International Financial Management - Example

Running Header: International Financial Management International Financial Management Student name: Institutional affiliation: Date of submission: 1. There are two types of quotes in the spot currency market, direct or indirect. 1. Direct quote is typically used in United States 2. Indirect quote is typically used in Europe 3. Indirect quote is typically used in Australia The following is the reason why Australia uses an indirect currency quote; Australia uses indirect quote where the AUD is stated as a per unit measure of other foreign currencies. There is no particular reason for this but it is conventional for some countries including Australia to use indirect quote. In this regard, the Australian dollar is viewed as the dominant currency. 2. If the quote in Australia is USD 0.80, the amount AUD 250,000 cost in USD is shown below;  In this case, the quote is AUD/USD = O.801. This means that one AUD is 0.801 of a USD. Thus, to convert AUD into USD, we need to multiply the AUD with 0.801 as shown in the formula below; 1AUD = 0.801 USD Thus, to convert AUD into USD, we multiply the AUD by 0.801. i.e. No. of USD = No. of AUD* 0.801 Thus; 250,000 AUD = 250,000 * 0.801 = USD 200,250 Thus, The AUD 250,000 will cost USD 200,250 in USD 3. If the GBP quote is USD 1.2772-87 1. If you converted $20,000 to GBP and then back to USD, its value in USD would be as shown below; The quote can be expressed as GBP/USD = 1.2772-87. This means that GBP/USD = 1.2772 is the bid rate at which we buy while GBP/USD=1.2287 is the ask rate at which we sell. In other words, we convert the GPB back to USD using the 1.2287 rate. Also note that the rate means that a GBP is worth USD 1.2772 at the bid price while a GBP is worth USD 1.2787 at the ask price. Thus, to convert a USD into GBP, we will divide USD by 1.2772 while to convert the GBP back to USD, we will multiply the GBP by 1.2787. Step 1: Convert USD to GBP by dividing USD by 1.2772 GBP = USD /1.2772 GBP = $20,000 /1.2772 = GPB15, 659.25 Step 2: We then convert the GPB back to USD by multiplying GPB by 1.2787 USD = GPB* 1.2787 USD = GPB15, 659.25* 1.2787 = 20023.49 Thus, after converting it back, its value will be $20,023.49 2. If you are able to buy pounds at the bid rate and sell them at the ask rate, the amount of USD you would need to earn $1,750 on a round-trip transaction (buying GPD for USD and then selling the GPD for USD) is given below; Supposing that the number of pounds bought is X, then the difference between their value at the time of buying and at the time of selling should be $1,750. The gain is the difference between buying price and selling price given as follows; x * 1.2787- x * 1.2772 = $1,750 1.2787x -1.2772x = $1,750 0.0015x = 1,750 To get x, divide every side by 0.0015 0.0015x/0.0015 = 1,750/0.0015 x= GPB 1,166, 666.67 Thus, you buy GPB 1,166,666.67 at $1.2772 each at a total cost of $1,490,066.67 and sell them at $1.2787 each at a total of $1,491,816.67 which would give a profit of $1,750. Answer: To make a total of $1,750 from the transaction, you need to buy GBP1, 166,666.67 at the bid price and sell them at the ask price. 4. Below is a critical discussion of the functions and contribution to society of the foreign exchange market, market participants and transactions; Functions and contributions From its definition, the foreign exchange market is a place where foreign currencies or moneys are bought or sold with exporters selling the foreign moneys while importers buy. In this regard, the foreign exchange market perform a number of functions. The first function is that of enabling transfer of finance and hence purchasing power from a certain country to the other. This is done through foreign remittances or bills that are effected through telegraphic transfer. They help facilitate the conversion of one currency to the other and hence help in facilitating international payments thus facilitating international trade. The markets also provide credit for international trade especially where foreign bills of exchange are used in making international payments which necessitates a credit for approximately three months till the bills expire. The foreign exchange market also perform a hedging function against foreign exchange risk (Jared, 2015). This is done through such facilities as forward contracts in exchange. In addition, it can be argued that the market also provide some form of employment for those who carry out foreign exchange purely for speculative purposes in a bid to make some profit as the value of different currencies keep on changing. There are a number of participants in the foreign exchange market who perform various functions. The first bunch can be termed as customers and include those involved in foreign trade, tourists, investors among others. This group plays the important role since they are the immediate users and suppliers of foreign currency into the market. Another group are the commercial banks who act as clearing houses between the earners and users of the foreign exchange. Then there are brokers whose actions help the commercial banks even out their foreign exchange inflows and outflows among themselves. Another important participant is the central bank which act as a lender of the last resort in case a nation’s total foreign exchange expenditures and earnings do not equal through its foreign reserves. Thus, it can be argued that the participants play an important role of convening the foreign exchange market and helping it perform the functions outlined above. Various transactions also take place in the foreign exchange market. These transactions facilitate the market to achieve its functions and hence helping the various participants in promoting international trade. On the other hand, brokers are able to make profits thanks to the transactions. The main contribution of the foreign exchange market to the society is through promotion of trade. The market is the backbone of international trade and global investing and plays a vital role in supporting imports and exports through its various functions outlined above. This in turn enables access to resources while creating additional demand for goods and services for the society. Without the market, the society may not be able to access markets for surplus goods or markets where to buy what they don’t have. This would be disadvantageous to the society and poverty levels would be high since companies’ prospects would be greatly hindered while economic growth would be very slow. Thus, it can be argued that the market, its participants as well as the transaction by boosting trade affect the society by reducing poverty while allowing access to markets and essential products and services. In addition, it allows investments hence providing additional avenues for employment in the society. 