Question 1
Maintaining a fixed exchange rate is critical in stabilizing the value of a currency against an anchor currency as it makes trade and investment easier and more predictable. Nonetheless, central banks face a number of problems in their attempts to maintain fixed exchange rate, two of which include balance of payment problems when attempting to maintain a weak currency and reduced risk perception while borrowing in foreign currency when attempting to maintain a strong currency. When maintaining a strong currency, a false perception arises that the foreign exchange rate may not change thereby leading to reduced risks perceptions when borrowing in foreign currency such as the case of Brazil. Trying to keep the currency weak makes exports cheaper abroad and members of the country have to pay more for imports. This leads to a reduction in standards of living relative to other countries since the country’s exports would be cheaper while the imports expensive such as the case of China. Devaluation leads to the falling of prices which control imports while stimulating exports, this presents dangers to BOP since prices will likely be forced to fall while the cost do not, hence leading to depression and unemployment.
Question 2
Jerry Putnam’s lists of exchange functions of executing orders, aggregating information and regulating exchange participants is incomplete as there are multiple additional functions. Exchange serve the function of price determination in that it provides mechanisms by which prices are set, both for the existing stock of financial assets and the newly issued ones. It also serves both the purposes of risk sharing in which it allows for the transfer of risk from investors to those providing risk for investment and efficiency, reducing information and transaction costs. Exchange also serve the function of borrowing and lending permitting funds transfer from one agent to another and also allowing liquidity, providing holders of financial assets with the opportunity to resell or liquidate. It also provides clearing house facility, facilitates healthy speculation, serves as economic barometer and facilitate evaluation of securities. The three primary functions of the international currency market are to convert currency of one country into another currency, facilitate international financial transactions and determine and stabilize the currency value of a country.
Question 3
The two main examples described in calculating an international index are the Morgan Stanly Capital International (MSCI) Emerging Markets Global (EMG) and the International Finance Corporation Global (IFCG). The indices are competing with each offering its own emerging market index weighted differently hence presenting the problem of ambiguity. MSCI (EMG) and (IFCG) are weighted by the total market capitalization, while MSCI (Emerging Market Free (EMF) and IFC Investable (IFCI) are weighted based on the proportion of market cap that foreigners can access. The second problem is that the two approaches have different implications hence making it difficult to determine the specific basis by which allocation decisions can be made. The two mechanisms results into less meaningful indices as a result of two reasons. First, none is objective since each of the mechanisms incorporate differing judgment on the weight of each country, each company and each industry. It is therefore difficult to rely on arbitrary index construction rules given the potential for active stock selection in adding value in emerging markets. Secondly, the cap weighted indices tend to concentrate their exposure within the highest-capitalization markets within any given time hence increasing portfolio risk while cutting returns by magnifying exposure to the overvalued markets. This result into very high transaction costs required to keep track of a cap-weighted index since emerging capital markets’ composition is constantly in flux. The indices are critical as they act as the guidelines for investors when considering investment options in the international market. The indices also help investors in optimizing weights thereby increasing returns and reducing risks. There is no existing means of overcoming the problems of calculating the international index since the shortcomings are as a result of several factors that define the emerging markets, hence are impossible for any of the indices to fix.
Question 4
The first reason provided to discourage firms from hedging is that hedging always turns out to be unfavorable due to the difficulty in managing financial risk. There have been multiple derivatives disasters such as the cases of AWA and Barings which have been as a result of firms’ inability to control the hedging process. It has also been argued that financial market risks are diversifiable hence there are no advantages in bearing already diversifiable risks. It has also been argued that on the basis of efficiency of the financial markets, hedging may not alter the expected future cash flow besides it is argued that since hedging does not change either the expected future cash flow or the required rate of return, it adds no value to the hedging risks which are diversifiable. Contrastingly, a number of reasons have been advanced in support of the hedging process key among them being that it increases firm’s borrowing capacity and reduces a corporation’s chance of falling into financial distress. Hedging reduces the volatility of corporate value thereby increasing the willingness of lenders to provide debt. Additionally, since hedging reduces the variance of future cash flow, it reduces a corporation’s chances of falling into financial distress.
Question 5
Theoretically, under the free trade policy, prices emerge from unregulated supply and demand which forms the sole determinants of resource allocation. Assuming that there are two countries, with two industries each having one factor of production labor, no cost of transport between them, no labor mobility between the countries, perfect competition, and full employment. And assuming that production technology may be different between the countries and consumers maximize utility based on budgetary constraints, then analyses indicate that the home and foreign countries would have varying unit labor inputs on the two products leading to difference in the rate of sacrifice. The difference would create a comparative advantage since as long as there are differences in the two countries’ labor inputs, there will always be a comparative advantage. Both the importing and exporting countries will have a comparative advantage hence everyone one would benefit from the trade. Non-cooperation of countries and unbalanced development may be some of the frictions that would prevent the gains of free trade from being realized. Free trade works when countries cooperate with each other, nonetheless, some countries may gain more by imposing import restrictions. Additionally, since countries have varying degrees of development, hence the more developed countries with more developed industries will have a comparative advantage over their less developed counterpart. The winners would be the industrialized nations while the losers, the developing, less economically stable nations.
Question 6
The three international parity conditions variables are the Purchasing Power Parity, the covered interest rate parity (CIRP) and the uncovered interest rate parity (UIRP). PPP is concerned with the prices and the exchange rates or the relative values of the two country’s currencies. CIRT identifies the relationships between the spot exchange, the interest rates and the forward exchange rates and URP establishes the relationship between the changes in exchange rates and interest rate differentials within the countries. The purchasing power parity is most likely to hold since it is based on the postulation that demand for a country’s currency is derived from the demand in the goods produced by this country. It therefore a critical indicator on whether nominal exchange rates have an impact on real variables such as the return on a portfolio of assets or the value of a firm.
