global finance

1. Ethical Standards

a. Can a multinational firm adopt varying ethical standards [such as with

regard to product safety (Pinto), employee benefits (Nike) and “kickbacks” to

win business (HP)] in its global operations? Why or Why Not? Discuss in

depth based on the goals of multinational corporations?

b. How do corporate governance and financial management differ for US

based corporations and global multinational corporations?

Answer 1 (a)

With the emergence of a global economy, MNCs are forced to adopt more specific ethical codes as part of their long-term corporate strategy. . Market globalization and trade bloc formation are two powerful concerns that forced MNCs to sign agreements on social responsibility. MNCs are also likely to adopt ethical standards as a response to the growing threat poised by an increasingly vocal consumer base who demand that corporations promote sustainable development strategies without sacrificing product and service quality.

A Multinational corporation (MNC) is a business firm that is incorporated in one

country and has its operations, production and sales in other countries. The main

goal of a multinational organisation is the same as that of any other organisation and

that is to create the maximum value that can be created for the shareholders. This

can be done by following practices that could enable sales growth or market share

growth, growth in the operating profit margin, lowering the cash tax rate,

incremental expenditure in capital expenditure that would reap benefits in future,

optimizing the investment in working capital, exploit the time period to gain

competitive advantage and finally lowering the cost of capital by optimizing the debt

to equity ratio.

A firm has many stakeholders that are both internal as well as external to the

organisation. The internal stakeholders includes shareholders, employees of the

organisation, debt holders, the management including the board of directors and the

external stakeholders include customers, debt holders, community, suppliers,

government etc.

All the stakeholders are aligned to the business operations in one way or the other

and to maximise the value a firm can generate, it needs to look into the interest of

each of its shareholders. For example employees, suppliers, government agencies,

and customers represent a major part of the value of the company. In order to

motivate employees to work hard for a company, a level of trust must be built. Such

trust can only grow from the perceived security that the interests of all individual

stakeholders are taken into account

Multinational corporations as mentioned above have operations in various countries

and each country follows different laws with respect to corporate governance and

business ethics. Each organisation in pursuit to maximise profits and value for the

shareholders should not forget the applicable laws that are in place. It is not only

important for corporations to comply with applicable laws but also adhere to the

social responsible behaviour that includes preservation of human capital, the

environment and the relationship with the stakeholders.

protect against bribery, child labour, environmental protection, and the like. In the

age of the Internet, information flows very rapidly across the world and sooner or

later people from around the world will find out about inappropriate behaviour of

corporations and hence would affect the operations in other countries as well.

Hence MNCs should generally adopt the same ethical standards on their subsidiaries as on their home operations. An economic rationale for a multinational's (MNC) imposing universal ethical standards can be based on the following argument:

1. Certain ethical commitments are believed by the management of a MNC to provide the MNC with a competitive advantage.

2. These ethical commitments which provide a durable competitive advantage abroad tend to be knowledge-based, to be embodied in individual employees or firm routines, and to be characterized by high asset specificity.

3. Highly specific assets, for example ethical commitments, associated with high return should not be diluted.

4. If ethical commitments vary among subsidiaries, these assets will be diluted due to the phenomenon of cognitive dissonance.

5. Therefore, a MNC should have common ethical commitments in all its subsidiaries.

Generally followed ethical standards can solve agency problems, lower transaction costs, and increase trust both within the organization and between organizations engaged in partnerships or strategic alliances. If a MNC has one set of ethical standards in the home country and different ethical commitments in host countries, cognitive dissonance will be created. Corporate stakeholders will not know which values, beliefs, and behaviours really represent the MNC. The ethical climate of the MNC will become confused and the ethical climate which had been an asset that provided competitive advantage will be diluted. To prevent the negative consequences of cognitive dissonance, the moral climate of the MNC should include standards that are applied universally, i.e., in both the home country and in host country subsidiaries. Thus if the MNC exceeds the legal requirements with respect of the environment at home, it should do the same abroad.

Suppose the home country norms vary widely from host country norms. Customers may not buy their product. When such situations occur the MNC must consider how important its ethical climate asset really is. If that asset truly is important, then it would be better for the MNC not to do business in that country than to dilute its ethical climate asset. For example: Conventional wisdom might consider the action of the Levi Strauss Company to exit China and Burma because of human rights violations there to be extremely foolish. After all they are leaving one of the major markets in the world. Levi Strauss recognizes that it cannot maintain a commitment to basic human rights and thereby to its basic moral integrity while simultaneously done business in a country that commits human rights violations. Levi Strauss places a high value on its reputation as a socially responsible MNC. This argument, however, does not apply to a MNC that does not consider being seen as socially responsible to be an asset.

(b)

The corporate governance laws are different in different countries and hence have

different legislations and needs to be dealt accordingly. After the Enron scandal and

other scandal, the US laws have become really strict by the introduction of Sarbanes

Oxley act and the latest being the Dodd Frank act that was bought into practice after

the 2008 economic crises.

Most organisations face the agency problems where the owners and

managers(including the board of directors) have different interest and the managers

try to enhance their returns sometime at the expense of the shareholders. Sometime

managers also enter into unethical practices as well; one fine example of the same

was Enron.

The structure of the corporate boards, the way the board is elected is different in

different countries and companies have to work accordingly. In the U.S.,

shareholders have the right to elect the board of directors. If the board remains

independent of management, it can serve as an effective mechanism for curbing the

agency problem. In Germany however the board is not legally charged with

representing the interests of shareholders, but is instead charged with representing

the interests of stakeholders. In England, the majority of public companies

voluntarily abide by the Code of Best Practice on corporate governance. It

recommends that there should be at least three outside directors and that the board

chairman and the CEO should be different individuals.

In Japan, most corporate

boards are insider-dominated and primarily concerned with the welfare of the

keiretsu to which the company belongs. In the United States and the United

Kingdom, concentrated ownership is relatively rare. Elsewhere in the world,

however, concentrated ownership is the norm.

So companies for example that are listed in the US stock exchange have to follow

certain laws and a structure in a way the board is selected, compliance with the

Sarbanes Oxley etc. The advantage multinational organizations that have practices in

large companies can become listed in the other countries stock exchange that has

less strict laws. For example a company got it self-listed in the UK stock exchange

because it wanted to evade the troublesome compliance to the Sarbanes Oxley act.

With the emergence of the Internet as a dominant influence in global

markets, many anticipated that the “

L

aw of

O

ne

P

rice” for all products would

evolve.

However that did not materialize.

.

What is “Law of One Price”?. When would that exist globally?

A.

Identify the major pricing strategies/ methodologies of corporations

in pricing products and services.

B.

Discuss the impact of the Internet on “Global Pricing Strategies” of

firms with specific reference to ‘Internet Pricing’ and ‘Brick and

Mortar pricing’.

