and “Off-shoring?” [Vernon’s Theory] c. What strategies should corporations adopt to minimize the impact of offshoring on its employees? a. Why do nations trade with one another? Explain in your own words. (Ricardo’s Comparative advantage Chapter 1 Appendix: Economics and Efficiency) This theory of comparative advantage, also called comparative cost theory, is regarded as the classical theory of international trade. According to the classical theory of international trade, every country will produce their commodities for the production of which it is most suited in terms of its natural endowments climate quality of soil, means of transport, capital, etc. It will produce these commodities in excess of its own requirement and will exchange the surplus with the imports of goods from other countries for the production of which it is not well suited or which it cannot produce at all. Thus all countries produce and export these commodities in which they have cost advantages and import those commodities in which they have cost disadvantages. Ricardo explained his comparative cost difference theory, by taking an example of England and Portugal as two countries & Wine and Cloth as two commodities. As pointed out in the assumptions, the cost is measured in terms of labour hour. The principle of comparative advantage expressed in labour hours by the following table.
Portugal requires less hours of labour for both wine and cloth. One unit of wine in Portugal is produced with the help of 80 labour hours as above 120 labour hours required in England. In the case of cloth too, Portugal requires less labour hours than England. From this it could be argued that there is no need for trade as Portugal produces both commodities at a lower cost. Ricardo however tried to prove that Portugal stands to gain by specialising in the commodity in which it has a greater comparative advantage. Comparative cost advantage of Portugal can be expressed in terms of cost ratio.
Cost ratios of producing Wine and Cloth ↓
Portugal has advantage of lower cost of production both in wine and cloth. However the difference in cost, that is the comparative advantage is greater in the production of wine (1.5 — 0.66 = 0.84) than in cloth (1.11 — 0.9 = 0.21). Even in the terms of absolute number of days of labour Portugal has a large comparative advantage in wine, that is, 40 labourers less than England as compared to cloth where the difference is only 10, (40 > 10). Accordingly Portugal specialises in the production of wine where its comparative advantage is larger. England specialises in the production of cloth where its comparative disadvantage is lesser than in wine.
Comparative Cost Benefits Both Participants ↓
Let us explain Ricardian contention that comparative cost benefits both the participants, though one of them had clear cost advantage in both commodities. To prove it, let us work out the internal exchange ratio. Let us assume these 2 countries enter into trade at an international exchange rate (Terms of Trade) 1 : 1. At this rate, England specialising in cloth and exporting one unit of cloth gets one unit of wine. At home it is required to give 1.2 units of cloth for one unit of wine. England thus gains 0.2 of cloth i.e. wine is cheaper from Portugal by 0.2 unit of cloth. Similarly Portugal gets one unit of cloth from England for its one unit of wine as against 0.89 of cloth at home thus gaining extra cloth of 0.11. Here both England and Portugal gain from the trade i.e. England gives 0.2 less of cloth to get one unit of wine and Portugal gets 0.11 more of cloth for one unit of wine. In this example, Portugal specialises in wine where it has greater comparative advantage leaving cloth for England in which it has less comparative disadvantage. Thus comparative cost theory states that each country produces & exports those goods in which they enjoy cost advantage & imports those goods suffering cost disadvantage.
b. What is Dynamic Comparative Advantage? What are the implications of this for the current debate on “Outsourcing” and “Off-shoring?” *Vernon’s Theory+ Dynamic comparative advantage refers to shifts in a system's competitiveness that occur over time because of changes in three categories of economic parameters-long-run world prices of tradable outputs and inputs, social opportunity costs of domestic factors of production (labor, capital, and land), and production technologies used in farming or marketing. Together, these three parameters determine social profitability and comparative advantage. In 1966, Vernon described a theory of international competition known as the international product life cycle model (PLC). The PLC proposes that capital intensive and technologically sophisticated innovations are typically developed in the USA for the domestic market, and progress through various stages in which production shifts to other developed countries and
finally to developing countries that become platforms for MNC exports to their home country and other developed markets Vernon (1966) emphasized the importance of local demand conditions as a catalyst for export abroad, and the subsequent commoditization of products as an impetus for FDI. Contrary to this slow, sequential internationalization, the inputs to final production of many services may be ‘de-coupled’ from intermediate inputs early in the internationalization process under offshoring schemes. Hence, the linkages between production location and core knowledge-based activities may be weak. Examples include film production, programming, back office, and call centre functions in audio-visual, software, legal, and accounting services. For production of these services, local demand is less (or un-) important, while specific country factors – land, labour, and infrastructure – are proportionately more important. As the emerging countries improve their education and infrastructure over time, offshoring evolves consequently due to Economic Advantages. First it Attracts it was blue collar jobs; The success leads way to White Collar, higher paying, skilled jobs. Finally to the top of the Value-chain jobs
The product life-cycle theory was developed by Vernon to explain the observed pattern of international trade and dynamic comparative advantage. The theory suggests that early in a product's life-cycle all the parts and labor associated with that product come from the area in which it was invented. After the product becomes adopted and widely used in the world markets, production gradually moves away from the point of origin. In some situations, the product even becomes an item that is imported by its original country of invention. Some historical patterns of this can be observed in the Automobile Industry, The Textile Industry and the Personal Computer Industry in the United States. The model applies to labor-saving and capital-using products. In the new product stage, the product is produced and consumed in the US; no export trade occurs. In the growth stage, mass-production techniques are developed and foreign demand expands; the US now exports the product to other developed countries. In the maturing product stage, production moves to developing countries, this lowers cost of production and which then export the product to developed countries. The model demonstrates dynamic Comparative Advantage. The country that has the comparative advantage in the production of the product changes many times from the innovating (developed) country to the cost-efficient developing countries. Product life-cycle There are four stages in a product's life cycle. Production location depends on the stage of cycle. (An identical case can be observed in Country Entry also for Multi-nationals) Stage 1: Launch New products are introduced to meet National needs, and new products are first exported to similar countries, countries with similar needs, preferences, and incomes. Stage 2: Growth A similar or comparable product is produced and introduced in the foreign country to capture global growth. This moves production to other countries, due to possible cost advantages. Stage 3: Maturity
The industry supply chain develops and optimizes -- the lowest cost producer wins here. Stage 4: Decline Newer product erode market share of product. Less affluent countries constitute the bulk of demand for the product. Therefore, all declining stage products are produced in lower cost developing countries. The surviving firm or industry stays in a market by adapting what they make and sell, i.e., by introducing new products. In a dynamic competitive global economy major portion of the revenues will be from products they did not sell few years ago. [Refer Lecture 3 Module B for more detail] c. What strategies should corporations adopt to minimize the impact of off-shoring on its employees? Potential impacts on the average U.S. standard of living, including average wages and prices Traditional economic theory predicts that offshoring is likely to be beneficial for the average U.S. standard of living Increase in productivity leading to increase in national income Provides consumers with lower prices and access to a broader range of goods and services. In addition U.S. companies will respond to the challenges of international competition by developing new areas of specialization in the global economy. Impact on employment and job displacement No long run effects on the net employment In the short run, workers will lose their jobs when employers relocate production abroad IT better than Manufacturing Offshoring may cause structural changes in the labor market (because increased trade alters the mix of goods and services produced in the U.S). Impact on distribution of income Offshoring could accelerate income inequality in the U.S Disappearance of the middle class? It could do so by lowering the wages of some lower-wage and middle-class jobs, while potentially increasing the wages of smaller numbers of highly compensated positions
Prohibit federal work or federally funded work from being performed in foreign countries Prohibit the federal government from providing assistance to, or doing business with, companies that in the last 5 years offshored jobs Prohibit government contracts from going to countries that have not signed trade agreements with the U.S.
During offshoring, the management of human resources is particularly challenging, both for the organization, which stands to lose experienced staff, and for individual staff members who face unwelcome change and the threat of job loss. Appropriate measures should be taken in an exemplary manner to mitigate the impact of offshoring on the staff. Communicating with the staff from the earliest possible moment is an essential part of managing them transition to offshoring. If staff representatives are not involved in consultations at the initial planning stage, and are only briefed by management after the
offshoring decision had been taken, creates confusion, frustration and negative perceptions among staff. Proper redeployment and voluntary separation package must be planned. Redeployment plans must give priority consideration to local recruitment and current suitable staff for vacant posts at headquarters. Training plans for the suitable staff, full contribution of the organisation in pensions and medical assistance for staff who had a couple of years to retire etc are few more measures.
a) To minimize the impact of offshoring on its employees, corporations should: Ensure proper communication with its employees, explaining the rationale behind offshoring Honesty with the employees is the most important Move the value chain higher for its employees, make employees concentrate more on value adding work Provide trainings to keep the employees updated with latest in all spheres Make sure employees adapt to the current environment, as offshoring is here to stay
7.Theoretical Relationship 2 : Relationship between Inflation and Interest Rates; Domestic Fisher Effect A. What is the ‘Domestic Fisher Effect’? B. What is the relationship between Inflation and interest rates ? C. Why is it important for the Global Financial manager? What is the ‘Domestic Fisher Effect’? In foreign exchange terminology, the Domestic Fisher Effect refers to the hypothetical longterm relationship between a country’s interest rates and its observed inflation rate that was originally developed by Irving Fisher. His hypothesis proposed that the real interest rate is equal to the nominal interest rate minus the rate of inflation Fisher Effect states that a country’s nominal interest rate (i) is the sum of required real rate (r) of interest and the expected rate of inflation (I) over the period for which the funds are to be lent. More formally Fisher’s Effect, i =r+I or more theoretically accurate i = (1+r)(1+I)-1 This theory explains why there are different interest rates among nations. For example, the U.S. and Japan has same real interest rate. rUS = rJapan = 5% But the inflation rates in the two nations are different.
