Exchange Rates and International Finance - Essay Example

Finance and Accounting Reflective essay: Knowledge from the lectures The lectures provided me an overview of international finance and different concepts pertaining to the topic. The concepts relate to main goals of Multinational Corporation in developing their businesses in the international market. I have acquired knowledge regarding agency problem that exists between the shareholders and management of a company. The centralized multinational financial management for two subsidiaries of a multinational company is elaborated in the lecture with the help of a figure, which is easy for me to understand the structure of operation among the company and subsidiaries. The concept of agency cost is also highlighted in the lectures and methods are explained, which can reduce the same. I have learned that a centralized management avoids agency problem and simultaneously reduces agency cost. I have also gained knowledge pertaining to international theories such absolute and comparative advantages, imperfect market theory and product cycle theory. I have also learned how different kinds of risks are hedged in the international market with the help of derivatives. There are four types of derivatives that are presently used extensively such as futures, forward, option and swap. However, in the lectures, futures, options and forwards are elaborated in details along with the process of calculation. I have also learnt about wider concepts of balance of payment, capital or financial account and the factors affecting international trade flows. 2. Absolute Advantage and comparative advantage Absolute Advantage Absolute advantage is defines the capability of an individual or firm or a country for producing more goods or services than its competitors by utilizing the same resources. The first initiator of this concept was Adam Smith and he described it in context with international trade by employing labor as the sole input (Pilbeam, 2006). Absolute advantage states that a particular country should manufacture the goods which they can produce efficiently and trade those goods, which does not require higher efficiency levels as the country itself is very much cost efficient in the process of production. The country is referred to have an absolute advantage in producing that good (G. Kim, and S. Kim, 2006). In such a situation, trade exists between two countries where they have absolute advantage in manufacturing two different products and at the same time earns profit from the same. The concept can be simply explained by comparing the labour productivities of two countries. It is impossible to have absolute advantage in anything but in that case no trade will happen between two countries as specified by the above mentioned theory (Hallwood and MacDonald, 2000). Adam Smith identified that it is impossible for the countries to become famous and rich only by following merchandise prescriptions as export of one country is import for the other. Nevertheless, he argued that all the countries would earn profit simultaneously if both practice free trade by following absolute advantage. The specialization in commodity and division of labour is the two main areas of his study. The concept of absolute advantage is explained by Smith through a simple example provided below: Figure 1: Example of Absolute advantage (Source: Madura and Fox, 2007) The above figure shows the amount of cloths and wheat produced by United Kingdom and United States respectively in one hour. It explains that US has absolute advantage in producing wheat and UK in cloth. However, Smith predicted that US should produce wheat and UK should manufacture cloth and if they are permitted to trade will they will exchange goods through trade. Hence, from the above discussion it can be stated that the countries have the opportunity to produce more quantities of the goods in which they gain absolute advantage with labour and trade other goods (G. Kim, and S. Kim, 2006). Example of Absolute advantage: Two countries Japan and United States (US) produces food and cars respectively by employing labour as the only input. It is assumed that the workers are immobile between the two countries and goods can be exchanged between them without much cost. The workers in the countries are productive however the technology used during production differs in these two countries. The above table defines few specifications regarding the production capacity of the two countries. Figure 2: An example of absolute advantage (Source: Eiteman, Stonehill and Moffett, 2001) From the above figure it is evident that Japan involves three units of labour for manufacturing one unit of food. However, US employ two units of labour for manufacturing the same. Thus, US is said to have absolute advantage is manufacturing food over Japan. Similarly, Japan has absolute advantage over US in manufacturing cars. Comparative advantage In 1871, David Ricardo became concerned with the difficulties arising from inactive resource allocation while defining the concept comparative advantage. The concept was determined by labor productivity ratios and not by absolute values of labor productivity. Hence, he stated that the concept of comparative advantage is very important to any country (G. Kim, and S. Kim, 2006). He defined it as the ability of a country or a firm to manufacture commodity or services at a reduced opportunity cost or marginal cost than that of a competitive country of firm. It provides the country with the capability to sell the commodity at a lower price than its rivals and thus have the advantage of drawing increased sales margin. Trade can occur between two countries or firms when one of them have absolute advantage in producing commodities; however it is advantageous to manufacture those goods in which they have comparative advantage and simultaneously earns profit (Shapiro, 2009). Example of comparative advantage: Sri Lanka and United States manufactures tea and wheat respectively and the resources required are explained in the table below: Figure 3: Comparative advantage Tea Wheat United States 5 4 Sri Lanka 10 10 (Source: Author’s creation) From the above table, it is evident that the opportunity cost of manufacturing tea is 1 unit in Sri Lanka; however the opportunity cost for manufacturing wheat in US is 2.5 units. Hence, it can be stated that Sri Lanka has comparative advantage in producing tea (Shapiro, 2009). 