International Business Terms

MGCR 382 - McGill University

tariff

taxes on goods coming in/out of a country

trade

a voluntary exchange of goods/services/assets between people or orgs

international trade

trade between the residents of two countries (crossing borders)

why trade?

belief that they will benefit from the voluntary exchange

1. better stuff

2. cheaper stuff

3. more stuff

early country based theories of trade

• focus on individual country

• commodity

• price is the decision making factor

modern firm based theories

• focus on firms role in promoting intl trade

• useful in describing patterns of trade in differentiated goods

• brand name is an important component of the customer’s purchase decision

mercantilism

• 16th century economic philosophy that maintains that a country’s wealth is measured by its holdings of gold and silver

• goal should be to enlarge these holdings by promoting exports and discouraging imports

• supporters today are called protectionists - it does benefit some firms & their workers

absolute advantage

• Adam Smith - attacked intellectual basis of mercantilism saying it:

  1. weakens a country

  2. squanders a country’s resources in producing goods it isn’t suited to produce in the process of avoiding imports at all costs

• Free trade among countries - it enables a country to expand the amt of goods and services available by specializing in the production of some goods and services and trading for others

• import what a country is less productive at than other countries

• export what a country is more productive at than other countries

comparative advantage

• trade should still occur even if a country has absolute advantage in both products

• David Ricardo

• relative productivity differences - incorporates the concept of opportunity cost in determining which good a country should produce

relative factor endowments (hecksher-olin)

• a country will have a comparative advantage in making products that use resources/factors of production it has in abundance

• export products that use relatively abundant factors of production & import products that need relatively scarce factors of production

country similarity theory

• phenomenon of intraindustry trade

• Steffan Linder

• intl trade in manufactured goods came from similarities of preferences among consumers in countries at the same stage of Econ development

• most trade in manufactured goods should be btwn countries w similar per capita incomes and intraindustry trade in manufactured goods should be common

• differentiated goods

new trade theory

• economies of scale occur if a firm’s average costs of producing a good decrease as output of that good increase

• intraindustry trade will be common

• continual competition as companies try to expand sales to capture sale economies

• harness comp. advantage to leverage own strengths and neutralize rivals

opportunity cost

the value of what is given up to get the good

opportunity cost = value of given up / value of pursued

Leontief paradox

• Huckster-Olin theory tested by Leontief after WWII

  • belief that US was a capital abundant & labour scarce economy

  • according to Heckscher-Olin theory, reasoned that US should export capital intensive goods and import labour intensive goods

  • results not consistent w the predictions of Hecksher-Olin theory - US imports were nearly 30% more capital intensive than exports

interindustry trade

exchange of goods produced by industry A in country A for goods produced by industry B in country B

intraindustry trade

trade between 2 countries of goods produced by the same industry

differentiated goods

products for which brand names & product reputations play a role in consumer decision making

FDI, foreign direct investment

companies directly invest in a foreign economy through their operations - control focused, acquiring foreign assets for purpose of control

foreign portfolio investment

passive holdings of stocks, bonds, other assets which entail no active management or control over the issuer of the securities by the foreign investor

2 main political factors affecting FDI decision

1. avoidance of trade barriers such as high tariffs on imported consumer goods

2. economic development incentives given by the government so that a company can create jobs in the country

dumping

when foreign sellers sell stuff below the price of home competitors which disadvantages lower sellers to then raise prices once client base forms

trade war

countries go back and forth with tariffs

threatening tariffs

assessing believability - once this is determined the countries will try to change the relationship to maximize gain / positive benefits

risk of tax / tariff

fuelled to the end customer who must pay the price

who receives the revenue from a tariff

the country that issues the tariff

indirect instruments of trade control

QUANTITY limited

tariffs (export, transit, import)

influences price

specific duty

tariffs charged on a per unit basis

ad valorem

tariffs charged on a percentage basis of the items value

compound tariff

combination of specific tariff and ad valorem tariffs

export tariff

countries that issue the export tariff are paid by the sellers from their country (within local market) - point is to keep the market local