IUS = 2.9% and IJapan = 1.5% ; Inflation differential is 1.4%. iUS = (1+0.05)(1+0.029) – 1 = 0.08045 = 8.04% iJapan = (1+0.05)(1+0.015) – 1 = 0.06575 = 6.58% Interest rate differential is 1.46% (8.04% - 6.58%), which is approximately close to inflation differential. Thus if the expected rate of inflation in the US is greater than that in Japan, US nominal interest rate will be greater than Japan’s nominal interest rate. What is the relationship between Inflation and interest rates ? The Domestic Fisher Effect implies that a given increase in inflation will result in an equal increase in the nominal interest rate, if the real interest rate holds steady. This theoretical relationship has been used to propose that the real interest rate for an economy is independent of monetary measures, which would include a central bank setting the nominal domestic interest rate, since such manipulation will be offset by changes in the rate of inflation. An increase in Inflation rate leads to an increase in the Nominal interest rate and a decrease in the inlfation rate leads to a decrease in the Nominal interest rate. The implications of this for the foreign exchange market are effected through the International Fisher Effect.
Why is it important for the Global Financial manager? The International Fisher Effect (IFE) extends the domestic Fisher effect theory to a global perspective. The IFE states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in the nominal interest rates between two countries. The expected change in the current exchange rate between any two countries is approximately equivalent to the difference between the nominal rates of those two countries in that time. Calculated as: Where: "E" represents the % change in the exchange rate "i1" represents country A's interest rate "i2" represents country B's interest rate The Fisher Effect is based on present and future risk-free nominal interest rates rather than pure inflation, and can be used by financial managers to predict and understand present and future spot currency price movements. Howerver, IFE is not a very good predictor of shortrun changes in spot exchange rates due to differences in borrowing costs or expected returns or when PPP does not hold good.
Implications of IFE: Currency with the lower interest rate expected to appreciate relative to one with a higher rate. Financial market arbitrage: insures interest rate differential is an unbiased predictor of change in future spot rate.
8.Theoretical Relationship # 3: Relationship between Inflation and Exchange Rates; Purchasing Power Parity A. Explain the concept of ‘purchasing power parity’ (PPP) in your own words. B. What are the requisite conditions for PPP to exist? C. What is the relationship between PPP and exchange rates ? Explain the concept of ‘purchasing power parity’ (PPP) in your own words. The PPP theory states that an identical good in two different countries has the same price when expressed in the same currency. In the absence of trade restrictions, the price of real goods should be the same in two countries, and since an exchange rate is merely the price of one currency in terms of another, it should equalize the prices of real goods in the two countries. The PPP theory estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power. The relative version of PPP is calculated as: S = P1/ P2 Where: "S" represents exchange rate of currency 1 to currency 2 "P1" represents the cost of good "x" in currency 1 "P2" represents the cost of good "x" in currency 2 For example, a chocolate bar that sells for C$1.50 in a Canadian city should cost US$1.00 in a U.S. city when the exchange rate between Canada and the U.S. is 1.50 USD/CDN. (Both chocolate bars cost US$1.00.) o o o
Two versions of Purchasing Power Parity (PPP): Absolute Purchasing Power Parity (for individual commodities) Price levels adjusted for exchange rates should be equal between countries One unit of currency has same purchasing power globally Relative Purchasing Power Parity (Commodity basket-many commodities) exchange rate of one currency against another will adjust to reflect changes in the price levels of the two countries The PPP theory leads to conclude that prices of individual commodities (when compared in the same currency) should be the same in two different countries, which also results in the Law of One Price for commodities through trade.
What are the requisite conditions for PPP to exist? Purchasing-power parity theory tells us that price differentials between countries are not sustainable in the long run as market forces will equalize prices to avoid arbitrage between countries and change exchange rates in doing so. 1.
Homogeneous Commodities should exist: [Utopian!]
2. 3. 4. 5.
Non-tradable Commodities (Land, Housing, Services Haircut) Transaction Costs/Restrictions on Trade will lead to differences. Similar Consumption Baskets should exist. Relative Price Changes will further impact equilibrium
Refer Lecture 4 Module A for more detail What is the relationship between PPP and exchange rates ? Exchange Rate Between two countries equals the ratio of the countries Price Levels. PPP says the currency with the higher inflation rate is expected to depreciate relative to the currency with the lower rate of inflation. 9.Theoretical Relationship # 4: Relationship between Interest Rates and Exchange Rates; Interest Rate Parity A. Illustrate the concept of ‘Interst Rate Parity’ and ‘Covered Interest Arbitrage’ with a numerial example. B. What are the implications of this for Foreign Exchange Market.? The Interest Rate differential between two countries, that do not have restrictions on Capital flows, should equal the difference between the Spot and Forward Exchange rates. Example: Consider two countries, Say England and U.S.A. Let the current Exchange rate be: Spot Rate 1 Pound = 1. 5 dollars Let Annual Interest Rate of Risk free security in England be: Let Annual Interest Rate of Risk free security in USA be: 4% What should the three month Forward Exchange Rate be?
8%
As per IRP, the forward exchange Rate should be 1 pound = 1.4853 dollars. Numerical Example: We examine this from the perspective of an Investor in England. Let us assume that one person in England has a 1 million pounds to invest on October 1, 2010. He wants to invest for 3 months till January 1, 2011. He has two options. Option 1: He can invest in England on October 1, 2010 and get a return of 2%. [Annual Return = 8%; Hence, three month Return = 2%] On January 1, 2011 he would have 1.02 million pounds. Option 2: Alternatively, he can convert his money to U.S. dollars on October 1, 2010. Given that the Spot Exchange rate is 1 pound = 1.5 dollars, he would get, 1.5 million dollars. He can then invest it in USA risk free securities for 3 months. He would get a return of 1%. On January 1, 2011 he would have 1.515 million dollars. This amount he can convert it back to British pounds. Since he can lock in the forward exchange rates on October 1, 2010 itself, he can convert it to England at the predetermined,
locked-up exchange rate. The lock in exchange rate hence should be at: 1 pound = 1.4853 dollars; Thus, and hence he will receive, 1.02 million pounds. Spot Rate (dollar for pound) Forward Rate (dollar for pound) Forward Exchange Rate changes by
= = =
1.5 1.4853 2% - 1% = 1%
FIRST VERSION SPOT EXCHANGE RATE 1 Pound = $ 1.5 Domestic Interest Rate = (UK 3 Month Rate) = 2% Foreign Interest Rate = (USA 3 Month Rate) = 1% Interest Rate Differenentials = Domestic Interest Rate – Foreign Interest Rate = [ 2 % - 1 % ] = 1% The New Forward Exchange rate, three months from today should be:
Now,
Spot Exc. Rate x (100 – Change in Interest) = Forward Exchange Rate Forward Exchange Rate = Spot Exc. Rate x (100 – Change in Interest)
PRACTICAL solution in the above problem from perspective of a British Investor = 1.50 x (100% – 1%) = 1.50 x (99%) = 1.50 x (99/100) = 1.485 Covered Interest Arbitrage WHAT HAPPENS WHEN THE FORWARD RATE IS NOT 1.4850? • • Say the three month forward rate is also 1.50 like the spot rate. • Say either you or your friend wants to invest $3,000,000 in T.Bill market. • Instead of investing in USA T. Bill market ($3,000,000) in the USA, you Convert the money to British Pounds, at the spot Exchange rate of 1.50; Get 2,000,000 British pounds, Invest it in UK for three months at the risk free rate at 2%; Get 2,040,000 at the end of three months. At the same time you Lock in the Forward Rate of 1.50 today. At the end of 3 months, you convert your accumulated British Pounds to US Dollars. You will get $3,060,000. • Alternatively, If you had invested at USA T. Bill market you would have gotten only, 1% return and you would have only $3,030,000. • You have made $30,000 extra money.
