APA 680: Essay Questions

BSAD 680.20 Final Exam
March 5, 2014

Directions:
Answer four of the following seven essay questions. Essay answers should be in paragraph form using complete sentences. (No bullet points) Use APA style for citations as needed. Exams may be subject to student submission using Turnitin at the professor 's discretion. Your answers should be submitted as a Word file attached to an email sent to me by the start of class on March 5th. While brevity is the soul of wit, essay answers should err on the side of completeness versus brevity. That said, I don 't want to see the answer to any question go beyond two single-spaced typewritten pages using a font size of 10-12 points.

1. Congratulations! You have just been elected ruler of a
small LDC. What steps will you take to manage the country 's balance of trade, and its currency? Name and use an actual country - don 't make one up. Sierra Leone is a country that is rich in agricultural and mining resources, yet the great majority (over 70%) of the country still lives in poverty. Economic growth is hindered by disadvantageous exchange rates and government budget deficits. As the recently elected President of Sierra Leone, I will take any and all necessary steps to bring this beautiful country out of poverty (www.heritage.org, 2014). Sierra Leone is currently working with the International Monetary Fund (IMF) to implement changes and improvements in our country’s economic system. Sierra Leone has made important strides in economic reconstruction and macroeconomic as well as political stability since the end of the civil conflict in 2002. Economic growth has strengthened in the last two years with a stream of iron ore production and increased infrastructure investment. As the new president, I will continue working with the IMF to manage the balance of trade and stabilize our currency (www.imf.org, 2013). In regards to Sierra Leone’s currency, the exchange rate system is classified as floating, with the value of the leone (currency) determined by the market.
Currently, the central bank’s interventions are limited and aimed at smoothing volatility in the market. In order to stabilize the currency, I will diligently work with the Bank of Sierra Leone (BoSL) and with the IMF to introduce a stringent stabilization policy and reduce our country’s debt. This policy will be aimed at first and foremost at tightening monetary regulations and reducing government borrowing. I will encourage the BoSL to move from a wholesale foreign exchange auction system to a retail auction system available to importers. This will enhance the currency’s stability in the market as well as improve competitiveness. I will also work with the BoSL to improve monetary policy signaling, address remaining gaps in banking supervision, monetary and foreign exchange operations. I will also work with the BoSL on access to finance in order to actively support initiatives to encourage the development of microfinance in rural areas. Lastly, and perhaps most importantly, I will continue to work with the IMF and the BoSL to develop a financial literacy campaign that will help to spread knowledge and motivation to continue efforts to stabilize the currency (www.imf.org,
2013) As president, I have also been charged with stabilizing trade in Sierra Leone. One of the biggest challenges in trade in Sierra Leone is that of smuggling and illicit trading activities. Sierra Leone is known for mining, especially diamonds, but poor regulation and policy enforcement, and high levels of corruption that lead to considerable levels of money laundering activities. As president, I will establish stricter controls and taxes around the mining trade, and crack down on corrupt government officials. I will continue to work with the government-created mining community development fund (DACDF), created to raise local communities ' stake in the legal diamond trade, which returns a portion of diamond export taxes to diamond mining communities (www.heritage.org, 2014). Throughout my term as president, I hope to create a great economic turnaround for Sierra Leone, not only through balancing the currency and trade in the country, but through many more positive changes. I hope that by reducing budget deficits and improving the fiscal position of the government, I will be able to rehabilitate our social and economic infrastructure, stabilize the economy and provide a better life for Sierra Leone’s people.

