FINC20023 - INTERNATIONAL FINANCIAL MANAGEMENT

FINC20023 - INTERNATIONAL FINANCIAL MANAGEMENT

Assessment Task 2 – (Individual) Test of Knowledge

Answer 1) Twin Agency Problem:

The management of the company or controlling shareholders can use their power and hold on decision making for their own benefit but at the expense of outside investors. The people in the management cadre are elected to act in the profit/wealth maximization of shareholders but they can act in a way so as to get profited themselves as they have access to varied internal information. For example, in many companies, the management shows inflated figures in balance sheets for profits but in actuality, there is no profit. The shareholders do not have information regarding the financial health of the company and they believe in figures posted by the management in balance sheets and account statements.  This case has happened in Enron. This is called the Twin agency problem.

In order to reduce Twin agency problem,

1) Regulations should be put in place via contract or laws so that the managers act in favour of the shareholders and put their interest below that of the shareholders. There should be laws that protect the shareholders in case of possible fraud/conflict of interest by the agents/ managers.

2) We can also give incentives or tie the compensation of managers/agents with the performance of the company so that they act in maximising the returns to the shareholders. They can be given ESOPs/ shares of the company/dividend payout etc. Their compensation can be tied to the company's performance in the form of issuance of the bonus if the company performs well. A bonus will be given to them only if they achieve the targeted performance value.

3) They can be threatened that if they do not act in favour of shareholders then they can lose their jobs or the company can be taken over.

4) The power, authority, and ownership can be decentralised and smaller organisations can be formed so mitigate the agency problem.

5)  Transforming the state holding company into an employee holding a dispersed company.

Answer 2)

The main goal of Shareholder wealth maximization for businesses is to maximize shareholders' wealth or the market value of a share of the company and to increase earnings per share (EPS). Whereas in the case of the Shareholder capitalism model, the interest of all the stakeholders of the company such as customers, suppliers, partners, investors, employees, shareholders, workers, etc. are considered equally. 

The shareholder wealth maximisation is a category of stakeholder capitalism model where only shareholders are given priority.

In the case of corporate governance, all the stakeholders are given priority and not only the shareholders so this leads to agency problems wherein there is a conflict of interest.

While considering these models ethically it is seen that in shareholder wealth maximisation model, the manager considers only things that will generate high profitability and lead to increase in price, which might include cost-cutting, reduction in pay wages, reduction in quality, etc. whereas in case of stakeholder capitalism model, this behaviour is called unethical as the other stakeholders of the company namely employees, customers are not considered at an equal level.

In case of SWM, the shareholders are affected by the performance of the company on financial basis whereas in the case of SCM many factors such as wages of the workers, quality of product and services, etc

The share price shows the intrinsic value of the firm as per SWM whereas in SCM there is no consideration of efficiency in the price of the shares.

The risk considered and paid importance is the systematic risk in the case of the SWM whereas, in the case of SCM, unsystematic risk is taken as important.

In SWM, the decisions are based on increasing the price of the stock in the short term whereas, in SCM, long term profitability and stability of the company is considered.

In SWM, the strategies are made on the behalf of shareholders by the managers(whose compensation may be tied to the performance of the company) whereas in case of SCM strategies are made by keeping in mind long-term stakeholders rather than mobile portfolio investors.

In case of shareholder wealth maximisation, the goal is to earn high profitability and increase in the market price of the company whereas in case of stakeholder capitalism the goals of each stakeholder may vary for example a customer wants low prices and better quality of product and services, employees want higher wages, benefits, etc. So in this model, the manager has to make a trade-off among these goals.

Answer 3) The Current account implies transactions relating to income and expenses while capital transactions include transactions relating to capital goods.

(a) Insurance payment is a current account transaction.

(b) The purchase of a Laptop is a current account transaction.

(c) German investor buys some Australian treasury bonds, will come Capital and Financial account.

(d) Hiring an Australian consultancy firm to solve some issues - Current account.