Covered Interest Arbitrage No Risk Involved; all positions are locked up before entering into transactions. Uncovered Interest Rate Parity: Risk involved; do not lock up the forward exchange rates. Limitations to IRP: 1. 2. 3.
Transactions Costs imposed by Traders Capital Controls imposed by Nations Political risk
4.
Differential tax laws.
A. What are the implications of this for Foreign Exchange Market.? a. It plays an essential role in the foreign exchange market b. The difference between the interest rates in any two countries is the same as the difference between the forward and spot rates of their respective currencies. c. Interest rate parity A currency is worth what it can earn d. The return on a currency is the interest rate for that currency plus the expected rate of appreciation over a given time period e. When the interest rate of two countries are equal, IRP prevails As per the above numerical example, the following series of events will occur and impact the foreign exchange market • The dollar interest rate will rise • The pound interest rate will fall • The spot exchange rate will rise • The forward exchange rate will fall • These adjustments will continue till IRP holds and prevails 10. Auctions Market Strategy: A. Are auctions the optimal method to sell a security or service? B. Explain the advantages, and disadvantages of the Auction method of Selling for the buyer and seller, using a specific example..
C. Explain why corporations do not sell “all” their products by auctions? D. What are the reasons for the success of Internet auction companies such as e-bay and Priceline?. Are auctions the optimal method to sell a security or service? Yes, auctions are becoming an optimal method for selling securities and services. Unlike physical assets from which you can derive satisfaction from the purchase experience (by feeling, touching, trying before purchase), you can derive little satisfaction from the purchase of intangible assets like securities through retail channels. With fixed price mechanisms you may not realize the full potential of your product. Auctions offer an alternative to enable prices to float and realize higher potential. Explain the advantages, and disadvantages of the Auction method of Selling for the buyer and seller, using a specific example.. Advantages for buyers 1. Ability to offer what one’s willing to pay, If best bid, can win item. 2. Access to large selection of products, usually available at below retail prices 3. Access to large number of sellers. 4. Anonymity; Enhanced purchase experience. The convenience to ship, any time of day, from any place; Lots of information available at fingertips; Convenient payment methods Advantages for sellers 1. Reduced cost of marketing product 2. Reduced setup costs. No need to have own facility to sell products
3. Faster mechanism to sell/dispose of items 4. A better chance of realizing full price potential on items 5. Access to a large number of buyers Disadvantages for buyers 1. Can be slow. Must wait for the auction to close. 2. No guarantee that will be able to purchase a particular item 3. Inability to select a vendor or establish relationships with specific product vendors. 4. Inability to examine products before purchase; No returns allowed; No item warrantees 5. Some buyers will end up paying more for the same items (winners remorse) Disadvantages for sellers 1. Final item price at mercy of buyers. 2. Availability of similar products at auction site makes it hard to get a higher price. 3. Once item entered into auction, seller must sell item even if price below expectations. Can minimize risk by setting a higher starting bid. 4. Some discouraged by complexity of process. But online options, has simplified process.
Explain why corporations do not sell “all” their products by auctions? 1. 2. 3. 4. 5.
They want to control the prices They want to avoid speculative-type trading They want to provide customers in-store experience associated with the product They have a niche segment for their product; odd lots; specialty products; They do not sell products directly to end customers but through dealers and distributors 6. Ability to charge higher prices at Stores than on the Internet. What are the reasons for the success of Internet auction companies such as e-bay and Priceline?. 1. Internet auction marketplaces e-bay/ Priceline provide the huge community of buyers & sellers. 2. Provides better customer experience, as buyers do not have to leave their home to buy. 3. No start-up cost involved for sellers as e-bay provide medium to buy and sell products. 4. You really don't have to set up a website to start selling. No extra overhead; Easy to learn 5. Internet auction companies such as eBay provides a marketplace for virtually all the products from automobiles to accessories and real estates to electronics 11.
Global Financial Crisis:
Briefly Explain these crisis in your own words, what these are about, what caused it, how it was resolved and what are the lessons learnt from it. A. Debt Crisis: 1. 2. 3.
Russia - 1997 Iceland - 2008 Greece -2012
B. Foreign Exchange Crisis: 1. 2. C.
Mexico Asian Crisis
Banking Crisis: 1. 2. 3.
Japan – 1990s USA Subprime -2008 Spain - 2012
12. Risk Management and Hedging Strategy Using Forwards You have been hired by Amerikan Airlines. Your primary task is to keep the Airline in Business and to ensure that you have to accomplish these two goals.
Keep airfares low and at a comparable steady price throughout the year
Protect the airline from fluctuating fuel costs
With these objectives you need to develop Hedging strategies in the Forward Market. An historical Review reveals that the Airline consumes 1 million barrels of fuel during the planned horizon and the price of fuel has fluctuated in the previous 5 years from $30.00 to $145.00. Fuel cost represents about 35% of the cost of operation and is next in importance to salaries and wages. Identify the steps you would initiate to protect the company from fluctuating fuel costs and achieve your above two objectives.
STEPS IN HEDGING Forward contracts provide an Hedge for an exposure at one particular time. With forward contracts you lock the price at which the asset will be bought or sold at a certain future time. 1. Forecast Your Demand; Forecast your future flights say for one year on a month by month basis; How much fuel is already available due to prior purchases or prior hedges; and How much more fuel would you need? What are the Normal, Optimistic and Pessimistic scenarios of future business and flights and fuel needs. 2. Identify Hedging Alternatives: Can you buy Spot Oil / commodity and hold? Or get Forward at different dates? or Option Contracts? What are the choices? What is your hedging horizon? One year or Two years? Should you institute a monty-by-month hedging? Cross- Hedging; Jets need Jet Fuel, No Jet Fuel Forwards exist; So use Oil, Which has a high correlation with Jet Fuel prices. 100% Hedge? Partial Hedge? Hedge Ratios? 3. Hedging and Competition: Identify What the Competition is doing? Match Competition Hedging may not always be the optimal strategy for a company. If Hedging is not the norm in your industry it can be dangerous for only your company to be hedging.
Competitive pricing with in the industry may lead to selling prices which fluctuate due to changes in raw materials prices. If NONE of your competitors or bench-marked institutions are hedging, you follow that pattern. Do NOT Hedge. If prices of raw materials increase, like competitors you pass it on to the consumers. If they hedge partially/ totally, you develop a hedging program. Practical Example Southwest Airlines hedged their fuel needs 100% at about $20 a barrel in 2002 [while United Airlines because of Bankruptcy could not buy forwards and hedge]. It turned out to be good for Southwest, because subsequently the prices rose to $80. However, the reverse could have happened. You hedge the fuel needs at $80 a barrel, then if future prices become $20, then you would have been locked in and lost a large amound of money. [See attached reading Airlines hedging]. If competitors like American Airlines, Delta etc. are Hedging partially, then you could follow suit. The diagram below shows you risk reward structure of Partial Hedging.
OPTIMAL HEDGING STRATEGY: The Effects of Hedging on Risk and Expected Return Expected return
Unhedged Selectively hedged
Fully hedged
Overhedged
0
Minimum
Risk
Risk Portfolio
4.
Obtain Approval from Management.
Hedging can result in increase or a decrease in Airlines’s profits relative to the position it would be in with No Hedging. Using derivatives, you have two costs. One is the Opportunity Cost and the second is the Out-of-pocket costs. Opportunity Costs 1. 2.
Say, To-days’ Spot price of Oil is $77 a barrel *November 1, 2010]; The Forward price of Oil one year from today is say $80 a barrel [November 1, 2011].
3. You institute a plan to buy the 12 million barrels of Oil at a forward price of $80 and sign a Forward Contract. If by November 1, 2011 the price of Oil goes down to $60 per barrel , the Airlines loses money due to hedging. If it had not locked in a forward price of $80, it could have bought the Oil at $60. For 12 million barrels, it would be a loss of $240 millions. You would have been better of by not Hedging. Alternatively, If by November 1, 2011 the price of Oil goes up to $110 per barrel, the Airlines gains money due to Hedging. It can buy the Oil at $80, while every one else will be paying $100 per barrel. For the 12 million barrels, it would be a gain of $360 millions. Out-of-pocket costs: Some times, like in the case of Options, Hedging results in out-of-pocket costs such as premium or marking-to market payouts, commissions and transactions cost in the case of futures. Sacrificial goat? While Hedging is primarily done to reduce risk, it could cost real money, due to market uncertainty. Hence, do not enter into a strategy alone as CFO. Have the top management understand, agree and approve the Hedging program. A often cited case in practice is the CEO of Lufthansa Airlines, who purchased two planes from Boeing. He hedged Lufthansa’s Foreign currency exposure and he was fired by the Board of Directors because the Hedges, [which lowered the Risk] but caused the Airlines to lose money. Do not become a sacrificial goat and get thrown under the bus when instituting a Hedging program! 13. Risk Management and Hedging Strategy Using Futures
You have been hired as a Financial Analyst at “Burger Donalds” and scheduled to begin on September 1, 2012. Your first Assignment involves the Futures Markets. The Burger Production Manager informs that he wants 5 million bushels of wheat on December 31, 2012 of the year to ensure continued and uninterrupted production of Super Burgers. You glance through the Wall Street Journal on September 1 and observe these prices. [Think Cost of Carry Models] Spot Price of Wheat on Sept 1 (Per Bushel)
$7.52
October Wheat futures price (Delivery on Oct 31)
$7.56
November Wheat futures price (Delivery on Nov 30)
$7.58
December Wheat futures price (Delivery on December 31)
$7.60
From Historical company records you know that if you buy the wheat ahead of the required time you can store it at a cost of 2 cents per bushel per month. Outline all your strategies (at least five!) and their implications.
