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Fundamentals of

MULTINATIONAL
FINANCE
Edition III

MICHAEL H. MOFFETT
Thunderbird School o f G lobal M anagement

ARTHUR I. STONEHILL
Oregon State University and
University o f Hawaii at Manoa

DAVID EL EITEMAN
University o f California, L os Angeles

PEARSON

Boston San Francisco N ew York
L ondon Toronto Sydney Tokyo Singapore M adrid
M exico C ity M unich. Paris Cape Town H o n g Kong M ontreal


Editor in Chief: Denise Clinton
Executive Editor: Donna Battista
Assistant Editor: Kerri M cQueen
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Cover Designers: Gillian Hall and B eth Paquin
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Production Coordination, Composition, and Illustrations:
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Cover image: © Image Source Pink

Library of Congress Cataloging-in-Publication Data
Moffett, Michael H.
Fundamentals of m ultinational finance / Michael H. Moffett, A rthur I.
Stonehill, David K, E item an.--3rd ed.
p. cm.

Includes index.
ISBN 978-0-321-54164-2
1. International business enterprises—Finance. 2. International finance.
3. Foreign exchange. I. Stonehill, A rthur I. II. Eiteman, David K. III. Title.
HG4027.5.M64 2008
332',042~dc22
2008000739

ISBN-13:978-0-321-54164-2
ISBN-10:0-321-54164-2
Copyright © 2009 Pearson Education, Inc. All rights reserved. No part of this
publication may be reproduced, stored in a retrieval system, or transmitted,
in any form ox by any means, electronic, mechanical, photocopying, record­
ing, or otherwise, without the prior written permission of the publisher.
Printed in the United States of America. For information on obtaining per­
mission for use of m aterial in this work, please submit a written request to
Pearson Education, Inc., Rights and Contracts Departm ent, 501 Boylston
Street, Suite 900, Boston, M A 02116, fax your request to 617-671-3447, or
e-mail at />
2 3 4 5 6 7 8 9 lO-DOW -12 11 10 09 08


Preface

F

undamentals o f Multinational Finance, third edition, views the m ultinational
enterprise (MNE) as an organization that poses unique demands on the business
leaders of tomorrow. Those leaders—possibly some readers of this text—will be
confronted with a m ultitude of challenges that will test not only their ability to com­

prehend global markets, but also m ore importantly, their ability to lead organizations
through the constantly shifting currents and tides of global change. Com petent leader­
ship may indeed be the scarcest global commodity.
This book is about multinational management, and more specifically, the financial
m anagement (dimensions of leading a multinational enterprise. The MNE itself acts as
a catalyst and facilitator of international trade, and as an important producer and dis­
tributor in the host countries where it operates. The M N E’s potential success, however,
rests in the hands of the truly competent global leader. The success of any MNE
depends on its leadership’s ability to lead and manage the global organization.
, In writing this book, our vision is to aid the development of tom orrow’s MNE
leaders. It is their ability to recognize and benefit from business opportunities such as
imperfections in national markets, unequal costs and efficiencies of production factors,
wellsprings of intellectual property, and sources of global funding to facilitate growth
that adds value.
The financial managers of MNEs face numerous foreign exchange and political
risks. These risks can be daunting, but if properly understood they also present oppor­
tunities for creating value. These risks and opportunities are most effectively under­
stood in the context of the global business itself, and the ability of m anagement to
integrate the strategic and financial challenges th at the business faces.


vi

Preface

Audience
Fundamentals o f Multinational Finance, third edition, is appropriate for university
level courses in international financial management, international business finance,
international finance, and similar subjects. It can be used at the undergraduate or grad­
uate level as well as in executive education courses.

A prerequisite course or experience in corporate finance or financial management
would be ideal. However, we review the basic finance concepts before we extend them
to the multinational case. We also review the basic concepts of international econom­
ics and international business.
We recognize the fact that many potential adopters of this book live outside the
United States and Canada. Therefore, we use a significant num ber of non-U.S. exam­
ples, mini-cases, and Global Finance in Practice boxes, as seen in the business and news
press (anecdotes and illustrations).

Organization
Fundamentals o f Multinational Finance, third edition, is organized into seven parts.
They are unified by the common thread of the globalization process by which a firm
moves from a domestic to a multinational business orientation.
•

Part i describes the road to globalization.

•

Part 2 introduces the global financial environment.

® Pari 3 explains foreign exchange theory.
•

Part 4 analyzes foreign exchange rate exposure.

® Part 5 analyzes financing the global firm.
•

Part 6 analyzes international investment decisions.

•

Part 7 examines managing multinational operations.

New in the Third Edition
• Chapter 1 , Globalization and the Multinational Enterprise, is new but mainly incor­
porates topics that were previously discussed in the chapter on Foreign Direct
Investment.
• Chapter 2, Financial Goals and Corporate Governance, is largely new and expands
on the discussion of corporate governance presented previously in Chapter l.T h e
chapter now includes private ownership of business and differing perspectives on
the value of good global corporate governance.
• Chapter 5, The Foreign Exchange Market, includes the (2007) results of the
“Triennial Central Bank Survey of Foreign Exchange and Derivatives M arket
Activity.”
• Chapter 13, Sourcing Equity Globally, includes the various capital m arket stock
exchange mergers, additional material on equity funds, and family-owned compa­
nies.


Preface

v¡¡

• Chapter 17, Foreign Direct Investment Theory and Strategy, has a new section on
emerging m arket MNEs.
® There are now 22 mini-cases, many of which are new; and in response to user feed­
back, fifteen of the most popular mini-cases are retained.
• There are m ore Global Finance in Practice, boxes.

• Internet exercises, end-of-chapter questions, and end-of-chapter problems are
updated. There are more than 200 problems throughout.
' In this book, we use foreign exchange quotations that sometimes may differ from
the latest computer code quotation symbols (three-digit symbols). This is a result of
constant change in the marketplace, coupled with our text being revised every three
years, and our preference to use traditional symbols—$, ¥, £, €—rather than three-digit
codes, which in our opinion are more sterile. We also recognize that we may appear out
of date when we reference specific rates of exchange. But that is what this book is par­
tially about—the difficulties and challenges of managing businesses in a rapidly chang­
ing financial environment. We also are cognizant that many professors have prepared
additional teaching materials based on our existing foreign exchange quotations.
Therefore, we try to continue a mix of selected existing quotations (from previous edi­
tions) with the introduction of the latest rates and movements in the marketplace. In
any case, we use the quotations to illustrate a particular problem, not as a basis for upto-the-minute solutions.

