Sixth Edition
INTERNATIONAL
FINANCIAL
MANAGEMENT
Jeff Madura | Roland Fox
Australia • Brazil • Canada • Mexico • Singapore • United Kingdom • United States
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International Financial Management,
6th Edition
US author: Jeff Madura
Adapting author: Roland Fox
© 2023, Cengage Learning EMEA
Adapted from International Financial Management, 14th Edition, by
Jeff Madura. Copyright © Cengage Learning, Inc., 2015, 2018. All Rights
Reserved.
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Jeff Madura:
To my mother Irene
Roland Fox:
To Marlene, Anna and Joe
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ABOUT THE AUTHORS
Jeff Madura is presently Emeritus Professor of Finance at Florida Atlantic University. He has w
­ ritten
several successful finance texts, including Financial Markets and Institutions (in its 13th edition). His
research on international ­finance has been published in numerous journals, including Journal of Financial
and Quantitative Analysis; Journal of Banking and Finance; Journal of Money, Credit and Banking;
Journal of International Money and Finance; Financial Management; Journal of Financial Research;
Financial Review; Journal of International Financial Markets, Institutions and Money; Global Finance
Journal; International Review of Financial Analysis and Journal of Multinational Financial Management.
Dr Madura has received multiple awards for excellence in teaching and research, and he has served as a
consultant for international banks, securities firms and other multinational corporations. He served as
a director for the Southern Finance Association and Eastern Finance Association, and he is also former
president of the Southern Finance Association.
Roland Fox graduated from Manchester University in Accounting and Finance and joined PwC. He
subsequently worked in the actuarial department of a multinational company and as a management
accountant for a multinational company, Invensys, before taking up a lecturing post. He was a Senior Lecturer
in Finance at Salford University and has published a number of papers on ­management accounting, finance
and education.
iv
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BRIEF CONTENTS
PART I The international financial
environment
1 Multinational financial management: an overview
1
2
2 International trade and investment: measurement and theories
29
3 International financial markets and portfolio investment
68
4 International ethical concerns: the Green movement, Islamic
finance and globalization
123
PART II Exchange rate behaviour
149
5 Exchange rate changes
150
6 Exchange rate history and the role of governments
172
7 Forecasting exchange rates
213
8 International arbitrage and covered interest rate parity
242
9 Relationships between inflation, interest rates and exchange rates
264
PART III Exchange rate risk
management
295
10 Measuring exposure to exchange rate fluctuations
296
11 Market insurance: currency derivatives
323
12 Non-market methods of transaction management
377
13 Economic and translation exposure management
414
PART IV Long-term asset and
liability management
437
14 Foreign direct investment
438
15 Country risk analysis
475
16 Long-term financing
499
PART V Short-term asset and
liability management
525
17 Financing international trade
526
18 Short-term financing
544
v
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vi
BRIEF CONTENTS
19
International cash management
563
20
Concluding comments
583
APPENDIX A: Answers to self-test questions
587
APPENDIX B: Statistics and project support
598
Glossary
610
Index
621
Online additional reading
1
Multinational restructuring
2
Multinational cost of capital and capital structure
3
Multinational capital budgeting
See the online resources.
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
CONTENTS
About the authors
Preface
PART I The international
financial environment
1 Multinational
financial management:
an overview
Understanding the context
Goal of the MNC
Conflicts with the MNC goal
Agency theory
External influences
Constraints interfering with the MNC’s goal
International business methods
International trade
Licensing
Franchising
Joint ventures
Acquisitions of existing operations
Establishing new foreign subsidiaries
Special Purpose Vehicles
Summary of methods
Exposure to international risk
Exposure to exchange rate movements
Exposure to foreign economies
Exposure to regulatory risk
Overview of an MNC’s cash flows
Host country MNC relationships
MNC valuation
Stock market valuation
Valuation in the accounts
Financial academic models
Organization of the text
Summary
Critical debate
Self test
Questions and exercises
Endnotes
iv
xiv
1
BLADES PLC CASE STUDY: Decision to
expand internationally
SMALL BUSINESS DILEMMA: Developing
a multinational sporting goods industry
2
13
13
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14
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21
22
23
23
23
25
27
2 International trade and investment:
29
measurement and theories
Balance of payments
2
3
3
3
7
9
10
10
10
11
11
11
12
12
26
Why the balance of payments balances
The IMF presentation of the balance of payments
Understanding the balance of payments
International trade and investment flows
Direction of trade
Trade and investment agreements
Trade disputes
Factors affecting international trade flows
Impact of inflation
Impact of national income
Impact of government restrictions
Impact of exchange rates on MNCs
The Marshall Lerner conditions*
Interaction of factors
Correcting a balance of trade deficit
Why a weak home currency is not a perfect
solution
International capital flows
Factors affecting foreign direct investment
Factors affecting international portfolio investment
Economic theories of international trade and
investment
Agencies that facilitate international flows
International Monetary Fund
World Bank
World Trade Organization
International Financial Corporation
International Development Association
Bank for International Settlements
Regional development agencies
BRICS
Summary
Critical debate
Self test
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vii
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viii
CONTENTS
Questions and exercises
Endnotes
BLADES PLC CASE STUDY: Exposure to
international flow of funds
SMALL BUSINESS DILEMMA: Developing
a multinational sporting goods industry
3 International financial markets
and portfolio investment
64
64
66
67
68
Functions of a financial market
69
Motives for using international financial markets 69
Motives for investing in foreign markets
Motives for providing credit in foreign markets
Motives for borrowing in foreign markets
Foreign exchange market
Foreign exchange transactions
Understanding the exchange rate
Currency pairs quote – standard notation
Avoiding currency conversion errors
Direct and indirect quotations
Currency futures and options markets
International money market
Origins and development
The rise of the Eurodollar
Central Bank Digital Currency (CBDC) and MNC
payments
Standardizing global bank regulations
International credit market
Syndicated loans
International bond market
Eurobond market
Development of other bond markets
Comparing interest rates between currencies
International stock markets
Issuance of foreign shares in the US
Issuance of shares in foreign markets
International financial markets and the MNC
Market efficiency and the efficient markets
hypothesis
Summary
Critical debate
Self test
Questions and exercises
Endnotes
BLADES PLC CASE STUDY: Decisions to
use international financial markets
SMALL BUSINESS DILEMMA: Developing
a multinational sporting goods industry
APPENDIX 3: Portfolio investment
4 International ethical concerns:
the Green movement, Islamic
finance and globalization
What are ethics?
The importance of ethical issues
69
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Poor regulation of markets
The Green movement
Islamic finance
The ethical arguments of capitalist interest
rates
Islamic finance principles
Prohibitions and encouraged practices
Islamic financial transactions
Globalization and its discontents
127
128
131
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135
135
136
Globalization
Discontent
Corporate Social Responsibility (CSR) and Socially
Responsible Investment (SRI)
138
International corporate governance
139
Corporate governance and outside parties
139
Differing control structures
140
Why do governance structures differ?
140
Summary
141
Critical debate
141
Self test
142
Questions and exercises
142
Endnotes
143
BLADES PLC CASE STUDY: Ethical debate
144
SMALL BUSINESS DILEMMA: Obtaining
finance
Part I: Integrative problem
Part I: Essays/discussion and academic
articles
PART II Exchange rate
behaviour
5 Exchange rate changes
Measuring exchange rate movements
Exchange rate movements – an overview
Demand for a currency
Supply of a currency for sale
Equilibrium
Factors that influence exchange rates
Relative inflation rates
Relative interest rates
Relative income levels
Government controls
Expectations
Speculation
Order flow models
Interaction of factors
Speculating on anticipated exchange rates
Summary
Critical debate
Self test
Questions and exercises
Endnotes
145
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153
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169
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CONTENTS
BLADES PLC CASE STUDY: Assessment
of future exchange rate movements
SMALL BUSINESS DILEMMA: Assessment
by the Sports Exports Company of factors
that affect the British pound’s value
6 Exchange rate
history and the role
of governments
Exchange rate systems
Fixed exchange rate system
Managed float exchange rate system
Pegged exchange rate system
Currency boards
Dollarization
Freely floating exchange rate system
The concept of an optimal currency area*
Classification of exchange rate arrangements
Government intervention – the process
Reasons for government intervention
Direct intervention
Indirect intervention
Exchange rate target zones
Intervention as a policy tool
Influence of a weak (relatively low value) home
currency on the economy
Influence of a strong home currency on the
economy
Balassa Samuelson effect
The law of comparative advantage?
The trilemma of government policy choice
A brief history of exchange rates
Summary
Critical debate
Self test
Questions and exercises
Endnotes
BLADES PLC CASE STUDY: Assessment of
government influence on exchange rates
SMALL BUSINESS DILEMMA: Assessment
of central bank intervention by the Sports
Exports Company
7 Forecasting exchange rates
Why firms forecast exchange rates
Forecasting techniques
Market efficiency
Technical forecasting
Fundamental forecasting
Market-based forecasting
Mixed forecasting
Forecasting services
Performance of forecasting services
Evaluation of forecast performance
Forecast accuracy over time
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230
Statistical test of forecasts – the de-trending
problem
Should MNCs make exchange rate forecasts?
Methods of forecasting exchange rate volatility
Summary
Critical debate
Self test
Questions and exercises
Endnotes
BLADES PLC CASE STUDY: Forecasting
exchange rates
SMALL BUSINESS DILEMMA: Exchange
rate forecasting by the Sports
Exports Company
8 International arbitrage and
covered interest rate parity
International arbitrage
Locational arbitrage
Triangular arbitrage
Covered interest arbitrage
Summary of arbitrage effects
Interest rate parity (IRP)
Derivation of interest rate parity
Determining the forward premium
The approximate relationship between forward
premium and interest rate differential
Graphic analysis of interest rate parity
Interpretation of interest rate parity
Does interest rate parity hold?
Considerations when assessing interest rate parity
Summary
Critical debate
Self test
Questions and exercises
Endnote
BLADES PLC CASE STUDY: Assessment
of potential arbitrage opportunities
SMALL BUSINESS DILEMMA: Assessment
of prevailing spot and forward rates by the
Sports Exports Company
9 Relationships between
inflation, interest rates and
exchange rates
Purchasing power parity (PPP)
Interpretations of purchasing power parity
Power parity theory – an informal approach
Derivation of purchasing power
parity – a more formal approach
Using PPP to estimate exchange rate effects
Graphic analysis of purchasing power parity
Testing the purchasing power parity theory
Why purchasing power parity does not occur
The real exchange rate
ix
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273
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x
CONTENTS
Purchasing power parity in the long and short run 275
Commodity currencies
277
International Fisher effect (IFE)
278
Relationship with purchasing power parity
278
Implications of the IFE for the foreign investment
market
279
Derivation of the international Fisher effect
281
Tests of the international Fisher effect
282
Comparison of the IRP, PPP and IFE theories 283
Summary
284
Critical debate
285
Self test
285
Questions and exercises
286
Endnotes
287
BLADES PLC CASE STUDY: Assessment
of purchasing power parity
SMALL BUSINESS DILEMMA: Assessment
of the IFE by the Sports Exports Company
APPENDIX 9*: Further notes on exchange rate
models
Part II: Integrative problem
Part II: Essays/discussion and academic
articles
PART III Exchange rate
risk management
288
289
290
293
294
295
10 Measuring exposure to exchange
296
rate fluctuations
Is exchange rate risk relevant?
Purchasing power parity argument
The investor/stakeholder hedge argument
Currency diversification argument
Creditor argument
The size argument
MNC response
Types of exposure
Transaction exposure
Estimating ‘net’ cash flows in each currency
Measuring the potential impact of the currency
exposure
Assessing transaction exposure based on
value-at-risk*
Economic exposure
Economic exposure of domestic firms
Measuring economic exposure
Translation exposure
Does translation exposure matter?
Determinants of translation exposure
Summary
Critical debate
Self test
297
297
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297
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298
298
299
299
299
301
306
309
311
311
315
316
316
318
318
318
Questions and exercises
BLADES PLC CASE STUDY: Assessment
of exchange rate exposure
SMALL BUSINESS DILEMMA: Assessment
of exchange rate exposure by the Sports
Exports Company
11 Market insurance: currency
derivatives
Overview
Forward market
How MNCs use forward contracts
Non-deliverable forward contracts
Currency futures market
Contract specifications
Trading futures
Pricing currency futures
How firms use currency futures
Currency swap market
Currency options market
Option exchanges
Over-the-counter market
Currency call options
Factors affecting currency call option premiums
How firms can use plain vanilla currency
call options
Speculating with currency call options
Further points
Currency put options
Factors affecting currency put option premiums
Hedging with currency put options
Speculating with currency put options
Contingency graphs for currency options
Contingency graphs for call options
Contingency graphs for put options
Lowering the cost of options: conditional
and barrier options and collars*
Conditional currency options
Barrier options
Collars
Option types
European and American currency options
Asian options
Options in emerging market economies
Cross-hedging
Financial management of derivatives for
non-financial companies
Summary
Critical debate
Self test
Questions and exercises
Endnotes
BLADES PLC CASE STUDY: Use of currency
derivative instruments
319
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369
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
CONTENTS
SMALL BUSINESS DILEMMA: Use of currency
futures and options by the Sports Exports
Company
370
APPENDIX 11A*: Currency option pricing
371
APPENDIX 11B: Currency option
combinations
373
12 Non-market methods of
transaction management
Transaction exposure
Identifying net transaction exposure
Non-market methods for reducing transaction
exposure
Market methods for reducing transaction
exposure
Futures hedge
Forward hedge
Currency option hedge
Comparison of hedging techniques
Hedging policies of MNCs
Limitations of hedging
Limitation of hedging an uncertain amount
Limitation of repeated short-term hedging
Hedging long-term transaction exposure
Long-term forward contract
Currency swap
Parallel loan
Borrowing policy
Cross-hedging
Summary
Critical debate
Self test
Questions and exercises
BLADES PLC CASE STUDY: Management of
transaction exposure
SMALL BUSINESS DILEMMA: Hedging
decisions by the Sports Exports Company
APPENDIX 12: Calculating the optimal size
of a cross-currency hedge: the hedge ratio
13 Economic and translation
exposure management
Economic exposure
377
378
378
378
383
384
384
387
389
397
398
398
399
400
401
401
402
402
402
403
403
404
404
410
411
412
Limitations of Silverton’s optimal hedging
strategy
Hedging exposure to fixed assets
Managing translation exposure
Limitations of hedging translation exposure
Summary
Critical debate
Self test
Questions and exercises
Endnote
BLADES PLC CASE STUDY: Assessment of
economic exposure
SMALL BUSINESS DILEMMA: Hedging the
Sports Exports Company’s economic
exposure to exchange rate risk
Part III: Integrative problem
Part III: Essays/discussion and academic
articles
415
Use of the income statement to assess economic
exposure
416
How restructuring can reduce economic exposure 418
Issues involved in the restructuring decision
420
A case study in hedging economic exposure
421
Silverton Ltd’s dilemma
422
Assessment of economic exposure
422
Assessment of each unit’s exposure
423
Identifying the source of the unit’s exposure
423
Possible strategies to hedge economic exposure 424
Silverton’s hedging solution
425
426
426
426
428
429
429
429
430
431
432
433
434
435
PART IV Long-term asset
and liability management
437
14 Foreign direct investment
438
The big picture
Investment appraisal – the modern approach
Net present value
Real options
Game theory and strategy
A combined view
Motives for foreign direct investment
Firm-specific advantages (ownership)
Internalization advantages
Country-specific advantages
Benefits of international diversification
Diversification analysis of international projects
Diversification among countries
Host government views of foreign direct
investment
The bargaining model
414
xi
Investment agreements
The Multilateral Agreement on Investment (MAI)
Subsidiary versus parent perspective
Tax differentials
Restricted remittances
Excessive remittances
Exchange rate movements
Summary of factors
Empirical studies
Internalization
Exchange rates
Taxes
Institutions
439
439
440
442
443
444
445
445
445
446
448
449
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452
453
455
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459
459
459
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460
461
461
461
461
462
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
xii
CONTENTS
Tariffs
Trade effects
Summary
Critical debate
Self test
Questions and exercises
Endnotes
BLADES PLC CASE STUDY: Consideration
of foreign direct investment
SMALL BUSINESS DILEMMA: Foreign direct
investment decision by the Sports Exports
Company
APPENDIX 14: Incorporating international
tax laws in the investment decision
15 Country risk analysis
Why country risk analysis is important
Political risk factors
Attitude of consumers in the host country
Actions of host government
Blockage of fund transfers
Currency inconvertibility
War
Bureaucracy
Corruption
Financial risk factors
Indicators of economic growth
Types of country risk assessment
Macroassessment of country risk
Microassessment of country risk
Techniques to assess country risk
Checklist approach
Delphi technique
Quantitative analysis
Inspection visits
Combination of techniques
Measuring country risk
Variation in methods of measuring country risk
Using the country risk rating for
decision-making
Comparing risk ratings among countries
Market approach to country risk rating
Incorporating country risk in capital
budgeting
Adjustment of the discount rate
Adjustment of the estimated cash flows
How country risk affects financial decisions
Reducing exposure to host government
takeovers
Use a short-term horizon
Rely on unique supplies or technology
Hire local labour
Borrow local funds
Purchase insurance
Summary
Critical debate
Self test
Questions and exercises
Endnotes
BLADES PLC CASE STUDY: Country risk
assessment
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SMALL BUSINESS DILEMMA: Country risk
analysis at the Sports Exports Company
16 Long-term financing
Long-term financing decision
Sources of equity
Sources of debt
Cost of debt financing
Measuring the cost of financing
Assessing the exchange rate risk of debt
financing
Use of exchange rate probabilities
Use of simulation
Reducing exchange rate risk
Offsetting cash inflows
Market methods
Currency swaps
Parallel loans
Diversifying among currencies
Interest rate risk from debt financing
The debt maturity decision
The fixed versus floating rate decision
Hedging with interest rate swaps
Plain vanilla swap
Project finance
Summary
Critical debate
Self test
Questions and exercises
BLADES PLC CASE STUDY: Use of long-term
foreign financing
SMALL BUSINESS DILEMMA: Long-term
financing decision by the Sports
Exports Company
Part IV: Integrative problem
Part IV: Essays/discussion and academic
articles
498
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511
512
515
516
516
517
517
519
520
521
523
PART V Short-term asset
and liability management
525
17 Financing international trade
526
Payment methods for international trade
Prepayment
Letters of credit (L/C)
Drafts
Consignment
Open account
Trade finance methods
Accounts receivable financing
Factoring
Letters of credit (L/C)
527
527
528
528
528
528
529
529
529
529
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CONTENTS
Banker’s acceptance
Working capital financing
Medium-term capital goods financing (forfaiting)
Countertrade
Government agencies for international trade
Summary
Critical debate
Self test
Questions and exercises
BLADES PLC CASE STUDY: Assessment
of international trade financing in Thailand
SMALL BUSINESS DILEMMA: Ensuring
payment for products exported by the
Sports Exports Company
18 Short-term financing
Sources of short-term financing
Euronotes
Euro-commercial paper
Eurobank loans
Trade credit
Internal financing by MNCs
Why MNCs consider foreign financing
Foreign financing to offset foreign currency
inflows
Foreign financing to reduce costs
Determining the effective financing rate
The variance of the rate divided into currency
and exchange rate movements*
Criteria considered for foreign financing
Interest rates
Interest rate parity (IRP)
Exchange rate variation
Term, roll over risk and regulatory risk
Exchange rate forecasts
Actual foreign financing
Financing with a portfolio of currencies
Summary
Critical debate
Self test
Questions and exercises
BLADES PLC CASE STUDY: Use of foreign
short-term financing
SMALL BUSINESS DILEMMA: Short-term
financing by the Sports Exports Company
19 International cash management
Cash flow analysis – subsidiary perspective
Subsidiary expenses
Subsidiary revenue
Subsidiary dividend payments
Subsidiary liquidity management
Centralized cash management
Techniques to optimize cash flows
533
536
537
537
538
539
539
540
540
Accelerating cash inflows
Minimizing currency conversion costs
Managing blocked funds
Managing intersubsidiary cash transfers
Complications in optimizing cash flow
Company-related characteristics
Government restrictions
Characteristics of banking systems
542
Investing excess cash
How to invest excess cash
Centralized cash management
Diversifying cash across currencies
Dynamic hedging
543
544
545
545
545
545
545
545
546
Summary
Critical debate
Self test
Questions and exercises
BLADES PLC CASE STUDY: International
cash management
SMALL BUSINESS DILEMMA: Cash
management at the Sports
Exports Company
Part V: Integrative problem
Part V: Essays/discussion and academic
articles
546
547
548
552
552
552
552
552
553
553
555
556
558
558
558
559
20 Concluding comments
The significance of international financial
management
Summary of the book
Advances
Remaining issues
Endnotes
xiii
565
565
567
567
567
570
570
571
571
571
571
571
572
572
574
574
575
575
576
576
578
579
580
582
583
584
584
584
585
586
APPENDIX A: Answers to self-test questions
587
APPENDIX B: Statistics and project support
598
Glossary
610
Index
621
561
562
563
564
564
564
564
Online additional reading
1
Multinational restructuring
2
Multinational cost of capital and capital structure
3
Multinational capital budgeting
See the online resources.
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PREFACE
Multinational corporations (MNCs) continue to expand their operations globally. They must not only be
properly managed to apply their comparative advantages in foreign countries, but they must also manage
their exposure to many forms and sources of risk. It can be said that all companies from large to SMEs
(small and medium-sized enterprises) are in some sense multinational, not least due to the internet. As
international conditions change, so do opportunities and risks. Those MNCs that are most capable of
responding to changes in the international financial environment will be rewarded. The same can be said
for today’s students who become the MNC managers of the future.
Lecturer notes
Textbook contribution
The role of this textbook is primarily to interest the reader in this very important topic not just by
informing and explaining but also by being critical and reflective. We try to explain the first steps in a
topic as simply as possible, and once that has been covered we move more quickly to the higher levels.
It is a learning curve after all. The topics range from the ethical issues in Chapter 4, to exotic options
in Chapter 11, to letters of credit in Chapter 17. Most modules would have to be selective. One of the
problems from experience is that for some, once they have grasped a theory or technical issue the rest
is seen as unimportant. We try to emphasize the shortcomings of theory and the failings of parametric
analysis in looking at topics such as market price behaviour. To be more persuasive in this regard we
encourage learners in the questions to go to the internet and analyze real data and review real reporting as
opposed to scenario-type questions which can appear rather too tidy in having an answer. These questions
have been highlighted with an icon and have appropriate links to the internet. The Blades Case Study and
the Small Business Dilemma further encourage learners to contrast theory and practice.
Allied to the textbook are PowerPoint slides including the exhibits from the book, an Instructor Manual,
and Discussion in the Boardroom as well as Running Your Own MNC activities. An additional test bank
offers additional multiple-choice questions for students to put their knowledge to the test.
Finally, our overall focus is on management and the multinational company, aware that for most readers
it is the use of finance that is important rather than the complexities of some of the formulae.
Sixth edition
This edition represents something of a completion of a style updating. Previous editions have stressed the
need to treat theory as no more than an attempt to discern what happens in practice, not to define practice.
We continue with that approach but this time fully extend the treatment to the questions. We have moved
the existing questions to the internet and replaced them with questions that more directly address the real
world. We ask the student to go on the internet and look at the real data. Creating frequency histograms
of 10 years’ worth of daily data is not a big task if shown the right free downloadable source and the basic
Excel commands. We do this. We hope it will excite students. Modern accounting and information systems
produce masses of information that need to be managed and interpreted using much the same skills as we
xiv
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PREFACE
xv
address here. To support this change, we have added a guide to relevant Excel commands and a note on
data presentation in Appendix B. The number of questions in each chapter has been limited to around 15
with the expectation that it is feasible, certainly at higher levels, for all questions to be answered.
There have also been a number of further changes to what has amounted to a considerable updating.
First, the level of difficulty is problematic for a text that supports both final year and postgraduate classes.
To be helpful, we have asterisked sections that we feel are more advanced. Second, we have updated events
and taken out some of the older examples leaving in those that have not been superseded. Third, some of
the longer explanations have been made shorter and more to the point, recognizing that textbooks are part
reference and part that uniquely ‘bigger space’ where issues can be considered in a more holistic manner
without being overlong. Finally, at the time of writing, interest rates have been very low. To avoid excessive
decimal places we have used higher rates in illustrations and similarly so for exchange rates.
We hope that these changes will keep the subject fresh and relevant to the big questions of the day
through the lens of MNCs and finance.
Acknowledgements
For the Europe, Middle East and Africa edition I would like to thank the reviewers for their sterling work
and encouraging comments. Marie Lebreton and Birgit Gruber of the publishing team at Cengage have
been very patient with me, so I thank them for that. The extensive changes in the sixth edition presented
a considerable logistical challenge which they carefully implemented. Colleagues at Salford University, in
particular Dr Rasol Eskandari, have been very supportive. Finally, I would like to thank my wife for her
tolerance in what is a time-consuming and absorbing process.
Roland Fox
The publisher would like to thank the following reviewers for their comments in this and previous
editions:
Hatem Akeel, University of Business and Technology, Saudi Arabia
Anup Chowdhury, Leeds Beckett University, UK
Adriana van Cruysen, Zuyd Hogeschool, the Netherlands
Dionysia Dionysiou, University of Stirling, UK
Seng Kiong Kok, RMIT University, Vietnam
Sammy Lio, United States International University-Africa, Kenya
István Magas, Corvinus University of Budapest, Hungary
Daniel Makina, UNISA, South Africa
Carl-Gustaf Malmström, SBS Swiss Business School, Switzerland
Peter Morrison, Abertay University Dundee, UK
Anh Nguyen, Université Catholique de Louvain, Belgium
Sven Nolte, Radboud University, the Netherlands
Jaume Bonet Pedrol, EADA Business School, Spain
Mohammad Arshad Rahman, Zayed University, UAE and Indian Institute of Technology Kanpur, India
Muhammad Azeem Qureshi, Oslo Metropolitan University, Norway
Kami Rwegasira, Maastricht School of Management, the Netherlands
Florinda Silva, University of Minho, Portugal
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xvi
PREFACE
Richard Kojo Tawiah, University of West Scotland, UK
Kai-Hong Tee, University of Loughborough, UK
Konstantinos Tolikas, Sheffield University Management School, UK
Dina Vasić, Zagreb School of Economics and Management, Croatia
The publisher would like to thank the following people who have contributed to the digital resources:
Adriana van Cruysen, Zuyd Hogeschool, the Netherlands
Katharina Felleitner-Goll, FH Technikum Wien, Austria
Anh Nguyen, Université Catholique de Louvain, Belgium
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PART I
The
international
financial
environment
We start with a look at the international environment as it affects a multinational corporation (MNC). Chapter 1 explains
the goals of the MNC along with the motives and risks of international business. Chapter 2 looks at how international
trade and investment are recorded in the balance of payments and the economic theories and practices relevant to
the economic effect of international trade. Chapter 3 describes the international financial markets and the theory and
practice of currency price movements. Chapter 4 addresses non-financial pressures that lead to regulatory changes
that can have a dramatic impact on MNCs. Together these chapters show how the economic and socio-political
environment affects MNCs.
Multinational
corporation (MNC)
Foreign exchange markets
Exporting and
importing
Foreign product markets
Imports
and exports
Dividend
remittance
and lending
Foreign
subsidiaries
Investing and
borrowing
International financial markets
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CHAPTER 1
Multinational
financial management:
an overview
LEARNING OBJECTIVES
The specific objectives of this chapter are to:
●●
Identify the main goal of the multinational corporation (MNC) and potential conflicts with that goal.
●●
Describe the key theories that seek to explain international business.
●●
Outline the common methods used to conduct international business.
Understanding the context
The main focus of this text is on the MNC and the effect of the international environment on financial management.
Where once it was thought that MNC referred only to large companies, the growth of the internet has meant that the
international dimension is now open to all businesses. Understanding the financial aspect of this environment and its
impact on pricing, investment and trade in goods and services is now a central part of finance.
The common view of multinational development is that initially, firms attempt to export products to a particular country
or import supplies from a foreign manufacturer. Over time, however, many recognize additional foreign opportunities
and eventually establish subsidiaries in foreign countries (foreign direct investment). Large European MNCs such as BP
plc (UK), Renault (France), Koninklijke Philips Electronics NV (the Netherlands) and many other firms have more than
half of their assets in foreign (non-euro) countries. Businesses such as Diageo (UK), ThyssenKrupp Group (Germany),
2
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CHAPTER 1 Multinational financial management: an overview
3
Alcatel (France), Tesco (UK) and adidas (Germany) commonly generate more than a third of their sales outside Europe.
In the Middle East, Forbes magazine in 2021 quoted the top 100 companies were making $670 billion in sales and
$148 billion in net profits. Not just oil companies and banking feature in the top 20 but also industrial, telecommunications,
logistics and construction. In Africa, the African Business Magazine quoted in 2021 the top 20 companies by capitalization
and country as South Africa (16), Morocco (2), and one each from Kenya and Egypt, their total market capitalization
being about $365 billion and ranging from technology, media and luxury goods to mining.
An understanding of international financial management is crucial not only for the largest MNCs with numerous foreign
subsidiaries but also for small and medium-sized enterprises (SMEs). Smaller firms often serve speciality markets where
they will not have to compete with large firms that could capitalize on economies of scale. While some SMEs have
established subsidiaries, many of them penetrate foreign markets through exports. In May 2018 Reuters reported that
‘Around 1,000 German Mittelstand (SME) firms have business ties to Iran and 1,340 firms have set up branches in the
country’; larger firms may feel more exposed to government control. International financial management is important
even to companies that have no international business because these companies must recognize how their foreign
competitors will be affected by movements in exchange rates, foreign interest rates, labour costs and inflation. Such
economic characteristics can affect the foreign competitors’ costs of production and pricing policies.
Companies must also recognize how domestic competitors that obtain foreign supplies or foreign financing will be
affected by economic conditions in foreign countries. If these domestic competitors are able to reduce their costs by
capitalizing on opportunities in international markets, they may be able to reduce their prices without reducing their
profit margins. This could allow them to increase market share at the expense of the purely domestic companies.
This chapter provides a background to the goals of an MNC and the potential risk and returns from engaging in
international business.
Goal of the MNC
The commonly accepted goal of an MNC is to maximize shareholder wealth. Some MNCs are former
state-owned companies where governments remain an important shareholder (e.g. Renault and Petro
China). Such companies seek stock market quotes to raise finance and therefore have to demonstrate by
means of the annual report and accounts that they are maximizing shareholder wealth in the same way as
a wholly privately owned company. Such companies may benefit more from government support, but in
all other respects there is little to suggest that they are in any way different from other MNCs.
Shareholder influence is another major difference between MNCs. Continental Europe has what
has been termed the blockholder system consisting of fewer, larger stakeholders in companies with
an emphasis on corporate governance laws that seek to protect creditors and employees. The UK–US
market-based approach has far more dispersed ownership and much greater emphasis on shareholders’
rights.1 In offering greater non-shareholder participation, the Continental system in theory gives greater
emphasis to long-term profitability as shareholders have the shortest time horizon: they want returns
in one or two years, whereas employees’ and governments’ interests are long term. In a questionnaire
survey of UK, Dutch, French and German respondents, Brouenen et al.2 found that customers, employees
and management were all rated more highly than shareholders; the German respondents even rated their
suppliers as more important and the French respondents gave a higher ranking to the general public!
Surveys have to be treated with caution; all respondents would recognize that the need to earn a surplus is
critical in any capitalist system.3
Conflicts with the MNC goal
Agency theory
The formal relationship between the employees of a company (including the directors) and the shareholders
is part of the concept of corporate governance. Quite simply, corporate governance is defined as ‘the
system by which companies are directed and controlled’.4 A basic concept of governance is stewardship.
This arose from the accounting function whereby in medieval times the steward of an estate (often a
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4
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
collection of farms) had to account for the financial transactions to the lord of the manor, the owner,
who was often an absentee landlord. There was a formal duty for the steward of the estate to act on
behalf of the landlord and to take decisions in his best interests. The accounts were a way of checking
that this was indeed the case. This concept has been translated to modern times whereby the board of
directors, as the steward, reports to the shareholders who replace landlords. There is therefore a strong
underlying assumption that the directors, and hence all whom they employ, act in the best interests of the
shareholders. For traditional modelling, this implies that a model need only take into account the goals of
the shareholders, namely wealth maximization, in analyzing the decision-making function within a firm.
This unanimity between directors and shareholders, the assumption that directors always act in the
best interests of shareholders, is seen by many as being unrealistic. Agency theory drops this assumption
and accepts that managers of a firm may make decisions that conflict with the firm’s goal to maximize
shareholder wealth. For example, a decision to establish a subsidiary in one location versus another
may be based on the location’s appeal to a particular manager rather than on its potential benefits to
shareholders. A decision to expand may be determined by a manager’s desire to make the division grow in
order to receive more responsibility and remuneration. When a firm has only one owner who is also the
sole manager, such a conflict of goals does not occur. However, when a company’s shareholders differ from
its managers, a conflict of goals can exist. This conflict is often referred to as the agency problem.
The costs of ensuring that managers maximize shareholder wealth (referred to as agency costs) are
normally larger for MNCs than for purely domestic firms for several reasons. First, MNCs with subsidiaries
scattered around the world may experience larger agency problems because monitoring managers of distant
subsidiaries in foreign countries is more difficult. Financial managers of an MNC with several subsidiaries
may be tempted to make decisions that maximize the values of their respective subsidiaries. This objective
will not necessarily coincide with maximizing the value of the overall MNC. Second, foreign subsidiary
managers raised in different cultures may treat the goals of their MNC in a different way from that intended
by the senior management. Third, the sheer size of the larger MNCs can also create communication
problems. Fourth, the complexity of operations may result in decisions for foreign subsidiaries of the MNCs
that are inconsistent with maximizing shareholder wealth for the company as a whole.
EXAMPLE
A subsidiary manager obtained financing from the
parent firm (headquarters) to develop and sell a
new product. The manager estimated the costs
and benefits of the project from the subsidiary’s
perspective and determined that the project was
feasible. However, the manager neglected to realize
that any earnings from this project remitted to the
parent would be heavily taxed by the host government.
The estimated after-tax benefits received by the
parent were more than offset by the cost of financing
the project. While the subsidiary’s individual value was
enhanced, the MNC’s overall value was reduced.
USING THE WEB
An excellent site for comparing cultures based on the work of Hofstede is: www.hofstede-insights.
com/country-comparison.
If financial managers are to maximize the wealth of their MNC’s shareholders, they must implement
policies that maximize the value of the overall MNC rather than the value of their respective subsidiaries.
The temptation to pursue their own goals, either personal or that of a subsidiary at the expense of the
overall goal, is referred to as moral hazard. To counteract moral hazard, companies will often have bonus
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CHAPTER 1 Multinational financial management: an overview
5
schemes linked to the overall share price performance of the company (such as share option schemes)
for the senior executives, but this does not solve the moral hazard problem at lower levels. Rules and
regulations in part are implemented to ensure that managers’ actions conform to company goals.
Many MNCs require major decisions by subsidiary managers to be approved by the parent. However,
it is difficult for the parent to monitor all decisions made by subsidiary managers, particularly in an
international context.
At times it can appear that the headquarters of an MNC (the parent) is pursuing goals not in the
shareholders’ interests: for example, environmental concerns, funding community projects or maximizing
market share or directors’ bonuses. The counter argument is that these are really a proxy for operational
goals necessary for long-term profit maximization. Motives can always be questioned and there will always
be the view that shareholders’ interests could be more vigorously pursued. In some respects it is reassuring
to note that the US company Enron’s demise (the most recent major case of corporate misbehaviour where
shareholders’ wealth was being sacrificed for managerial rewards) involved misleading shareholders by
false accounting and deception. If there had been a more honest disclosure of information, as is required,
the abuses would most likely not have taken place. The same can be said of the Italian food giant Parmalat
which collapsed in December 2003 with a €14.3 billion hole in its accounts. As with Enron the accounts
had been materially misstated. The need for proper implementation of the rules and regulations both
internally and externally is driven by moral hazard. To this end both internal and external auditing are
essential, especially for an MNC.
Agency theory itself is an abstraction of all relationships between levels in an organization. The higher
level is that of the principal who sets the goals and monitors the actions of the agent who carries out
the tasks either directly or indirectly. The principal is also responsible for the rewards which are geared
towards encouraging the agent to meet the principal’s goals. Moral hazard occurs as the personal goals of
the agent are not the same as those of the principal. Where an agent consumes resources to meet their own
ends, this is referred to as consumption of perquisites; this can be directly in the form of high expenses or
indirectly by substituting leisure for work. Monitoring is necessary to reduce moral hazard, particularly
where the principal does not have a good knowledge of the agent’s actions. The term used in cases where
the agent knows more than the principal, which is almost always the case, is information asymmetry.