A: The theory that the price of a given security, commodity or asset will have the same price when exchange rates are taken into consideration. The law of one price is another way of stating the concept of purchasing power parity.

The law of one price exists due to arbitrage opportunities. If the price of a security, commodity or asset is different in two different markets, then an arbitrageur will purchase the asset in the cheaper market and sell it where

prices are higher.

When the purchasing power parity doesn't hold, arbitrage profits will persist until the price converges across markets.

For example, an ounce of gold should cost the same on commodity exchanges in two different countries. If the gold costs more on one exchange, then traders would have incentive to purchase the gold on one exchange and sell it at the other one. They would do what is called an arbitrage.

However, this law does not always hold in practice. The reason is mostly transaction costs and trade barriers. There may be limits on how much gold one can export or import out of the country. It costs something to buy gold in one country and have it shipped to another.

B. Identify the major pricing strategies/ methodologies of corporations in pricing products and services.

A: There are many strategies organisations may use in pricing their products.

Competitive pricing strategy [Bottled Water, Pizzas]

‘Skimming the cream’ pricing strategy *High Technology, Plasma TVs+

Penetration pricing strategy [ Limit Pricing: PCs; Cosmetics or Colas in Emerging Markets]

Keep out pricing strategy [Predatory Pricing: Internet firm Webvan] - a pricing practice, common in oligopolistic market situations, in which the large companies maintain very low prices to discourage smaller competitors and thus protect their own market shares

Mark-up pricing strategy [Retailers, Walmart, K-mart] - widely used in retailing, where

the retailer wants to know with some certainty what the gross profit margin of each sale will be. An advantage of this approach is that the business will know that its costs are being covered

Target-return pricing strategy [Utilities, Auto Dealers?] - Pricing method whereby the selling price of a product is calculated to produce a particular rate of return on investment for a specific volume of production. The target pricing method is used most often by public utilities, like electric and gas companies, and companies whose capital investment is high, like automobile manufacturers.

Differntiated/dual product pricing strategy [Quaker Oats, Proctor and Gamble] -

Differential pricing

is the

strategy

of selling the same product to different

customers at different

prices

Dual - The practice of setting prices at different levels depending on the currency used to make the purchase. Dual pricing may be used to accomplish a variety of goals, such as to gain entry into a foreign market by offering unusually low prices to buyers using the foreign currency, or as a method of price discrimination.

Pricing methods

Cost orientated  Cost-plus pricing

 Contribution pricing

 Target (ROI) pricing

 Price-minus pricing

 Return on costs

Demand orientated  Marginal analysis

 Trial and error pricing

 Intuitive pricing

 Market pricing

 Monopsonistic pricing

Competition

 Product analysis pricing

 Value pricing

 Pricing leadership/ followership

 Competitive parity pricing

Pricing policy, objectives and methods

 To ensure survival,

 To achieve a target rate of return,

 To maintain or improve market share, and

 To meet or prevent competition.

C. Discuss the impact of the Internet on “Global Pricing Strategies” of firms with specific reference to ‘Internet Pricing’ and ‘Brick and Mortar pricing’.

A: The Internet makes global price differences obvious. There are certainly pros and cons to both business models. Online retailers like Amazon have low cost structures and can maintain larger inventories making it difficult for brick and mortar retailers like WalMart to compete on price and product selection. On the other hand, brick and mortar retailers offer real people to talk to, don't require credit cards, and can provide unique services that require the consumer to be in the store. Take

GameStop (GME) for example, which interestingly enough,was sold off by Barnes & Noble in 2004. GameStop purchases used games in exchange for in-store credit; one reason this service can't be completed online is because the purchaser has to confirm the game works before payment.

Internet pricing has also led to “showrooming” — consumers visiting brick and mortar stores to see and touch products before returning to the Internet to make their online purchases. Many brick and mortar retailers are feeling the pinch of showrooming and are taking steps to convert online buyers to in-store customers.

Graphics producers who specialize in creating environments and branding products can help retailers hold market share at their brick and mortar stores.

There are several changes taking place in the strategies of the retail community that are intended to help big-box stores better compete with online retailers:

 Manufacturers of items like TVs and appliances are trying to achieve unilateral pricing by removing or reducing online discounting. Apple is a master at managing

unilateral pricing. When the price in the store and the price online are the same, there is no need to shop twice.

 Brick and mortar stores are strengthening the value of onsite customer support and benefiting from instant availability. We’re also seeing stores offer selected products only through brick and mortar channels.

 Some brick and mortar retailers are using targeted coupons and special offers, delivered electronically to potential customers when they are in the vicinity of the store.

 And, near and dear to our imaging hearts, retailers are improving the onsite buying experience with improved shopping environments and exciting in-store branding.

However internet pricing doesn’t always affect the pricing strategies of brick and mortar stores. Luxury brands such as Gucci and Louis Vuitton are among the retailers least affected by showrooming. Not coincidentally, they are obsessive about their store environments. Their products carry a premium price and they know their customers are interested in the total buying experience, as well as the product. The elaborate store environment and in-store promotions contribute to the exclusivity of the brand. They are trend-setters in the use of environmental enhancement designed to contribute to the sale. Luxury brands are great clients for environmental graphic producers and the retail community can learn from their business practices.

3. A. What does Securitization of assets mean?

B. What are its costs and benefits for financial institutions?

C. Why has this market experienced such a tremendous growth in prior

decades?

D. Why did it cause a global crisis?

A.

 The pooling, and packaging of asset backed loans [began with mortgages] into marketable securities

 It is also known as Asset-Backed lending. More advanced and complex developments are now called Structured Finance.

 The marketable securities are sold to government agencies or to private investors. The proceeds enable banks to make new loans.

 Securitization is an off-balance-sheet transaction that allows a bank to increase net income, because the originating institution [bank] can continue to service the loans, in return for the ‘residual interest income’ and ‘servicing fees’.

 The interest and principal payments generated by the loan package are passed on to the investors who purchase the securities.

Bank loans on

balance

sheets.

Some loans are

removed from bank

balance sheets,

pooled, and placed

under control of a

separate special

Securities

are issued

against the

pool of

loans and

sold to

 Stakeholders/ Players in Securitization

 Originating Institution [Bank (SunTrust), Savings and Loans (Countrywide)] o Originates a cash generating asset

 Special purpose Entity [ SPE also, SP Vehicle or SP Trust or SP Corporation] o Acquires assets from the originator

o Sells them as securities to investors

 Investors [Pension Funds, Mutual Funds, Hedge Funds]

o Buyer of securities; main attraction: High Rates backed by Secured Assets

 Loan Processing / Service Institution (normally the originating institution) o Manages / administers the collection of Proceeds

 Credit Enhancer [s] [Prudential, AIG]

o Provides credit support for improving credit rating; insure risks for a fee.

