International Business Exam 3 (Chapters 10-13)

International Business transactions

conversion of foreign income

payment to foreign suppliers

borrowing capital in countries that offer lower interest rates

Foreign Exchange Market

A market for converting the currency of one country into that of another country

Spot exchange rate

the rate at which one currency is converted to another currency

Function of the ForEx market

hedging of foreign exchange risk

allows currency speculation

currency speculation

Involves short-term movement of funds from one currency to another in hopes of profiting from shifts in exchange rates.

Carry trade

involves borrowing in one currency when interest rates are low and using the proceeds to invest in another currency where interest rates are high

EUR/USD 1.3732

1 Euro = 1.3732 USD

EUR/USD 1.22 --> EUR/USD 1.3

Euro appreciates in value

Foreign Exchange Risk

Risk introduced into international business transactions by changes in exchange rates

Divided into 3 categories:

Transaction/Contractual exposure

Translation exposure

Economic/Operating Exposure

Transaction Exposure

extent to which the income from individual transactions is affected by fluctuations in foreign exchange value

Arises from: obligations for purchase at previously agreed prices, borrowing of funds in foreign currencies

Ex: if you buy now, you can guarantee exchange rate on a purchase, if you buy later it's up in the air

Translation Exposure

the impact of currency exchange rate changes on the reported financial statements of a company (past oriented)

Economic Exposure

the extent to which a firm's future international earning power is affected by changes in exchange rates (Future oriented)

Hedging

to reduce long term volatility of cash flows or earnings

Exploiting differences in interest rates

to create competitive advantage

-Raise funds in one country to finance investments in another

Risk mitigation strategies

hedging and exploiting differences in interest rates

Forward exchange rates

locking in exchange rates for the future so both sides know what to expect. Protecting buyer from fluctuations in currency prices

Rates are typically quoted for 30,90, or 180 days into the future

Currency swap

simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

Transacted between international businesses and their banks, between banks, between governments

How are exchange rates determined?

Exchange rates are determined by the demand and supply for different currencies

Factors: relative inflation levels, differences in interest rates, investor psychology

Law of one price

identical products should sell for the same price everywhere (just accounting for changes in currency)

US/EUR exchange rate is $1 = .78 euro

$50 jacket retails for 39 euros in Paris

Purchasing Power Parity theory (PPP)

price of a basket of goods should be roughly equivalent in each country (thinking about relative price).

PPP predicts that changes in relative prices --> changes in exchange rates

Inflation

occurs when supply of money grows faster than the output of a country

Interest Rates

reflect expectations about likely future inflation rates

High inflation rates bring around high interest rates (fisher effect) --> high interest rates are used to curb high inflation rates

International Fisher Effect

For any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between countries

Investor Psychology

short term exchange rate movements

Long term exchange rate

impacted by monetary growth, inflation rates, interest rate differentials

Short term exchange rate

impacted by investor expectations, psychological factors, bandwagon effects

To minimize transaction and translation exposure, managers should

buy forwards, use swaps, lead and lag payables and receivables

To reduce economic exposure, managers should

1. Distribute productive assets to various locations so the firm's long-term financial well-being is not severely affected by changes in exchange rates

2. Ensure assets are not too concentrated in countries where likely rises in currency values will lead to increases in the foreign prices of the goods and services the firm produces

International Monetary system

institutional arrangements countries adopt to govern exchange rates

International financial system

provides investment capital required for economic activities

Financial Revolution of 1970s

removal of capital controls by leading economies: deregulation, freedom of capital movement, increased integration of national capital markets, creation of the global financial system

benefits of the International financial system

enabled capital-poor countries to borrow funds

Fixed exchange rates

a system under which the exchange rate for converting one currency into another is fixed

Pegged exchange rates

the value of the currency is fixed relative to a reference currency

Floating exchange rates

the value of the currency is free relative to other currencies, and determined on the foreign exchange market

Dirty Float

hybrid of floating and fixed exchange rate system; the value of the currency is fixed within a specified range relative to a reference currency

Gold Standard

countries peg currency to gold and guarantee their convertibility

Strengths: powerful mechanism to achieve balance of trade equilibrium

Gold Par value

amount of currency needed to purchase one ounce of gold

WWI

time period where countries printed money to finance their military, increasing inflation

After war and inflation, most countries returned to the gold standard besides Britain

(Britain kinda screwed themselves with this)

Competitive Devaluations

attack of a currency

Bretton Woods

Representatives from 44 countries met in New Hampshire to design a new international monetary system; resulted in the establishment of the IMF and the World Bank.

