FINS3616 International Business Finance
Term T3 2020
Week 1 Reading Guide & Week 2 Tutorial Questions
Chapters 1, 2, 3: MNCs, International Monetary systems, and Exchange Rate
Determination
Week 2 Tutorial Questions
Chapter 1:
MNCs: Conceptual Question 2, 10
Appendix 1A: Question 3
Chapter 2:
Exchange Rate Changes: Conceptual Questions 1, 2, 3
Currency Appreciation/Depreciation: Problems 1, 2, 3, 4, 5
Chapter 3:
Exchange Rate Systems: Conceptual Question 1
Cross-Exchange Rates & Target-Zone Systems: Problems 1, 2
Chapter 1
Chapter 1, Question 2.
a. How does foreign competition limit the prices that domestic companies can charge and the
wages and benefits that workers can demand?
(Answer) As domestic producers raise their prices, customers begin substituting less expensive
goods and services supplied by foreign producers. The likelihood of losing sales limits the
prices that domestic firms can charge. Foreign competition also acts to limit the wages and
benefits that workers can demand. If workers demand more money, firms have two choices.
Acquiesce in these demands or fight them. Absent foreign competition, the cost of acquiescence
is relatively low, particularly if the industry is unionized. Since all firms will face the same
higher costs, they can cover these higher costs by all of them simultaneously raising their prices
without fear of being undercut or of being placed at a competitive disadvantage relative to their
peers. Foreign competition changes the picture since foreign firms' costs will be unaffected by
higher domestic wages and benefits. If domestic firms give in on wages and benefits, foreign
firms will underprice them in the market and take market share away. In this case, higher
domestic costs will put domestic firms at a disadvantage vis-à-vis their foreign competitors.
Recognizing this, domestic firms facing foreign competition are more likely to fight worker
demands for higher wages and benefits.
b. What political solutions can help companies and unions avoid the limitations imposed by
foreign competition?
(Answer) The classic political solution is protectionism. By limiting foreign competition, either
through tariffs or quotas, companies and workers limit the ability of foreign goods to restrain
domestic price increases. The government can also subsidize domestic firms in competing
against foreign firms. These subsidies allow domestic firms and unions to perpetuate
uneconomic work rules, wages, and productions processes.
c. Who pays for these political solutions? Explain.
(Answer) Consumers pay for protectionism in the form of higher prices for their goods and
service, fewer choices, and lower quality. These consumers include firms that use imports to
produce their own goods and services for sale. Taxpayers pay for subsidies in the form of higher
taxes or fewer of the other services provided by government.
Chapter 1, Question 10
10.
Is there any reason to believe that MNCs may be less risky than purely domestic firms? Explain.
ANSWER. Yes. International diversification may actually allow firms to reduce the total risk they face.
Much of the general market risk facing a company is related to the cyclical nature of the domestic
economy of the home country. Operating in a number of nations whose economic cycles are not
perfectly in phase may, therefore, reduce the overall variability of the firm's earnings. Thus, even though
the riskiness of operating in any one country may exceed the risk of operating in the United States (or
other home country), much of that risk is eliminated through diversification. In fact, as shown in Chapter
15, the variability of earnings appears to decline as firms become more internationally oriented.
Appendix 1A: Question 3
Given the resources available to them, countries A and B can produce the following combinations of
steel and corn.
Country A
Country B
Steel (tons)
Corn (bushels)
Steel (tons)
Corn (bushels)
36
0
54
0
30
3
45
9
24
6
36
18
18
9
27
27
15
12
18
36
6
15
9
45
0
18
0
54
a. Do you expect trade to take place between countries A and B? Why?
(Answer) Yes. Given the data presented, we can see that if country A has 6 units of resources
and it devotes X of these units to steel production, where X is an integer, it can produce a total
of 6X tons of steel and 3(6 - X) bushels of corn Similarly, with 54 units of resources, country
B of which it devotes Y units to steel production, it can produce Y tons of steel plus (54 - Y)
bushels of corn. The net effect of these production functions is that one bushel of corn is worth
2 tons of steel in country A. In contrast, one bushel of corn is worth only one ton of steel in
country B. These relative prices indicate that country A has a comparative advantage in the
production of steel, whereas B has a comparative advantage in the production of corn.
b. Which country will export steel? Which will export corn? Explain.
