Challenges to IMF Effectiveness and the Role of Derivatives in Protecting Against Failings of IFE and PPP

This article discusses the challenges to IMF effectiveness and the role of derivatives in protecting against the failings of IFE and PPP. It evaluates the theories of purchasing power parity and international Fisher effect and how derivatives can be used as a risk management tool. The article also highlights the criticisms of these theories.

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International Finance Management
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INTERNATIONAL FINANCIAL MANAGEMENT
IMF effectiveness is dependent on whether the players see it as impartial and competent.
According to the article, IMF is like a referee officiating a football match where it depends if
the players see it as impartial and competent (Eun and Resnick, 2014). The effectiveness of this
institution are limited by failure to meet its challenges. As an advisor, the institution’s
impartiality is called into question because it doesn’t always know what to advise. According to
the article, there are four challenges that pose a threat to the legitimacy of the IMF and thus the
institution’s capacity to execute its main functions (Kirton, 2009).
Organizing surveillance through which the institution monitors policies made by its member
countries both financial and economic policies is the first unmet challenge. This highlights
possible risks to advises that are needed on policy adjustments. The funds original mandate was
to focus on engaging in ruthless truth telling that would make exchange rates to be stable.
However, the surveillance moved from the main focus of exchange rates issues to virtually
everything and anything with implications for financial and economic stability (Levi, 2016).
There is no longer the blunt truth telling as envisaged and this can be clearly shown because the
fund did not warn the U.S of the subprime crisis , the Greek debt crisis or the global financial
crisis. On the three events, the IMF batted 0 to 3 showed that it has no capacity to highlight risks
to stability.
The second unmet challenge is the conditionality that IMF gives its loans out with. This is the
commitment that governments makes in terms of policy in order to receive assistance (Imf.,
2016). The disagreements comes in when questions of the number of commitments and what
kind of commitments that the IMF asks from the governments. This is because in some of the

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commitments , the IMF infringes on the sovereignty of the member country and so according to
the article, the member countries do not view the IMF institution as an institution that is out here
trying to promote the welfare of the individual member states (Hartley, 2011). If the IMF and the
member country have similar objectives , why are there conditions set in the first place.
The third unmet challenge is that there is disagreement about the role of IMF in sovereign debt
management. This challenge is created by the absence of a legal framework that is needed to
resolve debt crises , also contributing to this challenge is the existence of multiple stakeholders
and transaction costs that are significant. Confusion is brought about when we consider the form
that involvement should take (O'brien, 2017). IMF should provide liquidity assistance when the
debt that a member country holds is sustainable but private investors are not able to provide
coordination in the provision of liquidity required and they only facilitate to debt restructure
when the burden of debt is unsustainable.
Deep questions arises when statements about whether debt sustainability concept is meaningful
and whether the IMF is able to determine a member states sustainable debt. In reflecting on this
uncertainties, the institution has continued to lend to its member states and put off the
restructuring decision. This model allows investors to create a moral hazard and cut their losses.
This is because restructuring disrupts the economy and is also costly for the country.
The fourth unmet challenge according to the article is impartiality problem by the fund which is
an issue raise due to governance problems (Grath, 2005). When members have disproportionate
voice which enables some member states to sway decision making and make decisions that are in
line with their national interest, this is seen as if the institution is not partial. Some of the
decision made by some member states that have a lot of influence are at odds with both the

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interest of the stability of the IMF and its membership. Also, some members are inadequately
represented and they see the decisions made by the funds as neglecting their interests.
Consequently, the two sides are reluctant to give IMF the autonomy in choosing tactics and
designing programs. The failure by the IMF to meet the four challenges causes its impartiality
and competence to be questions by those who criticize its modus operandi (Bodie and Merton,
2001). The funds inability to solve these challenges leads members to question its legitimacy
according to the article. Legitimacy determines if the governments and their constituencies will
to bend to its authority and accept its recommendations.
According to political theorists, legitimacy has two sources. The public’s assessment about the
performance of the Fund is referred to as output legitimacy. If the funds advice brings in good
results, then the agents would be willing to acknowledge its authority. Second, input legitimacy
refers to the process through which power is exercised and decisions are reached. The first three
challenges , that is , surveillance, conditionality relevance and the utility of the funds approach
to debt problems can be solved through output legitimacy (Costa, 2006). On the other hand, the
fourth challenge which is the funds failure to adopt a system of governance raises questions
about its input legitimacy. The legitimacy problem will have to be solved so that the fund can be
effective in its mandate..
b) Explain why PPP and IFE in theory makes derivatives unnecessary
Today, there are several theories that explain the formation of the exchange rate and the nature of
its dynamics. So, one of the most famous theories is the theory of purchasing power parity (or

