Solution to economics questions based on international finance
How could multinational corporations make use of the world’s stock markets to help with their business?Explain two advantages and two disadvantages of using stock markets to help with their business in this way.Do you think the advantages outweigh the disadvantages of becoming a listed company? Explain.
2) How could multinational corporations make use of international bond markets to help raise debt finance?Why would the costs of raising debt finance vary from one company to another? Explain.
3) What is the meaning of Interest rate parity and how could it help determine the change in exchange rates theoretically?By looking at Turkey and UK’s current situations based on the Financial Times news articles, do you think this theory is applicable in the real world? Why or why not? Explain.
1. Multinational companies and stock markets
(a) Multinational companies use stock markets across the world to get access to funds. For instance, most Canadian companies are listed both in the US and Canadian exchanges. So, they exploit both the American and the Canadian markets to source funds and establish their market presence helping their brands to grow internationally.
(b) Advantages of using the stock market –
• Stock markets help businesses to get requisite funds from the investors in the market as part of ownership. The firms can use the funds for a longer tenure that need not be repaid except for liquidation.
• Business operations in the stock market are conducted openly and transparently(Dang, et al., 2018). It establishes the businesses’ reputation of fair dealings in their business activities and a trust factor to get more investment in the future.
Disadvantages of using the stock market –
• The stock market operates on speculation, an event may create hysteria in the market that can pull down the stock price. For instance, the ongoing Ukraine-Russia war has crippled the stock market in many countries across Europe.
• Listing the securities in the market requires the company to divulge their plans to the exchange officials(Baker, et al., 2020). Disclosure of such information may hamper the businesses as the competitors come to know about their plans.
(c) The advantages of being a listed company outweigh the disadvantages as the businesses get proper exposure in the market. The institutional investors come to know about the listed companies and invest bulk amounts in them leading to their growth and profitability.
2. Multinational companies and bond markets
(a) Besides equities, multinational companies have the option to exploit the bonds market for raising debt funds. Bonds are the fixed-income securities that multinationals issue for a specified project (Gillan, et al., 2021). The companies need to repay these fundsafter the scheduled period alongside an interest to the bondholders.
(b) Companies prefer debt capital to raise funds as the same does not dilute the company ownership(Dang, et al., 2018). But it can be hazardous if the interest rates keep rising and should be secured against adequate collaterals. Companies need to provide suitable collaterals to secure debt finance. The collaterals serve as a guarantee for repayments, and based on the collaterals and credit history of the lender, the cost of raising debt finance varies.
Again, if the interest rate rises in the market, the interest costs rise and vice versa. The cost of debts is directly dependent on the interest rate of the loans as some may carry a rate of 7% while others are 6%,and so forth. If the company acquires debt of 6% having a corporate tax of 30%,the cost of debts will be 0.06 x (1 – 0.3) or 0.42 or 4.20%. Thus, as the rate varies, the companies have to bear different costs to get such funding. Again, if another company manages to get the debt finance at a 7.5% interest rate, the rate varies based on the collateral and credibility of the lender.
3. Interest rate parity theory
(a) Interest rate parity is a conceptual theory in which the differences in the interest rate of two countries are equivalent to the differences between the forward and the spot exchange rate. Theoretically, the concept applies to the exchange rates as an investor to invest in various currencies for hedgingbut the outcome will be the same.
(b) Turkey is undergoing an economic crisis since 2018 as the country is experiencing high inflation, increasing borrowing costs, and the resultant number of rising defaults. Even its currency –the Turkish lira (TRY) leapt owing to the surge in current account deficits. The political outfit in Turkey is somewhat responsible for the situation due to its unconventional interest rate parity. As the Turkish crisis escalates, its currency is depreciating leading to the contraction of the economy(Askew, 2022).
Bank of England, the country’s central bank issued a warning that the UK is gradually entering the recessionary phase. The country is experiencing high inflation, rising food prices, and high energy costs(Issac, 2022). The interest rate is also skyrocketing sending shivers down the economy and despite being a wealthy country, the UK is experiencing a substantial decline in its standard of living.
Both Turkey and UK are facing undue crises as their economies are experiencing economic crises. Despite their respective crises, it cannot be termed as a case of interest rate parity. It is because the situation in both countries is not the same and Turkey lacks political goodwill. Contrarily, the UK government is trying to steer the economy on the right path to overcome such a crisis.
4. Sri Lanka’s crisis
The immediate cause of Sri Lanka’s crisis is that the country fell short of its foreign reserves. The country had very little to pay for the import bills. Since 2020, Sri Lanka experienced lower export, capital inflows, and loans in contrast to rising demand for foreign exchanges. The official foreign reserve of the country declined from US$8 billion to lower than $U2 billion(Jayaraman, 2022). The situation was so grim that Sri Lanka failed to pay the bills for important resources like paper and ink. Consequently, newspaper printing was stalled and so does school examinations. The major contributory aspect that led to its rapid decline in the exchange rate against US Dollars are –
• Since the pandemic, the country stalled its tourism activities which were one of its major resources. The inflow of foreigners into the island nation kept the country away from its vital foreign currencies.
• An abrupt decision on chemical fertilizer bans to shift to 100% organic farming led to a shortage of food crisis and the hoarding of essentials a norm.
• Sri Lanka is in a debt trap as it is struggling to pay back China loans worth $8 billion. The country expends billions of dollars monthly to pay off the loans.
• The country depends on imports heavily which requires sufficient foreign reserves that Sri Lanka is lacking currently.
Askew, J., 2022. 'Everything is overheating': Why is Turkey's economy in such a mess?. [Online]
Available at: https://www.euronews.com/2022/11/09/everything-is-overheating-why-is-turkeys-economy-in-such-a-mess
[Accessed 10 January 2023].
Baker, H., Kumar, S. & Pattnaik, D., 2020. Twenty-five years of the journal of corporate finance: a scientometric analysis. Journal of Corporate Finance, p. 101572.
Dang, C., Li, Z. & Yang, C., 2018. Measuring firm size in empirical corporate finance. Journal of Banking & Finance, 86(1), pp. 159-176.
Gillan, S., Koch, A. & Starks, L., 2021. Firms and social responsibility: A review of ESG and CSR research in corporate finance. Journal of Corporate Finance, p. 101889.
Issac, A., 2022. Worst fall in UK living standards since records began, says OBR. [Online]
Available at: https://www.theguardian.com/business/2022/nov/17/obr-confirms-uk-enters-year-long-recession-with-half-a-million-job-losses-likely
[Accessed 10 January 2023].
Jayaraman, P., 2022. 5 factors that led to the Soaring of Sri Lanka's economic crisis. [Online]
Available at: https://timesofindia.indiatimes.com/readersblog/prasanna-talks/5-factors-that-led-to-the-soaring-of-sri-lankas-economic-crisis-42347/
[Accessed 10 January 2023].