International financial management PDF

Running head: INTERNATIONAL FINANCIAL MANAGEMENT
International Financial Management
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Contents
Introduction:....................................................................................................................................2
Part a:...............................................................................................................................................2
Inability to stabilize exchange rates:............................................................................................2
Inability to control capital flows in an orderly manner:..............................................................3
Surveillance reviews are dominated by powerful countries:.......................................................3
Inability to develop advanced markets:.......................................................................................3
Inability to improve the loan defaults:.........................................................................................3
Scope of operations limited to imbalance in trade account:........................................................4
Discriminating treatments to provide extra benefits to certain countries:...................................4
Liquidity problem still remains a huge problem:........................................................................5
Problems is dollar system:...........................................................................................................5
Part b:...............................................................................................................................................6
Purchasing Power Parity theory and International Fisher Effects theory:...................................6
International Fisher Effects:........................................................................................................7
Differing ways in which derivative protects PPP and IEF failures:............................................9
Conclusion:....................................................................................................................................11
References:....................................................................................................................................12

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Introduction:
The importance of international financial management has increased multiple folds with
the increasing effects of globalization and cooperation between countries at global level.
International financial management is about considering the effects of exchange rates, rates of
inflation and rates of interests of different countries to manage internal finances affecting the
economic development and progress of respective countries. In this document a detailed
discussion on the failures of International Monetary Fund to tackle certain challenges shall be
made here. The Purchasing Power Parity and International Fisher Effects shall also be discussed
in this document for the benefit of the readers.
Part a:
Failure of International Monetary Fund to meet certain challenges
The role of International Monetary Fund (IMF) is immensely important to stabilize the exchange
rates and rates of inflation around the globe. The role of IMF is immensely significant in the
orderly economic development and progress of the globe. A detailed discussion on the failures of
IMF to tackle certain challenges has been discussed here in this document. This document shall
be helpful in understanding the lag between desired objectives and actual objectives achieved by
IMF.
Inability to stabilize exchange rates:
One of the main reasons behind establishment of IMF was to stabilize the exchange rates by
taking necessary steps in this regard. The disorderly and unstable exchange rates though to some
extent have been improved subsequent to the establishment of IMF however, the actual outcome
of decisions taken by IMF is far from the desired stability in exchange rates. The steps taken by

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IMF to stabilize exchange rates for orderly development of global economy has not been
achieved even after 88 years from the establishment of IMF (Polak. and Boughton, 2016).
Inability to control capital flows in an orderly manner:
Controlling capital flows in the global market is also one of many objectives of IMF. The
disorderly capital flows does not allow proper development and progress of different economies
in the world. The objective behind establishment of IMF was also to control capital flows in the
market to orderly develop different economies in the world. As a result the global economies
have not been developed in an orderly manner (Reinhart and Trebesch, 2016).
Surveillance reviews are dominated by powerful countries:
The whole objective behind establishing IMF was to ensure orderly economic development and
progress by allowing developing and underdeveloped nations to express their concerns in the
international stage. However, the voting rights and operational mechanism of IMF is such that it
allows only developed and economically powerful nations to use its might to affect the economic
and monetary strategy of IMF. The inability of IMF to monitor the global economic condition
without any bias towards the powerful and economically developed nations is still lacking
(Jenks, 2017).
Inability to develop advanced markets:
Total number of advanced markets in 2012 was 35 whereas the number of total advanced
markets in 2014 has only increased to 39 thus, despite huge amount of spending on number of
initiatives the inability of the organization to develop advanced markets in the globe is pretty
much evident from the fact that there was only about 39 advanced markets in 2014 on the planet.
What is more shocking is that it is still 23% of overall market in 2014 as it was in 2012 (Kawai,
2015).

