Corporate Tax Avoidance Project

According to Christensen et al. (2015), corporate tax avoidance means using the legal strategies to adjust the financial circumstances of an individual to lower the amount of tax the said individual is owing to the state. Corporate tax is achieved through claiming permissible credits and deductions. Most often, corporate tax avoidance is usually confused with tax evasion. Although the two phrases could sound similar, however, Armstrong et al. (2015) believe that tax evasion applies illegal techniques like under reporting the income of an individual to make him or her avoid paying the taxes. According to Sikka (2010) tax avoidance strategy of a given corporation is an ‘organized hypocrisy.’

Avoidance Strategy as an Organized Hypocrisy

I agree with Sikka’s Term that tax avoidance is an organized hypocrisy. Just to mention, companies tend to excel at speaking on social responsibilities when at the same time they devising structures to enable them evade paying taxes. The tenacity of corporate tax avoidance as well as the evasion lures a devotion to organized hypocrisy which can be properly comprehended as the gaps that exist between the decision, the action and the corporate talk, (Brunsson, 1989, 2003). Corporate tax avoidance is indeed an organized hypocrisy. In particular, a case of WorldCom, which is a US telecommunications organization, collapsed amid of allegations of fraud in the year 2002. Consequently, the second reason why I agree with Sikka’s claim that corporate tax avoidance is an organized hypocrisy is the case of KPMG that was borrowed in 1997 considering the initial fee of three million dollars. Later, KPMG recouped a half a million dollars fee which meant to carter for the feasibility study. Notably, the organization proceeded to earn the bonuses of performance totaling to extra two million dollars.

Main Costs of Tax Avoidance

According to Koester, Shevlin, and Wangerin, tax avoidance will keep on inflicting and results to costly consequences to millions of individuals as long as the leaders of low-income countries are excluded from the tax avoidance solution (2016). Notably, in July 2014 at Los Angeles College, President Obama proclaimed loudly that those who employed creative measures to ensure their taxes were reduced were merely corporate deserters renouncing their citizenship to shield profits. Gaertner (2014) reveals that such strategies by individuals to avoid corporate tax have severe costs. There are five main cost types which are generated by companies and individuals vigorously avoid tax.

First, the authorities handling tax collection attempt to counter ingenious tax avoidance practice and institute new opinions and regulations which in turn become supplementary to the tax code. Although the purpose of this measure is to increase certainty, however, the end results is a convoluted tax which leads to the second cost of tax avoidance which is corporate compliance cost.

The third cost of corporate tax avoidance is increasing the cost of administration. Forth, tax avoidance encourages the formation of lobbyists and tax specialist industries which are created to exploit the system. The last main cost of tax avoidance is the loss of the government revenue. According to Hanlon (1994) and Sikka (2003), the federal government of the United States losses fifty to one hundred and seventy billion dollars annually due to tax avoidance.

Key Issue Surrounding Tax Avoidance

According to the Guardian on 30th March 2009, developing countries often receives approximately one hundred and twenty billion dollars from G20 countries in the foreign aid in which the said developing countries are losing an approximate amount of between eight billion and one trillion dollars from the unlawful financial outflow every year to the countries of the west (Kar & Cartwright-Smith, 2008). As Baker (2005) and Cobham (2005), about five hundred billion dollars is lost over a variety of corporate tax avoidance structures in which a substantial amount is attributed to price practices which shifts profits from the developing countries to already developed countries.

Tax is a major cost to many companies and they formulate strategies which ensure that such costs are minimized thus causing tax avoidance. According to Finch (2004), although rules still remain to be rules, nevertheless, they are prone to be broken and thus no matter which legislations are in place, the lawyers and the accountants will always find a way around the game of tax avoidance. Multinational is the leading case studies of tax avoidance since they have multiple locations which allow them to organize profits in those countries which are favorable tax regimes (Bowler, 2009).

Moral and Economic Implications of Corporate Tax Avoidance

In my own thoughts, corporate tax avoidance has negative moral and economic implications. The company which avoids tax uses the definition of CSR and also relies on a set of moral principles to assess their taxpaying behaviors using the lens of morality and ethics. However, moral reasoning is more complex than one can imagine. Following the thoughts of KMPG (2006), tax payment forms a key responsibility in the contemporary corporation. Some people usually consider paying corporate tax as a moral problem although others find it as being moral while a good portion will find the payment of corporate tax as an immorality. On the other hand, economic implication of corporate tax is that it makes accounting companies be capitalist and thus cannot buck the system pressure to raise their own profits thus creating new tax avoidance schemes and reducing the contribution to the government (Sikka, 2005). When the tax is not collected fully, the accumulated tax compels the government to stop spending in critical areas like welfare and schools which leads to underdevelopment.

Ways in Which Corporate Tax Avoidance can be Restricted

I think that there are ways that can be used to restrict corporate tax avoidance. First is through legislation. Legislation can be achieved through standardizing corporate reporting systems to make the government process information and also compare taxes across firms to see who is avoiding the corporate tax. The legislation should aid in the detection of fraud and strictly monitor a company’s insiders on the matters of tax.

Corporate Tax Avoidance Project
Corporate Tax Avoidance Project

The legislation on the tax avoidance can be enforced through well-functioning courts through playing the central importance of law enforcement of the contracting parties. The other way in which tax avoidance can be restricted is through ensuring proper accounting standards. Leuz et al report that proper accounting standards bring about a global reporting coverage than often thought (2003). Single sets of accounting cannot sufficiently compare reporting and disclose any malpractice.

Harmonization of Accounting Standards- Implementation and Challenges

It is argued that there should be standardization of the accounting policy among nations to fully realize the global economy. Harmonization of accounting standards facilitates international transactions as well as minimizing the costs of exchange through the provision of standardized information to the world’s economy. The harmonization is done by the International Accounting Standards Committee (IASC), the International Accounting Standards Board (IASB) and the International Financial Reporting Standards (IFRS). The said bodies are mandated to implement the accounting standards across the world. However, there are challenges faced during the implementation. First is the challenge of comparability. Comparability can be achieved through like things looking alike as well as unlike things looking unlike (Trueblood, 1966). According to Truebold, “things” in the accounting include the regulatory culture, the culture of auditing, the culture of account as well as the financial and business culture. The other challenge is associated with the problem of interpretation in which language is a problem when translating IFRS from English or to English.

Most accounting standards are limited in bringing convergence. It should be noted that adopting a single set of accounting cannot be sufficient to allow comparability as well as disclose relevant practice even if the said principles are compulsory to all the countries. However, the idea of adopting common sets of accounting standards cause more comparable reporting techniques as well as high-quality accounting standards like the IFRS (Leuz et al. 2003). Adopting IFRS requires that the party countries must have the asset pricing market which provides accounting values.

High accounting standards cause high quality and transparent reporting to most companies. In addition, IFRS causes economic benefits as well as cost saving. When harmonizing the accounting standards, there is a challenge of public versus private owned enterprises which includes the related party transactions. Following the observation above, the issue of comparability in accounting becomes a problem because tricky auditing problems arises (Leuz et al. 2003).

The harmonization of accounting standards requires the implementation guidance. According to Baker (2005), the IFRS have the implementation guidance to the accounting standards either through the non-authoritative guides or being standard themselves. For instance, IFRS issued the share-based guidance which is made up of forty four paragraphs relating to the application guidance. Similarly, the body issued non-authoritative guidance which guides the implementation of IFRS to guide the harmonization of the accounting standards. The IASB body on the other hand created the international financial reporting interpretation committee which oversees the share-based payment guidance. However, Trueblood (1966) believes that the countries and enterprises which apply the IFRS in their accounting standards will become more heterogonous in terms of the size, the jurisdiction, the ownership structure as well as the structure of the capital and there will be an increase the degree of accounting sophistications.

According to Brunsson (1989), the international convergence on the harmonization of standards demands that the implementation of IFRS policies and guidance must be increased in order to achieve the intended accounting standards. The scholar adds that if the IASB committee fails to respond to the demands concerning the detailed implementation guide of the accounting standards, then the preparers of the harmonized standards must look for the implementation guidance from elsewhere. The preparers can turn to EITF consensus to obtain answers to the questions concerning the application of IFRS. On the contrary, the form of convergence generated above is not as a result of cooperative behavior or the joint decision but as a result of auditors and preparers who seek guidance from a non-IASB credible source.