 Rating Agency [S & P, Moody’s+

 Assesses credit risk profile of underlying asset/enhancements and rates it  Mortgage Backed Securities (MBS, Residential [RMBS], Commercial [CMBS])  Collateralized Debt Obligations [CDO, Collateralized Loan Obligations CLO,

Collateralized Bond Obligations CBO]  Asset Backed Commercial Paper [ABCP]  Asset Backed Securities [ABS]

Securitization Process- Transfer, Enhance, Rate, Issue , Manage [TERIM}

B. Advantages of Securitization

o Liquidity: Ability to sell asset readily o Profitability: Income on Sales

o Solvency: More efficient use of capital; reduce regulatory capital o Potential Service Income

o Diversified source of funds (regional, national, global)

Funds from the sale

flow back allowing it to

make new loans and

investments.

2. To Investors [Mutual, Pension, Hedge Funds]

a. High yields on enhanced and rated collateralized securities

b. Greater Liquidity due to enhanced secondary markets

c. Enhanced diversification

d. Potential Trading profits

3. To Consumers & Borrowers:  Lower cost of funds

 Increased selection of credit forms

 Competitive rates and terms nationally and locally

 Consistent availability of funds

4. To Investment Banks [Bear Stearns, Lehman]  New product lines

 Continuous flow of originations and fees

 Trading volume and profits

 Potential for Innovation and market expansion 5. To Rating Agencies *S & P, Moody’s+

 New product lines;

 3 Times fee income in rating ABS versus Bonds

6. Many other financial institutions, banks and non-banks, Brokers are now active in Securitization; Provides Liquidity, and active secondary market for Underlying Loans 6. Increases funding sources

7. Avoid risk associated with deposit funding 8. Helps Profitability and Solvency Ratios 9. Better Monitor/ Control of Institution

LIMITATIONS

 Risk Enhancement due to Leverage: Other asset-backed securities are riskier than the real estate backed mortgage security. They have less secure collateral

[Car/computer loans, a depreciating asset], or, in the case of credit cards, maybe none at all. They do not have the insurance or guarantee of the government as FNMA, GNMA loans have.

 Securitization Structure and Guarantee Risk: While securitizations enables banks to raise non-deposit funds and increase earnings, depending on the structure of securitization [pass through, ABS, pay through], The bank may guarantee the loans they securitize. While this protects the investor, it seriously undermines the security of the bank’s stockholders and depositors and FDIC. This is because the bank’s required capital reserves are lower than they would be if these loans were carried on the balance sheet.

 Moral Hazard: Window Dressing: The Off- balance sheet structure is a way for the banks to hide and unload risky loans that, perhaps, should never have been made, and for which they may still be liable in the event of default. [ENRON] If institutions is not expected to hold Loans in books, may create Lemon Loans.

 Poor Operational Performance: Enhanced Risk taking while it increases bank earnings, may hide poor performance in other operations.

C. This growth has been encouraged by the benefits that securitisation of financial assets brings to both issuers and investors. For issuers it offers cheaper and more efficient funding for operations combined with greater balance sheet flexibility. For investors, securitisation provides a broad selection of fixed income investment alternatives, most with higher credit ratings, less downgrade risk than corporate bonds and, more stable cash flows than other fixed income securities.

4. Financial Institutions Muti-goal Optimization Strategy:

a. Identify the major ‘objectives’ and ‘problems’ in the management of financial institutions globally. What strategies do institutions use to meet these challenges?

b. How do regulators evaluate the financial institutions?

c. Why did ‘Virtual Banks’ fail? Discuss in depth. Based on this, What are the prospects for Mobile Banking worldwide in the forthcoming decade?

Traditional Questions for Domestic

Firms

New and Additional Questions for

Global Firms

RISK MANAGEMENT

What domestic Operations and

Instruments we should immunize?

What Global Operations and

Instruments we should use for

immunization?

FINANCING DECISIONS

How Should we finance ourselves?

How should we finance our

Subsidiaries?

CASH MANAGEMENT

How Should we return Cash to

Shareholders?

How should we get money out of

Subsidiaries?

INVESTMENT / CAPITAL BUDGETING

DECISIONS

How Should we analyze Investment

Opportunities?

How should we analyze the same

investment opportunities in different

countries?

SIGNALLING / COMMUNICATION

How Should we communicate

information to Shareholders and

Lenders?

How Should we communicate financial

information inside the Firm?

CAPITAL STRUCTURE DECISIONS

How Should our ownership structure

The regulators evaluate and rate an institution’s financial condition, operational controls and compliance in six areas:

 Capital Adequacy: Evaluating and planning for an institution’s capital needs is a major responsibility for directors. To carry out this

responsibility, directors must monitor their institution’s capital position on an ongoing basis and identify factors that may influence the adequacy of this position over time. It also requires the directors to work with

management to develop strategies to meet identified needs.

 Asset Quality: Directors are responsible for asset quality and for ensuring their institution maintains an adequate reserve to absorb loan losses. This has been the main reason in financial institution failures. Board members should establish a policy to guide the institution’s lending activities. Additionally, there should be in place policies and processes to determine probable loss in the loan portfolio and to maintain an adequate reserve to cover these losses. Monitoring asset quality and the adequacy of the reserve to ensure that policies in place are operationally effective is essential in preserving an institution’s asset quality and protection from foreseeable losses.

 Management: The Board plays a key role in an institution’s governance process and success. Directors work for the shareholders in overseeing the operation of the institution. Directors set the course and direction of the institution via its strategic planning, policies and procedures. Management works for the directors in running the institution on a day-to-day basis, implementing its policies and procedures consistent with the strategic plan. Directors monitor management’s performance through the various reports it receives. Together, directors and management identify, measure, control and monitor the institution’s risks. Given this, it is of prime importance that the Board does its job well.

 Earnings: In monitoring an institution’s earnings, directors should receive reports that allow them to compare actual results to budgeted projections and assess the quality, or sustainability, of earnings. Earnings quality refers to the composition, level, trend and stability of institution earnings. For directors and management, earnings quality is a financial report card. It tells how the institution has managed its risk exposure. Where risk management is good, earnings will be consistently strong and earnings quality will be good. Where risk management is poor, the opposite will be the result. In such cases, dissecting earnings into its component parts provides insights regarding areas needing attention.

 Liquidity: Planning and managing liquidity are important aspects of an institution’s governance. Institutions need to plan for depositor and borrower demands so that funds are readily accessible at a reasonable cost. This planning is guided by policies adopted by the board of directors that set liquidity and interest rate risk tolerances, identify appropriate institution products, and provide a liquidity contingency plan in the event of significant, unforeseen circumstances.

