Risk and International Capital Flows - Essay Example

Summary of Risk and International Capital Flows of the of the No Summary of Risk and International Capital Flows Foreign Exchange Risks and Forecasting The foreign exchange risks that can be experienced in an economy occur in three forms, namely economic exposure, translation exposure and transaction exposure. If a country encourages dealing in forward-looking market instruments, invoice prices in currency value of the domestic country and accelerating collection process of currencies that are forecasted to depreciate, then the potential foreign exchange risks can be minimized. The difference between forward exchange rate and future spot value of exchange rate elaborates the value of premium of foreign exchange risk. If the returns from two investments are similar, then a risk reverse investor would always invest in the one that involves lower risks. The degree of risk aversion as well as risk accompanied with an asset determines differences between the returns on foreign and domestic assets. However, it should be noted that this effective return differential value of the assets is equivalent to that of the risk premium for every foreign exchange market. So, if effective rate of differential return between domestic and foreign assets is zero, then that implies that there exists no risk related to premium value in the foreign exchange market. Even so, the domestic currency would experience a positive risk return premium, provided that the host and foreign asset return differentials are positive (Hilsenrath and Peterson 1-5). It should be observed that if there is a positive risk premium value on the domestic currency of a nation, then investors in its economy will be willing to hold back foreign investments, even if returns procured from such investments are lower than that of domestic investments. All available product and service related information are reflected from price values in an efficient market system. In addition to that, it should be noted that if high efficiency exists in the foreign exchange market, then difference between expected value of future spot exchange rate and forward exchange rate would be correctly explained through value of the risk premium (Marsh 78). The multinational firms would not necessarily minimize their risk forecasting errors, if only good forecasts are made. For minimizing such errors, forecasted values of exchange rates set by multinational companies should be on correct side of the forward exchange rate (Melvin and Norrbin 1-335). Financial Management of the International Firm Multinational firms cannot control their operations without the help of adequate financial control. The management pattern of a multinational firm determines its method of governance. The governance pattern shared by a parent company with its foreign subsidiaries significantly influences the business centralization or decentralization activities. The liquid domestic and foreign assets of multinational firms are efficiently managed by its cash management system. If the cash management system of such firms is centralized in nature, then in order to lower overall cash requirements, parent body of the firm often offset receivables and payables of its subsidiary branches. Through the process of netting, payables and receivables of a multinational firm measured in terms of a single currency are consolidated. The trading is then accomplished through the only difference between them. Through the Letter of Credit (LOC), the bank assures to pay the exact amount that the exporter is supposed to receive from the importer, on behalf of the latter. Yet, exporters can only receive payments from bank with the help of certain legal documents relating to the trade deal. Payment cannot be received solely through LOC. Hence, with the help of a LOC, exporter would receive money from a trade deal, even if the importer fails to pay back the required money. The records regarding shipment of goods or receipt of these shipments are mentioned in the document, named bill of lading. The firms acquire money from banks in the form of draft and pay back the amount, only after completion of the maturity period. If one subsidiary of a multinational company transfers goods to another subsidiary, then the former charges a token money from the latter. This token charge is known as the transfer price. The transfer pricing strategies are used by multinational companies for lowering tax costs on profits. Under the regime of this system, the company transfers its profit from its subsidiaries located in high tax countries to branches in other economies, where tax rates are relatively lower (Melvin and Norrbin 1-335). The long-term investment decisions of corporate firms are determined through the process of capital budgeting. This process analyzes cash flow values of a project in present and future, by considering a particular value of money at a given point of time. The time required to pay back the investment amount of a project determines the underlying risk factor. The summation of the initial cost of investment of a project and its current cash flow value is termed as its adjusted present value. This summation often includes other financial costs that are related with investments. Financial Portfolio Management The process of two-way capital transfer between countries is termed as