The implementation of the harmonization of the accounting standards exhibits a challenge in which the individual party countries’ financial reporting outcomes which are partly determined by the requirements of the accounting standards and partly by the incentives. The premise of the financial reporting outcome is that the accounting standards requires sufficient judgment by the preparers and auditors so that the figures reported are materially affected by the incentives of the financial reporting outcomes and the requirements of the accounting standards. Nevertheless, the typical relationship between the accounting standards and the incentives of the financial reporting outcomes is not well understood which forms part of the challenges in the implementation of accounting standards.

Leuz et al. (2003) institute that allowing the adoption of the IFRS will allow for the test of incentives that interacts with two or more standard regimes within the accounting standards. Warfield et al (1995) reveals that the financial reporting outcome is majorly affected by the ownership structure of the international accounting structure. The evidence which is available on the above claim reveals the marked specific jurisdiction differences in the ownership structure that affects the harmonization of the accounting standards.

La Porta et al. (1999) have analyzed the ultimate ownerships of the mid and large size firms in the twenty seven wealthy countries and identified four types of ultimate owners who play a key role in the accounting standards. The types include the public held non-financial institutions, the public owned financial institutions, the families and individuals as well as the state. The ownership structure of an enterprise needs to be considered before making implementations on the harmonization of the accounting standards.

Harmonization of the accounting standards requires the globalization of the trends involving the technology as well as globalization of finance. In the United States comparability of the financial data is one of the major driving forces behind the accounting standards. The comparability has been within the companies of the United States until 1980s where they began focusing on the capital markets. Some countries prefer comparability while others do not (Leuz et al. 2003). In 1991 the FASB board was challenged to become more actively involved in globalizing trends and the internationalization of the accounting standards. The plan published by FASB instituted the objectives for achieving comparability between the accounting standards of the United States and the major national standards-setting bodies.

References

Armstrong, Christopher S., Jennifer L. Blouin, Alan D. Jagolinzer, and David F. Larcker. “Corporate governance, incentives, and tax avoidance.” Journal of Accounting and Economics 60, no. 1 (2015): 1-17.

Avoidance: Some Evidence and Issues. Accounting Forum, Vol. 29(3), 325-343.

Baker, R.W. (2005), Capitalism‘s Achilles Heel, New Jersey: John Wiley.

Beresford, D.R., Katzenbach, N. and Rogers Jr., C.B. (2003). Report Of Investigation by The Special Investigative Committee of the Board Of Directors Of WorldCom, Inc. Washington DC.

Bowler, T. (2009, February). Countering tax avoidance in the UK: Which way forward? Institute for Fiscal Studies. Discussion Paper No. 7.

Brunsson. N. (1989), ―The Organization of Hypocrisy: Talk, Decisions and Actions in Organizations‖, John Wiley, Chichester.

Christensen, D. M., Dhaliwal, D. S., Boivie, S., & Graffin, S. D. (2015). Top management conservatism and corporate risk strategies: Evidence from managers’ personal political orientation and corporate tax avoidance. Strategic Management Journal36(12), 1918-1938.

Christensen, J. and Murphy, R. (2004), ―The Social Responsibility of Corporate Tax Avoidance: Taking CSR to the Bottom Line‖, Development, Vol. 47 No. 3, pp. 37-44.

Cobham, A. (2005). ―Working Paper 129: Tax Evasion, Tax Avoidance, and Development Finance‖. The University of Oxford Finance and Trade Policy Research Centre.

Gaertner, F. B. (2014). CEO After‐Tax compensation incentives and corporate tax avoidance. Contemporary Accounting Research31(4), 1077-1102.

Hanlon, G., (1994). The Commercialisation of Accountancy: Flexible Accumulation and the Transformation of the Service Class, London: Macmillan.

Kar, D. and Cartwright-Smith, D. (2008). Illicit Financial Flows from Developing Countries: 2002—2006. Washington DC: Global Financial Integrity.

Koester, A., Shevlin, T., & Wangerin, D. (2016). The role of managerial ability in corporate tax avoidance. Management Science63(10), 3285-3310.

KPMG, (2005). ―KPMG International Annual Review 2005, KPMG.

La Porta, R., Lopez-de-Silanes, F., Shleifer, A. and Vishny, R. (1998) Law and finance, Journal of Political Economy, 106, pp. 1113–1155.

 La Porta, R., Lopez-de-Silanes, F. and Shleifer, A. (1999) Corporate ownership around the world, Journal of Finance, 54, pp. 471–517.

Leuz, C., Nanda, D. and Wysocki, P. (2003). ‘Earnings management and investor protection: an international comparison’. Journal of Financial Economics, 69: 505– 527.

Sikka, P. and Hampton, M.P. (2005). The Role of Accountancy Firms in Tax.

Trueblood, R.M., 1966. Accounting principles: the board and its problems, in Empirical Research in Accounting: Selected Studies 1966, The Institute of Professional Accounting, Graduate School of Business, The University of Chicago, Chicago, pp. 183–191.

US Bankruptcy Court Southern District of New York, (2004). Third and Final Report of the Insolvency Examiner: In re WORLDCOM, INC., et al, Chapter 11, Case No. 02-13533 (AJG), Kirkpatrick & Lockhart LLP, Washington DC.

Werther Jr., W.B., and Chandler, D., (2005). Strategic Corporate Social Responsibility: Stakeholders in a Global Environment. London: Sage.

Relevant Blog Posts

Finance Dissertation Topics | Accounting Dissertations

Tax Fairness and Tax Efficiency

Fiscal Policy Effectiveness within the European Union

The issue of monetary and fiscal policy within the EU is strongly debated at this moment in time. This is particularly true with the unconventional monetary policies being put in place for the first time by the European Central Bank such as quantitative easing; as the economy looks to recover from the sovereign debt crisis of 2008. This dissertation seeks to answer the following research questions: (1) Was the lack of a fiscal union a key contributing factor to the crisis? (2) Can a monetary union be effective without a unified fiscal policy to support it? (3) Has there been increased conformity in these key indicators since the crisis?

With these questions in mind, a literature review is undertaken to discuss and analyse the key issues within the European Union and beliefs and approaches regarding fiscal and monetary policy, including the heavily debated topic of whether or not a fiscal union is required. This dissertation also carries out a study of income and corporate taxation rates and expenditure figures for seven key EU countries in order to answer the above research questions.

A clear pattern of convergence is seen in the taxation rates and allows us to conclude that there has been increased conformity in key fiscal indicators since the sovereign debt crisis of 2008. We then link these findings back to the literature review and show that they fit with the beliefs of a large amount of previous academic work in the field. Our findings suggest that there has been increased fiscal conformity since the crisis and also that the lack of fiscal conformity (not necessarily achieved through the presence of a fiscal union) was a key contributing factor to the crisis.

Finally we also find that there can be an improved level of fiscal conformity without a fiscal union within a monetary union however we are unable to say conclusively that a monetary union can be effective without a unified fiscal policy.

This finance dissertation aims to establish the answer to a number of questions that stem from the 2008 European sovereign debt crisis:

  • Was the lack of a fiscal union a key contributing factor to the crisis?
  • Can a monetary union be effective without a unified fiscal policy to support it?
  • Has there been increased conformity in key fiscal indicators since the crisis?
Fiscal Policy EU
Fiscal Policy EU

Fiscal Policy Dissertation Contents

1 – Introduction
Overview of Research Aims and Strategy
Research Motivation
Introducing Monetary and Fiscal Policy
The Maastricht Treaty and the Stability and Growth Pact
Overview of Structure

2 – Literature Review
Can a monetary union be effective without the support of a fiscal union?
A monetary union can be effective without the support of a fiscal union
A monetary union cannot be effective without the support of a fiscal union
Was the lack of fiscal union a key reason behind the 2008 sovereign debt crisis?
The lack of a fiscal union was not a key reason behind the crisis
The lack of a fiscal union was a key reason behind the crisis
Shortcomings in the literature: Has there been increased fiscal conformity since the sovereign debt crisis hit?
Changing Role of the European Central Bank
Summarising the Literature
Anti Fiscal Union
Pro Fiscal Union
Lack of Fiscal Union was not key to Sovereign Debt Crisis
Lack of Fiscal union was key to Sovereign Debt Crisis

3 – Research Methodology
Sample Selection Criteria
Hypotheses Development and Reliability
Data
Top Band Personal Income Tax Rates (%)

4 – Findings
Income Tax Data
Corporate Tax Data
Total Tax Data
Government Expenditure Data
Implications of Findings

5 – Conclusion
Summary of the Results and their Implications
Limitations
Suggested Areas for Future Research

References

Relevant Blog Posts

Dissertation – An Evaluation of Monetary and Fiscal Policy Effectiveness within the European Union

International Financial Management

Did you find any useful knowledge relating to fiscal policy in the EU in this post? What are the key facts that grabbed your attention? Let us know in the comments. Thank you.

