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Theories of International Financial Management

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case study
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  1. Executive Summary
    1. A brief overview of the contents of the management report
  2. Introduction
    1. ]A brief introduction of international financial management as well as the theories that are used to explain this concept
  3. Mundell-Fleming Theory
    1. This section will highlight the assumptions that form the basis for this theory of international finance as well as its application in the real world
  4. Optimum Currency Area
    1. The theory will be explained and evaluated on the basis of its real life application to realistic situations
  5. Purchasing Power Parity
    1. The various models/versions that make up this theory will be explained as well as the assumptions that form the foundational basis
  6. Recommendations and Conclusions
    1. Recommendations on how these theories can be adjusted to reflect real world situations will be provided. The conclusion will be a summary of the report

The purpose of this management report will be to critically examine the main theories of international financial management and assess the extent to which these theories can be used in the real world. This will be a critical examination of any empirical evidence that exists on the theories used to explain international financial management which include the fisher effects theory, international fisher effects theory, purchasing power parity theory, Mundell-Fleming model theory, optimum currency area theory and the interest rate parity theory. The report will evaluate these theories based on their applicability to real world situations and offer suitable recommendations that will be used to improve the performance of these theories to international finance activities.

International finance is an important branch of economics that explains how exchange rates, interest rates and other aspects of international finance affect the movement of goods across borders. The field of economics also assesses capital flows of financial information as well as international investments and trade deficits (Siddaiah 2010). The theories that are used to explain international finance include the Mundell-Fleming model, the optimum currency area (OCA) theory, the purchasing power parity (PPP) theory, the fisher effects theory, international fisher effect theory and the interest rate parity (IRP) theory (Madura 2008). The theories that will be analyzed in this report will be the Mundell-Fleming model, the purchasing power parity theory and the optimum currency area.

[...] This index has been deemed to be very useful because it has its basis on a well-known product whose final price includes input costs from a wide range of sectors in the local economy such as the transport, agricultural and manufacturing sector. The Big Mac Index basically tests the validity and feasibility of the law of one price which is one of the assumptions guiding the purchasing power parity (Economist 2004). The purchasing power parity theory is made up of two versions which include the absolute version and the relative version of purchasing power parity. [...]


[...] Working Paper No.10. [...]


[...] The law of one price states that the prices of identical goods and financial assets that can be traded are within the transaction cost of equality. The free role of arbitrageurs allows them to take advantage of the disparities in product prices anywhere in the world. The unrestricted movement of goods or financial assets explains purchasing power parity to be a lack of any restriction for the movement of goods and financial assets (Kevin 2009). These assumptions are used to explain PPP as the type of rate that is placed on two exchange rates based on their purchasing power. [...]


[...] The traditional model of Mundell-Fleming is made up of the following equations: C+I+G+NX (the IS curve) where Y is GDP, C is consumption, I represents investment, G is government spending and NX represents net exports Another equation used by the Mundell-Fleming model is L (the LM curve) where M represents money supply, P is average price, L is liquidity, i is the interest rate and Y is the GDP The components that make up the IS curve include consumption gross domestic product taxes interest rate investment government and net exports (NX). One important assumption of the model is that there is equalization of the local and global interest rates (Mundell 1963). [...]


[...] This allows the central banking system to promote growth so as to contain inflation. The OCA with statutory expectations model has mostly been applied in the European Union and in the United States (Kouparitsas 2001). The second model of the optimal currency area is OCA with international risk sharing which explains how the uncertainty that accompanies the exchange rate interferes with the activities of an economy. This model differs with the previous one in that asymmetric shocks within the economy are not considered as undermining the common currency because of the claim that all regions have on the currency (Mundell 1961). [...]

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