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Inability to improve the loan defaults:
IMF provides financial assistance to Governments across the globe to deal with financial
difficulties as required. However, the increase amount of default in loan repayments by
sovereign nations have made it difficult for the organization to finance the economic
development and growth initiatives of IMF. It is a huge challenge to IMF to reduce the defaults
in loans provided by the organization to Governments (Gilpin, 2016).
Scope of operations limited to imbalance in trade account:
Even almost after 75 years since its establishment IMF has failed to expand its scope of
operations. Extreme limitation in scope operations has paralyzed the organization to play a major
role in stabilizing exchange rates internationally to control rates of inflation globally. The
organization primarily deals with current trade transaction imbalances between countries. The
glaring failure of the organization to adjust repayments of war loans and import and export fund
authorization has certainly left the institute red faced in the global community (Stern, 2017).
Discriminating treatments to provide extra benefits to certain countries:
The day to day functioning of the fund is often discriminating to benefit certain countries over
others. Due to the advantageous treatments provided to certain countries especially powerful and
rich countries IMF is also allegedly called as Rich countries club. The inability of the
organization to provide essential benefits to underdeveloped and developing nations is another
failure of the organization. Considering the objective with which the organization was formed
back in 1944 the alleged terminology of Rich countries club is certainly a huge stigma to the
international organization. Despite flouting the direction of IMF rich and powerful countries
wishes are given the utmost importance in day to day functioning of the organization. In fact no
disciplinary actions are taken against the developed and powerful countries even if these
countries continuously flout the directions of IMF. Thus, the fund has failed to bring necessary

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neutrality in the functioning of the organization to enhance the confidence of developing and
underdeveloped nations (Eichengreen and Woods, 2016).
Liquidity problem still remains a huge problem:
One of the objectives of IMF was to lend and sell foreign currencies from its stock to its member
countries to promote international liquidity. Though it is undeniable that the organization has
taken number of initiatives to improve the international liquidity position however, there is still
no permanent and fixed solution to the liquidity problem in the international market (Park, 2017).
Problems is dollar system:
The inability of the fund to tackle the problems with dollar currency. Many sterling pound
countries have faced severe dollar crunch and despite such shortage of dollar persistent in many
of these countries the failure on the part of IMF is very evident from its ineffective strategy to
make dollar freely available currency.
Conclusion: It is clear that despite number of achievements IMF also has some glaring failures as
discussed in the above section of the document. There are number of challenges which have not
been tackled effectively by the fund. Thus, necessary decisions and steps must be taken in the
future by the fund to meet these challenges.

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Part b:
Purchasing Power Parity theory and International Fisher Effects theory:
Exchange rate between two currencies is often a hot topic of debate as economists have
tie and time again devised different theories to track the reason for exchange rate variations.
Purchasing power parity theory, here in after to be referred to as PPP, explains that the exchange
rate between two currencies is equal to the purchasing power of two currencies in respective
countries (Ortiz and Monge, 2015).
The supply and demand of currencies is the biggest contributor to the exchange rate. The
international transaction of goods and services require foreign currencies. The demand of
particular currency and its relevant supply for the international transactions of goods and services
determine the exchange rates in international market. On the other hand PPP is based on the
relative purchasing power of different currencies in the respective domestic markets. The theory
states that the purchasing power of currencies in domestic market determine the exchange rate of
currencies. The law of one price is fuelled through the competition in the international market to
determine the exchange rates. According to the law of one price any traceable product has single
price in all countries, i.e. the product is sold for same value in different currencies in different
countries (Iyke and Odhiambo, 2017).
PPP theory is based on the goods and services which are not traded internationally, i.e. haircuts,
local transportation, construction, household services, restaurant foods and such other goods and
services. Despite these services and goods not traded internationally still the differences in the
prices of these goods and services in the domestic markets are quite enormous. The reasons for
such huge differences in market prices of these goods and services in domestic markets are

