International finance is becoming increasingly important in business due to the globalization of many businesses. Globalization brings about an integration of economies and diversification of the financial aspect of business and capital markets that broadens the role of financial managers in the global environment. International finance is thus founded on concepts that present challenges to financial management in the international commerce setting and thus are critical to financial decision making and analysis of investments in the global environment. Understanding the concepts of international finance equips financial managers and their counterparts with the knowledge of how problems in financial management and making of decisions in a multinational context can be resolved effectively to attain the goals and objectives of the business. Therefore, this paper discusses the concept of diversification, and it relates to opportunity costs of capital and the concept of the call option and their importance in financial decision making and the analysis of investments in multinational finance.
The concept of diversification and its relation to the opportunity costs of capital
The concept of diversification in finance refers to the allocation of capital in a way to reduce investments risks. The idea is to split aspects that are prone to more risk into portions as opposed to risking them together thus reducing the risk (Mahmoud, 2017, 1). Diversification provides that firms can distribute their resources on a broader spectrum to promote efficiency and utilization of resources which would otherwise be in excess without diversification. International business has a wide market base on which to diversify their portfolio and employ their capital to promote the firm’s efficiency through efficient deployment of assets across a larger market otherwise limited in a local business. Also, international organizations have access to more sources of capital as opposed to locally based firms which increases their potential capital. International organizations often have the opportunity to diversify across countries, markets and industries hence have several options to include in their investment portfolio for maximum returns. Diversification can be beneficial or destructive for a company; thus it is a strategic issue, especially in international firms. The effectiveness of diversification for a company depends on how it is executed and the structure and type of the company. For international companies, diversification has to offer lower cash flow and a high return. Diversified organizations have lower costs of capital compared to those that are not diversified (Elyasiani & Wang, 2015, 3). Therefore, diversification is a common strategy especially for international businesses to increase facilitates efficiency and promotes the capital returns.
The traditional perspective of diversification is that it only reduces particular risks and significantly associates with a reduction in the value of the firm. Conventional perspective, however, differs with the provisions for a number of reasons. Value discounts need to be adjusted for increased bond values as a company diversifies to take into account the benefits of diversifications. Also, diversification in international firms requires substantial control since it global companies diversify cross nations, industries and markets thus require strategy to realize the underlying benefits. Valuing diversification discount to an international firm thus needs to rely on present market values to realize the value and potential of diversification in promoting the efficiency of a firm either through increasing returns or reducing cash flows.
The concept of diversification closely relates to the opportunity costs of capital for business firms. Investors continually allocate capital to actualize their best ideas. Nevertheless, considering the fact that the capital is limited given the available market and opportunity, the issue of opportunity costs arises. An opportunity cost is the value of the forgone alternative in making decisions when one has one or more options. International organizations have to select their sources of capital strategically form the wide arrays of sources available for them. Conversely, international organizations have a wide array of ways and avenues to invest their capital for return, but the capital as resources is limited to the financial scope of the company. Since capital is limited, the firms have to select the areas to invest their capital for maximum returns and efficiency thus forgoing other options which hold their unique value thus the opportunity costs of capital (Chit, Chit, Papadimitropoulos, Krahn, Parkerand Grootendorst, 2015). Diversification
Diversification requires to be strategic in maximizing on the opportunity cost for capital by diversifying in the options that increase returns for the company and promotes capital investment efficiency. The investors’ opportunity costs should determine the cost of capital. Instead of taking the direction of the weighted average cost of capital, the best idea is to fix the opportunity cost as the obstacle to discount cash flows. However, this measure does neither take place in a vacuum nor operate in a vacuum since it has to be synchronized with interest rates and other anticipations. Investors need to focus on the rate of return that they will realize if they invest in the second-best option. Opportunity costs are said to reduce diversification since there is no need to invest in options or continue allocating capital to them yet the desired outcome can be obtained by investing in a particular option. The argument is that it is more sensible to fully invest in an opportunity until a better or an equal return level resurfaces instead of shifting from different opportunities.
Understanding the concept of diversification is important to financial decision making and analysis of investments in international finance. Comprehension of the concept of diversification helps financial managers understand that diversification in international business is a strategic approach that requires critical analysis to implement to gain value for the business. Diversification needs to be implemented in a particular way to draw its discounts and benefits to the business. Given the broad number of opportunities to diversify investment of capital in a global context, diversification needs to rely on strategy and analytics to ensure that investment is on eth most efficient and valuable options. Understanding the relation of diversification an opportunity cost is important in determining the most valuable options to allocate capital for maximum efficiency of the firm and its processes.
