Recent research in the area of macroeconomics has been focused on trying to identify the causes of the 2007 – 2008 global financial crisis and determining best central bank monetary policies to prevent future crises. A debate that has for the last few decades been settled is now being revived; “lean” versus “clean” handling of asset Price bubbles.
The prevailing consensus of central bank monetary policy has followed the “Greenspan Doctrine” established in the 1970’s for dealing with asset price bubbles. Alan Greenspan, who was the chairman of the U.S. Federal Reserve from 1987 to 2006, believed that cleaning up after an asset bubble burst was less costly and damaging to the economy than allowing central banks to burst bubbles; attempting to “Lean Against The Wind (LATW) (Wadhwani, 2008)” on rising asset bubbles to prevent a bigger burst. This perspective was widely accepted by central banks around the world.
There are mainly four arguments against LATW monetary policy. First, bubbles are difficult to predict; the market would likely detect asset bubbles before regulators would and the market would be able to orderly deflate those bubbles through natural market processes. Secondly, there is evidence that raising interest rates (a central bank strategy for determent) doesn’t reduce the inflation of bubbles since investors are likely to take the risk on high interest rate assets in the midst of an asset bubble based on the expectation of high returns on those assets. Third, the Fed is incapable of isolating dangerous asset bubbles from normal rising asset prices; monetary policy could ham-handedly attempt to prevent asset bubbles but have the effect of harming normal asset prices. Lastly, proactively bursting asset bubbles could make the burst harsher than if the bubble were allowed to burst on its own.
Those cautions have kept the Greenspan Doctrine in place since the late 80’s, but in the aftermath of the 2007 – 2008 crisis, many economists are beginning to wonder if the “lean” strategy may actually be cleaner than the Greenspan Doctrine. Not to mention, the Greenspan Doctrine assumed that bubbles could not be as destructive as the most recent housing bubble. Could central banks develop monetary policy strategies that are more precise in detecting and deterring asset bubbles?
Combating Price Bubbles
Clearly, setting aside the lean versus clean debate, there are standard monetary principles that have not always been followed or enforced. Namely, regulators should demand more transparent disclosure, require more capital and liquidity, apply stricter monitoring of risk, stronger enforcement of compliance, and more accountability for regulators charged with overseeing the financial stability of markets. These policies need to be either reinstated and or reinforced to help stabilize the markets during asset bubbles or otherwise.
But for central banks to devise better strategies for combating bubble driven asset pricing, it is necessary to rethink the Greenspan Doctrine considering how ill-prepared the central banks were for dealing with the crisis in the financial markets. Or, perhaps both strategies have a time and place in setting monetary policy. Frederic Mishkin argues that there is a way to apply the LATW strategy to the financial markets if first central banks understand that there are two different types of bubble driven assets and each one requires a different monetary strategy.
Asset-pricing bubbles are divided into “credit bubbles” – like the housing bubble – and “irrational exuberance bubbles” – like the dot-com bubble (Mishkin, 2011).” He argues that because credit bubbles are so destructive to the economy and so hard to clean up that it would be appropriate for central banks to focus their monetary policies on predicting and deflating credit bubbles before they grow too large. Credit bubbles are linked to the financial markets so intricately that whenever there is a credit bubble like the one just experienced, its bursting usually leaves in its wake a deep recession, a financial crisis and a long period of slow growth and high unemployment.
Asset Price Bubbles
Unlike normal recessions, there was no sharp recovery after the last three big asset bubbles. Because it is so hard to recover from credit bubbles, trying to head them off and prevent them is necessary. The LATW can be applied and should factor in to central bank policy because credit bubbles are much easier to identify. Each credit bubble shares certain symptoms that could alert regulators to the problem: lower lending standards, premiums on risk become abnormally low and credit is being extended at a much faster and higher rate (Mishkin, 2011).
The central bank targets these credit bubbles by slowly raising interest rates to discourage excessive risk taking in the credit markets. By inflating the interest rates on these assets, central banks can tamp down exuberance as well as spark growth in a slowing economy (The Financial Times LTD, 2014). This requires central banks to turn their focus more sharply and aggressively towards monitoring and reacting to irregularities in asset pricing more than the traditional singular focus on controlling inflation (Wadhwani, 2008) (Gambacorta & Signoretti, 2013). Lastly, this type of proactive monetary policy could have the effect of reducing moral hazard through proactive responses to booms as opposed to the reactionary approach to booms after the bust; this could discourage the reckless risk taking that typifies credit bubbles (The Financial Times LTD, 2014).
While economists are still debating the merits of the LATW strategy of curtailing asset price bubbles, it is without question that the traditional standards of monetary oversight have been too lax over recent decades and reinforcing those policies will go a long way to restoring healthy checks and balances to the world market. However, it has also become very clear that these boom and bust cycles threaten financial stability in such a way that central banks can no longer ignore fluctuations in credit markets. While focusing on controlling inflation is still a target for central bank monetary policy, central banks must now focus efforts on developing Bubble Policies (Rudebusch, 2005) that can prevent or deflate asset price bubbles before they can do real damage to the economy
References
Brittan, S., Meltzer, A. H., Wolf, M., Smaghi, L. B., Schlesinger, H., Mayer, M. Frankel, J. (2009, Fall). Should, or Can, Central Banks Target Asset Prices? A Symposium of Views
Gambacorta, L., & Signoretti, F. M. (2013, July). Should monetary policy lean against the wind? – an analysis based on a DSGE model with banking.
Mishkin, F. S. (2011). How Should Central Banks Respond to Asset Price Bubbles? The ‘Lean’ versus ‘Clean’ Debate After the GFC. Reserve Bank of Australia June Bulletin, 59-67.
Rudebusch, G. D. (2005, August 5). Monetary Policy and Asset Price Bubbles.
The Financial Times LTD. (2014, April 16). Definition of leaning against the wind. Retrieved from Financial Times Lexicon: http://lexicon.ft.com/term?term=leaning-against-the-wind
Wadhwani, S. (2008). Should Monetary Policy Respond to Asset Price Bubbles? Revisiting the Debate. National Institute Economic Review, 25 – 34.
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
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
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.
Did you find any useful knowledge relating to the 2007-2008 Financial Crisis in this post? What are the key facts that grabbed your attention? Let us know in the comments. Thank you.
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
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 Energy, 89, 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 Assessment, 20(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 Engineering, 1(1), 11-15.
Did you find any useful knowledge relating to costing methods in financial management in this post? What are the key facts that grabbed your attention? Let us know in the comments. Thank you.
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
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.
Did you find any useful knowledge relating to international financial management in this post? What are the key facts that grabbed your attention? Let us know in the comments. Thank you.
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.
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
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 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 fallibility. 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.
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