An organization can be characterized as a network of principal–agent relationships being director–senior
managers, senior managers–middle managers, middle managers–junior managers and so on. At the top of
the organization for a publicly quoted MNC, the shareholders are the principal to the managing director
or CEO, who is the agent. There is a very high level of information asymmetry between the shareholders
and the managing director, hence the use of independent auditors to check the accounts and the high
degree of regulation in the form of Companies Acts and accounting standards to control the content of the
annual report.
In the language of agency theory, we can say that information asymmetry and moral hazard are likely
to present particular difficulties for a company developing from a national company into an MNC. In
this way agency theory, first developed in the 1970s, has contributed to the language of business by neatly
encapsulating the problem of control in an organization. Its contribution to formal analysis has, however,
been hampered by the difficulty in developing tractable models.5 Despite the early promise of the greater
realism of agency theory, formal modelling still assumes a properly regulated stewardship function to
support the single aim of profit maximization. The role of agency analysis is more as a critique of academic
models rather than an alternative.
Impact of management control. The magnitude of agency costs can vary with the management style of
the MNC. A centralized management style, as illustrated in the top section of Exhibit 1.1, can reduce
agency costs because it allows managers of the parent direct control of foreign subsidiaries and therefore
reduces the power of subsidiary managers. However, the parent’s managers may make poor decisions for
the subsidiary if they are not as informed as subsidiary managers about local financial conditions.
Alternatively, an MNC can use a decentralized management style, as illustrated in the bottom section
of Exhibit 1.1. This style is more likely to result in higher agency costs because subsidiary managers may
make decisions that do not focus on maximizing the value of the entire MNC. Yet, this style gives more
control to those managers who are closer to the subsidiary’s operations and environment.
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6
PART I
EXHIBIT 1.1
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Financial management structures of MNCs
Centralized multinational financial management for subsidiaries A and B
Financial managers
of parent MNC
Cash management A
Cash management B
Stock and debtor management A
Stock and debtor management B
Finance A
Finance B
Investment A
Investment B
Decentralized multinational financial management for subsidiaries A and B
Financial managers
of parent MNC
Subsidiary financial
managers of A
Subsidiary financial
managers of B
Cash management A
Cash management B
Stock and debtor management A
Stock and debtor management B
Finance A
Finance B
Investment A
Investment B
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CHAPTER 1 Multinational financial management: an overview
7
To the extent that subsidiary managers recognize the goal of maximizing the value of the overall MNC
and are compensated in accordance with that goal, the decentralized management style can be more effective.
Given the obvious trade-off between centralized and decentralized management styles, some MNCs
attempt to achieve the advantages of both styles. That is, they allow subsidiary managers to make the key
decisions about their respective operations, but the parent’s management monitors the decisions to ensure
that they are in the best interests of the entire MNC. That this is not always a harmonious relationship is
perhaps not surprising.6
Internet facilities and software. The internet is making it easier for the parent to monitor the actions
and performance of its foreign subsidiaries. Before the advent of computerized systems much middle
management was concerned with preparing reports and budgets. Now a spreadsheet can automate much
of this work; a single worksheet has 250 columns and hundreds of thousands of rows. This enables a
wider span of control in an organization and potential de-layering (loss) of middle management in many
organizations. Whether this is contributing to the greater inequality of pay in organizations and wealth in
society is a current concern. What is not disputed is that wealth inequality is increasing around the world
as measured by the Gini coefficient.7
EXAMPLE
The parent of Jersey plc has subsidiaries in India
and Australia. The subsidiaries are in different time
zones, so communicating frequently by telephone
is inconvenient and expensive. In addition, financial
reports and designs of new products or plant sites
cannot be easily communicated over the telephone.
The internet allows the foreign subsidiaries to email
updated information in a standardized format to avoid
language problems and to send images of financial
reports and product designs. The parent can easily
track inventory, sales, expenses and earnings of each
subsidiary on a weekly or monthly basis. Thus, the
use of the internet can reduce agency costs due to
international business.
USING THE WEB
Internet millionaires
For those who manage to exploit the new trading conditions the rewards are high. Anecdotes are
provided at: www.entrepreneur.com/article/244808.
External influences
An important motive for internal control is to be able to manage threats to a company from the competitive
environment.
Hostile takeover threat. A major threat to both the company and its employees is the threat of a hostile
takeover if the MNC is inefficiently managed. Stock market analysts and shareholders will sell the shares
of companies they believe to be badly run. If this view is widespread in the market, the share price will fall.
Another firm might then acquire the MNC at a low price and is likely to terminate the contracts of the
existing directors who have not already resigned. Reorganizations involving extensive redundancies are
also common.8 In theory, this threat is supposed to encourage directors to make decisions that enhance
the value of MNCs. It is also in the interests of the directors to ensure good motivation and control of
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8
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
lower levels of management. In the past, this threat was not so positive for managers of subsidiaries
in many countries because their governments commonly protected employees, thereby effectively
eliminating the potential benefits from a takeover – France and Germany being notable examples.
Recently, however, governments have recognized that such protectionism may promote inefficiencies, and
they are now more willing to accept takeovers and the subsequent layoffs that occur. In Europe there is
currently much debate about the extent to which employee rights can be maintained in a world economy
where production has to compete with goods made in countries with poor employee rights. In France,
President Macron signed a series of decrees making it easier for firms to hire and fire and reducing the
power of collective bargaining. An important motivation was the unemployment rate standing at more
than double that of Germany, which was 3.8 per cent in 2017. In 2019 there was little change to French
unemployment. Hostile takeovers are governed by the Thirteenth Directive of the European Union (EU).
Generally, it imposes more restrictions on both the raider and the target compared to the equivalent US
legislation.
Investor monitoring. A second form of external influence is the monitoring by individuals, pressure
groups and institutions, including investment trusts, pension funds and insurance companies, all of whom
are major shareholders in the stock market. Their monitoring by means of the financial press, annual
and interim reports and, rather more controversially, by investor briefings given by companies, tends to
focus on broad issues such as: motivation packages, use of excess cash for repurchasing shares, investing
in questionable projects, ethical behaviour and attempts by MNCs to insulate themselves from the threat
of a takeover (by implementing anti-takeover amendments, for example). An MNC whose decisions
appear inconsistent with maximizing shareholder wealth will be subjected to shareholder activism as
pension funds and other large institutional shareholders lobby for management changes and threaten
votes of no confidence at the MNC’s annual general meeting (AGM). MNCs that have been subjected
to various forms of shareholder activism include Eastman Kodak, adidas, Shell, IBM and, more recently,
Rolls Royce.
Non-US banks also maintain large share portfolios (unlike US commercial banks, which do not use
deposited funds to purchase shares). Such banks are large and hold a sufficient proportion of shares of
numerous firms (including some US-based MNCs) to have some influence on key corporate policies.
In Germany, banks are often represented on the supervisory board of companies and will play a part in
their management. The concern is that either as lender, or as a member of the management, banks will
have access to private or insider information. The relationship is uneasy in that stock markets around
the world forbid the use of such information when taking investment decisions. If some investors used
private information, other investors would be disadvantaged and may sell shares to the informed investor
at a price that the informed investor knows for sure is undervalued. It would be like playing poker
against someone who knew which cards were going to be dealt next. The banks are supposed to have
‘Chinese walls’ inside the organization so that insider information cannot be used to make investment
decisions. Nevertheless, there is evidence that banks and other institutions use private information. In the
literature this is termed information asymmetry (as discussed earlier). Order flow models (Chapter 5),
that is the buy and sell orders in the market, are viewed as evidence of possible insider information and
hence information asymmetry. In international finance, the intervention of central banks in the foreign
exchange market is a source of insider information; prior knowledge of a central bank’s intention to
buy a currency to raise its value would lead to speculative purchasing. A study by Peiers9 found that the
Deutsche Bank adjusted its rates up to one hour before public release through Reuters of the news that
the German Central Bank (the Bundesbank) had intervened. In this way, certain traders are taken to be
market leaders; in this case, other banks were estimated to follow some 35 minutes after the Deutsche
Bank’s trading activities.
Private information is not limited to banks. Rating agencies will be informed about important moves
so that they can adjust their ratings immediately on announcement. Printing companies have the accounts
prior to publication. Research findings may be shared with universities. The opportunity for leaks is
extensive. Legal cases, such as the conviction of Raj Rajaratnam for insider trading in 2009, have led to
allegations against employees of many major companies. The general consensus, despite these cases, is that
private information revealed through unusual trades leads to gains that are relatively small and short lived.
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CHAPTER 1 Multinational financial management: an overview
9
Constraints interfering with the MNC’s goal
When financial managers of MNCs attempt to maximize their firm’s value, they are confronted with
various constraints that can be classified as environmental, regulatory or ethical in nature.
Environmental constraints. Each country enforces its own environmental constraints. Building codes,
disposal of production waste materials and pollution controls are examples of restrictions that force
subsidiaries to incur additional costs. The threat by MNCs to locate elsewhere in the face of overly
harsh local environmental laws acts as a significant restraint to countries wishing to pursue a strong
environmental policy. The failure of the US and Australia to sign the Kyoto Protocol on global warming
further weakens the environmental movement.
Regulatory constraints. Each country also enforces its own regulatory constraints pertaining to taxes,
currency convertibility, earnings remittance, employee rights and other policies that can affect cash flows of
a subsidiary established there. Because these regulations can influence cash flows, financial managers must
consider them when assessing policies. Also, any change in these regulations may require revision of existing
financial policies, so financial managers should monitor the regulations for any potential changes over time.
To recognize the potential impact of regulations, consider the regulation of employee rights. Although
it is understandable that every country attempts to ensure employee rights, countries are limited by the
threat of multinationals investing elsewhere.
EXAMPLE
Apple diversifies its supply chain
In September 2021 Forbes reported that Apple was
moving 20 per cent of its China-based manufacturing
to India thus reducing its exposure to the Chinese
economy. A more diversified geographic production
base is also seen as a response to the uncertain
effects of the coronavirus pandemic.
Source: Jennings, R. (2020) ‘Apple’s assemblers are looking
to shift some operations from China to ­India’. Available at:
www.forbes.com/sites/ralphjennings/2020/09/18/applesassemblers-are-looking-to-shift-some-operations-from-­
china-to-india/ [Accessed 27 April 2022].
Ethical constraints. There is no consensus standard of business conduct that applies to all countries.
A business practice that is perceived to be unethical in one country may be totally ethical in another. For
example, MNCs are well aware that certain business practices that are accepted in some less developed
countries would be illegal in their home country. Bribes to governments in order to receive special tax
breaks or other favours are common in some countries. Dieter Frisch, a former director-general of
development at the European Commission, estimates that on average at least 10–20 per cent of total
government contract costs are bribes.10 The dilemma facing MNCs can be seen as whether standards
should be relative (conforming to the law and practices of each country separately) or absolute (one set
of values applied worldwide). If they do not participate in such practices, they may be at a competitive
disadvantage. Yet, if they do participate, their reputations will suffer in countries that do not approve
of such practices. One solution to this dilemma is to adopt a set of ethical conventions for all MNCs
and countries to adhere to, thus eliminating the competitive disadvantage and conforming to morally
acceptable practice. The Equator Principles,11 a voluntary set of relatively loosely defined commitments,
represents one such initiative. But it remains voluntary and limited in scope to project finance. International
organizations such as the UN and the International Monetary Fund (IMF) have as yet failed to develop a
regulatory framework with a strong ethical foundation.
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10
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Managing within the constraints. Some MNCs have made the costly choice to refrain from business
practices that are legal in certain foreign countries but not legal in their home country. Thus, they follow
a worldwide code of ethics. This may enhance their global credibility, which can increase global demand
for their products. Recently, McKinsey & Co. found that investors assigned a higher value to firms that
exhibit high corporate governance standards and are likely to obey ethical constraints. The premiums that
investors would pay for these firms averaged 12 per cent in North America, 20 to 25 per cent in Asia and
Latin America and more than 30 per cent in Europe.
International business methods
Firms use several methods to conduct international business. The most common methods are:
1 international trade
2 licensing
3 franchising
4 joint ventures
5 acquisitions of existing operations
6 establishing new foreign subsidiaries
7 Special Purpose Vehicles.
Each method is discussed in turn, with emphasis on its risk and return characteristics.
International trade
Trading rather than investing abroad is a relatively conservative approach to international business that
can be used by firms to penetrate markets (by exporting) or to obtain supplies at a low cost (by importing).
The risk is minimal because the firm does not invest any of its capital abroad. If the firm experiences a
decline in its exporting or importing, it can normally reduce or discontinue this part of its business at a
low cost.
USING THE WEB
Trade conditions for industries
A comprehensive report on international trade conditions for industries in the US is provided at:
www.trade.gov. Other countries tend to be less forthcoming in their reporting.
Many large MNCs generate sales on a worldwide basis. For example, BP in 2021 reported US sales
of 34 per cent, UK sales of 7 per cent and ‘rest of the world’ sales of 59 per cent of their $157 billion
turnover. Nestlé in 2021 reported 30 per cent of their sales in the US, 28 per cent in the rest of the world
and 42 per cent spread across 15 countries for a total sales of 87 billion Swiss francs.
Licensing
Licensing involves selling copyrights, patents, trademarks or trade names or legal rights in exchange for
fees known as royalties. In this way, a company is selling the right to produce their goods. For example,
Pepsi-Cola licenses Heineken to make and sell Pepsi-Cola in the Netherlands. Oil companies need a licence
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CHAPTER 1 Multinational financial management: an overview
11
from the host government to drill for oil. Eli Lilly & Co. (US) has a licensing agreement to produce
drugs for Hungary and other countries. Licensing allows firms to use their technology in foreign markets
without a major investment in foreign countries and without the transportation costs that result from
exporting. A major disadvantage of licensing is that it is difficult for the firm providing the technology to
ensure quality control in the foreign production process.
How the internet facilitates licensing. Some firms with an international reputation use their brand name to
advertise products over the internet. They may use manufacturers in foreign countries to produce some of
their products subject to their specifications.
EXAMPLE
Springs SA (a fictitious French company) has set up
a licensing agreement with a manufacturer in the
Czech Republic. When Springs receives orders for
its products from customers in Eastern Europe, it
relies on this manufacturer to produce and deliver the
products ordered. This expedites the delivery process
and may even allow Springs to have the products
manufactured at a lower cost than if it produced them
itself. Springs has nevertheless to carefully monitor
the quality of production in the Czech Republic.
Franchising
Under a franchising agreement the franchisor provides a specialized sales or service strategy, support
assistance and possibly an initial investment in the franchise in exchange for periodic fees. For example,
McDonald’s, Pizza Hut, Subway sandwiches, Blockbuster video and Dairy Queen are franchisors who
sell franchises that are owned and managed by local residents in many foreign countries. Like licensing,
franchising allows firms to penetrate foreign markets without a major investment in foreign countries.
The recent relaxation of barriers in foreign countries throughout Eastern Europe and South America has
resulted in numerous franchising arrangements.
Joint ventures
A joint venture is a venture that is owned and operated by two or more firms. Many firms penetrate foreign
markets by engaging in a joint venture with firms that reside in those markets. In China it is currently a
requirement that one of the partners of a joint venture be a government-owned company. Most joint
ventures allow two firms to apply their respective comparative advantages in a given project. For example,
General Mills, Inc. joined in a venture with Nestlé SA, so that the cereals produced by General Mills could
be sold through the overseas sales distribution network established by Nestlé. Xerox Corp. and Fuji Co.
(of Japan) engaged in a joint venture that allowed Xerox Corp. to penetrate the Japanese market and
allowed Fuji Co. to enter the photocopying business. Joint ventures between automobile manufacturers
are numerous, as each manufacturer can offer its technological advantages. General Motors has ongoing
joint ventures with automobile manufacturers in several different countries, including Hungary and the
former Soviet states.
Acquisitions of existing operations
Firms frequently acquire other firms in foreign countries as a means of penetrating foreign markets.
Acquisitions allow firms to have full control over their foreign businesses and to quickly obtain a large
portion of foreign market share.
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12
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
EXAMPLE
C a d b u r y S c h w e p p e s g re w m a i n l y t h ro u g h
acquisitions including Wedel chocolate (Poland,
1999), Hollywood chewing gum (France, 2000), a
buyout of minority shareholders of Cadbury India
(2002), Dandy chewing gum from Denmark (2002)
and the Adams chewing gum business ($4.2 billion,
2003). Clearly, they were seeking synergies by being
dominant in the chewing gum business. Then in
early 2010 Cadbury Schweppes was taken over
by Kraft Foods (now called Mondelez) to create a
‘global confectionary leader’. In 2015 Kraft merged
with Heinz to create the Kraft Heinz company,
the third largest food producer in the US. In 2017
Kraft Heinz made a $143 billion bid for Unilever
that was eventually shelved. Currently, Berkshire
Hathaway, the investment vehicle of Warren Buffett,
is the largest share owner with a holding of over
25 per cent.
An acquisition of an existing company is a quick way to grow. An MNC that grows in this way also partly
protects itself from adverse actions from the host government as opposed to setting up independently. The
MNC has control of a usually well-established firm with good connections to its government. The risk is
that too much has been paid for the acquisition, also that there are unforeseen problems with the acquired
company. It has to be remembered that the sellers of the company have a thorough knowledge of the
business and the price at which they are selling is presumably higher than their estimate. The acquiring
company is therefore to a certain extent outguessing the local owners – a risky proposition.
Some firms engage in partial international acquisitions in order to obtain a stake in foreign operations.
This requires a smaller investment than full international acquisitions and therefore exposes the firm to
less risk. On the other hand, the firm will not have complete control over foreign operations that are only
partially acquired.
USING THE WEB
A good example of growth through acquisitions is the Dutch–UK company Unilever. Its history
can be found by searching ‘Unilever history timeline’ online, available at: www.unilever.com/files/
origin/3d0982a9cc0a89b9b4834edc8023cb1e54477f4e.pdf/formation-of-unilever-brochure.pdf
Establishing new foreign subsidiaries
Firms can also penetrate foreign markets by establishing new operations in foreign countries to produce
and sell their products. Like a foreign acquisition, this method requires a large investment. Establishing
new subsidiaries may be preferred to foreign acquisitions because the operations can be tailored exactly to
the firm’s needs. Development will be slower, however, in that the firm will not reap any rewards from the
investment until the subsidiary is built and a customer base established.
Special Purpose Vehicles
These are separate companies set up by one or more sponsoring MNCs to exploit a particular project.
This is part of what is termed project finance (Chapter 16). The Special Purpose Vehicle (SPV) is legally
and financially independent of the sponsors and other providers of capital. The success of the SPV depends
on the project’s ability to repay the contracted debt and reward the sponsors. Thus, an SME can take on
large projects. For larger companies the attraction is more in the way in which the SPV isolates the MNC
from downside risk (the risk of a loss). There is also the less virtuous motive of the activity being less
visible (‘off the balance sheet’) as the SPV appears as an investment rather than the constituent assets and
liabilities.
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CHAPTER 1 Multinational financial management: an overview
13
Summary of methods
The methods of increasing international business extend from the relatively simple approach of
international trade to the more complex approach of acquiring foreign firms or establishing new
subsidiaries. Any method of increasing international business that requires a direct investment in
foreign operations is normally referred to as a foreign direct investment (FDI) and is generally defined
as investments abroad where there is at least a 10 per cent ownership interest. International trade and
licensing usually are not considered to be FDI because they do not involve direct investment in foreign
operations. Franchising and joint ventures tend to require some investment in foreign operations, but to a
limited degree. Foreign acquisitions and the establishment of new foreign subsidiaries require substantial
investment in foreign operations and represent the largest proportion of FDI.
Many MNCs use a combination of methods to increase international business. Motorola and IBM, for
example, have substantial direct foreign investment, but also derive some of their foreign revenue from
various licensing agreements, which require less FDI to generate revenue.
EXAMPLE
The evolution of Nike began in 1962, when Phil Knight,
a business student at Stanford Graduate School of
Business, wrote a paper on how a US firm could use
Japanese technology to break the German dominance
of the athletic shoe industry in the US. After graduation,
Knight visited the Unitsuka Tiger shoe company in
Japan. He made a licensing agreement with that
company to produce a shoe that he sold in the US
under the name Blue Ribbon Sports (BRS). In 1972,
Knight exported his shoes to Canada. In 1974, he
expanded his operations into Australia. In 1977, the
firm licensed factories in Asia to produce athletic shoes
and then sold the shoes in Asian countries. In 1978,
BRS became Nike, Inc., and began to export shoes to
Europe and South America. As a result of its exporting
and its direct foreign investment, Nike’s international
sales reached $1 billion by 1992 and were over
$44 billion by 2021, a 13.9 per cent annual growth rate!
USING THE WEB
FDI analysis and trends can be obtained from the United Nations under the keywords ‘UNCTAD
World Investment report’. For a broader view refer to ‘IMF World Economic Outlook’, again by using
the title as the keywords in a search engine.
Exposure to international risk
Although international business can reduce an MNC’s exposure to its home country’s economic conditions,
it usually increases an MNC’s exposure to (1) exchange rate movements, (2) foreign economic conditions
and (3) regulatory risk. Each of these forms of exposure is briefly described here and is discussed in more
detail in later sections of the text. MNCs that plan to pursue international business should consider these
potential risks.
Exposure to exchange rate movements
Most international business results in the exchange of one currency for another to make the payment.
Since exchange rates fluctuate on a daily basis, the cash outflows required to make payments change
accordingly. Consequently, the number of units of a firm’s home currency needed to purchase foreign
supplies can change even if the suppliers have not adjusted their prices.
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14
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
EXAMPLE
Burt plc, a UK importer, buys rice from the US at $10
a sack. For each sack, Burt has to purchase 10 dollars
with British pounds and then with the $10 buy the rice
from the US company. The transaction is a double
purchase, first the dollars then the rice. If the value of
the dollar increases by 10 per cent, the effective cost of
the sack of imported rice for Burt plc will also increase
by 10 per cent. So, both the cost of the foreign
currency and the cost of the product are important to
the overall cost of the rice for Burt.
Exporters selling goods in their own currency will be exposed to exchange rate fluctuations. A German
company selling goods in euros to a British company, for example, will require the British company to
purchase euros and then purchase the goods. In this case, if the value of the euro goes up (strengthens), the
British company will have to pay more for the goods. The German exporter may well find that there is a
decline in the order book as customers who do not use euros find the goods too expensive. To avoid the
risk of currency changes for its customers, the German company may seek to invoice goods in the currency
of its customers, in this case the British pound. In effect it would now be the German company that would
bear the cost of exchange rate risk. If the value of the euro strengthens, the German company would now
suffer in that the foreign currency would convert into fewer euros. In this case, the British pounds would
convert into fewer euros. The exporter or the importer or the international financial markets must bear the
exchange rate risk.
For MNCs with subsidiaries in foreign countries, exchange rate fluctuations affect the value of cash
flows remitted by subsidiaries to the parent. When the parent’s home currency goes up in value, the
remitted foreign funds will convert to a smaller amount of the home currency.
EXAMPLE
The French subsidiary of Burt plc wishes to pay a dividend
of €150,000 to Burt at an exchange rate of 1.5 euros
for each British pound (£1) 2 a potential payment
of £100,000 (being €150,000 / 1.5 5 £100,000).
If the value of the pound increases to €2 for each
£1, the value of the payment will be only £75,000
(i.e. €150,000/2 5 £75,000).
Exposure to foreign economies
When MNCs enter foreign markets to sell products, the demand for these products is dependent on the
economic conditions in those markets. Thus, the cash flows of the MNC are subject to foreign economic
conditions. For example, Michelin (France), the world’s largest tyre manufacturer, experienced a 40 per
cent drop in lorry tyre sales in South East Asia due to the Asian crisis in 1998, but in the US that year
Michelin’s lorry tyre sales were up by 14 per cent.
Exposure to regulatory risk
Regulatory risk refers to changes in tariffs and trade policies, tax reform and changes to employment
and environmental laws. This is a particularly difficult risk for an MNC to manage as they cannot
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CHAPTER 1 Multinational financial management: an overview
15
afford the reputational risk of non-compliance. As was stated by Amazon when asked about its low tax
bill in the UK, ‘We pay all taxes required in the UK and every country where we operate,’ (BBC, ‘Amazon
pays £290m in UK tax as sales surge to £14bn’, 9 September 2020). The risk can be substantial and is
uninsurable, unlike exposure to exchange rate movements where the financial markets are able to offer
protection in the form of derivatives. MNCs are often accused of locating and arranging their affairs
so as to minimize regulatory risk. Whereas a country might want to pass employment protection and
environmental laws, their inevitable consequence is higher costs, which is a disincentive for MNCs. This
may not be a problem for countries confident of their own economic development such as China and
the EU (though not a country as such), but for developing countries failing to attract foreign investment
acts as a big restraint on developing a social agenda. When MNCs establish subsidiaries in foreign
countries, they become exposed to what is sometimes termed regulatory or political risk, and such
regulatory risk is often viewed as a subset of country risk, which is discussed in detail in Chapter 15.
For example, South Africa passed a law (the Medicines and Related Substances Control Amendment
Act) in 1997 to allow generic substitutes (copies) of patented drugs to be used. The following year 41
pharmaceutical companies including large multinationals brought an action against the South African
government. The law in South Africa had allowed their patented products to be copied legally – this is
just one of the many forms of political risk. The US government sought to protect its pharmaceutical
industry by putting the South African government on its special ‘watch list’ – but it was later removed.
A compromise solution was eventually achieved. Generally, governments cannot act on the world stage
in an unrestrained manner for fear of being isolated. Even where host governments have sought to
nationalize subsidiaries of MNCs, compensation will be paid.
USING THE WEB
A source of further analysis of regulatory issues is to be found in the open source European Journal of
Risk Regulation.
Terrorism and war. One form of exposure that is a uniquely political risk is terrorism. A terrorist attack
can affect a firm’s operations or its employees. The 11 September 2001 terrorist attack on the World
Trade Center reminded MNCs around the world of the exposure to terrorism. MNCs from more than
50 countries were directly affected because they occupied space in the World Trade Center. In addition,
other MNCs were also affected because they engaged in trade or had direct foreign investment in foreign
countries that may also have experienced an increase in terrorism.
Wars can also affect an MNC’s cash flows. The February 2022 Ukrainian war has seen a dramatic
escalation in the business implications of conflict. Multinational retail outlets such as McDonald’s
have closed all stores in Russia. Siemens (engineering) announced in May 2022 a complete withdrawal
from Russia and a halting of all business activities. The G7 countries have pledged to halt all oil
imports from Russia. The freezing of all dollar deposits held by Russia and associated oligarchs has
made coupon payments on bonds subject to delays. A technical default in June 2022 due to its failure
to pay interest on a delayed payment triggered credit default swaps (insurance against non-payment)
worth $2.5 billion. These are sudden, infrequent and dramatic changes that are outside the scope
of statistical analysis, which relies on frequency – preferably over 30 events. The outcome of the
war at the time of writing is unknown but similarities with the First World War and the war in
Afghanistan have been made. Non-statistical techniques such as scenario analysis and game theory
become relevant frameworks for using such knowledge and estimating possible outcomes and best
strategies for MNCs.
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16
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Overview of an MNC’s cash flows
Most MNCs have some local business similar to other purely domestic firms. Because of the MNC’s
international operations, however, their cash flow streams differ from those of purely domestic firms.
Exhibit 1.2 shows cash flow diagrams for three common profiles of UK MNCs. Profile A in this exhibit
reflects an MNC whose only international business is international trade. Thus, its international cash
flows result from either paying for imported supplies or receiving payment in exchange for products that
it exports.
EXHIBIT 1.2
Cash flow diagrams for UK MNCs
Profile A: MNCs focused on international trade
Payments received for products
Payments made for supplies
UK-based
MNC
Payments received for exports
Payments made for imports
UK customers
UK businesses
Foreign importers
Foreign exporters
Profile B: MNCs focused on international trade and international arrangements
Payments received for products
Payments made for supplies
Payments received for exports
UK-based
MNC
Payments made for imports
Fees received for services provided
Expenditures resulting from services provided
UK customers
UK businesses
Foreign importers
Foreign exporters
Foreign firms
Foreign firms
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CHAPTER 1 Multinational financial management: an overview
17
Profile C: MNCs focused on international trade, international arrangements
and direct foreign investment
Payments received for products
Payments made for supplies
Payments received for exports
Payments made for imports
UK-based
MNC
Fees received for services provided
Expenditures resulting from services provided
Funds remitted back to UK parent
Funds invested in foreign subsidiaries
UK customers
UK businesses
Foreign importers
Foreign exporters
Foreign firms
Foreign firms
Foreign subsidiaries
Foreign subsidiaries
Profile B reflects an MNC that engages in both international trade and some international arrangements
(which can include international licensing, franchising or joint ventures). Any of these international
arrangements can require cash outflows by the MNC in foreign countries to comply with the arrangement,
such as the expenses incurred from transferring technology or funding partial investment in a franchise or
joint venture. These arrangements generate cash flows to the MNC in the form of fees for services (such as
technology or support assistance) it provides.
Profile C reflects an MNC that engages in international trade, international arrangements and direct
foreign investment. This type of MNC has one or more foreign subsidiaries. There can be cash outflows from
the parent to its foreign subsidiaries in the form of invested funds to help finance the operations of the foreign
subsidiaries. There are also cash flows from the foreign subsidiaries to the parent in the form of remitted
earnings and fees for services provided by the parent, which can all be classified as remitted funds from the
foreign subsidiaries. In general, the cash outflows associated with international business by the parent are to
pay for imports, to comply with its international arrangements, or to support the creation or expansion of
foreign subsidiaries. Conversely, it will receive cash flows in the form of payment for its exports, fees for the
services it provides within its international arrangements and remitted funds from the foreign subsidiaries.
Many MNCs initially conduct international business in the manner illustrated by Profile A. Some of
these MNCs develop international arrangements and foreign subsidiaries over time; others are content to
focus on exporting or importing as their only method of international business. Although the three profiles
vary, they all show how international business generates cash flows.
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18
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Host country MNC relationships
A unique feature of an MNC is that it has to maintain good relationships with a range of countries.
This relationship is sometimes fractious due to the different interests of government and the MNC.
The interests of the MNC are commercial, to increase its overall wealth. One of the main concerns in
the literature is the lower level goals of MNCs in their pursuit of this overall goal. In a review of the
literature, van Tulder identifies a number of motives from a range of authors.12 Natural resource-seeking,
market-seeking, efficiency-seeking, strategic asset or capability-seeking, to diversify, tap growing world
markets for goods and services, follow the competitor, reduce costs, overcome protective devices, and take
advantage of technological expertise through FDI.
The first four motives were taken up by Dunning13 and serve as the principal classification of motives
in many texts. Clearly, the motives overlap so reducing costs can be seen as efficiency-seeking as well. The
potential for friction is evident in that market-seeking can mean competition with local companies, as can
natural resource-seeking, and reducing costs can impose pressures on government to keep low standards
and low taxation under the threat of the MNC leaving the country. Similarly, overcoming protective
devices can also mean that countries are under pressure not to impose rules and regulations. Nevertheless,
MNCs also have the potential to provide employment and wealth to a country and generally are seen as a
positive contribution to the economy.
The relationship between a country and an MNC is therefore not simple, in that there are positives
and negatives for both parties. We examine these issues in detail when looking at FDI (Chapter 14),
but in general terms, the bargaining power of governments is largely negative, being based on control,
whereas the actions of the MNC are more positive. To this model Ramamurti14 adds the relationship
between the host country and the home country of the multinational. This relationship is expressed
through bilateral investment treaties as well as bargaining through institutions such as the World Bank,
the IMF and the WTO. In addition, there are unilateral initiatives such as the Multilateral Agreement on
Investment, the Transatlantic Trade and Investment Partnership (TTIP) and the Trans Pacific Partnership
(TPP) sponsored by the US, all of which have failed with the exception of TPP which is now in reduced
form (notably without US membership) as the Comprehensive and Progressive Agreement for TransPacific Partnership. (Chapter 14). More limited regional bodies have had some success such as the AsiaPacific Economic Cooperation (APEC), Black Sea Economic Cooperation Zone (BSEC), European Free
Trade Association (EFTA) and the North American Free Trade Agreement (NAFTA). The economic
agenda of these bodies mainly concerns the liberalizing of trade and FDI. Economic history shows that
free trade and investment are part of successful economic development. In the past, Korea and Latin
America have been notable examples15 and more recently China has been tentatively relaxing its foreign
ownership and investment rules.16
Governments and MNCs both have bargaining powers and use those powers to employ tactics to
achieve goals. The overall concern of governments is mainly the development of the local economy and
local resources. From the host government’s perspective, access to resources that are attractive to MNCs
are important, being natural resources such as deposits of copper, lithium and so on, as well as human
resources such as cheap labour or research centres. Regulations and their application (intervention)
define their tactics in the relationship: labour laws, licensing and taxation being examples. The aim is
to benefit from technology, employment and taxation. These goals act as a restraint on the use of their
powers, and tax rates cannot be so high as to discourage investment. Labour laws that are too onerous
on MNCs will also discourage investment. Host countries are in competition with other countries and
in many cases will offer favourable terms in their regulations to attract foreign investment. In similar
fashion, the MNC has a wide range of tactics that can act as a restraint on regulations. This theme is
developed further in Chapter 14.
The academic literature has focused on the factors that create economic growth termed endogenous
growth theory and evolutionary economics. The effect of MNC FDI is part of this debate and in
particular spillovers, the question as to whether domestic industry benefits from such investment.
Although there are many anecdotal examples, there are no decided answers to such questions. Clearly,
there are examples of significant MNC operations in countries experiencing extreme poverty with little
evidence of any benefit to the wider economy, and examples of countries that have benefited through
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CHAPTER 1 Multinational financial management: an overview
19
extensive FDI – in recent years Ireland is one such example. In all such cases there are many other
factors as well, for example in the case of Ireland its membership of the EU is also a major factor as well
as its strong cultural links with the US.17
MNC valuation
There are three distinct ways of valuing a company: stock market valuation, the accounts and academic
models. Each approach produces a different valuation. In this respect the valuation process of an MNC
is much the same as for any other company. The only differences are that an MNC is more likely to be
cross-listed, that is its shares are quoted on more than one stock exchange. The attraction for the company
is to improve the liquidity of its shares, making them more attractive to investors, being easier to buy and
sell and also to spread the ownership.18 We examine each method in turn.
Stock market valuation
Not all major companies are owned by shareholders and hence are not quoted on a stock exchange. Boots
the chemist in the UK, Cargill in the US, the 12th largest company in the Fortune 500 with employees in
66 countries, are both privately owned. More recently, Tesla has been considering going private, citing less
disclosure and greater focus on the long term as benefits.19 The great majority of MNCs are, nevertheless,
publicly quoted. The value of quoted firms is measured as the price of the share multiplied by the number
of shares termed the market capitalization. This is only an estimate and probably an overestimate of the
stock market value in that the price is the marginal rate at which shares are being exchanged. If all the
shares were to be placed on the stock market the price would be lower to absorb the oversupply. An
exception is a takeover where the acquiring company can expect to have to pay a premium.
A valuation issue of particular relevance to MNCs is whether international diversification reduces
sensitivity to home country economic behaviour. The perhaps surprising conclusion is that this is not
the case. Beta, a measure of the performance of a share price in relation to a stock market index, shows
a much higher correlation for MNCs with home economic performance despite the fact that sales are
international.20 It does not preclude the finding that the share price is sensitive to international movements
though the sensitivity is slight.21 Similarly, academic research has considered whether exposure to exchange
rates affects the share price of companies, an obvious attribute of MNCs. Again, despite a strong rationale,
there is little evidence that such exposure affects the value of a company.22 The extent of foreign sales and
their diversity has also been tested, again with generally weak results.23
Although the literature is not unanimous, it is generally the case that MNC valuation in the stock
market is not systematically different from domestic companies. Although information on foreign sales
and subsidiaries will affect the valuation, it will not do so in any way that is different from any other
information affecting a share price; an international company has no separate status.
Valuation in the accounts
An alternative valuation is in the reported annual accounts of a company. These are prepared in accordance
with the law and requirements of the countries where the company is registered and the stock exchanges
where it is quoted. For example, BP prepares an annual report in accordance with UK requirements and
Form 20-F as required by the US Securities Exchange Act. The value of the firm to the shareholders is that of
the equity interest on the balance sheet. This is accepted by the markets as a conservative valuation because
the assets on the balance sheet will not include items such as reputation, the quality of the workforce, the
potential of the technology; in other words, the more speculative future prospects of a firm’s valuation that
might reasonably be included in the stock market valuation. This has led to a comparison between the book
value and the market value known as the book to market ratio,24 that is, the book value as in the accounts and
the market value being the market capitalization. This is similar to Tobin’s Q, which is similarly defined only
for the whole firm rather than just the shareholders. Returns to shares are generally positively related to book
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20
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
to market ratio; the suggestion is that firms with poor prospects will have low share prices in relation to their
book value and high returns reflecting their greater risk.25 Again there is no suggestion in the literature that
MNCs have any special status in this regard, though we might speculate that they should have good prospects
given their wider opportunities and hence have a lower book to market ratio than purely national companies.