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mainly due the differences in cost of labour and inflation factors in different countries (Keynes,
2018).
International Fisher Effects:
International Fisher Effects on the other hand describes that the exchange rate differences
between two currencies is approximately equal to the difference of nominal interest rates in the
two countries. To predict currency movements the International Fisher Effects, here in after to be
referred to as IEF in this document, theory is used. The interest rate on present value of
investment and the interest rate on the future value of investment are traced to predict the
currency movements. The theory is based on the premise that the real interest rate in countries
are not dependent on any monetary variables including the monetary policies of countries and
other such variables, thus, the real interests rates of countries provide better indication as to the
expected movement in currencies as the interest rates are directly associated with the health of
currencies (Bahmani-Oskooee et. al. 2017).
According to the IEF theory the countries with low interest rates will experience significantly
lower inflation rates in general as compared to the countries with higher interest rates. As a direct
consequence the nation with low interest rates will have relatively lower depreciation to the
value of the currency as the general inflation rate is also low due to low interest rate in the
country. Depreciation will be higher for the domestic currency of a country that has higher
interest rate and consequently higher inflation in general (Cohn, 2016).
In order calculate the International Fisher Effect (IFE) the following formula is used:

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The IFE theory is relatively simple to understand as it simply describes that the general interest
rate in the country is directly related to the value of the country’s currency. The higher the
interest rate in the country the higher would be the inflation rate to have larger depreciation on
the particular currency. For example the nominal interest rate of country X is 5% and the
nominal interest rate in country Y is 10% thus, according to the theory, IFE theory, and the
currency of country X will appreciate approximately by 5% from the currency of country Y.
thus, put it differently the higher nominal interest rate in country Y will result in increased
amount of depreciation in the value of the currency of the country as compared to the currency of
country X. Thus, the general interest rate in the country will affect the inflation rate and
subsequently the exchange rate between the currencies of two countries (McKinnon and Ohno,
2016).
The importance of derivative which derives its value from an underlying assets or commodity
lost its relevance due to the concept of purchasing power parity and general interest rates in
different countries. Purchasing power parity as the theory explains, that there is generally no
difference between the purchasing power as the exchange rate is exactly equal to the value of
purchasing power between respective currencies. Derivative derives its value from underlying
asset or commodity and with PPP explaining that the exchange rate between two countries is
nothing but equal to the ratio of purchasing power of respective currencies. Thus, the fluctuation

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and uncertainty attached with the value of derivate to a large extent is not associated as per the
theory of PPP. Thus, the necessity of derivative to derive value of a commodity to a large extent
is reduced as per the PPP theory (Friedman, 2017). International Fisher Effects (IFE) as already
mentioned based on the general interest rates in the country again reduces the importance of
derivative as the value of the underlying commodity or asset lose its value with the use of
nominal interest rates. However, it is important to note that though derivate has lost its value and
importance in determining the exchange rates however, it would be wrong to claim that
derivative is unnecessary even with PPP and IEF theories (Chetverikov, 2018).
Differing ways in which derivative protects PPP and IEF failures:
Purchasing power parity (PPP) theory based on the concept of relevant purchasing
powers in the domestic markets of relevant currencies and the fact that the exchange rate
between two currencies will be equal to the ratio of relevant purchasing power of domestic
currencies. On the other hand International Fisher Effects (IFE) theory is based on the concept
that the exchange rate between the domestic currencies of two countries shall be dependent on
the general interest rates of two countries. Thus, according to the theory the higher the interest
the higher would be the depreciation in the currency of the country (Peleg et. al. 2016). Thus, the
two theories have different takes on the exchange rates. It would be wrong to claim that one is
right and the other is wrong. Both theories have certain pros and cons thus, both theories are
relevant in their own way.
However, the biggest weakness of both the theories is the over simplification of exchange rate
and exchange rate differences. In PPP the exchange rate between two currencies has been
defined as the ratio of purchasing power of relevant countries in domestic market. There are
number of assumptions which are used in the PPP theory. However, most of these assumptions

