Twin Agency Problem, Shareholder Wealth Maximization, Stakeholder Capitalism, Currency Exchange Rates, Currency Market Intervention Strategies Essay.

Discuss what you understand by the term ‘twin agency problem’.

Discuss and compare the shareholder wealth maximization model and the stakeholder capitalism model.

Classify the following as a transaction reported in a sub-component of the current account, or the capital and financial accounts of the countries involved:

• An Australian company imports vegetables from a Chinese firm.
• An Australian resident pays Singapore Airlines for a flight to Singapore.
• A German investor buys some US treasury bonds.
• An Indian firm pays the salary of its executive working for a subsidiary in Australia.
• An Australian firm buys 100% share of a Japanese company.

Discuss what you understand by the term ‘impossible trinity’.ABM Ltd. is an Australian software development company which wishes to purchase a laptop and is making a choice between two laptop manufacturers. A laptop manufacturer in Japan has quoted the laptop price to be ¥50,000, while a laptop manufacturer in the US has quoted the price of a similar laptop to be $400. The spot exchange rate for the US dollar against the Australian dollar is $0.76/A$, and the spot exchange rate for the US dollar against the Japanese yen is $0.0089/¥.

1. Determine the Australian dollar cash outlay for ABM Ltd. if it buys:

(a) from the Japanese manufacturer

(b) from the US manufacturer

1. Which of the manufacturers should ABM choose, if the choice is solely based on required Australian dollar cash outlay?
2. Suppose the expected exchange rates after 3 months are respectively $0.80/A$ and $0.0077/¥. Also, suppose that the dollar and yen prices of the laptop will remain the same. Will there be any change in the purchase decision for ABM Ltd. if the laptop is purchased after 3 months and the spot exchange rates at that time equate the expected exchange rates?

A German car now costs €50,000. The spot exchange rate is A$1.40/€. If the expected inflation rates in Australia and Germany are respectively 1.6% and 2.0%, what will be the Australian dollar price of that car 1 year from now if there is 100% exchange rate pass through?

John is a US based Forex trader. He focuses principally on the Singapore dollar/US dollar (S$/$) cross-rate. The current spot rate is S$1.40/$. After considerable study, he concludes that the exchange rate, in the coming 180 days, will probably be about S$1.34/$. He has the following options on the Singapore dollar to choose from:

Discuss whether he should buy a Put on S$ or Call on S$, and what would be his net profit if the spot rate at the end of the 180 days is indeed S$1.34/$.Discuss and compare the different currency market intervention strategies.

As per the RBA, on Jun 20 2016, just before the United Kingdom Referendum on European Union Membership, the exchange rate between Australian Dollar and the Great Britain Pound (GBP) was £0.5114/A$; while on Jul 20 2016, it was £0.5725/A$. What was the percentage change? Was it a devaluation or revaluation or appreciation or depreciation of the GBP against the Australian dollar? Assume that Australian dollar is the home currency.

An Australian organization has a ¥40,000,000 account receivable from a Japanese customer in 3 months. The current Japanese yen (¥)/Australian Dollar (A$) spot exchange rate is ¥87.35/A$. The Australian organization expects the spot rate in 3 months to be ¥91.45/A$. The 3-month forward exchange rate is ¥89.50/A$. The Australian Dollar (A$) 3-month borrowing rate is 4.00% per annum and the Australian Dollar (A$) 3-month investment rate is 6.00% per annum. The Japanese yen (¥) 3-month borrowing rate is 8.00% per annum and the Japanese yen (¥) 3-month investment rate is 4.00% per annum. The organization’s weighted average cost of capital is 10% per annum. The organization is considering three hedge positions: remaining unhedged, forward market hedge and money market hedge. Which of these hedge positions should the organization adopt.

Twin Agency Problem

As per Scultz, twin agency problem is responsible for the existence of barriers with regards to capital flow even though the external barriers have been made extinct. He refers to two agency issues which through inter-related are actually separate. The first issue deals with corporate insider discretion which refers to the manner in which the corporate insiders exercise their control over the firm. They use their owner only for enhancing their own interest and not the firm which woos away the external investors.

This is because of the underlying costs of the given process which tends to hurt the interest of the minority shareholders especially. Besides, the rulers of the state may acting in a discretionary manner may try to further their own gains at the expense of the company which puts off the external investors who desire that state power should be constrained and investor interest needs to be protected.

Shareholder Wealth Maximization (SWM) – It refers to a theory which propagates the idea that the objective of the firms should be to maximize the wealth of the shareholders which are typically reflected from the capital gains and dividend income that the shareholders are able to derive.  Further, this model assumes the efficiency nature of the stock markets i.e. the market prices are representative of the actual stock performance.