A particular problem is accounting for the effects of changes in foreign exchange rates (IAS 21). Assets
in the home – usually the reporting or functional – currency, do not change value due to changes in
the value of the currency, unlike foreign assets. In particular, monetary assets are reported at the closing
exchange rate, and the resulting gains and losses are normally reported separately.
Financial academic models
A basic model in the study of finance is to apply the actuarial discounted cash flow model. The value of a firm
is seen as the discounted future-free cash flows. This measure is of future dividends and cash that could have
been distributed to shareholders but was kept within the company. Applied to MNCs the model becomes:
n
Vi = ∑j = 0 ∑t = 0
E(FCFj,t) × E(ERj,t)
(1 + kj)t
Where:
V 5 MNC shareholder value
E(FCFj, t ) 5 expected local currency value of the free cash flows due to the shareholders from all
projects undertaken by the MNC received at the end of period t in currency j
E(ERj, t ) 5 expected exchange rate at time t for currency j in direct form, i.e. £s to a single foreign
currency unit where £s are taken as the home currency
kj 5 the cost of capital for project j
n 5 distant time period
In words, this is the sum of the present value of the cash flows in local currency converted at the expected
exchange rate and discounted at the cost of capital appropriate to the project. Clearly, it is a conceptual
rather than a practical model. An increase in the risk of any of the projects will increase k and thereby
reduce the value of the firm, as will a devaluation in a local currency. The model shows this to be the case.
Also the firm is represented as a collection of projects rather than an entity in itself. There is no recognition
of any organizational concepts or issues; it is all just cash flows. Neither is there recognition of an overall
cost of capital, as each project should be charged with its own risk and hence its own k.26
More recent analysis recognizes a shortcoming in the valuation of a project and hence a shortcoming
in this model of firm valuation. In discounting expected returns, you may well ask about the distribution
of possible returns of which this is the average or expected return. That distribution is assumed to be
approximately normal, i.e. bell shaped. The model assumes that the project is taken up immediately and is
allowed to run its course, whether that is a good or bad outcome. This implies that there is no contingency
planning when, of course, most businesses in practice would consider what they would do if the project
proved to deviate significantly from expectations.27 An example might be a project that, if successful,
could be rolled out across a number of countries, or abandoning a project if it does not reach a certain
standard. These possible future returns are called real options, in part because they are similar in reasoning
to financial options and also because they are optional in nature. In having a fixed pattern of future
returns, the discounted cash flow model also does not take into account the possibility of competitor
reactions that could significantly affect the outcome. Such actions can be modelled using game theory,
but this is seen more as a business model rather than a financial model. There is no doubt, however, that
competition and future possibilities play a part in stock market valuation.
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CHAPTER 1 Multinational financial management: an overview
21
MANAGING FOR VALUE
Facebook’s decision to expand internationally
In 2021, Facebook (which changed its name in the
same year to Meta, but we continue with its more
familiar name) was seeking to expand into Indonesia,
India and Brazil. Each country presented regulatory
and political difficulties. In IT the returns to investment
are very difficult to estimate in the manner advocated
by net present value models. In 2012, Facebook
had an initial share price of $38 and a price earnings
ratio of 552. In 2021, Facebook’s partnership with
the Indonesian start-up company Gojek was facing
difficulties. This was to be Facebook’s entry into the
very large growing e-commerce market in SouthEast Asia’s largest economy. Government regulations
prevented it from offering a direct payments service,
so it took a stake in GoPay, which was Gojek’s
payments company. Gojek is an all-purpose app
offering takeaways and financial services. The
partnership has not developed, however, in part due
to Gojek’s interest in merging with Tokopedia. At
the time of writing Facebook was no longer actively
pursuing the partnership. Difficulties were also
experienced in Brazil where its WhatsApp payment
service was suspended a week after its launch and
has yet to get approval from the central bank in Brazil.
In India, Facebook’s reach was limited to 20 million
users out of a potential 400 million.
This description is what we hear of international
investments and it is easy to get the impression
that international investment is mainly political and
regulatory. Nevertheless, Facebook will have also
carried out a financial evaluation covering such
features as:
●●
An estimate of future earnings and their v­ ariability
including worst case scenarios.
●●
The finance needed to support the proposed
partnerships and sole ventures.
●●
The effect of exchange rates in its payments
service and whether any hedging is needed to
reduce the risk.
●●
An assessment of overall profitability including
accounting measures, payback and discounted
cash flow analysis.
●●
Cash management including payments to and
from the US parent company.
●●
The legal and regulatory risks.
All these issues are addressed in later chapters.
Together they amount to due diligence, an essential
process in any investment. Overall, it should be clear
that there is no single model of evaluation that will
produce an answer as to whether to invest or not. The
numbers inform a decision that ultimately depends on
subjective evaluation.
Organization of the text
Chapters are designed broadly to go from the general to the particular (Exhibit 1.3). Parts I to III address
the problem of finance in general and financial markets in particular focusing in on the exchange rate and
risk management. Parts IV and V adapt tools developed in the earlier sections as well as adding strategies
to economically manage risk. Taken together, the text aims to prepare the reader for a critical appreciation
of managing finance in an international and often turbulent context.
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22
PART I
EXHIBIT 1.3
THE INTERNATIONAL FINANCIAL ENVIRONMENT
From the general to the particular
Part I The
international
financial
environment
Chapters 1–4
Parts II & III
Exchange rate
behaviour and
Exchange rate risk
management
Chapters 5–13
M
N
C
Part IV Longterm asset and
liability
management
Chapters 14–16
Part V Shortterm asset and
liability
management
Chapters 17–20
Summary
●●
●●
The main goal of an MNC is to maximize
shareholder wealth. When managers are tempted
to serve their own interests instead of those
of shareholders, an agency problem exists.
Managers also face environmental, regulatory
and ethical constraints that can conflict with the
goal of maximizing shareholder wealth.
The most common methods by which firms
conduct international business are international
trade, licensing, franchising, joint ventures,
acquisitions of foreign firms and the formation of
foreign subsidiaries including Special Purpose
Vehicles. Methods such as licensing and
franchising involve little capital investment but
distribute some of the profits to other parties.
The acquisition of foreign firms and formation of
foreign subsidiaries require substantial capital
investments but offer the potential for large returns.
●●
MNCs have the special attribute of having to
conduct relationships with a host of differing
governments and a worldwide network of trade
agreements between countries.
●●
MNCs are valued as other companies are
in the stock market, the accounts and in
academic models. In the stock market there is
no discernible difference in risk valuation that
can be clearly attributed to the company being
multinational. The accounts face the special
problem of translating the value of foreign assets
into the reporting currency. Such profits are
reported separately. Academic models in line
with other companies are based on discounted
cash flows and the more recent additions of real
options valuation and game theory.
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CHAPTER 1 Multinational financial management: an overview
23
Critical debate
Proposition. MNCs stifle growth of local industry in
developing countries and use free trade to justify their
opposition to restrictions on their economic power.
Opposing view. On the contrary, MNCs bring
knowledge of wealth organization to a country for it to
learn from and benefit.
Critically evaluate these arguments. Use the
terminology in the chapter such as ‘endogenous growth’.
Consider the elements you agree with and disagree with
in both arguments. Also, consider what research you
would like to undertake that would help to provide further
insights. Remember, not all countries are the same. You
may like to distinguish between countries.
Self test
Answers are provided in Appendix A at the back of
the text.
2 Describe and evaluate the main international
constraints to profit faced by MNCs.
1 What are typical reasons why MNCs expand
internationally?
3 Identify the more obvious risks faced by MNCs
that expand internationally.
Questions and exercises
1 Agency problems of MNCs.
a Explain the agency problem of MNCs.
b Why might agency costs be larger for an MNC than for a purely domestic firm?
2 Benefits and risks of international business. As an overall review of this chapter, identify possible reasons
for growth in international business. Then, list the various disadvantages that may discourage companies from
conducting their business internationally.
3 Motives of an MNC. Describe constraints that interfere with an MNC’s objectives.
4 Centralization and agency costs. Would the agency problem be more pronounced for an MNC which has its
parent company make most major decisions for its foreign subsidiaries, or for an MNC which uses a decentralized
approach?
5 Methods used to conduct international business. Durve Ltd desires to penetrate a foreign market with either a
licensing agreement with a foreign firm or by acquiring a foreign firm. Explain the differences in potential risk and return
between a licensing agreement with a foreign firm and the acquisition of a foreign firm.
6 International business methods. Snyder GmbH, a German firm that sells high-quality golf clubs in Europe,
wants to expand further by selling the same golf clubs in Brazil.
a Describe the trade-offs that are involved for each method (such as exporting, direct foreign investment, etc.)
that Snyder could use to achieve its goal.
b Which method would you recommend for this firm? Justify your recommendation.
7 Impact of regulatory risk. Assess how regulatory risk can be taken into account in investment decisions.
8 How has the internet affected a firm’s ability to trade internationally?
9 International joint venture. Scottish and Newcastle Breweries (a real UK company) have joint ventures with
United Breweries in India, Chongquin (the fifth largest brewer in China) and Baltic Beverages and Holdings in
Eastern Europe.
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24
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
a Explain how the joint venture can enable Scottish and Newcastle breweries to achieve its objective of
maximizing shareholder wealth.
b Explain how the joint venture can limit the risk of the international business.
c Many international joint ventures are intended to circumvent barriers (business and cultural) that normally
prevent foreign competition. What barriers might Scottish and Newcastle Breweries be circumventing as a
result of the joint venture?
10 Impact of Eastern European growth. The managers of VGood Corp. (a US fictitious company) recently had
a meeting to discuss new opportunities in Europe as a result of the recent integration among Eastern European
countries. They decided not to penetrate new markets because of their present focus on expanding market share
in the US. VGood’s financial managers have developed forecasts for earnings based on the 12 per cent market
share (defined here as its percentage of total European sales) that VGood currently has in Eastern Europe. Is 12 per
cent an appropriate estimate for next year’s Eastern European market share? If not, is it likely to overestimate or
underestimate the actual Eastern European market share next year?
11 Valuation of an MNC. Turnip plc (a UK fictitious company), based in Birmingham, considers several international
opportunities in Europe that could affect the value of its firm. The valuation is dependent on four factors:
(1) expected cash flows in pounds, (2) expected cash flows in euros that are ultimately converted into pounds,
(3) the rate at which it can convert euros to pounds, and (4) Turnip’s weighted average cost of capital. For each
opportunity, identify the factors that would be affected.
a Turnip plans a licensing deal in which it will sell technology to a firm in Germany for £3,000,000; the payment is
invoiced in pounds, and this project has the same risk level as its existing businesses.
b Turnip plans to acquire a large firm in Portugal that is riskier than its existing businesses.
c Turnip plans to discontinue its relationship with a US supplier so that it can import a small amount of supplies
(denominated in euros) at a lower cost from a Belgian supplier.
d Turnip plans to export a small amount of materials to Ireland that are denominated in euros.
12 Valuation of Carrefour’s international business. In addition to all of its stores in France, Carrefour (a real French
company) has 24 hypermarkets in Argentina, 85 in Brazil, 27 in Mexico, 41 in China, 27 in Korea; a total of 1,207
stores in 30 countries. Consider the value of Carrefour as being composed of two parts, a euro area part and a
non-euro area part. Explain how to determine the present value (in euros) of the non-euro area part assuming that
you had access to all the details of Carrefour businesses outside the euro area.
13 Assessing direct foreign investment trends. The website address of the Bureau of Economic Analysis is www.
bea.gov. For UK data refer to www.ons.gov.uk/search?q=pink+book or search for ‘Pink Book’ plus the year.
a Use this website to assess recent trends in foreign direct investment (FDI) abroad by US or UK firms. Compare
the FDI in the UK with the FDI in France. Offer a possible reason for the large difference.
b Based on the recent trends in FDI, are UK-based MNCs pursuing opportunities in Asia? In Eastern Europe? In
Latin America?
14 Select a firm from the top ten firms from a European country (exclude financial institutions; a list may be found at
www.forbes.com/lists/ – choose the country option for selection). Go to the company website and download the
most recent annual report. Before selecting the company, ensure that it is engaged in international business. From a
reading of this document and with particular reference to this chapter:
a Review the goals of the MNC. Is there a mission statement? Are there notes on the company’s policy towards
the environment, its workforce, etc? Generally, review statements of intent in the document.
b How far do you think that the company’s development can be explained by theories of international business as
outlined in this chapter?
c What international business methods does this company principally employ? What do you think is the
reason for their international business strategy (i.e. why do they not pursue other strategies)?
d Outline the international opportunities and international risks faced by this company. Where these are not
specifically stated, outline what you think are the likely opportunities and risks. In your view, how great are
these international risks and international opportunities?
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CHAPTER 1 Multinational financial management: an overview
25
Discussion in the boardroom
Running your own MNC
This exercise can be found in the digital resources for
this book.
This exercise can be found in the digital resources for
this book.
Endnotes
1 See Goergen, M. (2012) International Corporate
Governance, Pearson, 25 et seq.
2 Brounen, D., de Jong, A. and Koedijk, K. (2004) ‘Corporate
finance in Europe: Confronting theory with practice’,
Financial Management, Winter, 71–101.
3 Cohen, G. and Yagil, J. (2007) ‘A multinational survey of
corporate financial policies’, Journal of Applied Finance,
Spring/Summer, 57–69.
4 Cadbury, A. (1992) Report of the Committee on the
Financial Aspects of Corporate Governance, Gee & Co Ltd.
5 See Hoenen, A. K. and Kostova, T. (2015) ‘Utilizing the
broader agency perspective for studying headquarters:
Subsidiary relations in multinational companies’, Journal
of International Business Studies, 46, 104–13, for a more
optimistic view.
6 See Tasoluk, B., Yaprak, A. and Calantone, R. J. (2007)
‘Conflict and collaboration in headquarters-subsidiary
relationships’, International Journal of Conflict
Management, 17(4), 332–51.
7 In economics this is a measure of the inequality of wealth
distribution. For further information read Picketty, T.
(2014) Capital in the Twenty First Century, Harvard.
8 The US food company Kraft took over Cadbury’s in 2009.
A week after promising to keep open Cadbury’s Somerdale
plant it changed its mind and closed it. This eventually led
the UK Panel on Takeovers and Mergers in 2011 to revise
the Takeover Code, requiring greater disclosure of future
plans.
9 Peiers, B. (1997) ‘Informed traders, intervention and price
leadership: A deeper view of the microstructure of the
foreign exchange market’, Journal of Finance, 52, 1587–
614. Also see Ito, T., Lyons, R. K. and Melvin, M. T. (1998)
‘Is there private information in the FX market? The Tokyo
experiment’, Journal of Finance, 53, 1111–30.
10 See Neyer, J. (2004) ‘Corruption: European export
credit agencies under scrutiny’, European ECA Reform
Campaign, April, Briefing Note, Issue 01, 1–4.
11 See Equator Principles III at: www.equator-principles.com/
index.php/ep3.
12 van Tulder, R. (2015) ‘Getting all motives right: A holistic
approach to internationalization motives of companies’,
The Multinational Business Review, 23(1), 36–56. Also see
Franco, C., Rentocchin, F. and Marzetti, G. (2010) ‘Why do
firms invest abroad? An analysis of the motives underlying
foreign direct investments’, The IUP Journal of International
Business Law, IX(1) and (2), 42–65.
13 Dunning, J. (1993) Multinational Enterprises and the
Global Economy, Addison-Wesley.
14 Ramamurti, R. (2001) ‘The obsolescing “bargaining
model”? MNC-host developing country relations revisited’,
Journal of International Business Studies, 32, First quarter,
23–39.
15 Seder, F. (1995) ‘Privatizing public enterprises and foreign
investment in developing countries, 1988–93’, World Bank:
Foreign Investment Advisory Service, Occasional Paper No. 5.
16 Zhang, Y. and Roelfsema, H. (2014) ‘Globalization, foreign
direct investment and regional innovation in China’,
Journal of International Commerce, Economics and Policy,
5(3), 1–26.
17 Skippari, M. and Pajunen, K. (2010) ‘MNE–NGO–host
government relationships in the escalation of an FDI
conflict’, Business & Society, 49(4), 619–51. Vivoda, V.
(2011) ‘Bargaining model for the international oil industry’,
Business and Politics, 13(4), Art. 3. Also as an example
of a wider literature, Gachino, G. (2011) ‘Determinants
of FDI spillover in the Kenyan manufacturing industry:
Firm-level evidence’, International Journal of Business and
Economics, 10(3), 235–55.
18 Dodda, O., Louca, C. and Paudyal, K. (2015) ‘The
determinants of foreign trading volume of stocks listed in
multiple markets’, Journal of Economics and Business, 79,
38–61.
19 Kolodny, L. (2018) ‘Why Elon Musk wants to take Tesla
private’, CNBC, 7 August.
20 Jacquillat, B. and Slonick, B. (1978) ‘Multinationals are poor
tools for diversification’, Journal of Portfolio Management,
Winter, 8–12; also refer to Eun, C. S., Kolodny, R. and
Resnick, B. G. (1991) ‘US based international mutual
funds: A performance evaluation’, Journal of Portfolio
Management, 19(1), 88–94. Counter evidence is not
strong, e.g. Chambliss, K., Madura, J. and Wright, F. (1994)
‘The changing risk profile of U.S. based multinational
corporations exposed to European Community markets’,
The Journal of Financial Research, XVII(1), 133–46.
21 Lee, C., Ng, D. and Swaminathan, B. (2009) ‘Testing
international asset pricing models using implied costs of
capital’, Journal of Financial and Quantitative Analysis,
44(2), 307–35.
22 Jorion, P. (1991) ‘The pricing of exchange rate risk in
the stock market’, Journal of Financial and Quantitative
Analysis, 26(3), 363–76.
23 Madura, J. and Rose, L. (1989) ‘Impact of international
sales degree and diversity on corporate risk’, The
International Trade Journal, III(3), 261–76.
24 Rather confusingly it is also called the market to book
ratio.
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26
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
25 Fama, E. F. and French, K. R. (1992) ‘The cross-section
of expected stock returns’, The Journal of Finance, 47(2),
427–65.
26 The only overall effect is the level of borrowing (leverage)
in so far as it cannot be identified with a particular project.
This assumes the Modigliani and Miller proposition that
shareholder risk increases with the level of borrowing
offsetting any lower interest rate from fixed interest
borrowing.
27 For an example refer to Denison, C., Farrell, A. and
Jackson, K. (2012) ‘Managers’ incorporation of the value
of real options into their long-term investment decisions:
An experimental investigation’, Contemporary Accounting
Research, 29(2), 590–620.
Essays/discussion and articles can be found at the end of Part I.
BLADES PLC CASE STUDY
Decision to expand internationally
Blades plc is a UK-based company that has been
incorporated in the UK for three years. Blades is
a relatively small company, with total assets of only
£15 million. The company produces a single type of
product, rollerblades. Due to the booming skateboard
market in the UK at the time of the company’s
establishment, Blades has been quite successful.
For example, in its first year of operation, it reported
a net income of £3.5 million. Recently, however,
the demand for Blades’ ‘Speedos’, the company’s
primary product in the UK, has been slowly tapering
off, and Blades has not been performing well. Last
year, it reported a return on assets of only 7 per cent.
In response to the company’s annual report for its
most recent year of operations, Blades’ shareholders
have been pressuring the company to improve its
performance; its share price has fallen from a high of
£20 per share three years ago to £12 last year. Blades
produces high-quality skateboards and employs a
unique production process, but the prices it charges
are among the top 5 per cent in the industry.
In light of these circumstances, Ben Holt, the
company’s Director of Finance, is contemplating his
alternatives for Blades’ future. There are no other
cost-cutting measures that Blades can implement
in the UK without affecting the quality of its product.
Also, production of alternative products would
require major modifications to the existing plant
setup. Furthermore, and because of these limitations,
expansion within the UK at this time seems pointless.
Ben Holt is considering the following: if Blades
cannot penetrate the UK market further or reduce
costs here, why not import some parts from overseas
and/or expand the company’s sales to foreign
countries? Similar strategies have proved successful
for numerous companies that expanded into Asia
in recent years to increase their profit margins. The
Managing Director’s initial focus is on Thailand.
Thailand has recently experienced weak economic
conditions, and Blades could purchase components
there at a low cost. Ben Holt is aware that many of
Blades’ competitors have begun importing production
components from Thailand.
Not only would Blades be able to reduce costs by
importing rubber and/or plastic from Thailand due to
the low costs of these inputs, but it might also be able
to augment weak UK sales by exporting to Thailand,
an economy still in its infancy and just beginning to
appreciate leisure products such as rollerblades. While
several of Blades’ competitors import components
from Thailand, few are exporting to the country. Longterm decisions would also eventually have to be made.
Maybe Blades plc could establish a subsidiary in
Thailand and gradually shift its focus away from the UK
if its UK sales do not rebound. Establishing a subsidiary
in Thailand would also make sense for Blades due to
its superior production process. Ben Holt is reasonably
sure that Thai firms could not duplicate the high-quality
production process employed by Blades. Furthermore,
if the company’s initial approach of exporting works
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CHAPTER 1 Multinational financial management: an overview
well, establishing a subsidiary in Thailand would
preserve Blades’ sales before Thai competitors are
able to penetrate the Thai market.
As a financial analyst for Blades plc you are
assigned to analyze international opportunities
and risk resulting from international business. Your
initial assessment should focus on the barriers and
opportunities that international trade may offer. Ben
Holt has never been involved in international business
in any form and is unfamiliar with any constraints that
may inhibit his plan to export to and import from a
foreign country. Mr Holt has presented you with a list
of initial questions you should answer.
27
1 What are the advantages Blades could gain from
importing from and/or exporting to a foreign
country such as Thailand?
2 What are some of the disadvantages Blades could
face as a result of foreign trade in the short run? In
the long run?
3 Which theories of international business described
in this chapter apply to Blades plc in the short run?
In the long run?
4 What long-range plans other than establishment of
a subsidiary in Thailand are an option for Blades
and may be more suitable for the company?
SMALL BUSINESS DILEMMA
Developing a multinational sporting goods industry
In every chapter of this text, some of the key
concepts are illustrated with an application to a
small sporting goods firm that conducts international
business. These ‘Small Business Dilemma’ features
allow students to recognize the dilemmas and
possible decisions that firms (such as this sporting
goods firm) may face in a global environment. For this
chapter, the application is on the development of the
sporting goods firm that would conduct international
business.
Last month, Jim Logan from Ireland completed
his undergraduate degree in finance and decided
to pursue his dream of managing his own sporting
goods business. Jim had worked in a sporting goods
shop while going to university in Ireland, and he had
noticed that many customers wanted to purchase a
low-priced basketball. However, the sporting goods
store where he worked, like many others, sold only
top-of-the-line basketballs. From his experience, Jim
was aware that top-of-the-line basketballs had a high
mark-up and that a low-cost basketball could possibly
penetrate the UK market. He also knew how to
produce cricket balls. His goal was to create a firm that
would produce low-priced basketballs and sell them
on a wholesale basis to various sporting goods stores
in the UK. Unfortunately, many sporting goods stores
began to sell low-priced basketballs just before Jim
was about to start his business. The firm that began
to produce the low-cost basketballs already provided
many other products to sporting goods stores in the
UK and therefore had already established a business
relationship with these stores. Jim did not believe that
he could compete with this firm in the UK market.
Rather than pursue a different business, Jim
decided to implement his idea on a global basis.
While basketball has not been a traditional sport
in many countries, it has become more popular in
some countries in recent years. Furthermore, the
expansion of cable networks in many countries
would allow for much more exposure to basketball
games in those countries in the future. Jim asked
many of his foreign friends from college days if
they recalled seeing basketballs sold in their home
countries. Most of them said they rarely noticed
basketballs being sold in sporting goods stores but
that they expected the demand for basketballs to
increase in their home countries. Consequently, Jim
decided to start a business producing low-priced
basketballs and exporting them to sporting goods
distributors in foreign countries. Those distributors
would then sell the basketballs at the retail level. Jim
planned to expand his product line over time once
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28
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
he had identified other sports products that he might
sell to foreign sporting goods stores. He decided
to call his business ‘Sports Exports Company’. To
avoid any rent and labour expenses, Jim planned
to produce the basketballs in his garage and to
perform the work himself. Thus, his main business
expenses were the cost of the material used to
produce basketballs and expenses associated with
finding distributors in foreign countries who would
attempt to sell the basketballs to sporting goods
stores.
1 Is Sports Exports Company an MNC?
2 Why are the agency costs lower for Sports Exports
Company than for most MNCs?
3 Does Sports Exports Company have any comparative
advantage over potential competitors in foreign
countries that could produce and sell basketballs
there?
4 How would Jim Logan decide which foreign markets
he would attempt to enter? Should he initially focus
on one or many foreign markets?
5 Sports Exports Company has no immediate plans
to conduct direct foreign investment. However,
it might consider other less costly methods of
establishing its business in foreign markets. What
methods might Sports Exports Company use to
increase its presence in foreign markets by working
with one or more foreign companies?
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CHAPTER 2
International trade and
investment: measurement
and theories
LEARNING OBJECTIVES
The specific objectives of this chapter are to:
●●
Explain the key components of the balance of payments.
●●
Describe the influence of economic and political factors.
●●
Explain the significance of country characteristics.
●●
Explain the principal economic theories of international trade.
International business is facilitated by markets that allow for the flow of funds between countries. The principal
international transactions are:
a borrowing from abroad by both government and business
b lending abroad, investing in foreign shares, setting up foreign subsidiaries, paying dividends to foreign parent
companies
c payments for imports
d receipts for exports.
The balance of payments is a record of these international money flows and is discussed in this chapter.
29
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30
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Financial managers of multinational corporations (MNCs) monitor the balance of payments so that they can
determine the nature of international transactions for a particular country and how they are changing over time. The
balance of payments is an indicator of the health of the economy and may even signal potential shifts in exchange
rates and tariff policies.
Balance of payments
The balance of payments as illustrated in Exhibit 2.1 is a summary of transactions between domestic
and foreign residents over a specified period of time. It represents the record of a country’s international
transactions for a period, usually a quarter or a year.
EXHIBIT 2.1 Illustrative balance of payments (a positive represents a demand for home currency, a negative a supply of home
currency – refer to Exhibit 2.2)
Amount
Balances
Current account
Exports
100
Imports
–80
Balance
20
Capital account
–5
Financial account
Investment in
Investment out
Balance
Overall balance
285
–300
–15
0
A resident is an individual or business or any organization operating in the particular country. For
an organization, this will normally entail setting up a company in the country under the commercial
company laws of that country. This will count as investment into the country. Individuals who earn their
income and live in the country are residents, though they might be foreign nationals. A business that
is resident is registered in the country and is a legal, taxpaying entity. Such businesses include all the
national companies, so for the UK, BP plc, Tesco plc, Barclays Bank plc and so on are resident companies.
Subsidiaries of foreign multinationals are also residents of the country they operate in, like any other
registered company in the country. For example, Matsushita Electric Industrial in Japan supplies consumer
and business-related electronics products in the UK. The operation is more than direct exporting from
Japan, so they have set up Panasonic Manufacturing (UK) Ltd (a wholly owned subsidiary) to manage the
operation. Panasonic Manufacturing (UK) Ltd is registered and located in the UK, pays taxes to the UK
government on its profits and pays dividends to its parent company in Japan. 1 Exports from Panasonic
Manufacturing (UK) Ltd will count as UK exports in the balance of payments statement. In this way,
multinationals play a full part in the economies in which they operate.
Data for the balance of payments are collected via questionnaires and returns to governments. Although
it is described in terms of a double entry system, it is not the same as a set of accounts in this respect.
The figures are only estimates and the accounts balance only because there is an account called ‘net errors
and omissions’. In the UK 2017 accounts, the net error was £20,313 million according to the 2018 edition
of The Pink Book in which the UK reports its balance of payments transactions. In the 2021 version,
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CHAPTER 2
International trade and investment: measurement and theories
31
the net errors and omissions for the 2017 accounts were reduced to £12,436 million. In other words, the
balance of payments numbers for each year are revised with each new addition of The Pink Book as new
information is received.
The definitions and structure of the balance of payments are defined by the International Monetary
Fund (IMF), whose task it is to monitor and report the balance of payments for all countries. Recently,
it has changed its format and this has meant a revision to the UK presentation. The analysis here follows
the new format. Details of the definitions and presentation can be found by searching online ‘Balance
of Payments and International Investment Position Manual’ currently in its 6th edition, available at
www.imf.org/external/pubs/ft/bop/2007/pdf/bpm6.pdf.
A balance of payments statement can be broken down into three main components: the current
account, the capital account and the financial account.2 The current account mainly consists of export
and import payments for goods and services between, in our example, the UK and the rest of the world.
The capital account refers mainly to intergovernmental and quasi-governmental (e.g. public corporations)
transactions, such as payments to joint government initiatives such as the Large Hadron Collider at CERN.
This account is a relatively small part of the overall balance of payments. The main account apart from
the current account is the financial account, which is mostly a summary of investments into and out of the
UK. This is a very important part of the balance of payments that is often missed by students. Investments
comprise two types: portfolio investment and real or direct investment, which cover investments into the
UK and investments from the UK to the rest of the world.
A portfolio investment is where the investor is only seeking a return in the form of interest and
dividend payments and has no interest in the management of the investment. As a rule of thumb this is
taken to represent less than a 10 per cent ownership interest in the company in the case of an investment
in shares.
A real investment is, in the context of the balance of payments, more commonly termed direct investment
and is an investment in enterprises where there is a managerial interest, as in the case of a wholly owned
subsidiary, but more generally where there is a greater than 10 per cent ownership interest.
Balance of payments statements are normally prepared for individual countries, but may also be
prepared for currency areas such as the euro, or for multinational entities such as the European Union
(EU). The transactions between home and foreign residents usually involve different currencies where
national residents offer their home currency in exchange for foreign currency and foreign residents
offer their foreign currency for home currency. An exception is for countries trading in the euro area:
many of the transactions will be in the same currency, but there is no fundamental difference to the
recording process.
Why the balance of payments balances
In simple terms as can be seen from Exhibit 2.2 the balance of payments balances because every crossborder transaction to take place must have both a demand and supply of the home currency involved
in every transaction. Cutting out intermediaries such as banks and bureaux de change, if you want
to import goods from the US you will need to ‘buy’ dollars by offering, say, 100 units of your home
currency. For this to happen you will need someone (probably in the US) to want to buy 100 units
of your home currency in exchange for dollars. The balance of payments records the reasons why
the supplier of dollars wanted the 100 units and why you wanted to offer 100 units. The number of
dollars involved is not important. In this case the reasons may be such that the transaction is recorded
in the balance of payments as ‘imports of 100 units’ (the demand) and ‘investment into the country’
(the supply). Banks and bureaux de change merely act as intermediaries saving you the trouble of
advertising for US dollars. Banks will give you your dollars immediately and wait for someone wanting
to offer US dollars for your home currency.
The old format used simply to list changes to exports, imports, investment in and investment out and
other transactions with simple plus and minus signs where plus indicated a demand and a minus indicated
a supply. This has changed following guidance from the IMF. A more accounting based model is now
applied though it must be stressed that this is all based on loose estimates that are sometimes highly
inaccurate as detailed above; in other words, there is no international double-entry book-keeping system.
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32
PART I
EXHIBIT 2.2
THE INTERNATIONAL FINANCIAL ENVIRONMENT
A foreign currency transaction
HOME CURRENCY
(currency held by residents
of home country)
Home currency offered mainly
to buy foreign goods or to
invest abroad (transactions
recorded as a ‘2’ in the
balance of payments).
Home currency demanded by
non-residents to buy goods
from the home country or to
invest in the home country
(transactions recorded as a
‘1’) in the balance of
payments.
TRANSACTION
(UK as the home currency)
FOREIGN CURRENCY
(currency held by residents
of foreign country)
For every £1 supplied for
foreign currency (2£1)
Amount of foreign currency
depends on the exchange rate
2 this changes continuously
£1 must be demanded by
foreign currency (1£1)
Transactions should
balance and total £0
Note:
• The balance of payments is a record of the demand and supply of currency held by home residents in transactions with non-residents.
EXAMPLE
Suppose, for the sake of clarity, that there are no
financial intermediaries such as banks and therefore
trading has to be direct. Wavy plc has to pay €150 for
imports. It offers over the internet £100 in exchange
for €150. That offer is accepted by Francophile SA
of France which wants to invest in a UK government
bond. The supply of the £100 of UK currency by
Wavy is recorded as a debit or negative in the
imports account, and the demand for the £100 of
UK currency by Francophile is recorded as a credit, a
portfolio investment in the UK. The deficit of £100 on
the current account is offset by the £100 surplus on
the financial account. Both transactions are at £100 –
note that it does not matter as far as the balance
is concerned how many euros were exchanged for
the £100.
The IMF presentation of the balance of payments
The conceptual model adopted by the IMF and seen as the model for all countries to follow is based on
the balance sheet and the income statement.
The current account is broadly treated as an income statement with exports instead of revenue and
imports instead of costs. Adopting the accounting language, exports are therefore credits and imports
debits.
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CHAPTER 2
International trade and investment: measurement and theories
33
The financial account records changes in the assets (an increase is a debit) and liabilities (an increase is
a credit) of the country or entity such as a group of countries. Thus an increase in liabilities is an increase
in finance from abroad (similar to a company borrowing from another entity). This finance is broadly
divided into direct investment (i.e. where there is an interest in management) and portfolio investment such
as buying foreign government bonds and shares purely for the return (i.e. where there is no management
involvement). Exhibit 2.3 gives a fuller explanation of the terms.
EXHIBIT 2.3
The UK balance of payments 2020 (£ million)
credits
debits
notes
Goods
308,679
437,420
Exports are credits and imports debits. A negative balance has been the
case since 1983.
Services
292,294
159,273
Exports are credits and imports debits. A surplus on services has existed
since 1965.
567
817
UK residents income from working abroad (credit) and non-UK residents
sending money abroad (debit).
134,336
163,770
585
2,897
17,231
45,403
753,692
809,580
1,210
3,073
The transfer of ownership of fixed assets by agreement rather than payment
including aid payments related to capital projects and debt forgiveness.
958
1,705
E.g. copyright acquisition and disposal.
2,168
4,778
Greater transfers in than out.
Direct investment
24,262
−40,912
A reduction in investment abroad and an increase in inward investment.
Portfolio investment
60,461
57,104
An increase in investment abroad and a slightly greater investment into
the UK.
30,383
Net estimated value.
Current account
Income abroad
Investment income
Other
Secondary income
Total current account
Dividends and interest received (credit) and paid (debit).
Taxes and subsidies on exports and imports.
Payments received (credits) and paid (debit) that are not business related,
e.g. food aid and other short-term grants paid and received.
A debit on the current account has existed since 1984.
Capital account
Capital transfers
Other long-term transfers
Total capital account
Financial account
Derivatives and stock
options (net)
Other investments
425,599
389,242
Reserves
Total financial account
Overall total
Errors and omissions
−2,582
510,322
433,235
1,266,182
1,247,593
−18,589
Deposits and loans both into the UK (credits) and to non-residents (debits).
A reduction in the holdings of reserve assets e.g. accounts with foreign
central banks.
The balancing figure as the data is based on estimates.
Source: The Balance of Payments Pink Book 2021
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34
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
USING THE WEB
Search online for ‘IMF balance of payments and international investment position statistics’ and choose
the top item. The current direct route is data.imf.org/regular.aspx?key=62805740. Select ‘data tables’ in
the bar. The IMF manual concerns definitions only. Register for free to download from this huge database.
Understanding the balance of payments
The somewhat unfashionable mercantilist view of the balance of payments is to analyze it in the same way
as a set of company accounts. A current account positive balance indicates sales (exports) greater than
costs (imports) and the positive balance as a ‘profit’. This is balanced by a net surplus of foreign currency
earned on the current account being invested abroad in the form of foreign loans and investments. Such
investments it is argued spread the influence and power of the country and are hence beneficial.
The counter argument regards this reasoning as nonsense! Suppose a company was the same as a
country and it designated its main supplier as a foreign country. It would obviously have a large negative
current account. But would it be worse off as a result? No, a negative balance for a country on its current
account means no more than that it has a number of foreign suppliers, but it is not worse off as a result.
Foreign investment means economic wealth for the recipient country with dividends and interest paid
abroad as a minimal cost.
What is the balanced view? It is important to understand that reasoning and theories in economics
are based on very rough crude models of economies. The social sciences are not the same as physical
sciences where measurements are more accurate and theories proven to a high degree of accuracy – this is
absolutely not the case here. So it is quite possible for both arguments to be right to a certain extent.
USING THE WEB
A list of current account balances as a percentage of GDP can be found online at the Trading
Economics site: tradingeconomics.com/country-list/current-account-to-gdp. A wealth of data on the
balance of payments can be found at www.imf.org/en/Data.