Currencies were fixed to the USD, USD was convertible to gold, devaluation was only allowed if currency was too weak to defend

Intermonetary Fund (IMF)

maintain order in the international monetary system - approve devaluations > 10%

Avoid financial chaos through discipline and flexibility

Fixed exchange rates discourages competitive devaluations and imposed monetary disciplines

World Bank

promote general economic development focusing on helping less developed countries

Countries can borrow through IBRD:

- Money is raised through bond sales, low interest loans given to risky customers (undeveloped nations)

IDA:

- Interest free loans to poorest countries, 50 years to repay. Funded by wealthy nations

Flexibility of IMF

Lending a limited amount of money during short periods of balance of payments deficit

Extensively but only with stringent supervision

Adjustable Parities

in cases of fundamental disequilibrium (permanent adverse shifts in demand for country's products), devaluations (>10%) were permitted

Jamaica Agreement

the 1976 international monetary order that allowed countries to adopt different exchange rate systems including floating their currencies in world markets

Because Bretton woods fell through and there was a lot of pressure on having USD as the central currency

Floating rates acceptable, gold abandoned as reserve asset, annual IMF quotas for membership

Floating exchange rates provide

monetary policy autonomy: gov. can pursue monetary policy in economic downturn

automatic trade balance adjustments

crisis recovery: export led recovery due to weak currency

Fixed exchange rates provide

monetary discipline for countries

minimizes speculation

reduces uncertainty

Currency crisis

speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency

Banking crisis

loss of confidence in the banking system leads to a run on the banks, as people and companies withdraw their deposits

Foreign debt crisis

Situation in which a country cannot service its foreign debt obligations, whether private-sector or government debt

IMF Crisis Management

provide loans with strong conditions:

increase taxes, cut spending, privatize state owned enterprises, raise interest rates, open economy to foreign investors

Investors

have surplus cash, seeking return on their investment

borrowers

individuals, companies and governments; raising funds to meet their needs

market makers

Financial service companies that connect investors and borrowers, either directly (investment banks, JP Morgan, Goldman Sachs) or indirectly (commercial banks, TD, chase, PNC).

Equity Loan

made when a corporation sells stock to investors

shares its profits by paying dividends (which are not fixed)

Debt Loan

-made when a corporation sells corporate bonds to investors

-corporation pays a predetermined portion of the loan amount at regular intervals regardless of profits

-fixed stream of money has to be paid to bond holders for a specified number of years

Cross border investment trends

these have been increasing YoY from 1999 to 2009, specifically increasing to parts of Asia and developing nations

Growth of global capital market factors

deregulation by governments, advances in information and communication technologies

Deregulation of markets by governments

has facilitated growth in international capital markets, began in the US and spread

Advances in information and communication technologies

advances in data processing capabilities and the growth of communications technology has allowed for instant communication between players decreasing cost of capital

Cost of capital

the rate at which you can borrow money

Systemic risk

the risk of collapse of an entire system or entire market due to the failure of a single entity or group of entities that can result in the breakdown of the entire financial system

contagion

the likelihood that significant economic changes in one country spread to other countries

Benefits of global capital market

borrowers benefit from supply of more money, lowering cost of capital

Investors benefit from wider range of investment opportunities, can diversify easier

Volatile exchange rates can make profitable investments unprofitable

Eurocurrency

Any currency banked outside its country of origin.