International Financial Management

International Financial Management – Evaluate the extent to which the bargaining model can be viewed as a practical implementation of the law of comparative advantage?

International financial management is a coined term in today’s world, and it is also known as International Finance. In simple words, it means financial management in an International business environment. International Financial Management is, however, different countries and regions due to the different currencies, government situations, political situations, deficient markets, varied opportunity sets (Susan, & Anil 2009, pp. 381–399)

It is said that international financial management came into the limelight when countries started opening up their borders due to the liberation and globalization policies that came with capitalism. Because of the open borders and increased freedom to conduct business in any country around the world. Entrepreneurs started to source for raw materials and establish their business in different countries provided that the state met the preferences of the entrepreneur (Wissam & Ellen 2014). The development of liberalization was further enhanced by the swift move towards development of telecommunication and transport technologies. Financial innovations such as currency derivatives, multi-currency bonds, cross-border stock listing and International mutual funds further catalyzed the development of international financial management (Frederic et al. 2010, pp. 395-427).

Globalization and Multi-national Firm

Globalization has manifested itself in today’s world through the relationship of financial markets, increasing roles of the multinational corporations, the dependence of the local economies on foreign trade, transfer of technologies. This type of relationship has led to demands for harmonization of the world statically standards (Susan, & Anil 2009, pp. 381–399). Harmonization and standardization include updating the National Accounts System and the Balances of payment among other systems that would make the exchange of capital easier. Multinational firms have contributed a lot towards international financial management, in fact, MNCs are the focal point for the studies of International Financial Management. Globalization has enabled companies to expand their territories to different countries and regions. For example countries like NIKE, Nescafé, and Shell Oil among others are present in almost the whole world.

According to Frederic et al. (2010, pp. 395-427), the structure of the global industry has experienced great changes especially in the 1990s due to the cross-border mergers and acquisitions; this is evident since most companies committing their affairs freely with stakeholders in different parts of the world is becoming standard. A massive increment by $200 billion to more than $500 billion in cross-border mergers was recorded in a span of only 2years i.e. from 1995 to 1999. This lead to the healthy of business especially to the advanced developing countries like Taiwan and Hong Kong who are currently leading in investing in China and other South East Asia countries. In South America Brazilian and Chilean firms have dominated the region. In the same sense, Brazil and Argentina based companies have reciprocated. Korean companies overseas are roughly one-third of the massive domestic investments during 1999.

Due to this traffic foreign investment and trade have developed to become inter-wined. There are exports of foreign affiliates in developing states to the parent organizations overseas. This accounts for one-third of all the exports that originate from developing countries while two-thirds of the developing states involve a multinational buyer or seller. In the least developed countries, these ratios are probably higher because of the advantage that Multinational Corporations take over the cheap labor available in these countries. The rise of Multinational companies and foreign ownership has given various opinions about their effects on the developing countries.

International Financial Management and International Monetary Systems

Chiara et al. (2010, pp. 42-65), outlines that the international monetary system involves the management of money flows in conjunction with institutions that are government related that keep track of vast bulk of money including supporting currency needs and it also ensures payment obligations within and across countries are met accordingly. Various institutions that are responsible and are part of the international monetary system include the central banks international financial institutions, commercial banks, and some monetary market funds.

International Financial Management Dissertations
International Financial Management Dissertations

Wissam and Ellen (2014), adds that one distinguishing factor that makes IMS different from other financial institutions is that IMS is not interest bearing. Instead, money is considered as a unit of account and also means of exchanging goods and service and capital flows across borders in order to facilitate and ensure a perfect environment for exchange of financial assets and the excellent of financial markets. The commonly known definition of money since time immemorial is that it’s an asset in addition to its storage of value.

The USD has incurred changes that have been unheard of especially the one noted in 1985 where the dollar had hit a peak of USD 100 Billion a year. According to most economists was far much beyond the equilibrium level that has ever been attained. This record was due to the high exchanging rate which was a sign of confidence in the US economy, the high rate of exchange was due to the sticker hypothesis of the Dornbusch to fiscal irresponsibility. It was then decided that the dollar value be lower without considering much what took it high by intervening in the foreign exchange markets, this was done for the protectionist sentiment that conducted the US Congress that was mounting trading deficit

A plaza agreement that was formed by the big five countries i.e. united states France Japan great Britain and West Germany, a coordinated program to reach the target of forcing down the enormously shooting US dollar value against other currencies, the program worked perfect was successful in the end. It lost 11 percent of its SDR in 1986, the decrement of the US dollar was steady when Italy and Canada joined the group 5, forming a new group known as the G-7.The policies worked like a charm, and the US promised to cut the budget deficit and ultimately lower the rate at which the dollar was growing. To achieve this further Japan and Canada promised to stimulate their economies, although they achieved the reduction of the dollar value the budget cuts weren’t forthcoming and so Germany and Japan never succeeded in their mission to stimulate their economies (Arthur 2003, pp. 979-992).

Trade is among the factors in addition to inequities that balances out countries in todays world. These fluctuations in a system of a freely floating exchange of goods and services gives the adjustment system to bring trade back to balances. A country that has both trade and account deficit could get back to balance through devaluing its currency which will increase its exports and lessen the amount of imports (Chiara et al. 2010, pp. 42-65).

In reality the existence of chronic trade deficits in country have consequences to the economy through the systems of flexible exchange rate. One of the main reason for the failure in adjustment of exchange rates is deficit for incentives for various states to keep their currency strong in order to attract foreign investments. But according to the reports by the World Bank over valued currencies only impairs trade more while calling for more inflow of foreign currencies. Finally the game reaches the end and the investors run away and the deficit country have a fall in their currency that erodes even the domestic savings and ushers in inflation and these leads to the international financial management emergency assistance that is directed towards economic austerity.

World Bank statistics recognizes the fact that a mechanism of semi-fixed exchange rates that provides for flexibility in a narrow range and orderly mechanism for adjustments for such ranges. In 1994 the former chairman of the Bretton Woods Commission Volcker Paul openly condemned the liberation of the exchange rates and advocated for the semi-fixed exchange rate regime (Jean et al. 2005, pp. 1-43). In exchange for the Bretton Woods Institution (World Bank and IMF) the countries suffering from deficits are expected to implement a range of deflationary fiscal and deflationary policies, in the late 1990s they were known as Structural Adjustment Program and mostly implemented through letters of intent. The process is usually refer to us loan conditionality’s since IMF financial assistance are conditioned when implementing policy reforms (Xiaoying & Xiaming 2005, pp. 393-407).

Foreign Direct Investments

The rise of foreign Direct Investment started over tree decades ago. From 1980s when the FDI flow was estimated to be 50 billion US Dollars per year OFD has grown up to 2.1 trillion US Dollars in 2007. Due to the economic recession in 2008 FDI fell down to 1.9 trillion US Dollars that is -10% (James & Mark 2000). Foreign direct Investments from developed countries have increased due to the high growth in economies and high performance from the corporate world of these countries.

OFDI particularly flows from the European Union and The United States of America who take up to 84%, the remaining 16% is represented by the transitional economies (BRIC countries).

International financial management, the distribution of emerging market OFDI has evolved considerably changed over the past years. Asia overtook Latin America and Caribbean America has become leading region for Foreign Direct Investment. While MNCs have become fundamental investors in many developing countries, they have also invested in developed countries. The general number of Multinational Corporations has been growing in tandem, with FDI (Caroline 2004, pp. 20-29). This rise does not only show the increasing ownership benefits of these firms but also the pressure for the companies to get a portfolio locality assets as foundation for International competitiveness (Arthur 2003, pp. 979-992).

