International Financial Management Answer 2022

Running head: INTERNATIONAL FINANCIAL MANAGEMENT
International financial management
Name of the Student
Name of the University
Author Note

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Table of Contents
Answer to question a).................................................................................................................1
Answer to question b)................................................................................................................5
Requirement i)............................................................................................................................5
Explaining the role of PPE and IFE theory in making derivatives unnecessary:.......................5
Requirement ii)...........................................................................................................................8
Explaining the different ways of protection by derivatives against the failings of IFE and
PPE:............................................................................................................................................8
References list:.........................................................................................................................12

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Answer to question a)
“A summary of: “The IMF’s Unmet Challenges” by Barry Eichengreen and Ngaire
Woods, Journal of Economic Perspectives—Volume 30, Number 1—Winter 2015—
Pages 29–52”.
The article presents a discussion on the critics of International monetary funds and its
incapability in discharging the core functions and how it also presents the views of its
advocates in addressing various issues at the global level. The impartiality and the
competence of the monetary funds in performing its functions is attributable to the issues
associated with its governance structure (Ridley 2020). The importance of the institution and
its contribution to the financial management is presented in terms of various factors with the
critics arguing about its commitment, information and coordination issues and the significant
impact it would have on the economies of the world.
The article tends to elaborate the shortcomings of the fund in terms of its effectiveness
which is limited by the failure to meet some challenges and respond to them effectively. Such
challenges which forms the center of attraction of the article includes conditionality that
should be attached to the loans, surveillance, role of the fund in the management of debt crisis
and sovereign and issues of governance. In this regard, IMF is placed to be on doubt due to
conditionality relevance, surveillance quality and the approach of funds in solving debt
issues. The legitimacy of the fund is questioned because of its failure in adopting an
appropriate governance system (Robinson 2020).
The surveillance challenge threatening the competence of IMF is presented in the
article by mentioning their role in the surveillance as corrective with the spillovers and risks
becoming central to such function. Function of IMF in conducting surveillance is challenged
by identifying various failures of sounding louder warnings in the banking crisis of Ireland,

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Iceland and some other countries and subprime crisis of United States. This was due to the
inappropriate and incorrect assessment made by the institutions which was further justified by
the presentation of some practical limitations to the analysis (Grima and Thalassinos 2020).
While on one end, article presents surveillance challenge faced by IMF, on other hand, it
outlines some its advocates that justifies the functioning of the institution.
Another challenge concerning the capital flows and exchange rate in the article is
explained for the damage to the perception of the institution for lacking the clarity in terms of
exchange rate and rationale. The article discusses about the adoption of Euro and the advice
from the institution in explaining this particular challenge. The critics presented that despite
the economist presenting seminal analysis on the euro experience, louder warnings was not
presented by the institutions on the issues of the fiscal union and the monetary union without
banking. There was a significant change on the advice and assessment of the institutions on
the capital control and this resulted due to the changes in staff guidance (Eichengreen and
Woods 2016).
The challenge associated with the conditionality presents the fact that the conditions
when expanded offers the powerful shareholders with the scope of advancing their national
interest by enlisting the institutions. There is a lack of evidence on the fact that the
conditionality of the IMF is attuned to the crisis country welfare. That is, the article sets out
several facts that presents the view that the institution is primarily concerned about the
interest of its principal stakeholders. It is further mentioned that there will always be criticism
on the conditionality of IMF as there would be inevitable opposition of the special interest
and compliance issues. Article also illustrates the measures taken for reforming the functions
of IMF and making the conditionality exclusively focusing on the macroeconomic policies.
The conditions of policy of the IMF should be specified for enhancing the prospects of
compliance and ownership of country (Eichengreen and Woods 2016).