Pedagogical Tools
To make Fundamentak o f Multinational Finance, third edition, as comprehensible as
possible, we use a large num ber of proven pedagogical tools. Again, our efforts have
been informed by the detailed reviews and suggestions of a panel of professors who
are recognized individually for excellence in the field of international finance, particu­
larly at the undergraduate level. Among these pedagogical tools are the following:
• A student friendly writing style combined with a structured presentation of m ate­
rial begins with chapter learning objectives and ends with a summarization of how
those learning objectives were realized.
• Numerous illustrations and exhibits provide a visual parallel to the concepts and
content presented. The book uses a multicolor presentation, which provides a
visual attractiveness that contributes significantly to reader attention and reten­
tion.
• A running case about a hypothetical U.S.-based firm, Trident Corporation, pro­
vides a cohesive framework for the multifaceted globalization process, and is rein­

forced in several end-of-chapter problems.
• Spreadsheet analyses prepared by Francis Clauss illustrate the quantitative dimen­
sions of the analysis. These spreadsheet analyses not only provide the computa­
tional support to improve reader understanding, but also provide the detailed
formula behind their construction.
• A mini-case at the end of each chapter illustrates the chapter content and extends
it to the multinational financial business environment.


viii

Preface

• Global Finance in Practice boxes illuminate the theory with accounts of actual
business practices. These applications extend the concepts without adding to the
length of the text itself.
• The power and resources of the Internet are leveraged throughout the text in a
variety of applications. Every chapter has end-of-chapter exercises that require the
use of the Internet, while a variety of Internet references are dispersed throughout
the chapters in text and exhibits.
• Additional end-of-chapter questions and problems assess students’ understanding
of the course material. All end-of-chapter problems are solved using spreadsheet
solutions. Selected end-of-chapter problem answers, indicated with an asterisk (*),
are now included at the back of the book.

A Rich Array of Support Materials
A robust package of materials for instructors and students accompanies the text to
facilitate learning and to support teaching and testing. All instructor resources are
available for download from the online catalog page for this book
(www.prenhall.com/finance or www.prenhall.com/irc).

•

Instructor’s Manual. The Instructor’s Manual, prepared by the authors, contains

answers to all end-of-chapter questions, problems, and mini-cases. All quantitative
end-of-chapter problems are solved using spreadsheets, which are available for
download and on the Instructor’s Resource CD-ROM.
• Test Bank. The Test Bank, prepared by Curtis Bacon of Southern Oregon
University, contains m ore than 1,200 multiple choice and short essay questions.
The multiple choice questions are labeled by topic and by category—recognition,
conceptual, and analytical. The test bank is available for download on the online
catalog page and on the Instructor’s Resource CD-ROM.
• Computerized Test Bank. The Test Bank is also available in Pearson Education’s

TestGen software for Windows® and Macintosh®. TestGen’s graphical interface
enables instructors to view, edit, and add questions; transfer questions to tests; and
print different forms of tests. Search-and-sort features enable the instructor to
locate questions quickly and arrange them in a preferred order. The Quizmaster
application allows the instructor to administer TestGen tests over the school’s
computer network. M ore information on TestGen software is available at
www.prenhall.com/testgen.
• Mini-Case PowerPoint® Presentations. A significant addition to the instructor’s
resources in this edition, each of the 22 m ini-cases has a stand-alone
PowerPoint presentation, which is available on the Instructor’s Resource CDROM and on the online catalog page for this book (www.prenhall.com/finance or
www.prenhall.com/irc).
•

PowerPoint Presentation Slides. The extensive set of PowerPoint slides available on
the Instructor’s Resource CD-ROM and on the online catalog page for this book
provides lecture outlines and selected graphics from each chapter.

•

Instructor’s Resource CD-ROM. This CD-ROM contains the Test Bank, Computerized
Test Bank files, the Instructor’s M anual files, and PowerPoint files.


Preface

•

ix

Study Guide. W ritten by Timo Korkeamaki of Gonzaga University, the Study Guide
enhances understanding and retention of concepts by providing detailed study
outlines. It helps students prepare for tests with a series of self-test questions,
including true/false, multiple choice, and short essay—all with answers.

• Web Site. A dedicated Web site (www.prenhall.com/moffett) contains the Web

exercises from the book with wired links, self-study quizzes, electronic flashcards
of glossary terms, and selected solutions and spreadsheets for end-of-chapter
problems.

international Editions
Fundamentals o f Multinational Finance and Multinational Business Finance have been
used throughout the world to teach students of international finance. O ur books are
published in several foreign languages including Chinese, French, Spanish, Indonesian,
Portuguese, and Ukrainian.

Acknowledgments
The authors are very thankful for the many detailed reviews and suggestions from
numerous colleagues. The third edition reviews included 15 detailed chapter-bychapter reviews. The final version of this edition reflects most of the suggestions pro­
vided. We appreciate the following reviewers: Torben Andersen, N orthwestern
University; K ristine Beck, U niversity of Wisconsin; G eorge Change, Bradley
University; O rkunt Dalgic, SUNY New Paltz; Robert Duvic, U T Austin; Ling He,
University of Central Arkansas; Pankaj Jain, University of Memphis; David Ng,
Cornell University; Rolando Pelaez, University of Houston; Niranjan Tripathy,
University of N orth Texas; Consheng Wu, University of Bridgeport; Jimmy Yang,
Oregon State.
Previous editions of Fundamentals o f Multinational Finance greatly benefited
from other reviewers including the following: M orten Balling, W. Brian Barrett, Cetin
Ciner, Joseph F. Greco, K en H unsader, Charmen Loh, Beverly B. Marshall, Daniel L.
McCounaughy, Simona Mola, Ali M. Parhizgari, Olgun Fuat Shahin, Jimmy Senteza,
James G. Tompkins, Phil Uhlm ann, and M iland M. Shrikhande.
We would also like to thank two people at Prentice Hall who have worked dili­
gently on this edition: D onna Battista, Executive E ditor for Finance, and Kerri
McQueen, Assistant Editor.
Finally, we dedicate this book to our parents, Bennie R uth and the late Hoy
Moffett, the late Harold and Norm a Stonehill, and the late Wilford and Sylvia
Eitem an, who m otivated us to become academicians and authors. We thank our wives,
Megan, Kari, and Keng-Fong, for their patience while we prepared Fundamentals o f
Multinational Finance, third edition.
Glendale, Arizona
Honolulu, Hawaii
Pacific Palisades, California

M.H.M.
A.I.S.
D.K.E.