Used as a way to protect against political risk

Eurodollars

U.S. dollars deposited in foreign banks outside the U.S. or in foreign branches of U.S. banks

Why did the eurocurrency market begin?

Eastern European countries feared that the US might seize their dollars to settle US claims on losses

Eurodollar use cases

in foreign countries, people borrow from eurodollar market instead of US itself

OPEC deposited dollars in London to avoid confiscation by the US

Eurocurrency Market

not regulated by the government, able to offer higher interest rates on deposits, and lower interest rates to borrowers

They don't have reserve requirements! Means additional risk is held by depositors

Foreign Bond

a bond issued in a host country's financial market, in the host country's currency, by a foreign borrower

Honda issues bond in USD in the US

subject to special regulations and host country regulations

used when companies think it will reduce the cost of capital

Eurobonds

issued in countries other than the one in whose currency the bond is denominated

bond issued by a British corporation denominated in USD, sold to investors outside of the US

Why use the Eurobond market?

lacks regulatory interference

it can be cheaper and less time consuming to offer Eurobonds (less stringent disclosure requirements)

more favorable in regards to taxes (don't need to withhold income tax on interest payments)

Equity markets

Financial markets where corporate stocks are traded.

Most tend to be national, NYSE, London stock exchange, etc.

International Equity Market allows firms to

attract capital from international investors, raise funds by issuing equity on exchanges around the world

opens up business internationally, but opens doors to foreign exchange risk as well

Firm strategy

The manner in which the organization intends to achieve its objectives.

Profitability

rate of return the firm makes on its invested capital

Profit growth

percentage increase in net profits over time

Value added

difference between costs of production and the value that customers perceive in a product or service

Differentiation strategy

creating value for customers through

1. Superior design

2. Styling

3. Greater Functionality

4. Enchanced features

5. Reliability

6. After Sales Service

Low cost strategy

creating value for customers through lowering production costs

Strategic positioning

choosing between differentiation and low cost strategy based on where they can find sufficient demand

How to maximize profitability

1. Pick a position on the efficiency frontier that is viable for the firm

2. Configure firm's internal operations, such as manufacturing, marketing, etc. so that they support that position

3. Ensure that the firm's organization structure is aligned with its strategy

Ensure strategy, operations, and organizational structure of firm are consistent and in line.

Value creation activities

Primary activities: relate to design, creation and delivery (R&D, production, marketing and sales, customer service)

Secondary activities: provide inputs that allows for primary activities to occur (Info systems, company infrastructure & logistics, HR)

Organization structure

formal division of org into subunits

centralized vs. decentralized decisions

establishment of integrating mechanisms to coordinate activities of subunits

How can a MNC increase profitability

expand market (sell internationally)

realize location economies (utilize locations to optimize labor costs, etc.)

realize greater cost economies from experience effects (cost savings by learning, economies of scale)

Leverage the multinational network (leverage skills developed in foreign operations and transfer them elsewhere)

Competitive pressure in global marketplace

pressures for cost reductions

pressures to be locally responsive

Pressures for cost reductions

force the firm to lower unit costs

arises when price is main mechanism of competition between firms

for commodity type products that fill universal needs, where there is persistent excess capacity, when major competitors are based in low cost locations

Pressures for Local Responsiveness

Require the firm to adapt its product to meet local demands in each market

◦ But, this strategy can raise costs

differences in consumer tastes and preferences, host government demands, etc.

International Strategy

take products produced for the domestic market and sell them internationally with minimal local customization

when there's low cost pressures and low pressures for local responsiveness

Localization strategy

increase profitability by customizing goods or services so that they match tastes and preferences in different national markets

when there's substantial differences across nations and cost pressures are not intense

Global standardization

Firms seek to market a standardized product worldwide to reap benefits from economies of scale, learning effects, and location economies

when there's low pressures for local responsiveness, and high pressures for cost

Transnational Strategy

strategy that attempts to combine the benefits of a localization strategy (high local responsiveness) with those of a global-standardization strategy (lowest-cost position attainable)

When there's both high pressures for local responsiveness and cost