Arbitrage Process When Fixed Exchange Rates Have Differing Prices and Illustrate Your Answer with the Supply and Demand Model
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MGT 3460 Assignment #1 Questions and Solutions 1. How is international financial management different from domestic financial management? Answer: There are three major dimensions that set apart international finance from domestic finance. They are: 1. foreign exchange and political risks, 2. market imperfections, and 3. expanded opportunity set. We are now living in a world where all the major economic functions, i.e., consumption, production, and investment, are highly globalized. It is thus essential for financial managers to fully understand vital international dimensions of financial management. This global shift is in marked contrast to a situation that existed when the authors of this book were learning finance some twenty years ago. At that time, most professors customarily (and safely, to some extent) ignored international aspects of finance. This mode of operation has become untenable since then. 2. State the theory of comparative advantage. From the following table calculate the opportunity costs for each country A and B of producing goods X and Y with a unit of generalized input K. Draw the production possibility boundaries for each country. Draw the consumption (trade) possibilities boundary for each on the PPB graphs assuming that the terms of trade are 50/50 (.5). What considerations might limit the extent to which the theory of comparative advantage is realistic? According to David Ricardo, with free international trade, it is mutually beneficial for two countries to each specialize in the production of the goods that it can produce relatively most efficiently and then trade those goods. By doing so, the two countries can increase their combined production, which allows both countries to consume more of both goods. This argument remains valid even if a country can produce both goods more efficiently than the other country. International trade is not a ‘zero-sum’ game in which one country benefits at the expense of another country. Rather, international trade could be an ‘increasing-sum’ game at which all players become winners. The theory claims that economic well-being is enhanced if each country’s citizens produce what they have a comparative advantage in producing relative to the citizens of other countries, and then trade products. Country A B Units of input (000,000) K 100 200 Output per unit of input X 50 20 Y 30 10 1 What considerations might limit the extent to which the theory of comparative advantage is realistic? Answer: Underlying the theory are the assumptions of free trade between nations and that the factors of production (land, buildings, labor, technology, and capital) are relatively immobile and there is full employment. To the extent that these assumptions do not hold, the theory of comparative advantage will not realistically describe international trade. The figure below shows the PPC for each country, with the respective opportunity costs for each good in each country. Country A can produce Y more efficiently (lower cost) and Country B can produce X more efficiently. Therefore the trade possibilities curves (dashed lines) at 50/50 sharing terms of trade start at the good each country will specialize in and expand out beyond the PPC. CountryA Y (Opp cost = 1.67) |Slope| = .6 3000 |Slope| = .5 The PPC slope for Country PPC TPC Trade Possibilities Curve: |Slope| = .55 5000 X (Opp cost = .6) Production & Trade Possibilities Country B Y (Opp TPC Trade Possibilities Curve: |Slope| = .55 cost = 2) 2000 |Slope| = PPC .5 |Slope| = .6 The PPC slope for Country 4000 X (Opp cost = .5) 2 3. Emphasizing the importance of voluntary compliance, as opposed to enforcement, in the aftermath of corporate scandals, e.g., Enron and WorldCom, U.S. President George W. Bush stated that while tougher laws might help, “ultimately, the ethics of American business depends on the conscience of America’s business leaders.” Describe your view on this statement. Answer: [There can be different answers to this question] If business leaders always behave with a high ethical standard, many of the corporate scandals we have seen lately might not have happened. Since we cannot fully depend on the ethical behavior on the part of business leaders, the society should protect itself by adopting the rules/regulations and governance structure that would induce business leaders to behave in the interest of the society at large. 4. What are the advantages and disadvantages of the gold standard. Explain the mechanism which restores the balance of payments equilibrium when it is disturbed under the gold standard. Answer: The advantages of the gold standard include: (I) since the supply of gold is restricted, countries cannot have high inflation; (2) any BOP disequilibrium can be corrected automatically through cross-border flows of gold. On the other hand, the main disadvantages of the gold standard are: (I) the world economy can be subject to deflationary pressure due to restricted supply of gold; (ii) the gold standard itself has no mechanism to enforce the rules of the game, and, as a result, countries may pursue economic policies (like de-monetization of gold) that are incompatible with the gold standard. Explain the mechanism which restores the balance of payments equilibrium when it is disturbed under the gold standard. The adjustment mechanism under the gold standard is referred to as the price-specie-flow mechanism expounded by David Hume. Under the gold standard, a balance of payment disequilibrium will be corrected by a counter-flow of gold. Suppose that the U.S. imports more from the U.K. than it exports to the latter. Under the classical gold standard, gold, which is the only means of international payments, will flow from the U.S. to the U.K. As a result, the U.S. (U.K.) will experience a decrease (increase) in money supply. This means that the price level will tend to fall in the U.S. and rise in the U.K. Consequently, the U.S. products become more competitive in the export market, while U.K. products become less competitive. This change will improve U.S. balance of payments and at the same time hurt the U.K. balance of payments, eventually eliminating the initial BOP disequilibrium. 5. Explain the arbitrage process when fixed exchange rates have differing prices and illustrate your answer with the supply and demand model. What would be the effect of transactions costs on your answer? Answer: As with anything bought and sold, if exchange rates are different in different markets yet are ‘fixed’ by each country there is an opportunity for arbitrage— the process of buying in the low priced market and selling in the high priced market and pocketing the difference as profit. See graph below for illustration using the supply and demand model. 3 Arbitrage Market A Market B P P S S S* PA Pe B D P D* D Y* QY Y* QY Sell in the high market S Buy in the low market D Arbitrage brings markets together over space, bringing a common price (except transaction costs). 6. Why did the Bretton Woods system fail? Answer: The answer to this question is related to the Triffin paradox. The US was providing the world with currency using the $35/ounce gold standard. Under the gold-exchange system, the reserve-currency country should run BOP deficits to supply reserves to the world economy, but if the deficits are large and persistent, they can lead to a crisis of confidence in the reserve currency itself, eventually causing the downfall of the system when there is a “run” on the bank, as in the case of France redeeming gold for large amounts of US$. 7. What are the criteria for a ‘good’ international monetary system? Answer: A good international monetary system should provide (i) sufficient liquidity to the world economy, (ii) smooth adjustments to BoP disequilibriums as they arise, and (iii) safeguard against the crisis of confidence in the system—A banker of last resort. 8. What do you consider determines the possibility for the euro to become another global currency rivaling the U.S. dollar? If the euro really becomes a global currency, what impact will it have on the U.S. dollar and the world economy? 4 Answer: The degree of use of the Euro in Europe and the in the world. In light of the large transactions domain of the euro, which is comparable to that of the U.S. dollar, and the mandate for the European Central Bank (ECB) to guarantee the monetary stability in Europe, the euro is likely to become another global currency over time. A major uncertainty about this prospect is the lack of political integration of Europe. If Europe becomes politically more integrated, the euro is more likely to become a global currency. If the euro becomes a global currency, it will come at the expense of the dollar. Currently, the U.S. derives substantial benefits from the dollar’s status as the dominant global currency – for instance, the U.S. can run trade deficits without having to maintain substantial foreign exchange reserves, can carry out international commercial and financial transactions in dollars without bearing exchange risk, etc. If the euro is to be used as a major denomination, reserve, and invoice currency in the world economy, dollar- based agents will start to bear more exchange risk, among other things. 9. Why is it useful to examine a country’s balance of payments data? Answer: It would be useful to examine a country’s BoP for at least two reasons. First, BoP provides detailed information about the supply and demand of the country’s currency. Second, BoP data can be used to evaluate the performance of the country in international economic competition.