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Views of the stakeholder on the impartiality and competence of the fund is associated
with the issues of governance. In this regard, article tries to address the issues of governance
faced by IMF by presenting some facts and example. It is presented that the members of the
funds is not represented adequately and they dismiss the advice and decision of the funds as
illegitimate. The role of funds of making adjustments in the national policies is weakened by
the skepticism of the members. In addition to the critics related to the governance of the fund,
article also mentions about the measures to be taken by the fund for enhancing its
effectiveness and legitimacy. Furthermore, it has been outlined in the article that the fund
seems to be overly influenced by the small set of creditor countries however, quota is the
form of resources provided to the institution for being a member countries and the reforms
associated with such quotas comes with its own advantage and disadvantage. The article
places importance on the reforms of governance in order to restore legitimacy of the
institution. Governance reforms are required to be modernized and the ability of the IMF to
respond to the international crises should be augmented (Eichengreen and Woods 2016).
In light of the detailed summary presented on the article, it is inferred that the main
focus on the paper is on the ongoing challenges faced by IMF that is adversely impacting its
legitimacy. For addressing such challenges and the institution accused of being impartial and
improving the core functioning of the IMF, article has suggested various measures in the
form of reforming its governance so that different stakeholders would be given with the
appropriate voices. That is for dealing with all the mentioned challenges in the article, it is
important for the institution to address such problematic concerns by introducing governance
reforms. It is so because the root cause of all the challenges presented impacting the
competence and legitimacy of IMF lies in inadequate and inappropriate governance. Last, but
not the least, it is emphasized by the various situations discussed and presented in the article
that the own policy room of the institution for maneuver is limited by the stakeholders

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perception of legitimacy and impartiality and governance issues (Eichengreen and Woods
2016).
Answer to question b)
Requirement i)
Explaining the role of PPE and IFE theory in making derivatives unnecessary:
PPP (Purchasing power parity) is a theory of determining the exchange rate by
making a comparison between the average cost of baskets of goods and services. It is based
on the assumption that the changes in the spot exchange rate is induced by the differences in
the cross country price that causes the importers and exporters to take action. That is the
parity offers with the rate of converting currencies by eliminating the differences in prices
between countries and equalizing their purchasing power. It is stated by the absolute PPP that
the relative price for the similar basket of goods determines the spot exchange rate. Any
opposite changes in the spot exchange rate would offset the changes in the differential
inflation rate when the spot exchange rates initiates in the equilibrium. However, the issue in
the usage of PPP theory lies in the fact that there can be deviation of the purchasing power of
currencies from the values of exchange rate (El Kalak and Hudson 2018). It is said as per the
theory that the relative price of the identical goods would remain same across countries due
to depreciation in the exchange rate of one nation in relation to other nation and increasing
the price level of the country. That is once the price is expressed in the common currency, it
is predicted by the theory that for the same goods, the international price would remain same.
Derivative instruments such as futures, options and forward contracts is well
explained by the purchasing parity. Forward contracts is the agreements between two parties

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to enter into a contract for delivering and receiving the assets at some future date. Parties to
the contract are required to pay forward premium or the forward discount which is the
difference between forward price and spot price which is explained by the purchasing parity.
Theory of purchasing power parity holds an important principle in the foreign exchange
market. The opportunities of arbitrage exists if the conditions laid down in the theory of
purchasing power parity is not met. Derivatives market are used by the participants to
minimize their risk and maximize the returns from any assets (Rout et al. 2019). The
importance of derivative instruments such as current contracts or the currency forward
contracts is nullified when it is explained in terms of theory of purchasing parity. This is so
because the theory helps in eliminating the effect created due to differences in prices across
countries using an artificial common currency by converting the expenditures that are
expressed in the respective national currencies. In addition to this, an important role is played
by the theory in hedging the currency risks naturally. It can be inferred from the explanation
that the existence of derivative market is casted adrift in the presence of the assumptions of
the theory of PPP (Ma et al. 2019). However, many a times, the theory fails to movement of
exchange rate in short run that makes it necessary to enter into contracts using derivative
instruments to minimize the exposure and guarantee a fix return.
The theory of international fisher effect says that the difference between the current
spot rate and future spot rate of foreign currency is attributable to the amount that equals the
difference between nominal interest rate of foreign and home countries. Since the higher
expected inflation is reflected by the higher nominal rates, the currency with higher interest
rate experiences depreciation. That is the investors should not experience higher return on the
foreign interest rate that is higher compared to domestic return. Country with higher interest
rate would experience higher capital inflow and this in turn causes the currency to appreciate.

