International bussiness the challenge of global competition 11e chapter 11

chapter eleven
Financial Forces

McGraw-Hill/Irwin
International Business, 11/e

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved.


Learning Objectives
 Explain how money can be made and lost in the
foreign exchange (FX) markets

 Understand foreign exchange quotations, including
cross rates

 Describe currency exchange controls
 Explain how financial forces such as tariffs, taxes,
inflation and the balance of payments can affect
international management

11-3


Fluctuating Currency Values
• Freely floating currencies fluctuate against each other
• Fluctuations may be quite large
• Financial managers must understand how to protect against
losses or optimize gains

11-4


Foreign Exchange Terminology

 Foreign Exchange Quotation
 The price of one currency expressed in terms of another
 Reported in the world’s currency exchange markets

 Central reserve asset
 Asset, usually currency, held by a government’s central bank

 Vehicle currency
 A currency used as a vehicle for international trade or investment

 Intervention currency
 A currency used by a country to intervene in the foreign currency
exchange markets, often to buy (strengthen) its own currency

11-5


Foreign Exchange Quotations

 Exchange Rates

 Foreign currency X’s per US$ rate can be computed
from the reciprocal of the US$ equivalent rate of
currency X (and vice versa)

(1) / (US$ equivalent rate of currency X) =
= (Currency X per US$ rate)

(1) / (Currency X per US$ rate) =
= (US$ equivalent rate of currency X)
11-6


Exchange Rate for June 19 and June 16,
2006

11-7


Exchange Rates

 Spot rates

 The exchange rate between two currencies for delivery
within two business days

 Forward currency market

 Trading market for currency contracts deliverable 30, 60,
90, or 180 days in the future

 Forward rate

 The exchange rate between two currencies for delivery in
the future, usually 30, 60, 90, or 180 days

11-8


Exchange Rates

 Trading at a premium

 A currency’s forward rate quote is stronger than
the spot rate

 Trading at a discount

 A currency’s forward rate quotes is weaker than
the spot rate

 Premium or a discount depends on the

expectations of the world financial community,
businesses, individuals, and governments
about what the future will bring
11-9


Exchange Rates
 Cross Rates
 Currency exchange rates for trading directly
between non-U.S. dollar currencies

 Bid price

 Price offered to buy
 Ask price
 Sales price

11-10


Influences of Exchange Rate Fluctuation
 Supply and demand of the currency
 Interest rates
 Inflation
 Expectations
11-11


Exchange Rate Fluctuation
• Monetary policies
– Government policies that control the amount of
money in circulation and its growth rate

• Fiscal policies
– Policies that address the collecting and spending of
money by the government

• Law of one price
– Concept that in an efficient market, like products
will have like prices

• Arbitrage
– The process of buying and selling instantaneously

to make profit with no risk
11-12


Exchange Rate Fluctuation
• Fisher effect
– The relationship between real and nominal interest
rates: the real interest rate will be the nominal
interest rate minus the expected rate of inflation

• International Fisher effect
– Concept that the interest rate differentials for any
two currencies will reflect the expected change in
their exchange rates

• Purchasing Power Parity (PPP)
– Theory that predicts that currency exchange rates
between two countries should equal the ratio of the
price levels of their commodity baskets
11-13


Exchange Rate Forecasting
 Efficient market approach
 Assumption that current market prices fully reflect all
available relevant information
 Random walk hypothesis
 Assumption that the unpredictability of factors suggests
that the best predictor of tomorrow’s prices is today’s
prices

11-14


Exchange Rate Forecasting
 Fundamental approach
 Exchange rate prediction based on econometric models
that attempt to capture the variables and their correct
relationships
 Technical analysis
 An approach that analyzes data for trends and then
projects these trends forward

11-15


Currency Exchange Controls

 Government controls that limit the legal uses

of a currency in international transactions
 Value of currency is arbitrarily fixed at a rate
higher than its market value
 If you see “official rate” next to a currency rate
quotation, that country has currency exchange
controls in place

11-16

Currency Exchange Controls

 A black market typically surfaces as a
result of currency exchange controls

 However, this type of currency exchange
transaction is illegal
 The black market is rarely able to
accommodate transactions of the size
involved in international business

11-17


Tariffs
• Tariffs
– Taxes, usually on imported goods
– May be ad valorem, specific, compound, or variable

11-18


Taxation
 Income tax
• Direct tax on personal and corporate income
 Value-added tax (VAT)
• A tax charged on the value added to a good as it
moves through production from raw materials to
final purchaser
 Withholding tax

• Indirect tax levied on passive income that the
corporation would pay out to non residents

11-19


Corporate Tax Rates

11-20


Inflation
• A trend of rising prices
– May be caused by demand exceeding supply
– May be caused by an increase in the money supply
• Measured by consumer price index (CPI)
– Basket of consumer goods
• Gross domestic product deflator--OECD
– Takes into account the prices of intermediate goods and
services

11-21


GDP Deflator. Average annual growth in
percentage, 1991-2004

11-22

Inflation and the International Company



High inflation rates





Make capital expenditure planning more
difficult
Cause the cost of goods and services to rise
Tend to cause BOP deficits
Could lead to more restrictive fiscal or
monetary policies, currency controls, export
incentives, and import obstacles
11-23


Inflation and the International Company



High inflation rates


Encourage borrowing because the loan will be repaid
with cheaper money



Bring high interest rates



Discourage lending



Make capital expenditure planning more difficult
11-24


Balance of Payments (BOP)

 The state of a nation’s BOP reveals the state
of that country’s economy

 If the BOP is slipping into deficit
 the government is probably considering one or

more market or nonmarket measures to correct or
suppress that deficit

Currency devaluation or restrictive

monetary or fiscal policies to induce
deflation are likely

Currency or trade controls may be near
11-25