import tariff

countries that bring a product into their market have to pay

direct instruments of trade control

price

subsidies, incentives, loans, aid

quota - quantity

limiting the amount of an imported product allowed in a country (voluntary or embargoes)

voluntary export restraint / quota

an unofficial agreement to not sell more than a given amount in a foreign market. typically motivated by a country’s interest or fear of threat, which is why they would oblige

embargoes

forced quantity is enforced

other miscellaneous methods of trade control

buy local legislation, standards and labels, and restrictions on services

world trade organization

organization that governs 164+ country’s trades, allows a small country to take a larger country to court and win

WTO rules are the base for new trade deals and WTO is also the arbiter of trade

import demand curve

shortfall between demand and supply curve for any given price. simply the demand beyond what the local market can supply at that price.

Q_import = Q_{home demand} - Q_{home supply}

exchange rates

price of a country’s currency in terms of another country’s currency

direct quote

care about numerator, home country price / unit of foreign currency

indirect quote

care about denominator, foreign currency price / home currency

bid rate

price at which an FX dealer is willing to buy currency

ask rate

price at which an FX dealer is willing to sell currency

mid rate

middle between bid and ask rates (math done on this rate)

spread

the difference between the bid and ask rates as quoted by an FX dealer

arbitrage

an opportunity to make riskless profit by exploiting currency price differences - exchange rates change all of the time and if you move fast you might make free money

measuring a change in an exchange rate formula

% change = (ending rate - beginning rate)/Beginning rate

spot rate

change all of the time - the rate at the given time

forward contract

agree to terms that in the near future, we will trade at a given rate. it is the agreed upon rate which may be different than the rate at the current time

forward premium/discount formula

forward premium / discount = (forward-spot)/spot * 360/# of days to settlement

implied rate

difference between forward and spot rates that can be compared

actual rate

what the rate is in reality

international monetary system

within different countries, there are different financial institutions and central bank

institutions must have a certain amount of money in a reserve in case people want their money back - rest (not in reserve) can be lent out at a multiple

1800s

currencies pegged to gold

1914 interwar years

hard to bring gold across the border, USD is pegged to gold

1929 Great Depression

countries want to invest to take advantage of the bad market

Bretton woods and the IMF 1944

established a USD based monetary system and created the IMF and world bank

countries fixed their currencies in terms of gold but were not required to exchange their currencies

up to 10% devaluation of one’s currency was allowed without IMF permission

floating era 1973-1997

exchange rates are less predictable and there were several market currency crises

emerging era - now

growth in emerging market economies and currencies

equilibrium price (supply and demand curve)

set the quantity of each curve equal to each other

Q_{home/foreign supply} = Q_{home/foreign demand}

opportunity cost, comparative advantage

calculate the cost of doing/not doing something

smaller number is less opportunity cost, which is therefore better

opportunity cost = opportunity given up/opportunity pursued

find the price given labour cost and output per hour

price = 1/(output per hour) x labour cost

government intervention in trade - economic reasons

1. fighting unemployment

2. protecting infant industries

3. developing an industrial base (industrialization)

4. economic relationships with other countries

government intervention in trade - non economic reasons

1. maintaining essential industries

2. promoting acceptable practices abroad

3. maintaining or extending spheres of influence

4. preserving national culture

change in exchange rate

% change = (end rate - beginning rate)/beginning rate

forward premium or discount

fwd perm/disc = (fwd-spot)/spot x 360/days to settlement

balance of payments

the measurement of all international economic transactions between residents of a country and foreign residents

current account items

• trade in goods

• trade in services

• income payments and receipts

• unilateral current transactions

financial account items

• direct investment

• portfolio investment

• net financial derivatives

• other investments

balance on goods

measures balance on imports and exports of merch

balance on current account

expands balance on goods to include receipts and expenses

basic balance

measures all international transactions due to market forces

overall balance

total change in a country’s fx reserves caused by basic balance and any govt action to influence fx reserves

fixed exchange rate system for BOP

govt must ensure BOP is near 0

• sum of current and capital accounts must be near 0

• govt buys or sells fx reserves to correct BOP

floating exchange rate system for BOP

govt has no responsibility to peg fx rate

• the current and capital accts should balance in theory when they sum to 0 by altering exchange rates (theoretically)