WSJ - Future Market DO NOTHING Buy Wheat @Spot on Dec 31 Spot Price of Wheat on Sept 1 (Per Bushel) Oct Wheat futures price (Delivery on Oct 31) Nov Wheat futures price (Delivery on Nov 31) Dec Wheat futures price (Delivery on Dec 31)
Cost
BurgerDolands Carrying Cost
$7.52 $7.56 $7.58 $7.60
Total Cost
$0.08 $0.04 $0.02 $0.00
$7.60 $7.60 $7.60 $7.60
14. Global Bond Market Indexation Strategy Illustrate the need for, motivation, and concept of Indexation with an example to protect against Inflation in the Global Debt Markets. L 8 Module B 16. Foreign Exchange Hedging using Foreign Currency Derivatives: Problem Scout Finch is the Chief Financial Officer [CFO] of Dayton Manufacturing, a U.S. based manufacturer of gas turbine equipment. She has just concluded negotiations for the sale of a turbine generator to Crown, a British firm for One million pounds. This single sale is quite large in relation to Dayton’s present business. Dayton has no other current foreign customers, so the currency risk of this sale is of particular concern. The sale is made in March with payment due three months later in June. Scout Finch has collected the following financial market information for the analysis of her currency exposure problem:
Spot Exchange rate: $1.7640 per British pound.
Three month forward rate: $1.7549 per pound (a 2.2676% p. a. discount on the pound)
Dayton’s cost of capital: 12%
U.K. three month borrowing interest rate: 10.0% (or 2.5% per quarter)
U.K. three month investment interest rate: 8.0% (or 2% per quarter)
U.S. three month borrowing interest rate: 8.0% ( or 2.0% per quarter)
U.S. three month investment interest rate: 6.0% (or 1.5% per quarter)
June put option in the over-the-counter (bank) market for 1,000,000 British pounds; Strike price $1.75 (nearly at-the money) 1.5% premium
June put option in the over-the counter (bank) market for 1,000,000 British pounds: Strike price $1.71 (out-of-the money) 1.0% premium
Dayton’s foreign exchange advisory service forecasts that the spot rate in there months will be $1.76 per British pound.
Like many manufacturing firms, Dayton operates on relatively narrow margins. Although Ms. Finch and Dayton would be very happy if the pound appreciated versus the dollars, concerns center on the possibility that the pound will fall. When Ms. Finch budgeted this specific contract, she determined that the minimum acceptable margin was at a sale price of $1,700,000. The budget rate, the lowest
acceptable dollar per pound exchange rate, was therefore established at $1.70 per British pound. Any exchange rate below would result in Dayton actually losing money on the transaction. Four alternatives are available to Dayton to manage the exposure: A. Remain un-hedged. B. Hedge in the forward market. C. Hedge in the money market. D. Hedge in the options market. What should Dayton do? Answer: Hedging Schedule and Sequence
Possible Answers: OBJECTIVE of Hedging: Receive Maximum from Sales while minimizing downside risk. 1.
Do Not Hedge: Do Nothing Possible Consequences
Excellent Profits or Firm Bankrupt ?
2. Forward Market Hedge: 1,000,000 x 1.7549 = $ 1,754,900
3. Money Market Hedge: Discount Future Payment in Money Markets in England. Get Brit. Pound 975,609.76 [1,000,000 / 1.025] British Pounds 1,000,000 Convert this to U. S. Dollars today. X 1.7640 = Get $1,720,975.61; what does the Firm do with this money? Choice One:
$1,720,975.61 [1,720,975.61 x 1.015] 1,746,790.24
Choice Two:
$1,720,975.61 [1,720,975.61 x 1.02] 1,755,395.12
Choice Three:
4.
$1,720,975.61 [1,720,975.61 x 1.03] 1,772,604.87
Use Options: At-the-Money-option
Option Premium = [Amount of Protection] x [Premium Cost] = [Size of Option x Spot Exchange Rate] x [Premium Cost] = [British Pound 1,000,000 x 1.764] x 0.015 = $26, 460 Incorporating time value of money for 3 months at cost of capital = $26,460 x 1.03 = $27,254 [Assumed that Option premium cost borrowed at cost of capital] Net Proceeds: 1,750,000 - 27,254 = $1,722,746 Out-of-the-money option: Option Premium = [Amount of Protection] x [Premium Cost] = [Size of Option x Spot Exchange Rate] x [Premium Cost]
= [British Pound1,000,000 x 1.764] x 0.01 = 17,640 Incorporate Time value of money for 3 months at Cost of Capital = $17640 x 1.03 = $18,169.20 [Assumed that Option premium cost borrowed at cost of capital] Net Proceeds: 1,710,000 – 18169.20 = $1,691,830.80
Exhibit 8.3 The Life Span of a Transaction Exposure Time and Events
t1
t2
t3
t4
Seller quotes a price to buyer (in verbal or written form)
Buyer places firm order with seller at price offered at time t1
Seller ships product and bills buyer (becomes A/R)
Buyer settles A/R with cash in amount of currency quoted at time t1
Quotation Exposure
Backlog Exposure
Billing Exposure
Time between quoting a price and reaching a contractual sale
Time it takes to fill the order after contract is signed
Time it takes to get paid in cash after A/R is issued
Copyright © 2004 Pearson Addison-Wesley. All rights reserved.
8-16
17. Country Risk and Global Capital Budegeting Strategy:
Your corporation has an opportunity to make a major investment in China of $100 million to develop an offshore manufacturing facility. When this plant is fully developed and becomes operational in two years the corporation can close down its current manufacturing facility in the United States and shift operations to China. At present, the expected annual savings in labor and benefit cost is expected to be $20 million. You are asked to develop a proposal to identify the potential risk of this proposal and ‘advantages’ and ‘problems’ of this opportunity. Explain how you would proceed. A. What are the inherent risks in this opportunity? B. What economic data would you need for your analysis? Why (How would you use them)? C. What potential factors that affect exchange rates between China and US ? How would you protect against that risk? What other strategies do you recommend before your corporation implements this proposal?
a) What are the inherent risks in this opportunity?
It comprises of a wide range of risks, associated with lending or depositing funds, or doing other financial transaction in a particular country. It includes economic risk, political risk, currency blockage, financial uncertainties, expropriation, and inadequate access to hard currencies.
b) What economic data would you need for your analysis? Why (How would you use them)?
Use ratings to evaluate country-risk (Foreign exchange controls, FDI barriers, Inflation, etc); industry specific challenges (Industry Regulations, Special taxes, Import restrictions on raw materials, etc.) and project specific problems (Marketing / advertising regulations). Ratings also take into account political risk, the country’s external (foreign trade, political ties, economic) and internal (govt stability, society, legal system etc) relationships. Micro Methods of Forecasting RiskGrand Tours – Executives visit potential host countries Old Hands – Advice is received from expert consultants Delphi-techniques – Risk factors are ranked and indices are produced, also using outside experts Quantitative analysis – Uses statistical techniques and estimates national frustration Both quantitative (Sensitivity analysis Monte Carlo Simulations Scenario Analysis) and subjective data (Questionnaire Behavioral /Subjective Assessments) used.
c) What potential factors that affect exchange rates between China and US? How would you protect against that risk?
