New Parity Concepts to Address Globalised Economy - Assignment Example

Financial institutions, pension funds, and institutional investors are reaching out to the developing and most prospective markets such as China, India and other Asian markets with a lot of investments. In this scenario, there has been a need for proper management of rate fluctuation, risk, and exchange rate, which allows the estimation of investment yields and global risk premiums. The important issue is hedging of specific international risks through currency overlay strategies, derivatives and credit risk management models.

In this highly globalized business scenario, issues in international business such as trade disputes, exchange rates, inflation and currency crises have necessitated more focus on international financial management. Some new approaches for this are characterized by high analytical rigor, substantial attention to empirical evidence, and integration of functional areas (including finance, economics, strategy, and accounting/taxation). (Reid W. Click, Joshua D. Coval, The Theory and Practice of International Financial Management, Prentice Hall; 1st edition) Global flows of funds have caused a substantial change in the international financial markets and foreign currency markets.

  These issues have a potential impact on currency values. Purchasing Power Parity (PPP), Interest Rate Parity, International Fisher Effect, Fisher Effect, and Forward Rates are some of the major theories on exchange rates.Regarding the parity issue, there are analytical problems with the standard comparisons based on market exchange rates existed in developing countries in the global economy. Purchasing Power Parity measures of Global Domestic Product of countries are popularly used for international comparisons.

In PPP measures as standard comparisons of GDPs across countries convert national currency aggregates to a common currency-the US dollar exchange rate. Purchasing Power Parity (PPP) is a theory of exchange rate determination and a way to compare the average costs of goods and services between countries. PPP has two versions, absolute PPP and relative PPP. The absolute version stands for an equal real price for a commodity in all countries. The relative PPP says that the exchange rate between the two countries will adjust to reflect changes in the price levels of the same countries.

(Solnik, International Investments, Adisson Wesley Longman, Inc, New York, 2000)However, interest rate parity thesis envisages as a relationship that holds between spot interest rates of two countries if there is to be no arbitrage opportunity. The relationship depends on the spot and forward exchange rates between the currencies. (http://www.riskglossary.com/link/interest_rate_parity.htm)The generalized version of the Fisher Effect states that real returns are equalized worldwide through arbitrage.

It says that many factors such as Psychological barriers, legal constraints, transaction costs, taxes, political risks, and currency risks have a direct bearing.