(Answer) Given these comparative advantages, A will export steel and B will export corn. The
price of corn will settle somewhere between one and two tons of steel. Suppose it settles at 1.5
tons of steel. Then, instead of producing, say, 30 tons of steel and 3 bushels of corn, it can
devote an additional resource unit to the production of an additional 6 tons of steel. It can trade
these 6 tons of steel with B for 6/1.5 = 4 bushels of corn, leaving it one bushel of corn better
off. Similarly, B can now get 6 tons of steel for the 4 bushels of corn it trades to A instead of
the 4 tons of steel it could produce on its own with the resources it took to produce the 4 bushels
of corn.
Chapter 2
Chapter 2, Question 1
1.
rates.
Describe how these three typical transactions should affect present and future exchange
a.
Joseph E. Seagram & Sons imports a year's supply of French champagne. Payment in euros
is due immediately.
ANSWER. The euro should appreciate relative to the dollar since demand for euros is rising.
b.
MCI sells a new stock issue to Alcatel, the French telecommunications company. Payment in
dollars is due immediately.
ANSWER. The spot value of the dollar should increase as Alcatel demands dollars to pay for the new
stock issue. The future value of the dollar should decline as dividend payments are sent to Alcatel and
other Alcatel equipment and parts are imported. However, the value of the dollar in the future could
increase if expanded MCI output substitutes for telecom imports.
c.
Korean Airlines buys five Boeing 747s. As part of the deal, Boeing arranges a loan to KAL
for the purchase amount from the U.S. Export Import Bank. The loan is to be paid back over the next
seven years with a two year grace period.
ANSWER. The spot price of the dollar should be unaffected. The future price of the dollar should
increase as KAL repays the loan.
Chapter 2, Question 2
2.
The maintenance of money's value is said to depend on the monetary authorities. What might
the monetary authorities do to a currency that would cause its value to drop?
ANSWER. The value of any good or asset is driven by its scarcity. What the monetary authorities
could do is to make money less scarce by issuing more of it. This would lower its scarcity value. Even
though its nominal value will always be the same, the added supply will reduce the purchasing power
per unit of money.
Chapter 2, Question 3
3.
For each of the following six scenarios, say whether the value of the dollar will appreciate,
depreciate, or remain the same relative to the Japanese yen. Explain each answer. Assume that
exchange rates are free to vary and that other factors are held constant.
a.
The growth rate of national income is higher in the United States than in Japan.
ANSWER. The value of the dollar should rise as more rapidly rising GNP in the United States leads
to a relative increase in demand for dollars.
b.
Inflation is higher in the U.S. than in Japan.
ANSWER. The value of the dollar should fall in line with purchasing power parity.
c.
Prices in Japan and the United States are rising at the same rate.
ANSWER. The exchange rate should remain the same.
d.
Real interest rates are higher in the United States than in Japan.
ANSWER. The value of the dollar should rise as the higher real rates attract capital from Japan that
must first be converted into dollars.
e.
The United States imposes new restrictions on the ability of foreigners to buy American
companies and real estate.
ANSWER. The value of the dollar should fall as foreigners find it less attractive to own U.S. assets.
f.
U.S. wages rise relative to Japanese wages, and American productivity falls behind Japanese
productivity.
ANSWER. Higher U.S. wages and declining relative productivity weaken the American economy and
make it less attractive for investment purposes. Assuming that a weak economy leads to a weak
currency, the dollar will fall. From a somewhat different perspective, when a nation's productivity
growth lags behind that of its major trading partners, the other countries will become more
depreciating currency is the market's way of restoring balance. The lagging country regains its
balance, but only by accepting a lower real price for its goods. In effect, the cheaper currency is the
market's way of cutting wages in the lagging country.
Chapter 2, Problem 1
1.
On August 8, 2000, Zimbabwe changed the value of the Zim dollar from Z$38/U.S.$ to
Z$50/U.S.$.
a.
What was the original U.S. dollar value of the Zim dollar? What is the new U.S. dollar value
of the Zim dollar?
ANSWER. The U.S. dollar value of the Zim dollar prior to devaluation was $0.0263 (1/38).