(e) Purchase of 100% shares of a foreign company is a capital account and financial transaction 

Answer 4) A trilemma offers three equal solutions to a complex problem. A trilemma suggests that countries will have three options from which to choose when making fundamental decisions about managing their international monetary policy agreements. However, the options of the trilemma are conflictual because of mutual exclusivity, which makes only one option of the trilemma achievable at a given time.

Trilemma often is synonymous with the "impossible trinity," also called the Mundell-Fleming trilemma. This theory exposes the instability inherent in using the three primary options available to a country when establishing and monitoring its international monetary policy agreements. The Impossible Trinity (Economic Trilemma) is an important concept in international economics which was developed independently by both Fleming and Mundell. It states that it is virtually impossible to have all of the following three at the same time and governments that have tried to simultaneously pursue all three goals have failed.

Fixed Foreign Exchange Rate

Free Capital Movement with no fixed currency exchange rate agreement (i.e absence of capital controls)

An independent/ autonomous monetary policy.

The above diagram shows "The Impossible Trinity or "The Economic Trilemma", in which only two policy positions are possible at a given point of time. For example, If a nation were to adopt position "a", then it would maintain a fixed exchange rate and allow free capital flows, the consequence of the same would be loss of monetary sovereignty /Independence. Now we shall discuss each type of policy alternatives available to the monetary authority under different scenarios with the help of the above diagram.

Side A of Triangle: A country can choose to fix exchange rates with one or more countries and have a free flow of capital with others. If it chooses this scenario, an independent monetary policy is not achievable because interest rate fluctuations would create currency arbitrage stressing the currency pegs and causing them to break.

Side B of Triangle: The country can choose to have a free flow of capital among all foreign nations and also have an autonomous monetary policy. Fixed exchange rates among all nations and the free flow of capital are mutually exclusive. As a result, only one can be chosen at a time. So, if there is a free flow of capital among all nations, there cannot be fixed exchange rates.

Side C of Triangle: If a country chooses fixed exchange rates and independent monetary policy it cannot have a free flow of capital. Again, in this instance, fixed exchange rates and the free flow of capital are mutually exclusive.

Answer 5)

Step 1: Buy € from Bank 2

1 A$ = €0.7143

1,500,000 A$ = € 1,111,950

Step 2: Now convert the € 1,111,950 into $ from Bank 3

1 € = $1.09

€ 1,111,950 = $ 1,212,025.50

Step 3:Convert $ to A$ from Bank 1

1$ = 1 / 0.5880 A$

$ 1,212,025.50 = 2,061,267.86 A$

Return = 2,061,267.86 - 1,500,000 = 561,267.86

Return in percentage = 561,267.86 / 1,500,000 = 37.42%

Answer 6)

Fisher Effect: It is an economic theory that tries to find out that the connection and association between inflation and both real and nominal interest rates. It was propounded by Irving Fisher. It states that the real interest rate equals the nominal interest rate minus the expected inflation rate. Therefore, when there is an elevation in the inflation rate, the real interest rates keep on falling as inflation increases, until and unless there is an increment in the nominal rates similar to that of inflation. For example, if the nominal interest rate on a savings account is 5% and the expected rate of inflation is 4%, then money in the savings account is really growing at 1%. The smaller the real interest rate the longer it will take for savings deposits to grow substantially when observed from a purchasing power perspective.

Organisation having global operations and dealings in multiple currencies need to understand the effect of this scenario (Fisher effect) so as to control their enterprise risk exposure to variation in the rate of foreign exchange. If the purchasing power in different countries is equal then this suggests that there is equilibrium in their exchange rates. This means that the ratio of the price level of a fixed amount of goods and services of the two countries and the exchange rate between those two countries must be equivalent. This theory is Purchasing Poer parity theory of exchange rate.

With respect to the global scenario, few factors are to be taken into account.