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ability) (Power Purchasing Parity). According to this doctrine, the rates of any two currencies
must be adjusted one to one according to the change in the price levels in these two countries. A
simple example gives an idea of the action of PPP theory and International Fishers effect
Summing up, it can be pointed out that the currency purchasing power parity doctrine can be a
good tool for forecasting the exchange rate provided there are significant differences in the price
levels of the countries being compared (Shapiro, 2014). The accuracy of the exchange rate
forecast is a derivative of the accuracy of the forecast of price levels in the two countries, and
therefore the time range of applying the principles of PPP is measured from one to five years.
The forecast rate for a period of less than one year is not justified for the inability to get rid of
many random factors in the main trend of the development of the phenomenon. This is the
presence of a lag between price changes and adjustments to this exchange rate, and intra-annual
seasonal and conjunctural fluctuations.
Forecasts for more than five years can have a significant error. The PPP theory has rather
limited forecasting possibilities, gives an idea of the prerequisites for long-term behavior of
exchange rates, but can not explain the run-up of rates for short periods. The key to
understanding the behavior of the exchange rate in the short term is consideration currencies that
form the exchange rate from the position of the asset market and the theory of demand for assets
(Manzur, 2008). The modern approach to the asset market stresses that, for short periods (less
than a year), the decision to own domestic or foreign assets (that is, cash in national or foreign
currency) will play a much greater role in determining the exchange rate than the demand for
export or import goods. Those. export-import flows are considered as secondary exchange rate
factors. According to the theory of demand for assets, the most important factor that affects the

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demand for domestic (national) and foreign money (this time we consider the non-cash form of
cash) is the expected return on these assets relative to each other friend The expected income for
the deposit of a certain currency in the transfer to foreign currency consists of the interest rate of
this currency and its expected price (+) or depreciation (-). When, for example, Americans or
foreigners expect that the income on dollar deposits will be higher than the income on deposits in
euros, then the demand for dollar deposits will be higher and, accordingly, the lower one for
deposits in euros This will encourage investors to convert funds into current assets. Nevertheless,
at the end of the investment period, they may incur exchange rate losses
e changes in the exchange rate, which, with a surplus, will block the interest income. To prevent
such losses, investors must enter into fixed-term contracts, i. agreements with the redemption of
currency, at the rate of "spot" plus the interest earned on the invested assets. These agreements
from interest arbitrage is a connecting link between the difference in interest rates of the national
money markets of the two countries and the forward rates of the respective currencies (Madura,
2012). This link acts as the basis of the theory of interest parity. To understand the mechanism of
the action of this theory, one should consider its formalized form.
b) Evaluate the differing ways in which derivatives can protect against the failings of IFE
and PPP
Purchasing power parity is an economic theory that states that people in a given country should
be able to buy services and goods at a price that is similar to people from another country. The
theory states that once the exchange rate difference is accounted for, then all the prices of goods
and services would be the same. The ability of purchasing power is illustrated by real per capita
spending. The basis for calculating PPP used by organizations such as UNDP is Gross National

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Product (GNP) (Olekalns, 2001). Since GNP cannot be compared directly, an International
Comparison Project (ICP) is formed which aims to "adjust" the real GDP rate, so it can be
compared. For this purpose is determined a number of commodities as a package for the basis of
comparison internationally. The resulting number, to reflect the standard benefits, is then
"adjusted" again with the Atkinson formula. This adjustment is deemed necessary, as a $ 500
increase for a country that already has a GNP of US $ 5000 will have a different benefit from the
same increase for a new country with a GNI of US $ 1000.
On the other hand, the international Fishers effect theory states that a change that is expected in
the exchange rate between currencies of two currencies is roughly equivalent to the difference
between their nominal interest rates(Holmes, 2002).
Using the interest rate difference to explain the occurrence of changes in foreign exchange rates.
IFE theory is closely related to theory of PPP because interest rates are often correlated closely
with the rate of inflation, therefore it can be concluded that the difference in interest rates which
occurs between several countries can be caused by the difference in the rate of inflation.
On the theory of Interest Rate Parity and Power Parity Purchasing, the theory allows us to
estimate the future of the exchange rate expected. Interest Rate Parity is related to risk-free
interest rate while Purchasing Power Parity theory of exchange rate is related to an inflation rate.
Putting them together basically tells us that interest rates are risk-free related to the rate of
inflation (Valsamakis, Vivian and Du Toit, 2010). This brings us to the International Fisher
Effect, The international Fisher effect states that the real interest rate is the same across

