International Financial Management - Assignment Example

International Financial Management Name Institution International Financial Management 1. In your own words define the separation of ownership and control based on Agency Theory. Discuss some of the complex issues facing Multinational Enterprises that may arise due to this separation of ownership and control. The separation of ownership and control in organizations refer to the practice of shareholders appointing managers to run firms for them. The managers are in control of the operations and decision made although they are not the owners of the organizations. Agency theory indicates that the managers and the shareholders of companies operate in a principal-agent relationship. The managers are the agents of the shareholders and they have to operate towards their best interest. In this relationship, the owners have to play an oversight role in order to ensure that the managers do not take advantage of the firm for their own good because they have authority to make decisions (Cheffins & Bank, 2009). The issue of the separation between ownership and control presents some serious challenges for multinationals. One of the main issues is the agency costs that the firm has to bear because of the asymmetric of the interests of the different stakeholders. The shareholders of a firm have to develop efficient oversight frameworks such as boards and audits to ensure due diligence in the actions of the managers. Another aspect of importance is that the firms have to provide significant motivation and incentives to align the interests of the managers and the shareholders. The issue of risk bearing and decision making is another problem facing multinationals. Agents are expected to make decisions that will produce the highest returns for the shareholders. However, these decisions may also involve significant risk that the shareholders may not appreciate (Ruiz-Porras & Lopez-Mateo, 2011). In this case, information asymmetry may hinder adequate decision making and risk bearing in multinationals. 2. Discuss in your own words, the functions of the foreign exchange market, market participants and transactions. The foreign exchange market involves the institutional and physical structure that enables money from one country to be exchanged for that of another country. It is a global structure because virtually every financial center has a center where the domestic currency is exchanged for foreign ones. The main function of the foreign exchange market is to enable the purchase and sale of foreign currencies by traders. The market plays an important role in determining the exchange rates for the different currencies because they are determined by the forces of demand and supply. It presents a ready framework for people in need of foreign currency in a country to get it easily in order to facilitate international trade (University of Colorado, 2013). The foreign exchange market has a transfer function in which it transfers purchasing power by converting one currency into another. In this way, it enables the consumers in one country to initiate bank drafts, international transfers, and foreign bills that clear debt in both directions. In this way, earnings made in one country can enter the national economy of another. The foreign exchange market also serves the function of providing credit for international trade. This is provided through foreign bills of exchange that enable the market to facilitate international trade and provide credit for a period of three months. The market also serves the purpose of minimizing foreign exchange risk faced by traders. Foreign exchange risk is addressed through hedging activities that are undertaken in the market. The market provides opportunities for investors and traders to mitigate changes in the foreign exchange rates and lower the risk of losses (University of Colorado, 2013). Market participants in the foreign exchange market are central banks, financial institutions, commercial banks, insurance companies, firms, and individual investors. The interbank or wholesale market consists of large volumes of currency and involves central banks, commercial banks, and non bank financial institutions. These institutions are involved in the market for speculative reasons as well as equity transactions to support trade. They are highly essential in providing liquidity in the foreign exchange market. Dealers also play a major role by buying foreign currencies and selling at slightly higher Ask prices. The retail market refers to the transactions undertaken in relatively