International Financial Systems - Coursework Example

INTERNATIONAL INVESTMENT EFFECTS NAME: INSTRUCTOR: INSTITUTE: COURSE: DATE: INTERNATIONAL FINANCIAL SYSTEMS An International financial system is related to the management as well as transactions in the international monetary and financial assets. The financial assets in the international financial systems comprises of rights on foreign deposits, foreign currency and investments together with foreign assets which can be denominated in a number of foreign currencies that are purchased and sold in addition to being involved in the exchange between various currencies. Hence, the dealings in the International financial system lead to; the lending and borrowing operations in foreign currencies (foreign currency market) and a foreign exchange deal which involves exchanging money from another country (currency) for another (foreign exchange market) i) The International Foreign Exchange Market The global monetary and profitable relationships among states are involved with the exchange of products and services as well as expenditures for the exchanged products where payments are changed from one currency to another. Exchanges between the cash and monetary properties of a given country for cash or monetary properties of another country establish the global financial dealings that are placed on the foreign exchange market. The market forces of demand and supply determine the product prices. The same principle applies in the exchange market where demand and supply of any currency act as the determinant for the exchange rate between the currencies. These financial properties could be money or money-related such as cheques, bank drafts and other negotiable instruments. The difference amid the local and global monetary structure is determined by the exchange rate between currencies; the local exchange is different from the global exchange rate in that the global exchange rate considers currencies from several countries as compared to the local exchange rate system. When exchanging currencies, the global market experience the transfer problem which is related to the problem of finding the proper source of supply to suit the demand for any foreign currency. This leads to an adjustment in the balance of payment of a given country which in turn depends on the type of global monetary system that is supposed to be applied in the market. The balance of payment can either be a deficit or surplus and the equilibrium can be restored through the appreciation or depreciation of the local currencies. The International Monetary Fund (IMF) was therefore established to enable businesses between the member-states and impart an element of stability in the international monetary scene, and the IMF sets controls the money supply in the international to prevent a surplus or deficit of a given currency in the market. Therefore, a country can buy and sell its currency from the International Monetary Fund for another currency of the member state to meet its requirements to pay for the purchased goods and services in the global market. ii) The Global Currency Markets These are markets where countries trade their reserved currencies. These markets related to the credits of reserve currencies with global banks at a fixed interest rate. The other components of the international financial system consists of the global capital and bonds markets such as Zurich that has lost its status greatly in the global market as a result of state constraints and a shortage of funds. Therefore, the global currency market is mainly controlled by the member states for the exchange of currency. In this market, the members control the currency circulation through controlling the interest rates. MULTINATIONAL ENTERPRISES (MNEs) This is a corporate organization that controls the production of goods and services in two or more countries apart from their local state, as a multinational corporation. These enterprises play an important part in the technological innovation as well as the research and development investment in both the host country and the local country. As a result of the huge market that the MNEs serve, they often benefit from economies of scale and therefore they have a strong financial capacity to invest in risky projects that other international corporations cannot invest in all around the globe. As a result of globalization, MNEs have adopted new and improved strategies in the production and sale of their goods and services all around the world. This has led to better products leading to an increase in the demand and supply of the same which in turn brings about high profits. Multinational enterprises are currently growing especially in the research and development industry due to increased competition levels between countries and regions. As much as research and development in the MNEs has direct impacts, it also brings about indirect impacts for instance improvement in the productivity levels of their competitors. These indirect impacts are related to the transmission of knowledge from international associates to domestic organizations, surrounding technology and all forms of production involved in the organization's activities. Hence it is essential for the national innovation policy to take into consideration the means to attract the inventive accomplishments of MNEs and how to encourage existing MNE associates to involve in invention domestically and to cooperate with local organizations and learning institutions. Therefore, MNEs contribute greatly to the growth and development especially in the less developed countries regarding creation of revenue and employment opportunities for the locals. To some extent as much as MNEs have positive impacts on the economy, they also have negative impacts particularly in the domestic producers who suffer in the market in terms of prices of goods and services. Additionally, they introduce better quality products that the local industries cannot compete with in the market leading to closing up of many local firms. The International monetary system and foreign exchange markets The international monetary systems comprises of a set of globally agreed upon rules and principles that enable international trade among nations. The international monetary system assigns a standard value of the international currency for a smooth running of business activities between nations due to the complexities of international trade as well as the financial markets. Consequently, the stand of the government’s on the regulations could affect the process of decision making in the system. For instance, if a government decides to change its trading policies the move may affect the global trade of goods and services in terms of prices which will, in turn, affect their demand and supply both locally and globally. The main objective of the international monetary system is to encourage nations to participate in the international trade so as to improve their