X

Preface

About the Authors
Michael H. Moffett. Michael H. Moffett is Associate Professor of Finance at
Thunderbird,The Am erican G raduate School of International Management. Formerly,
he was Associate Professor of Finance at Oregon State University (1985-1993). H e has
also held teaching or research appointm ents at the University of Michigan, A nn A rbor
(1991-1993); the Brookings Institution, Washington, D.C.; the University of Hawaii at
Manoa; the Aarhus School of Business (Denmark); the Helsinki School of Economics
and Business A dm inistration (Finland); the International C entre for Public
Enterprises (Yugoslavia); and the University of Colorado, Boulder.
Professor Moffett received a B.A. (Economics) from the University of Texas at
Austin (1977); an M.S. (Resource Economics) from Colorado State University (1979);
an M.A. (Economics) from the University of Colorado, Boulder (1983); and a Ph.D.
(Economics) from the University of Colorado, Boulder (1985).
He has authored, co-authored, or contributed to six books and fifteen other pub­
lications. His articles have appeared in Journal o f Financial and Quantitative Analysis,
Journal o f A pplied Corporate Finance, Journal o f International Money and Finance,
Journal o f International Financial Management and Accounting, Contemporary Policy
Issues, Brookings Discussion Papers in International Economics, and others. H e has
contributed to a num ber of collected works, including the Handbook o f Modern
Finance, the International Accounting and Finance Handbook, and the Encyclopedia o f
International Business. H e has co-authored two books on multinational business with
Michael Czinkota and Ilkka Ronkainen: International Business (sixth edition) and
Global Business (fourth edition).
Arthur I. S tonehili. A rthur I. Stonehill is a Professor of Finance and International

Business, Emeritus, at Oregon State University, where he taught for 24 years
(1966-1990). From 1991 to 1997 he held a split appointm ent at the University of
Hawaii at M anoa and Copenhagen Business School. From 1997 to 2001 he continued
as a visiting professor at the University of Hawaii at Manoa. He has also held teaching
or research appointments at the University of California, Berkeley; Cranfield School
of Management (U.K.); and the N orth European Management Institute (Norway).
Formerly, he was president of the Academy of International Business, and was a west­
ern director of the Financial Managem ent Association. \
Professor Stonehill received a B.A. (History) from Yale University (1953), an
M.B.A. from Harvard Business School (1957), and a Ph.D. in Business Administration
from the University of California, Berkeley (1965). H e was awarded honorary doctor­
ates from the Aarhus School of Business (Denmark, 1989), the Copenhaigen Business
School (Denmark, 1992), and Lund University (Sweden, 1998).
H e has authored or co-authored nine books and twenty-five other publications.
His articles have appeared in Financial Management, Journal o f International Business
Studies, California M anagement Review, Journal o f Financial and Quantitative
Analysis, Journal o f International Financial Management and Accounting, International
Business Review, European Management Journal, The Investment Analyst (U.K.),
National0konom isk Tidskrift (D enm ark), Sosial0konom en (Norway), Journal o f
Financial Education, and others.


Preface

xi

David K. E ite m a n . David K. Eitem an is Professor Emeritus of Finance at the John E.
Anderson Graduate School of M anagement at UCLA. He has also held teaching or
research appointments at the Hong Kong University of Science & Technology, Showa
Academy of Music (Japan), the National University of Singapore, Dalian University

(China), the Helsinki School of Economics and Business Administration (Finland),
University of Hawaii at Manoa, University of Bradford (U.K.), Cranfield School of
M anagement (U.K.), and ID E A (Argentina). Formerly, he was president of the
International Trade and Finance Association, the Society for Economics and
M anagement in China, and the Western Finance Association.
Professor E item an received a B.B.A. (Business A dm inistration) from the
University of Michigan, Ann A rbor (1952), M.A. (Economics) from the University of
California, Berkeley (1956), and a Ph.D. (Finance) from Northwestern University
(1959).
He has authored or co-authored four books and twenty-nine other publications.
His articles have appeared in The Journal o f Finance, The International Trade Journal,
Financial Analysts Journal, Journal o f World Business, Management International,
Business Horizons, M SU Business Topics, Public Utilities Fortnightly, and others.


Brief Contents
PART 1

GLOBAL FINANCIAL ENVIRONMENT

-

1

Chapter 1

Globalization and the Multinational Enterprise......................................... .... 2

Chapter 2

Financial Goals and Corporate Governance................................................. 27

Chapter 3

The International Monetary System .............................................................. 59

Chapter 4

The Balance of Paym ents.............................................................................. 90

Chapter 5

The Foreign Exchange M arket.................................................................... 123

PART 2
Chapter 6

FOREIGN EXCHANGE THEORY

153

International Parity Conditions.................................................................... 154

Chapter 7

Foreign Exchange Rate Determination and Forecasting............................. 189

Chapter 8

Foreign Currency Derivatives.......... ........................................................... 218

PART 3
Chapter 9

FOREIGN E X C H A iC i EXPOSURE

251

Transaction Exposure.................................................................................... 252

Chapter 10

Operating Exposure...................................................................................... 285

Chapter 11

Translation Exposure................................................................................... 312

PART 4
Chapter 12

FINANCING THE GLOBAL FIRM

.

331

The Global Cost and Availability of Capital................................................338

Chapter 13

Sourcing Equity Globally .............................................................................374

Chapter 14

Financial Structure and International D ebt..................................................400

Chapter 15

Interest Rate and Currency Swaps................................................................426

PART 5

INTERNATIONAL INVESTMENT DECISIONS

4SI

Chapter 16

International Portfolio Theory and Diversification..................................... 454

Chapter 17

Foreign Direct Investment Theory and Strategy......................................... 477

Chapter 18

Political Bisk Assessment and Management................................................501

Chapter 19

Multinational Capital Budgeting.................................................................. 531

part

6

m a n a g in g m u l t in a t io n a l o p e r a t io n s

s ss

Chapter 20

International Trade Finance.......................................................................... 560

Chapter 21

Multinational Tax Management................ ................................................... 588

Chapter 22

Working Capital Management............................................... ...................... 612

Answers to Selected End-of-Chapter Problems................................... ................ ..............A-l

xii

Glossary

............................... ...................................................................................... G-l

Index

.......... ...........................................................................................................

1-1


Contents
PART 1
GLOBAL FINANCIAL ENVIRONMENT

1

CHAPTER 3

CHAPTER 1
Globalization and the Multinational Enterprise

Summary of Learning Objectives......................... 53
Questions 54 • Problems 55 • Internet Exercises 58

2

Globalization and Creating Value in the Multina­
tional Enterprise........ ....................................... 4
Global Finance in Practice i.i
National Multinational or ‘A-National’? ...........6

The International Monetary System

59

History of the International Monetary System . 60
Global Finance in Practice 3.1
Hammering Out an Agreement
at Bretton Woods ............................................63

The Theory of Comparative Advantage...............7
What Is Different about Global Financial Manage­
ment? 12

Contemporary Currency Regimes .....................70
Emerging Markets and Regime Choices . . . . . . 73
The Birth of a European Currency: The Euro .. 76

Global Finance in Practice 1.2
The Mystery of Capital D eepens..................... 13

Global Finance in Practice 3.2

Market Imperfections: A Rationale for the Exis­
tence of the Multinational F irm .....................14
The Globalization Process , . , . ......................... 15

