International Financial Systems

Objective of the Firm

• Max the current value of the shareholders’
wealth
• Financial decisions have multi-period
dimensions
• Uncertainty
• CAPM and APT
The three propositions of CAPM & APT
• Investos are risk averse and they demand
premium for risky assets
• Two aspects: risk and return
• Risk = variability in cash flows; if it’s higher,
investors will use higher rate of discount,
hence price of that asset will be lower
• Unsystematic and Systematic risks
• Unsystematic risks are diversifiable
 The CAPM
• Security Market Line
• Expected Return = Risk-free return + Beta *
Excess return
• Sharpe, Markowitz, Miller
 APT
• An asset’s returns can be predicted using the
relationship between the same asset and
many common risk factors
• Ross (1976)
• Returns on an asset and returns of a portfolio
are linked through many macro variables
 Should the Firm take steps to avoid
Unsystematic risks :The Debate
• Risks are diversifiable, so firms should not spend money for
risk management
• But, risks do not affect all the firms in the same direction
• Modigliani-Miller theorem: in a world of no taxes, transaction
costs and no info asymmetries, a firm’s financing policy
doesn’t matter as long as it doesn’t affect its inv. Policy
• But, in practice,firms do spend money to hedge firm-specific
risks
• Avoid risky projects,make forward contracts, insurance etc.
• For efficient markets, it doesn’t matter whether firm takes
hedging or not
• Practically, most markets are inefficient
 Should the Firm take steps to avoid
Unsystematic risks :The Debate
• If active risk management adds shareholder value, then it
must be the case that, the it’s beneficial even after the cost of
hedging
• The firm can achieve this at a lower cost
• Hedging can increase shareholder wealth by influencing
future cash flows and by reducing the discount rate
• Froot et al (1994) : discretionary hedging is an optimal policy
• Shareholder value increases (good inv in R&D etc)
• Careful hedging can ensure availability of internally generated
cash
• The link between finance and investment
 Should the Firm take steps to avoid
Unsystematic risks :The Debate
• If unsystematic risk is unmanaged, it may lead to financial
distress
• Direct costs: bankruptcy, liquidation and re-organisation costs
• Indirect costs: Loss of credibility
1. Managerial incentives
2. Customers are scared away
3. Operating cost goes up
4. Creditworthiness shaken
5. More compensation demanded by all parties
• Tax treatment
 International Monetary System
• Exchange Rate regimes
• International liquidity
• Adjustment process
• Currency Blocks
 Regimes
• Procedures for determining exch rates
• Gold Standard
• Bretton Woods
 Regimes: Current Scenario
• No separate legal tender
• Currency board arrangements
• Conventional fixed peg
• Pegged with bands
• Crawling peg
• Managed float
• Independent float
 Optimal Regime?
• The impossible trinity
• Stable exch rate
• Open cap a/c
• Independent monetary policy
 Adjustments
• Own reserve
• IMF
• Others

Apte