If we look at current account balances in relation to GDP, we find prosperous countries such as Germany,
Switzerland, Denmark and Singapore with large current account surpluses but also low-income countries
such as Eritrea, Papua New Guinea, Zambia and the Congo. With regard to large negative balances on
the current account we find high-income countries such as the US, the UK and Bahrain and low-income
countries such as Mozambique, Sierra Leone and Myanmar. Clearly there is much more to determining a
country’s wealth than just the current account balance.
We suggest a number of interpretations of the balances, remembering that a negative current account
balance implies a positive financial account balance to get an overall balance. Interpretations 1 and 2 are
for the current and financial accounts respectively, thus:
A A positive current account (and negative financial account) could be associated with wealth if:
1 The country has a skilled workforce and is highly productive, resulting in a surplus of goods and services
and hence relatively high exports.
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CHAPTER 2
International trade and investment: measurement and theories
35
2 Large foreign investments are made with the foreign currency earned that increase in value.
B A positive current account (and negative financial account) could be associated with relative poverty if:
1 High levels of exports consist of natural resources needed by developed countries.
2 Foreign investment consists mainly of investment to produce those resources (gold, copper, lithium, etc.)
with a minimal effect on employment and local industry.
C A negative current account (and positive financial account) could be associated with wealth if:
1 Imports are of goods and services which are produced more cheaply abroad, releasing home resources
for more productive activities.
2 Foreign investment consists mainly of developing wealth in the home country producing activities that
could not be financed internally.
D A negative current account (and positive financial account) could be associated with relative poverty if:
1 Imports are of consumer products of little or no lasting benefit.
2 Foreign investment is used to make up for a lack of domestic savings due in part to low domestic taxation
receipts, corruption and lack of industrial and legal structures.
USING THE WEB
An update of exports and imports of goods and services is provided at the WTO site at: www.wto.org.
An update of foreign direct investment (FDI) is available at: unctad.org, the UNCTAD site (United
Nations Conference on Trade and Development).
The IMF now publishes a survey ‘The Co-ordinated Portfolio Investment Survey’ (CPIS) which
lists by country the holdings of portfolio investments abroad, that is investments with no managerial
involvement.
The UK government provides a detailed and well-explained view of their investment and trade
published as The Pink Book, which is easily found from a browser.
In each of the scenarios the exchange rate is in equilibrium, the demand for foreign currency equals
the supply. It is not right to argue that a negative balance on the current account leads to a fall in value
of the local currency. As an example, the large deficit on the US current account leads to a large supply
of dollars on the foreign exchanges which is met by a large demand for dollars by countries seeking to
buy US government bonds as a safe ‘store of value’, China being one of the main purchasers. Hence, a
deficit on the current account can be balanced by a surplus on the financial account being net inward
investment as is the case for the UK (refer to Exhibit 2.3).
China and Germany (and in previous years, Japan) have been cited as typical of scenario A; whereas
the UK and the US are sometimes accused of scenario D, where the counter argument to such analysis is
scenario C. Successful developing countries generally have taken the scenario A route, benefitting from
the knowledge and discipline brought by foreign investment. Unfortunately, scenario B is often associated
with low-income countries that fail to develop.
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36
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
International trade and investment flows
The themes to note from the following tables are:
1 the high levels of trade with China
2 the importance of physical proximity
3 the generally low level of trade with Africa compared to other countries.
Top ten exporters and importers ($ million)
Exports fob
2020
Imports cif
2020
US
2,326,547.21
China, (mainland)
2,506,516.61
China, (mainland)
1,799,159.57
US
1,404,152.93
Germany
1,167,913.12
Germany
1,348,440.51
UK
639,623.44
Japan
670,673.04
France
601,304.04
Korea, Rep. of
578,222.00
China, Hong Kong
576,751.87
Netherlands, The
573,817.54
Netherlands, The
576,599.53
France
521,327.89
Japan
576,335.43
Taiwan, Province of China
514,587.53
Korea, Rep. of
448,636.30
Italy
501,053.39
Italy
441,994.28
Mexico
440,998.50
Note:
• This is the export and import of goods only, other major elements of the current account are services and income sent and received from abroad.
Source: data.imf.org/regular.aspx?key=61726510
International investment position ($ million)
Assets invested abroad
Country
GDP
Foreign owned assets
(liabilities)
Direct
Portfolio
Direct
Portfolio
US
22,675,371
9,405,126
14,605,608
11,977,868
24,628,429
China (mainland)
16,462,318
2,413,410
899,852
3,179,292
1,954,512
84,077
5,653,696
5,871,118
4,804,404
6,971,519
UK
3,124,630
2,463,819
3,926,186
2,614,809
5,018,543
Germany
4,319,286
2,879,802
4,364,910
2,116,215
3,329,614
Brazil
1,491,772
425,785
51,758
1,463,466
488,811
329,529
249,820
190,238
142,901
231,294
Luxembourg
South Africa
Note:
•
Investments are in order of total investments in plus investments out.
Source: data.imf.org/regular.aspx?key=62805744
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CHAPTER 2
37
International trade and investment: measurement and theories
Direction of trade
South Africa ($ million)
Imports
2020
Exports
World
72,680.08
100%
China, (mainland)
15,132.42
21%
Germany
6,664.85
US
World
2020
85,877.49
100%
China, (mainland)
9,908.78
12%
9%
United States
7,163.86
8%
4,712.22
6%
Germany
7,073.63
8%
India
3,811.13
5%
UK
4,224.47
5%
Saudi Arabia
2,852.73
4%
Japan
3,816.28
4%
Nigeria
2,327.22
3%
Netherlands, The
3,339.35
4%
Thailand
2,271.88
3%
Botswana
3,291.58
4%
Japan
2,029.87
3%
India
3,163.76
4%
Italy
1,874.08
3%
Mozambique, Rep.
3,083.65
4%
UK
1,806.58
2%
Namibia
2,679.64
3%
United Kingdom ($ million)
Imports
World
2020
Exports
628,179.14
100%
China, (mainland)
75,519.95
12%
Germany
72,229.29
11%
US
58,329.39
Netherlands, The
World
2020
395,388.76
100%
US
57,305.05
14%
Germany
40,403.40
10%
9%
Ireland
26,925.16
7%
44,879.78
7%
Netherlands, The
24,011.27
6%
France
28,873.94
5%
France
23,061.64
6%
Belgium
28,302.95
5%
Switzerland
19,689.32
5%
Russian Federation
24,531.77
4%
China, (mainland)
18,589.96
5%
Italy
22,550.07
4%
Belgium
13,389.47
3%
Spain
18,064.73
3%
Spain
10,947.66
3%
Ireland
16,925.04
3%
Italy
10,724.89
3%
Source: data.imf.org/?sk=9D6028D4-F14A-464C-A2F2-59B2CD424B85
Trade and investment agreements
Many trade agreements have been signed over the years in an effort to reduce trade restrictions. Throughout
the 1990s, trade restrictions between European countries were removed. One implicit trade barrier was
the different regulations among countries. MNCs were unable to sell products across all European
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38
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
countries because each country required different specifications (related to the size or composition of the
products). The standardization of product specifications throughout Europe during the 1990s removed a
very large trade barrier. The adoption of the euro as a single currency in much of Europe had the potential
to encourage trade between European countries. It removed the transaction costs associated with the
conversion of one currency to another. It also removed concerns about exchange rate risk for producers
or customers based in Europe that were selling to other countries in Europe. Whether this did achieve a
significant increase in trade is open to question as trade within the EU of non-euro countries also increased
at the same time. A study by Berger and Nitsch3 using data from 1948 to 2003 found that the euro’s
impact was not significant once a trend in integration between euro countries had been taken into account.
In a later paper they find that having the restriction of a fixed exchange rate with other EU countries (i.e.
the same currency) considerably widened trade imbalances.4
The EU behaves in much the same way as an individual country – in effect taking the place of its
members – and conducts a number of summits and meetings with countries and trading areas such as
Latin America and Mercosur (Argentina, Brazil, Bolivia, Paraguay, Uruguay and Venezuela) designed to
further trade relations by means of lowering tariffs (a tariff is a tax on imported goods), or, in the case of a
textile agreement with China in Shanghai, 10 June 2005, to limit the growth of textile imports from China.
In 2003, the US and Chile signed a free trade agreement to remove tariffs on more than 90 per cent
of the products traded between the two countries. In June 2009 the EU concluded an interim Economic
Partnership Agreement with Southern African Development Countries (SADC): Botswana, Lesotho,
Namibia, Swaziland and Mozambique. It includes: no duties/quotas for SADC imports to the EU and
no duties/quotas for 86 per cent of EU exports. South Africa signed a separate Trade Development and
Co-operation Agreement with the EU in 2004.
General negotiations are now conducted under the auspices of the World Trade Organization (WTO),
which was set up after the Uruguay round of trade talks (1986–94) held by the now disbanded General
Agreement on Tariffs and Trade (GATT). The WTO also oversaw the Doha Development Agenda set up
in November 2001 to focus in particular on the problems of developing nations. This was abandoned in
2006 due in the main to a disagreement on agriculture between the EU and the US.
Larger non-regional trade agreements have tended to fail. The Transatlantic Trade and Investment
Partnership (TTIP) was abandoned following US President Trump’s 2017 election. Trade tariffs imposed
by President Trump also challenge the existing wisdom that free trade increases the wealth of all
participants. More recently the EU has seen a rise in euroscepticism, in particular from right-wing parties
in France, Hungary and Poland. In the EU, trade agreements are seen as threatening to local industry.
The gains are seen by many to be outweighed by the social costs of unemployment, a restraint on wages
in having to compete with lower-income members such as Poland, and a loss of economic control at the
national level. It is ironic therefore that in the case of the EU, left-wing parties are without exception in
favour of further EU integration.
Discussions on the Multilateral Agreement on Investment (MAI) were discontinued in 1998 when
several countries withdrew following protests from NGOs. This agreement hosted by the OECD
proposed a number of restrictions on the powers of governments in receipt of international investment
mainly, of course, from MNCs. Among them were clauses preventing the receiving countries requiring
MNCs to:
1 Export a given level or percentage of goods or services.
2 Achieve a given level or percentage of domestic content.
3 Purchase, use or accord a preference to goods produced or services provided in its territory, or to purchase
goods or services from persons in its territory.
4 Relate in any way the volume or value of imports to the volume or value of exports or to the amount of
foreign exchange inflows associated with such investment.
5 Transfer technology, a production process or other proprietary knowledge to a natural or legal person in its
territory.
6 Achieve a given level or value of research and development in its territory.
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CHAPTER 2
International trade and investment: measurement and theories
39
7 Hire a given level of nationals.
8 Establish a joint venture with domestic participation.
9 Achieve a minimum level of domestic equity participation.
This is an interesting list of the frustrations felt by MNCs as it reflects the potential benefits that
the receiving country could experience. The failure of this agreement perhaps shows that ultimately the
relationship has to be built on trust rather than international agreements that are potentially unenforceable.
No agreement since the MAI has come remotely close to the full list of these requirements.
USING THE WEB
For further information on trade agreements consult the homepage of the World Trade Organization at
www.wto.org/. The OECD has maintained the text of the MAI on its website; search online for ‘OECD MAI’
or www.oecd.org/investment/internationalinvestmentagreements/multilateralagreementoninvestment.htm.
Trade disputes
Countries seek to promote free trade so that their companies seeking to export goods are able to compete
in foreign markets without discrimination. Economic theories also advocate free trade as the basis of
greater wealth for all. For this reason, countries are members of organizations such as the WTO and
the OECD, which seek to encourage free trade for just these reasons. Yet countries also seek to restrict
free trade in order to protect domestic industry from foreign competition and, in doing so, cause trade
disagreements.
It is the specific task of the WTO to resolve multilateral trade disputes through an adjudication process.
The main problems with this process are, first, that it takes time and, second, the disputed unfair trade
practice remains in place during the consultation procedure. The WTO itself gives as a case study a dispute
over discrimination against the import of Venezuelan petrol in January 1995 that took two and a half years
to settle. The WTO allows a certain degree of retaliation including actions taken against dumping (selling
at an unfairly low price), actions to counteract subsidies by foreign countries to promote their exports and
emergency measures to limit imports in order to give temporary protection to domestic industries. Thus, a
kind of low level ‘trade war’ is permitted within the negotiating framework. It is important to remember
that the WTO is a member-driven organization; there are no powers of enforcement. All settlements are by
agreement. Therefore, most countries or groups of countries, including the US and the EU, have at various
times been accused of unfair trade practices. The job of the WTO is to prevent such actions escalating
to the point where countries impose tariffs and quotas indiscriminately. The reason why countries do
not want to be seen to be overtly in breach of WTO decisions is partly because of the risk of retaliation,
but also history. The Smoot Hawley Tariff Act of 1930 raised tariffs to their highest level and provoked
retaliation by other major industrialized countries, followed by a catastrophic collapse in world trade.
Therefore in trying to protect against imports, the US suffered a decline in exports as well and an overall
adverse effect on economic activity. US real exports (after adjusting for general price changes) fell by over
30 per cent and GDP fell by over 25 per cent between 1930 and 1933, events that have always been seen
as closely linked. This example above all others serves as a warning from history.
The argument about imports, however, remains. Foreign imports compete with local production
causing unemployment, sometimes in areas of high unemployment. In theory, such workers should retrain
for more productive employment and unemployment should be temporary. The loss of salary should,
therefore, only be short term and in the long run such workers should be better off. Unfortunately, the
theory does not specify the length of time for the short term. Governments are often in power only for the
short term and have to address these problems. Therefore the problem is finely balanced as countries try
to argue that their exports should not be restricted but the exports of certain other countries (imports to
them) should be restricted.
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40
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Consider the following situations that commonly occur:
1 The firms based in one country are not subject to environmental restrictions and, therefore, can produce at a
lower cost than firms in other countries.
2 The firms based in one country are not subject to child labour laws, have lower employment costs and are
able to produce products at a lower cost than firms in other countries.
3 The firms based in one country are allowed by their government to offer bribes to large customers when
pursuing business deals in a particular industry. They have a competitive advantage over firms in other
countries that are not allowed to offer bribes.
4 The firms in one country receive subsidies from the government, as long as they export the products. The
exporting of products that were produced with the help of government subsidies is commonly referred to
as dumping. These firms may be able to sell their products at a lower price than any of their competitors in
other countries.
5 The firms in one country receive tax breaks if they are in specific industries. This practice is not necessarily a
subsidy, but it is still a form of government financial support.
In all of these situations, firms in one country may have an advantage over firms in other countries
through lower social and environmental standards (e.g. situations 1 and 2), lower standards of governance
(e.g. 3 and 4) and differences in regulatory regimes that have the effect of creating an advantage (e.g. 5).
Every government uses strategies that may give its local firms an advantage in the fight for global market
share. Thus, the playing field in the battle for global market share is probably not even across all countries.
Yet, there is no formula that will ensure a fair battle for market share. Regardless of the progression of
international trade treaties, governments will always be able to find strategies that can give their local
firms an edge in exporting. Suppose, as an extreme example, that a new international treaty outlawed all
of the strategies described above. One country’s government could still try to give its local firms a trade
advantage by attempting to maintain a relatively weak currency. This strategy can increase foreign demand
for products produced locally because products denominated in a weak currency can be purchased at a
low price. In this respect Germany can be said to have benefitted from the Greek crisis, which lowered the
value of the euro.5
Using the exchange rate as a policy. At any given point in time, a group of exporters may claim that they
are being mistreated and lobby their government to adjust the currency so that their exports will not be
as expensive for foreign purchasers. Note that when exports are purchased, the foreign purchaser has in
effect to buy the currency and then with that currency buy the product or service. Thus, a cheaper currency
will be the same as lowering the price of the product. In 2004, European exporters claimed that they were
at a disadvantage because the euro was too strong. Meanwhile, US exporters claimed that they could not
compete with China because the Chinese currency (yuan) was maintained at an artificially weak level
(8.277 yuan:$l). In June 2010 the Chinese yuan abandoned its peg to the dollar and has since revalued by
over 20 per cent, potentially making Chinese exports more expensive and imports into China cheaper. Why
should the Chinese government allow this to happen? As we have seen, competitive trading is sometimes
seen as lowering standards, but it also has a more virtuous side in that it requires cooperation between
the buyer and seller. The US as a large ‘customer’ of Chinese exports and investments, has considerable
influence on Chinese policy. Broadly speaking it is in China’s interests that the US does not start to impose
tariffs on Chinese exports. Clearly, this adjustment was not sufficient given the tariffs imposed on Chinese
imports by the US in 2018.
USING THE WEB
For the latest trade disputes go to the WTO website and search online for ‘WTO trade disputes
examples’, currently at www.wto.org/english/tratop_e/dispu_e/find_dispu_cases_e.htm.
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CHAPTER 2
International trade and investment: measurement and theories
41
Outsourcing. One of the most recent issues related to trade is outsourcing. MNCs relocate their production
to countries such as Bulgaria, China, India and Vietnam to take advantage of lower labour costs. Even
services can be outsourced, for example telephone booking systems for airlines may be outsourced to
India. This form of international trade allows MNCs to conduct operations at a lower cost. The consumer
also benefits through lower prices. However, it shifts jobs to other countries and is criticized by the people
who lose their jobs due to the outsourcing.
EXAMPLE
In 2002 Dyson, the domestic appliance manufacturer,
moved their production of bagless vacuum cleaners
to Malaysia where costs were 30 per cent lower, and
in 2003 the decision was taken to also move washing
machine production to Malaysia, making a total of
865 job losses. This resulted in negative comments
from the then Prime Minister (Tony Blair) and trade
union leaders. Mr Dyson, the founder-owner, pointed
out that the outsourcing was of manual rather than
the higher knowledge-based labour and also that they
employed 1,300 engineers, scientists and managers
at their UK factory and were recruiting more staff. In
2018 Dyson announced that it was planning to build
electric cars in Singapore. The CEO noted that the
availability of an ‘extensive supply chain and a highly
skilled workforce’ were important factors. However,
costs may well have also been a factor as Dyson
announced in 2019 that it was scrapping its plans as
it was no longer commercially viable.
More generally, outsourcing is bound ultimately to
lead to economic development and competition at all
levels. The ethical concern is that such competition
should be limited to production and development and
not be due to lower employment conditions and less
democratic institutions.
Trade policies and political issues. The actions of MNCs designed to maximize profits are seen by many as
having strong political consequences for which governments and MNCs should be held to account. People
expect imports to be restricted from countries that fail to enforce environmental laws or child labour laws,
or from countries whose governments commit large-scale abuse of human rights. Every international trade
convention now attracts a large number of protesters, all of whom have their own agendas.
The problem for MNCs is whether they should follow relative or universal values. Should they respect
or comply with the values and practices of the countries in which they operate, which may include low
environmental standards, child labour and corrupt payments to government officials (known as relative
values); or should they adopt universal values of good practice and behave in the same way wherever they
operate? Relative values are in one sense non-political in that they respect the traditions and culture of
the countries in which they operate. The counter-argument is that MNCs become a strong moral force in
these countries. Should a country wish to improve its environmental laws, for instance, there is the implied
threat that a profit-making MNC will move to another location where the laws are laxer (an instance
of the ‘race to the bottom’). In this way, countries feel pressured to maintain low standards. There is a
political consequence even to relative values.
A small step was taken in the direction of universal values by the UN Sub-Commission on the Promotion
and Protection of Human Rights, which in 2003 approved the UN Norms on the Responsibilities of
Transnational Corporations and Other Business Enterprises with Regard to Human Rights (search on
the internet for the paper’s title). These appear to be no more than a set of aspirations and, as with much
UN work, of uncertain practical implications. There would nevertheless be real difficulties if these values
were to be actively enforced. Universal values are more obviously political and may be seen as interfering
in the governance of countries. Also, the status of UN rules in a sense undermines that of governments as
many would argue that it is for governments to regulate MNCs, not the UN. Such initiatives are therefore
likely to remain purely voluntary. In a similar vein the Equator Principles outline ‘good behaviour’ for
international project finance initiatives.
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42
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
International investments. Trade agreements will also contain clauses to protect foreign direct investments
referred to as Investor–State Dispute Settlement (ISDS). Currently, there are estimated to be over 3,000
such agreements. A dispute where, say, an MNC considers that it is being unfairly treated by a host
country, is taken to the United Nations Conference on Trade and Development (UNCTAD) and decided
upon by a secret panel of lawyers following international law as determined by the UN, World Bank or
International Chamber of Commerce. An early attempt to consolidate this process was the Multilateral
Agreement on Investment (MAI, Chapter 14). This initiative by the OECD was withdrawn in 1998 due to
criticisms by developing countries that it would enable multinationals to ride roughshod over developing
countries’ legislation. Notwithstanding this setback, the EU is currently engaged in a project to establish a
Multilateral Investment Court project. As the biggest participator in such bilateral agreements, the Court
would seek to replace local agreements of its members with an EU-wide agreement. Given that in 2015
ISDS was seen as a stumbling block in the TTIP negotiations between the US and the EU, now in abeyance
for exactly the same reasons as the objections of developing countries concerning MAI, it is hard to see
that any worldwide consolidation of these clauses by the EU is going to be successful. Multinational–
government conflict is more significant in the case of investment rather than trade in the sense that there is
a greater upfront expenditure. Examples are Philip Morris Asia suing the Australian government over its
legislation on tobacco packaging, the Swedish energy company Vattenfall seeking compensation from the
German government over its decision to phase out nuclear power and the Lone Pine Resources Company
suing Canada, its own government, through its US subsidiary over the decision by Quebec to call a
moratorium on fracking. The political unease over such lawsuits is self-evident.
Factors affecting international trade flows
Because international trade can significantly affect a country’s economy, it is important to identify and
monitor the important factors. The most influential factors are:
1 inflation
2 national income
3 government restrictions
4 exchange rates.
Impact of inflation
If a country’s inflation rate increases relative to the countries with which it trades, its current account will
be expected to decrease, other things being equal. Consumers and corporations in that country will most
likely purchase more goods overseas (due to high local inflation), while the country’s exports to other
countries will decline.
Impact of national income
If a country’s income level (national income) increases by a higher percentage than those of other
countries, its current account is expected to decrease, other things being equal. As the real income level
(adjusted for inflation) rises, so does consumption of goods. A percentage of that increase in consumption
(sometimes referred to as the marginal propensity to import) will most likely reflect an increased demand
for foreign goods.
Impact of government restrictions
A country’s government can prevent or discourage imports from other countries. By imposing such restrictions,
the government disrupts trade flows. Among the most commonly used trade restrictions are tariffs and quotas.
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43
Tariffs, quotas, subsidies and dumping. If a country’s government imposes a tax on imported goods (i.e.
a tariff), the prices of foreign goods to consumers are effectively increased. Some industries, however, are
more highly protected by tariffs than others. US apparel products and farm products have historically
received more protection against foreign competition through high tariffs on related imports. EU
agriculture has also been subject to criticism, in part due to dumping surplus production on African
markets, undermining local production. The surplus production is due to subsidies received by EU
farmers, and may be regarded as an indirect tariff. Rather than taxing exports, why not undermine the
foreign competition by exporting subsidized goods? For example,6 chicken farmers in Senegal and Ghana
used to provide 100 per cent of the countries’ needs, yet this industry has virtually disappeared due to
frozen imports from the EU being 50 per cent cheaper. Sugar prices for EU farmers are three times higher
than the world price, resulting in overproduction and dumping in Africa. Even within the EU there are
examples. For instance, the British flower industry has received no government support and is having
to compete with the Dutch industry, whose superior infrastructure and investment has been heavily
supported by their government. Such subsidies are the equivalent of a tariff on UK exports of flowers as
well as home production.
In addition to tariffs, a government can reduce its country’s imports by enforcing a quota, or a maximum
limit that can be imported. Quotas have been commonly applied to a variety of goods imported by the US
and other countries. For example, the EU imposes ‘tariff rate quotas’, that is, lower duties are limited to
a set total allotted to non-EU countries by the European Commission. Member countries of the EU apply
to the European Commission for quantities within the respective quotas. In April 2013, Japan increased
the quota restriction on the major US car manufacturers from 2,000 vehicles per vehicle type to 5,000. In
January 2015 US trade negotiators reportedly dropped attempts to lift this restriction in return for Japan
allowing an additional 10,000 tons of US rice to be imported. Such is the nature of the constant low-level
trade conflicts conducted worldwide.
USING THE WEB
Information about tariffs on imported products and anti-dumping orders by the US can be found at
the United States International Trade Commission (www.usitc.gov). The European equivalent can be
accessed at: ec.europa.eu/trade/index_en.htm.
Sanctions – trade and health motives. In 2001, an outbreak of foot-and-mouth disease occurred in the UK and
eventually spread to several other European countries. This disease can spread by direct or indirect contact
with infected animals. The US government imposed trade restrictions on some products produced in the UK
for health reasons. Consequently, UK exports to the US declined abruptly. In 2004 the EU banned the import
of tuna and swordfish products from countries that did not manage fish stocks in a sustainable manner.
There have also been attempts to use regulations to restrict imports. Japan for many years was accused
of excessive restrictive regulations. More notably there was the ‘Poitiers effect’ when in 1982, in order to
stem an ‘invasion’ from Japan of video recorders, the French government decreed that they must all pass
through Poitiers with its small contingent of customs officers. Checking times went up from a few days
to months and imports reduced to a trickle. Unfortunately, the decree also affected EU exports to France,
resulting in the country being taken to the European Community Executive Committee who charged them
in the European Court of Justice for breaching free trade rules. Interestingly, part of the agreement for
France to withdraw its decree involved greater local production by its home producer Thomas-Brandt of
the Japanese JVC recorders which it was previously importing and selling under its own label. Also, an
EC-wide limit on Japanese exports was negotiated shortly afterwards.
Sanctions – political and ethical motives. North Korea, Iran, Syria, Cuba, Venezuela and now Russia have
all been subject to major trade and investment sanctions imposed by the US for human rights abuses
and in the case of Iran nuclear developments contrary to agreements. The Russian sanctions following
the invasion of Ukraine have been especially severe resulting in major companies such as McDonald’s,
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44
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
IKEA, H&M, Coca-Cola and Starbucks closing down their activities. Investment has been affected as
Russian dollar reserves held by the US Fed, Bank of England, the Bank of Canada and the ECB were
frozen, increasing (at the time of writing, 2022) the risk of Russian bond default. Furthermore, the US has
warned China against any financial assistance, though Russian banks have been offering Chinese yuan
accounts. This situation is unique in that previous sanctions have been against small, isolated countries
and shown to be very effective. Against Russia, with an economy of similar size to Germany, the outcome
is less clear. From an MNC perspective, the effect is potentially very great, especially if supply chains
and revenues are not well diversified. It is very evidently not the type of risk that can be estimated by a
frequency distribution that is often close to the statistical normal distribution. Rather, as is picked up in
the distribution of exchange rates, such events lie outside the normal distribution on their own, and are
unpredictable and mostly uninsurable.
Impact of exchange rates on MNCs
Importing and exporting are subject to two prices, the price of the goods and the price of the currency in which
those goods are being sold. It is a common mistake to assume that these prices are independent. For example,
imposing a 10 per cent import tariff is assumed to result in prices being 10 per cent higher. This is not the case.
Exporting firms will most likely reduce their prices so that the net increase in price is less than 10 per cent. The
net effect is known as the pass-through. Thus, a firm facing a new 10 per cent tariff might lower its prices by
8 per cent, making the import price only 2 per cent higher. Obviously, this would have a significant effect on
profits: if the sales margin was 16 per cent then the 8 per cent reduction in price would amount to a 50 per
cent fall in profits per unit. The extent of any such reductions would depend on the elasticity of demand – the
quantity reaction to a price change. If demand was totally inelastic then there would be no fall in demand as
a result of increasing the price and no need to reduce the price. If the demand was highly elastic then there
would be a significant fall in demand as a result of an increase in price and a company might think of reducing
its price by 10 per cent as in the above example, thereby wholly offsetting the price increase.
EXAMPLE
A tennis racket that sells in the UK for £100 will
require a payment of €110 by a French importer if
the euro is valued at €1.1 5 £1. If the British pound
then becomes more expensive, costing say €1.2,
then the French importer will have to pay €120 to
buy the tennis racket. The French importer may be
willing to pay the extra 120 2 110 5 €10, in which
case UK’s exports will not be affected. But the cost
of the racket for the French importer has increased by
(120 2 110)/110 5 0.09 or 9 per cent, so it seems
likely that the French importer will look elsewhere and
the UK will experience a fall in export quantities and
value. Alternatively, the British exporter may suffer the
effect of the high pound by lowering the UK price to
110/1.2 5 £91.67 so that the euro price remains at
€110 despite the higher value of the pound. For goods
with small profit margins such price changes can
mean a significant loss of profitability. It may be that
the British exporter reduces the price to £95 making
the euro cost 95 3 1.2 5 114 a rise of 114/110 2 1 5
0.0364 or 3.64 per cent, considerably less than the
9 per cent. When changes in prices are also taken
into effect, the sensitivity of price change to currency
change is important. In this example the producer of
rackets reduced the price by 95/100 2 1 5 0.05 or
5 per cent in response to the 9 per cent revaluation.
This is calculated as a 0.05/0.09 5 0.5555 or 55.6
per cent pass-through.
The Marshall Lerner conditions*
In relation to the balance of payments, the Marshall Lerner conditions are a formalization of the arguments
about the reaction of the quantities of imports and exports to a change in price due to a devaluation or
revaluation of a currency or a tariff. In the case of, say, a devaluation, the immediate effect is that imports
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CHAPTER 2
International trade and investment: measurement and theories
45
are more expensive and, without any volume changes, the devaluation will have a negative effect on the
balance of payments. Too often, politicians and commentators assume that because imports are more
expensive the consequent reduction in the quantity of imports demanded will be such that the overall
import bill will be less. But will it be less? Similarly with exports, because a devaluation makes the currency
cheaper, the exports will be cheaper for foreign buyers. The demand for exports can only increase, other
things being held constant. But will the reduction in the quantity of imports and the increase in exports
together be sufficient to offset the adverse effect of the increase in the price of imports? In the longer term
we hope that the good quantity effects (a reduction in demand for the more expensive imports and an
increase in demand for the cheaper exports) will outweigh the bad price effect of the increased costs of
imports due to devaluation. The overall effects are summarized in Exhibit 2.4.
EXHIBIT 2.4
Current account balance for UK, effects of exchange rate devaluation and revaluation
Devaluation
Decrease in the value of the
£ in relation to other
currencies, e.g. €1.20 = £1
Revaluation
Current spot
rate, e.g.
€1.40 = £1
Increase in the value of the
£ in relation to other
currencies, e.g. €1.60 = £1
Imports are more expensive,
demand falls and probable fall
in total cost of imports
Imports are cheaper, demand
increases and probable rise in
total cost of imports
Exports cheaper for foreign
buyers, demand increases and
certain rise in £ value exports
Exports more expensive for
foreign buyers, demand falls
and certain fall in £ value exports
Probable
current
account
improvement
Probable
current
account
worsening
Notes:
• The total value of imports depends on the quantity reaction to changes in their price (elasticity) due to the change in the value of the pound.
• Although the increase and decrease in exports is certain, the size of the change is not certain.
The Marshall Lerner conditions state that:
For a devaluation and treating all numbers as positive, the percentage reduction in the quantity
of imports plus the percentage increase in exports should be greater than the devaluation for the
balance of payments to improve.
In Exhibit 2.5 we have the inelastic scenario 1.5% 1 2% , 5%, thus the devaluation worsens the balance
of payments from 0 to 21.4; but in the elastic scenario 3% 1 6% . 5% and the balance of payments
improves from 0 to 1.8.
For a revaluation and treating all numbers as positive, the percentage increase in the quantity of
imports plus the percentage decrease in exports should be greater than the revaluation for the balance
of payments to worsen.
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46
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
EXHIBIT 2.5 The Marshall Lerner conditions. An example showing that total elasticities greater than 1 (elastic) benefit the current
account, and total elasticities less than 1 (inelastic) worsen the current account
Inelastic
Opening current
account 1
5% devaluation
5% devaluation
price effect 2
Home price 3
Quantity
reaction 4
Closing current
account 5
101.5
Exports =100
–5%
100
+1.5%
Imports = 100
5%
105
–2%
Balance = 0
Elasticity 6
1.5/5 = 0.3
102.9
2/5 = 0.4
Balance = −1.4
Total = 0.7
Elastic
Opening current
account 1
5% devaluation
price effect 2
Home price 3
Quantity
reaction 4
Closing current
account 5
Elasticity 6
103.0
3/5 = 0.6
Exports =100
–5%
100
+3%
Imports = 100
5%
105
–6%
Balance = 0
98.7
6/5 = 1.2
Balance = 4.3
Total = 1.8
Notes based on column numbers:
1 The opening current account is the same in both scenarios.
2 Devaluation increases the cost of imports and decreases the cost of exports; for illustration devaluation is the same in both scenarios.
3 Exports and imports in the home price after devaluation assuming no quantity reaction. The home price of exports is unchanged as devaluation only
affects the price of the currency. The home price of imports increases as foreign currency is more expensive.
4 The quantity reactions differ and are chosen to illustrate the effect of elasticity.
5 Calculation of the closing current account for the inelastic scenario is 100 3 (1 1 0.015) 5 101.5 then 105 3 (1 2 0.02) 5 102.9 with similar
­calculations for the inelastic scenario.
6 The negative signs are omitted in the fractions as, for example: 2(1.5/25) 5 1.5/5 5 0.3 and so on. In the literature the first negative is sometimes
omitted and elasticity is reported as negative.
Another way of expressing the relationship is that:
eexp 1 eimp . 1
The elasticity of exports (eexp) plus the elasticity of imports (eimp) must be greater than 1.
For a revaluation, making imports cheaper and exports more expensive, a surplus on the current
account will only be reduced if the increase in the quantity of imports and the reduction in the quantity of
exports outweighs the percentage revaluation.
Measurement of the elasticities is an econometric task that is made difficult by a number of factors:
First, it should be remembered that the change in price of the currency is often accompanied by a
change in the price of the goods as well (the ‘pass-through’7). The conventional assumption is that prices
are sticky in the currency of the producer,8 but there is also evidence that export prices appear to fall
less than the increase in import prices. Exporters put up their prices in the event of a devaluation and
importers find that their foreign suppliers drop their prices, offsetting less of the devaluation effect. 9 It
should be stressed that this is an empirical finding that will differ between countries and over time. The
finding, nevertheless, illustrates the complex effect on prices of a devaluation.
Second, there is the problem of identifying the price of exported and imported goods in order to
calculate any change as part of the pass-through calculation.
Third, there is a timing problem; a devaluation and its price effect are in theory immediate, but the price
agreement on existing contracts may be spread over six months or so and a company may well have taken
out derivatives that protect against adverse currency effects for similar lengths of time.
Fourth, exports and imports are often between divisions of a multinational company. Blonigen10
quotes a survey that found that 47 per cent of US exports were intrafirm, that is, between differing
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CHAPTER 2
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47
divisions of an MNC. These could be sensitive to factors such as tax regulations and tariffs rather than
our simple price quantity model.
Understandably, there is great variability in estimates of economy-wide elasticities.11 The real benefit of
the Marshall Lerner conditions is not so much in trying to estimate the precise effect of a devaluation, but
rather as a concept that enriches any debate on devaluation. Devaluation is no longer necessarily ‘good’ for
the balance of payments. If the import and export elasticities are not sufficiently elastic, then devaluation
may increase a current account deficit. Inelastic imports mean that although imports now cost more as
foreign currency is more expensive, there is no significant change in the quantities and the import bill goes
up. A developing country relying on imports of oil will likely just have to pay more for the same quantity of
imported oil if its currency devalues, not benefitting the import bill. Also, cheaper exports do not necessarily
mean that demand will increase sufficiently to offset any adverse effect due to prices. As a result, the benefit
to the export industries and substitution effect on imports may well be decidedly limited.
From a company point of view export elasticity encases the question: ‘If our currency devalues what will
be the effect on demand for our exports?’ And import elasticity: ‘If our currency devalues, will companies
that import rival products switch to our product?’ Elasticity is the critical factor. Again, there can be no
precise calculation but judgement is improved with an understanding of the elasticity effect.
EXAMPLE
On 11 August 2015 the Chinese yuan, which is a
managed currency against a basket of currencies,
was devalued by the Chinese Central Bank by 3
per cent. The bank claimed it was a move towards
a more market-orientated economy, though the
market sentiment was that it was an attempt to
boost exports by making the yuan, and hence
exports denominated in yuan, cheaper. By early
2022, the yuan had further devalued by some 14 per
cent providing a further boost to exports at a time
when the growth rate in GDP had been declining
(www.statista.com/statistics/263616). Similarly,
Germany, the world’s second largest exporter,
benefits from an undervalued euro. This makes its
exports cheaper for the whole of the euro area and
imports more expensive compared to a higher value
of the euro. Both factors for purely financial reasons
boost the German and the euro economies. There
are two main reasons for this. First, the European
Central Bank only has limited powers to manage
the euro, making it a riskier currency to invest in
and, second, the high indebtedness and lacking
economic performance of the southern countries in
the euro area serve to depress the value of the euro.