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Any short run changes in the spot exchange rates cannot be adequately predicted by the
International fisher effect (Lindo 2018).
Results obtained from various studies shows that no significant impact is identified on
the exchange rate due to the difference in the interest rate across countries. The importance of
derivative markets to minimizing the risk and maximizing the return can be explained by
considering the results of a specific study that contradicts the results and assumptions of
international fisher effect. It has been found in one study that the majority of the transactions
where the future contracts of currencies were purchased on a higher rate of interest and future
on currencies is sold with lower rate of interest turned out to be profitable (Brookee 2016).
This finding contradicts the theory of IFE that the currencies of lower interest rate should
appreciate and currencies with higher rate of interest should depreciate and this would have
resulted the transactions to generate insignificant profits. The theory and its assumptions
cannot be held to be accepted and it comes with the limitation because inflation is not the
only primary factor influencing the exchange rate. As against the macroeconomic
fundamental factors, other aspects such as psychological factors also influences the exchange
rate.
The assessment and application of this particular theory requires caution and in the
daily currency transactions, it might not be appropriate to put the theory into practice.
Nevertheless, the theory assist in estimating the relationship between inflation, interest rates
and exchange rates. Since, there are various other short term factors effecting the prediction
of interest rate, inflation and exchange rate, theory has failed to predict such outcome (Carson
and Ghosh 2019). From the detailed analysis of the assumptions and facts presented under the
international fisher effect, it can be said that the theory does not make the derivative market
unnecessary as the derivatives financial instruments is very much essential for minimizing the
risks associated with transactions.

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Requirement ii)
Explaining the different ways of protection by derivatives against the failings of IFE
and PPE:
Theories such as IFE and PPP are not free from limitations as they might fail to
provide the right prediction like all the other methods of hedging. In the event of failures of
these two theories underlying various assumptions can be hedged by the application of
derivatives. Both the theories have been proven to be unpredictable because of several other
factors impacting the exchange rate other than inflation and nominal rates. In order to make
the financial decisions correctly, it is important to make corrective use of derivative market as
the instruments of derivatives can be used to protect against the changes in the exchange rate,
commodity price and interest rate fluctuations (Vo et al. 2019).
Trading of the assets using derivatives is done on the promise of providing the parties
to the contract with better future prices. On other hand, it is suggested by international fisher
effect theory that there would be depreciation in the currency of the country with higher
interest rate. Both the theories that is PPP and IFE suggests the existence of strong correlation
between inflation rate and interest rate. It is implied by the PPP theory that there is no
exchange risk due to the compensating changes in the exchange rate and interest rate. That is,
any changes in the price level is offset by the exchange rate. In this regard, an argumenta has
been presented that the adjustment between the exchange rate and price change is not
instantaneous and the empirical validity of the theory would be greater when the time horizon
is longer. Firm would be exposed to exchange risk when planning horizon of the firm is
shorter. Exchange rate risk arises due to change in the rate of exchange resulting from various
factors. Such risk can be hedged by the firms using the forward contracts and forward options
for hedging the exposure to the currency risks (Fiedor et al. 2017). The parties to the forward

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contract can lock in the exchange rate at which it is required to be transferred to another
currency on the particular date. On the other hand, instruments such as forward option can
also be used to hedge against the exposure to the foreign exchange currency. Under this
instrument, the concerned parties enters into a contract that offer the right to exchange the
currency at some pre-determined rate into other currency on some particular date
(Włodarczyk and Sikorska 2019). It is important to note that the parties have the right not the
obligation to perform the contract.
Derivative helps in addressing the risks associated with these theories about the fact
that the currency with higher interest rate will depreciate and that of with lower interest rate
will appreciate. In one of the study, that discussed on a contract of loan where a stimulated
strategy was developed where the currency quoted in the lower interest rate was borrowed
and invested in the higher interest rate. At the end of the investment period when the loan was
repaid, a positive difference was found between the cost of borrowing and return on
investment. It can be said that such derivative contracts can be contradictory to the theory of
IFE (Enomoto et al. 2018). There are various ways or various instruments that can be used to
protect the failings of the theories such as option, swap, contracts and future.
When it comes to determine the price of commodity correctly, derivatives play an
important role and determination of the commodity price using the tool of derivatives is
known as price discovery. Future and current price of the commodities are impacted by wide
range of factors such as political, economic and country related issues such as
macroeconomic factors. This causes the price of commodity to change continuously and
derivatives helps in discovering the price of commodity, which might not be determined or
predicted accurately by the theory of the fisher effect. Apart from determining the price of
commodity, derivatives also plays an important role in managing the risks associated with
various transactions such as exchange rate (Smith 2016). Many larger firms uses instruments