The Bargaining Model

According to the theory of bargaining, governments yearn for development and a stability payment balance. These goals can be achieved through attracting foreign investments. On the other hand, MNCs are in constant look for sources of raw materials and strategic manufacturing points near their targeted markets. These objectives can be satisfied when MNCs deal successfully with governments of host countries because it is through the sovereignty of the states that the MNCs can achieve these Governments seek economic development and balance-of-payments stability, for example, and both goals can be pursued by attracting and channeling the activities of foreign TNCs. TNCs seek inexpensive sources of raw materials and manufacturing sites (Chiara et al. 2010, pp. 42-65). According to Jean et al. (2005, pp. 1-43).The bargaining process is enhanced by the relative resources that each country has.

The government has its high points from the control over the two most fundamental requirement of the MNCs which are raw materials and intensive labor. On the other hand, the MNCs have goodies that the government desires that they use to influence the government with some of these goodies include helping in lowering the unemployment rate in the country, improving the host countries balance of payments through providing access to the International Markets (Arthur 2003, pp. 979-992). The relevance of these factors during the bargaining process substantially determines the expected outcome of negotiation between an MNC and the national government. Another factor that greatly influences the negotiation process is the situation between the firm and the government. The relative stakes that each party offers give a situation affecting the bargaining outcome.

Lastly the degree of similarity of interests that both the government and the multinational corporation have. The Similarity of interests makes negotiation more natural and smooth while different and parallel interests among the principles will make decision making very hard (Arthur 2003, pp. 979-992).

The Balance of Payments in International Financial Management

According to Wissam and Ellen (2014) defines this as an account records the payments and receipts of transactions of the citizens of that particular country with residents living in another country. Ones the payments and receipts of each country will include equally only if the operations are also included, neutrality will only favor one state at the expense of the other by allowing it acquire more assets from the not so preferred country. (Xiaoying & Xiaming 2005, pp. 393-407). An evident example is if Americans purchase automobiles from the Japanese, and don’t engage further in other transactions chances are the Japan will end up holding dollars either in the form of bank deposits or engage in other investments in the US. These payments are then balanced depending on the transactions made for the acquisition of the dollar assets (Jean et al. 2005, pp. 1-43).

However much the balancing is done deficits must occur as a result of inequalities and excess payments, therefore leading to a surplus in particular forms of transactions including the service trade merchandise trade (James & Mark 2000). The balance of payments in any country must refer to some class of operations.

Various definitions have been given to the balance of payments surplus and deficits in the past. Every definition had its distinct implications and purposes. It is until 1973 that there was a focus on the definition of balance-of-payments which had the intentions of measuring the ability of a country to meets its responsibilities of exchanging its currency for other currencies or for tagging it to the Gold system at a fixed rate exchange like the Great Britain did (Maurice 2010, pp. 1–23).

So as to meet the newly formed obligations countries strived to maintain a stock of official reserves, in the form of foreign country currencies or gold that they would use to in supporting their local currencies. The decline in this stores stock was seen as crucial balance-of-payment deficit since it threatened a country’s ability to meet its responsibilities (Arthur 2003, pp. 979-992).

This type of debt was not a good indicator at all when looking at the financial position of a state. The reason being that it never looked at the likelihood that the state would be called upon to meet its delegated duties and the willingness of the international monetary institution to provide assistance (James & Mark 2000).

Caroline (2004, pp. 20-29), points that after 1973, official reserves unit of measuring a country’s ability to meet its obligations diminished as various economic giants gave up their responsibility of converting their currency at a fixed exchange. The made reserves look more meaningless, and there was no longer any concern about the changes in a country’s reserves (Ngaire 2000, pp. 82-841).

Xiaoying and Xiaming (2005, pp. 393-407), purports that after the 1973 talks on the balance of payment surplus or deficits now refer to current accounts. This account has a trade in goods, investment incomes earned abroad and the unilateral transfers. It doesn’t include the capital account, which includes the sales of securities or property. Since the current account and the capital account sum up to the total account, which is necessarily balanced, debt in the current account always comes with an equal surplus in the capital account and vice versa (Maurice 2010, pp. 1–23). Deficit or surplus present in the current account cannot be evaluated without different explanations and the evaluation of an equal surplus or deficit in the capital account.

A State is considered to be in deficit when in its current account is higher its price level. When the Gross National Product is greater the interests rates are also higher and the lesser the barriers towards imports and more attractive it’s to international investors, compared to other countries (Barry 1999).

Kenneth (1996, pp. 647-668), argues that the impacts of any change in one of these factors on the country’s current account balance cannot be predicted without looking at the effects of the other international financial management factors. For instance, if the government increases tariffs, citizens are likely to import fewer goods, therefore, decreasing the current account deficit. In this case, where this decline will occur only when one of other factors changes to bring about a reduction in the capital account surplus.

According to Axel and James (2015, pp.120-148), if none of these factors changes then the decrease in imports due to an increase in tariffs will lead to a decline in the demand for the country’s foreign currency, this, in turn, will raise the local value of the respective country. The increase in the value of any countries increase makes that individual country exports more expensive and imports cheaper, therefore offsetting the implications of the growth in Tariffs. The overall result is that the increase in tariff will bring no change to the current account (Caroline 2004, pp. 20-29)

Contrary to the thoughts of most people, the existence of a deficit in the present account in itself is not a signal towards a recessing economy or irrational economic policies. If a country has a deficit in its current account, it can sometimes mean that the country is importing capital. Importing capital is no more a peculiar system it is just like importing coffee or tea.

References

 Arthur, C 2003. “The euro: faith, hope and parity, International Affairs.” pp. 979-992.

 Axel, D 2009. “IMF conditionality: theory and evidence, Public Choice.” pp. 233-267.

 Axel, D, Jan, E, S & James Vreeland 2015. “Politics and IMF Conditionality”. Journal of Conflict Resolution. Vol. 59, Vol. 1, pp.120-148.

 Barry, E 1999. “Kicking the Habit: moving from pegged exchange rates to greater exchange rate flexibility”. The Economic Journal C1 – C14 Equator Principles III.

 Caroline, M 2004. “Managing Exchange Rates: Achievement of Global Rebalancing or evidence of global co-dependency.” Business Economics, pp. 20-29.

 Chiara, F, Francesco, R & Giuseppe, M 2010. “Why do Firms Invest Abroad? An Analysis of the Motives Underlying Foreign Direct Investments.” The IUP Journal of International Business Law. Vol. 9, No. 1 & 2, pp. 42-65

 Frederic, B, Melika, B, S & Marine C 2010. “Detecting Mean Reversion in Real Exchange Rates from a Multiple Regime STAR model.” Annals of Economics and Statistics, pp. 395-427.

 James, R, L & Mark, P, T 2000. “Purchasing power parity over two centuries: strengthening the case for real exchange rate stability A reply to Cuddington and Liang.” Journal of International Money and Finance. Vol. 19, No.1, pp. 759–764.

 Jean, I, Haroon, M, Morten R & Helene Rey 2005. “PPP Strikes Back: Aggregation and the Real Exchange Rate.” The Quarterly Journal of Economics. Vol.34, No 1, pp. 1-43.

 John, H, D 2000. “The eclectic paradigm as an envelope for economic and business theories of MNE activity”. International Business Review 9, pp. 163–190.

 Kenneth, R 1996. “International Financial Management The Purchasing Power Parity Puzzle.” Journal of Economic Literature. Vol. 45, pp. 647-668.

 Maurice, O 2010. “Does the Current Account Still Matter?” American Economic Review. Vol.102, No. 3, pp. 1–23.

Ngaire, W 2000. “The Challenge of Good Governance for the IMF and the World Bank Themselves.” World Development. Vol. 28, No. 5, pp. 82-841.

Shaun, F & Andrew L 2004. “International Financial Management, new financial system? Towards a conceptualization of financial reintermediation.” Review of International Political Economy. Vol. 11, No.2, pp. 263-288.

 Susan, F & Anil G 2009. “Subsidiaries and Country Risk: internalization as a safeguard against weak external institutions.” Academy of International Financial Management, Vol. 52, No. 2, pp. 381–399.

 Wissam, H & Ellen, M 2014. “Hong Kong’s Currency Crisis: A Test of the 1990s.” Washington Consensus’ View, International Finance. Vol. 17, No.3, pp. 273–296.

Xiaoying, L & Xiaming, L .2005. “Foreign Direct Investment, International Financial Management and Economic Growth.” An Increasingly Endogenous Relationship World Development. Vol. 33, No. 3, pp. 393-407.