Exchange Rate Regimes: What Lies Ahead? . . . 81

m i n i -c a s e

M IN I-C A S S

Porsche Changes T a c k ........................................ 18
Summary of Learning Objectives .......................... 24
Questions 24 •Problems 25 •Internet Exercises 26

CHAPTER 2
Financial Goals and Corporate Governance

27

New EU Members and Adoption of the Euro .. 80

Global Finance in Practice 3.3
Calculating the Euro's Success ......................... 81

The Revaluation of the Chinese Yuan .............82
M IN I-CA SE APPENDIX

Public Announcement of the People’s
Bank of China or Reforming the RMS
Exchange Rate Regime ................................... 85
Summary of Learning Objectives......................... 86
Questions 86 • Problems 87 • Internet Exercises 89

Who Owns the Business? ....................................28
Global Finance in Practice 2.1
Family Controlled Firms in France
Outperform the Public S e c to r.........................30
What Is the Goal of Management? ...................30
Global Finance in Practice 2.2

What Drives Value? ..........................................35
Corporate G overnance........................................36
Global Finance in Practice 2.3
When Scandals Go Global............................... 42
Global Finance in Practice 2.4
Corporate Governance Reform in China ........ 48
M IN I-CA SE

Governance Failure at Enron . . . , ..................... 49

CHAPTER 4
The Balance of Payments

90

Typical Balance o f Payments Transactions . . . . 92
Fundamentals of Balance of
Payments Accounting ................................... 92
The Accounts of the Balance of Payments . . . . . 94
The Capital and Financial Accounts .................97
Global Finance in Practice 4.1
Official Foreign Exchange Reserves:
The Rise of China ......................................... 101

The Balance of Payments in T o ta l...................103
The Balance of Payments Interaction with Key
Macroeconomic V ariables........................... 105
Trade Balances and Exchange Rates ...............108

xiv

Contents

Global Finance in Practice 4.2
The United States as the World’s
Largest Debtor Nation................................... 108

Global Finance in Practice 6.2
Deviations from Purchasing Power
Parity in the Twentieth Century ...................163

Capital Mobility ................................................I l l

Global Finance in Practice 6.3
Currency Pass-Through at Porsche.................165

Global Finance in Practice 4.3
Thailand Fails to Stem Capital Inflows.......... 112
MS11-CAS1

Turkey’s Kriz (A): Deteriorating Balance
of Payments ..................................................115
Summary of Learning Objectives ..................
117
Questions 117 •Problems 119 •Internet Exercises 122
CH A PTER 5
The Foreign Exchange Market

123

Geographical Extent of the Foreign
Exchange M arket..........................................124
Functions of the Foreign Exchange Market . . . 125
Market Participants............................................126
Global Finance in Practice 5.1
The Foreign Exchange Dealer’s D ay...............127
Global Finance in Practice 5.2
My First Day of Foreign Exchange Trading . . . 128
Transactions in the Interbank M arket...............129
Global Finance in Practice 5.3
A Hedge Against Foreign
Exchange Exposure? ..................................... 131
Foreign Exchange Rates and Q uotations........ 134
M ill-C A S E

The Venezuelan Bolivar Black M arket.......... 144
Summary of Learning Objectives........................ 147
Questions 148 •Problems 148 •Internet Exercises 151

PART 2

FOREIGN EXCHANGE THEORY

155

Global Finance in Practice 6.4
The Carry Trade and the Japanese Yen.......... 173
Forward Rate as an Unbiased Predictor
of the Future Spot R a te ........................... .... 175

Prices, Interest Rates, and Exchange
Rates in Equilibrium ................................... 177
MINI-CASE
Iceland 2006—A Small Country
in a Global Capital Market ...........................178
Summary of Learning Objectives .......................182
Questions 182 • Problems 183 • Internet Exercises 188
CHAPTER 7
Foreign Exchange Rate Determination
and Forecasting

189

A Roadmap to Exchange Rate
Determination ..............................................190
Exchange Rate Determination:
The Theoretical T h read ............................... 191
The Asset Market Approach to Forecasting . . . 194
Global Finance in Practice 7.1
Uruguay infected ......................................... 195
Disequilibrium: Exchange Rates
in Emerging M arkets............................... .... 197
Illustrative Case: The Asian C risis...................197
Illustrative Case: The Argentine Crisis
of 2002 ............ , ....................................... .2 0 0
Forecasting in Practice ................................... 205
Global Finance in Practice 7.2
Technical versus Fundamental
Trading Strategies?........................................ .207
MINI-CASE

JPMorgan Chase's Forecasting Accuracy . . . . 211

CH APTER 6
international Parity Conditions

Interest Rates and Exchange Rates ............ .. .166

154

Prices and Exchange R ates............................... 155
Purchasing Power Parity and the
Law of One P rice......................................... 156
Global Finance in Practice 6.1
Purchasing Power Parity:
Burgers or Beans?......................................... 159

Summary of Learning Objectives.......................213
Questions 213 • Problems 214 • Internet Exercises 217
CHAPTER 8
Foreign Currency Derivatives

218

Foreign Currency Futures................................. 220
Currency Options................................................222


Contents

Global Finance in Practice 10.1

Volvo C a r ....................................................... 289

Foreign Currency Speculation .........................226
Global Finance in Practice 8.1
Rogue Currency Trader at Allied Irish Bank .. 227
\

Global Finance in Practice 8.2
Putting the Kiwi to Flight ............................... 229

Option Pricing and Valuation...........................234
Valuation ............................................................236
Prudence in Practice......................................... 239
Global Finance in Practice 8.3
A Select List of Derivative
and Managerial Disasters............................... 239
M INi-CASE

Rogue Trader, Nicholas Leeson.......................240
Summary of Learning Objectives.......................244
Questions 245 • Problems 245 • Internet Exercises 248

XV

Strategic Management of
Operating Exposure.....................................293
Global Finance in Practice 10.2
Goodyear’s Response to the
Mexican Peso’s Devaluation .........................294

Global Finance in Practice 10.3
Detroit Dreams of a Rising Yen
in the Fail of 2 0 0 7 ......................................... 295
Proactive Management of
Operating Exposure.....................................296
Contractual Approaches: Hedging
the Unhedgeable .......................... ..............304
MINI-CASE

Toyota’s European Operating Exposure........ 305
Summary of Learning Objectives .......................308
Questions 308 •Problems 309 •Internet Exercises 311

PART 3

F O R llG i ÍI C H Ã iS i EXPOSURE

151
CHAPTER 11
Translation Exposure

CHAPTER 9
Transaction Exposure

252

Types o f Foreign Exchange E xposure............ 253
Why Hedge? ..................................................... 255
Global Finance in Practice 9.1
Amazon.com's Quest for Profits:

The Roie of Currency Gains/Losses .............. 255

Global Finance in Practice 11.1

Measurement of Transaction Exposure .......... 257
Trident’s Transaction Exposure .......................260
Management of an Account Payable .............. 268
Risk Management in Practice...........................270

