international business exam 3 chapters 10-13

foreign exchange market

-place where people and businesses exchange one country's money for another --its a global network made up of banks, brokers, and currency dealers

-the US dollar is often used a common currency to make these exchanges easier

(spot) exchange rate

the rate at which one currency is converted into another currency

what is the function of the foreign exchange market?

-enable companies based in countries that use different currencies to trade with each other

-helps protect against the risk of currency value changes (hedging)

-allows people to make money by predicting currency movements (speculation) or taking advantage of price differences (arbitrage)

foreign exchange market actors

businesses, governments, investment funds, banks, and speculators from different countries

currency speculation

movement of funds from one currency to another in the hope of profiting from shifts in exchange rates

carry trade

when someone borrows money in a currency with low interest rates and then uses that money to invest in a currency with higher interest rates

currency conversion basics

EUR/USD: 1.3732

GBP/USD: 1.6035

-the currency to the left of slash (EUR EURO) is base currency

-the currency to the right of slash (USD) is quote or counter currency

-EUR/USD 1.3732 means 1 Euro=1.3732 USD

foreign exchange risk

-risk introduced into international business transactions by changes in exchange rates

-divided into three categories: transaction or contractual exposure, translation exposure, economic or operating exposure

transaction exposure

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

ARISES FROM:

- agreed to buy or sell goods and services at a set price (often in domestic currency)

- borrowed or lent money in a foreign currency

Foreign Exchange Risk

1. Transaction exposure example:

-In 2012, American Airlines agreed to buy 10 Airbus aircrafts for €120 million each

-Delivery is expected to be in 2013 and payment would be due then

Year (2012) Dollar/Euro Exchange rate ($1 = €0.77) Estimated Payment (AA expects to pay (120 x 10)/0.77 = $1.55 billion

Year (2013) Dollar/Euro Exchange rate ($1 = €0.72) Payment Due (AA pays (120 x 10)/0.72 = $1.66 Billion

translation exposure

2. Transition Exposure: The impact of currency exchange rate changes on the reported financial statements of a company

-concerned with the present measurement of past events

-gains or losses are on "paper"

-i.e. unrealized gains or losses

-Example: consider U.S. firm with a subsidiary in Mexico

-IF MXN depreciates against the dollar -> the dollar value if the firm's equity is reduced on the balance sheet

-increases the firm's debt ratio -> increase its borrowing costs

economic exposure

3. Economic exposure: the extent to which a firm's future international earning power is affected by changes in exchange rates

-concerned with the long-term effect of changes in exchange rates in future prices, sales, and costs

Foreign Exchange Risk Mitigation Strategies

Two types of risk management strategies:

1. Hedging: to reduce the long term volatility of cash flows or earnings

-Using financial instruments such as forwards and swaps

-Using lead and lag strategies

2. Exploiting differences in interest rates: to create competitive advantage

-Raise funds in one country to finance investments in another

Hedging: Forwards

Forward exchange contract

-two parties agree to exchange currency and execute the deal at some specific date in the future

-Used to protect the buyer from fluctuations in currency prices

-Can be canceled only with mutual agreement of both parties involved

-A forward exchange rate is used for these future transactions

-rates for currency exchange are typically quoted for 30, 90, or 180 days into the future

Forward Exchange Rates

AUD/USD-Spot; 1.0268

AUD/USD- 1M forward; 1.0235

AUD/USD- 3M forward; 1.0178

AUD/USD- 6M forward; 1.0103

-apparently foreign exchange dealers expect the Australian Dollar to depreciate against the US dollar

-the Australian dollar is trading at a discount on the forward market

-if the AUD/USD-6M forward was trading at, say, 1.0333

-then the Australian dollar would trading be at a premium on the 6-month forward market

Hedging: Currency Swap

-a currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

How are Swaps Transacted?

-between international business and their banks

-between banks

-between governments

What is a common type of swap?

Spot against forward

Example: Suppose Australian firm, Billabond needs USD 2 million to cover its US expenses now, and wants to transfer back USD 2 million in sales revenue in 6 months. Engage in a currency swap.

AUD/USD-Spot; 1.0268

AUD/USD-6M forward; 1.0103

-exchange (2/1.0268) i.e. AUD 1.948 million for USD 2 million, at spot rate

-enter into a 6 month forward exchange contract to exchange USD 2 million

-this contract would exchange USD 2 million to (2/1.0103) AUD 1.979 million

How are Exchange Rates Determined?

-exchange rates are determined by the demand and supply for different currencies

What are 3 factors that seem to impact future exchange rate movements?

