Posted: May 23rd, 2015

International Finance Question

 

Question One

Free trade encompasses unrestricted movement of goods and services across different countries and regions. Market forces, therefore, remain the main determinants of prices. There are several theories that have been advanced that have illustrated the importance and benefits of free trade. One of the theories that have been closely associated with free trade is the comparative advantage theory advanced by David Ricardo. He was one of the proponents for free trade and was heavily against protectionism.

The theory of comparative advantage propagates specialization in production of different products among countries and regions. The theory revolves around various countries resource endowment. Therefore, countries specialize in the production of goods in which raw materials and labour for the production of the goods are readily available. Goods are produced at relatively low prices and thus offer competitive prices at the international market. The Hechsher-Ohlin theory also advocates for free trade where countries specialize in the production of either capital or labour intensive goods. Therefore, countries specialize in the production of goods depending on the abundant resources.

The above theories advocate for international specialization among countries. Goods are, therefore, offered at competitive prices and thus ensuring that countries are able to realize their economic development. However, the emergence of protectionism has been hindrance to free trade. One of the tools used in protectionism is quotas. Quotas are quantitative restrictions for importation of particular goods. The main objective of the quotas is to ensure that domestic markets are not flooded with imports. This ensures that locally produced goods remain competitive in the domestic market.

In the global economy, countries can be divided into two major categories including net importers and exporters. Free trade, therefore, could favour net exporters rather than net importers. Net exporters are thereby in a position to export more capital goods whose prices are relatively high. Therefore, such economies balance of payments remains favourable as opposed to net importers whose expenditure remain higher than income. This results in an unfavorable balance of payments.

Question 2

International parity conditions create a link between three basic variables including price levels, interest rates and exchange rates. The parity conditions provide a basis from which different economies can be compared using the above variables. The law of one price for example, states that a price of a particular product remains the same across different economies. However, several assumptions are made including absence of transaction costs.

The ‘Big Mac index’ is a good example of the application of the law of one price. The assumption is made that the product is similar across different countries thus used to indicate relative prices across different currencies. Therefore, the exchange rate can be derived from the comparison of the relative prices in different currencies. The comparison between interest rates and exchange, on the other hand, is analyzed using international Fisher effect.

The international Fisher effect encompasses a comparison spot exchange rates and interest rates. It, therefore, states that change on the spot exchange rates is representative of the difference in the interest rates in different countries. However, the relationship is thereby negative where an improvement in a country currency is associated with a decline in the interest rates in the country. The above concept is used the estimation of such things as forward exchange rates. Potential investors are in a position make decisions on the currencies in which to invest in for arbitrage activities. This particular parity condition is mostly likely to hold as interest rates are less susceptible other factors as opposed to price parity above.

Question 3

There are several problems associated with the calculation of indices in emerging markets. One of the problems associated with calculation of indices in emerging markets is market instability. These markets are subject to huge swings and thus susceptible to increased market instability. Therefore, it’s becomes increasingly difficult for calculation of indices as such changes may not be reflected in the index. Similarly, the indices may not be a true reflection of the actual market situation and thus mislead potential investors

The second problem associated with calculation of indices is an increased number of new listings. Therefore, inclusion of such companies in the market indices could result in a substantial increase in the weighted average in the markets due to increased market capitalization. Some of the functions of the market indices include the fact that they can be used to indicate the performance of the companies. This, also, indicates the performance of the economy and thus helpful to potential investors in the countries.

A risk weighted portfolio can be introduced as one of the tools towards eliminating inefficiency in the calculation of indices in emerging markets. This ensures that such factors as the risk drag are taken into account. Also, the above portfolio will also ensure that countries are assigned based on long term expectations of the country. This ensures that some countries do not dominate the indices in the weighted portfolio.

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