International Financial Management - International Trade, Risk, and the Role of Banks - Assignment Example

PART A – MULTIPLE CHOICE QUESTIONS 1. Which of the following theories suggests that firms seek to penetrate new markets over time? a. Theory of comparative advantage. b. Product cycle theory. c. Imperfect markets theory. d. None of the above 2. Which of the following is an example of direct foreign investment? a. Exporting to a country. b. Establishing licensing arrangements in a country. c. Purchasing existing companies in a country. d. Investing directly (without brokers) in foreign stocks. 3. The demand for U.S. exports tends to increase when: a. Economic growth in foreign countries decreases. b. The currencies of foreign countries strengthen against the dollar. c. U.S. inflation rises. d. None of the above. 4. Which of the following factors probably does not directly affect a country's capital account and its components? a. Inflation b. Interest rates c. Withholding taxes on foreign income d. Exchange rate movements 5. An increase in U.S. interest rates relative to German interest rates would likely ____ the U.S. demand for euros and ____ the supply of euros for sale. a. Reduce; increase b. Increase; reduce c. Reduce; reduce d. Increase; increase 6. Under a fixed exchange rate system: a. A foreign exchange market does not exist. b. Central bank intervention in the foreign exchange market is not necessary. c. Central bank intervention in the foreign exchange market is often necessary. d. Central bank intervention in the foreign exchange market is not allowed. 7. Countries that have adopted the euro must agree on a single ____ policy. a. Monetary b. Fiscal c. Worker compensation d. Foreign relations 8. If a firm does not have foreign subsidiaries, it is not subject to ____. a. Transaction exposure b. Economic exposure c. A and B d. Translation exposure 9. A firm will likely benefit most from diversifying if: a. The correlations between country economies are high. b. The correlations between country economies are low. c. The variability of all country economy levels is high. d. B and C 10. Which of the following is a reason to consider international business? a. Economies of scale. b. Exploit monopolistic advantages. c. Diversification. d. All of the above 11. A U.S. firm has a Canadian subsidiary that remits some of its earnings to the parent on an annual basis. The firm has no other foreign business. The firm could best reduce its exposure to exchange rate risk by issuing bonds denominated in: a. U.S. dollars. b. Canadian dollars. c. Multiple currencies. d. Euros. 12. For the purpose of financing, ____ are beneficial because they may reduce transaction costs. However, MNCs may not be able to obtain all the funds that they need. a. Private placements b. Domestic equity offerings c. Global equity offerings d. Global debt offerings PART B – SHORT ANSWER QUESTIONS Question B1 (19 marks) i. Briefly discuss the factors that affect the international trade flows among various countries of the world (discuss any three factors). (6 marks) The following are some of the factors that influence international trade flows that occur among different countries worldwide: 1. Inflation – if a country’s inflation increases in relative terms, then the current account of the country in question will decrease as a result of decreased exports and increased imports. 2. National income – if a country’s income increases in relative terms, then the current account of the stated country will decrease as a result of increased imports. 3. Government restrictions – governments may choose to regulate imports into their economies by enforcing quotas or by imposing heavy tariffs on imports. ii. A country may weaken its currency in order to correct the balance-of-trade deficit. However, sometimes this solution may not be useful. Briefly discuss why the weak home currency solution may not be effective in correcting the deficit balance-of-trade (discuss any three reasons). (6 marks) The following are some of the reasons why weakening home currency may not be the solution to a balance-of-trade deficit: 1. After the measure is implemented by the home country, foreign corporations may opt to adjust their prices downwards with a view of maintaining their competitiveness. 2. Other foreign currencies may also weaken reducing the impact that a weak home currency would have. 3. The J-Curve effect – this refers to the fact that a number of international transactions are prior-planned and thus they cannot be changed immediately, thereby reducing the effect that a weak home currency will have on the international market. iii. What is an agency problem? Briefly explain the agency problem in the context of the multi-national corporations (MNCs). (4 marks) The agency problem is the problem that occurs when parties that are entrusted by others to look after the latter’s interests use the powers and authorities they are given for their own benefit. In the multi-national corporations’ context, an agency problem occurs when subsidiaries quit acting in the best interests of their headquarters, and concentrate on their own interests. This problem is normally solved using stock options, investor monitoring, hostile takeover threats and so forth. iv. Briefly explain the imperfect markets theory as applied to the international trade. An imperfect market refers to a market that is not perfectly competitive. Thus in an imperfect market there are manipulations, lack of full disclosures and the like. In international trade, one expects that countries would trade in a situation where the two trading countries are different in terms of technology and endowment. However, there have been cases of intra-industry trade between countries signalling the absence of perfect competition, hence imperfect markets. (3 marks) Question B2 (19 marks) i. Briefly explain the factors (any three factors) that influence the exchange rate between the currencies of two countries. (6 marks) The following are some of the factors that affect the exchange rates of the currencies of two countries: 1. Inflation differentials – generally, a nation whose rate of inflation is consistently lower normally has a currency value that is constantly rising because its purchasing power goes up in relation to the other competing currencies. 