Global Finance in Practice 11.2

Global Finance in Practice 9.2
Manipulation of Currency Gains and Losses . 271

M INI-CASE

Global Finance in Practice 9.3
Five Hedging Mistakes to Avoid .................. 272
M INI-CASE

312

Overview of Translation...................................313
Translation M ethods......................................... 316
Translation Example: Trident Europe ............ 321
Comparing Translation Exposure
with Operating Exposure.............................325
Managing Translation Exposure........ ..............325
Gyrus (UK): Translation Exposure
or Transaction Exposure? ................ . . . . . . . . 3 2 6

Hedging the Euro Away .................. ............ 329

laJolla Engineering Services .......... ............ 330

Summary of Learning Objectives........ ............ 332
Questions 333 • Problems 333 • Internet Exercises 335

Xian-Janssen Pharmaceutical (China)
and the Euro ............................................... 272
Summary of Learning Objectives.......................275
Questions 276 • Problems 276 • Internet Exercises 284
CHAPTER 10
Operating Exposure

285

Attributes of Operating Exposure ...................286
Illustrating Operating Exposure: T rident........ 288

PART 4
FINANCING THE GLOBAL FIRM
CHAPTER 12
The Global Cost and Availability of Capital

III
338

Global Cost and Availability of C apital.......... 339
Weighted Average Cost of C apital.................. 341

xvi

Contents

The Demand for Foreign Securities: The Role
of International Portfolio Investors............ 347
Global Finance in Practice 12.1
Market Liquidity........................................... 348
Illustrative Case: Novo Industri A/S (Novo).. .352
The Cost of Capital for MNEs
Compared to Domestic F irm s .....................358
Global Finance in Practice 12.2
Bang & Olufsen and Philips N.V. ...................359

CHAPTER 14
Financial Structure and International Debt

400

Optimal Financial Structure............................401
Optimal Financial Structure and the MNE . . . 402
Financial Structure of Foreign Subsidiaries . . . 406
Global Finance in Practice 14.1
Equity Carve-Outs ..........................................407
International Debt Markets............................... 410
Global Finance in Practice 14.2
Pricing and Structure of a
Syndicated Eurocredit................................... 412

Solving a Riddle: Is the Weighted Average
Cost of Capital for MNEs Really Higher
Than for Their Domestic Counterparts? . . . 361

Project Financing..............................................416

MINI-CASE
Petrobräs of Brazil and the Cost of Capital .. 363

Global Finance in Practice 14.3
Islamic Finance..............................................417

MINi-CASE APPENDIX ................................... 366

Global Finance in Practice 14.4
Project Finance B oom ................................... 419

Summary of Learning Objectives.......................367
Questions 368 • Problems 369 * Internet Exercises 373

CHAPTER 13
Sourcing Equity Globally

374

Designing a Strategy to Source
Equity G lobally........................................... 376
Global Finance in Practice 13.1
How Big Is Your Share Price?.........................379
Foreign Equity Listing and Issuance...............380

Global Finance in Practice 13.2
Demutualisation, Diversification,
and Globalisation................................... ..... 382
Global Finance in Practice 13.3
The Chicago Exchanges Merge .....................384
Effect of Cross-Listing and Equity Issuance
on Share Price ............................................. 385
Barriers to Cross-Listing and Selling
Equity A b ro ad ............................................. 387
Alternative Instruments to Source Equity
in Global Markets ........ ' .......................... .. 388
Global Finance in Practice 13.4
Equity Firms and Their Assets (billions) ........ 392
Global finance in Practice 13.5
Private Equity in Argentina and
the Argentine Crisis..................................... 393
MINI-CASE
Rosneft’s initial Ptibik Offering.......... ..........393

MIMI-CASE
Tirstrup BioMechanics (Denmark):
Raising Dollar D ebt....................................... 419
Summary of Learning Objectives.......................421
Questions 422 • Problems 423 • Internet Exercises 425

CHAPTER 15
Interest Rate and Currency Swaps

426

Defining Interest Rate Risk ............................. 427
Management of Interest Rate R isk ...................430
Global Finance in Practice 15.1
interest Rate Derivatives—
Booming in 2 0 0 7 ............................................432
Global Finance in Practice 15.2
A Floating-Rate World of Debt .....................433
Trident Corporation: Swapping
to Fixed Rates ................................... ..........440
Currency Swaps ................................................441
Trident Corporation: Swapping
Floating Dollars into Fixed Rate
Swiss Francs ................................................442
Counterparty R isk ..............................................444
Illustrative Case: A Three-Way
Back-to-Back Cross-Currency Swap . . . . . . 445
MiNI-CASE
McDonald’s Corporation’s British
Pound Exposure ............................................446

Summary of Learning Objectives........ ..............396

Summary of Learning Objectives.......................447

Questions 397 •Problems 397 •Internet Exercises 399

Questions 448 •Problems 448 •Internet Exercises 450


Contents

PART 5

INTERNATIONAL
INVESTMENT DECISIONS

#51

CHAPTER 16
International Portfolio Theory

454

and Diversification

xvii

Assessing Political R is k ................................... 503
Firm-Specific Risks ..........................................506
Country-Specific Risks: Transfer R isk .............509
Country-Specific Risks: Cultural
and Institutional R isk s................................. 513
Global Finance in Practice 18.1
Zimbabwe’s Disposable Currency ................. 515

International Diversification and R is k .............455

Global-Specific R isks........................................518

Global Finance in Practice 16.1

Global Finance in Practice 18.2
Enron International in India .........................519

Should Fund Managers Hedge Currency Risk? 459

Internationalizing the Domestic Portfolio ___ 459
National Markets and Asset Perform ance___ 464
Global Finance in Practice 16.2
Equity Market Crises in the
Twentieth Century .......... \ .......................... 466
m iii-c iis g

:

Strategic Currency Hedging..............................470

Summary of Learning O bjectives........................ 472
Questions 473 •Problems 474 •Internet Exercises 475

Global Finance in Practice 18.3
International Supply chain Security:
Time Is Money................................................522
Global Finance in Practice 18.4
Starbucks Coffee and Corporate
Social Responsibility..................................... 524
MINI-CASE
Mattel's Chinese Sourcing Crisis of 2 0 0 7 -----525
Summary of Learning Objectives....................... 528
Questions 528 • Internet Exercises 530

CHAPTER 17
Foreign Direct Investment Theory and Strategy 477

Sustaining and Transferring
Competitive A dvantage............................... 478
The OLI Paradigm and Internalization ...........481
Deciding Where to Invest................................. 483
How to Invest Abroad: Modes of Foreign
Involvement.................................................. 485
Global Finance in Practice 17.1
Keeping it in the Family: American Exports
to and imports from American-Owned
Affiliates Abroad (Billions of US$) .............486
Foreign Direct Investment Originating in
Developing Countries ................................. 489
Global Finance in Practice 17.2
Haier Builds Brands ........................................491
Global Finance in Practice 17.3
Embraer of Brazil ............................................491
M IN I-CASE