18. Global Growth and Global Economy Development Strategey The BRIC countries, as per Goldman Sachs study, are expected to be dominant economies in the world in the next 25 years and are projected to challenge the existing world economic order. What are the economicl and financial implications of this for U.S. financial managers with respect to the following: A. International Trade Transactions B. International Securities Transactions C. Central Bank Reserves
What exciting opportunities and critical challenges such a development pose for multinational corporations and U.S. citizens? How do we benefit from it? BRICs Growth Trade Implications GLOBAL TRADE: The BRIC countries are likely to become dominant players in the global economy over the next 25 years. In 2005, BRICs contributed 28% of global economic growth. In addition, in 2005 four BRIC countries had 15% share of global trade, held 30% of global reserves of gold and foreign currency, and got 15% of global foreign direct investment and took in 3% of FDI outflows. Therefore, U.S. financial managers must take into account the impact of BRICs in Global Trade. Intra-Trade: There are several economic reasons for these countries to engage in intratrading. The BRICs have the potential to form a powerful economic and trading bloc to the exclusion of the modern-day trading blocs [such as G7]. This would not be in the interest of the U.S. as it would probably have to pay more to receive these goods and in turn makes higher costs. World trade markets will also be greatly affected by dominance of BRICs as multinational corporations attempt to take advantage of the enormous potential offered by BRICs. Terms-of-Trade: [Higher or Lower prices?] Due to specialization, Brazil and Russia will become the dominant suppliers of raw materials and China and India are likely to become the dominant global suppliers of manufactured goods and services [like OPEC]. For example, far cheaper automobiles affordable to the consumers within the BRICs may be produced in lieu of the luxury models that U.S. automobile manufacturers sell. If this happens, the enhanced competition would imply a better price for the global consumers but lead to a decline in U.S. manufacturing. But, as BRIC continues to grow increasing demand for resources, will increase prices upward. For the U.S. , this means higher prices all around as well as more competition for U.S. products both internationally and domestically. Financial Centers and Markets: Historically, New York and London have maintained the pivotal leadership in capital markets, with their tradition of stability and financial innovations. In 1990s, Tokyo, Hong Kong and Singapore financial markets have gained ground as financial centers to the global economy, attracting great amounts of investors and money. As BRICs countries gain more global clout, new financial centers of power and influence will reshape the landscape. However, New York and London will remain the global players in this field with diminished importance. Central Bank Reserves and Global Currency: Since world war II, the U.S. dollar has been the dominant global reserve currency. But after the 2009 global financial crisis, ideas of creation of a new supranational currency to handle mutual and regional transactions are increasing. The move calls into question the role of dollar as the world’s top reserve currency. The BRIC nations and China have been promoting the need for a new global reserve currency that is 'diversified, stable and predictable' as they push for a bigger role in world affairs. This is a direct attack on the perceived 'dominance' of the US Dollar. In earlier years, Russia, Europe and Japan have raised this issue. Dollar has a dual role. The Central Bank Reserves of most nations are backed with U.S. dollars or gold. U.S. is the preferred investment destination for Central Banks of the world, and investors. An alternative, such as EURO, SDR, Gold or Basket of currencies would not be in the long term interest of the United States and lead to a diminished role of the U.S. dollar in world affairs. Creation of a new reserve currency and substitution of the dollar would lead to a fall in the value of the dollar against major currencies. A strong BRIC could minimize the importance of the US dollar globally. Products: Gains of Trade: Economics & Efficiency Cheaper Prices Better Products Higher standard of Life.
Investment opportunities: The rising status of BRICs as economic powers poses a great deal of opportunities for multinational corporations to grow profit, grow and consolidate in global market share. These companies must learn to penetrate these diverse markets and understand their consumers. In Brazil, US corporations have performed joint ventures in the import export business due to its vast natural resources. In India, many US corporations have outsourced and off-shored customer service departments and the business continue growing. In China, where labor costs are one of the lowest in the world, US corporations have built factories that produce goods that are imported from China. However, US financial managers must address the challenges this global trade represents. In Brazil and Russia, for example, corruption; In Russia, corporate governance and employment stability; In India, multinational corporations still have to cope with a very heavy bureaucracy, and in China, there is a intense business competition with Chinese national companies and foreign companies. On the other hand, United States citizens and residents as consumers can benefit from this phenomenon by getting much cheaper products and services with a great deal of variety. However, by off-shoring and outsourcing of many jobs in the current decade, U.S. manufacturing and employment has been impacted. U.S. corporations need dynamic strategies at the work place to train employees in other industries and professions.
19. Theoretical Relationship 6: Relationship between Spot and Forward Prices A. Illustrate the concept of “Spot-Forward pricing parity” relationship with a numerical example. B. What are the implications of this for Foreign Exchange Market?
Theoretical Relationship: Number 6. “Spot-Forward pricing parity” In Foreign Exchange Market First, let us explore what is the relationship between Spot and Forward prices of Commodities? Rational Expectations theory argues Spot and Forward prices should be equal. If carrying cost exists, the forward price can not be greater than Spot price and Carrying cost. Carrying cost could be positive or negative!!! THEORY Spot-forward parity is a condition that should theoretically hold, or arbitrage opportunities would exist. Spot-forward parity is an application of the Law of One Price. If one can purchase a commodity today for price S [Spot] and conclude a contract to sell it three month from today for price F [Forward], the difference in price should be no greater than the cost of using money minus any expenses (or earnings) from holding the asset; if the difference is greater, one would have an opportunity to buy the “spot’ commodity and sell the “forward" for a risk-free profit. If the difference is less, one can sell the “spot commodity” (by borrowing it) buy the forward and lock in a profit.
Example: What should be the Spot Price of barrel of Oil today and a year from now? Let us say, today Spot price is $80. Should we expect Forward price to be $120 a year from now, or $40 a year from now?
Answer: If cost of Oil is $80 a barrel today, and the Carrying cost is $1 per barrel per month, then the price of Oil cannot be more than $83 three months from now. If it is say $85, then someone can buy the Oil today at $80, carry it for three months, and sell forward today and profit $2 per barrel. The parity condition is the price of the Forward should equal the current Spot price adjusted for the cost of money, dividends, "convenience yield” " and any carrying cost including storage and financing costs. Limitations for Spot-Forward Parity:
Need Highly Liquid Markets High Transaction Costs National Regulations and Legal Restrictions Non-enforceable legal systems.
Spot-forward parity can be used for virtually any asset where a future may be purchased, but is particularly common in commodities, currencies and financial contracts. In Simplified mathematical form: F = S e r T , where F, S represents the cost of the good on the forward market and the spot market. e is the mathematical constant. r is the applicable interest rate (for arbitrage, the cost of borrowing; carrying cost). T is the time period applicable (fraction of a year) to delivery. This formulation assumes that transaction costs are insignificant. Financial Contracts If the carrying costs are negligible, or non-existent as in the case of financial contracts, then under the risk neutrality assumption: F = S. Example: Price of Stock Index today and a year from now. Price of Inflation Index today and 3 months from now. One of the major assumptions is that Risk Neutrality Assumptions exist. Opponents argue there is no risk neutrality and Speculators need to be rewarded. How are speculators rewarded? Reward for Speculators: If, Speculators are “Short” in forward contracts, then at present FS Forward prices at time of delivery would decrease and be the reward for speculators.
General Conclusion: Theoretically: Rational Expectations theory holds true. Spot Price Good representation of Forward price. Forward prices are the best estimates of Future prices based on all available information and, in the absence of substantial carrying costs Spot Prices = Forward Prices. Empirical Results are mixed. Hence, for practical purposes we assume that, Forward Prices = Unbiased predictor of future spot prices. If price of Oil is $80 today, we assume that the same will exist a year from now. In the absence of data or markets, assume in your calculations Spot Foreign Exchange Rate is a good predictor of Forward Exchange Rate.
20. Global Markets Investment Strategy: a. Why should investors consider investing overseas? b. What are the potential advantages, and perils? c. What is Market Efficiency? What are the implications of Market Efficiency, for the pricing of securities and investing corporations’ money? d. Why is psychology important in global setting?
a) Why should investors consider investing overseas? Foreign companies offer some of the best opportunities for growth. Diversifying with foreign companies may actually improve returns while also reducing overall portfolio volatility. ICAPM b) What are the potential advantages, and perils? c) What is Market Efficiency? What are the implications of Market Efficiency, for the pricing of securities and investing corporations’ money? Efficient Market Hypothesis- Concerned with the behavior of prices in asset market, Initially applied to the stock market; soon generalized to other asset markets. Implications- Implies that the market processes information rationally • Relevant information is not ignored • Systematic errors are not made • Prices always at level consistent with fundamentals However, implications of technical analysis for ECM Hypothesis are - Available evidence implies that financial market returns are partly predictable in ways that conflict with the EMH, suggesting the markets may not be efficient.
d) Why is psychology important in global setting?
Behavioral finance studies how psychology affects investor decisions and the implications for portfolio theory and valuation concern. Behavioral finance states that investor behavior is far different from that postulated in the standard finance theory. •
I
Investors do err in making investment decisions because they use rules of thumb. Heuristics or cognitive bias is a rule of thumb strategy that shortens decision time but can lead to systemic decision making biases
•
II
Investors are influenced by form and substance in making investment decisions. Framing is the way in which a situation or choice is presented to an investor and can lead to large differences in assessment of risk and return
MENTAL ACCOUNTING •
III
Prices in the financial market are affected by errors and decision frames. Involves how errors caused by heuristics and framing dependence affect the pricing of assets.