portfolio diversification; such transfers are present in situations where interest rates between nations are equal. The returns volatility from portfolio investments is measured by variance that shows deviation of each value from the mean figure. The certainties of portfolio returns are inversely related to the value of its returns variance. By diversifying the portfolio, volatility of its returns can be lowered. This is because through diversification, non-systematic risks can be lowered, though the systematic risks persist (Mankiw and Taylor 147). The investors often have a tendency to acquire larger proportion of home country assets in their portfolio. Even though their returns become more certain by inclusion of foreign assets, yet investors prefer these over the home assets; this is often known as home-bias puzzle. Nevertheless, home-bias puzzle can surface due to differences in home and foreign asset taxes, high cost of transaction for foreign assets and overvalued benefit estimated for international portfolio diversification. ADRs (American Depositary Receipts) are types of negotiable instruments, which represent shares owned by foreign firms. ADRs are sold in the United States stock market. Since this is the largest stock marketplace in the world, foreign companies desire to list their stocks in forms of ADRs in the U.S. market. Before advent of financial liberalization in 1980, stock markets of several economies had existed in form of segmented markets. Within these segmented markets, foreign investors were not allowed to trade their own stocks. The domestic investors were also not allowed to trade in foreign assets in such marketplaces (Snowdon and Vane 245). However, after trade liberalization, most financial institutions had become globalized. The risk premiums of assets of a home country are much lower since then. Such low risk premiums are accrued when the standard deviations of home and foreign country asset are greater than degree of correlation between international and home assets. Direct Foreign Investment and International Lending The foreign direct investment is a type of investment that involves capital flow whereby 10% or more of foreign firms voting shocks are acquired. Ownership powers of foreign companies are demanded because of imperfect competitive structures of markets and high quality performance of domestic firms. The level of foreign direct investments (FDI) has largely increased in U.S. and Europe, during the latter half of 1990 and in the periods of 2003 to 2007. The rise in investment in 1990 took place due to IT investment boom. On the contrary, the second rise was due to the bubble in real estate market. Figure 1: FDI Trends (Source: Melvin and Norrbin 1-335) Money supply can often experience a sudden fall in an economy due to political volatility, currency devaluation or recession. This process is known as capital flight. Extensive inflow of capital in an economy appreciates its currency value and lowers competitive advantages of the native business firms. The solvency related threats of creditors and large banks, during Latin American Debt crisis in 1980, had forced to postpone the debt repayments, instead of permitting defaults. Weak macroeconomic policies, poor domestic financial market system and external shocks had generated the Asian Financial Crisis in 1977. Any upcoming financial crisis in a nation can be forecasted correctly if the exchange rate system is fixed; the foreign reserves lower in an economy; and activities of the public authorities lack transparency. The Great Recession in 2008 was caused because foreign investors had invested in large amount of mortgaged backed securities, which were primarily backed by U.S. mortgages. The risks of mortgaged backed securities could be easily hedged through credit default swaps; there were several investors who simply leveraged their investment instruments as they felt overprotected. This had generated bankruptcies in multiple large investments banks (Melvin and Norrbin 1-335). Figure 2: Rising House Prices in U.S. (Source: Melvin and Norrbin 1-335) The International Monetary Fund (IMF) offers loans to countries, provided that nations alter their macroeconomic policies according to IMF, so that after implementing such policies, loan pay back capacities of the country improves in the long run. The clause of anti-corruption is also mentioned by IMF in the lending process. Through the country risk analysis, political and financial risks of an economy that can influence nation’s loan pay back capacity are analyzed. In this analysis, factors like, external debt to GDP, exports, international reserves and economic growth, are studied (Tucker 123). Works Cited Hilsenrath, Jon and Kristina Peterson. “Fed Doves Beat Hawks In Economic Prognosticating.” Wall Street Journal. (2013): 1-5. PDF file. Mankiw, Gregory N. and Mark P. Taylor. Microeconomics. Connecticut: Cengage Learning EMEA, 2006. Print. Marsh, David. The Bundesbank: The Bank that Rules Europe. London: Mandarin, 1992. Print. Melvin, Michael and Stefan C. Norrbin. “International Money and Finance.” Elsevier Inc. 2013, pp 1-335. PDF file. Web 31 March 2014. Snowdon, Brian and Howard. R. Vane. An Encyclopedia of Macroeconomics. Massachusetts: Edward Elgar Publishing, 2002. Print. Tucker, Irvin. B. Macroeconomics for Today. Connecticut: Cengage Learning, 2010. Print. Read More