2007-2008 Financial Crisis Essay

The 2007-2008 Financial Crisis

According to Saylor Academy (2012), a financial crisis happens when many financial markets function inefficiently or stop functioning completely; when one or few of the financial markets stop functioning the crisis that result is nonsystematic Saylor Academy (2012). The 2007 financial crisis started with subprime mortgages and in 2008 it turned severe systematic after major financial institutions failed.  The 2007-2008 Financial Crisis was a combination of many things, including: Monetary policy easing, banks taking excessive risks, consumers borrowing more than they could afford, the eventual US Housing Market Crash, stocks and poor risk pricing, the federal budget deficit, excessive leveraging by banks, predator lending, poor underwriting practices and the Federal Budget Deficit. This paper explores how the 2007-2008 Financial Crisis financial happened, what markets were impacted and how it was dealt with.

Monetary policy easing – Deregulating policies that were placed in placed to repeat historic failures is like playing Jenga, eventually everything will fall. According to (Market Oracle Ltd, 2009), the first block of deregulation happened in 1980 with the Depository Institutions and Monetary Control Act of 1980 – this was the first thing the banking system was being let a bit loose after the regulations that were put into place after the Great Depression.

The act accomplished the following: required less reserved from the banks, it created a committee to get rid of federal interest rate caps, increased insurance of Federal deposits, allowed banks to get credit advances from the Federal Reserve Discount Window and finally, it overstepped over state laws that restricted lenders by putting a ceiling on the interest rates they could charge from mortgage loans.

The second piece of monetary easing happened when the government and their great wisdom or greed decided to pick apart key pieces of the Banking Act of 1933 (Glass-Steagall Act of 1933). The act was in place to prevent banks from gambling with people’s savings, it separated commercial banks from investment banks – this was very important because investment banks could not take huge risks with people’s money.

Gramm-Leach-Bliley Financial Services Modernization Act was the drop that spilled the cup or the final straw that broke the camel’s back. This law, removed the last protective barrier that Glass-Steagall Act provided and allowed banks to do whatever they wanted; for example, Travelers investment bank was able to buy Citibank…Remember the law wanted to keep investment banks from using people savings? Well, this last act allowed investment banks to play with other people’s money (Market Oracle Ltd, 2009). Monetary policy easing removed all roadblocks that annoyed banks, but kept people’s savings intact and save; additionally, it gave birth to Subprime lending which later would be a major player in the Housing Market crash.

Banks taking excessive risks: According to (The Economist, 2013) Senator Phil Gramm once was quoted as saying “I look at subprime lending and I see the American Dream in action”. Due to the economy doing so well and low inflation, banks and investors were willing to take more risks in order to get a piece of the action. Banks were being irresponsible with mortgage lending and lower standards with subprime lending, borrowers who should not have gotten loans were able to get into houses they could not afford.

In order for banks to lessen or mitigate the risks, they played the numbers games, they gathered a many high-risk loan and put them together in groups (pooling), depending on the probability of defaults – in theory, this would decrease the risk because what were the probabilities that all borrowers in that pool could default on their loans? (The Economist, 2013)

Consumers borrowing more than they could afford – This comes back to subprime mortgages and just the timing of what was happening with the economy and the housing market. According to (John V. Duca, 2013) – traditionally, borrowers have to have good credit, good income and good debt to income ration in order to be the proud owners of a house with a white picket fence – those borrowers who did to meet the requirements above, would historically not qualify for any loans to buy a house. The ability of more people qualifying for mortgages they could not afford, lead to an increase in the housing market because the economy was experiencing more first-time home buyers.

The increase in demand created an increase in housing prices and it required more money to be borrowed by the people who were already stretched thin on the amount of money they were borrowing (John V. Duca, 2013). Up to this point, banks and consumers were lending and borrowing money banking on best case scenario and not planning for the worst. Added to the situation was the fact that the government had mandated Fannie Mae and Freddie Mac to increase home ownership, so both Fannie Mae and Freddie Mac had purchased lots of subprime mortgages (John V. Duca, 2013).