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Behavioral Finance Financial Decision Making

Behavioral Finance and the Psychology of Financial Decision

Behavioral finance and financial decisions have a big role in shaping critical decisions that people make. The study summarizes the facts about financial choices and the behavioral and psychological theories influencing them. We learn that people have predisposed cognitive constraints coupled with low levels of financial literacy, in such regard, their decision-making choices violate sound financial principles. The case studies teach us that most investors and managers over-extrapolate from past returns and trade, or they make decisions based on overconfidence and personal history.

We explain most of these behaviors based on behavioral finance theories like prospect theory, behavioral finance, and behavioral corporate finance. Many companies and institutions today shy away from traditionally defined benefit pension plans in favor of defined contribution plans, in such circumstance, the role of the financial adviser is gaining an integral value.

In this case study, a recent graduate from UMUC is employed to advise different clients on investment. The consultant delves into studying the biases in financial behavior that predict prospective theory. While applying the key concepts of behavioral finance, the consultant can recognize that the client (Violet) displays behavioral biases that impede optimal savings and consumption allocation. He can learn this by deducing from concepts of finance that assess how people organize their financial assets by creating separate slots for money designated for specific roles as well as other approaches such as mental accounting.

Expected Utility and Prospect Theory:

Unlike most of the economic theories, Expected utility theory is the most preferred by scholars ((Shiller, Robert J.). The approach attracts people because it has the best economical representation characterizing true rational behavior in uncertain situations. However, application of expected theory is criticized in many circumstances because of the systematical misrepresentation of human behavior.

Allais (503) proved that Prospect Theory refers to a mathematically developed theory that substitutes “value function” contrasted to “utility function” and “weights” contrasted to “probabilities” in expected utility theory. Here, people work to increase the weighted total value instead of utility such that probabilities do not equal weight. Simply put, people view extremely probable as certain but the improbable events as impossible.

In many circumstances, prospect theory appears inconsistent with expected utility theory. To begin with, in probabilities, utility is all linear but not value. Also, value is defined regarding losses and profits, but utility depends on final wealth.

Contrary to expected utility theory, prospect theory foretells that preferences depend on how a problem is approached. In case the reference point defines the outcome as an advantage, in this case, the resulting value function will be curved in, and those making decision will be risk-averse.  But if the reference point’s outcome is seen as a loss, those making decisions will be risk seeking since is a convex value function.

Violations of Expected Utility

The possible abuses of this theory include the Allais paradox (certainty effect), and inflation of small probabilities. As for Allais paradox, there is an extreme underweighting of high probabilities. In such a case, it falls short of certainties such that the travel time outcomes become extremely attractive. On the other hand, inflation of small probabilities violation projects itself in the form of a set of stated-preference route-choice challenges.

Value Function

The definition of the value function lies on variations from a reference point, and in most circumstances, it is risk aversion–concave for gains, convex for losses. Similarly, value function is acute for losses than for profits. In this case, the stress of decisions is less compared with the equivalent probabilities, with few exceptions in the assortment of low probabilities. A value strategy deals with the purchase of stocks that have low prices compared with the dividends, earnings, book assets, or similar measures of significant value.

The Implications of Prospect Theory for the Efficient Market Hypothesis

An efficient market, based on the definition by (Fama 1965), is characterized by a large pool of rational profit maximizers who compete against each other to interpret the market prices of individual securities in the years to come; out of which a large pool of the present information is easily available to all participants. The prevailing competition in such a market opens the effects of new information on the actual prices in an instantaneous way. In such a way, the prospect theory sets in under the circumstance that makes stock price unpredictable following a random pathway.

Provided that information flow is unrestricted and quickly reflects in the stock price, the probability for the future price to change will depend not on today’s price changes, but on tomorrow’s news. Given that news is unpredictable, consequently, price changes also turnout unpredictable, and this conforms to the principle of prospect theory whereby people view extremely probable as certain but the improbable events as impossible.

Efficient Market Hypothesis is characterized by the security prices that reflect available information. It is based on the traditional view that investors use rationale in executing the present information to increase the expected utility.

Anomalies

The Anomalies of Efficient Market Hypothesis’ set in when people feel there is something wrong with the concept of Efficient Market Hypothesis. Under such conditions, the rational approaches of investors lacks consistence. It is not wholly right and must be analyzed alongside other human behavior approaches like the prospect theory, overconfidence, or expected utility, or over and under reaction, as well as the limits to arbitrage. Examples of anomalies as expressed by prospect theory include the size, valuation, and the momentum effect.

  1. The Valuation Effect. Studies reveal that firms with higher P/B multiples are outperformed by those with low price/book (P/B) multiples.
  2. The Size Effect. Studies predict that firms with smaller market capitalizations outperform those with large market capitalizations, disregard of the controls in their higher risk.
  3. The Momentum Effect. Studies reveal that firms with good performance for the past six months to one year period outperform those that performed poorly over the same period.

Bias identification and how such behavioral finance concepts affect their investment decisions

The First Colleague: The Concept of Illusion of Control

The stated bias happens when people overly justify their ideas. It describes people’s propensity to believe that they can exert influence on the outcomes of action when, in the real sense, they cannot. When this kind of bias occurs, people behave as if they can fully control their situations than they actually can ((Ising, Alexander).

The first colleague responds by claiming to know the technology industry and is determined to invest in them. While he might have worked in the industry for a while, it is not justifiable to assume that the circumstances will prevail in the long run. He is preoccupied with the illusion of control bias.

However, the illusion of control bias can be financially damaging since entrepreneurs might be motivated to trade more than what is right. It may lead them to employ limit orders, maintain under-diversified portfolios, or other related means just to express a false sense of influence over their trade portfolios.

People who practice this bias find it hard acceding with the irrationality and the changing nature of markets and the fact that their expectation is a failed one. The outcome is a spiral of investment catastrophe with the rationalization that while their belief is right, the one who drove the buttons was so incompetent.

In the long run, the investor becomes overconfident. The consequences of long-term investment may not be affected by the immediate-term opinion, emotions, and impulses that frequently engulf financial transactions. Rather, the success or lack of it emanates from uncontrollable factors such as the prevailing economic conditions and corporate performance.

The Second Colleague: Confirmation Bias

According to the second colleague, the value of commercial property in the city has maintained a 14% increase since the year 2000 reported a famous newspaper article. Now, this is almost two decades down the line. It is very unbelievable to assert that the value of the property has remained consistent over such a lengthy period, and very few investors would settle on that. However, depending on the interest of the reader and the prevailing circumstance, we can only assume that the type of newspaper is biased towards such reports and that the investor too is biased and love reading similar reports.

According to confirmation bias, individuals are drawn to information that substantiates their existing perceptions. It is just similar when a person prefers watching news from a TV channel that represents his/her political views while evading those that feature commentators of divergent opinions. Similarly, people behave in the like manner concerning their financial issues. Entrepreneurs believe in the market conditions will make them walk toward information sources that validate such a belief.

While it is acceptable to attach an emphasis to the consequences of our aspirations, for example, investing heavily in the stock of the firm you’re working for, it poses significant risks when it comes to diversification. If you should overcome confirmation bias, stress must be levied on obtaining information from various.

The Third Colleague: Depicting Recency Bias

Recency bias is a cognitive intrusion that encourages to perceive the most recent information as more relevant compared to the old knowledge. However, this may not be necessarily true. People base their investment decisions on how the market has been recently performing. The exact state is seen on the third respondent whose investment decisions in the Omega Corporation are drawn from the current state of the company and industry. She denotes that from the decline of the industry to capitalize on her investments since she presumes that case to remain constant for some time.

Most entrepreneurs have the inclination to follow investment performance by investing more in the industry when it is peaking and just about to reverse. Given that the investment has been picking up recently, investors anticipate that to remain the case. However, based on the behavioral theory, it would be wrong for her to rely on this approach to make financial decisions. In most circumstances, people do extrapolate from recent performance and employ them as a signal of future performance which is very wrong. Consequently, entrepreneurs fall into the ploy of over-purchasing the now outperforming asset and under-own the now drifting asset.