smaller quantities for small investors and speculators. The transactions are carried out through foreign exchange brokers who are intermediaries between the wholesale and retail markets. The main participants in the retail market are investors, brokers and insurance or hedge funds. Unlike brokers, speculators and arbitragers trade in the market for profit by operating in their own interests. They operate in different markets in order to benefit from exchange rate changes (GTCM, 2015). The types of transactions in the foreign exchange market include spot transactions, forwards, and swaps. A spot transaction takes place almost immediately with delivery and payment taking place simultaneously. Forward transactions involve delivery of the purchased currency at a future value date for a specified exchange rate. The exchange rate to prevail is determined at the time of the agreement in order to mitigate unexpected changes. Swap transactions involve simultaneous sale and purchase of a given amount of foreign currency for two different dates. 3. Discuss in your own words, the theory of Purchasing Power Parity (PPP) and the difference between absolute purchasing power parity and relative purchasing power parity. The purchasing power parity is a formula for determining the amount of adjustment required on the exchange rate between two currencies for the exchange to equate the purchasing power of each country. It means that the nominal exchange rate between two currencies should equate to the ratio of the aggregate price levels in the two countries. By applying the purchasing power parity, a unit of currency in one country should have the same purchasing power in another. The theory suggests that a unit of currency should be able to purchase the same amount of goods as the equivalent amount of a foreign currency at the current exchange rate could purchase in a foreign country to ensure parity in the purchasing power of the unit of currency across the two economies (Taylor & Taylor, 2004). Absolute purchasing power refers to a situation where the purchasing power of a unit of currency is exactly equal in the domestic and foreign markets after considering the exchange rate. This means a bundle of goods should cost the same in one country as in another when the domestic currency is converted into the foreign one at the market exchange rate. Relative PPP refers to the variations in the purchasing power of different currencies because of inflation rates. Relative PPP indicates that the percentage change in the exchange rate over a period offsets the difference in inflation rates in the two countries during the same period. This is because higher inflation in one country causes the price of a basket of goods to rise hence the value of the currency has to depreciate in order to equate the prices of the commodities across the two economies (Ickes, 2001). In this case, the percentage in the nominal exchange rate is equal to the inflation differential between a foreign and domestic country. It provides an effective theory for assessing exchange rate movements when prices are changing very rapidly. 4. Happy Days (HDs) pet supplies company In order to determine the weighted average cost of capital for the company, it is necessary to determine the cost each of the two elements of debt and equity capital that are combined to form the capital base. Determination of the after tax cost of debt involves the prevailing cost of debt in the market multiplied by one minus the nominal tax rate to account for the tax deductibility of the interest expenses (NYU Stern, 2013). Cost of debt As a result, the firm’s projected costs of debt = pre-tax cost of debt * (1-marginal tax rate). Using the estimates from OzzBank, the projected cost of debt is HDs cost of debt in the Aus market * (1-corporate tax rate) = 6.5% *(1-0.3) = 6.5% * 0.7 = 4.55% In the case of AustBank, the cost of debt capital is = 6.8% *(1-0.3) = 6.8 * 0.7 = 4.76%. Cost of Equity The cost of equity capital consists of the risk free rate and a risk premium that is provided for the shareholders. Cost of equity capital = risk-free rate + (beta * market risk premium) Beta = covariance (Ra, Rb)/ variance of b. In this case, a is the asset under consideration while b is the benchmark (Tofallis, 2008). Market risk premium = market return – risk free interest rate For OzzBank, Beta = Cov (HDs, and market) / var (market) = 0.03888 / 0.03240 = 1.2 Market risk premium = 10% - 2.5% = 7.5% Cost of equity capital = 2.5% + (1.2 * 7.5%) = 2.5% + 9% = 11.5%. For AustBank, Beta coefficient = Cov (HDs, and market) / var (market) = 0.05610 / 0.04840 = 1.159 Market risk premium = 13% - 2.5% = 10.5% Cost of equity capital = 2.5% + (1.159 * 10.5%) = 2.5% + 12.18% = 14.68% Weighted average cost of capital  The WACC is determined by considering the weights of the two sources of capital based on their proportion in the total capital base. For OzzBank, WACC = (E/V) * cost of equity capital + (D/V) * cost of debt = (58/ 100)* 11.5% + (42/ 100) * 4.55% = 6.67 + 1.911 = 8.58% WACC = 8.58% For AustBank, WACC = (E/V) * cost of equity capital + (D/V) * cost of debt = (62/100) * 14.68% + (38/100) * 4.76% = 9.102 + 1.809 = 10.911% WACC = 10.911% 5. John is interested in inter-bank arbitrage.  