Secured Lending - 2007-2008 Financial Crisis
Secured Lending – 2007-2008 Financial Crisis

US Housing Market Crash – In the famous quote from Isaac Newton “What goes up must come down”.  Once housing market reached its plateau, mortgage financing and home selling became less attractive and that is when they began to drop in price, lenders and investors started losing money. The first casualty of subprime mortgages happened in April 2007, New Century Financial Corps filed for bankruptcy – after that, all the pooling that was done by experts to mitigate default risk was downgraded to high risk and many small subprime lenders went out of business.  Lenders stopped issuing loans, specially the high interest rate ones (subprime) – this resulted in less people getting loans after that and as a result, less houses being purchased by consumers.

Low demand for houses led to a drop-in price, the famous law of supply and demand had kicked in. Prices dropped so much that borrowers who were trying to sell them could not send them at the price they owed in their loans. Remember that government told Fannie Mae and Freddie Mac to increase home ownership? Well, as a result, Fannie Mae and Freddie Mac suffer major losses an all subprime mortgages they had purchased and insured (John V. Duca, 2013). The housing market was flooded by banks selling their foreclosed/repossessed homes, people trying to sell their houses because they get foreclosed, people doing short-sales and in addition the market was getting the normal number of houses being sold the usual sellers (new construction, people moving, etc.).

US House Prices - 2007-2008 Financial Crisis
US House Prices – 2007-2008 Financial Crisis

Stocks and poor risk pricing – Prior to the economic crisis, investors were unable to get the exact value of risk they would be bearing when taking up stocks or financial assets from the traders. Risk pricing or the cost of risk is implied in the rate of interest charged and the investors, with poor risk profile of certain assets in the market, would not know the value of the risk assumed when buying stocks or the value of risk exchanged when selling stocks (Amadeo, 2010; Williams, 2010). The market participants were thus inaccurate in their risk analysis due to the complex financial system and innovations among other factors such as ignorance and deceit from the traders themselves.

JP Morgan is quoted as selling and quoting the risk price of CDOs at a price way lower than the market price due to lacking accuracy or information as is contrasted to stable prices in a perfect market, where market information is publicly available, as per the Basel accords. In a similar risk pricing error and crisis, the AIG had to be taken over by the American government, settling about 180 billion US dollars from the tax payers’ money because AIG had taken premium guarantees to pay several CDS obligations to many lenders of small and global parties, whose risk profile was then uncertain to the lender and insurer and plunged the institution into near bankruptcy (Amadeo, 2010).

There was then no clear model of ascertaining the level of risk assumed by a guarantor or a borrower given the dynamic and complex financial innovations of the time and the slowly growing financial academia, practice and experience within a span of two years, that is, between 2007 and 2008 (Jickling, 2009).

The Role of The Federal Reserve in the 2007-2008 Financial Crisis

The Federal Reserve and liquidity – The Federal Reserve is the lender of last result to banks and thus, is the only last savior in a financial crisis. However, the reserve faced inadequate cash to lend to banks with the rapid mortgage and loan processing witnessed alongside booming borrowing and house financing by banks and financial institutions. Commercial banks couldn’t afford adequate liquidity to finance their obligations and the large sizes of mortgages they were buying.

In the same time, the price of commodities and especially minerals such as oil and copper were growing at an unsustainable rate, with most of the minerals being imported from outside. The rise would give the impression to traders that it was an opportunity to invest in the appreciating metals and thus, there was a general cash outflow from the US in exchange for metals and gems, which saw increased trading lead to a decline in the prices thereof and a general loss of cash from the American economy to oil producing and mining countries such as the middle east nations. The cash inflow into the US was less than the cash outflow and commercial  banks would earn less than they were paying as cost of leveraging. This Federal Reserve with less inject into the economy to facilitate liquidity among the commercial banks (Jickling, 2009).

Excessive leveraging by banks – Before the 2007-2008 financial crisis struck the market, banks and other institutions in the mortgage and finance sector had used massive leveraging, that is, using credits and other derivatives to acquire assets. Leveraging shifts the risk of lending to the leveraging institution, thus removes the risk adverseness of a financial institution. They trade with appetite for risky investments which they perceive are most productive. The state of affairs with the highly leveraged financial institutions, therefore, led to risky deals which ultimately led to high rates of defaulting. Also, a major contributor to the 2007-2008 financial crisis.

