Test: International Arbitrage & Multinational Capital Budgeting - UGC NET MCQ

The primary purpose of international arbitrage is to exploit price differences between two markets located in different countries. Traders engage in this practice by purchasing an asset at a lower price in one market and selling it at a higher price in another, thereby securing a risk-free profit. An interesting fact about international arbitrage is that it helps to maintain price equilibrium across markets; as traders act on these price disparities, the differences tend to diminish quickly, which is why such opportunities are rare.

The primary objective of market neutral arbitrage is to take a long position in an undervalued asset while simultaneously shorting it. This strategy aims to profit from the difference in price movements, where the long position appreciates and the short position depreciates, ideally by equal amounts. This approach minimizes exposure to overall market risk, allowing investors to capitalize on specific asset mispricings. An interesting fact is that this strategy is often used by hedge funds to generate returns irrespective of market direction, its appeal in volatile environments.

The primary purpose of covered interest arbitrage is to hedge against exchange rate risks while investing in higher-yielding currencies. This strategy allows traders to take advantage of interest rate differentials without exposing themselves to currency fluctuations. By using forward contracts, traders can lock in exchange rates, thus ensuring that their investments are protected from adverse movements in the currency market. An interesting fact is that covered interest arbitrage can lead to a convergence of interest rates between different countries, as the arbitrage activity balances the returns on investments across currencies.

- The Assertion (A) is correct because diversifying a portfolio with global investments can indeed lower risk by reducing exposure to any single market or asset class.

- The Reason (R) is also correct as a diversified portfolio does allow for a more balanced risk-return profile, which is a fundamental principle of investment strategy.

- Furthermore, the Reason provides a correct explanation for the Assertion, as it outlines how diversification contributes to risk reduction in financial investments.

Statement 1 is correct because estimating cash flows for an investment project indeed requires a comprehensive analysis of expected revenues, expenses, and capital expenditures, which are essential for assessing the project's viability.

Statement 2 is also correct as currency risk management is crucial for projects involving foreign investments, and using financial instruments such as forward contracts is a common method to mitigate the risks associated with currency fluctuations.

Since both statements are accurate, the correct option is C: Both 1 and 2.

The primary purpose of two-point arbitrage is to exploit price differences in different markets. Traders buy and sell the same asset at different prices on various exchanges to make a profit. This strategy is based on the principle that identical assets should have the same price globally, but discrepancies arise due to factors like time zones and transaction delays. By acting quickly on these differences, arbitrageurs can secure a risk-free profit, assuming that the gains exceed any associated transaction costs. An interesting fact is that despite the simplicity of the concept, effective arbitrage requires rapid execution and a deep understanding of market dynamics, often leveraging advanced technology to capitalize on fleeting opportunities.

Statement 1 is incorrect because while NPV is a crucial measure for evaluating investment projects, it is not sufficient to prioritize projects solely based on NPV. Risks associated with each project must also be considered to ensure a comprehensive evaluation of potential returns and the overall financial health of the firm.

Statement 2 is correct because due diligence plays a critical role in the investment decision-making process. It involves thorough research and analysis of market conditions, competitive landscape, and potential local partners, which are vital for assessing the feasibility and potential success of an investment project.

Thus, the correct answer is Option B: 2 Only.

- Assertion (A) is true: The selection of the appropriate cost of capital is indeed crucial for determining the net present value (NPV) of global investments.

- Reason (R) is also true: The cost of capital must account for national risk, inflation rates, and other market conditions to reflect the true cost of financing.

- Since both statements are true and the reason directly explains why the assertion is important, Option A is the correct answer. The reason elaborates on the factors that influence the selection of the cost of capital, thus providing a valid explanation for the assertion.

• The Assertion is correct: Effective management of currency exposure is indeed essential for multinational organizations to maintain stable cash flows, as it helps to mitigate the risks associated with exchange rate fluctuations.
• The Reason is also correct: Currency fluctuations can significantly impact the profitability of international operations by affecting cash inflows and outflows.
• The Reason is the correct explanation of the Assertion because managing currency exposure directly contributes to maintaining stable cash flows, thereby safeguarding profitability in the face of fluctuations.

• Assertion (A): This statement is true as the primary aim of multinational capital budgeting is indeed to maximize shareholder wealth through projects that yield positive NPV.
• Reason (R): This statement is also true; however, it does not directly explain how the complexity of global markets affects the goal of maximizing shareholder wealth. Instead, it is an important consideration in the budgeting process.
• Since both statements are true, but the reason does not serve as a correct explanation for the assertion, the correct option is B.