 Sensitivity to Market Risk: Steering an institution through different interest rate environments is an important task, guided by the policies set by the board of directors. These include a funds management or asset liability management policy, which includes risk tolerances that maintain earnings and protect capital as interest rates change. The policies should also include a reporting mechanism for the directors, so that the board may monitor the institution’s sensitivity to market risk and compliance with established policy.

A: Virtual bank is a financial institution that does not have physical branches

or location but operate over the World Wide Web using Internet technology.

BUSINESS MODEL: Profitability of a virtual bank can be explained by the

equation:

NI = (NII-burden-PLL) (1-t)

Where, NI = Net Income

NII = Net Interest Income

Burden = (Non Interest Expense – Non Interest Income)

PLL = Provision for Loan Loss

t = Bank’s Tax Rate

1. For a virtual bank to be profitable, the revenue has to exceed the cost of

maintaining their presence over the Internet.

2. Cost of designing a non-interactive, static Internet site ranges from $5,000 to

$50,000. Dynamic, interactive Internet channel ranges from $300,000 to

$500,000 for community banks, in 2005. The cost of initiating a full-fledged

virtual banking bank is over $2 Million, in 2005. In 2012, It is estimated to

be over $5 M.

3. A Bank’s net income depends on several factors. Two most crucial ones are:

a. Net interest income from deployment of assets & liabilities, and

b. Burden, the Excess of non-interest expenses over non-interest

revenue.

4. Theoretically, the comparative advantage for a virtual bank is lower

operating costs and hence lower burden. It was estimated in the early 2000s

that, the Operating cost for a brick-mortar-bank: 60% of revenue; and for a

virtual bank: 10% of revenue.

5. However, intense competition forced changes in their business models.

a. Heavy expenditure of web advertising to establish brand name;

b. Lack of name recognition; forced to pay higher Deposit rates,

increasing cost.

c. Lack of established lending relationships forced them to invest in

lower-yielding secondary margin securities and loans.

6. Virtual operations could not achieve economies of scale and scope;

7. Banking Customers wanted multi channel access, such as branches, ATMS,

and kiosks, in addition to Internet banking.

8. Competition from other wannabe virtual banks created downward pricing

pressures.

9. Superior Infrastructure alone does not guarantee profitability; Citibank’s

Citifi.

10. All the above mentioned factors eroded Virtual banks profitability; under

these circumstances established brick-and-mortar banks had a comparative

cost advantage.

For future prospects for Mobile Banking – Read Lecture 2 Module E – Slides 2,13,14,15,16,17,18

MOBILE BANKING:

Mobile banking transactions to excess US$860 billion by 2013. Informa Telecoms & Media forecasts that in 2013 almost 300 billion transactions, worth more than US$860 billion, will be conducted using a mobile phone

 Remote mobile payments  Local mobile payments  Mobile banking

 Mobile money transfer (MMT).

 Mobile phone and network technologies are now more sophisticated and more mature than ever before and, and thanks to industry initiatives, more coordinated and standardized agencies to take a more ‘enlightened’ approach to this market.  In developing markets it is recognized that mobile banking and mobile money

transfer services can facilitate and encourage economic growth in the poorest and most deprived regions

 Yet these new technologies and service opportunities do offer the potential to make real cost reductions, attract and retain customers and potentially drive new revenue growth and profit opportunities for mobile operators, banks and credit card

companies.

 Once the full ‘leather wallet’ analogy is achieved by the mobile wallet – with the mobile phone holding multiple ‘virtual’ accounts or cards, including loyalty cards as well as ad-hoc discounts (vouchers), and other applications such as ‘mTickets’ and ‘mAccess control’ – mobile payments and mobile banking will become fully integrated in the consumer’s lifestyle.

 In the developing world, the behavioral change amongst consumers has already begun; mobile payments and mobile banking are already the natural and only financial services to millions of previously unbanked consumers– it will lead the world in the use of mobile payments and banking.

 Mobile phone will inevitably become embedded in the financials services’ infrastructure and be accepted as a natural means of payment.

 Will not happen overnight, and that it will not happen in isolation.

 Will require unprecedented levels of collaboration and coordination between two very different industries. There is a strong appetite for these new business opportunities but the key players – mobile operators, banks and credit card companies – must acknowledge and take advantage of each others respective strengths, and work together to overcome the remaining barriers rather that attempt to control everything on their own.”

THREATS

 Mobile attack. Mobile phones today can be as smart as a small computer, but they typically do not have anti-virus programs installed, meaning they are more

vulnerable to attack.

 Next generation backing. Hackers today carry out targeted attacks and have the clear objective of gathering money. The victims are typically executive or celebrity targets, which hackers can search information about using search engines such as google.com or bing.com, together with “intelligent data gathering” from the databases of social networks.

 Inside threats or organized crime. More than 50 percent of cyber security threats are caused by internal figures or disgruntled employees.

 Insecure infrastructure and insecure outsourcing. As many organizations are likely to outsource at least some of their IT operations or infrastructure to third parties, many will use a managed security provider (MSSP) for log and security management.  Misunderstanding about GRC/increase in regulatory compliance. Top management

executives don’t know or understand the concept of GRC (governance, Risk

Management, Compliance) for IT governance, information security government and corporate governance.

 Increasing incidence of espionage and corporate fraud. Enemy countries have often engaged in espionage missions to each other. Cyber security threats at

inter-national level are called “Cyber Welfare” and have been carried out with the objective of gaining strategic advantage in political disputes, Cyber warfare techniques include Information Operation (IO), Information Assurance (IA) and Computer Network Operations (CNO).

5. Theoretical Relationship 1: Relationship between Money Supply and Inflation; Monetary Equation

a. What Causes Inflation? Discuss.

b. What is the ‘Monetary Equation’. Why is it important to the financial manager? c. What are the implications of this for the ‘foreign exchange market’?

Inflation is the rate at which the general level of prices for goods and services is rising. The purchasing power of the monetary unit such as dollar is declines when inflation is present.

Causes:

Long Term: Inflation occurs when the rate of growth of money supply consistently exceeds the growth rate of output. When the money supply grows too quickly than the output of goods and services inflation is high. When it grows only slightly faster than the output inflation is low and when it consistently decreases in relation to output there is deflation i.e. price level falls.

Think how economy responds to increase in money supply. Firms do not immediately increase their prices. Because of this lag, there is increase in the real money supply and this decreases the price of money we call ‘interest rate’. Lower interest rates stimulates

borrowing and spending by the firms and consumers, leading to the expansion of the

economy. Firms react to booming economy by raising prices until they match the increase in the money supply. This pushes back the real money supply. If money supply increases 10% faster than output every year, prices must rise eventually 10% per year. The gap between the average rate of money growth and average growth rate of output determines the average inflation. In theory difference in the inflation between different countries or time periods could be explained by difference in money growth or output, however in practice the most important factor is money growth. It varies from near zero in some countries to 100% in other countries. Variation in output growth is smaller and thus a secondary factor in explaining difference in gap in money growth and output growth. Why is money growth excessive? The answer depends on the type of the economy. Many countries with high level of government spending are unable to politically match the spending by tax revenue and finance the spending by creating new money. This produces high inflation (e.g. Israel and South American countries in past decade) In USA and many European economies

government spending is financed primarily by borrowing and not by printing money. Federal Reserve contributes less than 1% of total revenue by creating new money.