The high level of leveraging, also, exposed the banks to massive risk impact should a financial downturn result and when it did with the bursting housing prices balloon, the financial institutions came crumbling down, leading to a global and all-sector financial crisis with little identity as to which institutions were in bankruptcy (Amadeo, 2010). This was as a result of a complex system of financial derivatives and contracts that were difficult to determine given the limited financial information then available (Jickling, 2009).

Predator lending – Another factor that contributed greatly and grossly to the financial crisis of the time was the deceitful predatory lending by financial institutions. The institutions would entice borrowers or mortgage buyers with appealing interest rates and have them commit to the mortgages even when such a commitment had hidden charges or adjustments (The Economist, 2010). A common practice involved the use of very low interest rates to hook up people after financing. Upon the completion of the mortgage, the client would realize later that the mortgage was an adjustable one with rates rising gradually to almost double the value they borrowed.

Many would end up unable to pay back the commitments and have their mortgages seized or have to deal with a negative amortization mortgage (McLean & Nocera, 2010).  In one case, the California attorney sued Countrywide Financial for fraudulently enticing borrowers in to a bait-and-switch conman mortgage with expensive mortgage payments (The Economist, 2010). With the falling housing prices, the home owners with outstanding mortgages were demotivated to pay their dues against the devalued prices of their mortgages, leading to massive defaulting and a financial crisis in the industry (Jickling, 2009).

Poor underwriting practices – Another factor that led to the ultimate onset and peaking of the financial crisis was the poor underwriting practices by intermediaries, banks and even insurers. Regulations require that a loaning process should follow the loaning institutions documentation guidelines and the underwriting process ought to be understood in depth to avoid unforeseen difficulties or illegalities. However, the pre-crisis period was characterized by rapid underwriting processes with little or no attention to the lender’s procedures and rules of engagements.

Loans and mortgages would be processed with little or no official documentation completed as per the issuers rules of engagement, which would lead to borrowers being subjected to terms they didn’t sign for or they were unaware of, high defaulting rate by loan holders and selling of loans without full disclosure as to the terms attached to such loans (Greenberg & Hansen, 2009; Amadeo, 2010). At the end, the victims would be realized as unable to honor their commitment due to the inflated loans, some of which would never be recovered.

In this saga, about 1600 mortgages bought by the mortgage firm Citi from mortgage dealers were found to be defective and unenforceable while the mortgages had been passed on from the dealers to the banker. The poor and fraudulent underwriting process therefore contributed immensely to the financial crisis in which banks couldn’t provide financing as they had too many commitments to honor, alongside the housing crisis (Jickling, 2009).

2007-2008 Financial Crisis, in conclusion, this paper asserts the academic and scholarly authority that the largest and longest financial crisis witnessed post the great depression era was as a result of structural factors such as the easing on monetary policies, excess risk assumed by banks, excessive borrowing of cheap but risky loans by consumers, the fall of the US Housing Market, poor risk profile on stocks, the federal budget deficit, over leveraging by banks, predatory lending, poor underwriting and the Federal Budget Deficit. These factors made many banks and institutions to collapse.

References

Amadeo, K. (2010). “2008 Financial Crisis: The Causes and Costs of the Worst Financial Crisis Ever Since the Great Depression.” The Balance.

Greenberg, R., & Hansen, C. (2009). “If you had a pulse, we gave you a loan.” NBC news.

Jickling, M. (2009). Causes of the 2007-2008 Financial Crisis.

McLean, B., & Nocera, J. (2010). All the devils are here: unmasking the men who bankrupted the world. Penguin UK.

The Economist (2010). “Predatory lending: let’s not pretend we don’t understand how it worked.”

Williams, M.T (2010). Uncontrolled risk: the lessons of Lehman Brothers and how systemic risk can still bring down the world financial system. McGraw-Hill.

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Costing Methods Financial Essay

Costing Methods

Costing Methods in Financial Management – The globalization resulted in excessive heights of competition which compelled businesses to the concepts of products and prices. The differentiation strategy works well when the companies charge the lowest prices possible for their products. Business organizations can practice the differentiation in their products by working the quality of their products and implementing some of the marketing approaches like after sale services. With that in mind, the business must conduct market research to ascertain the specific market cost of the products and services then they aligned their products upon the established prices.