• market will rid itself of the imbalance by lowering the price

why does a govt restrict capital mobility

• insulating domestic monetary and financial economy

• political motivations

  • impossible trinity requires capital flows to be controlled for fixed exchange rate and independent monetary policy

law of one price

P^$ x S = P^Yen

purchasing power parity

measure of the price of specific goods in different countries, used to compare currencies

absolute PPP

if the law of one price is true for all goods/services, the PPP exchange rate could be found from any individual set of prices

• comparing prices of identical products in different currencies, one can find the real PPP if markets were efficient

  • the PPP exchange rate that should be

  • states that spot exchange rate is determined by the relative prices of similar baskets of goods

relative PPP

• PPP doesn’t help us to determine today’s spot rate, but does show the relative price changes between 2 countries over a period of time - which then determines the change in exchange rate over that period

• if spot exchange rate between 2 countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset in the long run by an equal but opposite change in the spot exchange rate

Big Mac index

good candidate for the law of one price and measurement of over or under valuation

1. the product is consistent in each market

2. the product is a result of local materials and input costs - domestic

limitations: the price of the Big Mac might be influenced by other factors (like real estate or taxes), the Big Mac cannot be traded across borders

undervaluation and PPP

if the currency is undervalued, theoretically, the market participants will purchase the currency in looking for a profit - thus driving up the currency’s price which will then eliminate the undervaluation

the fisher effect

• nominal interest rates in each country are equal to the real rate of return PLUS compensation for expected inflation

I = r + π + rπ

where I is the nominal I/r

r is the real I/r

π is the expected inflation rate over the lending period

approx form of fisher effect

I = r + π

international fisher effect

relationship between percent change in spot exchange rate over time and differential between comparable interest rate in different markets

fisher open: the spot exchange rate should change in equal amount but ion the opposite direction to the difference in interest rate in 2 countries

((s1 - s2) / s2 )× 100 = I^{rate one} - I^{rate two}

I rate one and two are national interest rates

s is the spot exchange rate using indirect quotes at the beginning S1 and end S2 at the end of the period (B- E / E)

precise formula for intl fisher effect

(s1-s2)/s2 = (i¹ - i²)/(1+i²)

interest rate parity

linkage btwn FX markets and intl money markets

• diff in national interest rates for securities of similar risk and maturity should be = to but opposite sign of the fwd rate discount or premium for the foreign currency except for transaction costs

covered interest arbitrage

the spot and fwd exchange markets are not constantly in the state of equilibrium described by interest rate parity

• when the market isn’t in =brium, there is an opportunity for arbitrage

CIA - arbitrager moving to take advantage of the disequilibrium by investing the currency offering higher return on a covered basis

uncovered interest arbitrage

investors borrow in currency with a low interest rate and then convert it to a currency w a higher interest rate

• uncovered = investor doens’t sell higher yielding currency proceeds forward, so they remain uncovered and accept risk

fwd rate calculation

uses

• spot rate

• domestic ir

• foreign ir

  • no predictive element in its calculation

fwd rate as an unbiased predictor

If the forward rate is an unbiased predictor of the future spot rate, the expected value of the future spot rate at time 2 equals the present forward rate for time 2 delivery, available now, E(S2) = F1

market efficiency assumes

1. all relevant info is quickly reflected in spot and fwd exchange markets

2. transaction costs are low

3. instruments denominated in different countries are perfect substitutes for each other

transaction costs

if the transaction costs for covered or uncovered interest arbitrage are large, then

• dissuade arbitrager from making small amt trades

• large discrepancies btwn market rates and quotes