July 23, 2007Discussion Section

Foreign Direct Investment; Political Economy of FDI; Foreign Exchange; International Monetary System

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Chapters 3,4,5,6 in a nutshell Review Chapters 7,8

◦ Discussion 1: Western automobile firms in Russia (time permitting)

Review Chapter 10, 11◦ Discussion 2: Chinese Currency Change

Q&A regarding the Midterm

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Chapter 3:◦ What is culture? What are the determinants of culture?

How does culture affect business? Chapter 4:

◦ What are ethical dilemmas? How do ethical dilemma’s arise? What are some of the standards used to evaluate ethics? Which ones are “straw men” arguments?

Chapter 5:◦ What are the theories that explain the observed pattern

of international trade? Chapter 6:

◦ What are some of the instruments that governments use to restrict trade? What are some political and economic justifications for trade intervention? Are these justifications “justified”? How has the world trading system developed?

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What is FDI? FDI in the world economy

◦ Trends; Direction of FDI; Source of FDI; Shift to Services

◦ Form of FDI Greenfield vs. Acquisitions and Mergers

Types of FDI◦ Horizontal FDI

Why undertake horizontal FDI? Transportation costs; market imperfections (internalization

theory: impediments to exporting, impediments to sale of know how); strategic behavior

◦ Vertical FDI Why undertake vertical FDI?

Strategic behavior; market imperfections (impediments to the sale of know how; investment in specialized assets)

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In 2003, inward FDI accounted for some 78% of gross fixed capital formation in Ireland, but only 0.6% in Japan. What do you think explains this differences in FDI flows into the two countries?

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Read the Management Focus on recent investments by Western automobile firms in Russia. Which theory best explains these investments? Why?

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Political Ideology and FDI◦ Radical View◦ Free Market View◦ Pragmatic Nationalism

What are the benefits of FDI to host countries?◦ Resource-transfer effects (capital, technology, know-how); Employment

effects; Balance-of-payment effects; Effect on competition and economic growth

What are the costs of FDI to host countries?◦ Adverse effect on competition; adverse effects on the balance of

payments; national sovereignty and autonomy What are the costs and benefits to home countries?

◦ Benefits: inward cash flow; employment effects; skills learned from abroad

◦ Costs: balance of payments; employment effects (outsourcing) What are some government regarding FDI?

◦ Home country: encourage some outward FDI; restrict some outward FDI◦ Host country: encourage some inward FDI; restrict other inward FDI

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Read the Country Focus on FDI in Ireland. How important has FDI been to the health of the Irish economy?

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Inward FDI is bad for (i) a developing economy and (ii) a developed economy and should be subjected to strict controls. Discuss.

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Firms should not be investing abroad when there is a need for investment to create jobs at home. Discuss.

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Do you think the successful conclusion of a multilateral agreement to liberalize regulations governing FDI will benefit the world economy? Why?

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What is the FOREX market for?◦ Currency conversion; insuring against foreign

exchange risk (using spot exchange, forward exchange, or currency swaps)

Arbitrage in FOREX markets Theories about how FOREX rates are

determined◦ Price and exchange rates: law of one price; purchasing

power parity; money supply and price inflation◦ Interest rates and exchange rates: Fisher Effect;

International Fisher Effect◦ Investor psychology and bandwagon effects

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For example, consider the US-based company ("Acme Tool & Die") that has raised money by issuing a Swiss Franc-denominated Eurobond with fixed semi-annual coupon payments of 6% on 100 million Swiss Francs. Upfront, the company receives 100 million Swiss Francs from the proceeds of the Eurobond issue (ignoring any transaction fees, etc.). They are using the Swiss Francs to fund their US operations.

[Why issue bonds in Swiss Francs? The only rationale for doing this is because there are investors with Swiss Franc funds who are looking to diversify their portfolios with US credits such as Acme's. They are willing to buy Acme's Eurobonds at a lower yield than Acme can issue bonds in the US. A Eurobond is any bond issued outside of the country in whose currency the bond is denominated.]

Because this issue is funding US-based operations, we know two things straightaway. Acme is going to have to convert the 100 million Swiss Francs into US dollars. And Acme would prefer to pay its liability for the coupon payments in US dollars every six months.

Acme can convert this Swiss Franc-denominated debt into a US dollar-like debt by entering into a currency swap with the First London Bank.

Acme agrees to exchange the 100 million Swiss Francs at inception into US dollars, receive the Swiss Franc coupon payments on the same dates as the coupon payments are due to Acme's Eurobond investors, pay US dollar coupon payments tied to a pre-set index and re-exchange the US dollar notional into Swiss Francs at maturity.