Therefore, the standard costing methods remain outdated at this point, and business firms installed more strategic costing procedures. Some of these strategic costs applied by contemporary businesses consist of target costing, life cycle costing, and the Kaizen costing. This report seeks to describe and discuss target costing, life cycle costing, and kaizen costing with their examples and make conclusion and recommendations about the application of three costing methods.

Introduction to Costing Methods

The contemporary customer is a vocal consumer who has the market knowledge thereby posing a stiff competition in the market. The increased competition compels companies to embrace marketing strategies which may make them meet the level of competition trend. As a result, to remain relevant companies must redesign their processes to maximize product quality at reduced costs. Company businesses must work with price reduction as a way to remaining gain the market share in a competitive environment. Therefore, for the realization of the above strategies a company cost detection mark it as the better option.

Therefore, cost methods used by the firm act as significant strategic tools for opportunities identifications that guarantee cost reduction and product quality improvements.  The report describes and discusses target costing, life cycle costing, and kaizen costing as the modern cost management techniques which the company can use to sustain a competitive market environment.

Target Costing

The target costing is a modern cost management technique that has ide coverage usage by most managers. According to Cooper, target costing relates to Functional Cost Analysis as well as Value engineering to align the products and services to match the market dynamics (Cooper 2017). The onset of cost management according to this cost method is at the development stage where the product attributes that match the next generation get incorporated with the intention of generating the required return on investment.

The whole process entails market segmentation to identify the most reliable segment to target and customize the products and services to meet the prevailing conditions. Also, the company must study the convenience of the rival firms in the same segment to deliver the same quality at a cheaper cost. The company proceeds to the next by filtering its activity which is relevant for the delivery of the already established product attributes.

With that in mind, the identified relevant activities are subject to costing to gauge their total costs against the anticipated returns. In the event of any variation, functional costing and value engineering get into play for cost reduction strategies to get employed without compromising the required product quality. The latter process gets continued in line with the market pricing spirit until the best cost is established then the company proceeds to invest in the production of the product required (Talebnia et al. 2017).

Furthermore, functional Cost Analysis together with the Value Engineering techniques help the inter-processes teams to creatively identify the best ways to install the alternative cost reduction product designs without charging the recommendable market features of the product (Talebnia et al. 2017). This is important when analyzing costing methods in the management of finace.

Also, for the company to achieve the maximum value engineering techniques, the company must go through two significant steps by performing some of the radical design changes at the development stage so long as the product is capable of delivering the required service. Second, the use of different design teams may get considered for cost reduction purposes (Talebnia et al. 2017).

According to hart, target costing offers the following advantages to any committed firm (Cooper 2017). First, helps the management with the required knowledge to the development of products and services that are market-oriented through the firm’s strategic objectives, they develop products are following the tastes and preferences of the customer regarding functionality and the delivery method.

Second, it forms an essential element of product development teams, while giving products that are flexible to dynamic costs and life cycle changes and services that are relevant in their application context.

Third, the target costing supports activity-based costing through well-presented costing data during the specific developmental stages. Finally, target costing provides market-driven product features by ascertaining the use of simple, relevant, and user-friendly products. The development teams use simple language to prevent time wastage during costs evaluation (Cooper 2017). 

Life Cycle Costing

The method of life cycle costing considers not only the initial cost of a company asset but also the costs involved over the useful life cycle of the same assets for a rational investment decision (Moreau & Weidema 2015). The life cycle technique confirms the significance of valuing the asset by considering the total ownership costs to provide a viable management decision making. The information about the whole life cycle of an asset can offer some insights such as; future required resources, investment evaluation, and supplier appraisal, resources accountability, improved system design, and asset economic life assessment.

The complexity of the asset in the question determines the kind of life costing approach to get applied, and the annual costing can ask directly approach as opposed to complex computerized processes of future costing. The life cycle costing involved the analysis of the entire asset life span cycle by considering the initial acquisition costs, operating costs, loss of failures, repair cost, preventive costs, and maintenance costs. Other expenses include interest rates, depreciation, present value, and discount rates.

According to Nasik, the life cycle analysis is possible in a spreadsheet with the fair, necessary cost values because it only entails adding up of the respective costs and other rates like discount and interest (Daylan & Ciliz 2016). The costs involved by finding the summation of all the expenses are deterministic, on the other hand, some values are probabilistic like costs concerning the asset reliability and maintainability (Daylan & Ciliz 2016).