EXAMPLE
The President looked across the table at his Chief
Economist and mused: ‘So, if we devalue our currency
from 1 lira to the US dollar to 1.15 liras to the dollar you
are saying that all our exports will be cheaper to buy?’
The Chief Economist looked pleased: ‘Yes, holders
of dollars will have to pay about 15 per cent less to
buy a lira. Our tobacco, cars and clothing will all be
much cheaper for them – we should be able to export
more.’ The President looked out of the window and
eyed a passing plane: ‘Imports are going to be more
expensive – the dollar costs more, so fewer mobile
phones and foreign cars.’ ‘Yes, if they want to buy a
foreign car it is now going to cost them 15 per cent
more’, replied the Chief Economist.
The President sensed that his Economist was
simply trying to get him to agree: ‘But what if they
don’t want to give up their phones and foreign cars,
our import bill could go up.’ The Chief Economist
suddenly felt that the President was about to dismiss
his advice: ‘Sir, a cheaper currency should increase
our exports, yet our existing levels of imports will be
more expensive, but we confidently expect that the
demand for imports on average will fall and that the
increase in exports and fall in import quantities will
offset the increase in import prices. Our balance of
payments should improve.’ The President noted
the caution: ‘Should, should ... what are the other
factors?’
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48
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Interaction of factors
We have considered devaluation in isolation but in reality, this is not so. Purchasing power parity (PPP)
theory tells us that inflation should be the cause of a devaluation. Imports may be more expensive, but
home goods will be more expensive too. The decline in value of the currency will offset inflation differences.
For example, if there is 3 per cent inflation in South Africa and 10 per cent inflation in the UK, then, in
approximate terms, a South African importer would expect the UK pound to devalue by the difference
10% – 3% = 7%. Thus, import prices for the South African importer would have increased at the same rate
as domestic prices. In this way demand remains in equilibrium through the interaction of the exchange rate
and pricing. The currency acts as a kind of financial lubricant between differing inflation rates.
A devaluation also affects the outlook for an economy. If a devaluation is seen as a sign of poor financial
management, such as excessive borrowing, reduced investment and the loss of confidence, these factors
may have a much bigger effect than the devaluation itself. For these other less measurable factors we have
no clear models.
Terms of trade. Terms of trade is a measure of export prices divided by import prices. Taking the exchange
rate as fixed, an increase in the terms of trade (higher export prices and/or lower import prices) would
be beneficial if there are no quantity effects. Similarly, a worsening in the terms of trade (a lowering of
export prices and/or an increase in import prices) would on its own worsen the current account.
A flexible exchange rate may well offset movements in the terms of trade under the pressures that
drive PPP. If the terms of trade improve (an increase in export prices and/or a decrease in import prices) a
devaluation would make exports cheaper and imports more expensive, offsetting the change. The question
arises therefore as to whether economies with flexible exchange rates are able to adjust better to changes
in the terms of trade. This question is of particular concern to developing countries as they tend to have
inelastic demand where a price shock could upset the economy. A study by Broda found that developing
countries with fixed exchange rates were affected more by shock changes in the terms of trade than similar
countries with flexible rates, this being further evidence of the benefit of flexible exchange rates.12
Correcting a balance of trade deficit
As we have been suggesting, a balance of trade deficit is not necessarily a problem. It may be that a
country’s consumers benefit from imported products that are less expensive than locally produced
products. However, the purchase of imported products implies less reliance on domestic production in
favour of foreign production. Thus, it may be argued that a large balance of trade deficit causes a transfer
of jobs to foreign countries. The problem a government faces is how to limit imports without being accused
of unfair restrictions on trade and suffering retaliatory actions.
It is almost inevitable that countries with different economic and social policies will in some way be
subsidizing economic activities. For example, environmental policies can be seen as a subsidy to the clean
energy industry. A lower commercial tariff for electricity can be seen as a subsidy to all industries that
are heavy users of electricity. According to Eurostat, based on data taken in 2017, the industrial price of
electricity in the UK was 60 per cent higher than in the Netherlands. A country may impose countervailing
duties to compensate for a subsidy but a complete equalization is not really possible. 13 For European,
North American and Latin American countries a reduction in tariffs in recent years has seen an increase in
anti-dumping measures.14 The commitment to free trade seems never wholehearted, however. Judgements
are made through national processes and the WTO to limit more overt trade restrictions. Ultimately it
seems to be a political as much as an economic process.15
Economic policies can also help correct a deficit. When the world was on the gold standard, a deficit
meant that gold was transferred abroad and there was a reduction in the money supply and a deflation
in the economy that would reduce imports and lower prices, thereby increasing exports. Now that the
money supply is within the government’s remit or that of its central bank, this effect is no longer valid
as there is no longer an automatic reduction in the money supply. As we have said, the exchange rate is
subject to market opinion, there being no mechanistic relation between a deficit and the exchange rate.
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CHAPTER 2
International trade and investment: measurement and theories
49
As an example of the more complex relationship, the US normally experiences a large balance of trade
deficit, which should place downward pressure on the value of the dollar. Yet, in some years, there is
substantial investment in dollar-denominated securities by foreign investors. This foreign demand for the
dollar places upward pressure on its value, thereby offsetting the downward pressure caused by the trade
imbalance. So, on the international exchanges the excess of dollars being offered for foreign currency to
pay for imports is met by a demand by holders of foreign currency to buy dollars in order to buy bonds,
shares and deposit accounts in the US. The deficit on the current account due to the surplus imports is
being met by a positive balance on the financial account due to surplus investment into the US. Thus, a
balance of trade deficit will not always be corrected by a currency adjustment.
This particular scenario is unique to the US and possibly may be the case with the euro in the future.
In effect, the US dollar is acting as a world currency. The US can print dollars (expand its money supply),
import goods with that money and the money is not exchanged but simply deposited back in the US by
a foreign institution and used for international trade. This relationship relies on the confidence of foreign
investors in the dollar. If that confidence is lost, then the value of the dollar could fall rapidly, as happened
in the early 1970s. It is currently thought that these large imbalances may be a continuing feature of the
world economy, especially as investment becomes increasingly international.
Why a weak home currency is not a perfect solution
Even if a country’s home currency weakens, making imports more expensive and exports cheaper, its
balance of trade deficit will not necessarily be corrected for the following reasons.
Demand for imports and exports is too inelastic. As discussed above, devaluing a currency does not
necessarily mean that the increase in the quantity of exports and the reduction in the quantity of imports
will offset the increase in the price of imports.
Counterpricing by competitors. When a country’s currency weakens, its prices become more attractive
to foreign customers, and many foreign companies lower their prices to remain competitive with the
country’s firms.
Impact of other weak currencies. The currency does not necessarily weaken against all currencies at the
same time.
EXAMPLE
When the British pound weakens in Europe, the
British pound’s exchange rates with the currencies
of Hong Kong, Singapore and South Korea may
remain more stable. As some UK firms reduce
their demand for supplies produced in European
countries, they may increase their demand for
goods produced in Asian countries. Consequently,
the British pound’s weakness in European countries
causes a change in international trade behaviour
but does not eliminate the UK trade deficit.
Prearranged international transactions. Many international trade transactions are prearranged and cannot
be immediately adjusted. Therefore, a weaker British pound may attract foreign purchasers who cannot
immediately sever their relationships with suppliers from other countries. Over time, they may begin to
take advantage of the weaker British pound by purchasing UK imports, if they believe that the weakness
will continue. The lag time between the British pound’s weakness and the foreign purchasers’ increased
demand for UK products could be as long as 18 months or even longer.
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50
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
The UK balance of trade may actually deteriorate in the short run as a result of British pound
depreciation. As we have noted, the price effects (increased cost of imports) are likely to occur more
quickly than the more favourable quantity effects (reduction in quantity of imports and increase in the
quantity of exports). The short term is inelastic compared to the medium term. This pattern is called the
J-curve effect, and it is illustrated in Exhibit 2.6. The further decline in the trade balance before a reversal
creates a trend in the current account balance that can look like the letter J.
EXHIBIT 2.6
UK current
account
balance
J-curve effect
Exports are cheaper, imports more
expensive. Improved balance if
export volumes increase and import
volumes decrease sufficiently
+
Time
UK devaluation makes
imports more expensive,
balance worsens
immediately
Imports slow down
due to higher prices
Exports are cheaper
and increase
–
Intracompany trade. A fifth reason why a weak currency will not always improve a country’s balance of
trade is that importers and exporters that are under the same ownership have unique relationships. Many
firms purchase products that are produced by their subsidiaries in what is referred to as i­ ntracompany trade
(‘intra’ means within and ‘inter’ means between). This type of trade makes up a significant proportion of
international trade; about a third of US exports are intracompany transactions that will be carried out at
transfer prices agreed between the two subsidiaries of the same company. This type of trade will normally
continue regardless of exchange rate movements. If the US subsidiary exports to the European subsidiary
and the value of the euro falls then the transfer price between the two subsidiaries can be adjusted or
simply left as the gain of one subsidiary, which will be the loss of the other leaving no overall gain or loss
to the company. Thus, the impact of exchange rate movements on intracompany trade patterns is limited.
International capital flows
The financial account at first glance appears to be about the buying and selling of shares and bonds and
not about investments in factories, offices, retail outlets and so on. This is not true in the case of direct
transactions. Companies cannot operate in foreign countries without having a legal presence there. They
have to set up companies such as Panasonic UK Ltd consisting of shares wholly owned by their Japanese
parent company in this case. The purchase of shares in Panasonic UK Ltd would count as an increase
in ‘Direct Liabilities Equity’ in the UK balance of payments. Liabilities represent the value of assets in
the UK financed by non-resident entities, mirroring liabilities on a company balance sheet. If Panasonic
UK Ltd wanted more money, then it could issue bonds again purchased by the parent company and this
would count as an increase in ‘Direct Liabilities Debt’ in the UK balance of payments. In similar fashion, if
Roberts Radio wanted to operate in Japan, they would have to set up a company Roberts Radio GK (the
equivalent of Ltd) and the purchase of shares by the parent company in their Japanese subsidiary would,
in the UK balance of payments, count as an increase in ‘Direct Assets Equity’ and similarly so with issuing
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CHAPTER 2
51
International trade and investment: measurement and theories
bonds recorded as ‘Direct Assets Debt’. Negative figures represent a reduction in such holdings in both
assets and liabilities. For example, a parent company in a foreign joint venture may sell its foreign shares
or debt or it may close its subsidiary and dispose of its assets. Both would be recorded as negative figures.
Thus, these rather abstract terms represent real economic activity.
Portfolio transactions, traditionally defined as less than 10 per cent interest, are concerned with the
buying and selling of shares and bonds in the financial markets with no control over decisions. They
nevertheless represent the potential for direct investment, a potential offsetting source of foreign currency
(to match up with foreign expenditure) or simply a store of value in preference to the home currency.
In looking at the numbers in Exhibit 2.7, the first matter to note is their variability over time. The US
recorded a reduction in foreign holdings of shares of $8,483m in 2021; the previous year it was $648,399m
positive! The equity investment in South Africa of $41,275m in the previous year was $3,154m in 2021 – a
more typical figure. This reflects not only the ease of international investment but also the uncertainty in
current times. Uncertainty is also reflected in the negative numbers. Over a quarter are negative representing
a reduction of investment into a country (liabilities) and from that country abroad (assets). The historically
large portfolio liabilities of the US reflect its role as the world reserve currency as other countries purchase
US bonds and shares as a store of value. The difference between the African and US and European countries
is also clear. Assets less liabilities, not shown here, will also show whether a country experienced a net
investment in or out for a particular year. An average over a number of years would be more instructive.
The expectation for developing countries should be net inward investment and for developed countries
net outward investment, following the view that wealthy developed countries have a surplus of savings.
Alternatively, successful developing countries may generate a surplus of earnings through export-led growth
and invest abroad as a store of value in a more stable currency such as the dollar.
EXHIBIT 2.7
Foreign investment: direct (more than 10% holding) and portfolio (less than 10% holding)
2020
2021
2021
2021
2021
2021
Egypt
Euro area
Germany
South Africa
UK
US
—
−18,988
134,532
1,137
113,919
460,513
327
198,391
59,158
−1,143
−12,316
40,776
Equity
3,863
−203,406
43,817
41,275
61,602
392,757
Debt instruments
1,989
38,300
29,838
14
−39,997
56,&53
1,573
423,955
187,803
18,948
−111,398
153,873
—
486,359
75,078
7,937
21,877
450,261
−1,997
601,954
−7,133
−27,961
63,770
−8,434
4,585
−190,730
-29,897
−341
194,739
591,720
$million
Direct assets
Equity
Debt instruments
Direct liabilities
Portfolio assets
Equity
Debt instruments
Portfolio liabilities
Equity
Debt instruments
Notes:
• Equity includes investment in equity funds not just individual companies.
• Assets (portfolio and direct) measures changes in holdings of foreign investments.
• Liabilities (portfolio and direct) measures changes in foreign investment into the home country.
Source: IMF, 2021
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52
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
USING THE WEB
A reminder that balance of payment figures can be retrieved from ‘IMF Balance of Payments and
International Investment Position’ and selecting ‘by economy’. The manual, also available, is a
definition of the terms and does not contain the data. Note that the 2021 figures quoted here are
likely to be revised in later years as new information is reported.
In recent years average external assets and liabilities of major countries have tripled (these figures
include direct investment). This increase has been accompanied by a decline in home bias of investments,
as the increase in overseas investments is much more than the increase in the total value of domestic
investment markets. The cause of the increase has been largely due to the liberalization of capital markets
in the 1980s and 1990s. Businesses, trade and investment, and increasingly the political debate, have
moved from being essentially national to international.
USING THE WEB
Information on foreign direct investment (FDI) can be found in the UNCTAD World Investment
Report, an annual report. The download is currently available at: www.unctad.org/; documents
can be retrieved by using the local search engine. Significant multinational investors abroad are:
General Electric (US), Vodafone (UK), Ford Motor Co. (US), BP (UK), General Motors (US), Shell
plc (UK, Netherlands), Toyota (Japan), Total (France), France Telecom (France) and ExxonMobil (US).
The annual reports of these companies can be downloaded from the internet with the name of the
company and the words ‘annual report +pdf’. All major companies disclose the geographical location
of foreign investments and report on the investment policies of the company.
Factors affecting foreign direct investment
Some of the more common factors that could affect a country’s ability to attract FDI are identified here.
Changes in restrictions. During the 1990s, many countries lowered their restrictions on FDI, thereby
opening the way to more FDI in those countries. Many MNCs have been investing in less developed
countries such as Argentina, Chile, Mexico, India and China. New opportunities in these countries have
arisen from the removal of government barriers.
Privatization. Several national governments have recently engaged in privatization, or the selling of some
of their operations to corporations and other investors. Privatization is popular in Brazil and Mexico,
in Eastern European countries such as Poland and Hungary, and in such Caribbean territories as the
Virgin Islands. It allows for greater international business as foreign firms can acquire operations sold by
national governments.
Privatization was used in Chile to prevent a few investors from controlling all the shares and in France
to prevent a possible reversion to a more nationalized economy. In the UK, privatization was promoted
to spread stock ownership across investors, which allowed more people to have a direct stake in British
industry.
The primary reason that the market value of a firm may increase in response to privatization is the
anticipated increased emphasis on profits. Managers in a privately owned firm can focus on the goal of
maximizing shareholder wealth, whereas in a state-owned business, the state must consider the economic
and social ramifications of any business decision. Also, the salaries of managers are more closely linked
to profits than would be the case in a nationalized equivalent. Whatever your views about the merits or
otherwise of nationalization it is undoubtedly the case that the trend worldwide is to denationalize or at
least to adopt the market-orientated philosophy of private enterprise.
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CHAPTER 2
International trade and investment: measurement and theories
53
USING THE WEB
Foreign direct investment information
Further information on FDI can be obtained from the World Bank website at: www.worldbank.org.
The ‘Investment Policy Review’ and the ‘World Investment Directory’ are useful further links from
this page. The OECD offers a developed country viewpoint at: www.oecd.org; choose the ‘By
Topic’ option. Finally, the search engine at: www.corporatewatch.org offers a decidedly alternative
(dissident) view of investment.
Potential economic growth. Countries that have greater potential for economic growth are more likely
to attract FDI because firms recognize that they may be able to capitalize on that growth by establishing
more business there.
Exchange rates. Firms typically prefer to direct FDI to countries where the local currency is expected to
strengthen against their own. Under these conditions, they can invest funds to establish their operations in
a country while that country’s currency is relatively cheap (weak). Then, earnings from the new operations
can periodically be converted back to the firm’s currency at a more favourable exchange rate. Emerging
markets can be expected to exhibit strengthening currencies.
Tax rates. Countries that impose relatively low tax rates on corporate earnings are more likely to attract
FDI. When assessing the feasibility of FDI, firms estimate the after-tax cash flows that they expect to
earn. High taxes can be to a certain extent avoided by MNCs by manipulating transfer prices such that
subsidiaries in high tax countries report low taxable profits. The traditional response of multinationals to
such accusations is ‘we pay all the taxes we owe’ rather than ‘we focus on tax minimization’, but there is
evidence of the latter.16
Factors affecting international portfolio investment
The desire by individual or institutional investors to direct international portfolio investment to a specific
country is influenced by the following factors.
Tax rates on interest or dividends. Investors normally prefer to invest in a country where the taxes on
interest or dividend income from investments are relatively low. Investors assess their potential after-tax
earnings from investments in foreign securities.
Interest rates. Portfolio investment can also be affected by interest rates. Money tends to flow to countries
with high interest rates, as long as the local currencies are not expected to weaken. Such investment is
known as the carry trade (Chapter 5).
USING THE WEB
Information on capital flows and international portfolio transactions is provided at: www.
worldbank.org and at the website for the Bank for International Settlements: www.bis.org/; follow
the ‘Statistics’ link.
Exchange rates. When investors invest in a security in a foreign country it has to be purchased in the
currency of that country – a simple point that is often overlooked. Return is therefore affected by: (1) the
change in the value of the security, and (2) the change in the value of the currency in which the security is
denominated. If a country’s home currency is expected to strengthen, foreign investors may be willing to
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54
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
invest in the country’s securities to benefit from the currency movement. Conversely, if a country’s home
currency is expected to weaken, foreign investors may decide to purchase securities in other countries and
withdraw their investments from the less stable currency. This is referred to as capital flight.17
Economic theories of international trade and investment
International trade has been a significant part of economic life since prehistoric times, judging from
the widely dispersed origin of artefacts found in prehistoric graves and settlements. International
investment has been important since medieval times when endorsed bills of exchange (‘you owe me’
notes that are signed over) were preferred to cash for international transactions – such bills being
worthless except to the endorsee.
The role of economic theories has been to try to find a rationale for trade and in particular to address
the concern that international trade might be weakening or indeed strengthening an economy. Such
concerns motivated US President Trump’s imposition of tariffs in 2018, contrary to the main economic
models of international trade. This does not mean that he was wrong. Models are simplifications of the
real world and are always reliant on their assumptions that can at times be unrealistic.
In this section we address five theories in chronological order. Our focus is that of the MNC and
therefore we need to understand the logic and intuition of each theory rather than the precise effect on the
wealth of nations.
Mercantilism. This is the oft-expressed view that exports are good and imports are somehow bad. This
is in contrast to free trade arguments that deficits can still enhance a country’s wealth. A surplus on the
current account creates surplus funds that can be invested abroad and this has typically been understood
as a source of influence and power. Three countries in modern times have this broad profile: China, Japan
and Germany. The mercantilists would argue that it is their export surplus and the protectionist attitude
towards inward investment and imports that is the source of their economic growth. More generally,
mercantilists argue that free trade and the loss of jobs are linked because imports destroy domestic
industries. Anti-dumping legislation, accepted by all as necessary, is in part a recognition of this argument
because free trade must also be fair trade. The definition is problematic in that, for instance, to what
extent is it fair that employers in some countries face considerable employment taxes and social security
provisions that do not exist in other countries? Should such countries be protected from imports that are
cheaper because taxes are lower? If not, then the only way to compete is to lower taxes and hence lower
social services. This is the ‘race to the bottom’ critique. Yet trade has always brought wealth. There are
winners and losers and no clear conclusions here apart from noting that, in academic writing, mercantilism
is unfashionable but a constant theme in the literature.18
The theory of absolute and comparative advantage. These theories are important as they are often cited
directly or indirectly as a justification for reducing tariffs and encouraging world trade and hence underlie
the philosophy of globalization.
The overall rationale is that international total production of goods and services should be maximized
and then shared out through trade. The result is that every country will be better off in every way (a Pareto
Optimal solution).
In the case of absolute advantage, the benefits are easy to see. For example, there are gold deposits in
the rivers of Scotland and Wales. Industry’s need for gold in the UK could possibly be met by extensive
investment in retrieving the gold from these rivers. Alternatively, gold can be mined in South Africa
using far fewer resources. Similarly, in South Africa certain machinery may well be very difficult to
produce compared with gold. It makes sense for the UK to produce the machinery and for South Africa
to produce gold and to trade the products. In essence this is a productivity argument in the context of
international trade.
The economist David Ricardo extended this argument to cases where a country is less productive in all
respects and showed that if it concentrated on what it was less inefficient at producing there would still be
a Pareto Optimal solution. We illustrate the argument in Exhibit 2.8.
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CHAPTER 2
EXHIBIT 2.8
International trade and investment: measurement and theories
55
The law of comparative advantage – example
Countries A and B are similar with regard to the factors of production (land, labour, machinery, etc.). The only
traded product is pizzas made up of a base and a top. The productivity rates are as follows:
NO TRADE
Productivity: minutes per item
A
B
Base
1
2
Top
1
3
30
12
Pizzas/hour
SPECIALIZE
World
42
Output per hour
AND TRADE
A
B
World
Base
15
30
45
Bases:
Top
45
0
45
45
Pizzas/hour
A
B
Opening
15
30
Trade
17
–17
Closing
32
13
45
0
–13
13
32
13
Tops:
Opening
Trade
Closing
Thus the output per hour for A has increased from 30 to 32 and for B from 12 to 13.
There are nevertheless a number of important assumptions which lessen the strength of this argument:
1 The factors of production are assumed to be fixed. In the case of natural resources this is obviously the case.
But machinery can be exported and labour can emigrate. For example, the term ‘brain drain’ was used to
refer to the movement of scientists from the UK to the US in the 1960s.
2 If both countries are equally productive then there is no rationale for trade as there is no advantage to be
gained. Increasingly, this is the case as automation makes productivity more transportable.
3 There is no consideration of the economic effects within the country. In our example, trade makes the pizza
top producers in Country B redundant. The term is frictional unemployment as they are required to find
other employment.
4 There is no consideration of price. Aside from tariffs it may be that there are more workers and more wheat
and farming in Country B compared with A. Although not as productive, the supply can nevertheless be
greater and the price cheaper.
5 There is no consideration of employment costs and costs from other differences such as regulatory and
environmental factors.
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56
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Heckscher–Ohlin theorem. The focus of this theory is abundance. Labour may be less productive, the
land less fertile, the machinery less efficient, but if the quantities of land, labour and machinery are much
greater, then such countries may well develop a tradeable surplus. The Heckscher-Ohlin theorem translates
these ideas of productivity and resource abundance to the price mechanism. Prices, unconstrained by tariffs
and quotas, should guide the profit motive and result in specialization and international trade reflecting
the relative abundance and productivity of each country.
This explains why less developed countries with less expensive labour are large producers of clothes,
basic computers and other lower technology equipment even though they may be less productive than
a developed country. Another example chiefly related to productivity is that of the island economies
(Martinique, the Seychelles and Virgin Islands), which specialize in tourism and rely completely on
international trade for most products. Although these islands could produce some goods, it is more
efficient for them to specialize in tourism. That is, the islands are better off using some revenues earned
from tourism to import products rather than attempting to produce all the products that they need
(a condition known as autarky).
A critical condition of these theories is international trade, and here we have support from history.
Countries that have been excluded from international trade (e.g. North Korea, Iran, Libya, Cuba and
arguably Eastern Europe) have all suffered from backward economies and there have been clear benefits
when restrictions have been eased. Note that these are examples of the successful exclusion of relatively
small countries from international trade, all for political reasons. At the time of writing, sanctions are
being imposed on Russia for the invasion of Ukraine. With regard to international finance, success is
less likely. For example, exclusion from the SWIFT international payments system is likely to result in
payments being diverted through friendly countries such as China or India. Nevertheless, there will no
doubt be considerable initial impact and there are, at the time of writing, predictions of recession in Russia
as a result. The underlying point still remains that trade equates with greater wealth both in theory and
practice.
Although the theories provide a rationale for much of observed trade, there are examples that are
more difficult to explain. On average, imports into the US are more capital intensive than their exports.
You would expect this of a developing country rather than the world’s most developed country
(this observation is known as the Leontief paradox).
EXAMPLE
From the above discussion, suppose that Countries
A and B produce all their own food and machinery,
producing about as much food and as much
machinery as each other – these equal size
assumptions are to simplify calculations and are
otherwise not important. Country A is more efficient
at food production and Country B more efficient
at machinery production. Then international trade
is introduced. Country A reduces its machinery
production by 4 per cent to 96 per cent and with
those resources increases its food production by
20 per cent to 120 per cent of before trade levels.
Country B reduces its food production to 95 per
cent and increases its machinery production to
114 per cent of before trade levels. They then trade
as in the following table.
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CHAPTER 2
Gains from international trade
Country A
Country B
Machinery
Food
Machinery
Food
Before international trade, A and B self-sufficient
producing about the same amounts of food and
machinery as each other
100%
100%
100%
100%
Specialization due to international trade (A in food,
B in machinery)
96%
120%
114%
95%
Exchange: B trades surplus machinery for A’s
surplus food
17%
210%
27%
110%
After international trade
103%
110%
107%
105%
Notes:
• Country A can reduce its production of machinery by 4 per cent
and increase its production of food by 20 per cent because the
resources released through reducing machinery production can
be more productively used in producing food.
•
57
International trade and investment: measurement and theories
Country B in similar fashion releases resources by reducing its
food production by 5 per cent and uses those resources more
productively to produce machinery.
•
Country A exchanges 10 per cent of its food surplus in exchange for
7 per cent of B’s machinery surplus. Both countries are now better
off as they now have more food and machinery than before trade.
•
Country A can be less productive than B at both machinery and
food and there will still be gains from international trade, similarly
B can be less productive than A. Alternatively, A may have more
abundant food resources and B more abundant machinery
resources.
Imperfect markets theory. The unrestricted mobility of factors would create equality in costs and returns
and remove the comparative cost advantage. However, the real world suffers from imperfect market
conditions where factors of production are somewhat immobile. There are costs and restrictions related
to the transfer of labour and other resources used for production. There may also be restrictions on
transferring funds and other resources among countries, for example tariffs and restrictions on imports
that can only be overcome by producing in the relevant country. Because markets for the various resources
used in production are ‘imperfect’ in the home market, firms often invest abroad to capitalize on a foreign
country’s resources. So, another way of looking at the comparative advantage argument is to see that
foreign trade and investment are motivated by the need to overcome imperfect markets. It should be
stressed that perfect markets are not thought to be necessarily desirable.
It is unfortunate that the words ‘perfect’ and ‘imperfect’ have ethical connotations. If business faces
restrictions on the factors of production in order to protect the environment, then to what extent is this an
imperfection? A state of unregulated, uncontrolled international trade is clearly not a state of perfection.
Theories have been criticized for advocating a ‘race to the bottom’ in failing to value regulations. Is a
multinational investing in a country because of its low environmental standards or its poor labour
legislation? And are not such motives putting pressure on countries to lower their standards in order to
compete?
Product cycle theory. One of the more popular explanations as to why firms evolve into MNCs and engage
in international trade is the product cycle theory. According to this theory, firms first become established in
the home market to meet local demand. A lack of information and a lack of resources create a preference
for single market development. Where the product is successful, the firm will experience foreign demand
for its products from exporters, foreign companies or even via the internet from foreign customers. As time
passes, the firm may feel the only way to retain its advantage over competition in foreign countries is to
produce the product in foreign markets, thereby reducing its transportation costs. The competition in the
foreign markets may increase as other producers become more familiar with the firm’s product. The firm
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58
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
may develop strategies to prolong the foreign demand for its product. A common approach is to attempt
to differentiate the product so that other competitors cannot offer exactly the same product. These phases
of the cycle are illustrated in Exhibit 2.9. Most of the established MNCs today have followed this route.
Greater availability of finance, knowledge and better communications as well as the internet suggests that
in future more developments may start at an international level, but currently the product life cycle theory
remains a good description.
EXHIBIT 2.9
International product life cycle
Level of
foreign sales
International market stabilizes,
production located internationally
to exploit cost savings
Exports product
to meet foreign
demand
Creates product
to meet local
demand
Time
Global strategies. International business is seen as a product of global strategies being pursued by MNCs.
The large investments required for medical research can only be recouped by patenting and marketing the
products worldwide. It is similar for the aircraft industry and big budget films. Prestigious brand names
(France’s Louis Vuitton, Ralph Lauren in the US, Swiss Rolex watches) require a worldwide market as part
of their attraction. Where there is already a strong international market, firms need to produce and sell
internationally to protect their sales. For example, computer chip production and car production cannot
be profitably viewed as single-country products unless catering for a niche market only.
Agencies that facilitate international flows
A variety of agencies have been established to facilitate international trade and financial transactions. These
agencies often represent a group of nations. A description of some of the more important agencies follows.
International Monetary Fund
The United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire,
in July 1944, was called to develop a structured international monetary system. As a result of this
conference, the International Monetary Fund (IMF) was formed. The major objectives of the IMF, as
set by its Charter, are to: (1) promote cooperation among countries on international monetary issues,
(2) promote stability in exchange rates, (3) provide temporary funds to member countries attempting to
correct imbalances of international payments, (4) promote free mobility of capital funds across countries,
and (5) promote free trade. It is clear from these objectives that the IMF’s goals encourage increased
internationalization of business.
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CHAPTER 2
International trade and investment: measurement and theories
59
The IMF is overseen by a Board of Governors, composed of finance officers (such as the head of the
central bank) from each of the 189 member countries. It also has an Executive Board composed of 24
executive directors representing the member countries. This board is based in Washington, DC, and meets
at least three times a week to discuss ongoing issues.
One of the key duties of the IMF is its compensatory financing facility (CFF), which lends money in
order to reduce the impact of export instability on country economies. Although it is available to all IMF
members, this facility is used mainly by developing countries. A country experiencing financial problems
due to reduced export earnings must demonstrate that the reduction is temporary and beyond its control.
In addition, it must be willing to work with the IMF in resolving the problem.
Each member country of the IMF is assigned a quota based on a variety of factors reflecting that country’s
economic size and involvement in international trade and investment and the variability of its trade and
investment. Members are required to pay this assigned quota. The amount of funds that each member can
borrow from the IMF depends on its particular quota. Voting rights are also dependent on quotas.
The financing by the IMF is measured in special drawing rights (SDR). The SDR is an international
reserve asset created by the IMF and allocated to member countries to supplement currency reserves.
The SDR is not an issued currency but simply a unit of account for measuring only. It may be thought of
as literally a basket of currencies. Currently, there are $0.58252, €0.38671, 1.0174 yuan, 11.90 yen and
£0.085946 in the basket, making up 1 SDR. Thus to work out the value of the SDR in any one currency
you just have to convert the basket into that currency at the current exchange rates. Therefore the SDR’s
value fluctuates in accordance with the value of the currencies in the basket.
Funding dilemma of the IMF – conditionality and austerity. The IMF typically specifies economic reforms
that a country must satisfy to receive IMF funding (the term ‘conditionality’ refers to IMF requests attached
to lending). In this way, the IMF attempts to ensure that the country uses the funds responsibly. Although
its lending powers have not kept pace with the growth of the international economy, the IMF retains great
authority. Banks are generally unwilling to lend unless the IMF has agreed terms with the country.
Conditionality is seen by critics as pursuing an overly free market philosophy that does not address the
causes of the financial problems. Conditionality packages are often referred to as austerity packages or fiscal
consolidation (bringing down government deficits) as opposed to fiscal stimulus (government expenditure
to increase economic activity) as they require governments to reduce their expenditure and reduce their
borrowing and control the money supply. It is arguably the case that overspending is likely to be part of a
country’s problems. The result however seems anomalous, rescuing an economy by asking the government
to reduce spending, cutting back on projects and financial obligations such as pensions and salaries that will
have the immediate effect of reducing demand and economic activity. Surely this will worsen not improve
the situation? This is a current economic debate.19 On the one side there are the Keynesian-type economists
arguing that economies recover through greater government borrowing and spending to increase demand;
on the other side the monetarists (sometimes called revisionists) argue that government spending and
borrowing is crowding out the private sector and keeping interest rates artificially high.20
As an example, during the Asian crisis (1997–98), the IMF agreed to provide $43 billion to Indonesia.
The negotiations were tense, as the IMF demanded that President Suharto break up some of the monopolies
run by his friends and family members and close a number of weak banks. Citizens of Indonesia interpreted
the bank closures as a banking crisis and began to withdraw their deposits from all banks. In January
1998, the IMF demanded many types of economic reform, and Suharto agreed to them. The reforms may
have been overly ambitious, however, and Suharto failed to institute them. The IMF agreed to renegotiate
the terms in March 1998 in a continuing effort to rescue Indonesia, but this effort signalled that a country
did not have to meet the terms of its agreement to obtain funding. A new agreement was completed
in April, and the IMF resumed its payments to support a bailout of Indonesia. In May 1998, Suharto
abruptly discontinued subsidies for gasoline and food, which led to riots. Suharto blamed the riots on the
IMF and on foreign investors who wanted to acquire assets in Indonesia at depressed prices.
More recently the IMF was part of the ‘troika’ that imposed an austerity package on Greece in 2010
as a condition for a €110 billion loan. Naturally there are concerns as to whether Greece will ever fully
recover; in 2019 the economy was the same size as in the year 2000.21
The dilemma for the IMF is that its terms for lending (conditionality) have inevitable political
consequences. Votes in the IMF are proportional to SDR quotas, that is, to the financial contribution of the
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60
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
country; it is therefore dominated by the richer countries. Developing countries feel aggrieved that a body
with no democratic status should have a greater influence on their lives than the UN.22 The UN website
supports this view and has suggested that the IMF and World Bank economic conditionality packages
increase levels of poverty and inequality in developing countries.
Perhaps not surprisingly academic papers have also supported the view that the IMF should be more
accountable and also that it should be less reliant on the dollar. The practical feasibility of replacing
the dollar is questionable.23 Creating a world alternative as a reformed SDR, with the potential wealth
distribution consequences combined with a belief that this wealth can be distributed in a democratic
manner among members, is indeed a bold idealistic concept. An alternative suggestion is to have regional
IMFs. This follows the view that the IMF has been more favourable to Greece than to, say, Thailand
because Greece is closer to the major funders of the IMF.24
In sum, the notion that the IMF can be a world funding body has existed in one form or another since
Bretton Woods, but the problem has been that its funding cannot keep pace with the development in
world trade. Instead it has increasingly placed the role of reporting onto economies, and the finding that
an economy is pursuing sound economic policies is used as assurance by other lenders in assessing country
risk (Chapter 15).
World Bank
The International Bank for Reconstruction and Development (IBRD), also referred to as the World
Bank, was established in 1944. Its primary objective is to make loans to countries to enhance economic
development. For example, the World Bank extended a loan to Mexico for about $4 billion over a 10-year
period for environmental projects to facilitate industrial development near the US border. Its main source
of funds is the sale of bonds and other debt instruments to private investors and governments. The World
Bank has a profit-orientated philosophy. Therefore, its loans are not subsidized but are extended at market
rates to governments (and their agencies) that are likely to repay them.
A key aspect of the World Bank’s mission is the Structural Adjustment Loan (SAL), established in 1980.
A significant problem of international investment in developing countries is that foreign investment is
in areas profitable to the developed world. MNCs cannot be expected to invest in schools, the judiciary
or a proper social service and pension provision. The imbalance created by such commercial investment
can lead to corruption, problems in contract enforcement, lawlessness and political unrest. The SALs are
intended to counteract such tendencies. For example, a SAL to the Colombian government is described as
having the particular aims of providing:
New incentives for employers to create jobs for young, elderly, disabled and unemployed Colombians;
Expansion of apprenticeship and training opportunities; More nutrition and child care assistance to
poor families; Health insurance for more low-income workers.
World Bank website press release No:2003/82/LAC
Given that the progress of developing countries has in many cases been very slow over the years, the
effectiveness of such loans has been called into question.
Because the World Bank provides only a small proportion of the financing needed by developing
countries, it attempts to spread its funds by entering into co-financing agreements. Co-financing is
performed in the following ways:
1 Official aid agencies. Development agencies may join the World Bank in financing development
projects in low-income countries.
2 Export credit agencies. The World Bank co-finances some capital-intensive projects that are also
financed through export credit agencies.