1. relative inflation levels

2. differences in interest rates

3. investor psychology

Law of One Price

law of one price: in competitive markets free of transportation costs and trade barriers

- identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency

-otherwise there is an opportunity for arbitrage until prices equalize between the two markets

-ex: U.S./Euro exchange rate: $1=€.78

-ex: a jacket selling for $50 in New York should retail for €39 in Paris (50x.78)

Purchasing Power Parity Theory (PPP)

PPP: given efficient markets

-the price of a "basket of goods" should be roughly equivalent in each country

-ex:If a basket of goods costs 100 US Dollars in the US and the same basket of goods costs 6000 Rupees in India, then the dollar/rupee exchange rate should be $100/Rs 6000 because 1 USD=60 INR

-PPP Theory predicts that changes in relative prices

->changes in exchange rates

-fairly accurate in the long run and for countries with high inflation and underdeveloped capital markets

How Do Prices Influence Exchange Rates?

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

-high inflation: more supply of money on the foreign exchange market currency depreciates relative to others

-IB managers attempting to predict future currency movements should examine a country's policy toward monetary growth

-controlled rate of growth in money supply ->low future inflation rate

-government can increase the money supply by telling the country's central bank to issue more money

How Do Interest Rates Influence Exchange Rates?

-economic theory tells us that interest rates reflect expectations about likely future inflation rates

-high inflation correlates with high interest rates (fisher effect)

-PPP theory tells us that inflation rates->exchange rates

International Fisher Effect

it follows that there must also be a link between interest rates and exchange rates

Investor Psychology can be influenced by...

-political factors

-microeconomics events

-bandwagon effect: traders moving as a herd in the same direction at the same time

Exchange Rates are affected...

IN THE LONG-RUN BY:

-monetary growth

-inflation rates

-interest rate differentials

IN THE SHORT-TERM BY:

-investor expectations

-psychological factors

-bandwagon effects

To minimize transaction and translation exposure, managers...

-buy forwards

-use swaps

-lead and lag payables and receivables

To reduce economic exposure, managers...

-distribute productive assets to various locations

-to reduce impact of adverse changes in exchange rates

International Monetary System

-the institutional arrangements that govern exchange rates

-facilitate trade-related international transactions

International Financial System

provides investment capital required for economic activities

What happened Post WWII?

-monetary and financial affairs were in general isolated from one another

-international monetary system consisted of fixed exchange rates

-every country maintained capital controls

The Financial Revolution of the 1970s

-removal of capital controls by leading economies

-led to the freedom of capital movement

-resulting in increased integration of national capital markets

-and creation of a global financial system

Benefits of International Financial System

-enabled capital-poor countries to borrow funds

-but international capital flows->increased volatility in the foreign exchange markets

International Monetary System (IMS)

-the institutional arrangements that govern exchange rates

-Gold standard (1880-1914)

-Bretton Woods (1944-1973)

Mixed System (1976-Present)

Fixed exchange rates

value of a set of currencies are fixed against each other at mutually agreed on exchange rate

Pegged exchange rates

the value of the currency if 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

-dates back to ancient times

-payment for imports was made in gold or silver

-by 1880, adopted by most worlds' major trading nations

-refers to a system in which countries peg currencies to gold and guarantee their convertibility

STRENGTHS:

-powerful mechanism to achieve balance-of-trade equilibrium

-in case of a trade

deficit->more USD paid than received->foreigners convert USD into gold->US gold reserves shrink->US inflation drops->US goods become cheaper->US exports rise->international trade is balanced

Gold Par Value

-amount of currency needed to purchase one ounce of gold

UNDER THE GOLD STANDARD:

-1 ounce of gold cost $20.67

-1 ounce of gold cost £4.25

The Inter-War Period

-during WWI, many countries printed money to finance their military expenditures

-as a consequence, at the end of the war (1918), inflation was up everywhere

-Great Britain, despite higher inflation, pegged the pound at its pre-war gold par value in 1925

CONSEQUENCES:

-loss of international competitiveness-recession

-loss of confidence in British Pound

-UK suspended convertibility in 1931

-A series of competitive devaluations (initiated by the US) eventually shattered the entire system

-By 1939, the Gold Standard was dead

Bretton Woods System

-representatives from 44 countries gathered at Bretton Woods, N.H. in 1944

INITIAL CONSENSUS:

-fixed exchange rates are desirable

-collapse of Gold Standard due to a lack of multinational institution

The New Bretton Woods System Agreement

-fixed exchange rate system was established

-foreign currencies fixed

(+/- 1%) to the USD

-only the USD remained convertible (at $35 gold par value)

-countries agreed to no longer engage in competitive devaluation

-devaluation (<10%) was allowed only if currency became too weak to defend

International Monetary Fund (IMF)

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

GOAL:

-avoid financial chaos through discipline and flexibility

World Bank

promote general economic development

Adjustable Parties

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

The World Bank

-initially established to help finance rebuilding of war-torn economies of Europe