The project manager has the responsibility of assessing the present asset condition, the budgeted value for the purchase of the asset, historical background to define the best alternative asset the company may consider worth the investment with the assurance of service delivery beyond the expected levels (Moreau & Weidema 2015).

Therefore, the making it possible for a rational decision concerning capital and expenditures, prioritize every company projects regarding total costs of ownership, and build management confidence when doing their report to major company stakeholders. Life cycle cost analysis also boosts management morale since the analysis assists in project validation calculation, risk reduction strategies, and consistent ways of project evaluation.

The asset life span starts immediately during creation planning to the time of disposal (Daylan & Ciliz 2016). For example, the asset passes through some stages such the concept definition, development of the design features, features specifications and documentation, manufacturing, the awarded warranty duration, and utilization stages. The other steps during the operation include maintenance and finally disposal.

Most importantly, is the strategic and periodic asset life span cycle which always commenced at the strategic planning, the asset formulation, operations level, asset in house maintenance, possible rehabilitation, and finally disposal. The life cycle of the asset is subject to necessary maintainability, technological developments, and the dynamic nature of the operational requirements are the few factors that may influence the life span of an asset (Moreau & Weidema 2015).

Costing Methods Financial Management
Costing Methods Financial Management

Kaizen Costing

The kaizen has its roots from the Japan where the knowledge of continuous improvement originated. According to Hert, the target costing planning process is compatible with the kaizen process in the production stage while firms which concentrate more on the shorter life cycle products usually use the target charging planning instead of combining the two charging methods (Kaplan & Atkinson 2015).

On the other hand, most of the companies with a complex life cycle practice kaizen during their operations at different stages of target costing to get products which are relevant to all generations. Kaizen holds every business organization player to get responsible and embrace never ending the quest for quality improvement through constant job processes evaluation.

All that this method need is just embracing the organization culture whereby all company processes get interconnected in a way that promotes learning from each other on the cost reduction strategies and quality improvement. As a result, kaizen is more aligned with knowledge sharing among the team members with the sole objective of enhancements. The kaizen costing holds the mighty aim of showing the management direction on how to apply the kaizen costing to ascertain a culture of continuous improvement across the organization (Mena et al. 2018). 

In the field of management accounting, kaizen assists firms to gain a competitive edge as it helps the management to do an appraisal to its strategic plans, activities, and long-term operations goals (Mena et al. 2018). With that in mind, the activities such as increasing company improvements, the permanent cost reduction along the production line, and ever diligent in the product design and development stages help the active management to reduce wastes and costs during production. Therefore, the output from the company processes meets the required quality to guarantee customer satisfaction at affordable prices in the market to make the company competitive.

Kaizen differs with the target costing in that the target costing involves product development stages while kaizen comes in during the manufacturing stage to eliminate wastes and reduce costs along the manufacturing lines. Furthermore, the kaizen uses the value analysis method in the form of value engineering to ascertain cost reduction at each process level. Notably, kaizen stresses the improvement in quality and cost delivery through the controlling the product market cost, timely delivery, and distribution.

According to Mark adults, the kaizen profits by getting the difference between corporate management projected profits and lower control expected profits (Kaplan & Atkinson 2015). For a company to achieve the benefits through kaizen costing it must install kaizen costing teams in every department to assist in planning, monitoring, and an evaluation of the processes.

Second, the target charging team must work hand in hand with the kaizen team for compatibility of refined product attributes with the set manufacturing kaizen standards and any variations in kaizen costing must get reported in time to the relevant authority for expert action. Third, the culture of continuous improvement gets supported by active channels of communication across the entire company.

The kaizen principles must get formal communications for kaizen costing information dissemination. Finally, the management ought to establish an evaluation method to gauge the kaizen success on a yearly basis and make the necessary adjustments (Mena et al. 2018).   

Costing Methods Conclusion

The three costing methods are very vital for any business organization to remain competitive in the contemporary market. They help in aligning the products and services offered with the requirement of the dynamic and volatile competitive current markets consisting of a knowledgeable consumer. The knowledge of target costing assist the design and development teams to come up with designs that are generational oriented after thorough market analysis.

