Presentation on Flow of Funds and Shocks

8/3/2019 Presentation on Flow of Funds and Shocks

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Presentation on

Flow of Funds

and Shocks

International Financial

Management


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Capital Flow

The movement of money for the purpose of investment,

trade or business production. Capital flows occur withincorporations in the form of investment capital and capital

spending on operations and research & development. On

a larger scale, governments direct capital flows from tax

receipts into programs and operations, and through trade

with other nations and currencies. Individual investorsdirect savings and investment capital into securities like

stocks, bonds and mutual funds.


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Channels for International Flow ofFunds

The International financial market can be

compartmentalised into two segments.

} International Money Market

} International Capital Market


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Cont.

Irrespective of such distinction between the two segments,

there are a number of agencies and instruments through

which funds move to the resource-needy institutions or firms.

The resources providing agencies may be:

}Official agencies

}Non- official agencies


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Selection of Sources and Forms of Funds

When a firm selects a particular source or form of funds, it

does so in order to suit its corporate objectives. Some of

the objectives are:

}Minimisation of Cost of Funds

} Borrowing to Conform to Capital Structure Norms

} Selection of OptimalMaturity

}Avoidance of legal and procedural Formalities


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Minimisation of Cost of Funds

} Effective cost of borrowings depends on both the

interest rate and the exchange rate changes.

} The effective cost of borrowings in a foreign

market is obtained as:

Kbf= (1+rf) (1+Ef) 1

Where, rf =

rate of interest in the foreign market

Ef = change in the exchange rate


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Borrowing to Conform to CapitalStructure Norms

} Sourcing of funds is related essentially to minimizing thecost of capital, but not through selection of currency of

borrowings but by adhering to the capital structurenorms.

}Multinational enterprise raises funds, it does it throughmixing debt capital with equity in a way that minimizesthe cost of capital.

} If the capital structure norms conform to the loacalnorms in the host country, they are well in line with themonetary and financial policy of the host government.


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Selection of OptimalMaturity

A multinational firm likes to maintain a proper

balance between :

} Short term liabilities and

} Long term liabilities


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Avoidance of legal and proceduralFormalities

} Any firm raising funds does not like to undergo too

many procedural formalities.

} From this viewpoint, the issue of international bond is

too complex, much more complex than the Euro notes.

}Again, the borrowings programme can be designed

only in frame work of local laws.

} If the government prohibits the issue of a particular

instruments, the borrower can not issue it despite its

cost efficiency.


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Financial Crisis

} The term financial crisis is applied broadly to a variety

of situations in which some financial institutions orassets suddenly lose a large part of their value.

}Many financial crises were associated with banking

panics, and many recessions coincided with these panics.


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}Other situations that are often called financial crises

include stock market crashes and the bursting of other

financial bubbles, currency crises, and sovereign

defaults.

} Financial crises directly result in a loss of paper wealth;

they do not directly result in changes in the real economy

unless a recession or depression follows.

}Many economists have offered theories about how

financial crises develop and how they could beprevented.


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Types of Crisis

}Banking crisis

} Speculative bubbles and crashes} International financial crises

} Wider economic crises


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Banking crisis

} BANK RUN

} Banks lend out most of the cash they receive in deposits} Bankruptcy

} Causing many depositors to lose their savings unless

they are covered by deposit insurance


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}A situation in which bank runs are widespread is calleda systemic banking crisis or just a banking panic.

}A situation without widespread bank runs, but in which

banks are reluctant to lend, because they worry that they

have insufficient funds available, is often called a creditcrunch.

} Examples:

1. Bank of the United States in 1931.

2. Collapse of Bear Stearns in 2008 has also sometimesbeen called a bank run, even though Bear Stearns was

an investment bank rather than a commercial bank.


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Speculative bubbles and crashes

} Financial asset (stock, for example) exhibits a bubble

when its price exceeds the present value of the future

income (such as interest or dividends)

} If most market participants buy the asset primarily in

hopes of selling it later at a higher price, instead of

buying it for the income it will generate, this could be

evidence that a bubble is present.


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} If there is a bubble, there is also a risk of a crash in asset

prices: market participants will go on buying only as

long as they expect others to buy, and when many decide

to sell the price will fall.

} It is difficult to tell in practice whether an asset's price

actually equals its fundamental value, so it is hard to

detect bubbles reliably.


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International financial crises

}When a country that maintains a fixed exchange rate is

suddenly forced to devalue its currency because of a

speculative attack, this is called a currency crisis or

balance of payments crisis.

}When a country fails to pay back its sovereign debt, this

is called a sovereign default.


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}While devaluation and default could both be

voluntary decisions of the government For,

1. To stop Capital Flow

2. To encourage Capital Flow


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Wider economic crises

}Negative GDP growth lasting two or more quarters is

called a recession.

}An especially prolonged recession may be called a

depression

}while a long period of slow but not necessarily negative

growth is sometimes called economic stagnation.


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} Example: bank runs and stock market crashes.

} The subprime mortgage crisis and the bursting of other

real estate bubbles around the world also led to recession

in the U.S. and a number of other countries in late 2008and 2009.

} Financial crises are caused by recessions instead of the

other way around, and that even where a financial crisis is

the initial shock that sets off a recession.


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Causes and

Consequences of FinancialCrises

}Strategic complementarities in financial markets

}Leverage}Asset-liability mismatch

}Regulatory failures

}

Fraud}Contagion


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Strategic complementarities infinancial markets

} Reflexivity: Intentions of other investors.

}

Secondly Investors have incentives to coordinate theirchoices.

}Who thinks other investors want to buy lots of Japanese

yen may expect the yen to rise in value, and therefore has

an incentive to buy yen too.

} Incentive to mimic the strategies of others strategic.


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Leverage

}borrowing to finance investments, is frequently cited as a

contributor to financial crises

}When a financial institution (or an individual) only

invests its own money, it can, in the very worst case, lose

its own money. But when it borrows in order to invest

more, it can potentially earn more from its investment,

but it can also lose more than all it has.


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}Magnifies the potential returns from investment,

but also creates a risk of bankruptcy.

}The average degree of leverage in the economy

often rises prior to a financial crisis.


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Asset-Liability Mismatch

}A situation in which the risks associated with an

institution's debts and assets are not appropriately

aligned.

} The mismatch between the banks' short-term liabilities

(its deposits) and its long-term assets (its loans) is seen

as one of the reasons


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} Many emerging market governments are unable to sell

bonds denominated in their own currencies, and therefore

sell bonds denominated in US dollars instead.

} This generates a mismatch between the currency

denomination of their liabilities (their bonds) and their

assets (their local tax revenues), so that they run a risk of

sovereign default due to fluctuations in exchange rates


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Regulatory failures

}Governments regulating the financial sector.

}

transparency: All procedures to be standardized.}Goals:

1. Reserves Requirement

2. Capital Requirement

3. Leverage


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For example, the Managing Director of the International

Monetary Fund, Dominique Strauss-Kahn, has blamed the

financial crisis of 2008 on 'regulatory failure to guard

against excessive risk-taking in the financial system,

especially in the US'.


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Fraud

} Fraud has played a role in the collapse of some financial

institutions.

}When companies have attracted depositors with

misleading claims about their investment strategies, or

have embezzled the resulting income


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Contagion

} idea that financial crises may spread from one

institution to another.

} Example: Bank Run, currency crises, sovereign

defaults, or stock market crashes spread across

countries.

} idea that financial crises may spread from one

institution to another.

Presentation on Flow of Funds and Shocks

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