3 Commercial banks. The World Bank has joined with commercial banks to provide financing for
­private-sector development. In recent years, more than 350 banks from all over the world have participated in co-financing.
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61
The World Bank recently established the Multilateral Investment Guarantee Agency (MIGA), which
offers various forms of political risk insurance. This is an additional means (along with its SALs) by which
the World Bank can encourage the development of international trade and investment.
World Trade Organization
The World Trade Organization (WTO) was created as a result of the Uruguay round of trade
negotiations that led to the GATT accord in 1993. This organization was established to provide a forum
for multilateral trade negotiations and to settle trade disputes (refer to the Trade disputes section earlier)
related to the GATT accord. It began its operations in 1995 with 81 member countries and now has 164.
Member countries are given voting rights that are used to make judgements about trade disputes and
other issues.
International Financial Corporation
In 1956 the International Financial Corporation (IFC) was established to promote private enterprise within
countries. Composed of a number of member nations, the IFC works to promote economic development
through the private rather than the government sector. It not only provides loans to corporations but also
purchases stock, thereby becoming part owner in some cases rather than just a creditor. The IFC typically
provides 10 to 15 per cent of the necessary funds in the private enterprise projects in which it invests, and
the remainder of the project must be financed through other sources. Thus, the IFC acts as a catalyst, as
opposed to a sole supporter, for private enterprise development projects. Traditionally it has obtained
financing from the World Bank but can borrow in the international financial markets.
International Development Association
The International Development Association (IDA) was created in 1960 with country development
objectives somewhat similar to those of the World Bank. Its loan policy is more appropriate for less
prosperous nations, however. The IDA extends loans at low interest rates to poor nations that do not
qualify for loans from the World Bank.
Bank for International Settlements
The Bank for International Settlements (BIS) attempts to facilitate cooperation among countries with
regard to international transactions. It also provides assistance to countries experiencing a financial crisis.
The BIS is sometimes referred to as the ‘central banks’ central bank’ or the ‘lender of last resort’. It played
an important role in supporting some of the less developed countries during the international debt crisis in
the early and mid-1980s. It commonly provides financing for central banks in Latin American and Eastern
European countries.
An important role is to provide support for the Basel Committee on Banking Supervision (BCBS),
which sets out regulations for international banking supervision. In particular, the BCBS recommends
liquidity requirements for banks. Recently it has issued recommendations known as Basel III on banking
supervision. The agreements are voluntary on the part of its members, but failure to comply would mean
a loss of confidence in the particular bank that would have severe financial consequences. Governments
have gradually adopted the ratios and recommendations concerning governance of financial institutions
by the BCBS. Its influence has spread from large banks to small credit unions and thereby the whole of the
financial system. Of all the international financial bodies, the BIS is one of the most anonymous and most
influential.
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62
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Regional development agencies
Several other agencies have more regional (as opposed to global) objectives relating to economic
development. These include, for example, the Inter-American Development Bank (focusing on the needs of
Latin America), the Asian Development Bank (established to enhance social and economic development in
Asia) and the African Development Bank (focusing on development in African countries).
In 1990, the European Bank for Reconstruction and Development was created to help the Eastern
European countries adjust from communism to capitalism. It now helps to promote projects that lead
towards open and democratic market economies, very much supporting the philosophy of free trade.
Western European countries taken together are the major shareholders with the US as the biggest single
country holding a 10 per cent interest. Japan, Italy, Germany and the UK are the next largest members
with an 8.5 per cent subscription each.
BRICS
The BRICS alliance (Brazil, Russia, India, China and South Africa) is a representative group of the major
(economically) developing nations. Whether this becomes a new voice in international finance has yet
to be determined. Given that the US is taking a more aggressive approach to trade, BRICS serves as a
potentially powerful opposition, but there seems to be little by way of joint action.
Summary
investment or portfolio investment. Direct foreign
investment tends to occur in those countries
that have no restrictions and much potential for
economic growth. Portfolio investment tends
to occur in those countries where taxes are not
excessive, where interest rates are high and
where the local currencies are not expected to
weaken.
●●
The key components of the balance of payments
are the current account and the financial account.
The financial account is a broad measure of
the country’s international trade balance. The
financial account is a measure of the country’s
long-term and short-term capital investments,
including direct foreign investment and
investment in securities (portfolio investment).
●●
A country’s international trade flows are affected by
inflation, national income, government restrictions
and exchange rates. High inflation, a high national
income, low or no restrictions on imports and a
strong local currency tend to result in a strong
demand for imports and a current account deficit.
●●
Economic theories of international trade offer a
justification for international trade but also offer a
critique based on the assumptions on which the
theories rest. The main theories are mercantilism,
the theory of absolute and comparative
advantage and the Heckscher-Ohlin theorem.
●●
Although some countries attempt to correct
current account deficits by reducing the value of
their currencies, this strategy critically depends
on import and export elasticities.
●●
●●
A country’s international capital flows are affected
by any factors that influence direct foreign
International transactions are overseen by a
number of international bodies, being mainly the
International Monetary Fund, the World Trade
Organization and the Bank for International
Settlements. Other agencies encourage trade
and investment.
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CHAPTER 2
International trade and investment: measurement and theories
63
Critical debate
Trade and human rights
International finance and accountability
Proposition. Some countries do not protect human
rights in the same manner as European countries. At
times, European countries should threaten to restrict
EU imports from, or investment in, a particular country
if it does not correct human rights violations. The EU
should use its large international trade and investment
as leverage to ensure that human rights violations do
not occur. Other countries with a history of human rights
violations are more likely to honour human rights if their
economic conditions are threatened.
Proposition. The sheer size of the foreign currency
Opposing view. No. International trade and human rights
are two separate issues. International trade should not
be used as the weapon to enforce human rights. Firms
engaged in international trade should not be penalized
for the human rights violations of a government. If the
EU imposes trade restrictions to enforce human rights,
the country will retaliate. Thus, the EU firms that export
to that foreign country will be adversely affected. By
imposing trade sanctions, the EU is indirectly penalizing
the MNCs that are attempting to conduct business in
specific foreign countries. Trade sanctions cannot solve
every difference in beliefs or morals between the more
developed countries and the developing countries. By
restricting trade, the EU will slow down the economic
progress of developing countries.
Who has the better argument and why? Search
the web under ‘UN Norms on the Responsibilities of
Transnational Corporations and Other Business Enterprises
with Regard to Human Rights’.
markets makes MNCs and their free market philosophy
intimidating even for developed countries. Countries can in
effect no longer regulate their financial institutions or their
currencies. Only the IMF and the G8 have any influence
and neither of those are democratic bodies. The UN has
tried, but frankly, its statement of Norms for Transnational
Corporations is not very strong. Although MNCs do not
want to give the impression that they are above the law, it
is difficult to see what law they are obeying.
Opposing view. Nonsense. Companies are registered in
their home country and their subsidiaries are registered
in their country of operation. They obey all the laws of
those countries and more – transgressions by MNCs, if
you look on the web, are remarkably few. MNCs in their
annual reports demonstrate that not only do they comply
with all local laws, but also they have overriding concerns
about the environment and working conditions. If countries
wanted to stop trading in foreign assets, they could pass
laws and ban the practice. But all countries know that
MNCs are a source of wealth and prosperity and that their
standards are higher than the local equivalent.
With whom do you agree? You may search online for
‘MNCs’, ‘accountability’, ‘+OECD’ and ‘+pdf’ as one
search and ‘UN Global Compact’, ‘OECD Guidelines for
Multinational Enterprises’ and finally ‘FTSE4Good’, but be
aware that there is a bias towards the proposer’s viewpoint.
Self test
Answers are provided in Appendix A at the back of
the text.
2 Explain why UK tariffs will not necessarily reduce a
UK balance of trade deficit.
1 Briefly explain how changes in various economic
factors affect the UK current account balance.
3 Explain why a devaluation will not necessarily
improve the current account balance.
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64
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Questions and exercises
1 a What are the main elements of the current account?
b In which account would you enter the transfer of income home by foreign workers?
c In which account would royalties appear?
2 What are the arguments for and against the view that a deficit on the current account is a sign of a weak economy?
3 In what sense is the balance of payments an account, yet not an account?
4 What are the main components of the balance of payments and how do they balance?
5 What is meant by portfolio and real investment and where do they occur in the balance of payments?
6 How is it that the balance of payments balances when the foreign currency units to the reported currency is
changing every day?
7 Does the balance of payments balance, and if not, why not?
8 Search for ‘Balance of Payments Analytic Presentation by Country’ online and select the US.
a For the most recent year comment on the meaning of the balances (note that for more detail on the
classifications consult the internet for the Balance of Payments and International Investment Position Manual,
currently in its 6th edition).
b Convert the data into a column for debits and a column for credits (left and right respectively, hint: negative assets are
credits and negative liabilities are debits. Balances are credits less debits) and see that you agree with the balances.
c Comment on the meaning of the credits and debits.
d Briefly comment on the overall structure of the three elements of the balance of payments.
9 Repeat the exercise in Question 8 for Germany and compare the two balances of payments.
10 Outline the nature and governance of trade disputes.
11 How do government actions affect the balance of payments and what are the motives of governments with respect
to the balance of payments?
12 Explain how the Marshall Lerner conditions establish that a devaluation will not necessarily ‘improve’ the balance of
payments (i.e. reduce a deficit).
13 What would an increase in the interest rates have on the balance of payments, potentially the economy and the
value of the currency?
14 How might an MNC react to a devaluation in the currency of a country to which it exports?
15 The law of comparative advantage takes no account of ethical standards or sovereignty. Examine the arguments
for and against this proposition.
Endnotes
1 Their accounts can be downloaded from Companies House.
2 In older texts the financial account is referred to as
the capital account; under the IMF reorganization, the
financial account replaces the old capital account for most
of the non-current account transactions.
3 Berger, H. and Nitsch, V. (2008) ‘Zooming out: The trade
effect of the euro in historical perspective’, Journal of
International Money and Finance, 27, 1244–60.
4 Berger, H. and Nitsch, V. (2014) ‘Wearing corset, losing
shape: The euro’s effect on trade’, Journal of Policy
Modelling, 26, 136–55.
5 Mody, A. (2015) ‘Germany, not Greece, should exit
the euro’. Available at: www.bloomberg.com/opinion/
articles/2015-07-17/germany-not-greece-should-exit-theeuro [Accessed 1 October 2019].
6 Details taken from ‘Trade unionists against the EU’; the
EU denies that its subsidies to EU farmers is having this
effect; refer to European Commission (2019) ‘Food for
thought: EU farming and the global opportunity’. Available
at: ec.europa.eu/commission/commissioners/2014-2019/
malmstrom/blog/food-thought-eu-farming-and-globalopportunity_en [Accessed 1 October 2019].
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CHAPTER 2
International trade and investment: measurement and theories
7 For example, refer to Fabling, R. and Sanderson, L. (2015)
‘Export performance, invoice currency and heterogeneous
exchange rate pass through’, The World Economy, 38(2),
315–39.
8 Obstfeld, M. and Rogoff, K. (1995) ‘Exchange rate dynamics
redux’, Journal of Political Economy, 102, 624–60.
9 Choudri, E. and Hakura, D. (2012) ‘The exchange rate
pass-through to import and export prices: The role of
nominal rigidities and currency choice’, IMF Working
Paper, 12, 226.
10 Blonigen, B. (2005) ‘A review of the empirical literature
on FDI determinants’, Atlantic Economic Journal, 33,
383–403.
11 Compare results from Hooper, P., Johnson, K. and Marquez,
J. (2000) ‘Trade elasticities for the G7 countries’, Princeton
Studies in International Economics, No. 87 and Tokarick, S.
(2014) ‘A method for calculating export supply and import
demand elasticities’, The Journal of International Trade &
Economic Development, 23(7), 1059–87.
12 Broda, C. (2004) ‘Terms of trade and exchange rate
regimes in developing countries’, Journal of Economics,
63, 31–58.
13 Hansen, J. G. and Nielsen. J. U. M. (2014) ‘Subsidy-induced
dumping’, The World Economy, 37(5), 654–71.
14 Sudsawasd, S. (2013) ‘Tariff liberalization and the rise of
anti-dumping use: Empirical evidence from across world
regions’, The International Trade Journal, 26, 4–18.
15 Drope, J. M. and Hansen, W. L. (2006) ‘Anti-dumping’s
happy birthday?’, World Economy, 29(4), 459–72.
16 Klassen, K., Lisowsky, P. and Mescall, D. (2016) ‘Transfer
pricing: Strategies, practices and tax minimization’,
Contemporary Accounting Research, 34(1), 455–93.
65
17 Loungani, P. and Mauro, P. (2001) ‘Capital flight from
Russia’, World Economy, 24(5), 689–706.
18 Katz, R. (2016) ‘The great Chinese mercantilist myth’,
The International Economy, Summer, 36–39 and
Aizenman, J., Jinjarak, Y. and Zheng, H. (2018) ‘Chinese
outward mercantilism: The art and practice of bundling’,
Journal of International Money and Finance, 86, 31–49.
19 For a test and review refer to Harakey, W. and Meade, E.
(2014) ‘Hong Kong’s currency crisis: A test of the 1990s
“Washington Consensus” view’, International Finance,
17(3), 273–96.
20 For a review of the anti-austerity side refer to Minetti, R.
(2015) ‘Financial cycles, housing and the macroeconomy’,
International Finance, 18(2), 249–62 and Blyth, M. (2013)
Austerity: The History of a Dangerous Idea, Oxford.
21 Refer to Chari, A. and Henry, P. B. (2015) ‘Two tales of
adjustment: East Asian lessons for European growth’, IMF
Economic Review, 63(1), 164–96.
22 Refer to Woods, N. (2000) ‘The challenge of good
governance for the IMF and the World Bank themselves’,
World Development, 28(5), 823–41.
23 McCauley, R. N. and Schenk, C. R. (2015) ‘Reforming the
International Monetary System in the 1970s and 2000s:
Would a special drawing right substitution account have
worked?’, International Finance, 18(2), 187–206.
24 Desai, R. and Vreeland, J. (2011) ‘Global governance in a
multipolar world: The case for regional monetary funds’,
International Studies Review, 13(1), 109–21. Also refer to
Dreher, A., Sturm, J. E. and Vreeland, J. (2015) ‘Politics and
IMF conditionality’, Journal of Conflict Resolution, 59(1),
120–48 and Dreher, A. (2009) ‘IMF conditionality: Theory
and evidence’, Public Choice, 141, 233–67.
Essays/discussion and articles can be found at the end of Part I.
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66
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
BLADES PLC CASE STUDY
Exposure to international flow of funds
Ben Holt, the Finance Director of Blades plc, has decided
to counteract the decreasing demand for ‘Speedos’
rollerblades by exporting this product to Thailand.
Furthermore, due to the low cost of rubber and plastic
in South-East Asia, Holt has decided to import some
of the components needed to manufacture ‘Speedos’
from Thailand. Holt feels that importing rubber and
plastic components from Thailand will provide Blades
with a cost advantage (the components imported from
Thailand are about 20 per cent cheaper than similar
components in the UK). Currently, approximately
$15 million, or 10 per cent, of Blades’ sales are
contributed by its sales in Thailand. Only about 4 per
cent of Blades’ cost of goods sold is attributable to
rubber and plastic imported from Thailand.
Blades faces little competition in Thailand
from other UK rollerblades manufacturers. Those
competitors that export rollerblades to Thailand
invoice their exports in British pounds. Currently,
Blades follows a policy of invoicing in Thai baht
(Thailand’s currency). Holt felt that this strategy would
give Blades a competitive advantage, since Thai
importers can plan more easily when they do not
have to worry about paying differing amounts due to
currency fluctuations. Furthermore, Blades’ primary
customer in Thailand (a retail store) has committed
itself to purchasing a certain amount of ‘Speedos’
annually if Blades will invoice in baht for a period of
three years. Blades’ purchases of components from
Thai exporters are currently invoiced in Thai baht.
Ben Holt is rather content with current arrangements
and believes the lack of competitors in Thailand, the
quality of Blades’ products and its approach to pricing
will ensure Blades’ position in the Thai rollerblade
market in the future. Holt also feels that Thai importers
will prefer Blades over its competitors because Blades
invoices in Thai baht.
As Blades’ financial analyst, you have doubts as
to Blades’ ‘guaranteed’ future success. Although
you believe Blades’ strategy for its Thai sales and
imports is sound, you are concerned about current
expectations for the Thai economy. Current forecasts
indicate a high level of anticipated inflation, a
decreasing level of national income and a continued
depreciation of the Thai baht. In your opinion, all
of these future developments could affect Blades
financially, given the company’s current arrangements
with its suppliers and with the Thai importers. Both
Thai consumers and firms might adjust their spending
habits should certain developments occur.
In the past, you have had difficulty convincing
Ben Holt that problems could arise in Thailand.
Consequently, you have developed a list of questions
for yourself, which you plan to present to the
company’s FD after you have answered them. Your
questions are listed here:
1 How could a higher level of inflation in Thailand
affect Blades (assume UK inflation remains
constant)?
2 How could competition from firms in Thailand and
from UK and European firms conducting business
in Thailand affect Blades?
3 How could a decreasing level of national income in
Thailand affect Blades?
4 How could a continued depreciation of the Thai
baht affect Blades? How would it affect Blades
relative to UK exporters invoicing their rollerblades
in British pounds?
5 If Blades increases its business in Thailand and
experiences serious financial problems, are there
any international agencies that the company could
approach for loans or other financial assistance?
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CHAPTER 2
International trade and investment: measurement and theories
67
SMALL BUSINESS DILEMMA
Developing a multinational sporting goods industry
Recall from Chapter 1 that Jim Logan planned to
pursue his dream of establishing his own business
in Ireland (called the Sports Exports Company)
of exporting basketballs to one or more foreign
markets. Jim has decided to initially pursue the
market in the UK because British citizens appear
to have some interest in basketball as a possible
hobby, and no other firm has capitalized on this idea
in the UK (the sporting goods shops in the UK do
not sell basketballs but might be willing to sell them).
Jim has contacted one sporting goods distributor
that has agreed to purchase basketballs on a
monthly basis and distribute (sell) them to sporting
goods stores throughout the UK. The distributor’s
demand for basketballs is ultimately influenced by
the demand for basketballs by British citizens who
shop in British sporting goods stores. The Sports
Exports Company will receive British pounds when
it sells the basketballs to the distributor and will
then convert the pounds into euros. Jim recognizes
that products (such as the basketballs his firm will
produce) exported from Ireland to foreign countries
can be affected by various factors.
Identify the factors that affect the current account
balance between Ireland and the UK. Explain how
each factor may possibly affect the British demand
for the basketballs that are produced by the Sports
Exports Company.
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CHAPTER 3
International financial
markets and portfolio
investment
LEARNING OBJECTIVES
The specific objectives of this chapter are to:
●●
Examine the role of markets.
●●
Describe spot, forward, futures and option markets.
●●
Describe currency quotes and exchange rates.
●●
Examine cryptocurrencies and eurodollars.
●●
Describe the role of banks.
●●
Describe international stock and bond markets.
●●
Review market pricing and the efficient markets hypothesis.
Due to the growth in international business and investment, there has been a large increase in the size and variety of
international financial markets. According to the 2019 Triennial Survey by the Bank for International Settlements, turnover in
the foreign exchange market for all instruments (spot, options, swaps, etc.) since the 1990s has grown by an astonishing
8.7 per cent a year. Financial managers of MNCs need to understand these markets and, in particular, how prices behave in
these markets in order to operate effectively.
68
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CHAPTER 3 International financial markets and portfolio investment
69
Functions of a financial market
A financial market can at times seem like a place where a lot of money is made for little effort. It is therefore
appropriate to briefly list the benefits that it confers on a society and hence explain why countries are keen
to develop their own financial markets. The benefits are:
1 Maturity transformation. Short-term savings are converted into long-term borrowing. This is because the
shares, bonds and other certificates of ownership of money collectively termed financial instruments can
be traded. A promise to repay a borrower in 10 years’ time can be sold by the lender a week later to another
lender who again can sell on the certificate. In this way the lenders can recoup their investment much earlier
than the 10 years by selling on. Without a market, the process of finding a buyer would be more difficult,
though the internet is facilitating many such deals.
2 Risk transformation. Funds lent are split up into shares or bonds being a small part of the overall loan. In
this way the investor is buying only a few shares or bonds and is not taking on the risk of the overall loan.
Failure to repay by the borrower will result in a loss that is spread across the lending community.
In the derivatives market companies can, in effect, take out insurance against adverse price movements
and receive compensation; but they can also all too easily end up in the position of the insurance company
and risk having to make large payouts.
3 Liquidity. A financial market enables small savings to be added together to enable borrowers to borrow
amounts that are beyond the means of any one investor. This follows directly as a result of issuing financial
instruments, which is the process of creating financial instruments secured on the assets or reputation of the
borrower.
4 Valuation. Maturity and risk transformation, in particular, rely on the ability of the lender to sell the
financial instrument. As with any market, it is important that the price obtained for the share, bond or financial
instrument is a fair price. Much of the activity of a market is therefore to adjust the price of the financial
instrument so that it reflects all that is known about its future value.
These are the basic attributes of a market; to this we add the role of the international financial market.
Motives for using international financial markets
There are a number of barriers that prevent markets for real or financial assets in different countries from
becoming completely integrated; these barriers include:
tax differentials, tariffs, quotas, labour immobility, cultural differences, financial reporting differences
and significant costs of communicating information across countries.
Nevertheless, barriers can also create unique opportunities for specific geographic markets that will attract
foreign creditors and investors. For example, barriers such as tariffs, quotas and labour immobility can
cause a given country’s economic conditions to be distinctly different from others. Investors and creditors
may want to do business in that country to capitalize on favourable conditions unique to that country.
At the same time these imperfections have also been a motive for developing larger international markets
capable of taking advantage of such opportunities.
Motives for investing in foreign markets
Investors invest in foreign markets for one or more of the following motives:
1 Economic conditions. Investors may expect firms in a particular foreign country to achieve a more favourable
performance than those in the investor’s home country. For example, the relaxing of restrictions in Eastern
European countries created favourable economic conditions there. Such conditions attract foreign investors
and creditors.
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70
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
2 Exchange rate expectations. Some investors purchase financial securities denominated in a currency that is
expected to appreciate against their own. The performance of such an investment is highly dependent on the
currency movement over the investment horizon.
3 International diversification. Investors may achieve benefits from internationally diversifying their asset
portfolio. When an investor’s entire portfolio does not depend solely on a single country’s economy,
cross-border differences in economic conditions can allow for risk-reduction benefits. A share portfolio
representing firms across European countries is less risky than a share portfolio representing firms in any
single European country. Furthermore, access to foreign markets allows investors to spread their funds
across a more diverse group of industries than may be available domestically. This is especially true for
investors residing in countries where firms are concentrated in a relatively small number of industries.
Motives for providing credit in foreign markets
Investors have one or more of the following motives for providing credit in foreign markets:
1 High foreign interest rates. Some countries experience a shortage of loanable funds, which can cause market
interest rates to be relatively high, even after considering default risk. Foreign creditors may attempt to
capitalize on the higher rates, thereby providing capital to overseas markets. Often, however, relatively high
interest rates are perceived to reflect relatively high inflationary expectations in that country. For example,
in year 2000, Turkey had an inflation rate of 55 per cent and an interest rate of 62 per cent. To the extent
that inflation can cause depreciation of the local currency, the benefit of high interest rates can be lost due
to the depreciation of the currency. The simple fact often overlooked by students and those not directly
involved is that foreign investments have to be made in the foreign currency. If that currency loses value, the
high return is lost when converted back into the home currency. In the previous example, for instance, the
Turkish lira devalued by 24 per cent in 2000 and by 120 per cent the following year! The relation between
a country’s expected inflation and its local currency movements is not precise; several other factors can
influence currency movements as well. Thus, some investors may believe that the interest rate advantage
in a particular country will not be offset by a local currency depreciation over the period of concern. Such
investors are called carry traders.
2 Exchange rate expectations. Investors may consider supplying capital to countries whose currencies are
expected to appreciate against their own. Whether the form of the transaction is a bond or a loan, the
creditor benefits when the currency of denomination appreciates against the investor’s home currency.
3 International diversification. Investors can benefit from international diversification, which may have the
effect of reducing the probability of simultaneous bankruptcy across its borrowers. The effectiveness of such
a strategy depends on the correlation between the economic conditions of countries. If the countries of
concern tend to experience somewhat similar business cycles, diversification across countries will be less
effective.
4 Crises. Money may be invested in currencies that are expected to maintain their value in times of crises.
This is the ‘safe haven’ argument. The US dollar, the Swiss franc and to a lesser extent the euro are seen by
investors as currencies that are unlikely to suffer large devaluations.
Motives for borrowing in foreign markets
Borrowers may have one or more of the following motives for borrowing in foreign markets:
1 Exchange rate expectations. When a company borrows from abroad, there are two ‘costs’ that must be
considered. The first is the interest rate, as with any borrowing. The second is unique to international
borrowing and investing, which is the effect of changes in the exchange rate. When money is borrowed in a
foreign currency for use in the home country, it must be converted into the home currency to be usable. At
the end of the borrowing period, the repayment must be in the foreign currency for the exact amount owed.
The loan must therefore be converted back into the foreign currency. If the value of the foreign currency has,
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CHAPTER 3 International financial markets and portfolio investment
71
say, increased in the intervening period, the cost of borrowing will have effectively increased. If, for example,
a UK company borrows from abroad in foreign currency and converts the loan into £100,000 at the start
of the period at 0 per cent interest rate, but at the end of the borrowing period it costs £120,000 to repay
because the foreign currency has gone up in value, then the cost of borrowing from abroad is the £20,000
increase in repayment due to exchange rate movement. On the other hand, if a foreign currency declines
in value over the borrowing period, the cost of repayment could be less than the original converted cost of
the loan. In the example above, if the foreign currency has fallen in value by, say, 5 per cent, then the cost
of repayment will be £95,000 (i.e. (1 2 0.05) 3 100,000), a saving of £100,000 2 £95,000 5 £5,000. Such
savings in practice will reduce and even offset interest payments, making foreign borrowing potentially very
cheap. Because exchange rate movements can make borrowing cheaper or more expensive, all that can be
said in general is that borrowing and investing abroad is riskier.
When a foreign subsidiary of an MNC remits funds to its parent, the funds must be converted to the home
currency and are subject to exchange rate risk. The MNC will be adversely affected if the foreign currency
depreciates at that time. If the MNC expects that the foreign currency will depreciate against the dollar, it
can reduce the exchange rate risk by having the subsidiary borrow funds locally to support its business.
The subsidiary will remit fewer funds to the parent if it has to pay interest on local debt before remitting the
funds. Thus, the amount of funds converted to home currency will be smaller, resulting in less exposure to
exchange rate risk.
Offsetting foreign currency inflows with outflows is an important non-market means of risk reduction.
Reducing the size of any foreign currency conversion reduces the risk due to a currency depreciation; but it
also loses potential gains due to currency appreciation.
2 Low interest rates. Some countries have a large supply of funds available to lend compared to the demand by
borrowers for these funds – interest rates are likely to be low as a result. A country with relatively low interest
rates is often expected to have a relatively low rate of inflation, which can place upward pressure on the
foreign currency’s value and offset any advantage of lower interest rates. The relationship between expected
inflation and currency movements is not precise. As with investing, borrowers borrow in the expectation
that the gains, in this case low interest rates, will not be offset by adverse currency movements. If the home
country borrowing rate is 5 per cent and the foreign currency interest rate is 2 per cent, then in approximate
terms the hope of the borrower in the foreign currency is that the foreign currency does not become more
than 3 per cent more expensive when repayment is due.
Foreign exchange market
When MNCs or other participants invest or borrow in foreign markets, they commonly rely on the foreign
exchange market to obtain the currencies they need. By allowing currencies to be exchanged, the foreign
exchange market facilitates international trade and financial transactions. MNCs rely on the foreign
exchange market to exchange their home currency for a foreign currency that is needed to purchase
imports or to use for direct foreign investment. Alternatively, they may need the foreign exchange market
to convert foreign revenues to their home currency.
The difference between the market for foreign currency and any other market is that the price of
currency has been subject to far more government intervention. The reason is simple. The price of a
currency affects the price of all goods denominated in that currency. Therefore if the value of the euro goes
up in relation to the British pound, all goods in Europe will cost more for the British purchaser as the more
expensive euro has to be purchased in order to purchase the goods. The pervasive effect of a change in the
value of a currency naturally makes its price of great interest to a government.
Foreign exchange transactions
The foreign exchange market should not be thought of as a specific building or location where traders
exchange currencies. Companies normally exchange one currency for another through a commercial bank
over a telecommunications network.
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Spot market. The most common type of foreign exchange transaction is for immediate exchange at
the so-called spot rate (immediate is interpreted as being within two days). The market where these
transactions occur is known as the spot market. The global foreign exchange market daily turnover in
2016 (according to the last survey by the Bank for International Settlements) was $5.1 trillion – the dollar
being involved in 88 per cent of trades. The daily turnover is larger than the annual gross domestic product
of Germany, the fourth largest economy in the world. It is a hugely significant figure as it illustrates the
powerlessness of governments to influence the market through intervention. The market has outgrown
any single government.
Transactions do not comprise just the spot trades but include forwards, futures, swaps and options.
These are promises about future currency exchanges known as derivatives (Chapter 11). The spot element
makes up 33 per cent of this market, swaps 47 per cent (91 per cent involving the dollar), forwards 14
per cent, and options and other products 7 per cent. Currencies involved after the most frequently used,
the dollar at 88 per cent, were the euro (31 per cent), the Japanese yen (22 per cent) and the British
pound (13 per cent).
USING THE WEB
Historical exchange rates
Historical exchange rates are available via a browser by adding ‘exchange rate’ to ‘World Bank’
or ‘IMF’.
Some commodities such as oil are traditionally traded in US dollars. The US dollar may also be an
intermediary currency, for example British pounds could be converted to Malaysian ringgit by first
converting to US dollars and then to Malaysian ringgit – simply because it is cheaper. Although banks in
London, New York and Tokyo, the three largest foreign exchange trading centres, conduct much of the
foreign exchange trading, many transactions occur outside these trading centres. Banks in virtually every
major city facilitate foreign exchange transactions between MNCs. Trading also takes place outside the
market, known as the over-the-counter (OTC) stock market. Here the trading takes place without an
intermediary, in a process also known as disintermediation. Buyers and sellers of currencies trade directly
with each other, a process made much easier with the development of the internet.
EXAMPLE
Max NV, a Dutch firm, purchases supplies priced
at $100,000 from Amerigo, a US supplier, on the
first day of every month. Max instructs its bank to
transfer funds from its account to the supplier’s
account also on the first day of each month. It
only has euros in its account, whereas Amerigo’s
invoices are in dollars. When payment was made
one month ago, the dollar was worth 1.08 euros, so
Max NV needed €108,000 to pay for the supplies
($100,000 3 1.08 5 €108,000). The bank reduced
Max’s account balance by €108,000, which was
exchanged at the bank for $100,000. The bank
then sent the $100,000 electronically to Amerigo by
increasing Amerigo’s account balance by $100,000.
Today, a new payment needs to be made. The
dollar is currently valued at 1.12 euros, so the bank
will reduce Max’s account balance by €112,000
($100,000 3 1.12 5 €112,000) and exchange it
for $100,000, which will be sent electronically to
Amerigo.
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CHAPTER 3 International financial markets and portfolio investment
The bank not only executes the transactions
but also serves as the foreign exchange dealer.
Each month the bank receives euros from Max NV
in exchange for the dollars it provides. In addition,
the bank facilitates other transactions for MNCs
in which it receives euros in exchange for dollars.
73
The bank maintains a stock of euros, dollars and
other currencies to facilitate these foreign exchange
transactions. If the transactions cause it to buy as
many euros as it sells to MNCs, its stock of euros will
not change. If the bank sells more euros than it buys,
however, its stock of euros will be reduced.
Other intermediaries also serve the foreign exchange market. Some other financial institutions such as
securities firms can provide the same services described in the previous example. In addition, most major
airports around the world have foreign exchange centres, where individuals can exchange currencies. In
many cities, there are retail foreign exchange offices where tourists and other individuals can exchange
currencies.
Use of the dollar. The US dollar is commonly accepted as a medium of exchange between non-US residents,
especially in countries such as Bolivia, Brazil, China, Cuba, Indonesia, Russia and Vietnam where the
home currency is either weak or subject to foreign exchange restrictions. In Ecuador, El Salvador, Liberia
and Panama the US dollar is the official currency.
Spot market structure. Hundreds of banks facilitate foreign exchange transactions, but the top half dozen
handle about 50 per cent of the transactions. Citibank (US), JP Morgan (US), UBS (Switzerland), Deutsche
Bank (Germany), Bank of America Merrill Lynch (US) and Barclays (UK) are the largest traders of foreign
exchange. Some banks and other financial institutions have formed alliances (one example is FX Alliance
LLC) to offer currency transactions over the internet.
At any given point in time, the exchange rate between two currencies should be similar across the
various banks that provide foreign exchange services. If there is a large discrepancy, customers or other
banks will engage in riskless arbitrage and purchase large amounts of a currency from whatever bank
quotes a relatively low price and immediately sell it to whatever bank quotes a relatively high price. Such
actions cause adjustments in the exchange rate quotations that eliminate any discrepancy. As one would
expect given computerized buying and selling, such discrepancies will almost never occur.
If a bank begins to experience a shortage in a particular foreign currency, it can purchase that currency
from other banks. This trading between banks occurs in what is often referred to as the interbank
market. Within this market, banks can obtain quotes, or they can contact brokers who sometimes act as
intermediaries, matching one bank desiring to sell a given currency with another bank desiring to buy that
currency. About ten foreign exchange brokerage firms handle much of the interbank transaction volume.
Although foreign exchange trading is conducted only during normal business hours in a given location,
these hours vary among locations due to different time zones. Therefore at any given time on a weekday,
somewhere around the world a bank is open and ready to accommodate foreign exchange requests.
When the foreign exchange market opens in the US each morning, the opening exchange rate quotations
are based on the prevailing rates quoted by banks in London and other locations where the foreign
exchange markets have opened earlier. Suppose the quoted spot rate of the British pound was $1.80 at
the previous close of the US foreign exchange market, but by the time the market opens the following day,
the opening spot rate is $1.76. News occurring in the morning before the US market opened could have
changed the supply and demand conditions for British pounds in the London foreign exchange market,
reducing the quoted price for the pound.
With the newest electronic devices, foreign currency trades are negotiated on computer terminals, and a
push of a button confirms the trade. Traders now use electronic trading boards that allow them to instantly
register transactions and check their bank’s positions in various currencies. Also, several US banks have
established night trading desks. The largest banks initiated night trading to capitalize on foreign exchange
movements at night and to accommodate corporate requests for currency trades. Even some medium-sized
banks now offer night trading to accommodate corporate clients.
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74
PART I
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Spot market liquidity. The spot market for each currency can be described by its liquidity, which reflects
the level of trading activity. The more willing buyers and sellers there are, the more liquid a market is.
The spot markets for heavily traded currencies such as the euro, the British pound and the Japanese yen
are very liquid. Conversely, the spot markets for currencies of less developed countries are less liquid.
A currency’s liquidity affects the ease with which an MNC can obtain or sell that currency. If a currency
is illiquid, the number of willing buyers and sellers is limited, and an MNC may be unable to quickly
purchase or sell that currency at a reasonable exchange rate.
Forward transactions. In addition to the spot market, a forward market for currencies enables an MNC to
lock in the exchange rate (called a forward rate) at which it will buy or sell a currency. A forward contract
specifies the amount of a particular currency that will be purchased or sold by the MNC at a specified
future point in time and at a specified exchange rate. Commercial banks accommodate the demand
from MNCs for forward contracts. MNCs commonly use the forward market to hedge future payments
that they expect to make or receive in a foreign currency. In this way, they do not have to worry about
fluctuations in the spot rate until the time of their future payments. The liquidity of the forward market
varies among currencies. The forward market for euros is very liquid because many MNCs take forward
positions to hedge their future payments in euros. In contrast, the forward markets for Latin American and
Eastern European currencies are less liquid because there is less international trade with those countries
and therefore MNCs take fewer forward positions. For some currencies, there is no forward market. Banks
will however quote a synthetic forward rate given a reliable spot market quote and interest rate because,
as will be discussed in Chapter 8, the market forward rate can be determined from these inputs.
Like many prices in finance the forward rate is calculated to avoid the possibility of arbitrage (making a
riskless profit). A riskless profit is like free money. If I promise to pay you £1.20 for every £1 you give me
that would be a riskless profit of £0.20 per £1. You would soon be borrowing £1 million, giving me the £1
million then asking me for £1.2 million, and I would soon be bankrupt! Financial institutions and markets
set prices to avoid that possibility.
Attributes of banks that provide foreign exchange. The following characteristics of banks are important to
customers in need of foreign exchange:
1 Competitiveness of quote. For example, a saving of one cent per dollar on an order of $1 million is worth
$10,000.