Short Term:

Demand shock and Supply shock are major sources of short run changes in

inflation. Demand shock is sudden shift in aggregate demand (i.e. desired spending by government, businesses and consumers). As the demand rises the economy expands, firms increase production and unemployment decreases. This leads to higher wages and prices, inflation rises. Fall in aggregate demand causes recession. Supply shock is sharp increase in the price of particular goods or decrease in availability of these goods. Bad weather, OPEC Cartel, War, Terrorist attack are some examples that causes disruption of supply. The inflationary effects of price shocks can be explained by 1) inertia in prices and 2) magnitude of the rise and fall of relative prices. Firms do not instantly adjust the prices to every change. They only change if the desired price change is large enough to justify the cost of adjustment. This implies that large shocks have larger effects on prices and adjust to them quickly while makes smaller shock adjustment slowly.

Theoretical Relationship Number 1 - Money Supply and Inflation(Milton

Friedman_

MS=K Yo P o

Where:

Ms

= Money Supply

K

= [1 / Velocity of Money Supply]

Yo

= Amount of Goods and Services Produced in the Economy

or GNP

Po

= the respective prices of Goods and Services in the

Economy.

In the short run, If Money Supply is increased by say 10%, in the RHS equation,

K a constant does not change, Yo The GNP of a nation which increases 2% or 3%

in a year does not change, hence to balance out Ms increase leads to a 10%

increase in Prices or Inflation.

If MS increases by 10%, then P increases by 10% If MS decreases by 5% , then P decreases by 5%

Why is it important to the financial manager?

One of the responsibilities of a finance manager in a corporation can be international trade in the global market. He has to deal with foreign exchange in the import export of products and services. The inflation and currency exchange rate are the most important determinants of a corporation’s relative level of economic health. Inflation is one of the determinants of exchange rate. A higher currency makes a company’s exports more expensive (Japanese pay higher price ¥110 instead of ¥100 for $1 item) and imports cheaper (US pays less for Japanese goods); a lower currency makes a company's exports cheaper and its imports more expensive in foreign markets.

The Central Bank controls Money Supply in Four Major Ways: 1. Printing Of Money

2. Open market operations

3. Federal Discount Rate mechanism 4. Setting Bank Reserve Requirements

6.Trade Policy and Offshoring Strategy:

a. Why do nations trade with one another? Explain in your own words. (Ricardo’s Comparative advantage Chapter 1 Appendix: Economics and Efficiency)

b. What is Dynamic Comparative Advantage? What are the implications of this for the current debate on “Outsourcing” and “Off-shoring?” [Vernon’s Theory] c. What strategies should corporations adopt to minimize the impact of off-shoring on its employees?

a. Why do nations trade with one another? Explain in your own words. (Ricardo’s Comparative advantage Chapter 1 Appendix: Economics and Efficiency)

This theory of comparative advantage, also called comparative cost theory, is regarded as the classical theory of international trade.

According to the classical theory of international trade, every country will produce their commodities for the production of which it is most suited in terms of its natural

endowments climate quality of soil, means of transport, capital, etc. It will produce these commodities in excess of its own requirement and will exchange the surplus with the imports of goods from other countries for the production of which it is not well suited or which it cannot produce at all. Thus all countries produce and export these commodities in which they have cost advantages and import those commodities in which they have cost disadvantages.

Ricardo explained his comparative cost difference theory, by taking an example of England and Portugal as two countries & Wine and Cloth as two commodities.

As pointed out in the assumptions, the cost is measured in terms of labour hour. The principle of comparative advantage expressed in labour hours by the following table.

Portugal requires less hours of labour for both wine and cloth. One unit of wine in Portugal is produced with the help of 80 labour hours as above 120 labour hours required in England. In the case of cloth too, Portugal requires less labour hours than England. From this it could be argued that there is no need for trade as Portugal produces both commodities at a lower cost. Ricardo however tried to prove that Portugal stands to gain by specialising in the commodity in which it has a greater comparative advantage. Comparative cost advantage of Portugal can be expressed in terms of cost ratio.

 Cost ratios of producing Wine and Cloth ↓

Portugal has advantage of lower cost of production both in wine and cloth. However the difference in cost, that is the comparative advantage is greater in the production of wine (1.5 — 0.66 = 0.84) than in cloth (1.11 — 0.9 = 0.21).

Even in the terms of absolute number of days of labour Portugal has a large comparative advantage in wine, that is, 40 labourers less than England as compared to cloth where the difference is only 10, (40 > 10). Accordingly Portugal specialises in the production of wine where its comparative advantage is larger. England specialises in the production of cloth where its comparative disadvantage is lesser than in wine.

 Comparative Cost Benefits Both Participants ↓

Let us explain Ricardian contention that comparative cost benefits both the participants, though one of them had clear cost advantage in both commodities. To prove it, let us work out the internal exchange ratio.

Let us assume these 2 countries enter into trade at an international exchange rate (Terms of Trade) 1 : 1.

At this rate, England specialising in cloth and exporting one unit of cloth gets one unit of wine. At home it is required to give 1.2 units of cloth for one unit of wine. England thus gains 0.2 of cloth i.e. wine is cheaper from Portugal by 0.2 unit of cloth.

Similarly Portugal gets one unit of cloth from England for its one unit of wine as against 0.89 of cloth at home thus gaining extra cloth of 0.11. Here both England and Portugal gain from the trade i.e. England gives 0.2 less of cloth to get one unit of wine and Portugal gets 0.11 more of cloth for one unit of wine.

In this example, Portugal specialises in wine where it has greater comparative advantage leaving cloth for England in which it has less comparative disadvantage.

Thus comparative cost theory states that each country produces & exports those goods in which they enjoy cost advantage & imports those goods suffering cost disadvantage.

b. What is Dynamic Comparative Advantage? What are the implications of this for the current debate on “Outsourcing” and “Off-shoring?” *Vernon’s Theory+

Dynamic comparative advantage refers to shifts in a system's competitiveness that occur over time because of changes in three categories of economic parameters-long-run world prices of tradable outputs and inputs, social opportunity costs of domestic factors of production (labor, capital, and land), and production technologies used in farming or marketing. Together, these three parameters determine social profitability and comparative advantage.