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countries. Real interest in risk-free rate minus the inflation rate. Real interest rates are generally
used more often compared with the nominal interest rate to measure currency exchange rate
movements. The nominal interest rate is not an accurate measuring tool, because it still contains
inflation element inside.
International Fisher Impacts Impact
The relationship between the difference between the two countries' interest rates and the
expected change in exchange rates under IFE is as follows: first, the actual return for investors is
the interest rate offered on the securities market term deposit money banking short, where the
investor's actual return depends on the foreign interest rate if and the change of the foreign
exchange.
The determination of actual effective return abroad is:
According to IFE, the effective return of foreign investment should, on average, be an effective
return on investment domestic, therefore, IFE states that estimates of investment in local money
market investments: Where r is an effective return on foreign deposits and i is the deposit interest
rate of the country of origin. Then it can determine as evidenced above, the IFE theory states that
when interest if, e will be positive because of the relatively small foreign interest rate reflecting
the relatively low estimated foreign inflation, in other words, foreign currency will appreciate
when foreign interest rates are smaller compared to origin interest rate.
A financial derivative is an agreement between two parties where the payments conditions are
also agreed by the two parties. Derivatives are from underlying assets such as contracts, swaps or
even stocks. Some of the conditions include purchasing the asset at the price and at the date

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which the underlying asset achieves that price(Valsamakis, Vivian and Du Toit, 2010).. A
common derivative is a call option that gives the buyer the option but not the obligation to buy
the stock at a certain date and at a certain price.
The PPP and IFE theories make derivatives unnecessary because of the inflation factor. As we
know, the two theories factor in inflation of underlying assets but derivatives are meant to protect
the buyer from purchasing the underlying asset with inflation factored in.
Advantages of derivatives
 Transactions of derivatives take place in future therefore giving a chance to individuals
and traders to execute all sorts of strategies in the futures and options market. Therefore,
if the individual want to short some stock for a long time they can do it in this market.
 There is benefit of leverage in this market because people can transact huge transactions
with small amounts hence trading with derivatives requires a less amount of money.
 Derivatives are a great risk management tool with a lot of benefit to the user.
There are several criticisms that associated with these theories. The purchasing power parity
theory does not factor in the tarrifs and the demand for derivatives can be different. Also another
criticism of this theory is the differing taxes in different regions.
Evaluate the differing ways in which derivatives can protect against the failings of IFE and
PPP.
As speculators take a market risk position, speculation is a spare part that makes futures and
options markets(derivative market) work well and efficiently w. A speculator in futures trading is
one goal, which is profit (profit) from its success in anticipating price movements. The time

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horizon of the speculator is very different from the hedger, commercial users, and other
professional users, therefore tends to act as a bridge between large market users and other market
users, with different time horizons. So speculation is a major component because the speculator
improves market liquidity, and also increases market efficiency. A speculator in futures trading
is with one goal, which is to profit from its success in anticipating price movements. Inflation
and interest rates challenges are overcome by these speculation.
Hedging is a strategy created to reduce the occurrence of unexpected business risks which
includes inflation, in addition to the possibility of profit from the investment. Differential interest
rates Differential interest rates between the two countries predict future changes in spot exchange
rates. In the financial risk hedge, there are factors that cause exchange rate changes (Manzur,
2008). Knowledge of this will help in forecasting the direction of currency movement. These
factors include differential inflation, monetary policy, trade balance, the balance of payments,
international monetary reserve, national budget, and deferential interest rate, and associated
currency behavior, unofficial exchange rate, forward exchange quotes.
Not all hedges are financial instruments. For example, a producer who exports to another country
can hedge the currency exchange risk by calculating his production costs in the currency he
wants (Taylor, 2013). The following ways that derivatives can protect from the failings of IFE
and PPP theories.
References
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Hartley, W. (2011). International finance. [Place of publication not identified]: Bibliolife.
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Imf. (2016). Forecasting at the imf. [Place of publication not identified]: Intl Monetary Fund.
Kirton, J. (2009). International finance. Aldershot: Ashgate.
Levi, M. (2016). International finance. London [u.a.]: Routledge.
Madura, J. (2012). International financial management. Mason, Ohio: South-Western, Cengage
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Manzur, M. (2008). Purchasing power parity. Cheltenham (Reino Unido): Edward Elgar.
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Valsamakis, A., Vivian, R. and Du Toit, G. (2010). Risk management. Sandton: Heinemann.