-overshadowed by the U.S. Marshall plan

-US gave 12B (equals approx 120 billion in current dollars) from 1948-1952

-as a result, World Bank refocused on helping less developed countries

International Bank for Reconstruction and Development (IBRD)

-money is raised through bond sales

-low interest loans provided to risky customers

-such as governments of underdeveloped nations

International Development Association (IDA)

-an arm of the bank created in 1960

-IDA loans (interest-free) go only to the poorest countries

-money raised through subscription from wealthy members

- borrowers have 50 years to repay

Floating Exchange Rates

-Bretton Woods system collapsed in 1973

-the USD as the central currency put pressure on US monetary policy (this increased inflation and trade deficit put pressure on value of USD)

-initial dollar devaluation was too small (8%) but there was no agreement on further devaluations

-US dollar came under speculative attack

Jamaica Agreement

-a new exchange rate system was formalized in 1976

-the rules that were agreed on then are still in place today

UNDER THE AGREEMENT:

-floating rates were declared acceptable

-gold was abandoned as a reserve asset

-total annual IMF quotas-the amount member countries contribute to the IMF-were increased to $41 billion today they are about $300 billion

Monetary policy autonomy

-in times of economic downturn, government can pursue expansionary monetary policy

Automatic trade balance adjustments

-under Bretton Woods, a permanent trade deficit required intervention by the IMF for a currency devaluation

-but it is not a strong argument for US

Crisis recovery

-export led recovery due to weak currency

-South Korea after Asian Crisis in 1997

-Iceland after 2008-2009 Crisis

What does a fixed exchange rate system?

1.Ensures monetary discipline

-as governments need to maintain a fixed exchange rate

-so they do not expand their money supplies at inflationary rates

2.minimizes speculation

3.reduces uncertainty

-promoted growth of international trade and investment

Exchange Rate System in Practice

-21% of IMF members follow a free float policy

-23% of IMF members follow a managed float system

-5% of IMF members have no legal tender of their own (excluded Euro Zone countries)

-the remaining countries use less flexible systems such as pegged arrangements, or adjustable pegs

Currency Crisis

happens when a lot of people start betting that a country's money will lose value. this can make the currency's value drop quickly. to stop this, the country's leaders might spend a lot of their foreign currency reserves or raise interest rates a lot to keep the currency stable

-Brazil in 2002

-Asian crisis in 1997

Banking Crisis

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

-Iceland in 2008

Foreign Debt Crisis

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

-Greece and Ireland 2010

Crisis Management by the IMF

-the IMF provided conditional loans to countries facing economic crisis

-loans come with strong conditions for economic reform

SOME OF THE CONDITIONS:

-increase taxes

-cut public spending

-privatize State Owned Enterprise

-raise interest rates

-open the economy to foreign investors

How has the IMF done?

-by 2019, the IMF was committing loans to 40 countries in economic and currency crisis

-all IMF loan packages require tight microeconomic and monetary policy

Business Strategy

-firms must carefully manage their foreign exchange transactions and exposures

-hedging through forward contracts

-real hedging through production dispersion

-use short term supply contracts

Investors

- people who have surplus cash

- seek return on their investment

- ex: corporations, individuals

Borrowers

- individuals, companies, and governments

- raise funds to meet their needs

Market Makers

- the financial service companies that connect investors and borrowers

- either directly (investment banks) or indirectly (commercial banks)

Primary Markets

- create new securities

- governments and companies raise cash by selling newly issued securities to buyers

Financial Intermediaries

- financial institutions that identify and connect buyers' and sellers' needs in real time or over time

- help determine market price so that transactions can occur and funds can be allocated efficiently

Secondary Markets

- enable the buying and selling of previously issued securities

- most of the activity in the capital markets takes place in these markets

Equity Loan

- made when a corporation sells stock

- corporation shares its profits by paying dividends to its shareholders

- dividends are not fixed in advance; determined by the management based on profits made

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 had to be paid to bond holders for a specified number of years

Growth of GCM: Deregulation by governments

- has facilitated growth in international capital markets

- since the 1980s, capital controls have been falling

- deregulation began in the U.S. then moved to Great Britain, Japan, and France

Growth of GCM: Advances in information and communication technologies

- advances in data processing capabilities

- dramatic increase in computing power

- the growth of communications technology

ON THE DARK SIDE

- "shocks" also spread quickly

- financial crisis of 2008 in US spread globally

Systemic risk

- the risk of collapse of an entire financial system or market

Contagion

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

Benefits of GCM: For the Borrowers

- borrowers benefit from the additional supply of funds global capital markets provide

LOWERS THE COST OF CAPITAL:

- the price of borrowing money or the rate of return that borrowers pay investors

Benefits of GCM: For the Investors

- investors benefit from the wider range of investment opportunities

- diversify portfolios and lower risk

- as movements in stock market prices across countries are not perfectly correlated

- volatile exchange rates can make profitable investments, unprofitable

Eurocurrency

- any currency banked or held outside its country of origin

- about 2/3 of all Eurocurrencies are Eurodollars (dollars banked outside the U.S.)