5. There are a number of strategic motives why businesses go international. They include; i) Market development- A business may become multinational as a market development strategy. This is where an organization is looking to grow its business area via market development or expanding to new markets in new places. This strategic move enables the organization to capitalize the products of its home country in international markets. Through selling in international markets, the organization is able to increase its profitability and hence cash inflows (Heiko and Mario, 2015). For instance, many network provider companies such as Airtel are increasingly venturing into the African markets with an aim of increasing their profitability before the market is fully saturated. ii) First move- An organization may become a multinational as a first move before its major competitors enter the international markets and increase their profitability through strategic benefits including technological leadership, brand image, customer loyalty and competitive position. For example, Volkswagen which is a leading auto maker was the first to locate in Shanghai which gave it a monopoly for a long time. iii) Government incentives- Governments world over give incentives for companies willing to do business in their countries. Thus, some companies may want to take advantage of these incentives and hence become multinationals. For example, owing to the good incentives offered by the Rwandan government, the first laptop manufacturing company in the region PostivoBGH chose to establish a branch there. Why firms may not become multinational One motive why a firm may not become multinational is when it does not have adequate capital to support international operations. In that case, its owners may choose not to go international until such a time enough capital is found. For example, a green grocer may need to first expand locally to have enough capital base to operate internationally in future. 6. The following is a discussion of the theory of Purchasing Power Parity (PPP), including the difference between absolute purchasing power parity, relative purchasing power parity and whether PPP is useful in practice and why, drawing on your understanding of the Big Mac Index. Meaning of purchasing power parity If the domestic purchasing power of two currencies at a certain exchange rate are equivalent, then the exchange rate between the two currencies are in equilibrium. In other words, the exchange rate between two currencies will be equal to the ratio of the two currencies respective purchasing power. This is the purchasing power parity theory which means that a bundle of a certain good in country A ought to sell at the same price in country B when the exchange rates between the two countries is considered. Thus, supposing that a USD is equivalent to 2AUD on the foreign exchange market, then an item costing 2USD in the US should sell for 4USD in Australia if we have purchasing power parity. Difference between absolute purchasing power parity and relative purchasing power parity Under absolute purchasing power parity, a bundle of a certain good ought to cost the same anywhere world over if the exchange rate is taken into account. If the cost of the bundle of goods deviates from this, then it would be expected that relative prices as well as the exchange rates between the two countries will move towards a level at which the bundle of goods will have the same price in the two countries. On the other hand, relative purchasing power parity is about the change in two countries expected inflation rates to the changes in exchange rates. In other words, relative purchasing power parity considers the effect of inflation on prices in different countries. In this case, inflation will reduce the real purchasing power of a country’s currency. Thus, if country A has an inflation rate of 15% relative to country B, then country A’s currency will purchase less real goods compared to country B. Thus, relative power parity is concerned with changes in price levels between different countries with the exchange rate changing to compensate for differences in inflation between the two countries. Is Purchasing power parity theory useful in practice? The big Mac index measures the relative prices of big Mac in various countries in an attempt to examine whether purchasing power parity is applicable in practice. For instance, if big Mac costs $5 in the US, it should cost the same in china (Yevheniya and Serletis, 2010). However, if it costs $2 in china, then this shows that there is no purchasing power parity between the two countries. With time, the big Mac index has demonstrated that purchasing power parity is not applicable in practice for various reasons. The reasons include transport costs, taxes, government intervention, non-traded services, market competition, inflation and labor. Owing to differences in these factors across countries, the prices of big mac are unlikely to be at parity internationally and this applies to other products. Thus, though purchasing power parity dictates that the price of a good in one currency ought to be the same price in other currencies based on the prevailing exchange rate, this does not hold in practice owing to the factors listed above. However, it would hold in the long run if it is adjusted for the above factors. References: Cfainstitute.org, 2017, Currency exchange rates, Retrieved on 2nd September 2017, from; https://www.google.com/search?client=firefox-b-ab&q=What+is+direct+quote+a nd+indirect+quote+in+foreign+exchange%3F&sa=X&ved=0ahUKEwjL74aPqIb WAhVBKsAKHRx0A ckQzmcIQg&biw=1192&bih=731 Jared, B2015, Issues in general economic research and application, London, Rutledge. Heiko, H& Mario, F2015, When small businesses go international: alliances as a key to entry, Journal of Business Strategy, vol. 36, no. 3, pp. 37-45. Yevheniya, H&, Serletis, A2010, Purchasing power parity over a century, Journal of Economic Studies, vol. 37, no. 1, pp. 117-144. Read More