In 1966, Vernon described a theory of international competition known as the international product life cycle model (PLC). The PLC proposes that capital intensive and technologically sophisticated innovations are typically developed in the USA for the domestic market, and progress through various stages in which production shifts to other developed countries and

finally to developing countries that become platforms for MNC exports to their home country and other developed markets

Vernon (1966) emphasized the importance of local demand conditions as a catalyst for export abroad, and the subsequent commoditization of products as an impetus for FDI. Contrary to this slow, sequential internationalization, the inputs to final production of many services may be ‘de-coupled’ from intermediate inputs early in the internationalization process under offshoring schemes. Hence, the linkages between production location and core knowledge-based activities may be weak. Examples include film production,

programming, back office, and call centre functions in audio-visual, software, legal, and accounting services. For production of these services, local demand is less (or un-) important, while specific country factors – land, labour, and infrastructure – are proportionately more important.

As the emerging countries improve their education and infrastructure over time, offshoring evolves consequently due to Economic Advantages.

First it Attracts it was blue collar jobs; The success leads way to White Collar, higher paying, skilled jobs. Finally to the top of the Value-chain jobs

The product life-cycle theory was developed by Vernon to explain the observed

pattern of international trade and dynamic comparative advantage. The theory

suggests that early in a product's life-cycle all the parts and labor associated with that

product come from the area in which it was invented. After the product becomes

adopted and widely used in the world markets, production gradually moves away

from the point of origin. In some situations, the product even becomes an item that is

imported by its original country of invention. Some historical patterns of this can be

observed in the Automobile Industry, The Textile Industry and the Personal Computer

Industry in the United States.

The model applies to labor-saving and capital-using products. In the new product

stage, the product is produced and consumed in the US; no export trade occurs. In the

growth stage, mass-production techniques are developed and foreign demand

expands; the US now exports the product to other developed countries. In the

maturing product stage, production moves to developing countries, this lowers cost of

production and which then export the product to developed countries. The model

demonstrates dynamic Comparative Advantage. The country that has the comparative

advantage in the production of the product changes many times from the innovating

(developed) country to the cost-efficient developing countries.

Product life-cycle

There are four stages in a product's life cycle. Production location depends on the stage of cycle. (An identical case can be observed in Country Entry also for Multi-nationals)

Stage 1: Launch

New products are introduced to meet National needs, and new products are first exported to similar countries, countries with similar needs, preferences, and incomes.

Stage 2: Growth

A similar or comparable product is produced and introduced in the foreign country to capture global growth. This moves production to other countries, due to possible cost advantages.

The industry supply chain develops and optimizes -- the lowest cost producer wins here. Stage 4: Decline

Newer product erode market share of product. Less affluent countries constitute the bulk of demand for the product. Therefore, all declining stage products are produced in lower cost developing countries. The surviving firm or industry stays in a market by adapting what they make and sell, i.e., by introducing new products. In a dynamic competitive global economy major portion of the revenues will be from products they did not sell few years ago. [Refer Lecture 3 Module B for more detail]

c. What strategies should corporations adopt to minimize the impact of off-shoring on its employees?

Potential impacts on the average U.S. standard of living, including average wages and prices

 Traditional economic theory predicts that offshoring is likely to be beneficial for the average U.S. standard of living

 Increase in productivity leading to increase in national income

 Provides consumers with lower prices and access to a broader range of goods and services.

 In addition U.S. companies will respond to the challenges of international competition by developing new areas of specialization in the global economy.

Impact on employment and job displacement

 No long run effects on the net employment-

 In the short run, workers will lose their jobs when employers relocate production abroad

 IT better than Manufacturing

 Offshoring may cause structural changes in the labor market (because increased trade alters the mix of goods and services produced in the U.S).

Impact on distribution of income

 Offshoring could accelerate income inequality in the U.S

 Disappearance of the middle class?

 It could do so by lowering the wages of some lower-wage and middle-class jobs, while potentially increasing the wages of smaller numbers of highly compensated positions

 Prohibit federal work or federally funded work from being performed in foreign countries

 Prohibit the federal government from providing assistance to, or doing business with, companies that in the last 5 years offshored jobs

 Prohibit government contracts from going to countries that have not signed trade agreements with the U.S.

 During offshoring, the management of human resources is particularly challenging, both for the organization, which stands to lose experienced staff, and for individual staff members who face unwelcome change and the threat of job loss. Appropriate measures should be taken in an exemplary manner to mitigate the impact of offshoring on the staff.

 Communicating with the staff from the earliest possible moment is an essential part of managing them transition to offshoring. If staff representatives are not involved in consultations at the initial planning stage, and are only briefed by management after the

offshoring decision had been taken, creates confusion, frustration and negative perceptions among staff.

 Proper redeployment and voluntary separation package must be planned. Redeployment plans must give priority consideration to local recruitment and current suitable staff for vacant posts at headquarters.

 Training plans for the suitable staff, full contribution of the organisation in pensions and medical assistance for staff who had a couple of years to retire etc are few more

measures.

a) To minimize the impact of offshoring on its employees, corporations

should:



Ensure proper communication with its employees, explaining the

rationale behind offshoring



Honesty with the employees is the most important



Move the value chain higher for its employees, make employees

concentrate more on value adding work



Provide trainings to keep the employees updated with latest in all

spheres



Make sure employees adapt to the current environment, as

offshoring is here to stay

7.Theoretical Relationship 2 : Relationship between Inflation and Interest Rates; Domestic Fisher Effect

A. What is the ‘Domestic Fisher Effect’?

B. What is the relationship between Inflation and interest rates ? C. Why is it important for the Global Financial manager?

What is the ‘Domestic Fisher Effect’?

In foreign exchange terminology, the Domestic Fisher Effect refers to the hypothetical long-term relationship between a country’s interest rates and its observed inflation rate that was originally developed by Irving Fisher. His hypothesis proposed that the real interest rate is equal to the nominal interest rate minus the rate of inflation

Fisher Effect states that a country’s nominal interest rate (i) is the sum of required real rate (r) of interest and the expected rate of inflation (I) over the period for which the funds are to be lent.

More formally Fisher’s Effect, i =r+I or more theoretically accurate

i = (1+r)(1+I)-1

This theory explains why there are different interest rates among nations. For example, the U.S. and Japan has same real interest rate.

rUS = rJapan = 5%

IUS = 2.9% and IJapan = 1.5% ; Inflation differential is 1.4%.

iUS = (1+0.05)(1+0.029) – 1 = 0.08045 = 8.04% iJapan = (1+0.05)(1+0.015) – 1 = 0.06575 = 6.58%

Interest rate differential is 1.46% (8.04% - 6.58%), which is approximately close to inflation differential. Thus if the expected rate of inflation in the US is greater than that in Japan, US nominal interest rate will be greater than Japan’s nominal interest rate.