- other eurocurrencies: euro-yen, euro-pound, euro-euro

Eurocurrency Market

- an important source of low-cost funds for international companies

- The eurocurrency market began in the 1950s

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

- so, they deposited them in Europe (banks in London)

Eurocurrency Market (History)

- in 1957, UK stopped its banks from lending pounds to foreigners

- British banks started using U.S. dollars instead and this helped grow the Eurocurrency market

- London became the main hub for Eurocurrency

- in the 1960s, U.S. rules made it harder for American banks to lend abroad

- as a result, foreign borrowers came to the Eurocurrency market for dollars

- after oil price hikes in the 1970s, Arab OPEC countries had lots of dollars

- to avoid U.S. control, they deposited their dollars in London Banks

What makes the Eurocurrency Market Attractive?

- the eurocurrency market is not regulated by the government

- banks can offer higher interest rates on Eurocurrency deposits

- banks can charge lower interest rates to Eurocurrency borrowers

- Eurocurrency banks do not have to follow the strict rules that central banks set for regular banks in their own country

Reserve requirements

- the money a bank must keep and not lend out

- ex: if reserve requirement is 10% and a customer deposits $100 the bank must keep $10 and can only lend out $90

Drawbacks of the Eurocurrency Market

1. Eurocurrency market has little regulation, so it is riskier, if a bank fails, depositors might lose their money

2. Borrowing in Eurocurrencies can be risky for companies because exchange rates can change, making it more expensive to repay the loan

Foreign Bond

- bond issued by a company in a different country, using that country's currency

- ex: Dow Chemical issues bonds in yen in Japan (samurai bond)

- ex: Honda issued bonds in USD in the US (yankee bond)

- must follow local rules and possibly extra rules for foreign companies

- companies issue foreign bonds to save money on borrowing

Euro Bonds

- bond issued outside the country of the currency used

- ex: a UK company issued a bond in US dollars and sells it outside the US

- handled by a group of international banks (syndicate)

- sold in multiple countries at the same time

- borrowers can be companies, governments, state-owned firms, or banks

What makes the Eurobond Market Attractive?

1. Fewer regulations: making issuing bonds cheaper

2. Less Paperwork and disclosure than in domestic markets: saves time and money

3. Tax benefits: since 1984, companies do not have to withhold taxes on interest paid to foreign investors

Global Equity Market

- equity markets tend to be national

MOST TAKE PLACE IN:

- New York Stock Exchange in US

- London Stock Exchange in UK

- Tokyo Stock Exchange in Japan

- reduced capital controls since the 1980s so firms can raise funds in international markets

The International Equity Market allows firms to

1. Attract global investors who want to diversify their portfolios

2. Raise money by selling shares in foreign markets

- helps bring in capital from that country

- can pay local employees with stock

- boosts the company's reputation locally

- makes it easier to buy other companies in that country later

What does GCM mean for Managers?

- borrow money internationally, often at a lower cost than at home

- diversify investments to reduce risk

- BUT, they must manage currency risk, since exchange rates can change and affect costs or returns

Strategy

- actions that managers take to attain the goals of the firm

- firms pursue strategies that increase profitability and profit growth

Profitability

- is the rate of return the firm makes on its invested capital

Profit growth

- the percentage increase in net profits over time

What is IB Strategy?

Enterprise Valuation

I

I

Profitability & Profit Growth

I I

I I

Reduce Costs Sell More and

I Enter Markets

I

Add Value and Raise Prices

Value Added

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

Value Creation

- Micheal Porter argues that firms can be profitable by:

1. Creating more value for its customers (differentiation strategy) through:

- superior design

- styling

- greater functionality

- enhanced features

- reliability

- after sales service

2. Lowering production costs

Strategic Positioning

- needs to choose between differentiation strategy vs. low cost strategy (Porter, 1980)

- the position should make sense, there should be demand for it

- the way the company is set up should match its plan

- the way the company works should help it succeed in the market

How to Maximize Profitability?

Strategy, Operations, and Organization

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

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

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

Operations: Value creation activities

1. Primary activities: relate to design, creation, and delivery

2. Support activities: provide inputs that allows primary activities to occur

Organizational Structure

- consists of three dimensions

1. formal division of the organization into subunits

2. location of decision-making responsibilities which is centralized and decentralized

3. establishment of integrating mechanisms, such as teams, liaison roles, etc to coordinate activities of subunits