Stakeholder Capitalism Model  (SCM) –  This refers to an alternative theory where it is believed that objective of the firm should be the maximization of the overall stakeholder capital rather than just limiting to the interest of the shareholders.

Comparison

• SWM focuses on shareholders while SCM focuses on stakeholders.
• SWM focuses on gains in terms of stock price and dividends which are essentially short term while SCM focuses on long term value creation.
• SWM believes in efficiency of stock markets while SCM do not believe that markets are efficient andhence ignore share returns.
• Current Account
• Current Account
• Capital Account
• Current Account
• Capital Account

In accordance with the impossible trinity  concept, the following three cannot be achieved by any economy simultaneously and at best two of the below mentioned objectives can be fulfilled simultaneously.

As a result, the central banks have the choice to choose the most relevant two objectives which they consider critical for the economy. For instance, if there is a free capital flow along with sovereign monetary policy, then the exchange rate cannot be fixed as in accordance with the direction of flow, it is essential the exchange rate would change. Further, if there is a sovereign monetary policy along with fixed exchange rate, there would be restrictions and regulations of capital flow as free capital flow would lead to the movement in exchange rate if monetary policy sovereignty is maintained.

• The cash outlay needs to be determined given the following information.

1 AUD = 0.76 USD

I Japanese Yen = 0.0089 USD = (0.0089*0.76 = 0.006764 AUD

• Japanese Manufacturer

Price of laptop in Japanese Yen = ¥50,000

Price of laptop in AUD = 50,000 * 0.006764 = AUD 338.2

• US Manufacturer

Price of laptop in USD = USD 400

Price of laptop in AUD = 400/0.76 = AUD 526.32

• Based on the outlay in AUD, it is evident that purchase should be made from the Japanese manufacturer and not the US manufacturer as the former is cheaper.
• The new exchange rates are given below.

1 AUD = 0.80 USD

I Japanese Yen = 0.0077 USD = (0.0077*0.80 = 0.00616 AUD

Japanese Manufacturer

Price of laptop in Japanese Yen = ¥50,000

Price of laptop in AUD = 50,000 * 0.00616 = AUD 308

US Manufacturer

Price of laptop in USD = USD 400

Price of laptop in AUD = 400/0.8 = AUD 500

Now, also the purchase would be made from the Japanese manufacturer since it is offering a lower price in AUD terms and hence the decision would not change.

The existing exchange rate is A$1.40/€.

Expected inflation over next year in Australia = 1.6%

Expected inflation over next year in Germany  = 2%

Hence, exchange rate after 1 year = A1.4*(1.016/1.02)/€ or A1.39451/€

Price of the German car currently = € 50,000

Price of German car next year = € 50,000*1.02 =€ 51,000

Price of the car next year in AUD = 51000*1.39451 = AUD 71,120

It is apparent that the trader expected Singapore Dollar to appreciate with regards to USD which is why a decrease in the exchange rate is expected as shown in the given values.  The appropriate option that he should buy is a put available for Singapore dollar as it expected the price to fall.

Strike price of the put option = S$ 1.36/$

Closing price of the currency at the expiry of the option  = S$ 1.34/$

Hence, profit  = 1.36-1.34 = S$ 0.02

Cost of purchasing the option = $ 0.003/S$ pr S$ 0.003*1.34 = S$ 0.004

Thus, net profit = 0.02-0.004 = S$0.016

The various currency market intervention strategies are indicated below.

• Sterilised Intervention – In this strategy, there is no change in monetary base and currency exchange rate is influenced through the sale or buying of foreign currency based on the exact requirements of the situation.  However, this amount is offset through domestic currency transactions.
• Managed exchange rate – The central bank tends to intervene in market and adds to the money supply by either supplying foreign currency or mopping up the same depending on the exact requirement so as to ensure that critical currency levels are not breached and currency remains in  a broad range.

Comparison

• The sterilised intervention does not lead to increase in money base which is not the case in managed exchange rate.
• Sterilised intervention is mainly required on account of foreign capital inflows while managed exchange rate is for ensuring the exchange rate remains range bound so as to avoid adverse impact on economy.
• There is no net use of foreign exchange in sterilised while is not the case in managed exchange rate which tends to increase or decrease the applicable exchange rate.

Exchange rate before the referendum = £0.5114/A$

Exchange rate after the referendum = £0.5725/A$

Hence % change = (0.5725 - 0.5114)/ 0.5114 = 11.95%

Therefore, AUD has appreciated by 11.95% and GBP has depreciated by the same amount.

The GBP has depreciated since for getting AUD 1,more GBP would be required after the referendum thus indicating that the value of GBP has gone done. Devaluation and depreciation both produce the same result but their contributory reasons are different. Devaluation is caused due to government intervention while depreciation is caused due to market forces including speculation. Since the government had no direct role to play in declining value of currency, hence this would be termed as depreciation.