balance of payment (BOP) and therefore minimize deficits brought about by trade activities. The main achievements of the international monetary system brought about the establishment of the International Monetary Fund (IMF) and the World Bank in 1944. Foreign exchange markets The foreign exchange market is a market in which members have the ability to purchase, sell, exchange and gamble on currencies. Foreign exchange markets consist of banks, commercial companies and central banks. The countries set an exchange rate for all the member countries in the market to enable an easy transaction between the nations. Foreign exchange risk management and evaluate the basic hedging strategies. A foreign exchange risk is a financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company. Many countries that participate in international trade whether in the money or goods market are exposed to such risks. The risks include; Transaction risk; this is the gain or loss arising on conversion between the transaction date and the subsequent settlement date. This risk is mostly associated with imports and exports. Economic risk; a company is exposed to economic risk either directly or indirectly. Direct exposure; if the local currency strengthens external market participants will gain sales at the expense of the local firm since their products appear to be expensive both locally and internationally. Indirect exposure; even if the local currency does not move at the same rate as the client’s currency, the local firm may lose their competitive position in the market. For instance, if a firm from Zambia is selling into China with Australia as its main competitor. If the Australian dollar weakens against that of China, then Zambia will lose its competitive position. Translation risk; the financial statements of external companies are regularly translated into the local currency so that they can be combined into the group's financial statements. This stated presentation of a foreign company in the local currency terms can be sternly misleading in case there has been a major movement in the foreign exchange. Hedging strategies 1) Forward contracts The customer can use forward contracts to either sell or purchase foreign currency amounts at a future time and a given exchange rate. The settlement takes place at the time and the exchange rate mentioned in the contract, irrespective of any variations in the exchange rate on the foreign exchange market. Forward contracts are beneficial because; i) The risk of variations in the exchange rate is alleviated ii) It increases the cash-flows and profitability control by the management of companies. iii) The exchange rate applied in the budgeting process is fixed. 2) Flexible forward transactions A flexible forward transaction consists of similar features as a forward transaction except it has a difference in the terms of settlement where the settlement of the deal can be sealed at any given time up to the time when the deal matures. The customer can choose to settle the deal partially at any time until the contract is termed mature, where his only obligation is to exchange the entire estimated amount until maturity. This hedging method has the following benefits; i) Provides a supple mood for the dealings in the foreign exchange since the clearance may occur at any time between the day of purchase and maturity date applying the same exchange rate that was pre-established ii) A company is in a better position to manage its liquidity. iv) It provides better organization between profits and expenses of a company. 3) Currency Swaps This deal represents a contract that enables clients to make an exchange between currencies at a fixed exchange rate. There are two dealings occurring in a simultaneous manner; buying and selling the same amount of product at two dates that are set differently at an exchange rate that is pre-agreed immediately the deal is closed. In a currency swap, the client with foreign currency exchanges it currency for another currency of an equal amount. Hence, the customer exchanges his interests along with currency rate exposures from one currency to another otherwise benefiting the bank by low rate funding. 4) FX Options An option agreement is more the similar to an insurance contract in that the client pays premiums for him/her to be in a better position to benefit from an option in case a certain incident happens. Like other hedging strategies, this strategy has the following benefits; i) It completes risk hedging in the foreign exchange ii) In this strategy, the client enjoys better cash-flow and can manage its profits well. iii) The company can establish an exchange rate that is applied to the company budget.   iv) The company is likely to benefit from favourable exchange rate since they are the ones who set the rates. Therefore hedging is important in any form of business since it prevents the company from unforeseen losses that it could incur in the future. Through hedging, a company is to some extent protected from losses that a company may incur as a result of unavoidable circumstances such accidents like fire. The distinction between transaction, operating and translation exposures and their management. Multinational corporations play an important role in the commercial business environment. These businesses deal in two or more currencies and are therefore exposed to the international financial risks. Foreign Exchange exposures are therefore the vulnerabilities businesses face due to the existence of foreign exchange exposures in the exchange rates. These exposures include; Transaction exposure; it measures value change in the deal between the time it was signed and when the deal takes place as a result of changes in the exchange rate. Companies in international trade face the risk of changes occurring in exchange rates after a legal binding which may cause losses in the affected company. Operating /economic exposure; this kind of exposure deals with an estimated value change of a firm as a result of expected changes in the company's cash flows brought about by the unexpected change in the exchange rate. Translation/ accounting exposure; this is the alteration in the proprietor’s capital as a result of the translation of foreign currency into one. Changes in a foreign currency will lead to significant changes in the investors capital which may lead to an expansion of the business. Differences between the foreign exchange exposures The operating exposure differs from the translation exposure since it involves providing a predetermined value of all future cash flows and thereafter measure the fluctuations experienced in the exchange rates whether the deal has occurred or not. Transaction exposure has direct effects on the cash flows while the translation exposure has their profits and losses either directly or indirectly on the company cash flows or stakeholder’s equity respectively. Translation exposure represents an exposure that has