The GM-AvtoVAZ Joint Venture.....................492
Summary of Learning Objectives ....................... 498
Questions 498 * Internet Exercises 499
CHAPTER 18
Political Risk Assessment and M anagem ent

501

Defining Political Risk ......................................502

CHAPTER 19
M ultinational Capital Budgeting

531

Complexities of Budgeting for a
Foreign Project..............................................533
Project versus Parent Valuation .......................534
Illustrative Case: Cemex Enters Indonesia . . . 535
Global Finance in Practice 19.1
Prospecting for Riches in the Tax Code ........ 546
Real Option A n aly sis........................................549
MINI-CASE
Trident’s Chinese Market Entry—
An Application of Real Option Analysis . . . . . 550
Summary of Learning Objectives.......................552
Questions 553 • Problems 554 • Internet Exercises 557

PART 6
MANAGING MULTINATIONAL
OPERATIONS

559

CHAPTER 20
International Trade Finance

560

The Trade Relationship ....................................561
The Trade D ilem m a.......... ...............................563
Benefits o f the S ystem ......................................564
Letter of Credit (L/C) ........................................ 566


xvîîi

Contents

Draft
....................................................
568
Bill of Lading (B/L) ......................................... 570
Example: Documentation in a
Typical Trade Transaction........................... 571

M INI-CASE •

Stanley Works and Corporate Inversion........ 604
Summary of Learning Objectives........................ 608
Questions 608 •Problems 609 •Internet Exercises 611

Global Finance in Practice 20.1
The Resurgence of Transaction Banking
and Letters of C re d it ..................................... 573

Government Programs to Help
Finance E xports............................................573

Trade Financing Alternatives........................... 574
Global Finance in Practice 20.2
Tunisian Private Equity and Factoring........... 577

Forfaiting: Medium- and
Long-Term Financing ................................. 578
M iN i-C A SE

Crossweil international's Precious
Ultra-Thin Diapers......................................... 580
Summary of Learning Objectives ........................ 583
Questions 584 •Problems 585 •Internet Exercises 587

Working Capital M anagem ent

612

Trident Brazil’s Operating C y c le .....................614
Trident’s Repositioning D ecisions................... 615
Constraints on Repositioning Funds ...............617
Global Finance in Practice 22.1
P&G’s Acquisition and Financial
Management in In d ia ................................... 617
Conduits for Moving Funds by
Unbundling Them ....................................... 618
International Dividend Remittances.................619
Net Working C apital..........................................621
International Cash Management...................... 627
Financing Working Capital............................... 633
M IN I-CA SE

CH A PTER 21
Multinational Tax Managem ent

CH APTER 22

Honeywell and Pakistan
international Airways ................................... 636

588

Tax Principles....................................................590
Global Finance in Practice 21.1
Should the United States Cut

Summary of Learning Objectives ........................ 638
Questions 639 •Problems 641 •Internet Exercises 644

Corporate Taxes? ........................................... 595

Transfer Pricing ................................................598
Tax Haven Subsidiaries and International
Offshore Financial Centers .........................602
Global Finance in Practice 21.2
The Activities of Offshore
Financial Centers............................................... 603

Answers to Selected
End-of-Chapter Problems

A-i

Glossary

G-i

Index

l-i


Globalization and the

Ente rprise

rinar.ciai Goals and Corporate Ccvernanc c.

The internatioflal /Vionetaa* System

The Balance of Payments

The Foreign Exchange Market


Globalization
and the Multinational
Enterprise
LEARNING O B J E C T IV E S
Examine the requirements for the creation of value
Consider the basic theory, com parative advantage, and its requirements for the

explanation and justification for international trade and commerce
-

Discover what is different about international financial m anagement
Detail which market imperfections give rise to the m ultinational enterprise

- -Consider how the globalization process moves a business from a p jre ly domestic
focus in its financial relationships and composition to one truly global In scope
■- Examine possible causes to the lim itations to globalization in finance-

MI NI-CASE

INTRODUCTION

Porsche Changes Tack
A fter reading this chapter, you will be able to debate the question posed by this chap­
ter’s main mini-case entitled Porsche Changes Tack—whether Porsche’s new strategy
will increase or decrease its returns to its shareholders.
Porsche’s financial results—including returns to shareholders— had been the envy of the
automobile industry for a decade. It was indeed the world’s most profitable automobile com­
pany Porsche's CEO, Dr. Wendelin Wiedeking, had been credited with clarity of purpose and


Chapter i: Globalization and the Multinational Enterprise

3

sureness of execution. As one colleague described him: “He grew up PSD: poor, smart, and :
driven.” He was now rich, smart, and riding.
Porsche’s strategy had been unique among high-end European automakers. Ii had cho- i

sen to remain largely Germany-based (or more accurately European-based). Unlike Mercedes
or BMW, it had chosen not to build manufacturing facilities in its largest single market, the
United States. Instead, it maintained all manufacturing and assembly in Europe, but did so :
with corporate partners in different ways. The Boxster, what some called the "poor man's
Porsche," was manufactured by Va Imet of Finland under an outsourced manufacturing agree­
ment. The Porsche Cayenne, the $80,000 sport utility vehicle, was largely assembled on the
Volkswagen Touareg assembly line in Bratislava in the Slovak Republic. Porsche had achieved
some of the highest returns on invested capital in the auto industry by using other people’s
But Porsche had just announced two strategic initiatives, wh'ch seemingly were a com­
pletely new competitive direction. It would begin the design and development of a fourth
auto model, the Panamera, but would do so completely in-house, using its own money and
own facilities. Simultaneously, it shocked the markets by spending more than €3 billion to
acquire a controlling interest in whal was considered one of Europe’s worst automobile com­
panies—Volkswagen. Shareholders and analysts alike were aghast. What was this company

To check your understanding, read the chapter and the mini-case in its entirety
(the complete mini-case is located toward the end of this chapter), and then answer the
case questions at the end.

his book is about international financial management with special emphasis on
the multinational enterprise. The multinational enterprise (MNE) is defined as
one that has operating subsidiaries, branches, or affiliates located in foreign coun­
tries. It also includes firms in service activities such as consulting, accounting, con­
struction, legal, advertising, entertainm ent, banking, telecommunications, and lodging.
MNEs are globally headquartered. Many of them are owned by a mixture of
domestic and foreign shareholders. The ownership of some firms is so dispersed inter­
nationally that they are known as transnational corporations. The transnationals are
usually managed from a global perspective rather than from the perspective of any sin­
gle country.
Although Fundamentals o f Multinational Finance emphasizes MNEs, purely

domestic firms also often have significant international activities. These include the
import and export of products, components, and services. Domestic firms can also
license foreign firms to conduct their foreign business. They have exposure to foreign
competition in their domestic m arket. They also have indirect exposure to interna­
tional risks through their relationships with customers and suppliers. Therefore,
domestic firm managers need to understand international financial risk, especially
those related to foreign exchange rates and the credit risks related to trade payments.
Fundamentals o f Multinational Finance is written in English and usually uses the
U.S. dollar in its exposition. However, the authors have tried to m ake it relevant for all

T


4

PART 1

Î

Global Financial Environment

multinational enterprises by using numerous non-U.S.-based MNEs. We will use the
term multinational enterprise (MNE) throughout this text for two very im portant rea­
sons. First, the term multinational is used rather than international because we will
focus on the third phase of the globalization process in which firms operate businesses
in many different countries. Second, we use the term enterprise instead o f corporation
because as businesses move into many emerging markets, they will enter into joint ven­
tures, strategic alliances, or simply operating agreements with enterprises that may not
be publicly traded or even privately owned (and therefore not corporations), but actu­
ally extensions of government.