2. Interest-rate differentials – Countries can influence their currencies’ exchange rates by manipulating interest rates because high rates of interest tend to attract foreign capital which in turn leads to a rise in the exchange rate. 3. Current-account deficits – a deficit in a nation’s current account simply means that a country needs much more foreign currency to sustain its economy than it gets through its exports. This therefore means that it may have to trade its currency at a lower-than-desirable value. ii. In the context of currency markets, what is a bid-ask spread of a currency? Briefly explain the factors that influence the spread on a currency quotation. (6 marks) A bid-ask spread of a currency refers to the difference between what one will obtain as quote currency after selling a base-currency unit and what has to be given in terms of the quote currency to get a base-currency unit. The following are the factors that affect the spread on the quotation of a currency: 1. Trading volume – the bid-ask spread is normally reduced by the trading volume. 2. Uncertainty – the bid-ask spread tends to increase when there are instances of uncertainty and high risk. 3. Presence of dealers – the spread is normally reduced by the presence of too many dealers in the foreign exchange market. iii. In the context of the international credit markets, briefly explain the concept of syndicated loans. (4 marks) Multinationals normally require large amounts of capital. If such multinationals need to obtain credit financing in terms of a bank loan, a single bank may be unable to fully support such a request. The bank may therefore coordinate with its international counterparts to create a syndicate in which several banks take part in financing the loan. Such loans are known as syndicated loans. iv. Briefly explain the concept of cross exchange rate. Give an example. (3 marks) Cross exchange rates refer to a situation where the exchange rates of two different currencies are given in a common currency, which enables one to compute the exchange rate between the two currencies. For instance, when the Japanese Yen is given in terms of US dollars and Chinese Yuan is also given in terms of US dollars, the exchange rate between the Japanese Yen and the Chinese Yuan can be easily computed. Question B3 (19 marks) i. Briefly discuss the advantages (any two advantages) and disadvantages (any two disadvantages) of the fixed exchange rate system. (6 marks) The following are some of the advantages of having a fixed exchange rate: 1. Avoid currency fluctuations – the fact that a fixed exchange rate avoids fluctuation of currencies is an advantage because such fluctuations would cause problems for firms. E.g. a firm depending on imported raw materials will incur high costs if the currency is devalued. 2. Stability leads to more investment – the uncertainty that is characteristic of an exchange rate that is not fixed may discourage investment in export capacity. The following are some of the disadvantages of having a fixed exchange rate system: 1. Less flexibility – a fixed exchange rate cannot easily respond to temporary shocks. 2. Current-account imbalances – a country that has a fixed exchange rate may be faced with current-account imbalances. For instance, an exchange rate that is overvalued will lead to a deficit to the current account. ii. In the context of foreign exchange markets, explain the term ‘international arbitrage’. Briefly discuss three main types of international arbitrage. (6 marks) International arbitrage involves buying securities or goods in a certain market and selling them in a different market in the international market. The arbitrage takes advantage of the already existing price differences in different countries for the goods that the investment is based on. The following are three main types of international arbitrage: 1. Location arbitrage – this kind of arbitrage occurs when one bank’s bid price happens to be higher than another’s ask price for a given currency, therefore giving a chance for a riskless profit. 2. Triangular arbitrage – this occurs when the spot rate is different from the exchange rate that exists between two currencies. One converts a currency into another currency and then converts it to the first currency. 3. Interest rate arbitrage – this involves spot rates, and forward and interest rates. iii. Briefly explain the difference between spot and forward exchange rates. (4 marks) A spot exchange rate refers to the current exchange rate while a forward exchange rate is a rate of currency exchange, which is quoted at a given time, but delivered and paid at a later/future date. iv. Briefly explain the concept of transaction exposure in the context of MNC. (3 marks) Transaction exposure refers to the effect of unexpected changed in rates of currency exchange on a multinational company. Such effects are possible because multinationals normally have cash flows that are denominated in other currencies in the short term. For instance, goods bought on credit in other currencies and funds lent in other currencies. Question B4 (19 marks) i. Briefly discuss the motives (any four motives) why the MNCs make direct foreign investments. (6 marks) The following are some of the motives for Foreign Direct Investments (FDIs), which are usually done by Multinational Companies (MNCs): 1. Market seeking – companies may opt to invest in foreign countries in order to get new buyers for their services or goods. 