already happened while operating exposure is concerned with future exposure. While translation and transaction exposures are concerned with individual companies, operating exposures are concerned with how changes in the exchange rates affect competitors. Transaction exposure has short term effects while translation and economic exposures have long term effects. Theoretical concepts involved in international financing, multinational investment decisions and capital budgeting International financing deals with the monetary and macroeconomic relationships between two or more countries. Global trade theories include; classical trade theory, factor proportion theory and product life cycle theory. The Classical trade theory This theory claims that a nation’s exports and imports related to the countries transaction activities with other countries. Tin that, a country will benefit only if they devote their resources to producing goods and services in which they have an economic advantage. The factor proportion theory When compared to the classical trade theory, this theory can offer a clarification for the differences that are showed in the advantages of engaging in trading countries with other nations. According to this theory, countries will produce and export goods and services that couple large amounts of abundant factors of production that they own, while they will import goods and services that need huge amounts of the factors of production which might be comparatively rare. This theory, therefore, provides an extension of the economic advantages enjoyed by a nation by taking into consideration the endowment as well as the factors of production costs. Product life cycle theory The main objective of this theory is to explain and predict the patterns of international trade as well as the expansions that occur in the multinational enterprises. This theory proposes that a trade cycle arises from where a product is manufactured by the parent company, then through its overseas firms and lastly any other place in the world where production costs are low. From the above arguments, therefore, an investor has an idea of what is going on the market both locally and internationally in terms of the company's trading activities making it easy for them to make investment decisions. Capital budgeting This is a planning process that is applied in organizations to determine whether its long term investments are worth the funding of cash done by the organization's capitalization structure. It helps an organization determine projects that need immediate attention and also investments that will result in high returns. Capital budgeting applies methods such as; The Internal Rate of Return; this is a method that is used to measure the efficiency of an investment with a discount rate that results in zero Net Present Value (NPV). Advantages It is easy to compute The method considers time value of money Disadvantages It ignores the economies of scale Inconsistencies may appear in the values of future cash flows where some values can be positive and others negative. The Net Present Value Method; this method involves discounting cash flows to the present value. Capital budgeting projects are either independent or mutually exclusive. The main advantage of this method is that it considers the time value of money. Foreign Direct Investment (FDI) and political risk According to Froot, K. (2008), Foreign Direct Investment is a form of investment that is in the form of controlling ownership of a business centre in a given country by a unit that is based in another country. FDI can occur; By integrating a solely owned company anywhere in the world. Through merger and acquisition of a company that is unrelated to the acquirer. Through obtaining stocks in a related enterprise. Foreign Direct Investment can take any of the following forms; The platform FDI; in this form of investment affects economic growth in the retail sector of the countries where the investment takes place. These effects can either be positive or negative depending on the type of investment. Horizontal FDI; this form of investment occurs when a company is involved in the same activities as in the home country in the host country in that a company applies the same methods of production that are used in the home country. This move can lead to the success or failure of the new firm taking into the products and the production techniques required for the same. Vertical FDI; this occurs when a firm either moves up or down in the different value chains; the growth or decline of a firm in the new market. Advantages and disadvantages of foreign direct investment Advantages Through FDI, there is an introduction of new technologies which could lead to better means of production which will, in turn, lead to quality products. As developed countries develop their businesses abroad through FDI, it provides an opportunity for the local business to grow to make it easy for small business that has no abilities to invest to expand in the local market Disadvantage As much as technologies are good especially in the less developed countries, it may lead to the closure of some businesses as a result of the introduction of cheap products from developed countries in the local market. A multinational corporation that invests abroad due to low costs of production will lead to competition for the local markets between small business and the multinational corporation who will end up selling their products are cheaper prices as compared to the local business who invested a lot in order to produce better products for the local market. This will slow down the growth of the small business. Political risks associated with foreign direct investment Stability of the local economy; foreign direct investment may bring about instabilities in the local economy in the sense that most investors benefit from the economy than the benefits they bring, this can be best described by the revenues brought about by the FDIs to the local economy. Free transfer of profit from the host country; in cases e international investors have the upper hand especially in the developing countries, the investors can simply transfer profits to their countries hence the local country will not benefit from the investment. Fair and equal treatment by the host government; governments may favour international investors more than the local investors which may lead to disputes between the local and international investors. REFERENCES DESBORDES, R. (2010). GLOBAL AND DIPLOMATIC POLITICAL RISKS AND FOREIGN DIRECT INVESTMENT. Economics & Politics, 22(1), 92-125. http://dx.doi.org/10.1111/j.1468-0343.2009.00353.x Froot, K. (2008). Foreign Direct Investment. Chicago: The University of Chicago Press. Morrissey, O., & Udomkerdmongkol, M. (2012). Governance, Private Investment and Foreign Direct Investment in Developing Countries. World Development, 40(3), 437-445. http://dx.doi.org/10.1016/j.worlddev.2011.07.004 Read More