2. Compare and contrast the different methods of hedging transaction exposure. Include both derivative and non-derivative solutions. Transaction exposure is one of three types of foreign currency exposure. It is a type of risk that companies involved in international trade will face when entering fixed-price financial contracts. The risk occurs after the financial contract is made, and the subsequent fluctuations in currency exchange rates occur randomly and unpredictably. Although transaction exposure is considered short-term economic exposure, these changes in exchange rates can still affect the contract negatively, resulting in significant losses for the firm. Therefore, companies participate in various hedging activities to avoid losses from transaction exposure (Eun & Resnick, 2012). In transaction hedging, there are both derivative as well as non-derivative solutions. Derivatives are simply a contract between two parties. One of the ways which firms hedge transaction exposure is through the use of derivatives such as options contacts. Options are contracts used to reduce the risk of transactions by using calls (sell) or puts (buy) on a financial asset at an agreed-upon price at some time in the future, which is known as exercising the option. Options also have a maturity or expiration date. In Europe, options can only be exercised at their maturity date, whereas in the United States, options can be exercised any time during the contract (Eun & Resnick, 2012). Another derivative solution is a futures contract. Futures contracts are an agreement to buy or sell an asset at an agreed-upon price in the future. Unlike options, futures contracts are standardized for an amount of the asset, and are settled daily. However, delivery of goods is rarely made, as a reversing trade is usually transacted to exit the market. Hedgers avoid price variation in the market by and pass off risk to a speculator who will take a long or short position in the futures contract. The speculator is considered to be more willing to take on the price risk variation. Futures contracts are short-term and profits and losses are realized on a daily basis (Eun & Resnick, 2012). Somewhat similar to a futures contract is a forward contract. Forwards are also a contract to buy or sell an asset at an agreed-upon price in the future, however, forward contracts have a specific maturity date unlike the daily settlements used in futures contracts. Rather than being a standardized contract, forwards are tailor made to the needs of the participants. Also different than futures is that when trading forwards, forwards are often settled through the delivery of goods or cash (Eun & Resnick, 2012). There are numerous other types of derivatives used to mitigate foreign exchange risk, but the most common are forward and futures contracts, futures options, and swaps which will be discussed later in this exam (Eun & Resnick, 2012). Many MNCs also participate in non-derivative methods for hedging transaction risk. These are often used if a firm has positions in less liquid currencies. In order to mitigate risk in these cases, cross-hedging is a common technique in which a firm will hedge a position in one asset by taking a position in another asset. Effectiveness of cross-hedging is highly dependable on the strength of the relationship between the commodity futures prices and the exchange rate (Eun & Resnick, 2012). Another non-derivative method to avoid transaction exposure is hedging via lead and lag. A company can lead, to pay or collect on an invoice early, or lag, which means to pay or collect late. By timing the lead and lag strategy correctly, the firm can protect themselves against depreciation or appreciation of the foreign currency they are dealing in (Eun & Resnick, 2012). Hedging through invoice currency can help firms diversify exchange exposure by using currency basket units. A currency basket is a selected group of currencies in which the weighted average is used as a measure of the value of a contract or obligation. It functions as a benchmark for regional currency movements. Because it is a portfolio of currencies, its value is more stable and can be useful as a hedging tool, especially for long-term contracts where there are no forward or options contracts available (Eun & Resnick, 2012). The last non-derivative form of transaction hedging that we will discuss is that of exposure netting. Exposure netting helps to centralize a firm’s exchange exposure management function in one location, typically in a reinvoice center. All invoices from intrafirm transactions are sent here, where overall exposure is analyzed and determined. Foreign exchange experts can then determine the optimal hedging methods for the portfolio of transactions and move forward to implement them (Eun & Resnick, 2012). Overall, we have seen that there are numerous options to hedge transaction exposure. There are some similarities among them, but they differ from each other and are applicable to different needs. Derivative forms of hedging are typically contractual, relatively short term solutions to transaction exposure, whereas non-derivative solutions are long term techniques that can be applied over a firm’s lifecycle. No matter what the case, however, it is prudent for any MNC to determine a strategy for transaction hedging before going into significant overseas contracts.