2. Resource seeking – a firm may find that producing services or goods in a foreign country is cheaper than producing the same in its home country. 3. Strategic asset seeking – companies may opt to invest in foreign firms in order to get strategic assets like new technology and distribution networks. 4. Efficiency seeking – MNCs may decide to change their international holdings due to economic changes. For instance, if a free trade agreement is signed among a number of countries an MNC may opt to have a subsidiary within one of those countries to enjoy lower tariffs. ii. The MNC which wants to engage in direct foreign investment, may at times face some barriers. Briefly discuss the barriers (any four barriers) faced by the MNCs while engaging making direct foreign investments. (6 marks) The following are some of the barriers that MNCs face as they make Foreign Direct Investments: 1. Limits on foreign ownerships – countries and corporations may set a limit to which they can allow foreign investment. 2. Approval and screening procedures – in some countries, approval procedures may be too bureaucratic that they act as an impediment to FDIs. 3. Limitations on establishment types – some countries may limit the establishment of subsidiaries by multinationals, thereby discouraging FDIs. 4. Discriminatory treatment – some countries may discriminate against foreign investors and thus discourage FDIs. iii. Sometimes, the MNCs acquire businesses under the privatisation programme of foreign governments. Briefly discuss the reasons (any three reasons) why is it difficult to make the valuation of the government-owned businesses. (4 marks) 1. Government interference – the government selling the business may interfere with the valuation process leading to over-valuation. 2. Wrong value estimates – the book value of the business may not be equal to its market value. 3. Intangible assets – these are difficult to value for a state-owned business because they are not guaranteed for the private entity taking over the business. iv. MNCs do the valuation while acquiring a foreign firm (target). Briefly explain why different MNCs will put different value for the same target firm (provide any two reasons). (3 marks) 1. Estimated cash flows – MNCs will have different expected cash flows since this depends on the oversight or management of each MNC. 2. Effects of exchange rates on remitted funds – the targets value may vary among MNCs because the different MNCs may use different exchange rates for funds remitted by the target to its parent. Question B5 (19 marks) i. The MNCs often acquire subsidiaries (target) in foreign countries. Briefly discuss the country-specific factors (any three factors) which potentially affect the valuation of the target. (6 marks) The following are some of the country-specific factors that influence a target’s valuation as MNCs acquire subsidiaries: 1. Local economic conditions – targets that are in countries with good economic conditions are likely to sell more of their products and have high cash flows. 2. Local political conditions – targets that are located in countries with a favourable political environment are not likely to go through adverse cash flow shocks. 3. Currency conditions – before acquiring a foreign target, an MNC considers the effect of fluctuations in exchange rates on the currency cash flows of the target. ii. Large banks use various methods to provide finance to MNCs which engage in the international trade. Briefly discuss the methods (any three methods) used by the banks for financing international trade. (6 marks) 1. Letters of credit – these refer to instruments that are issued on a buyer’s behalf by a bank with a promise to the exporter that the importer will pay after shipping documents are presented to him/her in accordance with agreed terms. 2. Prepayment – in this method, the importer sends the transaction money to the exporter by wire transfer, or by electronic debit or credit through a bank that acts as an intermediary. 3. Drafts – this is whereby an exporter asking for payment from the buyer upon presentation. Drafts offer exporters less protection as compared to the letters of credit because the bank is not obligated pay on behalf of the buyer (Niepmann & Schmidt, 2013). iii. Corporate governance is very important for the MNCs. Briefly explain why the governance by board members may not always be effective (any two reasons). (4 marks) Governance by board members may not be effective in MNCs because of the following reasons: 1. MNCs operate in more than one country and therefore their business is governed by different legal environments. Having a Supreme Board of Directors in the parent may not be effective because the members of the board are not adequately familiar with the legal environments under which subsidiaries operate. 2. Often, the interdependence between subsidiaries and the parent is not clearly defined and thus a Supreme Board of Directors may face some hurdles when implementing management decisions in subsidiaries. iv. In order to prevent hostile takeover by MNCs, the target firms may implement ‘poison pills’. Briefly explain the term poison pills. (3 marks) A poison pill refers to a strategy that is employed by firms to avoid a corporate raids and hostile takeovers. The poison pill involves taking a financial step that will make the company unattractive. For instance, the target may offer stock options to its shareholders at an undesirably huge premium to the company in order to make the high cost of the acquisition untenable. In addition, a target can acquire a debt that will make it unprofitable to avoid hostile takeover. Reference List Niepmann, F & Schmidt, T. 2013. International Trade, Risk and the Role of Banks. Accessed Nov. 9, 2014. < http://www.newyorkfed.org/research/staff_reports/sr633.pdf > Read More