Acme's US operations generate US dollar cash flows that pay the US-dollar index payments. First London Bank make Swiss-Franc denominated payments. In essence, Acme and First London Bank have “swapped currencies”

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The interest rate on South Korean government securities with one-year maturity is 4% and the expected inflation rate is 2%. The interest rate on U.S. government securities with one-year maturity is 7%, and the expected rate of inflation is 5%. The current spot exchange rate for Korean won is $1 = W1,200. Forecast the spot exchange rate one year from today. Explain the logic of your answer

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Drawing on what we know about the Fisher effect, the real interest rate in both the US and South Korea is 2%. The international Fisher effect suggests that the exchange rate will change in an equal amount but in an opposite direction to the difference in nominal interest rates. Hence since the nominal interest rate is 3% higher in the US than in South Korea, the dollar should depreciate by 3% relative to the South Korean Won. Using the formula from the book: (S1 - S2)/S2 x 100 = i$ - iWon and substituting 7 for i$, 4 for iWon, and 1200 for S1, yields a value for S2 of $1=W1165.

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Two countries, Great Britain and the United States, produce just one good: beef. Suppose the price of beef in the United States is $2.80 per pound and in Britain it is ₤3.70 per pound.◦ According to PPP theory, what should the dollar/pound

spot exchange rate be?◦ Suppose the price of beef is expected to rise to $3.10

in the United States and to ₤4.65 in Britain. What should the one-year forward dollar/pound exchange rate be?

◦ Given your answers to parts a and b, and given that the current interest rate in the United States is 10%, what would you expect the current interest rate to be in Britain?

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(a) According to PPP, the $/£ rate should be 2.80/3.70, or .76$/£.

(b) According to PPP, the $/£ one year forward exchange rate should be 3.10/4.65, or .67$/£.

(c) Since the dollar is appreciating relative to the pound, and given the relationship of

the international Fisher effect, the British must have higher interest rates than the US. Using the formula (S1 - S2)/S2 x 100 = i£ - i$ we can solve the equation for i£, with S1=.76, S2=.67, I$ = 10, yielding a value of 23.4% for the British interest rates.

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You manufacture wine goblets. In mid-June you receive an order for 10,000 goblets from Japan. Payment of ¥400,000 is due in December. You expect the yen to rise from the present rate of $1 = ¥130 to $1 = ¥100 by December. You can borrow yen at 6% a year. What should you do?

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(1) The simplest solution would be to just wait until December, take the ¥400,000 and convert it at the spot rate at that time, which you assume will be $1=¥100. ◦ In this case you would have $4,000 in mid-December.

(2) Forward Contract◦ If the current 180-day forward rate is lower than 100¥/$, then a forward contract might be

preferable since it both locks in the rate at a better level and reduces risk. ◦ If the rate is above ¥100/$, then whether you choose to lock in the forward rate or wait and see

what the spot does will depend upon your risk aversion.

(3) Borrow Money◦ There is a third possibility also. You could borrow money from a bank that you will pay back

with the ¥400,000 you will receive (400,000/1.03 = ¥388,350 borrowed), convert this today to US$ (388,350/130 = $2,987), and then invest these dollars in a US account. For this to be preferable to the simplest solution, you would have to be able to make a lot of interest (4,000 - 2,987 = $1,013), which would turn out to be an annual rate of 51% ((1,013/4000) * 2). If, however, you could lock in these interest rates, then this method would also reduce any exchange rate risk. What you should do depends upon the interest rates available, the forward rates available, how large a risk you are willing to take, and how certain you feel that the spot rate in December will be ¥100 = $1.

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1. China, which has been under strong political pressure for some time to revalue its currency, has finally agreed to do just that, only in a very small way. Is this move by China a win for the U.S. or a win for China? What are the political implications of this action?

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2. Until now, China’s currency valuation has represented a significant subsidy to Chinese exporters, a situation that is seen in a negative light by American exporters. However, as a beneficiary of cheap goods made in China, how do you feel about the U.S.’ efforts to force China to raise its currency?

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3. After more than a decade, the value of the yuan has risen relative to the dollar. While the revaluation amounts to just a two percent difference at the moment, there is speculation that the Chinese will continue to allow the yuan to rise. What effect will this initial movement have on Chinese workers and consumers? What are the effects if the yuan continues is ascent?

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4. China’s revaluation of the yuan was echoed in other parts of Asia. For example, in India, the rupee appreciated, as did the Japanese yen. Consider the implications of further currency revaluations for the Asian region.

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Different exchange rate regimes:◦ Fixed◦ Floating: pegged; dirty float

Fixed versus Floating Exchange Rates◦ Why choose floating exchange rates?

Monetary policy autonomy Trade balance adjustments

◦ Why choose fixed exchange rates? Monetary discipline Speculation Uncertainty Trade Balance Adjustment

◦ Who is right?

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Debate the relative merits of fixed and floating exchange rate regimes. From the perspective of an international business, what are the most important criteria in a choice between the systems? Which system is the more desirable for an international business?

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Imagine that Canada, the United States, and Mexico decide to adopt a fixed exchange rate system. What would be the likely consequences of such a system for (a) international businesses and (b) the flow of trade and investment among the three countries?

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