Behavioral Finance Dissertation
Behavioral Finance Dissertation

Behavioral Finance and Investments

Siosan’s utility function. Contrasted with that assumed in traditional finance theory

Traditional finance posits that humans are risk-averse, they love greater certainty than limited certainty and have a perfect utility function. Conversely, behavioral theorists assume that people display multiple characteristics and while they may be risk-averse, they may also be risk-seeking, risk-neutral, or any blend of the three. Depending on how things present themselves influences decision making.

The utility function measures an individual’s preferences over a set of products, measured in units referred to as utils. Utils exemplify the level of satisfaction of a consumer from choosing a specific type or number of products. Traditional finance is built on the utility theory with an assumption of diminishing marginal return. On the other hand, Behavioral theorists assume that human beings don’t always act in their best financial interests.

Appropriate in this case study, the utility function specifies the satisfaction of an investor out of all possible combinations. For example, an investment with low risk and high return has a bigger utility than that with high risk and low gain. This kind of function represents both their welfare along with their preferences. Violet expresses utility function that follows the behavioral approach. She wants to spend more. However, she’s quite unaware of the circumstances of tomorrow reflected in her limited investments. Under a traditional approach, Violet would either invest or not invest at all. It would be that she has knowledge of the future market or she does not, and if she lacks, her utility function would be concave. She would spend less just to avoid the risks in the future.

Similarly, she purchases expensive goods like cars and takes vacations for her satisfaction although, she feels reluctant to incur debts. This is opposed to traditional finance that assumes a diminishing marginal utility; Violet proposes utility function that will always satisfy her interests and won’t diminish. Violet expresses some mix of traditional and behavioral approach in some part, and traditional finance is reflected in the way she detests debts. Albeit, she does little to avert those debts, thus in part demonstrating a behavioral approach.

Siosian’s Behavioral Biases and how a rational economic individual in traditional finance would behave differently concerning each bias

Various cognitive predispositions cause several behavioral biases or under-saving inclinations. This is according to the perception by behavioral scientists who present several biases that emanate from such predispositions by grouping them into three categories. Such include preference biases, perceptions of prospects, perceptions on how to make decisions bearing in mind the rest of variables, and price perceptions. The typical behavioral bias presented in this case is the preference bias, and it manifests itself in the form of the self-control, loss aversion, and anticipatory utility.

Costly self-control bias- Living for today

Behaviorists propose that many people struggle with self-control in various fields. It may present itself through over-eating, under-saving, or over-snoozing, what we can call as “living for today”. Approaches to costly self-control also suggest that such people will value commitment such that they will choose, and even pay, to limit their future decision in some way, in an attempt to discourage their future over-consumption predilections.

However, in this case, study, Violet fits this model of costly self-control bias. We find that she engages in costly endeavors like buying expensive cars and paying for expensive meals in upscale vacation resorts. She does this at the expense of investing. In fact, she would do all the best she can to live a luxurious life while doing little on her mortgage and other investments. Her approach is behavioral and contrary to how traditional theorists would behave since they would fear the risks of tomorrow and would spend less on consumption and be concerned about the future.

Loss Aversion

The bias is comparative to some reference point like current consumption, or friends’ consumption. Loss aversion may also be seen as a potential threat to consumers leveraging their savings rates. People fear more to invest in their view of avoiding losses (Thaler, Richard, and Shlomo 164-187).

Loss aversion occurs when people easily notice the reduction in investment portfolio more than how they view gains, and this may be even when the profits are greater. They frequently get upset when they lose money during the market recession such that they remember those losses forever, but they would hardly remember the time they made 40-percent increase, just the time they lost 30-percent. We can state that Violet has an outspoken loss aversion bias when she says she detests making losses. Given that she has very little investment but high expenditure, this might be the reason why she rarely invests. Her approach reflects a traditional finance theory that assumes people are risk-averse.

Siosian’s Retirement Portfolio and Justification

Violet’s retirement portfolio is such that she maintains a minimal retirement plan where she deposits half the sum of money coming from her annual bonuses and none-salary incomes. On the other, we notice that she runs a very small mortgage and limited investments that can sustain her. Basing on such decisions, her retirement portfolio is so inefficient.

The Social Security Administration posits that on average, a 65-year pensioner can expect to stay for the next 18–20½ years after quitting the job (Benz par 3). Nonetheless, health advancements now make people stay for more years, and it would be advisable that you schedule a retirement portfolio of 30 or more years, and in such a case, the retirement saving plan becomes so essential. Rather than just depositing money in the portfolio, it should be used in investment opportunities to generate more wealth for old age. The objective is remaining invested—and that implies having some part of the money assigned to stocks, but in the right standing with other investments.

The objective of investing retirement portfolio is to generate a mix of investments that merge to preserve capital, create income, and expand. Such a combination of stock, bond and cash investments must be in line with age, income, financial needs, time, and risk. For this reason, we can say Violet’s retirement portfolio is very weak and inappropriate (Williams par 6).

Behavioral Corporate Finance

MEMO

TO: CFO

FROM:

DATE: 28/04/2019

RE: Recent Behavioral Finance Literature dealing with the Board of Directors.

We can study behavioral finance featuring the panel of executives under the concept of corporate governance ((Shivdasani, Anil, and Marc Zenner). Management of financial institutions has taken a different approach given the attrition of the significance of corporate governance in guiding financial decisions. Albeit, this is very recent studied by contemporary economists who assert the role of the board of governors in guiding the company’s value creation and improved financial performance particularly during this onset of consistent corporate flaws. Many companies have since collapsed, examples of Lehman Brothers, Rank Xerox, and Enron just to name a few, all blamed the faulty board of governors (Shivdasani, Anil, and David Yermack).

We have several lessons to learn from this shrinking–specifically–there is one lesson that stands out clear–the role of corporate governance in determining its capacity to contest positively particularly in stormy environmental conditions where others strive hard to exits.

Contemporary literature on behavioral finance vis-à-vis corporate governance emanates from Adolph, Berle and Means (23) study where they assert that, in reality, managers of companies sought their interest at the expense of the shareholders’ interests.  Their investigation stressed the need for an effective plan to help aid in mitigating the conflict of interests between company owners and managers. Therefore, while the concept of corporate governance might appear new, it addresses typical concerns present since time long (Ayuso, Silvia, and Argandoña 2-19).

Many countries, corporations, and agencies across the globe have started to respond to the corporate flaws by initiating a series of legislation and guidelines that guide decisions of the board of governors in financial implications. Such rules are referred to as the codes of best practices. These legislations guide the behavior and structure of the board of directors while doing their monitory and supervisory duties (Shivdasani, Anil, and David Yermack).

Such codes, though, issued in different regions, they have similar peculiarities regarding corporate culture and general corporate environment, and alignment of the interest of parties (Shareholders and Management). Corporate governance codification of governance aims at mitigating the corresponding deficiencies in or lack of appropriate shareholders shields (Shivdasani, Anil, and David Yermack).

Your Future and Behavioral Finance Post 2008

Behavioral Finance Lessons during and after the Great Recession

Several themes emerge drawing from the issues aired by Stephanie pertaining behavioral finance during and after the great recession. While the economic downturn attracted several consequences on the corporate world, I believe the corporate directors and other stakeholders had the mandate to prevent its occurrence, and correspondingly, they can stop the reoccurrence of the same by studying behavioral finance theories. The recession affected the entire globe since businesses collapsed, and many people lost jobs and houses. However, I believe that if financial behaviorist can avoid a repeat of the 2008 great recession, they should derive from behavioral finance theories, Shefrin and Staman reports this in their book, ‘Behavioral Finance in the Financial Crisis’.

Several factors drew the crisis, and such factors persist that perpetuate the current crisis. They include; a weak government regulation, investment banks that exceedingly leverage debts, and strained homeowners’ finances. We can explain the consequences of 2008 crisis from a financial theory basis. While traditional economics base their assumptions of rationality, they assert that people make rational economic choices as they try to maximize their earnings. On the contrary, behavioral economists assume that people make their financial selections based on their emotions psychological conditions, as well as on cognitive errors.

The 2008 crisis is best explained by the principles of behavioral economics. Here, we find a correlation of the crisis with the overly optimistic lending behaviors of people since such is connected to the stock market fluctuations even as witnessed currently. Psychologists have effectively documented the propensity of people to perceive the through rose-tinted lenses, often referred to as the optimism bias.

Much of the 2008 crisis revolved around financial psychology. We can study psychology as part of the behavioral finance theory. In essence, it incorporates aspects like overconfidence, perception and cognition, aspirations, emotions, and culture (Morgenson, Gretchen and Joshua Rosner).