Globalization and Creating Value
in the Multinational Enterprise
“I define globalization as producing where it is most cost-effective, selling where it is
most profitable, and sourcing capital where it is cheapest, without worrying about
national boundaries.”
—Narayana Murthy, President and CEO, Infosys
Global business, like any business, is the social science of managing people to organize,
maintain, and grow the collective productivity toward accomplishing productive goals,
typically to generate profit and value for its owners and stakeholders. Reaching that
goal—building firm value—requires combining three critical elements: 1 ) an open mar­
ketplace; 2) high quality strategic management; and 3) access to capital. As shown in
Exhibit 1.1, any MNE attempting to create value would need to combine these three
critical elements composing the sides of the firm value pyramid.
fJCHIBfT 1.Î
Creating Firm Value in Global Markets

Building
Firm Value

faillie

Level (II

Econom ie;

Pac dly C,'ev<=:opin't

Le-vi ([

Cour-tf-es

Emerging '‘■Aaikc.T Counrries

Level I

Access to

Capital
Strategic
Management

Open
Marketplace

The challenge to building firm value—value for all stakeholders including stockholders,
corporate stakeholders, and social community— is in the expansion and development
of all three sides of the global pyramid: an open marketplace; access to
affordable capital-, and high-quality strategic management.


Chapter i: Globalization and the Multinational Enterprise

5

An Open Marketplace
M arket economics is the fundamental condition for value creation. The MNE has little
opportunity to thrive and grow if it is not operating within a marketplace that allows
free movement and competition of labor, capital, technology, and the spirits of innova­
tion and entrepreneurship. The rapid economic development of China, and the many

businesses arising within China today, are ready examples of the power of the increas­
ingly open marketplace. There are, however, many complexities to fostering healthy
m arket economics in any country, and many countries have yet to find the magical mix.

Strategic Management
Although the ability to compete in a m arketplace is a requirement, the ability to see
business opportunities, and then to design, develop, and execute a corporate strategy
through all levels of leadership and management is needed to create value. Although
the basic elements of innovation and entrepreneurship are probably embedded in the
human DNA, good strategy and m anagement are not. Yet insightful strategy and
adept leadership is critical to creating value. It is not something that has yet been
quantified or captured; as any business student knows, if computers could do it, they
wouldn’t hire you.

Access to Capital
Open markets and insightful leadership is all for nought, however, if the MNE cannot
gain ready access to affordable capital. It is the capital that allows the investment
needed to obtain the technology, execute the strategy, and expand across global m ar­
kets. It is the “capital” in capitalism; it is the ability of the enterprise to reach out and
obtain resources from outside of the firm to pursue the firm’s vision and create the
value for all of the key stakeholders in the enterprise itself, and subsequently for the
community and society of which it is an integral element.
The level of development of these three combined elements, Levels I—III shown in
Exhibit 1.1, is representative of the degrees of depth, breadth, and sophistication acces­
sible by the MNE. For example:
® General Electric (USA) may be considered a resident of Level III. It is a global
MNE with widely recognized strategic leadership and management quality, ready
access to cheap and plentiful capital, and a key competitor in the most competitive
and open m arketplaces in the world.
• Cemex (Mexico) may be an example of a resident of Level II. A rapidly growing

competitor in its global industry, it is based in Mexico, which is rapidly emerging as
a market economy of nearly limitless potential. Yet Cemex is still sometimes ham ­
pered in its access to ready and affordable capital to support its business goals.
• The Haier Group (China) may be representative of an MNE resident in Level I of
the value pyramid. Although highly successful and an MNE to be reckoned with
in a growing number of marketplaces, H aier is still struggling to overcome barri­
ers and limitations of all three critical elements from its Chinese base.
As described in Global Finance in Practice 1.1, the evolution of the domestic company
to multinational and “a-national” is generating significant benefits for all stakeholders.
These three firms are residents of the pyramid. Their positions in the pyramid are
the result of the complex interaction of the three key elements—the three sides of the
pyram id—with the level of economic development and openness of the countries


PART 1

Global Financial Environment

¡lobal Finance In Practice 1.1
Jational Multinational or'A-National'?
/hen Isaac Merritt Singer set up a branch of his against America’s largest trading partners over the
sewing machine maker in Paris in 1855, he probably past seven years, making it easierfor US exporters to
jr did not think he was blazing a trail US companies sell to the world and boosting the dollar value of
? would still be following more than 150 years later. overseas earnings. Second, US multinationals have
been boosted by global economic growth, which has
Singer's expansion in France turned the New York: based company into the first US multinational, pio- largely been driven by emerging markets hungry for
i:
neering a business model that would be adopted by infrastructure and consumer goods—two of America
1 ;i
other icons of American capitalism, from Ford to Inc’s strongest suits.

But even if economic changes and internal revolu­
tandard Oil to General Electric. But perhaps the
lost important legacy of Singer’s daring move was tions at companies mean, in the words of Steve Mills,
nat it worked: within six years of the French open- head of IBM’s global software business, that “things
i - ing, foreign sales had exceeded US revenues. It is a cannot go back to the way they were”, will more com­
panies abandon national allegiance and become
lesson not lost on today's corporate leaders.
Over the past three months, blue-chips such as truly "a-national”? “Big Blue”—as IBM is known—
t 3 _ General Electric, the conglomerate, IBM,the technol- claims to be just that, with operations in more than
>gy giant, and UPS, the logistics group, have hitched 150 countries and key functions spread around the
ride on a global economy growing faster than the world. Its head of procurement, for example, is based
S.
By contrast, companies that depend on domesticin Shenzhen, China, half a world away from Mr
Palmisano’s headquarters in Armonk, New York.
; consumers such as Wal-Mart, the retail bell-wether,
ind Home Depot, the do-it-yourself chain, have “Ours is a boundary-less way of thinking,” says Mr
released disappointing results and gloomy predic­ Mills.
However, many US chief executives regard such
tions.
moves as impractical, if not outright dangerous.They
But if foreign earnings have helped US multinas - tionals stave off a fall in profitability, the question is argue that being rooted in the US is not only an
insurance policy in case the globalisation tide turns,
.vhether the current reliance on the rest of the world
but also a way of maintaining order and focus in
; just a cyclical phase or the harbinger of a transfor*
mation in corporate America. Could the importance increasingly complex and dispersed enterprises—of
f overseas markets destroy—as Sam Palmisano,
letting everybody know where the buck stops and
. IBM’s chief executive, has argued—the old multina- who is in charge. Jeffrey Immelt, who heads GE, one
of the most "global” companies in the US, recently