3. Difference between forward and future contract Definition: A future contract is defined as the standardized contract that is prepared by the buyer and seller to buy or sell a particular underlying asset at a future date at the strike price. A forward contract is defined as an agreement that exists between two parties for selling or buying an underlying asset at a pre-agreed date in future at a specified price (Hallwood and MacDonald, 2000). Purpose and structure of the contract: Future contracts are standardized and an initial payment is required at the time of preparation of the contract. These types of contracts are specially required for speculative purposes and hedging. Forward contracts are customized and there is no initial payment during the preparation of the contract. It is basically used for hedging (Hallwood and MacDonald, 2000). Method of transaction: The future contracts are traded and quoted on exchange. The forward contracts are directly negotiated between the sellers and buyers without the help of any exchange (Hallwood and MacDonald, 2000). Market regulation: The future contracts are directed by the government regulated markets. The forward contracts do not require any market regulation (Hallwood and MacDonald, 2000). Risk: The future contracts are linked with lower counterparty risk. The forward contracts are exposed to higher counterparty risk (Hallwood and MacDonald, 2000). Expiry date: The expiry date of future contract is specified by the regulators and thus it is standardized. However, the expiry date of forward contract is dependent on the transactions (Hallwood and MacDonald, 2000). Guarantees: In future contract the guarantees are standardized and specified by the government. In forward contract there is no guarantee for settlement till the date of maturity which is based on the strike price of underlying asset (Hallwood and MacDonald, 2000). Contract size: Future contacts are standardized by the government regulations. Forward contracts depend on the transactions that are made between the parties. Market: Future contracts are traded in primary market. The forward contracts are traded in both primary and secondary market (Hallwood and MacDonald, 2000). a) Stronger dollar explains that the dollars are traded for larger amount of foreign currency. It is obvious that the strength of dollar effects exports and imports to a great extent as services and goods and services are purchased from foreign countries in currency of manufacturing country. Hence, stronger dollar will make export expensive in United States and it is difficult for the importers to import goods as a result imports reduce (Copeland, 2008). To control the situation, imports become cheaper which escalates the imports. However, weaker home currency raises import prices for purchase and prices are reduced for foreign businesses for exports. This decreases the demand for import in the home country and increases demand for foreign exports thereby increasing current account deficit (Sarno and Taylor, 2002). b) The current account deficit highlights net sale of home currency in an exchange for different currencies. This imposes downward pressure on the value of the home currency. When the currency weakens, it reduces the home demand of foreign goods (as the goods become more expensive) and at the same time increases the home export volume (as the exports become cheaper in foreign countries). c) J curve is the diagram where curve falls at outset and eventually moves upward to a higher point than starting point. This movement suggests the letter J. Here, J-curve can be applied to various data in different fields. However, the J-curve effect is very important for the private equity funds and economy. Figure 4: J-curve (Source: Pilbeam, 2006) J -curve effects are observed in economy when trade balance of a country worsens followed by a depreciation or devaluation of currency. Higher exchange rate corresponds to increased cost of the imports and exports become less valuable, which leads to higher initial deficit or smaller surplus.  Reference list Copeland, L., 2008. Exchange rates and international finance. New Delhi: Prentice-Hall. Eiteman, D., Stonehill, A. and Moffett, M., 2001. Multinational business finance. Boston: Addison Wesley. Hallwood, C. and MacDonald, R., 2000. International money and finance. Oxford: Blackwell. Kim, G. and Kim, S., 2006. Global corporate finance. New York: John Wiley & Sons, Inc. Madura, J. and Fox, R., 2007. International financial management. New York: Thomson learning. Pilbeam, K., 2006. International finance. Basingstoke: Palgrave Macmillan. Sarno, L. and Taylor, M.P., 2002. The economics of exchange rates. Cambridge: Cambridge University Press. Shapiro, A. 2009. Multinational financial management. New York: John Wiley & Sons, Inc. Read More