3. Compare and contrast a plain vanilla currency swap with a plain vanilla interest rate swap. Describe and justify a situation where a MNC would use each type of swap. As discussed briefly above, swap transactions are a type of derivative used to mitigate currency exposure in forward trades. A swap is an agreement between two parties to exchange a sequence of cash flows over a period of time- a simultaneous sale of spot foreign exchange against a forward purchase of an equal amount of foreign currency (Eun & Resnick, 2012). A plain vanilla interest rate swap is the most common and simplest type of swap. They are customized contracts that can be paid monthly, quarterly, yearly, or on a basis decided on by the firms involved. In a plain vanilla interest rate swap, one part agrees to pay the contract at a fixed interest rate, while the other party agrees to pay at a floating interest rate, and the two cash flows are paid in the same currency. The swap typically has a set date of maturity set at some point in the future (McCaffrey, 2012). A plain vanilla currency swap, unlike the plain vanilla interest swap, interest and principal payments on a loan are exchanged in 2 currencies. In the plain vanilla currency swap, the two parties exchange payments at the beginning and end of the swap, which also differs from interest rate swaps (McCaffrey, 2012). In the case of plain vanilla interest rate swaps, MNCs or MFIs would use these when they are paying a floating rate of interest on liabilities and earning a fixed rate of interest on assets. It can be highly risky for a firm to have such a mismatch between assets and liabilities. Therefore, the firm could use a plain vanilla interest rate swap to rectify the imbalance in their interest payments (McCaffrey, 2012). For the case of the plain vanilla currency swap, a firm would be interested in conducting this type of swap when the firm wants to expand operations into another country, but has comparative advantage in its home country. The firm will likely have more favorable financing in its home country, and therefore could perform a currency swap with the country it is expanding into, and gain the necessary funds in the new currency to finance its startup and operations (McCaffrey, 2012). 4. Discuss the issues and potential solutions for a MNC contemplating foreign direct investment in a LDC. By definition, a MNC or Multinational Corporation, is registered and/or has operations in more than one country. These types of firms engage in FDI, or Foreign Direct Investment. FDI is an investment made by a company based in one country into a company or entity based in another country. MNCs making direct investments typically have a significant degree of influence and control over the company into which the investment is made. Open economies with skilled workforces and good growth prospects tend to attract larger amounts of foreign direct investment than closed, highly regulated economies (www.investopedia.com, 2014). FDI can have numerous risks and obstacles for the MNC involved. LDCs, or Less Developed Countries, are often troubled with both economic and political risk. Foreign direct investment can be an important source of employment opportunities for developing countries. However, anti-corporate advocates criticize MNCs for entering LDCs that have low human rights or environmental standards. They claim that multinationals give rise to large merged conglomerations that reduce competition and free enterprise, raise capital in host countries but export the profits, exploit countries for their natural resources, limit workers ' wages, erode traditional cultures, and challenge national sovereignty. However, they remain attractive to investors due to low costs of labor, poorly enforced environmental and economic regulations, and inexpensive resources (www.investopedia.com, 2014). Economic risk depends on the foreign country’s financial state. A country with stable finances and a sound economy will be more attractive to foreign investors than one that has currency fluctuations and difficulty paying debt. Trade barriers and shareholder diversification issues can all be part of the economic risks taken on by a MNC that is contemplating FDI (Eun & Resnick, 2012). Trade barriers can often be overcome by moving trade through other countries without trade restrictions. In the case of physical trade barriers, such as poor transportation, FDI can be put into place to improve infrastructure and reduce transportation costs (Eun & Resnick, 2012). Political risk emerges when the political climate in a foreign country becomes unfriendly to investors. Political risk can be classified into three types: transfer risk, operational risk, and control risk. Transfer risk arises from uncertainty about cross border flows of capital and payments. Operational risk arises when the host country’s policies affect the MNC. Lastly, control risk is caused by uncertainty about the host country’s policies regarding ownership and control of local operations (Eun & Resnick, 2012). When contemplating investing in a LDC, the MNC should take care to meticulously research and define the level of risk for doing business with the LDC they are considering, and also outline possible solutions in case of risk exposure. For example, those seeking more in-depth coverage of a particular country or region, two excellent sources of objective, comprehensive country information are the Economist Intelligence Unit and the Central Intelligence Agency World Factbook. Either of these resources provides an investor with a broad overview of the economic, political, demographic and social climate of a country. The EIU also provides ratings for most of the world 's countries. These ratings can supplement those issued by Moody 's, S&P and the other "traditional" ratings agencies (www.investopedia.com, 2014). After completing the country analysis, the investing MNC will have to decide on a sound investment approach. One of the recommended approaches is for the MNC to invest in a broad international portfolio. Diversification is a fundamental principle of domestic investing, and is even more important when investing internationally. Even in a more concentrated portfolio, investments should be spread among several countries to maximize diversification and minimize risk (www.investopedia.com, 2014). After deciding where to invest, an investor must decide which type of investment to enter. The choice of investment vehicle depends on each investor 's individual knowledge, experience, risk profile and return objectives. When in doubt, it may make sense to start out by taking less risk; more risk can always be added to the portfolio later. In addition to thoroughly researching prospective investments, an international investor also needs to monitor his or her portfolio and adjust holdings as conditions dictate. As in the U.S., economic conditions overseas are constantly evolving, and political situations abroad can change quickly, particularly in emerging or frontier markets. Situations that once seemed promising may no longer be so, and countries that once seemed too risky might now be viable investment candidates (www.investopedia.com, 2014). The study of FDI and MNCs is both fascinating and important for understanding economic globalization. There has been substantial progress in the literature in the past several decades, but it is complicated enough that, in many ways, we are still in the process of uncovering what we don 't know. Foreign direct investment by a MNC can be a very profitable venture if carried through correctly. There are great risks but also the promise of great profits, such that overseas investing involves a careful analysis of the economic, political and business risks to prevent significant unexpected investment losses (www.investopedia.com, 2014).

Works Cited
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Eun, Cheol S., and Bruce G. Resnick. International Financial Management. New York, NY: McGraw-Hill, 2012. Print.
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