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 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
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
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.
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
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.
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
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.
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.
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
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
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
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envelope for economic and business theories of MNE activity”. International Business Review 9, pp. 163–190.
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Maurice, O 2010. “Does the Current Account
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Vol.102, No. 3, pp. 1–23.
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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.
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.
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.
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
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
The Valuation Effect. Studies reveal that firms with higher P/B multiples are outperformed by those with low price/book (P/B) multiples.
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.
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
The Second Colleague: Confirmation Bias
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.
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
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 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
Costly self-control bias- Living for today
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.
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.
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
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
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
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
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
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).
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.
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.
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
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
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
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,
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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Analysis of the Stock Market Crash and Global Financial
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.
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.
Allen, S. (2013). Financial risk management.
Hoboken, N.J.: Wiley.
Bloch, E. (1989). Inside investment banking.
Homewood, Ill.: Dow Jones-Irwin.
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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Investment appraisal is normally undertaken by a company before committing to any form of high-level capital spending. The appraisal has two main features including the assessment of the level of returns expected that could be earned from the investment made and an estimate of the future benefits and costs in the span of the project (Ross et al. 2010). In this regard, long-term forecasting is important for estimates of future benefits and costs especially in the purchase of the non-current asset. There are several techniques for investment appraisal, but the two most basic include the payback and return on capital employed (ROCE).
ROCE follows the same principle with the accounting rate of returns as they both relate the investment and the accounting profits (Lumby & Jones 2001). It is computed by getting the percentage of average pre-tax annual profits to the initial capital costs. The method has the advantages of simplicity, especially in the computation. This is because it gives a percentage that indicates the rate of return expected from an investment that is familiar to the management. Also, the technique can be easily linked to other accounting measures (Lumby& Jones 2001). However, the method has disadvantages in that it cannot account for project life, the timing of cash flows and mostly varies depending on policies of accounting employed. Additionally, the method ignores working capital and fails to measure the absolute gain attained while it still lack definitive signal for investment (Watson & Head 2010).
The ROCE technique is quite popular in the assessment of the business performance after the investments are completed (Haka 2006). This technique is widely used as a measure of the business performance as well as to measure the performance of the management (Lumby & Jones 2001). It is most commonly used in the privately owned businesses as it depicts an increase of wealth for the owner. Also, it can be applied in the expression of the financial goals of a business (Watson & Head 2010). Both independent and mutually exclusive projects can employ the ROCE technique. For example, if a project needs an investment of $800,000 and earns cash inflows of 100, 200, 400, 400, 300,300, 200 and 150 in terms of thousand dollars in a span of seven years.
In addition the assets will be sold at $100,000 at the end of the seven years. The ROCE for this project will be 18.75%. The decision rule as to accept the project or not is determined by looking at the expected ROCE and the hurdle rate from the management. If the expected ROCE is more than the target rate, then the project is accepted (Haka 2006). The popularity of this techniques has however been declining most probably due to the inflation rates that have led to higher interests rates making the decision-making process difficult. In this case, the method is best suited for short-term business approaches (Haka 2006).
Payback period, by definition, is the rough estimate of the time taken to recoup the investments made in a project (Lefley 1996). This technique has two variants: discounted and simple payback periods. The periods are calculated by computing the quotient of initial investment divided by annual cash flow (Lefley 1996). This investment appraisal method has the advantages of simplicity and can use the cash flows and not the accounting profits. This is because the profits in the company cannot be sent and are subjective (Watson & Head 2010). Also, cash is used as the dividends have to be paid. For instance, an expenditure of $2million to get cash inflows of $500,000 per year for some seven years can be assessed using payback. The estimated period will be 4 years and the cumulative cash flow would change over the years. The decision rule in using payback is that the objects that pay up to the specified target payback should be accepted (Wambach 2000). Also, the fastest paying option is always considered.
Also, payback has proven to be very useful in some conditions such as in the improvement of the investment conditions and adaptation to the rapidly changing technology (Lefley 1996). Additionally, the technique maximizes the liquidity, increases company growth while still minimizing the risk.
Comparison of the Two Methods
Despite the numerous advantages, the payback method also has some limitations (Wambach 2000). It does not take into consideration the returns that occur after the period and also disregards the cash flow timings although this can be done by the discounted payback period. In the same regard, it does not provide a definitive investment signal making the method subjective (Lefley 1996). Lastly, the payback method does not take into account the profitability of the project.
The best of the methods in this case would be the payback. This is especially because of the cash flows involved in the projects. The method puts into consideration the time as well as the value for money. Payback is also invaluable especially in the world of unlimited resources and the information provided is understandable (Lefley 1996). ROCE and payback period are both classical techniques in investment appraisal (Wambach 2000). Industries are divided among the two methods although it is possible to utilize both although the non-finance managers prefer to use ROCE (Ross et al. 2010). In this regard, two decisions could be made. For instance, a project could be accepted if the ROCE is below 13% and it can payback within four years (Watson & Head 2010).
The forecasts are important for any business before embankment of any project. Although the investment appraisal may but produce accurate results, it would be important to use as many techniques to avoid losses. Spending on too much on current assets is unrealistic, and the forecasts need to be very careful in order for the best possible value to be gotten. Although several methods for the investment appraisal exist, the return on capital employed and payback remains the most popular one especially with the managers with low skills on finances.
Lefley, F 1996, ‘The payback method of investment appraisal: a review and synthesis’, International Journal of Production Economics, 44(3), 207-224.
Wambach, A 2000, ‘Payback criterion, hurdle rates and the gain of waiting’, International Review of Financial Analysis, 9(3), 247-258.
Lumby, S, & Jones, C 2001, Fundamentals of investment appraisal, Cengage Learning Business Press.
Haka, S F 2006,‘A review of the literature on capital budgeting and investment appraisal: past, present, and future musings’ ,Handbooks of Management Accounting Research, 2, 697-728.
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