Empirical Investigation of Structural Breaks †MyAssignmenthelp

Question: Disacuss about the Empirical Investigation of Structural Breaks. Answer: Introduction: IMF effectiveness is dependent on whether the players see it as impartial and competent. According to the article, IMF is like a referee officiating a football match where it depends if the players see it as impartial and competent (Eun and Resnick, 2014). The effectiveness of this institution are limited by failure to meet its challenges. As an advisor, the institutions impartiality is called into question because it doesnt always know what to advise. According to the article, there are four challenges that pose a threat to the legitimacy of the IMF and thus the institutions capacity to execute its main functions (Kirton, 2009). Organizing surveillance through which the institution monitors policies made by its member countries both financial and economic policies is the first unmet challenge. This highlights possible risks to advises that are needed on policy adjustments. The funds original mandate was to focus on engaging in ruthless truth telling that would make exchange rates to be stable. However, the surveillance moved from the main focus of exchange rates issues to virtually everything and anything with implications for financial and economic stability (Levi, 2016). There is no longer the blunt truth telling as envisaged and this can be clearly shown because the fund did not warn the U.S of the subprime crisis , the Greek debt crisis or the global financial crisis. On the three events, the IMF batted 0 to 3 showed that it has no capacity to highlight risks to stability. The second unmet challenge is the conditionality that IMF gives its loans out with. This is the commitment that governments makes in terms of policy in order to receive assistance (Imf., 2016). The disagreements comes in when questions of the number of commitments and what kind of commitments that the IMF asks from the governments. This is because in some of the commitments , the IMF infringes on the sovereignty of the member country and so according to the article, the member countries do not view the IMF institution as an institution that is out here trying to promote the welfare of the individual member states (Hartley, 2011). If the IMF and the member country have similar objectives , why are there conditions set in the first place. The third unmet challenge is that there is disagreement about the role of IMF in sovereign debt management. This challenge is created by the absence of a legal framework that is needed to resolve debt crises , also contributing to this challenge is the existence of multiple stakeholders and transaction costs that are significant. Confusion is brought about when we consider the form that involvement should take (O'brien, 2017). IMF should provide liquidity assistance when the debt that a member country holds is sustainable but private investors are not able to provide coordination in the provision of liquidity required and they only facilitate to debt restructure when the burden of debt is unsustainable. Deep questions arises when statements about whether debt sustainability concept is meaningful and whether the IMF is able to determine a member states sustainable debt. In reflecting on this uncertainties, the institution has continued to lend to its member states and put off the restructuring decision. This model allows investors to create a moral hazard and cut their losses. This is because restructuring disrupts the economy and is also costly for the country. The fourth unmet challenge according to the article is impartiality problem by the fund which is an issue raise due to governance problems (Grath, 2005). When members have disproportionate voice which enables some member states to sway decision making and make decisions that are in line with their national interest, this is seen as if the institution is not partial. Some of the decision made by some member states that have a lot of influence are at odds with both the interest of the stability of the IMF and its membership. Also, some members are inadequately represented and they see the decisions made by the funds as neglecting their interests. Consequently, the two sides are reluctant to give IMF the autonomy in choosing tactics and designing programs. The failure by the IMF to meet the four challenges causes its impartiality and competence to be questions by those who criticize its modus operandi (Bodie and Merton, 2001). The funds inability to solve these challenges leads members to question its legitimacy according to the article. Legitimacy determines if the governments and their constituencies will to bend to its authority and accept its recommendations. According to political theorists, legitimacy has two sources. The publics assessment about the performance of the Fund is referred to as output legitimacy. If the funds advice brings in good results, then the agents would be willing to acknowledge its authority. Second, input legitimacy refers to the process through which power is exercised and decisions are reached. The first three challenges , that is , surveillance, conditionality relevance and the utility of the funds approach to debt problems can be solved through output legitimacy (Costa, 2006). On the other hand, the fourth challenge which is the funds failure to adopt a system of governance raises questions about its input legitimacy. The legitimacy problem will have to be solved so that the fund can be effective in its mandate. Today, there are several theories that explain the formation of the exchange rate and the nature of its dynamics. So, one of the most famous theories is the theory of purchasing power parity (or ability) (Power Purchasing Parity). According to this doctrine, the rates of any two currencies must be adjusted one to one according to the change in the price levels in these two countries. A