The concept of the call option
A call option can be defined on the basis of the underlying stock, the expiration date of the option, and the strike price of the option. A call option is a security that grants an owner the right to buy a stock at a particular price and on a particular date. The particular price is what is referred to as the strike price while the specific date is the expiration date. It is referred to as a call option because the owner can decide and has actually the right but not the obligation to buy the stock at the strike price. That is to mean. It is not guaranteed that the owner of the option honor the option and buy the stock. If buying the stock at the stock price is unprofitable, the possessor of the call can leave the option to expire. Generally, a stock price can go up, decline, or even remain in the same position. For an individual who thinks that the stock price is about to go up, they can make a profit by buying the stock, buying call options on the stock, or writing put options on the stock. When buying a call option, traders first need to identify a stock that they believe will rise in price, identify its ticker symbol and then proceed to review its option chain. Once that is done they should choose an expiration month after which they determine the strike price. Lastly, they need to analyze if the market price is achievable or reasonable. A stock’s option chain can be accessed through links provided in the stock’s sites.
The good thing with owning a call option is that the owner of the call has technically unlimited profits whereas the loss is only limited to the amount paid for the option. Given that owning options is usually cheaper than owning the real stock, it always more profitable to own calls on the stock instead of owning the stock itself if an individual is sure that the stock price is about to rise. Owning calls allows the buyer to lock in the highest maximum price for a stock as call options owners the right to buy the stock at a fixed price. It is a maximum price since if the market price is lower than the buyer’s strike price it means that the buyer would purchase the stock at the lower market price instead of the buyer’s option high price. All securities have important ticker symbols while the buyers and sellers decide their prices, and so do call options. Their prices are determined by a collection of sellers and buyers as well as how they expect an underlying stock to move. Additionally, call options have bid and ask prices just as stock. However, considering the fact that options have lower volume than stocks, the spread between the asking and bid price is also higher as compared to the spread observed on stocks. The bid/ask spread on stocks is mostly one or two cents, but the ask/spread on call options can rise to as high as twenty cents or even more.
Not all stocks trade on options as this applies for the most popular stocks. Also, buyers do not always buy calls with the strike prices they desire for an option. Strike prices come in intervals of $5 although most popular stocks have values such as $22.5 and 27.5$. It is also common that people do not always find their desired expiration months on the call option for the closest two months and every three months subsequently. Even if buyers find an option for which they want to buy calls, they have to ensure that it has adequate volume trading on it to offer liquidity so that the buyers can resell it if the is a need to. On the same note, some options are not widely traded and thus have a high bid/ask spread. The option prices are determined by the underlying stock, the strike price, the general volatility of the stock, and the number of days left to expiration. Traders generally agree on the days of expiration, the stock and strike price mostly debate on the volatility and is, therefore, the element that drives prices.
The person selling a call option best known as the writer gives a buyer the right to purchase a stock at a particular price and by a specific date. The writer, therefore, can be coerced to sell at the strike price. If a seller writes a call option on a stock for which he possesses the underlying stock, it is regarded as writing a covered call while it is known as writing a naked call if the seller does not possess the underlying stock. Writing a covered call is viewed as the safest way of trading. Option writers win because time works on their favor while at the same time it works against the buyers. Time value is one of the most important factors in investment. Options that have more time before expiry have more value. The concept call option is important for financial decision making and for the analysis of investments as they give business persons the right and not the obligation to invest. The call options despite being a risky mode of investment are actually less risky as compared to equities, they are cost effective due to their great leveraging power, and have a high potential return. Moreover, options offer diverse investment alternatives as they are very flexible. Therefore, the elements of cost, time value, and the level of returns make call options an important concept to consider while making financial decisions and investments. Similarly, the level of risk involved in the trading process and flexibility of call options are also important considerations in making financial decisions and investments
Chit, A., Chit, A., Papadimitropoulos, M., Krahn, M., Parker, J. and Grootendorst, P., 2015. The Opportunity Cost of Capital: Development of New Pharmaceuticals. INQUIRY: The Journal of Health Care Organization, Provision, and Financing, 52, p.0046958015584641.
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