The theory suggests that asset prices will not reflect their fundamental value because of the way investors make decisions inconsistent with the normative theory, e.g. the inefficient market
PSYCHOLOGICAL BIASES IN INVESTING
Overconfidence
Driving Performance Survey
Physical Beauty Survey
People tend to overstate their knowledge, understate risks and exaggerate ability to control events. Evaluations of self based on what are best possible performance / potential; Evaluation of others based on prior historical averages/ past performance.
Overconfidence causes investors to misrepresent the accuracy of information Overestimate their skills in analyzing them. This leads to poor investment decisions, excessive trading, risk taking and Ultimately trading losses.
Endowment Effect: Demand more to sell an object than they would be willing to pay for it. Fear of Regret and Seeking Pride (Disposition Effect)
Investors avoid actions that create regret, documents our mistakes, acknowledge our errors and seek actions that cause pride, presents us in a glorious light. Sell winners too early Hold losers too long.
Past History: Irrational Actions due to Personal Bias Irrationality Investors use their own past experience in evaluating the current decision. They are willing to take more risks after gains [House Money Effect] and Take less risk after losses [Snake Bite Effect or Risk Aversion]. However, Losers don’t always avoid risk; they work to make up their losses (to breakeven). Since not made peace with their losses, willing to accept gambles that would be unacceptable to them otherwise.
Barings Bank collapse of 1995.
The Barings Bank employee Nick Lesson, lost $1.4 billion dollars primarily on futures contract speculation, and through manipulating the records, hid his actions. When the losses were revealed, Barings Bank, one of the oldest and most prestigious in the world, becme bankrupt. Because of the absence of oversight, Leeson was able to make seemingly small gambles in the futures arbitrage market at Barings Futures Singapore (BFS) and cover for his shortfalls by reporting losses as gains to Barings in London. By December 1994 Leeson had cost Barings $340 million. He reported to a $175 million profit. If the company had uncovered his true financial dealings then, collapse might have been avoided as Barings had capital of $600 million. To compensate for the losses using the hidden "five-eights account," Leeson began to aggressively trade in futures and options. His decisions routinely lost substantial sums, but he falsified trading records in the bank's computer systems, and used money intended for margin payments on other trading. However, his luck ran out when the Kobe earthquake sent the Asian financial markets into a tailspin. Leeson bet on a rapid recovery by the Japanese Nikkei Stock Averages which did not to materialize and he could not meet the margin calls.
Cognitive Dissonance: Investors view themselves as smart and nice; to avoid damage to self image, they tend to ignore or minimize or filter away decisions that conflict with that image.
Mental Accounting Drive towards Simplicity Tendency of the brain to create short cuts with how it perceives information and ending with outcomes that are difficult to view any other way.
Forming portfolios. For CAPM, expected return, risk, correlation analysis is needed. However mental accounting these analyses is ignored and intuition used in forming portfolio. Representative and familiarity: Brain uses shortcuts to reduce complexity and generate an estimate of an answer before digesting all available information. Confusing a good company with a good investment Overreaction and Familiarity
Market Mania: Herd Behavior 2000 Internet Stock bubbles. 2005 Real Estate Crash A)
21
European Sovereign Debt Crisis
Currently many European Nations, especially the PIIGS [Portuagal, Ireland, Italy, Greece and Spain] countries have a Soveriegn Debt problem. A. What are the ultimate causes for the current crisis? B. What are the potential implications of this problem for Euro-Currency and European Monetary Integration. C. What are the Implications of this problem for India? WHAT IS THE EUROPEAN DEBT CRISIS? In its most basic form, it's just this: Some countries in Europe have way too much debt, and now they risk not being able to pay it all back. Simple! There's more to it than that, of course, but when people talk about the "crisis," what they're worried about is that a big, scary, flashpoint event will happen -- like one or more of the eurozone countries defaulting on its debts -- causing investors to panic and triggering a massive banking shock. The possibility also looms that one or more countries will pull out of the eurozone -- the 17nation bloc that use the euro currency, which has been around since 1999. Should any of the eurozone nations drop out of this group, it could lead to a rash of bank failures in Europe, and possibly in the United States as well. Under these circumstances, people and businesses who need money might not be able to get any. We'd be looking at depression for Europe and recession for the rest of the world. Some people argue that an orderly, controlled eurozone break-up would be a good thing for certain struggling debtor nations. Still, even this relatively benign scenario carries economic fallout for Europe and maybe beyond. HOW DID THIS HAPPEN? The reason everyone is freaking out now is that while some eurozone countries are relatively sound from an economic standpoint, other countries are way over-leveraged, meaning they have too much debt relative to the size of their economies. And the troubles of a few countries could end up affecting everyone, yoked together under one currency for the last decade -- even though their economies functioned according to different habits and enjoyed very different degrees of financial health. Portugal, Ireland, Italy, Greece and Spain -- gathered under the unfortunate acronym PIIGS -are some of the most highly leveraged eurozone countries, and most people think that if a disaster happens, it will start with one of them. Italy's debt is 121 percent the size of its economy. For Ireland, that figure is 109 percent. In Greece, it's 165 percent. The PIIGS took different paths to this scenario. Ireland, for example, underwent a massive real estate bubble, and its banks sustained giant losses. The Irish government wound up rescuing its banks, and now the country is burdened under a huge debt load. Spain, which now has a 22 percent unemployment rate, also experienced a huge housing bubble. The country didn't indulge in excessive borrowing -- rather, it ended up with high deficits because it couldn't collect enough tax revenue to cover its expenses. Greece, on the other hand, not only borrowed beyond its means, but exacerbated the problem with lots of overspending, little economic production to make up the difference, and some creative bookkeeping to prevent eurozone authorities from realizing the true extent of the situation. The deficits weren't piling up everywhere. Countries with strong economies like Germany and France were keeping their output high and their debt at a manageable level. But when 17 nations use the same currency, trouble spreads quickly. Now that the size of the PIIGS' debt has become clear, investors are getting more and more reluctant to buy bonds from European countries, since many of those countries are heavily in debt -- and the ones that aren't in debt look like they might have to assume responsibility
for the ones that are. Investors don't want to put their money into bonds if they think they might not eventually get that money back. And governments in Europe have a lot of debt and not much money -- and it's not clear how they're going to correct this. WHOSE FAULT IS IT? Blame often gets cast on the "irresponsible" countries who borrowed too much, taking advantage of the low interest rates available to all euro member nations. However, many argue that it's not right in all cases to blame indebted governments for their own situation, since not every country with high deficits actually engaged in reckless borrowing. Others say the euro currency itself is to blame -- arguing that the idea that a single currency could meet the needs of 17 different economies was inherently flawed. Typically, a country's central bank can adjust a nation's money supply to encourage or inhibit growth as a way of dealing with economic turmoil. However, the nations yoked together under the euro frequently haven't had that option. If Spain and Germany hadn't both spent the last several years on the euro, for example, then they wouldn't have been able to borrow at the same low interest rates -- an interest rate set by the European Central Bank, and one that made more sense for Berlin than for Madrid. Greece might still be shouldering huge debts if not for the euro, but maybe it wouldn't be in a position to take down the rest of Europe with it. And if the PIIGS all still had their own individual currencies, they might be able to export their way out of the mess they're in -selling goods on the international market until their respective situations were a little less dire. But as it is, they can't. Alternatively, if you like, you could say the interconnectedness of the modern financial industry is to blame. That's certainly a reason default by Italy or a departure of the eurozone by a fed-up Germany -- to name two examples -- could reverberate around the world. FROM THE OLD WORLD TO THE NEW The crisis in Europe could end up affecting the U.S. in some very direct ways. American banks have billions of dollars at risk in European banks. And while that's actually a relatively small fraction of U.S. banks' holdings, the indirect damage could be greater: U.S. business owners could be facing a credit crunch if overseas banks topple. Further, the U.S. stands to suffer huge trade losses if Europe slips into a recession. Fourteen percent of all U.S. exports go to the eurozone, so weak consumption in Europe spells trouble in the States. At the moment, a downturn in Europe is the last thing the U.S. needs. Growth is slow in America, and millions of people aren't working who'd like to be. The U.S. needs to be producing and exporting more, not less, and it's already hard enough for small businesses in the States to get credit from banks. The Great Recession technically ended in 2009, but for a lot of people -- people in poverty, people who can't afford food, people working long hours for low wages -- it feels like things are as bad as ever. A financial emergency in Europe, triggered by some event that sends investors running for cover, could take all of America's problems and make them bigger. WHAT HAPPENS NEXT? This is a fast-moving story, and by the time you read this, circumstances may have already changed. As of this writing, though, all of Europe is basically trying to do damage control. European Union authorities have put together a funding package of 150 billion euro for the International Monetary Fund to disperse to debt-stricken eurozone nations, and many countries are using inventive asset-juggling tricks to get capital into their banks without officially bailing anyone out. Earlier this month, eurozone authorities drew up a tentative proposal to enforce stricter consequences on countries that borrow beyond an agreed-upon limit. The deal would also require eurozone nations to balance their budgets, and aims to bring members of the currency bloc into greater sync from a fiscal standpoint.