Subsequent to devaluation, the Zim dollar was worth $0.02 (1/50).
b.
By what percent has the Zim dollar devalued (revalued) relative to the U.S. dollar?
ANSWER. The U.S. dollar value of the Zim dollar has changed by (0.02 - 0.0263)/0.0263 = -24%.
Thus, the Zim dollar has devalued by 24% against the U.S. dollar.
c.
By what percent has the U.S. dollar appreciated (depreciated) relative to the Zim dollar?
ANSWER. The U.S. dollar has appreciated against the Zim dollar by an amount equal to (50 - 38)/38
= 31.58%.
Chapter 2, Problem 2
2.
In 1995, one dollar bought ¥80. In 2000, it bought about ¥110.
a.
What was the dollar value of the yen in 1995? What was the yen’s dollar value in 2000?
ANSWER. The dollar value of the yen in 1995 was $0.0125 (1/80). By 2000, the yen had fallen to
$0.00909.
b.
By what percent has the yen fallen in value between 1995 and 2000?
ANSWER. Between 1995 and 2000, the yen fell by 27.27%, calculated as (0.00909 - 0.0125)/0.0125.
c.
By what percent has the dollar risen in value between 1995 and 2000?
ANSWER. During this same period, the dollar appreciated by 37.5%, calculated as (110 - 80)/80.
Chapter 2, Problem 3
3.
On February 1, the euro is worth $0.8984. By May 1, it has moved to $0.9457.
a.
By how much has the euro appreciated or depreciated against the dollar over this 3-month
period?
ANSWER. Since the euro is now worth more in dollar terms, it has appreciated against the dollar. The
amount of euro appreciation is (0.9457 - 0.8984)/0.1984 = 5.27%.
b. By how much has the dollar appreciated or depreciated against the euro over this period?
ANSWER. The flip side of euro appreciation is dollar depreciation. The dollar has depreciated by an
amount equal to
1
1
0.9457 0.8984 = 0.8984 - 0.9457 = - 5.00%
1
0.9457
0.8984
Chapter 2, Problem 4
4.
In early August 2002 (the exact date is a state secret), North Korea reduced the official value
of the won from $0.465 to $0.0067. The black market value of the won at the time was $0.005.
a.
By what percent did the won devalue?
ANSWER.
Using Equation 2.1, the won devalued ($0.067-$0.465)/$0.465)=98.56%
Following the initial devaluation what further percentage devaluation would be necessary for the won
to equal its black market value?
ANSWER. 25.4%
Chapter 2, Problem 5
5.
On Friday, September 13, 1992, the lira was worth DM 0.0013065. Over the weekend, the
lira devalued against the DM to DM 0.0012613.
a.
By how much has the lira devalued against the DM?
ANSWER. Using Equation 2.1, the lira devalued by (0.0012613 - 0.0013065)/0.0013065, or -3.46%.
b.
By how much has the DM appreciated against the lira?
ANSWER. Using Equation 2.2, the DM appreciated against the lira by [(1/0.0012613) (1/0.0013065)]/(1/0.0013065), or 3.58%.
c.
Suppose Italy borrowed DM 4 billion, which it sold to prop up the lira. What were the Bank
of Italy's lira losses on this currency intervention?
ANSWER. Prior to devaluation, DM billion was worth Lit (4 billion/0.0013065). Following
devaluation, the DM 4 billion borrowing would cost Lit (4 billion/0.0012613) to repay. Hence, the
Italian government would lose Lit 4 billion x [(1/0.0012613) - (1/0.0013065)] = Lit 109,716,164344,
or DM 138,384,998 at the new exchange rate.
d.
Suppose Germany spent DM 24 billion in an attempt to defend the lira. What were the
Bundesbank's DM losses on this currency intervention?
ANSWER. The Bundesbank would have bought Lit 24 billion/0.0013065. Following lira devaluation,
these lira would be worth DM (24 billion/0.0013065) x 0.0012613, or DM 23,169,690,012. The result
is a foreign exchange loss for the Bundesbank of DM 830,309,988 on this currency intervention.
Chapter 3
Chapter 3, Question 1
1. a.
What are the five basic mechanisms for establishing exchange rates?
ANSWER. The five basic mechanisms for establishing exchange rates are free float, managed float,
target-zone arrangement, fixed-rate system, and the current hybrid system.
b.