simple example gives an idea of the action of PPP theory and International Fishers effect Summing up, it can be pointed out that the currency purchasing power parity doctrine can be a good tool for forecasting the exchange rate provided there are significant differences in the price levels of the countries being compared (Shapiro, 2014). The accuracy of the exchange rate forecast is a derivative of the accuracy of the forecast of price levels in the two countries, and therefore the time range of applying the principles of PPP is measured from one to five years. The forecast rate for a period of less than one year is not justified for the inability to get rid of many random factors in the main trend of the development of the phenomenon. This is the presence of a lag between price changes and adjustments to this exchange rate, and intra-annual seasonal and conjunctural fluctuations. Forecasts for more than five years can have a significant error. The PPP theory has rather limited forecasting possibilities, gives an idea of the prerequisites for long-term behavior of exchange rates, but can not explain the run-up of rates for short periods. The key to understanding the behavior of the exchange rate in the short term is consideration currencies that form the exchange rate from the position of the asset market and the theory of demand for assets (Manzur, 2008). The modern approach to the asset market stresses that, for short periods (less than a year), the decision to own domestic or foreign assets (that is, cash in national or foreign currency) will play a much greater role in determining the exchange rate than the demand for export or import goods. Those. export-import flows are considered as secondary exchange rate factors. According to the theory of demand for assets, the most important factor that affects the demand for domestic (national) and foreign money (t his time we consider the non-cash form of cash) is the expected return on these assets relative to each other friend The expected income for the deposit of a certain currency in the transfer to foreign currency consists of the interest rate of this currency and its expected price (+) or depreciation (-). When, for example, Americans or foreigners expect that the income on dollar deposits will be higher than the income on deposits in euros, then the demand for dollar deposits will be higher and, accordingly, the lower one for deposits in euros This will encourage investors to convert funds into current assets. Nevertheless, at the end of the investment period, they may incur exchange rate losses e changes in the exchange rate, which, with a surplus, will block the interest income. To prevent such losses, investors must enter into fixed-term contracts, i. agreements with the redemption of currency, at the rate of "spot" plus the interest earned on the invested assets. These agreements from interest arbitrage is a connecting link between the difference in interest rates of the national money markets of the two countries and the forward rates of the respective currencies (Madura, 2012). This link acts as the basis of the theory of interest parity. To understand the mechanism of the action of this theory, one should consider its formalized form. Purchasing power parity is an economic theory that states that people in a given country should be able to buy services and goods at a price that is similar to people from another country. The theory states that once the exchange rate difference is accounted for, then all the prices of goods and services would be the same. The ability of purchasing power is illustrated by real per capita spending. The basis for calculating PPP used by organizations such as UNDP is Gross National Product (GNP) (Olekalns, 2001). Since GNP cannot be compared directly, an International Comparison Project (ICP) is formed which aims to "adjust" the real GDP rate, so it can be compared. For this purpose is determined a number of commodities as a package for the basis of comparison internationally. The resulting number, to reflect the standard benefits, is then "adjusted" again with the Atkinson formula. This adjustment is deemed necessary, as a $ 500 increase for a country that already has a GNP of US $ 500 0 will have a different benefit from the same increase for a new country with a GNI of US $ 1000. On the other hand, the international Fishers effect theory states that a change that is expected in the exchange rate between currencies of two currencies is roughly equivalent to the difference between their nominal interest rates(Holmes, 2002). Using the interest rate difference to explain the occurrence of changes in foreign exchange rates. IFE theory is closely related to theory of PPP because interest rates are often correlated closely with the rate of inflation, therefore it can be concluded that the difference in interest rates which occurs between several countries can be caused by the difference in the rate of inflation. On the theory of Interest Rate Parity and Power Parity Purchasing, the theory allows us to estimate the future of the exchange rate expected. Interest Rate Parity is related to risk-free interest rate while Purchasing Power Parity theory of exchange rate is related to an inflation rate. Putting them together basically tells us that interest rates are risk-free related to the rate of inflation (Valsamakis, Vivian and Du Toit, 2010). This brings us to the International Fisher Effect, The international Fisher effect states that the real interest rate is the same across countries. Real interest in risk-free rate minus the inflation rate. Real interest rates are generally used more often compared with the nominal interest rate to measure currency exchange rate movements. The nominal interest rate is not an accurate measuring tool, because it still contains inflation element inside. International Fisher Impacts Impact The relationship between the