Multinational Corporations (MNC's)
firms that engage in some form of international business
- Goal: Maximize shareholder wealth
Agency Problems
conflict of goals between a firm's managers and its shareholders
Agency Costs
costs of ensuring that managers maximize shareholder wealth (larger for multinational corporations due to difficulty of monitoring over long distances)
International Business Theories
1. Theory of Comparative Advantage
2. Imperfect Markets Theory
3. Product Cycle Theory
Theory of Comparative Advantage
countries specialize in certain products and rely on trade for others that they can't produce as efficiently (due to climate or other restrictions)
Imperfect Markets Theory
factors of production are somewhat immobile (costs and restrictions related to transfer of labor and other resources used for production)
- provides incentive to seek out foreign opportunity
Product Cycle Theory
- firms first become established in their home market as a result of some perceived advantage
- foreign demand accommodated by exporting and potentially moving production to foreign countries to reduce transportation costs
International Trade
- exporting to penetrate foreign markets
- importing to obtain material from low cost suppliers
Licensing
obligates a firm to provide its technology in exchange for fees or other benefits (Ex. Starbucks technology in trains)
Franchising
obligates a firm to provide a sales/service strategy, support assistance, and an initial investment in return for periodic fees
Acquisitions
acquiring other firms as a means of penetrating foreign markets (quickly obtain a large portion of foreign market share; subject to risk of substantial losses)
Establish Subsidiaries
establishing new operations in foreign countries to produce and sell their products (preferred to acquisitions because it is more tailored to firm's needs)
Direct Foreign Investment (DFI)
any method of increasing international business operations that requires a direct investment in foreign markets (DOES NOT include international trade and licensing)
Factors of International Risk/Uncertainty
1. International economic conditions
2. International political risk
3. Exchange rate risk
Effect of International Economic Conditions
weakened economic conditions causes income earned by consumers of foreign country to drop, which decreases sales and causes a reduction of firms cash flows in that country
Effect of International Political Risk
foreign government may increase taxes or impose trade barriers on imported goods, which would have a negative impact on a firm's cash flows
Effect of Exchange Rate Risk
if foreign currency of subsidiary weakens against the dollar, the MNC will receive a lower dollar amount cash flow for exports (opposite risk for imports: if foreign currency appreciates against the dollar, the MNC pays a larger cash outflow)
Balance of Payments
summary of transactions between domestic and foreign residents for a specific country over a specific period of time
Current Account
flow of funds between a country and all other countries due to PURCHASES of goods or services (IMPORTS; cash outflows)
Capital Account
flow of funds between a country and all other countries resulting from the SALE of assets (EXPORTS; cash inflows)
Trade Deficit
economic measure of a negative balance of payments/trade (IMPORTS > EXPORTS)
International Monetary Fund (IMF)
- promote cooperation among countries on international monetary issues
- stabilize exchange rates
- provide temporary funds for countries attempting to correct imbalances
- promote free trade
World Bank (IBRD)
makes loans to countries to enhance economic development (SAL- structural adjustment loans; long-term stability)
World Trade Organization (WTO)
provide forum for multinational trade negotiations and to settle trade disputes
International Financial Corporation (IFC)
promote private enterprise within countries (promote economic activity through the private sector)
Exchange Rate Systems classified by:
degree to which they are controlled by the government
Fixed Exchange Rate System
exchange rates are either held constant or allowed to fluctuate only within narrow boundaries (high degree of government intervention; devalue/revalue currency)
Bretton Woods (1944-1971)
each currency was valued in terms of gold (currencies were fixed relative to each other)
Smithsonian Agreement (1971-1973)
called for devaluation of US dollar against other currencies (<8%)
Advantages of Fixed Exchange Rate
no exchange rate movement risk (currency won't appreciate or depreciate over time)
Disadvantages of Fixed Exchange Rate
government might revalue or devalue currency
Freely Floating Exchange Rate System
exchange rate values are determined by market forces without government intervention (more insulated from inflation and unemployment problems)
Managed Float Exchange Rate System
(mostly exists today) exchange rates are allowed to fluctuate on a daily basis but governments can intervene when necessary to prevent their currency from moving too far in one direction
Pegged Exchange Rate System
home currency's value is pegged to one foreign currency or to an index of currencies (exchange rate with the dollar is fixed; currency moves against non-dollar currencies by the same degree as the dollar)