1) There are majorly two different types of financial exposures in multinational organisations. They are transactions exposure and Translation exposure. An in-depth comprehension of the Fisher Effect will help in devising and formulation of strategies so as to mitigate the risk emerging due to changes in the rate of interest and the resultant consequences of the variation in the purchasing power of the currency.

2) The multinational organisations tend to invest in many different countries and their economies via stock markets and money market instruments. The Fisher Effect can help the decision-makers in deciding whether to hold the investment or sell it considering the variations in the exchange rates.

3) The companies trading in the global environment manage the exchange rate risk with the help of options, forward and futures contracts. Their prices can be compared to the expected value by using the Fisher effect and fair value can be reached.

Answer 7)

The following details are provided in the problem

a) Initial spot exchange rate= €0.7143/A$

b) The initial price of the car is €50,000

c) Forecast of Australian $ inflation rate is 0%

d)Forecast of Germany inflation at 2%

To calculate the export price for the Car at the beginning of the year by using the formula

= Initial price of a car / initial spot exchange rate

= 50000 / 0.7143 = A$69998.6

4) Assuming 80% pass-through of the exchange rate, the dollar price of a Car be $ at the end of the year:

The inflation rate in Germany is 2 % and PPP pass through is 80%, the proportionate change is 2% x 0.8 is 1.6%

The Effective exchange rate used by the car to price in A$ for end of the year is 0.7143 /1.016 is 0.70305 and the Australian dollar price of the car will be

= 50000/0.70305 = A$ 71118.697

Answer 8)

Since John is expecting an appreciation in yen he should go long on Yen. Whenever you want to go long on an asset you buy a call option so he should buy a call option.

Net Profit & Loss = Spot price- Strike price-Premium

Profit= $.01-$0.009615-$0.000041= $.000344 per Yen

Answer 9) Initially, Great Britain Pound (GBP) and the Australian Dollar exchange rate is £0.6223/A$.

Australian Dollar and Euro exchange rate is A$1.55/€

After some time, Great Britain Pound (GBP) and the Australian Dollar exchange rate is £0.6101/A$.

Australian Dollar and Euroexchange rate is A$1.50/€

Percentage Change in Australian dollar with respect to GBP 

= {(1.6069419-1.63907)/1.6069419}*100

= -1.99933%

Percentage Change in Australian dollar with respect to Euro 

=  {(0.64516- 0.66667)/0.64516}*100

= -3.334%

In both cases, the Australian dollar is depreciating with respect to other currencies.

Answer 10) Given Information:

Amount receivable = ¥40,000,000

Spot rate: 1A$ = ¥87.35, 2 month Spot rate: 1A$ = ¥91.45 and 2 month forward rate: 1A$ = ¥89.50

2 month borrowing rate: Australia Dollar = 6.00% and Japanese yen = 8.00%

2 month investment rate: Australia Dollar = 4.00% and Japanese yen = 3.20%

Weighted average cost of capital = 10%

Option A: Remain unhedged:

Amount to be received in A$ = 40,000,000 / 91.45 = A$ 437397.48

Option B: Forward Market:

Amount to be received in A$ = 40,000,000 / 89.50 = A$ 446927.37

Option C: Money Market Hedge:

Borrow in  ¥, Convert in A$, invest in A$, convert¥ in 2 months.

Amount of ¥ that need to be invested today to get 40m after 2 months = 40,000,000 / {1+ 0.0133**} = ¥39473814.0585

Amount of A$ needed to be converted in ¥ = ¥39473814.0585 / 87.35 = A$ 451903.996

Interest and principal on A$ loan after 2 months = 451903.996 x 1.006667** = A$ 454915.701

Amount in Yen after 2 months = 454915.701*91.45 = ¥41,602,040.923

Decision: The organisation must adopt the money market hedge because it results in the maximum amount to be paid in the Australian dollar and an excess amount is left.

**Rate for investment and borrowing is calculated on a monthly basis as the given rate is on a per annum basis.