Overconfidence– Behavioral economists had warned of the inhibiting economic crisis. While banks, businesses, and many corporations received such warnings, many were overconfident in their investments. Overconfidence Before the great 2008 recession, economists warned that the economy was going under. Entrepreneurs were such overconfident such that they hardly analyzed the risk of holding such huge portfolios in mortgage-backed securities, provided the threat of being in a bubble. Most of the homeowners took out loans just to satisfy the American dream — they purchased during a bubble overconfident that housing prices would skyrocket and remain persistent.

However, an increase in the housing market, and the stock market, only works to raise people’s overconfidence since they would ascribe the gains or losses they achieve as a result of their proficiency in finance, although, it results from market moods.

Recency bias was one implication that cultivated the crisis. That’s because entrepreneurs make choices based on the most recent information. Decisions may be constructed on the very latest feedback. Although, such information may not be primarily relevant. During the time, investors overreacted because of the congress’s finance rescue project.

Similarly, people’s emotions such as anger, fear, and sadness influence the type of decisions made, including economic choices. More fearful people become risk-averse, but more angry people become more enthusiastic to incur risks, even financial risks. As for the economic downturn, people had others in mind to accuse of the financial crisis. Take the example of Wall Street banks that became so angry such that they easily took the financial risk to punish the offenders.

Behavioral economists assume that the kind of financial errors made aren’t haphazard, and the choice made too aren’t fundamentally rational. Rather, they are built on psychological conditions such as cognitive errors and biases.

In our attempts to evade the similar crisis in our market, we can learn a lot from the economic downturn of 20008 and the related occurrences of the past. For instance, the 1974-75 economic recession almost resembled the 2007-2009 crisis. On the same note, the twin Reagan-era recessions of the 1980s had profound consequences such as joblessness and a subsequent S&L and sovereign debt crunch. The 1990s foreign currency crisis mandated an immediate discarding of the Long-Term Capital Management without interfering with the worldwide economic system. Just like Lipsky reports, the 2008 housing bubble was a consequence of a simmering stock market.

Hindsight bias wrongly predisposes us to imagine we can see and analyze the future crises pretty well the way we do the previous and establish strategies that would impede future crises. However, we are limited to devise policies that can avert future crises should we even be able to identify them since those who would lose are in our paths standing against us. No doubt restraining bank leverage would do some good; nonetheless, bankers have the smack to strangle it. Consequently, we have a few decision left–our psychological fallibilities. Assessing our psychological biases will work a great deal in averting and mitigating some crises.

Conclusion

From the discussion above, behavioral finance case studies focus on determining the clear-cut direction to which various market forces—such as rational analysis of organization-specific and macroeconomic basics; cultural, human and social psychology trends—affect investors and managers expectations and define their level of confidence.

Works Cited

Adolph, Berle, and Gardiner Means. The Modern Corporation and Private Property. New York, NY, Macmillan, 1932.

Allais, M. “Le Comportement De L’homme Rationnel Devant Le Risque: Critique Des Postulats Et Axiomes De L’ecole Americaine.” Econometrica, vol 21, no. 4, 1953, p. 503. JSTOR.

Ayuso, Silvia, and Antonio Argandoña. “Responsible Corporate Governance: Towards A Stakeholder Board of Directors?” SSRN Electronic Journal, 2009, p.2-19. Elsevier BV.

Benz, C. “The Bucket Investor’s Guide to Setting Asset Allocation for Retirement.” News.Morningstar.Com, 2016, par 3.

Ising, Alexander. “Pompian, M. (2006): Behavioral Finance And Wealth Management – How To Build Optimal Portfolios That Account For Investor Biases.” Financial Markets and Portfolio Management, vol 21, no. 4, 2007, pp. 491-492. Springer Nature.

Lipsky, J. Overcoming the Great Recession An Address to the Japan National Press Club, Remarks by John Lipsky, First Deputy Managing Director of the International Monetary Fund, at the Japan National Press Club, Tokyo, May 18, 2009. Tokyo: Japan National Press Club, 2009.

Morgenson, Gretchen, and Joshua Rosner. Reckless Endangerment: How Outsized Ambition, Greed, And Corruption Led To Economic Armageddon. New York, New York, St. Martin’s Griffin, 2012.

Shefrin Hersh, &Meir Statman. Behavioral Finance in the Financial Crisis: Market Efficiency, Minsky, and Keynes. Santa Clara: Santa Clara University, 2011.

Shiller, Robert J. “Bubbles, Human Judgment, and Expert Opinion.” Financial Analysts Journal, vol 58, no. 3, 2002, pp. 18-26. CFA Institute.

Shivdasani, Anil, and David Yermack. “CEO Involvement in the Selection Of New Board Members: An Empirical Analysis.” The Journal of Finance, vol 54, no. 5, 1999, pp. 1829-1853. Wiley-Blackwell.

Shivdasani, Anil, and Marc Zenner. “Best Practices In Corporate Governance: What Two Decades Of Research Reveals.” Journal of Applied Corporate Finance, vol 16, no. 2-3, 2004, pp. 29-41. Wiley-Blackwell.

Thaler, Richard H., and Shlomo Benartzi. “Save More Tomorrow™: Using Behavioral Economics To Increase Employee Saving.” Journal of Political Economy, vol 112, no. S1, 2004, pp. S164-S187. University Of Chicago Press.

Williams, Rob. “Plan, Allocate and Distribute: Structuring Your Retirement Portfolio for Your Income Needs.” Par 6. Schwab Brokerage, 2017.

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Stock Market Crash Global Financial Crisis

Analysis of the Stock Market Crash and Global Financial Crisis

The stock market crash in the autumn of 1987 is labeled as one of the sharpest markets down in history. Stock markets around the world plummeted in a matter of hours. The Black Monday, as it is labeled, is market as one of the major contemporary global financial crisis after the great depression that hit the global market between 1929 and 1941 (Markham, 2002). In the US, the stock market crash was marked by the 22.6 percent drop in a single trading session of the Dow Jones Industrial Average (DJIA).

In the years leading up to the stock market crash on October 19, 1987, there was an extension of a continuation of a highly powerful bull market. At this period, running from 1982, the market had started to embrace globalization and the advancement in technology. In the years 1986 and 1987, the bull market was fueled by hostile takeovers, low-interest rates, leveraged buyouts and increased mergers (Bloch, 1989).

The business philosophy at the time encouraged exponential business growth by acquisition of others. At the time, companies used leveraged buyouts to raise massive amounts of capital to fund the procurement of the desired companies. The companies raised the capital by selling junk bonds to the public. The junk bonds refer to the bonds that pay high-interest rates by the virtue of their high risk of default. Initial public offering or IPO was another trend used to drive market excitement.

During that time of increased market activity, the US Securities, and Exchange Commission (SEC) found it extremely hard to prevent shady IPOs and the existing market trends from proliferating. 

In the events leading to the stock market crash, the stock markets witnessed a massive growth during the first half of 1987. The Dow Jones Industrial Average (DJIA) had by August that year gained a whopping 44 percent in just seven months. The ballooned increase in sales raised concerns of an asset bubble. The numerous news reports about a possible collapse of stock markets undermined investor confidence and further fueled the additional volatility in the markets.

At the time, the federal government announced that there were a larger-than-expected trade deficit and this lead to the plunge of the dollar in value. Earlier in the year, the SEC conducted investigations on illegal insider trading that spooked the investors (Bloch, 1989). High rates of inflation and overheating were experienced at the time due to the high level of credit and economic growth. The Federal Reserve tried to arrest the situation by quickly raising short-term interest rates to decrease inflation, and this dampened the investors’ enthusiasm in the market.

Markets began to show a prediction of the record loses that would be witnessed a week later. On October 14th, some markets started registering significant daily losses in trading.  At the onset of the stock market crash, many institutional trading firms began to utilize portfolio insurance to cushion them against a further plunge in stock (Markham, 2002). The portfolio insurance hedging strategy uses stock index futures to shield equity portfolios from broad stock market declines. In the midst of increased interest rates, many institutional money managers tried to hedge their portfolios to cushion the businesses from the perceived stock market decline.