3
tional model whereby companies decentralised
nanufacturing and sales operations but kept key distilled this view: "We're an American company but
in order to be successful we've got to win in every
unctions such as the executive office, research and
iproduct design in the "home country”? And if so, are corner of the world. "In other words, global aspira­
Jsome US companies ready to become truly "transna- tions tinged with national pride—which Singer
£ tional” by scattering their top executives around the would have understood—is just as recognisable
-world?
today among US business leaders.
At first sight, there are significant cyclical forces
Ifcehind the recent rise of US multinationals—forces,
Source-. Excerpted from “US Companies Choose: National
||h other words, that could change in the near future. Multinational or 'A-National'?," Francesco Guerrera, Financial Times,
First, the dollar has lost nearly a third of its value August 16,2007, p. 7.

of their business activities. The Porsche mini-case at the end of the chapter will chal­
lenge the reader to determine where it might fall within the architecture of the value
pyramid.


Chapter 1: Globalization and the Multinational Enterprise

7

As we shall see throughout this book, the global economy is seeing an unprece­
dented growth in the resident MNEs in the value pyramid, and the size and shape of
the pyramid tomorrow is probably limitless. We now move to the underlying principle
driving the growth of the global business—comparative advantage.

The Theory of Comparative Advantage
The theory o f comparative advantage provides a basis for explaining and justifying
international trade in a model world assumed to enjoy free trade, perfect competition,
no uncertainty, costless information, and no government interference .1 The theory con­
tains the following features:
• Exporters in Country A sell goods or services to unrelated importers in Country B.
® Firms in Country A specialize in making products that can be produced relatively
efficiently, given Country A’s endowment of factors of production; that is, land,
labor, capital, and technology. Firms in Country B do likewise, given the factors of
production found in Country B. In this way the total combined output of A and B
is maximized.
® Because the factors of production cannot be moved freely from Country A to
Country B, the benefits of specialization are realized through international trade.
® The way the benefits of the extra production are shared depends on the terms of
trade, the ratio at which quantities of the physical goods are traded. Each country’s
share is determined by supply and demand in perfectly competitive m arkets in the
two countries. Neither Country A nor Country B is worse off than before trade,
and typically both are better off, albeit perhaps unequally.

An Example of Comparative Advantage
For an example of the benefits of free trade based on comparative advantage, assume
that Thailand is more efficient than Brazil at producing both sports shoes and stereo
equipment. With one unit of production (a mix of land, labor, capital, and technology),
efficient Thailand can produce either 12 shipping containers (ctrs) of shoes or 6 ship­
ping containers of stereo equipment. Brazil, being less efficient in both, can produce
only 10 containers of shoes or 2 containers of stereo equipment with one unit of input.
These production capabilities are as follows:
Production Capability

Containers of

sports shoes

Containers of
stereo equipment

Thailand has -i.ooo production units: 12 containers/unit

6 containers/unit

Brazil has 1,000 production units:

2 containers/unit

10 containers/unit

A production unit in Thailand has an absolute advantage over a production unit in
Brazil in both shoes and stereo equipment. Nevertheless, Thailand has a larger relative
advantage over Brazil in producing stereo equipment (6 to 2) than shoes (12 to 10). As
long as these ratios are unequal, comparative advantage exists.
theory of comparative advantage was first proposed by David Ricardo in Principles o f Political
Economy, 1817.


8

PART 1

I

Global Financial Environment

E X H IB IT 1.1

_

_

_

_

_

The Theory of Comparative Advantage: A Numerical Example of Brazil and Thailand
Production if No Trade
Shoe Produt tion (dis)
Thailand produces and consumed

-

^

Brazil produces and consumes
Total world production and consumption

Stereo Production (ctrs)

30 0 x12 = 3,600

7 0 0 x 6 = 4,200

30 0 x10 = 3,000

7 0 0 x 2 = 1,400

6,600

5,600 :

Shoe Production (ctrs)

Stereo Production (ctrs)
1,000 x 6 = 6,000 ;

Complete Specialization
tSrfandiproduces only stereo equipment
Brazil produces only shoes
ïSateliWOFld production and consumption

1,000 x 10 = 10,000
10,000

6,000 •

Assume that no trade takes place, and each country divides its own production
units between shoes and stereo equipment. Each country elects to allocate 300 pro­
duction units to shoes and 700 production units to stereo equipment, resulting in the
production and consumption outcomes in the top half of Exhibit 1.2.
Now assume complete specialization. Thailand produces only stereo equipment
and Brazil produces only shoes. World production would be higher for both shoes and

stereo equipment, as shown in the bottom half of Exhibit 1.2.
Clearly, the world in total is now better off because there are now 10,000 contain­
ers of shoes instead of just 6,600. A nd there are 6,000 containers of stereo equipm ent—
instead of just 5,600. But distribution is quite distorted. The Thais now tap bare feet to
their music, and the Brazilians dance during Carnival with good shoes but no recorded
music!
Trade can resolve this distribution problem. Assume initially that trade between
Thailand and Brazil takes place at the ratio of 2 containers of shoes for 1 container of
stereo equipment. This “exchange rate” of 2 containers of shoes for 1 container of stereo
equipment is Thailand’s “domestic” price; that is, the ratio of trade within Thailand
should it produce both items and not engage in international trade. Assume further that
Thailand exports 1,800 containers of stereo equipment to Brazil and imports 3,600 con­
tainers of shoes from Brazil. The situation would be as shown in Exhibit 1.3.
EX H IB IT 1.3

Trade at Thailand’s Domestic “Price”
For each container of stereo equipment exported, Thailand imports two containers of shoes from Brazil

iiteilandsproduces 6,000 containers of stereo
¿sqSpnaantiarod exports 1,800 containers
Brazil produces 10,000 containers of shoes and
exports 3,600 containers
é te ld p ro é action and consumption

Shoe Production
plus/minus trade (ctrs)

Stereo Production
plus/minus trade (ctrs)

o -t 3,600 -= 3,600

6,000 -1,800 = 4,200

10 ,0 0 0 -3,6 0 0 -6 ,4 0 0
10,000

0 + 1,800 = 1,800
6,000