What is the relationship between Inflation and interest rates ?

The Domestic Fisher Effect implies that a given increase in inflation will result in an equal increase in the nominal interest rate, if the real interest rate holds steady. This theoretical relationship has been used to propose that the real interest rate for an economy is

independent of monetary measures, which would include a central bank setting the nominal domestic interest rate, since such manipulation will be offset by changes in the rate of inflation.

An increase in Inflation rate leads to an increase in the Nominal interest rate and a decrease in the inlfation rate leads to a decrease in the Nominal interest rate. The implications of this for the foreign exchange market are effected through the International Fisher Effect.

Why is it important for the Global Financial manager?

The International Fisher Effect (IFE) extends the domestic Fisher effect theory to a global perspective. The IFE states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in the nominal interest rates between two countries. The expected change in the current exchange rate between any two countries is approximately equivalent to the difference between the nominal rates of those two countries in that time.

Calculated as: Where:

"E" represents the % change in the exchange rate "i1" represents country A's interest rate

"i2" represents country B's interest rate

The Fisher Effect is based on present and future risk-free nominal interest rates rather than pure inflation, and can be used by financial managers to predict and understand present and future spot currency price movements. Howerver, IFE is not a very good predictor of short-run changes in spot exchange rates due to differences in borrowing costs or expected returns or when PPP does not hold good.

Implications of IFE:

 Currency with the lower interest rate expected to appreciate relative to one with a higher rate.

 Financial market arbitrage: insures interest rate differential is an unbiased predictor of change in future spot rate.

8.Theoretical Relationship # 3: Relationship between Inflation and Exchange Rates; Purchasing Power Parity

A. Explain the concept of ‘purchasing power parity’ (PPP) in your own words. B. What are the requisite conditions for PPP to exist?

C. What is the relationship between PPP and exchange rates ? Explain the concept of ‘purchasing power parity’ (PPP) in your own words.

The PPP theory states that an identical good in two different countries has the same price when expressed in the same currency.

In the absence of trade restrictions, the price of real goods should be the same in two countries, and since an exchange rate is merely the price of one currency in terms of another, it should equalize the prices of real goods in the two countries.

The PPP theory estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power.

The relative version of PPP is calculated as: S = P1/ P2

Where:

"S" represents exchange rate of currency 1 to currency 2 "P1" represents the cost of good "x" in currency 1 "P2" represents the cost of good "x" in currency 2

For example, a chocolate bar that sells for C$1.50 in a Canadian city should cost US$1.00 in a U.S. city when the exchange rate between Canada and the U.S. is 1.50 USD/CDN. (Both chocolate bars cost US$1.00.)

Two versions of Purchasing Power Parity (PPP):

 Absolute Purchasing Power Parity (for individual commodities)

o Price levels adjusted for exchange rates should be equal between countries o One unit of currency has same purchasing power globally

 Relative Purchasing Power Parity (Commodity basket-many commodities)

o exchange rate of one currency against another will adjust to reflect changes in the price levels of the two countries

The PPP theory leads to conclude that prices of individual commodities (when compared in the same currency) should be the same in two different countries, which also results in the Law of One Price for commodities through trade.

What are the requisite conditions for PPP to exist?

Purchasing-power parity theory tells us that price differentials between countries are not sustainable in the long run as market forces will equalize prices to avoid arbitrage between countries and change exchange rates in doing so.

2. Non-tradable Commodities (Land, Housing, Services Haircut) 3. Transaction Costs/Restrictions on Trade will lead to differences. 4. Similar Consumption Baskets should exist.

5. Relative Price Changes will further impact equilibrium

Refer Lecture 4 Module A for more detail

What is the relationship between PPP and exchange rates ?

Exchange Rate Between two countries equals the ratio of the countries Price Levels.

PPP says the currency with the higher inflation rate is expected to depreciate relative to the currency with the lower rate of inflation.

9.Theoretical Relationship # 4: Relationship between Interest Rates and Exchange Rates; Interest Rate Parity

A. Illustrate the concept of ‘Interst Rate Parity’ and ‘Covered Interest Arbitrage’ with a numerial example.

B. What are the implications of this for Foreign Exchange Market.? The Interest Rate differential between two countries, that do not have restrictions on Capital flows, should equal the difference between the Spot and Forward Exchange rates.

Example:

Consider two countries, Say England and U.S.A. Let the current Exchange rate be:

Spot Rate 1 Pound = 1. 5 dollars

Let Annual Interest Rate of Risk free security in England be: 8% Let Annual Interest Rate of Risk free security in USA be: 4%

What should the three month Forward Exchange Rate be?

As per IRP, the forward exchange Rate should be 1 pound = 1.4853 dollars.

Numerical Example:

We examine this from the perspective of an Investor in England.

Let us assume that one person in England has a 1 million pounds to invest on October 1, 2010. He wants to invest for 3 months till January 1, 2011. He has two options.

Option 1:

He can invest in England on October 1, 2010 and get a return of 2%. [Annual Return = 8%; Hence, three month Return = 2%]

On January 1, 2011 he would have 1.02 million pounds.

Option 2:

Alternatively, he can convert his money to U.S. dollars on October 1, 2010. Given that the Spot Exchange rate is 1 pound = 1.5 dollars, he would get, 1.5 million dollars.

He can then invest it in USA risk free securities for 3 months. He would get a return of 1%. On January 1, 2011 he would have 1.515 million dollars.

This amount he can convert it back to British pounds. Since he can lock in the forward exchange rates on October 1, 2010 itself, he can convert it to England at the predetermined,

locked-up exchange rate. The lock in exchange rate hence should be at: 1 pound = 1.4853 dollars; Thus, and hence he will receive, 1.02 million pounds.

Spot Rate (dollar for pound) = 1.5 Forward Rate (dollar for pound) = 1.4853 Forward Exchange Rate changes by = 2% - 1% = 1%

FIRST VERSION

SPOT EXCHANGE RATE 1 Pound = $ 1.5

Domestic Interest Rate = (UK 3 Month Rate) = 2% Foreign Interest Rate = (USA 3 Month Rate) = 1%

Interest Rate Differenentials = Domestic Interest Rate – Foreign Interest Rate = [ 2 % - 1 % ] = 1%

The New Forward Exchange rate, three months from today should be:

Spot Exc. Rate x (100 – Change in Interest) = Forward Exchange Rate Now, Forward Exchange Rate = Spot Exc. Rate x (100 – Change in Interest)

PRACTICAL solution in the above problem from perspective of a British Investor

= 1.50 x (100% – 1%)

= 1.50 x (99%) = 1.50 x (99/100) = 1.485

Covered Interest Arbitrage

WHAT HAPPENS WHEN THE FORWARD RATE IS NOT 1.4850?