difference between the two countries' interest rates and the expected change in exchange rates under IFE is as follows: first, the actual return for investors is the interest rate offered on the securities market term deposit money banking short, where the investor's actual return depends on the foreign interest rate if and the change of the foreign exchange. According to IFE, the effective return of foreign investment should, on average, be an effective return on investment domestic, therefore, IFE states that estimates of investment in local money market investments: Where r is an effective return on foreign deposits and i is the deposit interest rate of the country of origin. Then it can determine as evidenced above, the IFE theory states that when interest if, e will be positive because of the relatively small foreign interest rate reflecting the relatively low estimated foreign inflation, in other words, foreign currency will appreciate when foreign interest rates are smaller compared to origin interest rate. A financial derivative is an agreement between two parties where the payments conditions are also agreed by the two parties. Derivatives are from underlying assets such as contracts, swaps or even stocks. Some of the conditions include purchasing the asset at the price and at the date which the underlying asset achieves that price(Valsamakis, Vivian and Du Toit, 2010).. A common derivative is a call option that gives the buyer the option but not the obligation to buy the stock at a certain date and at a certain price. The PPP and IFE theories make derivatives unnecessary because of the inflation factor. As we know, the two theories factor in inflation of underlying assets but derivatives are meant to protect the buyer from purchasing the underlying asset with inflation factored in. Advantages of derivatives Transactions of derivatives take place in future therefore giving a chance to individuals and traders to execute all sorts of strategies in the futures and options Therefore, if the individual want to short some stock for a long time they can do it in this market. There is benefit of leverage in this market because people can transact huge transactions with small amounts hence trading with derivatives requires a less amount of money. Derivatives are a great risk management tool with a lot of benefit to the user. There are several criticisms that associated with these theories. The purchasing power parity theory does not factor in the tarrifs and the demand for derivatives can be different. Also another criticism of this theory is the differing taxes in different regions. Evaluate the differing ways in which derivatives can protect against the failings of IFE and PPP. As speculators take a market risk position, speculation is a spare part that makes futures and options markets(derivative market) work well and efficiently w. A speculator in futures trading is one goal, which is profit (profit) from its success in anticipating price movements. The time horizon of the speculator is very different from the hedger, commercial users, and other professional users, therefore tends to act as a bridge between large market users and other market users, with different time horizons. So speculation is a major component because the speculator improves market liquidity, and also increases market efficiency. A speculator in futures trading is with one goal, which is to profit from its success in anticipating price movements. Inflation and interest rates challenges are overcome by these speculation. Hedging is a strategy created to reduce the occurrence of unexpected business risks which includes inflation, in addition to the possibility of profit from the investment. Differential interest rates Differential interest rates between the two countries predict future changes in spot exchange rates. In the financial risk hedge, there are factors that cause exchange rate changes (Manzur, 2008). Knowledge of this will help in forecasting the direction of currency movement. These factors include differential inflation, monetary policy, trade balance, the balance of payments, international monetary reserve, national budget, and deferential interest rate, and associated currency behavior, unofficial exchange rate, forward exchange quotes. Not all hedges are financial instruments. For example, a producer who exports to another country can hedge the currency exchange risk by calculating his production costs in the currency he wants (Taylor, 2013). The following ways that derivatives can protect from the failings of IFE and PPP theories. References Bodie, Z. and Merton, R. (2001).Finance. Upper Saddle River, NJ: Prentice Hall. Costa, C. (2006).Introducing finance. Chichester: John Wiley. Eun, C. and Resnick, B. (2014).International finance. New York: McGraw-Hill. Grath, A. (2005).International trade finance. London: Nordia Publishing for the Institute of Export. Hartley, W. (2011).International finance. [Place of publication not identified]: Bibliolife. Holmes, A. (2002). Risk Management. Chichester: Capstone Pub. Imf. (2016).Forecasting at the imf. [Place of publication not identified]: Intl Monetary Fund. Kirton, J. (2009).International finance. Aldershot: Ashgate. Levi, M. (2016).International finance. London [u.a.]: Routledge. Madura, J. (2012).International financial management. Mason, Ohio: South-Western, Cengage Learning. Manzur, M. (2008).Purchasing power parity. Cheltenham (Reino Unido): Edward Elgar. O'brien, T. (2017).Applied International Finance. [S.L.]: Business Expert Press. Olekalns, N. (2001).An empirical investigation of structural breaks in the ex ante Fisher effect. Melbourne, Victoria. Shapiro, A. (2014).Multinational financial management. Hoboken (NJ): J. Wiley. Taylor, M. (2013).Purchasing Power Parity and Real Exchange Rates. Hoboken: Taylor and Francis. Valsamakis, A., Vivian, R. and Du Toit, G. (2010).Risk management. Sandton: Heinemann.