Eurozone
countries that participate in the euro
- eliminates foreign exchange transaction costs
- firms can easily determine where they can get products at lowest cost
Problems With Eurozone
prevents individual countries from solving local economic issues with its own monetary policy (unfavorable conditions in one Eurozone country can be transmitted over to other participating countries)
Goals of Government Intervention
- to smooth exchange rate movements
- to establish implicit exchange rate boundaries
- to respond to temporary disturbances
Direct Intervention (Force Depreciation)
flood the market" with dollars by exchanging dollar reserves for other foreign currencies (forces downward pressure on the dollar --> larger supply of dollars)
Direct Intervention (Force Appreciation)
exchange foreign currency reserves for dollars to lessen the amount of dollars available and force upward pressure on the dollar's value
Non-Sterilized Intervention
Fed intervenes in foreign exchange currency market without adjusting for the change in money supply
Sterilized Intervention
Fed intervenes in foreign exchange market and simultaneously engages in offsetting transactions in treasury securities market
Indirect Intervention
Fed influences factors that determine the dollars value including: relative inflation rates, relative interest rates, relative income levels, change in government controls, change in expectations of future interest rates
Demand for a Currency
*
DOWNWARD SLOPING
* American firm obtains British pounds in order to purchase British products (more pounds demanded at a lower dollar price; takes less dollars to obtain desired amount of pounds)
Supply for a Currency
*
UPWARD SLOPING
* British supply of pounds for sale (British firms supply more pounds when it is valued higher to exchange for a larger amount of dollars in order to buy more US products)
Factor Affecting Exchange Rate: Relative Inflation Rates
If US inflation goes up, consumers demand more British products/pounds (demand shifts up), and British firms are less attracted to supplying pounds to exchange for dollars (supply shifts down)
Factor Affecting Exchange Rate: Relative Interest Rates
If US interest rates go up, investors are more attracted to dollar investments rather than pounds (demand shifts down), and British firms supply more pounds to the market to exchange for dollars, since they can earn more (supply shifts up)
Factor Affecting Exchange Rate: Relative Income Levels
If US income levels go up, there is an increased demand for British products and pounds (demand shifts up), while supply of British pounds remains unchanged
Factor Affecting Exchange Rate: Government Controls
imposing foreign exchange and trade barriers, and buying/selling of currencies in foreign exchange market
Factor Affecting Exchange Rate: Future Expectations
news of potential inflation, economic performance/conditions, etc,
Carry Trade Steps
1. Borrow
2. Convert
3. Invest
4. Convert Back
5. Pay Loan
Foreign Exchange Market
allows for the exchange of one currency for another
Spot Market
immediate foreign exchange transactions (spot rate is the exchange rate that it is currently trading at)
Bid Quote
(BUY) commercial banks buy a currency at this price
Ask Quote
(SELL) banks sell to consumers/investors
Bid-Ask Spread
at any given time, the ask quote will be higher than the bid quote (difference/profit accommodates the costs incurred by banks in order to make exchange rate transactions)
Bid-Ask Spread Formula
(Ask Rate - Bid Rate) / Ask Rate
Direct Quotation
stated in terms of dollars (home currency); represents the value of a foreign currency in dollars ($1 = MP 90)
Indirect Quotation
reciprocal of corresponding direct quotation; stated in terms of foreign currency (how many dollars can buy a Mexican peso) ($0.011 = MP 1)
Cross-Exchange Rates
amount of one foreign currency per unit of another foreign currency (for two non-dollar currencies)
Cross Exchange Rate Formula
(Currency A / $) / (Currency B / $) = Cross Exchange Rate(Currency B in terms of Currency A)
Forward Contracts
agreement that specifies the currencies to be exchanged, the exchange rate (forward rate), and the date at which the transaction will occur (customized contracts)
Use of Forward Contracts
MNC's use forwards to hedge IMPORTS. That is, to lock in the rate at which they purchase goods
Currency Futures Contracts
specifies standard volume of a particular currency to be exchanged on a specific settlement date at the future exchange rate (standardized contracts)
Use of Currency Future Contracts
*
BUY CURRENCY FUTURES
* To hedge future payables (lock in purchasing rate of imports)
*
SELL CURRENCY FUTURES
* To hedge future receivables (lock in selling rate of exports)
Currency Options (Calls and Puts)
CALLS- right to buy a specific currency at a preset price (strike price) by the preset date *
HEDGE PAYABLES
*
PUTS- right to sell a specific currency at a preset price by the preset date *
HEDGE RECEIVABLES
*
Factors Affecting Currency Option Pricing
1. Difference between spot rate and exercise rate (St-X), (X-St)
2. Time to maturity (more time = higher option price)
3. Implied Volatility of currency (higher volatility = higher option price)