The market segmentation helps the team to understand profoundly different needs of a different category of consumers. Also, life cycle costing is an important in management accounting because the methods help the organization concerned with asset acquisition the required knowledge for charging the asset ownership costs, supplier evaluation, and the general company projects evaluation skills.

Moreover, the life cycle helps the procurement and costs expert to acquire the relevant production machines at fair prices. Finally, kaizen costing is an equally more important approach that ascertains reduction of wastes and unnecessary cost along the production lines and, therefore, verifies quality products at affordable market prices. The combined knowledge of the three methods of costing makes a company to gain a competitive advantage in the global markets and assure sustainability.

For the organizations to apply the three costing methods successfully, they need to integrate the accounting knowledge with the strategic management approach thinking for effective internal control systems. Also, the company must work on its both inbound and outbound logistics, production policies and procedures, distribution channels, and marketing strategies like after sales services to offer it a better market advantage over rival firms. Therefore, the successful application of cost management strategies needs an effective and efficient supply chain management.

References

Cooper, R. (2017). Target costing methods and value engineering. Routledge.

Daylan, B., & Ciliz, N. (2016). Life cycle assessment and environmental life cycle costing analysis of lignocellulosic bioethanol as an alternative transportation fuel. Renewable Energy89, 578-587.

Kaplan, R. S., & Atkinson, A. A. (2015). Advanced management accounting and Costing Methods. PHI Learning.

Mena, C., Van Hoek, R., & Christopher, M. (2018). Leading procurement strategy: driving value through the supply chain. Kogan Page Publishers.

Moreau, V., & Weidema, B. P. (2015). The computational structure of environmental life cycle costing. The International Journal of Life Cycle Assessment20(10), 1359-1363.

Talebnia, G., Baghiyan, F., Baghiyan, Z., & Abadi, F. M. N. (2017). Target Costing, the Linkages Between Target Costing and Value Engineering and Expected Profit and Kaizen. International Journal of Engineering1(1), 11-15.

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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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Financial Ratios Financing Constraints

Impact of Financial Ratios and Financing Constraints on Firms

Importance of financial ratios and financing constraints on modern business. The target audiences of this paper are investors looking for financial investment options and small business firms seeking growth.  Therefore, the article and information might be contained in a financial magazine such as wall street journal. The goal of this paper is to inform audiences on the important financial ratios, and how they are important in determining whether a company is worth investing in or not. Any business owner will want to find out the performance of his or her company in order to make informed management decisions.

In addition, an investor will want to have accurate financial position of any business firm for investment decision processes. In this regard, business organizations and financial analysts use a variety of analytical tools that are aimed at comparing the existing relative strengths and weaknesses of their businesses. These basic tools and techniques have enabled the investors as well as the analysts to develop fundamental analysis systems (Butzen & Fuss, 2003). Therefore, ratio analysis was developed as a tool that established the functions of quantitative analysis in the financial statement numbers. These ratios link the financial statements and determine figures that are comparable between sectors, companies, and across industries. Therefore, financial ratios have a significant financial analysis technique that is used for comparative analysis.

Financial Ratios and Business Growth

Small and growing business firms use financial ratios to determine how their businesses perform.  A significant financial ratio is the activity ration that is used in measuring how companies are efficient in utilizing their assets (World Bank, 2005). Therefore a negative ratio will force a company or an organization to either increase or decrease their assets or liabilities. These ratios are widely used by investors who can easily check out the overall operation of a prospective company for investment decisions (Harrison et al, 2002). If the overall performance of a company is determined to be poor, a company may lose investor confidence and as a result, lose business.

In addition, activity ratios are deemed to be turnover ratios that are associated with a balance sheet line item and an income statement line item. Generally, income statements are used for measuring the performance of any company, but for a specified period of time. However, the balance sheet provides data for a specific point in time. The advantage of using activity ratios is that they are able to give an average figure between the two financial statements. This means that companies or organizations are able to determine the rate of turning over their liabilities or assets. This helps the companies to control their receivables or inventories per year (Harrison et al, 2002).

Moreover, there are inventory turnovers that are used in the management effectiveness of any business organization (Butzen & Fuss, 2003). This ratio is determined when the cost of goods sold is divided by the average inventory. In this regard, a company is able to know whether its inventory is sold at a higher rate, when the turnover is recorded to be high.