EU leaders will meet again on January 30 to further discuss this deal. In the meantime, European governments are doing all they can to soothe investors -- a task made harder by ominous rumblings from credit rating agencies like Moody's, Fitch and Standard & Poor's, which have all downgraded or threatened to downgrade numerous countries and financial institutions in the eurozone and elsewhere. (You may remember Standard & Poor's from the fun downgrade debacle of this past summer, when that agency lowered the United States' sovereign credit rating one notch and caused markets to spaz out.) At the moment, it's not clear whether any of the curative measures in the works will allow Europe to avoid a major financial downturn. Some onlookers are skeptical that the eurozone nations can reach a workable deal, since the countries have a poor track record of working together on financial matters. And things are likely to remain on a hair trigger even if a deal progresses, since bank-to-bank relationships rely on trust and credibility, and even the perception of a crisis could quickly become self-fulfilling. Meanwhile, as all this is going on, troubled eurozone countries are pledging to cut back government spending to show they can be trusted -- even though this results in financial misery for the people in those countries, and will in all likelihood make it harder for Europe's economy to gain any momentum in the months to come. Is there anything you can do about the situation in Europe? Not really -- except keep an eye on it. Disaster isn't a foregone conclusion at this point, but if things do go south on the Continent, the business climate in America will likely get worse before it gets better. You'll want to be able to see that coming if it does. Below are graphics featuring a country-by-country break down of some of the most important indicators of the crisis : Debt As A Percentage Of GDP The Unemployment Rate Projected Gross Domestic Product
Impact of Euro Debt Crisis on India (From Business line http://www.thehindubusinessline.com/features/investment-world/article2288107.ece There is little evidence to suggest any major economic slowdown in India, driven by trade or investment flows. As I sit here in leafy Surrey, just outside London, gazing over my garden pond to the fields beyond, it would be easy to imagine that this rural milieu is a reflection of the universe at large. Alas, of course, this is not the case. The UK and several other major Western economies are still wrestling with the aftermath of the 2008 credit crisis. Confidence remains desperately low, particularly within financial services, but also in public sectors, where much-needed spending limitations are contributing to current unemployment and spreading uncertainty regarding the future. Pressure on household spending is causing havoc on the high street too and many major retail brands have shut their doors. House prices, the bedrock of middle-class financial security, are stagnant at best and probably falling in real terms, in most places outside London's Grade A areas, which are
propped up by foreign buyers. Many banks have been effectively nationalised and owe their continued existence to those hard-pressed taxpayers. The reversal in asset prices and the ongoing constrictions in bank lending have contributed to an extremely low level of money supply growth. To add insult to injury, the debt crisis, which has already engulfed the sovereign states of Ireland, Portugal and Greece now appears likely to affect other Eurozone economies in a significant way, starting with relative weaklings such as Spain and Italy and raising concerns of another wave of bank problems even before the 2008 issues are close to being overcome. BUYING BACK GREEK BONDS The stronger economic powers within Europe are struggling to reach an agreement on how to cauterise the Greek problem, but there are bound to be significant losses and the need for ongoing financial help in the form of some type of support mechanism, which allows Greece to continue to fund vital services at a fraction of the open market rate. The German and French governments appear to have come together around the principle of buying back Greek bonds at a discount, a process which would probably cause an orderly, selective default. This could be good news in the short term for larger states such as Italy and Spain, which might be able to continue to borrow in bond markets at reasonable rates. STAGFLATION? However, let us step away from these albeit serious technical issues and consider the bigger picture. We have here a set of (erstwhile) leading economies which are suffering from a major debt hangover and which, despite extraordinarily low interest rates (UK 10-year bonds yield around 3 per cent, money market rates are hovering around 0.5 per cent), remain desperately short of demand. At the same time, inflation remains uncomfortably high in many countries (nearly 5 per cent in the UK). Causes include currency movements, global food and energy shortages and supply disruptions, with speculative premiums stoking prices further. It feels like stagflation and it represents a terrible tax on living standards. To the extent that this could be described as demand-pull inflation, the incremental demand is coming not from mature Western economies, but from Brazil, Russia, India and China (BRIC) and other emerging economies. Meanwhile, the US has its own much-debated debt problems to contend with. But the root causes are the same — too much overhanging debt and too little growth to service it. Let us now cast our eyes towards India. One would certainly not suggest that it is without its own problems — supply-chain dislocations, state and local government corruption concerns, a stock market down 10 per cent year-to-date, compared to a flat UK market and a buoyant 510 per cent return so far for the various US indices. Yet, in India, the problems are of a very different and arguably healthier hue. CYCLICAL SLOWDOWN GDP growth is slowing, but from a breakneck 9.3 per cent in last year's June quarter to just under 8 per cent now. Inflation stood at a worryingly high 9.74 per cent in the latest quarter and it would be no surprise to see continued rate increases slowing the economy further
and bringing inflation to heel. In other words, we are dealing with a typical cyclical, managed slowdown in an economy where demand has outstripped supply in a number of areas. What impact are we seeing from the Western economies' problems? India's foreign trade account is hovering around a negative $10 billion per month, but that is no worse than several years ago and it is hard to detect a deteriorating pattern. Foreign direct investment flows are higher for April and May than for the same months last year, and they actually seem to have picked up. Foreign indirect investment flows do appear to have come down near term, which has clearly contributed to the recent stock market weakness. Yet this number set is highly volatile — flat in March, up by $3.7 billion in April, negative $1.7 billion in May. In short, there is little hard evidence to suggest any major economic slowdown, driven by trade or investment flows, although foreign portfolio investors appear to have taken some money off the table as a safety shot ahead of the widely predicted monetary tightening. To conclude, in the face of a near perfect economic hurricane in the West, India seems to be barrelling along on a better trajectory. The linkages of the past, when such markets were seen as warrant plays on the more mature economies, appear to be weakening . Perhaps at least some of Don Quixote's ‘hulking gigantic enemies' are just windmills after all. Further Readings http://finmin.nic.in/workingpaper/euro_zone_crisis.pdf 22. Electronic Fraud: “An increasingly high percentage of the World population is adopting the Internet and the Global Financial Transactions are increasingly Electronic. Under such a scenario, the greatest threat to Global Finances is Cyber Security. A breach could have catastrophic consequences” A. What are the positive aspects of adoption of Electronic Finance globally? B. What are the major challenges due to the increasing use of E-Finance? C. What should Governments, and Financial institutions do to preserve and protect global citizens and ensure that they are not exploited by vested interests in the cyber world?
What are the positive aspects of adoption of Electronic Finance globally?
Lower cost and Increase in efficiency and transparency of Operations for Institutions Speed of transactions / Fast Operations in Internet time for Consumers Convenience [24x7x365] and Ease of Operation for Consumers Accurate Records for Institutions available immediately Increased Control and Monitoring for Management, and Regulators Easier to compare services and products, reduce duplication, increase competition among institutions, and enable increase penetration new markets expand their geographical reach
D. What are the major challenges due to the increasing use of E-Finance?
Regulation and Supervision of Electronic Transactions Security Risk, Privacy Violation and Security Costs for Institutions and Consumers Fraud and Operational Risk for Individual Institutions Systemic Risk and Worldwide contagion for Regulators Regulatory risk. Who Regulates? Internet allows services to be provided from anywhere in the world, there is a danger that banks will try to avoid regulation and supervision Legal risk. E-Banks in some cases not fully versed in a jurisdiction's local laws and regulations. Money laundering activity has been greatly facilitated by ebanking because of the anonymity it affords Operational risk. The reliance on new technology to provide services makes security and system availability the central operational risk of e-banking; confidentiality of data, Integrity of the system/data Reputational risk. Breaches of security and disruptions damage a bank's reputation. If one e-bank encounters problems customers lose confidence in electronic delivery channels as a whole. Reputational risks also stem from customer misuse of security precautions or ignorance about the need for such precautions
E. What should Governments, and Financial institutions do to preserve and protect global citizens and ensure that they are not exploited by vested interests in the cyber world?
Regulations to ensure Security, Safety and Soundness of System Regulations to Prevent failures and Punish Fraud Regulations to ensure Privacy and secrecy of Individuals Contingent Plan or Plan B if there is a failure or major fraud. It is a never ending job. Constantly must be ahead of Fraudsters Educate Inform and Improvise; Build systems based on Error-learning-feedback. There are four key tools that regulators need to focus on to address the new challenges posed by the arrival of e-banking.