How does each work?
ANSWER. In a free float, exchange rates are determined by the interaction of currency supplies and
demands. Under a system of managed floating, governments intervene actively in the foreign exchange
market to smooth out exchange rate fluctuations in order to reduce the economic uncertainty associated
with a free float.
Under a target-zone arrangement, countries adjust their national economic policies to maintain their
exchange rates within a specific margin around agreed-upon, fixed central exchange rates.
Under a fixed-rate system, such as the Bretton Woods system, governments are committed to
maintaining target exchange rates. Each central bank actively buys or sells its currency in the foreign
exchange market whenever its exchange rate threatens to deviate from its stated par value by more than
an agreed-on percentage.
Currently, the international monetary system is a hybrid system, with major currencies floating on a
managed basis, some currencies freely floating, and other currencies moving in and out of various types
of pegged exchange rate relationships.
c.
What costs and benefits are associated with each mechanism?
ANSWER. Benefits of a Floating Rate System. At the time floating rates were adopted in 1973,
proponents said that the new system would reduce economic volatility and facilitate free trade. In
particular, floating exchange rates would offset international differences in inflation rates so that trade,
wages, employment, and output would not have to adjust. High-inflation countries would see their
currencies depreciate, allowing their firms to stay competitive without having to cut wages or
employment. At the same time, currency appreciation would not place firms in low-inflation countries
at a competitive disadvantage. Real exchange rates would stabilize, even if permitted to float in
principle, because the underlying conditions affecting trade and the relative productivity of capital
would change only gradually; and if countries would coordinate their monetary policies to achieve a
convergence of inflation rates, then nominal exchange rates would also stabilize. Another benefit is
that–as Milton Friedman points out–with a floating exchange rate, there never has been a foreign
exchange crisis. The reason is simple: The floating rate absorbs the pressures that would otherwise build
up in countries that try to peg the exchange rate while simultaneously pursuing an independent monetary
policy. For example, the Asian currency crisis did not spill over to Australia and New Zealand because
the latter countries had floating exchange rates. A floating rate system can also act as a shock absorber
to cushion real economic shocks that change the equilibrium exchange rate.
Costs of a Floating Rate System. Many economists point to excessive volatility as a major cost of a
floating rate system. The experience to date is that the dollar's ups and downs have had little to do with
actual inflation and a lot to do with expectations of future government policies and economic conditions.
Put another way, real exchange rate volatility has increased, not decreased, since floating began. This
instability reflects, in part, nonmonetary (or real) shocks to the world economy, such as changing oil
prices and shifting competitiveness among countries, but these real shocks were not obviously greater
during the 1980s than they were in earlier periods. Instead, uncertainty over future government policies
has increased.
Benefits of a Managed Float. The potential benefit of a managed float is that governments can reduce
the volatility associated with a freely floating exchange rate.
Costs of a Managed Float. The costs of a managed float stem from the demonstrated inability of
governments to recognize the difference between a temporary exchange rate disequilibrium and a
permanent one. By trying to manage exchange rates when a permanent shift in the equilibrium exchange
rate has occurred, governments run the risk of creating an exchange rate crisis and wasting reserves.
Benefits of a Target Zone Arrangement. The experience with the European Monetary System is that
the target zone arrangement in effect forced convergence of monetary policy to that of the country–
Germany–with the most disciplined anti-inflation policy and led to low inflation.
Costs of a Target Zone Arrangement. Maintaining a genuinely stable target zone arrangement
requires the political will to direct fiscal and monetary policies at that goal and not at purely national
ones. This turns out to be difficult for countries to achieve. In the case of the European Monetary
System, the result was periodic currency crises. Another cost of this system is that fundamental changes
in the equilibrium exchange rate cannot get reflected in actual exchange rate changes without a currency
crisis occurring.
Benefits of a Fixed Rate System. A permanently fixed exchange rate system–such as that achieved by
a currency board, dollarization, or monetary union–results in currency stability and the absence of
currency crises. In a system such as existed under Bretton Woods, where there is a commitment to a
fixed exchange rate system, but no mechanism to bind that commitment, you will have more monetary
discipline than in a freely floating system and hence lower inflation than might otherwise be the case.
