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MGMT2023 - Assignment on International Finance Management

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University of the West Indies, Mona

   

Financial management (MGMT2023)

   

Added on  2020-03-07

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MGMT2023 - In this assignment, we will discuss International Finance Management under which we have covered returns from Investments in Argentina, Carry Trade, Triangular Arbitrage, Implication of Triangular Arbitrage,  Inflation and Forward Rate, Benefits and Cost of range forward or collar arrangements, Non-Market versus Market Hedging.

MGMT2023 - Assignment on International Finance Management

   

University of the West Indies, Mona

   

Financial management (MGMT2023)

   Added on 2020-03-07

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Running head: International Finance Management 1International Financial Management AssignmentStudent’s NameName of University
MGMT2023 - Assignment on International Finance Management_1
International Finance Management 21(a) Returns from Investments in ArgentinaInvestment in Argentina may not yield a higher return on investment than that in the United Kingdom despite having high-interest rates. This is because of the high inflation rates recorded in Argentina versus those in the United Kingdom. The relationship between interest rates, exchange rates and inflation is given by the Purchasing Power Parity (PPP) and the InterestRate Parity (IRP) theories. According to the propositions of the IRP, high-interest rates cause thevalue of the currency, (Argentinean Peso) to increase. According to the PPP, when a country’s inflation increases relative to the foreign country, the high inflation depresses the home country’scurrency (Jasper, n.d.). The exchange rates adjust to take into account the changes in inflation rates. In April 2017, inflation in the UK was 2.7 and in Argentina, the inflation rate stood at 27.5(Trading Economics, 2017). The investor would convert pounds to Argentinean pesos so as to take advantage of the high-interest rates. However, the investor faces losses when converting the pesos back to pounds given the deterioration of the peso due to high inflation rates.1(b) Carry Trade The carry trade refers to a situation whereby investors borrow funds in countries with lower interest rates to invest in countries with higher interest rates (Mander, 2017). The investors’ profits are realised due to the interest differential between the two countries. According to Ames, Bagnarosa, and Peters (2014), the presence of a carry trade is a financial puzzle because foreign exchange risks are present. The Uncovered Interest Parity (UIP) assumes that the potential for foreign exchange risk, which would result from changes in exchange rates, would offset the potential benefits realised by way of profits that arise from the interest rate differentials. The interest rate parity is based on the assumption that there is capital mobility, andthere is a perfect conversion from domestic to foreign assets. In addition to the foreign currency
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International Finance Management 3risk, there is the risk of default on the part of the borrower. The best example of the default risk associated with the carry trade was in 2008-2012 that resulted in the Icelandic financial crisis.1c) Hedging It is important for the beef importers to use derivatives to hedge against interest-rate movements. This is because the movements in the interest rates will have an impact on the foreign currency market. According to the interest parity condition, arbitrageurs can achieve profits by borrowing in countries where the interest rate is low, changing the borrowed funds intoforeign currency and investing in the foreign country with high-interest rates (Mishkin, 2009). As such the value of the Argentinean Peso is expected to increase as foreign investors seek to earn the high-interest incomes. The strengthening peso could negatively impact the beef importers. In order to hedge against the potential losses arising from currency movements occasioned by high-interest rates, the beef importers can use derivatives. Hedging involves taking an investment position that is designed to offset anticipated losses. Hedging does not eliminate the risk; it merely reduces the risk (Madura, 2007). Derivatives are financial contracts that stipulate certain terms and conditions such as the date of performance, the value of performance, identify the underlying assets, and define the contractual obligations of parties to the contract (Hull, 2011). The beef importers could use options, forwards, futures and swaps. 2(a) Triangular Arbitrage In the school of finance, the term arbitrage refers to the situation where there is a difference between the price of a specific commodity in two or more markets. These differences between two or more markets offer opportunities to make profits. The arbitrageur identifies the differences in the prevailing market conditions and makes deals that exploit the differences in the
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International Finance Management 4market. The profit is the difference between the buying price and selling price prevailing in the two markets (He, 2013). The most common type of arbitrage in the currency market is the two point arbitrage. This occurs where there is a negative spread between the ask price and the bid price (Forex Capital Markets, 2017). Triangular arbitrage also referred to as cross-currency arbitrage involves more than two currencies. The relationship between the three currencies is given as Currency 1/ Currency 2 x Currency 3/Currency 1 = Currency 3/Currency 2USDARS x GBPUSD= GBPARS 14.25 x 1.3= 18.53 ≠ 19.5Where the equation does not hold then a situation of arbitrage exists. Given that there is apricing discrepancy, then the condition of triangular arbitrage exists.2(b) Implication of Triangular Arbitrage The implications of triangular arbitrage are two- fold. Firstly, the transactions can lead to volatility in the foreign exchange markets. Using technology, market participants (mostly banks) are able to identify foreign exchange differentials use arbitrage to capitalise on the differences. This entails moving large amounts of currency in and out of different markets then revising the situation a few minutes later. The movement from one currency to another results in sudden changes in prices and creates volatility in the currency markets (Fenn, Howison, McDonald, Williams, & Johnson, 2009). The second implication of triangular arbitrage is counter to that given by Fenn et al., (2009). According to Madura (2007), triangular arbitrage creates stability in the currency markets. In situations where small price discrepancies are not identified quickly, the discrepancies continue to increase and become more pronounced. As a result, firms and individuals who transact in foreign currency spend more time searching for the
MGMT2023 - Assignment on International Finance Management_4

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