•

• Say the three month forward rate is also 1.50 like the spot rate.

• Say either you or your friend wants to invest $3,000,000 in T.Bill market.

• Instead of investing in USA T. Bill market ($3,000,000) in the USA, you Convert the money to British Pounds, at the spot Exchange rate of 1.50; Get 2,000,000 British pounds, Invest it in UK for three months at the risk free rate at 2%; Get 2,040,000 at the end of three months. At the same time you Lock in the Forward Rate of 1.50 today. At the end of 3 months, you convert your accumulated British Pounds to US Dollars. You will get $3,060,000.

• Alternatively, If you had invested at USA T. Bill market you would have gotten only, 1% return and you would have only $3,030,000.

• You have made $30,000 extra money.

Covered Interest Arbitrage

No Risk Involved; all positions are locked up before entering into transactions. Uncovered Interest Rate Parity:

Risk involved; do not lock up the forward exchange rates. Limitations to IRP:

1. Transactions Costs imposed by Traders 2. Capital Controls imposed by Nations 3. Political risk

4. Differential tax laws.

A. What are the implications of this for Foreign Exchange Market.? a. It plays an essential role in the foreign exchange market

b. The difference between the interest rates in any two countries is the same as the difference between the forward and spot rates of their respective currencies.

c. Interest rate parity A currency is worth what it can earn

d. The return on a currency is the interest rate for that currency plus the expected rate of appreciation over a given time period

e. When the interest rate of two countries are equal, IRP prevails

As per the above numerical example, the following series of events will occur and impact the foreign exchange market

• The dollar interest rate will rise • The pound interest rate will fall • The spot exchange rate will rise • The forward exchange rate will fall

• These adjustments will continue till IRP holds and prevails

10. Auctions Market Strategy:

A. Are auctions the optimal method to sell a security or service?

B. Explain the advantages, and disadvantages of the Auction method of Selling for the buyer and seller, using a specific example..

C. Explain why corporations do not sell “all” their products by auctions?

D. What are the reasons for the success of Internet auction companies

such as e-bay and Priceline?.

Are auctions the optimal method to sell a security or service?

Yes, auctions are becoming an optimal method for selling securities and services.

Unlike physical assets from which you can derive satisfaction from the purchase experience (by feeling, touching, trying before purchase), you can derive little satisfaction from the purchase of intangible assets like securities through retail channels. With fixed price mechanisms you may not realize the full potential of your product. Auctions offer an alternative to enable prices to float and realize higher potential.

Explain the advantages, and disadvantages of the Auction method of Selling for the buyer and seller, using a specific example..

Advantages for buyers

1. Ability to offer what one’s willing to pay, If best bid, can win item.

2. Access to large selection of products, usually available at below retail prices 3. Access to large number of sellers.

4. Anonymity; Enhanced purchase experience. The convenience to ship, any time of day, from any place; Lots of information available at fingertips; Convenient payment methods

Advantages for sellers

1. Reduced cost of marketing product

3. Faster mechanism to sell/dispose of items

4. A better chance of realizing full price potential on items 5. Access to a large number of buyers

Disadvantages for buyers

1. Can be slow. Must wait for the auction to close.

2. No guarantee that will be able to purchase a particular item

3. Inability to select a vendor or establish relationships with specific product vendors. 4. Inability to examine products before purchase; No returns allowed; No item

warrantees

5. Some buyers will end up paying more for the same items (winners remorse) Disadvantages for sellers

1. Final item price at mercy of buyers.

2. Availability of similar products at auction site makes it hard to get a higher price. 3. Once item entered into auction, seller must sell item even if price below

expectations. Can minimize risk by setting a higher starting bid.

4. Some discouraged by complexity of process. But online options, has simplified process.

Explain why corporations do not sell “all” their products by auctions?

2. They want to avoid speculative-type trading

3. They want to provide customers in-store experience associated with the product 4. They have a niche segment for their product; odd lots; specialty products; 5. They do not sell products directly to end customers but through dealers and

distributors

6. Ability to charge higher prices at Stores than on the Internet.

What are the reasons for the success of Internet auction companies such as e-bay and Priceline?.

1. Internet auction marketplaces e-bay/ Priceline provide the huge community of buyers & sellers.

2. Provides better customer experience, as buyers do not have to leave their home to buy.

3. No start-up cost involved for sellers as e-bay provide medium to buy and sell products.

4. You really don't have to set up a website to start selling. No extra overhead; Easy to learn

5. Internet auction companies such as eBay provides a marketplace for virtually all the products from automobiles to accessories and real estates to electronics

11. Global Financial Crisis:

Briefly Explain these crisis in your own words, what these are about, what caused it, how it was resolved and what are the lessons learnt from it.

A. Debt Crisis:

1. Russia - 1997 2. Iceland - 2008 3. Greece -2012

B. Foreign Exchange Crisis: 1. Mexico 2. Asian Crisis C. Banking Crisis: 1. Japan – 1990s 2. USA Subprime -2008 3. Spain - 2012

12. Risk Management and Hedging Strategy Using Forwards

You have been hired by Amerikan Airlines. Your primary task is to keep the Airline in Business and to ensure that you have to accomplish these two goals.

 Keep airfares low and at a comparable steady price throughout the year

 Protect the airline from fluctuating fuel costs

With these objectives you need to develop Hedging strategies in the Forward Market. An historical Review reveals that the Airline consumes 1 million barrels of fuel during the planned horizon and the price of fuel has fluctuated in the previous 5 years from $30.00 to $145.00. Fuel cost represents about 35% of the cost of operation and is next in importance to salaries and wages. Identify the steps you would initiate to protect the company from fluctuating fuel costs and achieve your above two objectives.

STEPS IN HEDGING

 Forward contracts provide an Hedge for an exposure at one particular time.

 With forward contracts you lock the price at which the asset will be bought or sold at a certain future time.

1. Forecast Your Demand;

 Forecast your future flights say for one year on a month by month basis; How much fuel is already available due to prior purchases or prior hedges; and How much more fuel would you need?

 What are the Normal, Optimistic and Pessimistic scenarios of future business and flights and fuel needs.

2. Identify Hedging Alternatives:

 Can you buy Spot Oil / commodity and hold? Or get Forward at different dates? or Option Contracts? What are the choices?

 What is your hedging horizon? One year or Two years? Should you institute a monty-by-month hedging?

 Cross- Hedging; Jets need Jet Fuel, No Jet Fuel Forwards exist; So use Oil, Which has a high correlation with Jet Fuel prices.

 100% Hedge? Partial Hedge? Hedge Ratios?

3. Hedging and Competition: Identify What the Competition is doing?  Match Competition

 Hedging may not always be the optimal strategy for a company.

 If Hedging is not the norm in your industry it can be dangerous for only your company to be hedging.