Suppose that the following exchange rates are available to him and that he may either buy or sell at these rates. a. Does an opportunity exist to profit from arbitrage between the three markets? In order to determine whether an opportunity exists for profit between three currencies, the arbitrager focuses on assessing whether the one can gain from converting money from one currency to a second one and to a third one (Campbell, 2014). In this case, the currency may be converted from US Dollars to Euros then sterling Pounds and back to USD or US Dollars to Sterling pounds then to Euros and back to USD. In the first trade, USD-to-Euro-to-GBP- to- USD, The exchange rates for the three sets of trade are USD/ Euro = 1/ 0.77495, Euro to GBP = 1/0.89283, GBP to USD= 0.67782 Arbitrage profit for USD-to-Euro-to-GBP- to- USD = (1/0.77495) * (1/0.89283) * 0.67782 = 0.979652 In this case, the investor would not get any profit from the trade because for every US Dollar traded in Citibank New York, the value will decline to 0.979652 at the end of the three transactions. As a result, the trades would produce a loss for the arbitrager and it would not be advisable (Investopedia, 2015). In the USD-to-GBP-to-Euro-to-USD trade, The exchange rates are USD to pound = 1/0.67782, Pound to Euro = 0.89283, Euro to USD = 0.77495 Arbitrage profit = (1/0.67782) * 0.89283 *0.77495 = 1.02077 By exchanging the US Dollars for British Pounds then to Euros, and back to Dollars, the arbitrager would gain a profit. The trades produce a profit of 0.02077 US Dollars for each dollar that is traded in the first market and taken through the set of three transactions. It would be advisable for the arbitrager to take these transactions because they produce a profit from the triangular arbitrage in the three markets. b. If John has US$1 million to arbitrage with, what would be the result (profit or loss) from triangular arbitrage? If John has a million US Dollars, USD-to-Euro-to-GBP- to- USD would produce 1,000,000 * (EUR1/USD 0.77495) * (GBP1/EUR 0.89283) * USD0.67782/GBP1 = 1,000,000 * (1/0.77495) * (1/0.89283) * 0.67782 = USD 979,652 This produces an arbitrage loss of 1,000,000 – 979,652 = USD 20,348 With a million dollars using the second trade, USD-to-GBP-to-Euro-to-USD produces 1,000,000 * GBP1/USD 0.67782 * Euro 0.89283/ GBP1 * USD 0.77495/ 1 Euro = 1,000,000 * (1/0.67782) * 0.89283 *0.77495 = 1,020,770 This produces an arbitrage profit of $1,020,770- $1,000,000 = $20,770. References Campbell, B. (2014). Triangular Arbitrage. Retrieved Aug 26, 2015, from http://financialexamhelp123.com/triangular-arbitrage/ Cheffins, B., & Bank, S. (2009). Is Berle and Means really a myth? Business History Review , 83 (3), 443–474. GTCM. (2015). Forex Market Participants. Retrieved Aug 26, 2015, from http://www.gtcm.com/Knowledge-Center/Forex-Market-Participants Ickes, B. W. (2001). Lecture Note on Absolute and Relative PPP. Retrieved Aug 26, 2015, from http://grizzly.la.psu.edu/~bickes/real.pdf Investopedia. (2015). Triangular Arbitrage. Retrieved Aug 26, 2015, from http://www.investopedia.com/terms/t/triangulararbitrage.asp NYU Stern. (2013). The Weighted Average Cost of Capital Tutorial. Retrieved Aug 26, 2015, from http://pages.stern.nyu.edu/~igiddy/articles/wacc_tutorial.pdf Ruiz-Porras, A., & Lopez-Mateo, C. (2011). The Separation of Ownership and Control and Investment Decisions in Mexican Manufacturing Firms. International Business Research, 4 (1), 51-61. Taylor, A. M., & Taylor, M. P. (2004). The Purchasing Power Parity Debate. Journal of Economic Perspectives, 18 (4), 135-158. Tofallis, C. (2008). Investment Volatility: A Critique of Standard Beta Estimation and a Simple Way Forward. European Journal of Operational Research, 187 (3), 1358–1367. University of Colorado. (2013). The Foreign Exchange Market. Retrieved Aug 26, 2015, from http://www.colorado.edu/Economics/courses/boileau/4999/sec3.PDF Read More