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of derivatives for hedging their exposure to the fluctuations in the exchange rate. Various
instruments of derivatives are used by the firms to break down the risks associated and bring
it to an acceptable level and get it distributed amongst those willing to take the risks. The
desired level of risks can be identified easily with the help of derivatives so that it is well
aligned with the actual level of risks faced by means of speculation and hedging. For
instance, investors can enter into a spot position and at the same time, future counter position
can also be held. Using the derivatives, this makes the investors offset some of the loss
associated with its spot position.
A lot of arbitrage is involved in trading using derivatives and this helps in bringing
correct price of the commodity. This in turn reflects the true and correct economic value and
price of the underlying assets. The market is brought into an equilibrium position due to such
correct and accurate price and thereby contributing in making the market efficient.
Financial instruments such as forward can be used to hedge the risks associated with
the changes in price of commodities and fluctuations in the exchange rates. Such hedging can
be done by means of speculation so that the quality of underlying instruments can offer
advantageous position to the parties involved. It is important to gain an insight into the fact
how the firms use derivatives instruments to limit the exposure of the risks of the fluctuation
of the underlying assets value (Uribe 2018).
Firms are subjected to exchange rate risks due to the imperfections in the financial
assets and in the market for real goods and services. It is important to explain whether such
risks should be managed by the ultimate beneficiaries or the firm. The failure of the theories
to account for all the real factors impacting the price of commodity and the risks associated
with the fluctuations in rate due to the exposure of all such real factors can be addressed by
the derivatives. Certain level of risks associated with the trading of assets is controlled by

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derivatives instruments along with utilizing the instruments for some specific speculation
activities so that the total return can be enhanced. With speculation and hedging as the two
important functions of derivate, it can be said that the shortcomings of the theories
concerning incorporation of the real world factors influencing the risks (Awrey 2016).

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References list:
Al‐Hadi, A., Hasan, M.M., Taylor, G., Hossain, M. and Richardson, G., 2017. Market risk
disclosures and investment efficiency: International evidence from the Gulf Cooperation
Council financial firms. Journal of International Financial Management & Accounting, 28(3),
pp.349-393.
Awrey, D., 2016. The Mechanisms of Derivatives Market Efficiency. NYUL Rev., 91,
p.1104.
Brooke, M.Z., 2016. Handbook of international financial management. Springer.
Carson, S.J. and Ghosh, M., 2019. An Integrated Power and Efficiency Model of Contractual
Channel Governance: Theory and Empirical Evidence. Journal of Marketing, 83(4), pp.101-
120.
Eichengreen, B. and Woods, N., 2016. The IMF's unmet challenges. Journal of Economic
Perspectives, 30(1), pp.29-52.
El Kalak, I. and Hudson, R., 2018. An Empirical Study of the Cross Market Efficiency of the
Index Options Market: A Case Study from the Italian Derivatives Market. Forthcoming,
Review of Accounting and Finance.
Enomoto, M., Kimura, F. and Yamaguchi, T., 2018. A cross‐country study on the relationship
between financial development and earnings management. Journal of International Financial
Management & Accounting, 29(2), pp.166-194.
Fiedor, P., Lapschies, S. and Országhová, L., 2017. Networks of counterparties in the
centrally cleared EU-wide interest rate derivatives market (No. 54). ESRB Working Paper
Series.

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Grima, S. and Thalassinos, E.I., 2020. Financial Derivatives Use: A Literature Review.
In Financial Derivatives: A Blessing or a Curse?. Emerald Publishing Limited.
Lindo, D., 2018. Why derivatives need models: the political economy of derivative valuation
models. Cambridge Journal of Economics, 42(4), pp.987-1008.
Ma, J., Du, K. and Gu, G., 2019. An efficient exponential twisting importance sampling
technique for pricing financial derivatives. Communications in Statistics-Theory and
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Rao, D.P. and Hajargasht, G., 2016. Stochastic approach to computation of purchasing power
parities in the International Comparison Program (ICP). Journal of econometrics, 191(2),
pp.414-425.
Ridley, D., 2020. Capitalism/democracy/rule of law interactions and implications for
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Robinson, T.R., 2020. International financial statement analysis. John Wiley & Sons.
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Smith, M., 2016. A Privatized Approach to Derivatives Regulation: The CPMI-IOSCO's
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Uribe, M., 2018. The neo-Fisher effect: econometric evidence from empirical and optimizing
models (No. w25089). National Bureau of Economic Research.

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Vo, D.H., Huynh, S.V. and Ha, D.T.T., 2019. The importance of the financial derivatives
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Włodarczyk, R.W. and Sikorska, M., 2019. The importance of swap transactions in the
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