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are unrealistic and impractical. A brief description about these assumptions shall be helpful in
understanding how impractical the theory is in real world situation (Tuzcu, 2015).
The general employment rates: The general employment rate in two countries are considered to
be same which is practically not possible. Thus, the assumption is impractical and unrealistic.
The demand and supply rules: The price of different commodities in domestic markets to a large
extent is dependent on the demand and supply of such commodities. However, in PPP theory
both demand and supply aspects of products and commodities are overlooked while determining
the exchange rate between two currencies (Adam and Ofori, 2017).
Preference of customers: Preference of customers is completely overlooked in determination of
exchange rate difference between two currencies by using PPP theory. This is important to
understand as often the customer preferences determines the demand and subsequent price of the
products and commodities (Bhatti and Moosa, 2016).
The above assumptions are very much unrealistic and impractical thus, it would be under
exceptional situation to expect the exchange rate to be in conformity with PPP theory.
International Fisher Effects on the other hand again does not consider the importance of macro
and micro economic factors such as general inflation levels, economic conditions in different
countries, employment rates and general income level in the countries (Arize et. al. 2018).
Thus, the possibility of failure of both PPP and IEF theory to correctly explain the exchange
rates between two currencies is very much possible. It is important to note that both the concepts
are dependent on number of underlying assumptions most of which are impractical. In case
failure of PPP to define the exchange rate between two currencies the use of derivative often

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provides relevant certainty to understand the exchange rates between two currencies by using the
changes in the value of underlying asset or commodity. The fact that derivative derives its value
from underlying asset or commodity is often assuring for the economists as the value of the
derivative will only change if there is any change in the value of underlying asset or commodity.
Hence, when the theory fails to provide relevant certainty regarding the exchange rate use of
derivative could provide significant certainty in regards to the value of the value of derivative
based on the value underlying asset or commodity (Alam, Alam and Shuvo, 2017).
The chances of IFE theory failing is relatively less as compared to PPP theory because the
former is based on the concept of changes in general interest rates in a country. General interest
rates in a country does affect the general inflation level in the country and subsequently the
depreciation on the value of currency. Higher rate of interest in the country would be
supplemented by higher rate of inflation to depreciate the value of currency at higher rate. In
contrast lower rate of nominal interest in the country shall be complemented by the low inflation
rate of interest to reduce the rate of depreciation in currency value. However, often interest rate is
not the only factor to determine the rate of inflation and the value of currency in the country
hence, important factors such as general inflation in the country is often ignored at the expense
of other factors. Using derivative to derive the value of an underlying asset or commodity often
provides more accurate value as it directly changes value with the actual changes in underlying
value of asset or commodity (Uddin, Alam and Alam, 2008).
Conclusion:
Purchasing Power Parity theory and International Fisher Effects theory are based on relevant
purchasing power and nominal interest rates of different countries. Both theories have strengths

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as well as weaknesses. It is important to use the theories by taking into consideration both the
strengths and weaknesses to correctly predict the exchange rate movements in the country.

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References:
Adam, A.M. and Ofori, D., 2017. Validity of International Fisher Effect in the West African
Monetary Zone. Journal of Economic Cooperation & Development, 38(3), pp.121-143.
Alam, M., Alam, K. and Shuvo, A., 2017. Empirical Evidence of International Fisher Effect in
Bangladesh with India and China.
Arize, A., Kallianiotis, I., Malindretos, J., Panayides, A. and Tsanacas, D. (2018). A Comparison
of the Current Account and the Monetary Theories of Exchange Rate
Determination. International Journal of Economics and Finance, 10(2), p.102.
Bahmani-Oskooee, M., Chang, T., Chen, T. and Tzeng, H. (2016). Revisiting purchasing power
parity in Eastern European countries: quantile unit root tests. Empirical Economics,
52(2), pp.463-483.
Bhatti, R.H. and Moosa, I.A., 2016. International parity conditions: Theory, econometric testing
and empirical evidence. Springer. 1st ed. London: Palgrave Macmillan UK.
Chetverikov, D. (2018). TESTING REGRESSION MONOTONICITY IN ECONOMETRIC
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Cohn, T.H., 2016. Global political economy: Theory and practice. Routledge.
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Friedman, M., 2017. Quantity theory of money. The New Palgrave Dictionary of Economics,
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Gilpin, R., 2016. The political economy of international relations. Princeton University Press.
Iyke, B.N. and Odhiambo, N.M., 2017. Foreign exchange markets and the purchasing power
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