Financial Ratios Essays
Financial Ratios Essays

This ratio is then significant in giving companies signals for inventory management effectiveness. In addition, this kind of inventory ratio communicates that there are less resources which are tied up in the company’s inventory (Butzen & Fuss, 2003). However, it is also important to understand that an unusually high turnover means that the company’s inventories are too lean. Consequently, the management discovers that the company may be ineffective in keeping up with the demand that is increasing (Harrison et al, 2003). Therefore the management is forced to act swiftly in adjusting the company’s operations to fit a favorable inventory ratio. Investors are keen in checking out companies with high inventory turnovers since it means that that specific industry gets stale quickly, thus an attractive investment option.

Another significant financial ratio is the receivables turnover ratio, that enables a business organization determines how fast it collects the bills that are outstanding (Harrison et al, 2002). This specific ratio determines the effectiveness of any company credit policy towards its customers. In this regard, negative receivables will force a company to have stringent credit policies that are aimed at ensuring that bills are collected as easily and fast as possible (Butzen & Fuss, 2003). This particular ratio is achieved by dividing the all the net revenues with the average receivables. In this case a company is able to know how many times per financial period, it is able to collect all its outstanding bills and have the cash used in the operations of the business.

However, it is important for a prospective investor to understand that a high turnover does not only indicate that the company is operating in the best interests of its customers. A high turn over may also indicate that the business company policies are too stringent and thus the company is missing out on sales opportunities to its competitors (Harrison, et al, 2002). Alternatively, a low turnover or which is seen declining means that the company’s customers are struggling with the credit policy that is set out by the company and thus are having trouble paying their bills. In this regard, this turnover ratio is very significant when any company is developing its credit policy.

Creditors are able to measure how effective companies are in paying off their financial obligations, when determining whether to extend their credit facilities to them. The financial ratio that is used in this case is the liquidity ratio, that helps establish any company’s ability in meeting its financial obligations usually short term financial obligations (Harrison et al, 2003). However, it is important to understand that the level of liquidity is not standard and thus varies from different existing industries. One example is a business that runs a grocery store; this business entity, usually demands cash on a regular basis in order to run its business operations. In contrast, a technological run store will need less operational cash in the daily running business operations. In addition, every business has its own unique trend over the liquidity ratio that is recorded over a financial period.

When a company wants to expand its business operations, it is the ideal option of seeking long term financial services. In this regard, a company is able to measure or determine its payback ability by calculating its solvency ratio. This is an important financial ratio that either allows a company to get long-term financing or to stay steer on it. This ratio is able to do this because it provides an insight to the capital structure of any company as well as its existing financial leverage that is being used by a firm (Butzen & Fuss, 2002). In the recent years, investors use the insolvency ratio in determining whether firms have adequate cash flows that are important in paying fixed charges or even the interest payment. Therefore, a company that presents low cash flows is deemed to be overburdened with its debts. In this scenario, investors may opt out and the company’s bondholders are likely to push the company into default.

Ratios are an important tool of making profitable financial decisions from any angle, whether as an investor or as a business firm. All these financial ratios have their own distinct impact of firms and business organizations. They present financial constraints that may hinder firms from accessing venture capital or financial aid from companies. In addition, other constraints may include rising interest rates as well as inflation (World Bank, 2005). Therefore, it is very stringent for companies strive in building contingencies in their cash flow budgets that are important in dealing with such adverse changes that may occur in the financial environment. In addition, it will be a bad idea for any start up firm to rely fully on loans from financial institutions such as banks or funding from venture capitals for their business plans (World Bank, 2005). This is because there could be a rise of financial constraints that would be unfavorable for the company. A financial constraint such as inflation could mean that raw materials or labor costs may consequently increase to higher levels causing such start ups to close business.

References

Butzen P., Fuss, C. (2003) Firm’s Investment and Finance Decisions: Financial Ratios Theory and Practice. New York: Routledge

Harrison, A., McMillan M., & Love, I. (2002). Global Capital Flows and Financing Constraints. New York: Rowman & Littlefield Publishers.

World Bank. (2005). Financial Ratios in the Finance Sector: A Handbook. New York: International Monetary Fund.

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If you enjoyed reading this post on financial ratios and financing constraints, I would be very grateful if you could help spread this knowledge by emailing this post to a friend, or sharing it on Twitter or Facebook. Thank you.