2 Special relationship with the bank. The bank may offer cash management services or be willing to make a
special effort to obtain even hard-to-find foreign currencies for the corporation.
3 Speed of execution. Banks may vary in the efficiency with which they handle an order. A corporation needing
the currency will prefer a bank that conducts the transaction promptly and handles any paperwork reliably.
4 Advice about current market conditions. Some banks may provide assessments of foreign economies and
relevant activities in the international financial environment that relate to corporate customers.
5 Forecasting advice. Some banks may provide forecasts of the future state of foreign economies, the future
value of exchange rates and the like.
This list suggests that a corporation needing a foreign currency should not automatically choose a bank
that will sell that currency at the lowest price. Most corporations that frequently need foreign currencies
develop a close relationship with at least one major bank in case they ever need special services from a
bank.
Understanding the exchange rate
End of day exchange rate quotations for widely traded currencies are published in the Financial Times and
in business sections of many newspapers on a daily basis. The internet will give quotes on a more frequent
basis. With some exceptions, most notably the eurozone, each country has its own currency.
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CHAPTER 3 International financial markets and portfolio investment
75
A quote is written as so many units of one currency (the term or quote currency) for one unit of another
(the base currency), so 60 pence or £0.60 to the dollar can be written as £0.60:$1. To convert, say, $100
into British pounds at this rate is simply $100 3 0.60 5 £60. To convert, say, £150 into dollars at this rate
is £150/0.60 5 $250. Note that conversion is achieved either by multiplying or dividing; it is important
not to apply the wrong operation!
Currency pairs quote – standard notation
For the most part in this text we will be using quotes in the form of £0.60:$1 for clarity. On the internet,
ticker symbols are used (ISO currency codes). Each currency has a three-letter code recognized throughout
all financial markets. The main ones that we will be using are:
EUR 5 euro; USD 5 US dollar; GBR 5 British pound; CNY 5 Chinese yuan; JPY 5 Japanese yen
A quote has two elements:
Base = single unit
Term = cost of the base
The standard notation is BASE then TERM hence USDEUR 0.88, which in words is ‘0.88 euros for $1’.
It is a little confusing that the first currency in the notation is the base because when spoken it is the
other way around.
Unfortunately, not all publications and databases observe this convention correctly and it is sensible
to check that the base is on the left with an exchange rate you know. Typically, check that there is more
than $1 for €1 or £1. Nevertheless beware, at the time of writing the euro is less than $1. In addition, a
list of exchange rates will not always be in the same direction for typographical reasons. A quote may be
in dollars per euro or dollars per UK pound but yen per dollar. The reason is simply for greater accuracy
given a limited space, thus there are $0.0088 per yen but the first three numbers are always zeros and
hence wasted; JPY 113.16 per dollar makes better use of a five figure number and is hence more accurate.
MANAGING FOR VALUE
Intel’s currency trading
When Intel needs to exchange foreign currency,
it no longer calls a bank to request an exchange of
currencies. Instead, it logs on to an online currency
trader that serves as an intermediary between Intel
and member banks. One popular online currency
trader is Currenex, which conducts more than $300
million in foreign exchange transactions per day. If
Intel needs to purchase a foreign currency, it logs on
and specifies its order. Currenex relays the order to
various banks that are members of its system and are
allowed to bid for the orders. When Currenex relays
the order, member banks have 25 seconds to specify
a quote online for the currency that the customer
(Intel) desires. Then, Currenex displays the quotes
on a screen, ranked from highest to lowest. Intel has
five seconds to select one of the quotes provided,
and the deal is completed. This process is much more
transparent than traditional foreign exchange market
transactions because Intel can review quotes of many
competitors at one time.
Avoiding currency conversion errors
Choosing the right operation – multiplying or dividing – always poses a small problem for most students.
Apart from intuition there are various ways of avoiding error and a simple mnemonic is offered here.
Remembering that the ‘base’ is the term given to the single unit in the exchange, for example, given $1.3:£1
the British pound is the base:
If the currency you are converting is the base, multiply, otherwise divide.
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76
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
A number of examples are given in Exhibit 3.1.
EXHIBIT 3.1
Currency conversion
Quote
Base
Convert €100
into destination
currency . . .
If the destination
currency is the
base then divide,
otherwise multiply
Converted value of €100
€0.9192:$1
dollars
US dollars
Divide
:100>0.9192 5 $108.7903
$1.0880:€1
euros
US dollars
Multiply
:100 3 1.0880 5 $1.0880
EURINR 73.2656
euros
Indian rupees
Multiply
:100 3 73.2656 5 7,326.56 INR
CADEUR 0.6843
Canadian dollars
Canadian dollars
Divide
:100>0.6843 5 146.1347 CAD
Direct and indirect quotations
1 Direct quote. The number of units of home currency for one unit of the foreign currency (the foreign currency
is the base).
2 Indirect quote. The number of units of foreign currency for one unit of the home currency (the home currency
is the base).
There is a reciprocal relationship between the two:
Indirect quotation 5 1/Direct quotation
£ and euro indirect quotes
So
£ and euro direct quotes
8 rand:£1
is the same as
£0.125:1 rand
as 1/8 5 0.125
5 peso:£1
is the same as
£0.20:1 peso
as 1/5 5 0.20
135 yen:€1
is the same as
€0.0074:1 yen
as 1/135 5 0.0074
Some students like the equation approach. For example, 8 rand:£1 can be written as: 8 rand 5 £1.
Divide both sides by 8 and we have 8/8 rand 5 £1/8 or £0.125:1 rand.
A direct quote can be described as ‘the value of foreign currency’, and an indirect quote can be described
as ‘how much home currency will buy abroad’. The indirect quote was once used in the UK and parts of
the former British Empire. It is a relic of the days when the British pound was non-decimal and it was
easier to apply fractions to decimal currency than the then-complex UK currency. Now that the British
pound is decimalized direct quotes are used.
Much analysis in international finance seeks to explain the value of foreign currency and account for
the variation in its value. The direct quote is the natural rate to use. If the value of foreign currency
goes up, the direct rate goes up. Taking the British pound as the home currency and an exchange rate of
£0.56:$1, if the value of the dollar increases by 10 per cent then the new rate will be £0.56 3 (1 1 0.10)
5 £0.616, that is £0.616:$1. Similarly, if the value of the dollar falls, the direct rate will fall. If the rates
used were indirect, the relationship would be the opposite, so an increase in the rate would mean a fall in
the value of foreign currency – not surprisingly this is very confusing and should be avoided. In equations
therefore, the more straightforward direct rate is used.
As a consequence of the direct and indirect methods of quoting, to write ‘the exchange rate increased’
is meaningless as it depends on the method of quoting. Far better to write: ‘the value of the currency
increased (or decreased)’, since this is clear.
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CHAPTER 3 International financial markets and portfolio investment
77
EXAMPLE
Mr Y, a Finance Director, has been given the following
rates from his bank: 4 zloty:€1, £0.68:€1 and
6 zloty:£1. He wonders if he changed £1,000 into
Polish zloty, converted his Polish zloty into euros and
then converted the euros back into British pounds,
would he have the £1,000 he started with? He works
out that £1,000 would buy him 6,000 zloty, then 6,000
zloty would buy 1,500 euros (i.e. 6,000 zloty/4 5
1,500) and finally 1,500 euros would buy £1,020 (i.e.
1,500 euros 3 0.68), a profit of £20 or 2 per cent
([1,020 2 1,000]/1,000). ‘Great’ he thinks, ‘I can
earn certain money just by picking up the telephone.’
When he tells the Bank Manager, she laughs: ‘You’ve
forgotten the transaction costs, we would charge
nearly 2 per cent for those transactions and then your
zloty euro rate is for converting euros into zloty not
zloty into euros. All told, you would make a loss. Don’t
worry we would not allow you to make a profit for
nothing – you’ve got to take a risk to do that.’ Refer to
Triangular arbitrage, Chapter 8.
Quotations of spot and forward rates. The spot rate normally means delivery within two days and is quoted
for all the major currencies in the financial press. Some quotations of exchange rates include forward rates
for the most widely traded currencies. Other forward rates are not quoted in business newspapers but
are quoted by the banks that offer forward contracts in various currencies. Quoted rates are normally for
one month, three months and one year, but may be tailored by a bank to an MNC’s individual needs.
Forward quotes are difficult to find even on the internet. As we have said, one reason is that they can be
calculated from the spot rates and the interest rates in the two countries of the exchange rate quote. The
exact calculation is given in Chapter 8.
It may seem odd at first that we can apparently quote a rate in the future with such certainty; surely
the future is unknown? The point being missed is that the spot rate is also about that same future. If a
government announces that in 30 days’ time it will impose tariffs, the exchange rate now (the spot rate)
will be affected as well as the 30-day forward rate. The only difference between the information set that
informs the spot rate and the set that informs the forward rate is the passage of time. The effect of time
we can establish with near certainty by using the interest rates on virtually no-risk investments such as
government bonds. The event, whether it be tariffs or the announcement of indicators of economic activity,
will affect both the spot rate and the forward rate simultaneously on the announcement of the news.
This relationship between the spot and forward rate is more than academic assertion; the market
forces the relationship through arbitrage (no-risk trading). Again, we explore this relationship further in
Chapter 8. Here as something of a foretaste we can observe that it would be possible as a UK investor
seeking a 30-day return for no risk to a) convert on day one a set sum of pounds at the spot rate to buy
German government 30-day Treasury bills for a guaranteed interest rate; then b) also on day one the
investor could arrange to convert the euros from the maturing German bills back into pounds at a 30-day
forward rate. A moment’s reflection should confirm that on day one the investor will know with certainty
how much will be earned in pounds through this market transaction. It is a riskless transaction. Another
way of earning a riskless return is to invest it in a 30-day UK government bill. There are therefore two
routes for earning a riskless return: route one, convert at spot, invest in foreign bills and convert back at
a quoted forward rate; route two, invest in UK government bills. Both offer a riskless return. If route one
offered a higher return than route two then the forward demand for buying euros now and selling on
the forward market would be very high. Through simple market supply and demand, the spot value of the
euro would increase and the forward value of the euro would fall to the point where there is no benefit
from investing abroad. The adjustment is likely to be quick, as a UK speculator who could borrow at the
UK government rate could invest abroad taking route one and make a guaranteed profit at the expense
of other traders. This is a return to our no arbitrage profit rule (above); economists have referred to this
possibility as a ‘money pump’. The idea of arbitrage is encapsulated in the market concept of the ‘law of
one price’. The same ‘product’, in this case a riskless investment, should have the same price (i.e. interest
rate) to avoid riskless profits.
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PART I
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Bid/ask spread of banks. Commercial banks charge fees for conducting foreign exchange transactions.
At any given point in time, a bank’s bid (buy) quote for a foreign currency will be less than its ask (sell)
quote. As with the retail of any other product, the retailer (bank) will buy the product (currency) at the
lower price and sell at the higher price. The service offered by the bank is availability, convenience and a
competitive price. The bid/ask spread represents the differential between the bid and ask quotes, and is
intended to cover the costs involved in accommodating requests to exchange currencies. From the bank’s
point of view the longer they have to hold the cash ‘in stock’ the more costly, both in terms of the relatively
low interest earned for cash, as opposed to lending, and also the greater the risk that the currency will lose
value. The bid/ask spread is set to cover these potential costs. Hence currencies that are not often traded
tend also to be quite volatile and can expect to be subject to a wide spread between bid and ask – though
the margins in general are very small. The bid/ask spread is normally expressed as a percentage of the ask
quote. The following example considers these issues in more detail.
EXAMPLE
To understand how a bid/ask spread could affect you,
assume you live in France and have €1,000 and plan
to travel from France to the US. Assume further that
the bank’s bid (buy) rate for the US dollar is €1.28:$1
and its ask (sell) rate is €1.31:$1. Before leaving on
your trip, you go to this bank to exchange euros for
dollars. Your €1,000 will be converted to $763.36 as
follows:
euros S US dollars: €1,000/€1.31:$1
5 $763.36
The bank’s ask rate is relevant here because that
is the rate at which it is selling dollars. Note that
the conversion is rounded to the smallest unit of
currency $0.01 or 1 cent. Now suppose that because
of an emergency you cannot take the trip, and you
reconvert the $763.36 back to euros, just after
purchasing the US dollars. If the exchange rate has
not changed, you will be quoted the bank’s bid rate
for buying dollars and receive:
US dollars S euros: $763.36 3 €1.28:$1
5 €977.10
Due to the bid/ask spread, you have €22.90 less
(€1,000 2 €977.10 5 €22.90) or 2.29 per cent less.
Obviously, the euro amount of the loss would be
larger if you originally converted more than €1,000
into dollars. The loss can be worked out directly as a
percentage by measuring the percentage difference
between the two rates thus:
(1.31 2 1.28)/1.31 5 2.29%
Comparison of bid/ask spread among currencies. The differential between a bid quote and an ask quote
will look much smaller for currencies that have a smaller value. As stated above, this differential can be
standardized by measuring it as a percentage difference between the two rates divided by the ask rate (the
first part of the transaction).
EXAMPLE
Somerset Bank quotes a bid price for yen of £0.005
and an ask price of £0.0052. In this case, the
nominal bid/ask spread is £0.005 2 £0.0052 or just
two-hundredths of a penny. Yet, the bid/ask spread
in percentage terms is actually slightly higher for the
yen in this example than for the dollar in the previous
example. To prove this, consider a traveller who sells
£1,000 for yen at the bank’s ask price of £0.0052.
The traveller receives about ¥192,308 (computed as
£1,000/£0.0052). If the traveller cancels the trip and
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CHAPTER 3 International financial markets and portfolio investment
79
per cent. This spread exceeds that of the British
pound (2.29 per cent in the previous example)
although the figures are much smaller. The size of
a currency unit is no more significant than whether
your height is measured in metres or millimetres,
it is the percentage movement in a currency that
matters.
converts the yen back to pounds, then, assuming no
changes in the bid/ask quotations, the bank will buy
these yen back at the bank’s bid price of £0.005 for
a total of about £961.54 (computed by ¥192,308 3
£0.005), which is £38.46 (or 3.846 per cent) less
than the traveller started with – measured directly
as (0.0052 2 0.005)/0.0052 5 0.03846 or 3.846
Both the previous examples calculated the bid/ask spread as a percentage. The following is the general
formula for calculating the spread:
Bid>Ask spread 5
Ask rate 2 Bid rate
Ask rate
Using this formula, the bid/ask spreads are computed in Exhibit 3.2 for a selection of currency quotes.
EXHIBIT 3.2
Computation of the bid/ask spread
Currency
Bid rate
Ask rate
Ask rate 2 Bid rate
5 Spread
Ask rate
US dollar
£0.54:$1
£0.56:$1
0.56 2 0.54
5 0.03571 or 3.571%
0.56
Nigerian naira
£0.004:N1
£0.0042:N1
0.0042 2 0.004
5 0.04762 or 4.762%
0.0042
British pound
€1.46:£1
€1.48:£1
1.48 2 1.46
5 0.01351 or 1.351%
1.48
Notice that the spread represents the bank’s profit margin. Sometimes travel firms who similarly
buy and sell currencies will also add a commission or ostentatiously advertise zero commission.
In all cases, however, money is made through buying more cheaply than selling. For larger so-called
wholesale transactions between banks or for large corporations, the spread will be much smaller.
The bid/ask spread for small retail transactions is commonly in the range of 3 per cent to 7 per cent;
for wholesale transactions requested by MNCs, the spread is between 0.01 and 0.03 per cent.
Commercial banks are normally exposed to more exchange rate risk when maintaining these
currencies.
In the following discussion and in examples throughout much of the text, the bid/ask spread will
be ignored. That is, only one price will be shown for a given currency to allow you to concentrate on
understanding other relevant concepts. These examples depart slightly from reality because the bid
and ask prices are assumed to be equal. Although the ask price will always exceed the bid price by a
small amount in reality, the examples should nevertheless hold even though the bid/ask spreads are not
accounted for. In some examples where the bid/ask spread can contribute significantly to the concept, it
will be accounted for.
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80
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Various websites, including bloomberg.com, provide bid/ask quotations. To conserve space, some
quotations show the entire bid price followed by a slash and then only the last two or three digits of the
ask price (known as the ‘pips’).
EXAMPLE
Assume that the prevailing quote for wholesale
transactions by a commercial bank for the euro
is $1.0876/78. This means that a US commercial
bank is willing to buy euros for $1.0876 per euro.
Alternatively, it is willing to sell euros for $1.0878. The
bid/ask spread in this example is:
Bid>Ask spread 5
$1.0878 2 $1.0876
$1.0878
5 0.00018386 or 0.0184%
to 4 decimal places
Factors that affect the spread. The spread on currency quotations is influenced by the following factors:
Spread 5 f(Order costs, Inventory costs, Competition, Volume, Currency risk)
1
1
2
2
1
1 Order costs. Order costs are the costs of processing orders, including clearing costs and the costs of
recording transactions.
2 Inventory costs. Inventory costs are the costs of maintaining an inventory of a particular currency. Holding
an inventory involves an opportunity cost because the funds could have been used for some other purpose.
If interest rates are relatively high, the opportunity cost of holding an inventory should be relatively high. The
higher the inventory costs, the larger the spread that will be established to cover these costs.
3 Competition. The more intense the competition, the smaller the spread quoted by intermediaries. Competition
is more intense for the more widely traded currencies because there is more business in those currencies.
4 Volume. More liquid currencies are less likely to experience a sudden change in price. Currencies that have a
large trading volume are more liquid because there are numerous buyers and sellers at any given time. This
means that the market has sufficient depth that a few large transactions are unlikely to cause the currency’s
price to change abruptly.
5 Currency risk. Some currencies exhibit more volatility than others because of economic or political conditions
that cause the demand for and supply of the currency to change abruptly. For example, currencies in
countries that have frequent political crises are subject to abrupt price movements. Intermediaries that are
willing to buy or sell these currencies could incur large losses due to an abrupt change in the values of these
currencies.
Cross exchange rates. Most tables of exchange rate quotations express currencies relative to the British
pound, US dollar or euro, or all three. But in some instances, a firm will want or be concerned about
the exchange rate between two other currencies. For example, if a UK firm wants to convert earnings
in Mexican pesos (New pesos) to Australian dollars (A$) to pay for imports from Australia, an estimate
of the likely rate can be calculated as a cross exchange rate. The diagram in Exhibit 3.3 illustrates the
relationship.
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CHAPTER 3 International financial markets and portfolio investment
EXHIBIT 3.3
81
Cross exchange rates
UK
£1
Australia
A$2.30:£1
Cross exchange rate
Mexico
20 New pesos:£1
A$2.30 = 20 New pesos (both worth £1)
(dividing both sides by 2.3)
A$1 =
20 New pesos:£1 = 8.70 New pesos:A$1
A$2.30:£1
Note:
• For an implied or cross rate, the right-hand side of the quote (the base) must be the same currency for both rates and the denominator (lower half)
of the ratio becomes the base of the new quote.
EXAMPLE
From Exhibit 3.3 if there are A$2.30:£1 and 20 New
pesos:£1 then A$2.30 and 20 New pesos have
the same value being both worth £1; so using the
equation approach A$2.30 5 20 New pesos. To
convert to an exchange rate with A$ as our base,
divide by 2.3 as in the example, or if New pesos is
to be the base then divide both sides by 20. To work
out the cross exchange rate: 1) equate the currencies
to one unit of a third currency; 2) use the equation
approach to derive an exchange rate.
Currency futures and options markets
A currency futures contract specifies a standard volume of a particular currency to be exchanged on a
specific settlement date at a specific exchange rate. Some MNCs involved in international trade use the
currency futures markets to hedge their positions. The term hedge means to ‘lower exposure to’, in this
case, exchange rate changes.
EXAMPLE
Alpha Ltd sells goods imported from Mexico. A month
ago, when the contract was signed, 1 peso was worth
£0.034 but now the peso is some 5.9 per cent higher
at £0.036. At the time of signing the contract a price
of £0.034 meant a 10 per cent profit margin so the
current rate will more than halve their profits. Payment
is due in 30 days and Alpha asks its bank for a 30-day
forward rate. If necessary, Alpha will adjust its selling
price but in any event it will not lose out due to an
unexpected increase in the value of the Mexican peso.
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PART I
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Futures contracts are somewhat similar to forward contracts except that they are sold on an exchange,
whereas forward contracts are offered by commercial banks. Additional details on futures contracts,
including other differences from forward contracts, are provided in Chapter 11.
Currency options contracts can be classified as calls or puts. A currency call option provides the right
but not an obligation to buy a specific currency at a specific price (called the strike price or exercise price)
within a specific period of time. It is used to hedge future payables. A currency put option provides the
right to sell a specific currency at a specific price within a specific period of time. It is used to hedge future
receivables.
Currency call and put options can be purchased on an exchange. They offer more flexibility than
forward or futures contracts because they do not require any obligation. That is, the firm can elect not to
exercise the option.
Currency options have become a popular means of hedging, particularly in the US. The Coca-Cola Co.
has replaced about 30 per cent to 40 per cent of its forward contracting with currency options. FMC, a
US manufacturer of chemicals and machinery, now hedges its foreign sales with currency options instead
of forward contracts. The annual reports of all the major companies now disclose their hedging policies.
Additional details about currency options, including other differences from futures and forward contracts,
are provided in Chapter 11.
International money market
Financial markets exist in every country to ensure that funds are transferred efficiently from surplus units
(savers) to deficit units (borrowers). These markets are overseen by various regulators, the most immediate
being the clearing house, that attempt to enhance the markets’ creditworthiness (ensuring that debts are
paid) and efficiency. The financial institutions that serve these financial markets exist primarily to provide
information and expertise. The increase in international business has resulted in the development of an
international money market. Financial institutions in this market serve MNCs by accepting deposits and
offering loans in a variety of currencies. In general, the international money market is distinguished from
domestic money markets by the types of transactions between the participating financial institutions and
the MNCs. The financial transactions are in a wide variety of currencies, and large, often the equivalent
of $1 million or more. The foreign currency markets form a large share of the overall international
financial markets which are overseen by the Bank for International Settlements (BIS) (Exhibit 3.4). Note,
in particular, the large rise in transactions and the central role of London.
EXHIBIT 3.4
Exchange market overview
Instrument
Foreign exchange instruments
2016 $bn
2019 $bn
5,066
6,595
Spot transactions
1,652
1,987
Outright forwards
700
999
2,378
3,203
82
108
254
298
Foreign exchange swaps
Currency swaps
Options and other products1
Note:
1 Foreign exchange swaps and currency swaps – Chapters 11 and 15.
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CHAPTER 3 International financial markets and portfolio investment
Currency distribution of OTC foreign exchange turnover
Net-net basis, percentage shares of average daily turnover in April
Currency
2004
2007
2010
2013
2016
2019
Share
Rank
Share
Rank
Share
Rank
Share
Rank
Share
Rank
Share
Rank
USD
88.0
1
85.6
1
84.9
1
87.0
1
87.6
1
88.3
1
EUR
37.4
2
37.0
2
39.0
2
33.4
2
31.4
2
32.3
2
JPY
20.8
3
17.2
3
19.0
3
23.0
3
21.6
3
16.8
3
GBP
16.5
4
14.9
4
12.9
4
11.8
4
12.8
4
12.8
4
AUD
6.0
6
6.6
6
7.6
5
8.6
5
6.9
5
6.8
5
CAD
4.2
7
4.3
7
5.3
7
4.6
7
5.1
6
5.0
6
CHF
6.0
5
6.8
5
6.3
6
5.2
6
4.8
7
5.0
7
CNY
0.1
29
0.5
20
0.9
17
2.2
9
4.0
8
4.3
8
HKD
1.8
9
2.7
8
2.4
8
1.4
13
1.7
13
3.5
9
NZD
1.1
13
1.9
11
1.6
10
2.0
10
2.1
10
2.1
10
Percentage share of OTC foreign exchange turnover by market
2016
2019
%
%
UK
36.9
43.1
US
19.5
16.5
Singapore
7.9
7.6
Hong Kong, China
6.7
7.6
Japan
6.1
4.5
France
3.8
2.0
Switzerland
2.4
3.3
Note:
• The share is out of 200% as two currencies are in each transaction.
Source: BIS
Origins and development
The international money market includes large banks in countries around the world. Large financial
institutions such as Deutsche Bank and JP Morgan Chase are major participants. Two other important
elements of the international money market are the European money market and the Asian money market.
The overall picture is of a lessening of control by governments over currencies. The two major factors
are the trading in currencies on a worldwide basis as in the Asian dollar market and the eurodollar, and
the rise of cryptocurrencies. It may be that central bank digital currencies may regain some of the lost
sovereignty but this development is still in a nascent stage – see later in this chapter.
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84
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
European money market. The origins of the European money market can be traced to the Eurocurrency
market that developed during the 1960s and 1970s. As MNCs expanded their operations during that period,
international financial intermediation emerged to accommodate their needs. Because the US dollar was widely
used even between non-US countries as a medium for international trade, there was a consistent need for
dollars in Europe and elsewhere. Some foreign depositors in US banks were worried that their assets might
be frozen for political reasons due to the Cold War. Other depositors were unhappy with the US government
restrictions on banks. The financial system developed such that when the US limited foreign lending by US
banks in 1968, foreign subsidiaries of US-based MNCs could obtain US dollars from banks in Europe via the
Eurocurrency market. Similarly, when ceilings were placed on the interest rates paid on dollar deposits in the
US, MNCs transferred their funds to European banks, which were not subject to the ceilings. A significant
number of foreign depositors in US banks also transferred their dollar deposits to London. In effect, they sold
their US accounts to a London bank who held the deposits in the US bank and in return gave the sellers an
account in London denominated in US dollars. Soon, London banks were using their dollar deposits to lend to
corporate customers based in Europe. These dollar accounts in London (and on other continents as well) came
to be known as Eurodollars, and the market for Eurodollars came to be known as the Eurocurrency market.
(‘Eurodollars’ should not be confused with the ‘euro’ currency.) Note that the actual dollars themselves remain
in the US, the dollar accounts in London are promises of payment in dollars.
The growing importance of the Organization of the Petroleum Exporting Countries (OPEC) also
contributed to the growth of the Eurocurrency market. Because OPEC generally requires payment for
oil in dollars, the OPEC countries began to use the Eurocurrency market to deposit a portion of their oil
reserves. These dollar-denominated deposits are sometimes known as petrodollars. Oil revenues deposited
in banks have sometimes been lent to oil-importing countries that are short of cash. As these countries
purchase more oil, funds are again transferred to the oil-exporting countries, which in turn create new
deposits. This recycling process has been an important source of funds for some countries.
Today, the Eurocurrency market is not used as often as in the past because domestic markets are now
more competitive. Governments are aware that they cannot restrict bank operations without distorting
the market and disadvantaging their own banks. The European money market nevertheless remains an
important part of the network of international money markets. Participation is limited to large MNCs
and financial institutions who can benefit from rates that are better than elsewhere because the amounts
traded are large and there is a very low risk of bankruptcy.
Asian money market. Like the European money market, the Asian money market originated as a market
involving mostly dollar-denominated deposits. Hence, it was originally known as the Asian dollar market.
The market emerged to accommodate the needs of businesses that were using the US dollar (and some
other foreign currencies) as a medium of exchange for international trade. These businesses could not rely
on banks in Europe because of the distance and different time zones. Today, the Asian money market, as it
is now called, is centred in Hong Kong and Singapore, where large banks accept deposits and make loans
in various foreign currencies (Exhibit 3.4).
Cryptocurrency (bitcoin) market. In 1998 a programmer working under the pseudonym Satoshi Nakamoto
created the first truly internet-based currency. Like the internet it has no central administration and is run
by a network of computers acting as servers which is open to all to join (known as ‘miners’). The currency
is known as a bitcoin. Just as you have a username and password to access particular information on the
internet, so the purchaser by a similar process owns a bitcoin. A bitcoin is created by the miners. The process
is deliberately made difficult by only allowing certain kinds of keys which are difficult to compute but easy
to check (a bit like Sudoku). As the miners’ computing power increases, so the keys become more demanding
such that the rate of creation is more or less constantly decreasing until the total number reaches 21 million.
This is designed to assure the market that there will be no overproduction. However, liquidity is ensured by
allowing a bitcoin to be divided into units, the smallest being a Satoshi, which is 100 millionth of a bitcoin!
The distinguishing feature of the bitcoin is that the market is the internet and exchange is on a peerto-peer basis with no necessary intermediary or identifiable record of the transaction – it cannot be
identified and mapped to any particular user. Bitcoin transactions are verified by blockchains, which are
records of the transaction in code distributed to all miners around the world, making it impossible to alter
(known as a distributed ledger). This anonymity and freedom from government control initially made
it attractive to illegal drug traders. More recently with disclosure of accounts in tax havens such as the
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CHAPTER 3 International financial markets and portfolio investment
85
British Virgin Islands and Switzerland, it has been viewed as a potential store of wealth for money wishing
to avoid scrutiny for whatever reason. The market is not confined to illegal usage. Many legitimate
businesses are beginning to accept bitcoins. The main problem at the moment is the very volatile price of
bitcoins; during 2021 the price varied from £22,000 to £50,000! The market capitalization of the bitcoins
is $110 billion. There are other crypto­currencies, the second most popular being etherium ($20 billion).
The Eurodollar. The Eurodollar is a dollar denominated bank account that is located outside the US.
This may seem odd but remember that banks typically hold only 10 per cent of deposits in cash or near
cash assets for domestic banking. Cash requirements will be even less for large businesses. Where cash
is required, banks will pay from their US bank accounts. The origins were in the 1960s, where dollar
accounts outside the control of the US authorities operated in London and initially were attractive to,
among others, the Norodny Bank in Russia who feared that their accounts in New York would be frozen
due to the Cold War between the US and Russia. During the 2022 Russian invasion of Ukraine (post
24 February) the Russian Central Banks reserves held in the Federal Reserve, Bank of England, Bank
of Canada and European Central Bank were frozen. This further prompted a sharp fall in the value of
the rouble. By early March the rouble had bottomed out a devaluation of over 40 per cent compared to
pre-invasion rates. Russian banks started to offer Chinese yuan accounts, in effect creating a ‘euroyuan’
currency and causing speculation that the yuan may eventually rival the US dollar.
The rise of the Eurodollar
As early as the start of the 1960s there was speculation that dollar deposits held abroad could serve as an
international currency.1 Eurodollars are easily transferred between countries, their value is underwritten
by the US economy and they offer stability. This is both a strength and a weakness. Although it confers
greater liquidity to a country in that the banks, if short of funds, can borrow on the Eurodollar markets,
it is a weakness in that it lessens the ability of any one country to manage its monetary policy, 2 since
the amount of credit available for banks to lend out is no longer as easily controlled by a country’s
central bank. No doubt for that reason, as early as 1962 the then-European Economic Community issued
a programme of action to result in monetary union by 1970, some 30 years before actual union was
achieved.3 The advent of the Eurodollar as anticipated by the European Economic Community was the
start of the internationalization of the financial markets.
There were fears in the early development of the market that it would increase liquidity and have
a very disruptive effect. That this has not proved to be the case is in part due to the modest maturity
transformation (as above).4 The credit creation process of banks means that for a €1 deposit the banks
can issue loans of eight to nine times that amount for longer-term loans, but if banks only lend on €1 at
a similar maturity there is no credit creation. In the past many of the loans and deposits were interbank,
but of late this has been reducing.5 Increasingly banks around the world are depositing their Eurodollars
in London with amounts then being lent out increasingly to non-financial organizations including MNCs.
For many countries the dollar serves as a kind of ‘hard’ currency, an alternative available to the wealthy
and businesses. In countries with unstable currencies, holding funds in dollars is an attractive alternative and
borrowing in dollars may also be more attractive except that it creates exposure to the risk of significant
devaluation of the local currency. In 2001, Argentina experienced a dramatic devaluation of the peso when
it was unpegged from the dollar – the peso price of the dollar went from 1 peso to over 3 pesos. This left
many who were borrowing in dollars for house purchases but earning in pesos unable to repay their loans.
Central Bank Digital Currency (CBDC) and MNC payments
It is interesting to reflect on the fact that the creation of money is mainly through private enterprise.
Governments benefit through the initial creation of money, but once spent, the money is then in the hands
of banks who will lend out more than the cash held as most transactions are essentially numbers on a
statement. CBDC offers a spectrum of possibilities that may well disrupt this long-standing process.
A digital currency operated by the central bank with transactions monitored by blockchain could mean
that all accounts are held by the central bank with no liquidity requirement as there are no anonymous
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86
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
coins or notes, i.e. ‘bearer’ currency or money owned by whoever holds it. It would not be possible to
withdraw money, you could only pay from your account to another. This would amount to a wholly
nationalized, centralized and controlled use of money. All transactions would be recorded and all loans
subject to government scrutiny. At the other end of the spectrum, such digital currency may be held as a
form of cash by banks and used simply as a cheaper and more secure means of recording transactions, a
more efficient form of cash. There are many possibilities between these extremes.
From the perspective of the MNC such developments do not seem especially attractive. For a transaction
to take place bitcoins have to be deposited making it in effect a prepayment system. The distributed ledger
makes transactions irreversible and the digital wallets for storing bitcoins are exposed to hacking. As noted
previously, the exchange rate is highly volatile and attempts to stabilize it via a futures market have been
unsuccessful. The anonymity of the distributed ledger, much touted when created, can hardly be described
as an advantage from an MNC perspective as it would clearly damage relations with host governments
were it to be implemented on a large scale. Anonymity would, of course, be lost if bitcoins were translated
into dollars or other currencies. Despite these issues, in September 2021, El Salvador passed legislation
making bitcoins legal tender effectively forcing companies to accept bitcoins as payment. The extreme
volatility of the bitcoin has prompted speculation over the effect of such a disruptive currency as part of
the economy. It also prompted the IMF in January 2022 to ask El Salvador to reverse the move.
There are a number of cryptocurrencies with varying features designed to improve on bitcoins. The
term ‘stablecoins’ is used to classify digital currencies that are tied to a currency or commodity such as
gold. The dollar serves as an attractive peg, tether and dai being two principal examples. In a national
context, the first stablecoin was the ‘Bahamas Sand Dollar’ fixed to the Bahamian dollar and helpful to
tourists as well as saving significant transaction costs given the 30 or so inhabited islands that make up the
Bahamas. The damage and chaos caused by storms has also been a motivating factor.
The other major development is the Chinese digital yuan (sometimes referred to as the digital renminbi
and currently still being trialled). This again is issued by the central bank and is simply an alternative way
of paying but with a ledger that is controlled by the state.
MANAGING FOR VALUE
An opportunity for greater surveillance? Central Bank Digital Currency (CBDC) –
the People’s Bank of China (PBOC) and the Bank of England
The PBOC’s Fan said the digital yuan would have
‘controllable anonymity’. This would involve those
operating digital yuan wallets to disclose transactions
to the PBOC as the ‘sole third party’. Users would
have a ‘loose coupling of accounts’ which means
that their current bank account may not necessarily
be closely linked to their digital yuan account … The
PBOC says agencies operating digital yuan services
should ‘submit transaction data to the central bank via
asynchronous transmission on a timely basis’. That
would allow the PBOC to ‘keep track of necessary
data’ in order to crack down on money laundering
and criminal offenses.
Kharpal, A. (2021) ‘China’s digital yuan: What is it, and how
does it work?’ Available at: www.cnbc.com/2021/03/05/
chinas-digital-yuan-what-is-it-and-how-does-it-work.html
[Accessed 27 April 2022]
A similar statement has been issued by the Bank of
England:
A CBDC would need to comply with regulations around
anti‑money laundering (AML), countering the financing
of terrorism (CFT) and sanctions. Feedback from
respondents has, however, emphasised the importance
that users place on having privacy in their transactions.
Subject to meeting compliance requirements and
government objectives around tackling financial crime,
any CBDC should ensure that users would have a
strong level of privacy around their transactions.
Bank of England (2022) ‘Responses to the Bank of England’s
Discussion Paper on new forms of digital money’. Available at:
www.bankofengland.co.uk/paper/2022/responses-to-the-bankof-englands-discussion-paper-on-new-forms-of-digital-money
[Accessed 27 April 2022]
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CHAPTER 3 International financial markets and portfolio investment
87
Standardizing global bank regulations
The growing standardization of regulations around the world has contributed to the trend towards
globalization in the banking industry. Four of the more significant regulatory events allowing for a more
competitive global playing field are: the Single European Act, the Basel Accord, the Basel II Accord and the
Basel III Accord. Banks are central to international finance: exchanging currencies, speculating, investing
internationally, trading in derivatives and so on. The balance sheet of banks is very risky due to the nature
of their trade. They are financed by current accounts and similar short-term deposits from the public and
businesses yet lend long term to businesses, keeping only about 10 per cent of current account deposits in
liquid form. Hence in similar fashion to financial markets, they manage maturity transformation borrowing
short term (in the form of current and deposit accounts) and lending long term (lending to businesses). In
more detail, on the financing side, shareholder capital is relatively small compared to the very large current
liabilities created by the deposit accounts. In effect the bank owes you the money you have deposited
and that is much more than the shareholder value. On the assets side, most of the money is in lending to
clients. As we have said, very little of the money deposited with banks is kept as cash. This is potentially
a very risky position. If depositors all asked to withdraw their money (known as a run on the bank) the
bank would not have the money. Also, if a few large clients went bankrupt, those loans would have to be
written off against reserves, i.e. shareholder capital. Because shareholder capital is relatively small, it is
possible that a bank could become bankrupt by having negative shareholder capital. This would occur if
the amount of the write-off were larger than the shareholder value. Arguably, during the Third World Debt
crisis which began in 1982, many banks found that sovereign loans (loans to countries) of doubtful quality
were greater in value than their shareholding. The share capital inadequacy of banks became apparent.