Adaptation. In light of how rapidly technology is changing and what the changes mean for banking activities, keeping regulations up to date has been, and continues to be, a far-reaching, time-consuming, and complex task. Legalization. New methods for conducting transactions, new instruments, and new service providers will require legal definition, recognition, and permission. For example, it will be essential to define an electronic signature and give it the same legal status as the handwritten signature Harmonization. International harmonization of electronic banking regulation must be a top priority. This means intensifying cross-border cooperation between supervisors and coordinating laws and regulatory practices internationally and domestically across different regulatory agencies Integration. This is the process of including information technology issues and their accompanying operational risks in bank supervisors' safety and soundness evaluations. In addition to the issues of privacy and security, for example, bank examiners will want to know how well the bank's management has elaborated
its business plan for electronic banking. A special challenge for regulators will be supervising the functions that are outsourced to third-party vendors.
24. XYZ Triangular Arbitrage Strategy: - Comprehensive Problem You are the Financial Manager of the Trading Division of XYZ Foreign Exchange Division. Your Asian Division based in Hong Kong is providing you the following quotations from Asian Banks. (You may either buy or sell at the stated rates). Singapore Bank: Singapore dollar quote for Korean Won Hong Kong Bank: HK$ quote for Singapore dollars Korean Bank: Korean won quote for Hong Kong dollars 175.00/HK$
Won HK$ Won
644.00/S$ 3.50/S$
Your Latin American Division in Miami is providing you the following quotations from South American banks. (You may either buy or sell at the stated rates). Bank of New York: US dollar quote for Mexican Peso: Bank of Cancun: Sol Quote for Mexican Peso: Bank of Lima: Dollar quotes for Peru’s Sol: Sol
Peso Sol USD
10.00/1$ 1 / 3 Peso 1.00 / 3.2
Assume you have an initial wealth of $1,000,000 Hong Kong Dollars in Hong Kong, and $1,000,000 U.S. dollars in U.S.A. A.
Country
Bank Quotes Singapore Bank Quote Hong Kong Bank Quote Korean Bank Quote
Is Triangular Arbitrage Possible with Asian Currencies? If so, compute XYZ’s profits? 1. Home Country – HongKong 2. Table of countries, currencies across the bank quotes
Left Hand HOME Right Hand Side [RHS] Side [LHS] Korean Won Singapore Hong Dollar Kong Dollar
1 SD
1 SD
644 KW
3.50 HKD
1 HKD
Use any of the two quotes above to get the implied or THEORETICAL rate between two other currencies.
KW
In this case: 1 SD = 644 KW {Singapore Bank} and 1 SD = 3.50 HKD {Hong Kong Bank} Therefore, theoretically the rate between Korean Won and HKD should be: 644 KW = 3.50 HKD Or simplifying to the smallest possible denomination [Dividing both sides by 3.50]; the idea is to make the smallest number above to equal 1. [644 KW / 3.5] = THEORETICAL RATE
[3.5 HK /3.5]
184 KW = 1 HKD
Compare this with the Actual Quote from the third Bank, in this case Korean Bank Actual Rate 1 HKD = 175 KW
5. If the theoretical Quote and Actual Quote ARE NOT equal, Arbitrage is possible and beneficial. You can trade in the three currencies and make money. How do you make money? You will be converting your money into all the three currencies, and using all the three banks. How you go about it, step-by-step, is explained below. 6.
You have to offer to the third bank [in this case Korean Bank] either the LHS currency and get the RHS currency or the RHS currency and get the LHS currency. Which direction you do the trade depends on the Theoretical and Actual Rate.
7. In this problem you have to give KW to Korean Bank and Get HKD because they are giving 175 KW for 1 HKD; theoretically you should get 184. 8. With Hong Kong Bank exchange HK$ for Singapore$ HK$ 1,000,000 / 3.5 = S$ 285,714.28 9. With Singapore Bank trade Singapore$ for Korean Won S$ 285,714.28 x 644 = KW 184,000,000 10. With Korean Bank Trade Won for HK$ KW 184,000,000/ 175 = HK$1,051,428.571 11. Since you started with 1,000,000 HKD your profit is HKD 51,428.571
B.
Is Triangular Arbitrage Possible with Latin American Currencies? If so, compute XYZ’s profits? $1 = 10 Pesos 1 Sol = 3 Peso $1 = 3.2 Sol 10 Peso = 3.2 Sol 1 Sol = 3.125 Peso – Theoritical Rate
1 Sol = 3.2 Peso – Actual Rate 1. Convert $1,000,000 into Peso [1,000,000*10 = 10,000,000 Peso] 2. Peso into Sol [10000000/3.2 = 3,333,333.33 Sol] 3. Sol into USD [3,333,333.33*3 = $10,666,666.67
C.
As a percentage return on Investment [(Profits/ Investment) x 100], which is a more profitable investment for XYZ, Asian or Latin American currencies?
D. If the cost per transaction in Asia is $8,000 HK Dollars per transaction, and in Latin America it is $25,000 US Dollars per transaction which is a more profitable for XYZ after adjusting for transactions costs: Asia or Latin America?
6. Foreign Exchange Market: A. How is the Foreign Exchange Rate for a country Determined? There are various factors that determine an exchange rate. Trade value, inflation, and interest rates, to name a few. Model 1 A: Base Case before current year trade Two Countries: India and Japan INITIAL Exchange Rate: 100 Yen = $1.00 or 1 Yen = $0.01 50 Rupees = $1.00 1 Rupee = $0.02 100 Yen = 50 Rupees 50 Rupees = 100 Yen 1 Yen = 0.5 Rupee 1 Rupee = 2 Yen Indian Economy Size $1 Trillion Japan Economy Size $4 Trillion $1,000,000,000,000 Economy $4,000,000,000,000 Economy Total Economy in Local Currency units Total Economy in Local Currency units 50,000,000,000,000 Rupees 400,000,000,000,000 Yen Model 1 B: Base Case current year trade Statistics India Exports to Japan U.S. $100 Billion Goods and Services India Imports from Japan U.S. $200 Billion Goods and Services Nett, INDIA HAS TO PAY $100 Billion to JAPAN FOR CURRENT ACCOUNT BALANCE; Assume India Pays. After payment, and Other Things Remaining Same: India now has: Japan now has: 45 Trillion Rupees which now buys $900 Billion 400 Trillion Yen Plus $100 Billion Dollar Which buys $4.1 Trillion dollars of goods New Yen Exchange Rate: 400 Trillion Yen = $4.1 Trillion 1 Yen = $4.1/400 =$0.01025 or 2 Yen = $0.0205 Since nothing has changed between US and India: $0.0205 buys = [1 x0.0205 /0.02] = Rupee 1.025 Yen Value has appreciated; Rupee has depreciated at the end of the period. Model 2: Introduce Government Aid After the trade, Japan Unilaterally transfers 20 Billion dollars to India for Aid from current trade surplus. So India has to pay only $80 billion. New Exchange Rate: 400 Trillion Yen = $4.08 Trillion
1 2
Yen = 4.08/400 = $ 0.0102 Yen = 2 x 0.0102 = $ 0.0204 Which can now buy = [1 x 0.0204 / 0.02] = Rupees 1.02
Model 3: Introduce Government Aid and Capital Account Investments Japan transfers $20 billion in aid to India. Out of the balance, Japan invests the balance $80 billion in India by buying properties and government securities. No money flows out of the country. Exchange Rate is Unchanged: 1 Yen = 0.5 Rupee 1 Rupee = 2 Yen However, there is an $80 billion investment by Japan in India. If this money is taken out now or in future, then the Japanese currency will appreciate and Indian currency will depreciate. Determinants of Exchange Rates Numerous factors determine exchange rates, and all are related to the trading relationship between two countries. Remember, exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are some of the principal determinants of the exchange rate between two countries. Note that these factors are in no particular order; like many aspects of economics, the relative importance of these factors is subject to much debate. 1. Differentials in Inflation As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates. (To learn more, see Cost-Push Inflation Versus Demand-Pull Inflation.) 2. Differentials in Interest Rates Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates. (For further reading, see What Is Fiscal Policy?) 3. Current-Account Deficits The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. (For more, see Understanding The Current Account In The Balance Of Payments.)
4. Public Debt Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future. In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate. 5. Terms of Trade A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners. 6. Political Stability and Economic Performance Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.
B. Is the Foreign Exchange Market Efficient? Discuss. Please refer to the following docs: http://www.philadelphiafed.org/research-and-data/publications/businessreview/1994/brmj94gh.pdf http://www.nber.org/papers/w0476.pdf?new_window=1