Costs of a Fixed Rate System. In a permanently fixed system, the exchange rate cannot cushion the
effects of real economic shocks, such as devaluation of a major competitor’s currency. Instead, prices
must adjust. Given the lack of flexibility of many prices–because of government regulations or union
restrictions–the result of these economic shocks can be higher unemployment and less economic
growth. In a system such as Bretton Woods, the result of changes in the equilibrium exchange rate will
likely be currency crises and eventual devaluation or revaluation.
Benefits of a Hybrid System. The current system gives countries the option to select the system that
best meets their needs. However, all too often, the decision is based on political rather than economic
calculations.
Costs of a Hybrid System. The costs of a hybrid system, such as the one currently in place, is that there
is no constraint on the choices that governments can make. The resulting choices can be good ones or
bad ones.
d.
Have exchange rate movements under the current system of managed floating been excessive?
Explain.
ANSWER. Excessive movements would indicate that there are profits to be earned by betting against
the market. In effect, if currency fluctuations are excessive they would exhibit the phenomenon of
overshooting (i.e., currency rates would overreact to economic events and then return to equilibrium).
There is no evidence that one could profit by betting that rate movements are excessive.
Chapter 3, Problem 1
1.
During the currency crisis of September 1992, the Bank of England borrowed DM 33 billion
from the Bundesbank when a pound was worth DM 2.78 or $1.912. It sold these DM in the foreign
exchange market for pounds in a futile attempt to prevent a devaluation of the pound. It repaid these
DM at the post-crisis rate of DM 2.50/GBP. By then, the USD/GBP exchange rate was USD1.782/GBP.
a.
By what percentage had the pound sterling devalued in the interim against the Deutsche mark?
Against the dollar?
ANSWER. During this period, the pound depreciated by 10.1% against the pound and by 6.8% against
the dollar.
(2.50 – 2.78) / 2.78 = -10.1%
(1.782 – 1.912) / 1.912 = -6.8%
b.
What was the cost of intervention to the Bank of England in pounds? In dollars?
ANSWER. The Bank of England borrowed DM 33 billion and must repay DM 33 billion. When it
borrowed these DM, the DM was worth £0.3597, valuing the loan at £11.87 billion (DM 33 billion x
0.3597). After devaluation, the DM was worth £0.4000. Hence, the Bank of England's cost of repaying
the DM loan was £13.20 billion (DM 33 billion x 0.4), a rise of £1.33 billion. Thus, the cost to the Bank
of England of this DM borrowing and intervention was £1.33 billion.
In dollar terms, intervention cost the Bank of England $825 million. This estimate is based on the
difference of $0.025 between the DM's initial value of $0.6878 (1.912/2.78) and its ending value of
$0.7128 (1/2.50) times the DM 33 billion borrowed and spent defending the pound. Specifically, the
cost calculation is $0.025 x 33,000,000,000 = $825 million.
Chapter 3, Problem 2
2.
Suppose the central rates within the ERM for the French franc and DM are FF 6.90403:ECU
1 and DM 2.05853:ECU 1, respectively.
a.
What is the cross-exchange rate between the franc and the mark?
ANSWER. Since things equal to the same thing are equal to each other, we have FF 6.90403 = DM
2.05853. Hence, FF1 = DM 2.05853/6.90403 = DM 0.298164. Equivalently, DM 1 = FF
6.90403/2.05853 = FF 3.35386.
b.
Under the original 2.25% margin on either side of the central rate, what were the approximate
upper and lower intervention limits for France and Germany?
ANSWER. Given the answer to part a, the French franc could rise to approximately DM 0.298164 x
1.0225 = DM 0.304872 or fall as far as DM 0.298164 x 0.9775 = DM 0.291455. Similarly, the upper
limit for the DM is FF 3.42933 and the lower limit is FF 3.27840.
c.
Under the revised 15% margin on either side of the central rate, what are the current
approximate upper and lower intervention limits for France and Germany?
ANSWER. Given the answer to part a, the French franc could rise to approximately DM 0.298164 x
1.15 = DM 0.342888 or fall as far as DM 2.98164 x 0.85 = DM 0.253439. Similarly, the upper limit for
the DM is FF 3.85694 and the lower limit is FF 2.85078.