The stock markets had started plunging in other regions even before the US markets opened for trading that Monday morning. On October 19, the stock market crashed. The crash was caused by the flooding of stock index futures with sell orders worth billions of dollars within a very short time. The influx of the sell orders in the market caused both the futures and the stock market to crash. Additionally, due to the increased volatility of the market, many common stock market investors tried to sell their shares simultaneously and which overwhelmed the stock market.

Stock Market Crash and Global Financial Crisis
Stock Market Crash and Global Financial Crisis

On the same day, the 500 billion dollars in market capitalization vanished from the Dow Jones Stock Index within minutes. The emotionally-charged behavior by the common stock investors to sell their shares led to the massive crash of the stock market. Stock markets in different countries plunged in a similar fashion. The knowledge of a looming stock market crash resulted in investors rushing to their brokers to initiate sales of their assets. Many investors lost billions of investment during the crash. The number of sell orders outnumbered willing buyers by a wider margin creating a cascade in stock markets. Following the 19th October 1987 crash, most futures and stock exchanges were shut down in different countries for a day.

Federal Reserve Stock Market Crash

The Federal Reserve in a move to reduce the extent of the crisis, short-term interest rates were lowered instantly to avert a recession and banking crisis. The markets recovered remarkably from the worst one-day stock market crash. In the aftermath of the stock market plunge, regulators and economists analyzed the events of the Black Monday and identified various causes of the crash.

One of the findings shows that in the preceding years, foreign investors had flooded the US markets, accounting for the meteoric appreciation in stock prices several years before the crisis. The popularization of the portfolio insurance, a new product from the US investment firms was found to be a cause of the meltdown in stock markets. The product accelerated the pace of the crash because its extensive use of options encouraged further rounds of selling after the initial losses.

Soon after the crisis, the economists and regulators identified some flaws that exacerbated the losses experienced in the stock market crash. These flaws were addressed in the following years. First, at the time when the crisis hit the market, stock, options, and futures markets used different timelines for clearing and settlement of trades. The differences in timelines for clearing and settlements of trades created a potential for negative trading account balances and forced liquidations.

At the time of the crisis, the securities exchange had no powers to intervene in the large-scale selling and rapid market declines. Soon after the Black Monday, the trade-clearing protocols were overhauled to bring homogeneity to all important market products. Other rules known as circuit breakers were introduced, enabling exchanges to stop trading temporally in the event of exceptionally large price meltdowns. Under current rules, for instance, the NYSE is mandated to halt trading when the S&P 500 stock exchange plunged by 7%, 13%, and 20% (Markham, 2002). The reasoning behind the formation of this rule is to offer investors a chance to make informed decisions in cases of high market volatility.

The Federal Reserve responded to the crisis by acting as the source of liquidity to support the financial and economic system. The Federal Reserve also encouraged banks to continue lending money to securities firms on their usual terms. The intervention of the Federal Reserve after the Black Monday restored investors’ confidence in the central bank’s ability to restore stability in the event of severe market volatility.

The intervention of the Federal Reserve made securities firms recover from the losses encountered in the Black Monday crisis. The DJIA gained back 57% or 288 points of the total losses incurred in the black Monday crisis in two trading sessions (Bloch, 1989). In a period of less than two years, the US stock markets exceeded their pre-cash highs.

Stock Market Crash – Explain the role played by derivative trading in the 2008 global financial crisis

The world economy faced one of the most severe recessions in 2008 since the great depression of the 1930s (Landuyt, Choudhry, Joannas, Pereira, & Pienaar, 2009). The meltdown began in 2007 when the high home prices in the US began to drop significantly and quickly spreading to the entire US financial sector. The crisis later spread into other financial markets overseas. The financial crisis hit the entire banking industry; two government-chartered companies to provide mortgages, two commercial banks, insurance companies, among others like companies that rely heavily on credit. During the crisis, the share prices dropped significantly throughout the world. The Dow Jones Industrial Average recorded a 33.8% loss of its value in 2008.

Derivatives are defined as financial contracts that obtain their value from an underlying asset. These financial contracts include; stocks, indices, commodities, exchange rates, currencies, or the rate of interest. The financial instruments help in making a profit by banking on the future value of the underlying asset.

Their derivation of value from the underlying asset makes them adopt the name, “Derivatives.” However, the value of the underlying asset changes from time to time. For instance, the exchange rate between two currencies may change, commodity prices may increase or decrease, indices may fluctuate, and stock’s value may rise or fall (Santoro & Strauss, 2012). These variations can work for or against the investor. The investor can make profits or losses according to these changes in the market. The correct guessing of the future price could lead to additional benefits or serve as a safety net from losses in the spot/cash market, where the trading of the underlying assets occurs.

Standard derivatives are usually traded on an exchange. Other types of derivatives are traded over the counter and are unregulated. The use of derivatives can be dangerous when used for investment or speculation without enough supporting capital. Various factors caused the financial crisis of 2008; derivative trading was among them.

Financial innovation can be associated with the 2008 fall in the global financial market. The financial innovation invented derivative securities that claimed to produce safe instruments by diversifying/removing the inherent risks in the underlying assets. The financial innovations, however, did not reduce the inherent risk but increased it (Santoro & Strauss, 2012).

Derivative instruments were created to help manage risks and create insurance against a financial downturn. In the period leading to the 2008 financial crisis, the intentions of the derivatives have been entirely altered. The derivatives were initially invented to defend against risks and protect against the downside. However, in 2003-2007, the derivatives became speculative tools to make more risk in a move to make more profits and returns. During this period, securitized products which were difficult to analyze and price were traded and sold. Additionally, many positions were leveraged with the aim of maximizing the profits gained from trading the derivatives.

Banks created securitized instruments and sold them to investors. The Federal National Mortgage Association rolled out a concerted effort to make home loans more accessible to citizens with lower savings than the required amount by the lenders. The reasoning behind this idea was to help each American citizen acquire the American dream of home ownership.

However, the banks issued poor underlying credit quality which was passed on to the investors. The information that the rating agencies offered the investors about the certification of the quality of the securitized instruments was not sufficient (Allen, 2013). Usually, derivatives ensure against risk if used correctly, in the case of the events leading to the financial crisis of 2008, neither the borrower nor the rating agency understood the risks involved.

In the turn of events in the meltdown, the investors got stuck holding securities that proved to be as risky as holding the underlying loan. The banks were as well stuck because they held many of these instruments as a way of satisfying fixed-income requirements. They used the assets as collateral.

Financial institutions incurred write-downs during the crisis. A write-down refers to the reduction of the book value of an asset because it is overvalued compared to the prevailing market value. In the events leading to the financial plunge in 2008, assets were overvalued, and the financial institutions and investors felt an enormous negative surprise for holding these “safe instruments.”

In the years leading to the financial plunge, banks borrowed funds to lend so as to create more securitized products. Consequently, most of the instruments were created using borrowed capital or margin meaning that the financial institutions did not have to issue a full outlay of capital. The use of leverage (the use of different financial instruments or borrowed capital like margin to increase the potential profit of investment) magnified the crisis.

Credit default swaps also played a part in the crisis. Unlike options and futures, CDSs are traded in over-the-counter (OTC) markets meaning that they are unregulated. In the period before the financial bubble, the advantageous leverage, and convenience of the CDSs made dealers rush to issue and purchase CDSs written only in debt that they did not own.

The derivatives on different underlying assets are traded in unregulated markets. Derivatives such as CDSs are not widely understood since they are not exchange traded (Allen, 2013). Counterpart default risk in OTC markets produces a series of inter-dependencies among market actors and creates room for risk volatility. The result of this is a systemic risk as witnessed in 2008 in the case of Lehman Brothers Holdings Inc. the lack of transparency in the OTC markets played a part in the occurrence of the economic bubble in 2008. The OTC derivatives and risks associated with them were priced incorrectly, and it overwhelmed the financial market during the recession.

References

Allen, S. (2013). Financial risk management. Hoboken, N.J.: Wiley.

Bloch, E. (1989). Inside investment banking. Homewood, Ill.: Dow Jones-Irwin.

Landuyt, G., Choudhry, M., Joannas, D., Pereira, R., & Pienaar, R. (2009). Capital market instruments ;Analysis and valuation. Basingstoke: Palgrave Macmillan.

Markham, J. (2002). A financial history of the United States. Armonk, N.Y.: M.E. Sharpe.

Santoro, M. & Strauss, R. (2012). Wall Street values. Cambridge: Cambridge University Press.

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