There is also the possibility that interest rates become volatile, making it more likely that banks might be
in a position of having to offer rates to customers that would threaten their profits. Also, off-balance sheet
activities resulting in financial guarantees, as in the case of options, have not always been well reported
and can conceal the risk of banking.
Basel Accord. Before 1988, share capital standards imposed on banks varied across countries, which
allowed some banks to have a comparative global advantage over others. As an example, suppose that
banks in the US were required to maintain more capital than foreign banks. Foreign banks would grow
more easily, as they would need a relatively small amount of capital to support an increase in assets.
Despite their low share capital, such banks were not necessarily perceived as too risky because the
governments in those countries were likely to back banks that experienced financial problems. Therefore,
some non-US banks had globally competitive advantages over US banks, without being subject to
excessive risk. In December 1987, 12 major industrialized countries attempted to resolve the disparity
by proposing uniform bank standards. In July 1988, in the Basel Accord, Central Bank Governors of
the 12 countries agreed on standardized guidelines. Under these guidelines, banks must maintain share
capital equal to at least 8 per cent of their assets (referred to as Tier 1 capital and subject to a detailed
definition). For this purpose, banks’ assets are weighted by risk – the higher the risk, the higher the
weighting. So, for example, government debt in the form of bonds (sovereign loans) that are rated AAA
receive a zero weighting. Banks can invest in these bonds without needing to increase their reserves. If the
bond is weighted BBB1 to BBB then the weight is 50 per cent under the Basel II standard approach. If
there is an 8 per cent requirement then if a bank invests £100 in such bonds, it must increase reserves by
50 per cent × 8 per cent 5 4 per cent of the £100, i.e. £4 to provide against possible default. Thus, there
is a higher required capital ratio for riskier assets. Off-balance sheet items are also accounted for so that
banks cannot circumvent capital requirements by focusing on services that are not explicitly shown as
assets on a balance sheet.
Basel II Accord. Banking regulators that form the so-called Basel Committee agreed a new accord (known
as Basel II) to correct some inconsistencies that still existed. For example, banks in some countries required
better collateral (security) to back their loans – if the borrower from the bank could not pay, the banks
had a lien (ownership right) on the collateral and could sell the assets pledged to the bank in the event of
non-payment.
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88
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
The agreement, effective from December 2006, is based on three ‘pillars’:
1 Minimum capital requirements. Share capital must be at least 8 per cent of a special valuation of lending.
The formula for valuing lending is made up of credit risk (the risk that the borrower, e.g. a business, will not
pay), market risk (exposure to uncertain market value of investments by the bank in shares, bonds, etc.) and
operational risk (the risk from fraud and failing operational processes internal to the bank).
2 Supervisory review. Banking supervisors have powers to ask a bank to increase its share capital requirements
if weaknesses are found in its capital assessment processes.
3 Market discipline. Let investors decide on the risk of buying shares in the bank by requiring greater
disclosure of their risk management policies in the annual report. Barclays Bank plc, for instance, prepares
a Consolidated Basel 2 Pillar 3 Disclosure 2008 report of some 43 pages. For a non-bank operation, the
equivalent report would normally be between one and five pages. In its 2012 report it explains that it
borrows in US dollars and euros to offset the effect of exchange rate movements in its investments in those
currencies, thus minimizing the effect of currency movements on its regulatory capital ratios.
Basel III Accord. This accord keeps the three pillars and makes further recommendations concerning their
implementation. It introduces a minimum leverage ratio of 3 per cent defined as Tier 1 capital (mainly shares
and retained earnings) divided by total assets. A bank is a much riskier operation than a commercial company.
International credit market
MNCs and domestic firms sometimes obtain medium-term funds through loans from local financial
institutions or through the issuance of notes (medium-term debt obligations) in their local markets. However,
MNCs also have access to medium-term funds through banks located in foreign markets. Loans of one year
or longer extended by banks to MNCs or government agencies in Europe are commonly called Eurocredits or
Eurocredit loans. These loans are provided in the so-called Eurocredit market. The loans can be denominated
in dollars or many other currencies and commonly have a maturity of five years.
Because banks accept short-term deposits and sometimes provide longer-term loans, their asset and
liability maturities do not match. This can adversely affect a bank’s performance during periods of rising
interest rates, since the bank may have locked in a rate on its longer-term loans while the rate it pays on
short-term deposits is rising over time. To avoid this risk, banks commonly use floating rate loans. The
loan rate floats in accordance with the movement of market interest rates. This used to be the London
Interbank Offered Rate or LIBOR. However in 2012 the Financial Times published an allegation from
a former trader that since at least 1991 the rate had been manipulated between fellow traders across the
major banks. A number of prosecutions followed. There were suspicions that the LIBOR rate was suspect,
particularly during the global recession in 2008, but there were no clear statements to that effect. Following
the Wheatley report the UK reorganized the administration of the process broadly basing it more on actual
transactions with an audit trail. However, over time, the market on which the rate was determined has
shrunk and it has now been decided that non-USD LIBOR rates will no longer be published, neither will
most USD rates. LIBOR was in effect retired as of 2021. There are a number of alternatives and markets
are free to use whatever alternative they want in specifying contracts. However, the leading contender is
the Secured Overnight Financing Rate (SOFR). This is the risk-free rate secured with US treasuries and is
transaction based for a market that is approximately $1 trillion, compared with LIBOR’s $500 million.
The Bank of England produces the Sterling Overnight Index Average (SONIA), there are also RFRs which
are overnight rates based on real transactions. For convenience we will use the acronym SOFR for what is
clearly a less well-defined source of risk-free variable interest rates in differing currencies.
The international credit market is well developed in Asia and is developing in South America.
Periodically, some regions are affected by an economic crisis, which increases the credit risk. Financial
institutions tend to reduce their participation in those markets when credit risk increases. Thus, even
though funding is widely available in many markets, the funds tend to move towards the markets where
economic conditions are strong and credit risk is tolerable.
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CHAPTER 3 International financial markets and portfolio investment
89
Syndicated loans
Sometimes a single bank is unwilling or unable to lend the amount needed by a particular corporation or
government agency. In this case, a syndicate of banks may be organized. Each bank within the syndicate
participates in the lending. A lead bank is responsible for negotiating terms with the borrower. Then the lead
bank organizes a group of banks to underwrite the loans. The syndicate of banks is usually formed in about six
weeks, or less if the borrower is well known because the credit evaluation can then be conducted more quickly.
Borrowers that receive a syndicated loan incur various fees besides the interest on the loan. Front-end
management fees are paid to cover the costs of organizing the syndicate and underwriting the loan. In
addition, a commitment fee of about 0.25 per cent or 0.50 per cent is charged annually on the unused
portion of the available credit extended by the syndicate.
Syndicated loans can be denominated in a variety of currencies. The interest rate depends on the currency
denominating the loan, the maturity of the loan and the creditworthiness of the borrower. Interest rates on
syndicated loans are commonly adjustable according to movements in an interbank lending rate, and the
adjustment may occur every six months or every year.
Syndicated loans not only reduce the default risk of a large loan to the degree of participation for each
individual bank, but they can also add an extra incentive for the borrower to repay the loan. If a government
defaults on a loan to a syndicate, word will quickly spread among banks, and the government will likely
have difficulty obtaining future loans. Borrowers are therefore strongly encouraged to repay syndicated loans
promptly. From the perspective of the banks, syndicated loans increase the probability of prompt repayment.
International bond market
Bonds (or debentures or bills) are issued by companies and governments. A bond typically offers a fixed interest
payment for a number of years or term, combined with a repayment (redemption) of the nominal amount
borrowed at the end of the term. They may be secured on the assets of the company in case of non-payment.
Unlike shares, there is no ownership interest, and so no voting rights. Although MNCs, like domestic firms, can
obtain long-term debt by issuing bonds in their local markets, MNCs can also access long-term funds in foreign
markets. MNCs may choose to issue bonds in the international bond markets for three reasons.
First, issuers recognize that they may be able to attract a stronger demand by issuing their bonds in a
particular foreign country rather than in their home country. Some countries have a limited investor base,
so MNCs in those countries seek financing elsewhere.
Second, MNCs may prefer to finance a specific foreign project in the local currency and therefore
reduce exposure to exchange rate changes, as payments on the loan will partially offset project receipts.
Third, financing in a foreign currency with a lower interest rate may enable an MNC to reduce its
cost of financing, although it may be exposed to exchange rate risk (as explained in later chapters). Some
institutional investors prefer to invest in international bond markets rather than their respective local
markets when they can earn a higher return on bonds denominated in foreign currencies.
International bonds are typically classified as either foreign bonds or Eurobonds. A foreign bond is
issued by a borrower foreign to the country where the bond is placed. For example, a US corporation may
issue a bond denominated in Japanese yen, which is sold to investors in Japan. In some cases, a firm may
issue a variety of bonds in various countries. The currency denominating each type of bond is determined
by the country where it is sold. These foreign bonds are sometimes specifically referred to as parallel bonds.
Eurobond market
Eurobonds are bonds that are sold in countries other than the country of the currency denominating
the bonds. The emergence of the Eurobond market was partially the result of the Interest Equalization
Tax (IET) imposed by the US government in 1963 to discourage US investors from investing in foreign
securities. Thus, non-US borrowers that historically had sold foreign securities to US investors began to
look elsewhere for funds. Further impetus to the market’s growth came in 1984 when the US government
abolished a withholding tax that it had formerly imposed on some non-US investors and allowed US
corporations to issue bearer bonds directly to non-US investors.
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90
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Eurobonds have become very popular as a means of attracting funds, perhaps in part because they
circumvent registration requirements. US-based MNCs such as McDonald’s and The Walt Disney
Company commonly issue Eurobonds. Non-US firms such as Guinness, Nestlé and Volkswagen also use
the Eurobond market as a source of funds.
In recent years, governments and corporations from emerging markets such as Croatia, Romania and
Hungary have frequently utilized the Eurobond market. New corporations that have been established in
emerging markets often rely on the Eurobond market to finance their growth. They have to pay a risk premium
of at least 3 percentage points annually above the US Treasury bond rate on dollar-denominated Eurobonds.
Features of Eurobonds. Eurobonds have several distinctive features. They are usually issued in bearer
form, and coupon payments are made yearly. Some Eurobonds carry a convertibility clause allowing them
to be converted into a specified number of shares of common stock. An advantage to the issuer is that
Eurobonds typically have few, if any, protective covenants. Furthermore, even short-maturity Eurobonds
include call provisions. Some Eurobonds, called floating rate notes (FRNs), have a variable rate provision
that adjusts the coupon rate over time according to prevailing market rates.
Denominations. Eurobonds are commonly denominated in a number of currencies. Although the US dollar is
used most often, denominating 70 to 75 per cent of Eurobonds, the euro will likely also be used to a significant
extent in the future. Recently, some firms have issued debt denominated in Japanese yen to take advantage
of Japan’s extremely low interest rates. Because interest rates for each currency and credit conditions change
constantly, the popularity of particular currencies in the Eurobond market changes over time.
Underwriting process. Eurobonds are underwritten by a multinational syndicate of investment banks and
simultaneously placed in many countries, providing a wide spectrum of fund sources to tap. The underwriting
process takes place in a sequence of steps. The multinational managing syndicate sells the bonds to a large
underwriting crew. In many cases, a special distribution to regional underwriters is allocated before the
bonds finally reach the bond purchasers. One problem with the distribution method is that the second and
third-stage underwriters do not always follow up on their promise to sell the bonds. The managing syndicate
is therefore forced to redistribute the unsold bonds or to sell them directly, which creates ‘digestion’ problems
in the market and adds to the distribution cost. To avoid such problems, bonds are often distributed in higher
volume to underwriters that have fulfilled their commitments in the past at the expense of those that have
not. This has helped the Eurobond market maintain its desirability as a bond placement centre.
Secondary market. Eurobonds also have a secondary market. The market makers are in many cases the
same underwriters who sell the primary issues. A technological advance called Euro-clear helps to inform all
traders about outstanding issues for sale, thus allowing a more active secondary market. The intermediaries
in the secondary market are based in ten different countries, with those in the UK dominating the action.
They can act not only as brokers but also as dealers that hold inventories of Eurobonds. Many of these
intermediaries, such as Bank of America International, Salomon Smith Barney and Citicorp International,
are subsidiaries of US corporations.
Before the adoption of the euro in much of Europe, MNCs in European countries commonly preferred to
issue bonds in their own local currency. The market for bonds in each currency was limited. Now, with the
adoption of the euro, MNCs from many different countries can issue bonds denominated in euros, which
allows for a much larger and more liquid market. MNCs have benefited because they can more easily obtain
debt by issuing bonds, as investors know that there will be adequate liquidity in the secondary market.
Development of other bond markets
Bond markets have developed in Asia and South America. Government agencies and MNCs in these regions use
international bond markets to issue bonds when they believe they can reduce their financing costs. Investors in
some countries use international bond markets because they expect their local currency to weaken in the future
and prefer to invest in bonds denominated in a strong foreign currency. The South American bond market has
experienced limited growth because the interest rates in some countries there are usually high.
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CHAPTER 3 International financial markets and portfolio investment
91
Comparing interest rates between currencies
It is a common mistake to think that because interest rates are higher in some countries, borrowing would be
more expensive and investment more profitable. If that were the case then from Exhibit 3.5 everyone would
be borrowing in France and investing in Ghana. Speculators do indeed engage in such transactions, which
are known as the carry trade, but they are a minority (borrowing in yen and investing in Australian dollars
has been one popular such trade). Why is this not more popular? The simple reason is the exchange rate. In
our example, euros would be borrowed and the investment would be in Ghanaian cedi. So, 100 euro at the
current rate would translate to 714 cedi to invest in Ghana. Although this would earn 17.1 per cent and be
worth 836 cedi in one year’s time, the exchange rate will have changed. In fact we can say that the market
will expect the exchange rate to be such that 836 cedi will convert to 101 euros. This would make investing
in Ghana no more or less profitable than investing in France with an interest rate of 1 per cent. As there is no
mass investment in Ghana, it is reasonable to assume that the market does indeed expect a devaluation of the
cedi. In exchange rate terms, the cedi is expected to devalue from EURGHS 7.14 to EURGHS 8.28. Carry
traders are therefore indirectly gambling on the Ghanaian cedi to not devalue by as much. If it only devalued
to say EURGHS 8.00, the 836 cedi would convert to 104.5 euros, a 4.5 per cent return.
EXHIBIT 3.5
Market interest rates 2020
Banks’ loans to the
private sector
Inflation
26.8
5.4
21.4
France
1.0
1.1
–0.1
Germany
1.1
1.8
–0.7
Ghana
17.1
8.1
9.0
Nigeria
14.9
17.0
–2.1
South Africa
7.1
3.7
3.4
UK
4.0
1.2
2.8
US
3.3
1.9
1.4
India
8.8
5.0
3.8
Brazil
Estimate of real rate
(including risk)
Source: EIU
EXAMPLE
Suppose in February 2021 a UK investor bought
1-year Indian government bonds yielding 4 per cent.
At the exchange rate, £1,000 would have purchased
bonds to the value of 101,380 rupees and after
12 months the bonds would have matured to the
value of 105,436 rupees (inclusive of the 4 per cent
return). The GBPINR exchange rate over that period
changed from GBPINR 101.3804 to 102.2826, and
converting back into UK pounds the investor would
have 105,436/102.2826 = £1,030.83, a 3 per cent
profit. This is known as the carry trade, in effect
gambling on the Indian government supporting the
rupee restricting its fall in value. In this case the carry
trader won and gained by 3 per cent, at the expense
of the Indian government. Such traders are not just
individuals but include banks, wealth funds and
financial institutions, sometimes termed the shadow
banking sector.
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92
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
International stock markets
MNCs and domestic firms commonly obtain long-term funding by issuing shares locally. However, MNCs
can also attract funds from foreign investors by issuing shares in international markets. The share offering
may be more easily digested when it is issued in several markets. In addition, the issuance of shares in a
foreign country can enhance the firm’s image and name recognition there.
The conversion of many European countries to a single currency (the euro) has resulted in more share
offerings in Europe by US- and European-based MNCs. In the past, an MNC needed a different currency
in every country where it conducted business and therefore borrowed currencies from local banks in those
countries. Now, it can use the euro to finance its operations across several European countries and may be
able to obtain all the financing it needs with one share or bond offering denominated in euros. The MNCs
can then use a portion of the revenue (in euros) to pay dividends to shareholders and interest to bondholders.
Issuance of foreign shares in the US
Non-US corporations or governments that need large amounts of funds sometimes issue shares in the US
(these are called Yankee stock offerings, note that ‘stock’ is the US term for share in this context) due to
the liquidity of the new-issues market there. In other words, a foreign corporation or government may be
more likely to sell an entire issue of shares in the US market, whereas in other, smaller markets, the entire
issue may not necessarily sell.
When a non-US firm issues shares in its own country, its shareholder base is quite limited, as a few large
institutional investors may own most of the shares. By issuing shares in the US, such a firm diversifies its
shareholder base, which can reduce share price volatility caused when large investors sell shares.
The US investment banks commonly serve as underwriters of the shares targeted for the US market and
receive underwriting fees representing about 7 per cent of the value of shares issued. Since many financial
institutions in the US purchase non-US shares as investments, non-US firms may be able to place an entire
share offering within the US.
Firms that issue shares in the US typically are required to satisfy stringent disclosure rules on their financial
condition. However, they are exempt from some of these rules when they qualify for a Securities and Exchange
Commission guideline (called Rule 144a) through a direct placement of shares to institutional investors.
Many of the recent share offerings in the US by non-US firms have resulted from privatisation
programmes in Latin America and Europe. Thus, businesses that were previously government owned are
being sold to US shareholders. Given the large size of some of these businesses, the local stock markets are
not large enough to digest the share offerings. Consequently, US investors are financing many privatized
businesses based in foreign countries.
American depository receipts. Non-US firms also obtain equity financing by using American depository
receipts (ADRs), which are certificates representing bundles of shares. The use of ADRs circumvents some
disclosure requirements imposed on share offerings in the US, yet enables non-US firms to tap the US
market for funds. The ADR market grew after a number of businesses were privatized in the early 1990s,
as some of these businesses issued ADRs to obtain financing.
Since ADR shares can be traded just like shares, the price of an ADR changes each day in response to
demand and supply conditions. Over time, however, the value of an ADR should move in tandem with the
value of the corresponding share that is listed on the foreign stock exchange, after adjusting for exchange
rate effects. The formula for calculating the price of an ADR is:
PADR 5 Conv 3 Pfs 3 S
Where:
PADR 5 the price of the ADR in dollars
Conv 5 number of foreign shares that can be obtained for one ADR
Pfs 5 the price of the foreign shares measured in foreign currency
S 5 the spot rate of the foreign currency, i.e. US dollars per foreign currency unit
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CHAPTER 3 International financial markets and portfolio investment
93
EXAMPLE
The ADR of the French firm Pari represents one
share of this firm that is traded on the French stock
exchange. The share price of Pari was 20 euros when
the French market closed for the day’s trading. As the
US stock market opens, the euro is worth $1.05, so
the ADR price should be:
PADR 5 Conv 3 Pfs 3 S
5 1 3 20 3 $1.05
5 $21
If there is a discrepancy between the ADR price and the price of the foreign share (after adjusting for
the exchange rate), investors can use arbitrage to capitalize on the discrepancy between the prices of the
two assets. The act of arbitrage should realign the prices.
EXAMPLE
Assume no transaction costs. If PADR 6 (Pfs 3 S),
then ADR shares will flow back to France. They will be
converted to shares of the French company and will
be traded in the French market. Investors can engage
in arbitrage by buying the ADR shares in the US,
converting them to shares of the French company,
and then selling those shares on the French stock
exchange where the share is listed.
The arbitrage will: (1) increase the demand for
ADRs traded in the US market, thereby putting
upward pressure on the ADR price, and (2) increase
the sale of the French shares traded in the French
market, thereby putting downward pressure on the
share price in France. The arbitrage will continue until
the discrepancy in prices disappears.
ADRs are a good example of the subtlety and international nature of financial markets.
Issuance of shares in foreign markets
The locations of an MNC’s operations can influence the decision about where to place its shares. The
ability to raise funds and the active trading of its shares are the principal attractions. Consequently,
the shares of the largest MNCs are widely traded on numerous stock exchanges around the world. For
example, Alcatel (France), Nokia (Finland), Coca-Cola Co., IBM and many other MNCs have their shares
listed on several different stock exchanges. It is important to understand that stock exchanges have both
foreign firms listed and foreign investors. The London Stock Exchange has some 1,300 companies listed
from 70 countries with over 50 per cent of the shares by value held by foreign investors. The location
of a stock exchange does not prevent it from being an international source for raising large funds and
investing.
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94
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Comparison of stock markets. Stock exchanges are not government institutions but are independent
companies much like any other. A stock exchange competes with other exchanges in its ability to raise
funds, to quote a fair price and to have a diverse range of buyers and sellers. In other words a market that
is both broad and deep and actively traded.
Stock markets are also not the only source of funding, as banks, financial institutions and wealth funds
all compete. Economies have very different configurations of fund sources, for example the capitalization
of German quoted firms amounts to 54 per cent of its GDP with many well-known companies being
unquoted family-owned businesses, whereas in the UK the figure is 108 per cent.
EXHIBIT 3.6
Percentage of world stock market capitalization by country 2020
% of world total
market capitalization
US
46.0
China (incl. HK)
14.0
Japan
6.0
Euronext
4.0
London Stock Exchange
3.5
Saudi Arabia
2.4
Other
24.1
Total
100.0
Source: visualcapitalist.com
USING THE WEB
Stock market trading information
Information about the market capitalization of listed companies and other stock market data is
provided at: www.worldbank.org and follow their link to data.
International financial markets and the MNC
Exhibit 3.7 illustrates the foreign cash flow movements of a typical MNC. These cash flows can be
classified into three activities, all of which generally require use of the foreign exchange markets.
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CHAPTER 3 International financial markets and portfolio investment
EXHIBIT 3.7
95
Foreign cash flow chart of an MNC
MNC
Foreign exchange markets
Exporting and
importing
Product markets
Imports and
exports
Dividend
remittance
and interest
payments
Subsidiaries
FDI, portfolio investment
and borrowing
Financial markets
Long term
International stock markets
Medium term
International bond markets
(e.g. Eurobond)
Short term
International credit
markets (e.g. Eurocredit)
The first two activities are concerned mainly with trade in goods and services: either exporting
and importing to and from foreign product markets, or dealing with operations that have been set up
abroad. These transactions appear in the current account. The third activity concerns investment where
transactions are recorded in the financial account of the balance of payments. When the investment is with
a company registered abroad and there is a more than 10 per cent ownership, the transaction is seen as a
direct investment, for example lending money to a foreign subsidiary owned 100 per cent by the MNC.
If there is less than 10 per cent ownership interest, for example a UK MNC buying US treasury bills, that
is seen as portfolio investment. Taken together, Exhibit 3.7 illustrates the central role of the exchange rate
and how it affects all transactions. The exchange rate, although it may not seem so, is nothing more than
the price of each foreign currency in terms of the home currency as we discussed earlier in this chapter.
How it behaves is therefore of central importance.6
Market efficiency and the efficient markets hypothesis
The behaviour of market prices is central to financial management. Exchange rates, share prices and
commodity prices can change dramatically. A financial manager needs to understand the nature of these
price changes in order to take decisions about how much protection a firm needs and how risk can be
avoided while minimizing the effect on profits.
We start by considering price in general. When buying a share, currency or a car, you are buying an
information set. In the case of a car, that information set is outlined in the car manual. It is a very stable
information set: if the car does not meet the specification, if the engine is missing for instance, then you
can get compensation. The price of the car does not change much if at all over a given year. A higher
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price should indicate a better specification if the market is efficient in setting prices. If you found that you
had paid more for a car that was not as good as a cheaper car, then you would feel cheated and would
not want to buy from whatever marketplace you went to again. A market for our purposes is any place
of purchase: it could be at an auction, a dealership, a street market, the small advertisement pages of a
newspaper or a stock exchange – they are all markets.
When buying a currency or a share, you are also buying an information set. In the case of a share it is a
promise of dividends; in the case of a currency it is a promise of buying power. But there are no guarantees
and no specification as with the car. The value of the buying power promise is very unclear – you can have
no more than an expectation as to the dividends you might receive or the buying power of the currency. That
expectation in the marketplace will change on a daily basis as the economic outlook changes. Furthermore,
we are never sure as to exactly what changes expectations. Traders do not have to give reasons for their
purchases or their sales and even if we were to ask, the reasons they give are often unclear.
All we can say is that the currency market requires traders to look into the future and, using the
information to hand, estimate the value of the currency. Information plays a key role in the valuation
process. The value of a currency may fall if a current account deficit is larger than expected. The value may
rise if there is an economic report that is better than expected.
It is tempting but wrong to say that therefore a good economic report will result in an increase in
the value of the currency; or that reporting a current account surplus will result in an increase in the
value of the currency. Though such movements will often happen, there will be exceptions because it is
expectations about the event not just the event itself that matters. The value of a currency may fall if a good
economic forecast was not as good as expected or a current account surplus was not as big as expected.
Unfortunately, although we can measure the current account and economic forecasts, we cannot really
measure expectations. Therefore, we cannot be sure as to how the market will react to any piece of news.
We are at least sure that we are unsure about how the market will react to any given piece of news. We
therefore proceed by modelling our uncertainty! Such analysis is surprisingly powerful in its predictions.
Market price movements. The binomial lattice is the simple model that underlies our understanding
of uncertainty in finance generally as well as uncertainty over the price of a foreign currency, and is
represented in Exhibit 3.8a. Period 0, point A represents the present and the current exchange rate. At this
point there is in this model an equal probability of a rise or a fall by the same amount. Period 1 may be
a minute, hour, day or week later. Point B represents a rise at which point there is again the prospect of
the same rise or fall and similarly so if the price should fall to point C. In this way the price path moves
through the lattice.
EXHIBIT 3.8a
The binomial lattice
Probabilities:
Paths/Total paths
D, 1/16 = 6.25%
Price of currency
E, 4/16 = 25%
B
Current price A
F, 6/16 = 37.5%
C
G, 4/16 = 25%
H, 1/16 = 6.25%
0
1
2
3
Time periods
4
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CHAPTER 3 International financial markets and portfolio investment
So, what can be said about these price paths? After 4 periods the price ranges from nodes D to H. The
number beside each of the end nodes is the number of paths that reach that node. Thus there is only one
path to the top node being up,up,up,up whereas there are 4 paths to the node below (down,up,up,up;
up,down,up,up; up,up,down,up; up,up,up,down). It is therefore four times more likely that, after four
time periods, the price of the currency will be D rather than E. Extending the analysis we can trace
16 paths in all. As 4 of them are to price E we say that the probability of the price being E is 4/16ths or
25 per cent. The reasoning really is as simple as that and is the basis of the main academic pricing models
from NPV to CAPM. The probability of prices D to H is illustrated in Exhibit 3.8b. It looks rather like the
bell shaped normal distribution. As we extend the periods (which could be hours or even just seconds) the
distribution has more and more possible prices that eventually form the normal distribution exactly.
EXHIBIT 3.8b
The distribution of outcomes in period 4
40.00%
35.00%
Probability
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
D
E
F
G
Period 4 outcomes − Exhibit 3.8a
H
From this simple model we can make four surprisingly strong statements about exchange rate
movements:
1 The current exchange rate is the best estimate of the future rate with the small added difference in the
riskless interest rates.
2 The risk or spread of possible prices increases over time at a regular rate being: the variance for shorter
period 3 the number of shorter periods in the longer period.
If the variance (s2) in period 1 is 2% then in period 4 it should be 2% 3 4 5 8%. More commonly, this is
expressed in terms of the standard deviation (the square root of the variance), i.e. s 3 !n in this case
!2% 3 !4 5 2.8284%, thus a standard deviation of 2.8284% after 4 periods (note that this is the same
result as 2.8284 is the square root of 8).
3 Prices in financial markets, in this case exchange rates, are best described as following a random walk.
A random walk does not imply that traders spin a coin every now and then to determine if the price should
rise or fall. It is random because information is randomly better or worse then expected.
4 The movement in rates is lognormally distributed. An exchange rate is multiplied by the percentage change
but the binomial model adds change. Logarithms treat multiplication as addition and so bridges the difference.
All these propositions follow from the basic lattice diagram of Exhibit 3.8a. In Exhibit 3.9 we compare
the minute by minute quote for a bitcoin in US dollars for the month of January 2018 with a random walk
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PART I
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created using the Excel instruction in the B2 cell: 5 B1 1 NORMSINV(RAND())>$C$1 where B1 holds
the same number as the bitcoin price and C1 is a scaling factor, in this case 0.025 – visually there seems to
be little difference.
EXHIBIT 3.9
BTCUSD rates per minute for January 2018 and a random walk
20,000
18,000
16,000
14,000
12,000
10,000
8,000
6,000
4,000
2,000
0
The question arises from Exhibit 3.9 as to why there appears to be a pattern in the actual price and the
random walk imitation; they should both appear random. The answer can be found by considering the
sample size. The movements we measured were the minutes in January 2018, a sample of N 5 44,640.
How come there is a downward trend if it is supposed to be random? The answer is that the ‘trend’ is
over January a sample of 1. If we were to compare it with other months we would find that the monthly
movement was indeed random, sometimes up, sometimes down.
Trying to guess the unique shape of a particular period is the basis of technical analysis and in an
efficient market such activity should be, over time across many such periods, without profit.
In Exhibit 3.10 we show the frequencies of the changes in the random walk (a) compared with
changes in the bitcoin price and (b) where we have excluded non-trading minutes.7 There are differences:
in particular, there are more extreme values than we would expect from a normal distribution. For the
negative movements, where we would expect the lowest 2.5 per cent of movements from a normal
distribution, we in fact find 3 per cent of the movements, and for the positive movements, we find 2.8 per
cent of the sample, where we would expect 2.5 per cent of the movements. As is commonly the case, there
are more movements in the top and bottom tails than we would expect, a feature known as fat tails. This
finding is unfortunate, as the extreme movements are potentially the most important when it comes to risk
management. A sensible reaction of a financial manager is to always increase any risk tolerances derived
from statistics.8
The random walk interpretation of movements over time also closely approximates the increase in
risk over time. In this example, the variance of the one-minute movements were compared with the
variance of the ten-minute movements. Theory tells us that the variance should be ten times larger or
the standard deviation !10 5 3.16 times larger.9 For the random walk in Exhibit 3.9, the standard
deviation was 3.15 times larger so 99.7 per cent accuracy and for the bitcoin price, the standard
deviation was 2.94 times larger – an accuracy of 93 per cent . The real world is not quite the same as the
theoretical world but pretty close. We make a rough comparison in Exhibit 3.10.
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CHAPTER 3 International financial markets and portfolio investment
99
EXHIBIT 3.10 Distribution of changes from a random walk (a) compared with changes in the BTCUSD rate in minutes for January
2018 and (b) excluding zero changes (partly non-trading)
2,000
1,800
1,600
1,400
1,200
1,000
800
600
400
200
(a)
0
2,500
2,000
1,500
1,000
500
(b)
0
For what is a behavioural rather than a scientific measure, both the prediction of the distribution of price
movements overall and their growth over time are remarkably accurate. Yet the implication that prices
follow a random walk is certainly not intuitive and its interpretation needs to be carefully understood. For
this we turn to the efficient markets hypothesis.
Efficient markets hypothesis. This is the most important concept in finance, yet, strangely, it was initially
thought to be so obvious that it was hardly worth stating. The modern form of the hypothesis was formulated
by Professor Harry Roberts in 1967 but what were lecture notes were never published. It was only three
years later that Eugene Fama published the hypothesis based on the original lectures. In this section we have
already established the importance of information to pricing. The testing of the hypothesis seeks to establish
this relationship. The simplest version is from Eugene Fama:
I take the market efficiency hypothesis to be the simple statement that security prices fully reflect all
available information.10
This simple statement is sometimes misinterpreted by students to include all information about the past –
which is wrong. To quote Stanley Jevons, ‘bygones are forever bygones’. The information set is entirely about
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PART I
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the future. That information may relate to matters that are true in the present or in the past data, but if that
information is not relevant to the future then it has no place in determining prices. Note also that currency is
a security and that what is normally discussed in terms of share prices is relevant to the price of currencies,
bonds and all tradeable promises of future value including physical goods. A camera is after all a promise,
albeit physical, of future pictures! Finally, without wishing to be too legalistic, note that the statement does
not exclude the possibility that non-information-based movements may also be possible that would include
behavioural and technical causes.
Although not exclusive, as discussed above, the role of information is of prime importance to all
markets, but this is particularly the case in the market for financial promises due to the volatility of
the information set. Shares have been the main subject of analysis but the exchange rate or the price of
currencies is another important instance. It is the testing of the hypothesis that shows its implications.
What is termed the weak-form test seeks to confirm that prices move randomly by looking for patterns in
the prices. We have discussed how market prices closely resemble a random walk, but there is no conclusive
test for randomness hence the search for the opposite – patterns. If exchange rate movements were to conform
to a pattern, then by analyzing the past you could identify where you are in the pattern and predict the future
movement – but then so could everyone else! If there were a greater probability of a rise in the exchange rate
tomorrow as part of a pattern, the rate would increase today in anticipation. Prices adjust to the point where
the market is unsure as to whether the price will increase or decrease the next day – or at any point of time
in the future, second, minute, hour, day, month, year and so on. The lattice structure assigns a probability of
50 per cent to the probability of a rise or fall resulting in a random walk for each of the two outcomes.
Initially, it is hard to accept that an efficient price should move randomly. Surely, when exchange rates
fall over the year it must have been predictable at least halfway through the year. Exhibit 3.10 makes the
point that news whether or not it is good or bad can equally result in an increase or a decrease in the
exchange rate – hence our lattice structure.
Testing for patterns is probably the most popular form of efficient market testing, partly because it can
be easily carried out from a computer. Runs tests performed by packages such as MINITAB count a run as
consecutive values above the mean or below the mean. This is tested against what you would expect from
a random price movement and the probability is given that it is not random. You can devise your own
runs test by using nested If instructions, for example, 5 IF(C8 . C7,“ ”,IF(C7 . C6,“ ”,IF(C6 . C5,“ ”,1)))
will test for three successive falls or no change in price for cells C5 to C8. Alternatively, you can test for the
growth of the variance over time as carried out above – these are termed variance ratio tests.
Some studies simply look for patterns such as whether some months are more prone to falls in the value
of a currency than other months, in other words testing for a specific pattern. The number of tests is infinite.
We do not report these findings11 because an efficient market should ‘trade out’ such patterns and this is
what is found – if the value of the dollar is found to more likely fall in January then it will be short sold in
December and the price will fall in December in anticipation and a regular fall will disappear in January.
Further tests in the efficient markets literature identify specific information related to a currency and note
whether or not there is an unusual movement when the information comes to market – these are termed
semi-strong tests. Exchange rates12 are very obviously sensitive to news. Finally, there are strong form tests
where the test is to find whether prices react to information that has not yet been made public. This is difficult
to test in relation to currencies; tests are in relation to shares where private information such as earnings
before publication is easy to identify. There is nevertheless evidence of this in order flow models (Chapter 5).
Therefore, as information flows into the market on a daily basis, traders in the marketplace buy and sell
currencies on the strength of that information and, as a result, the price changes. Note that the definition of
good and bad information is always in relation to expectations. Information is not inherently good or bad
in finance. As noted above, a piece of ‘good’ news may bring about a fall in the value of a currency if it is
not as good as expected; ‘bad’ news causes a rise in the value of the currency if it is not as bad as expected.
The role of the market is to ensure that information is available to all traders. In the market for shares
this requirement implies strict rules on the disclosure of information to ensure that some traders do not
have access to private company information and therefore have an unfair advantage. There is no real
equivalent for currencies; private information of relevance to currencies is held by governments and major
economic institutions. Governments are keen to avoid speculation in their currency and are therefore
likely to ensure that private information is kept confidential until announced to the market as a whole.
Major institutions would lose status if their reports were leaked to the market.
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CHAPTER 3
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101
EXAMPLE
The trading department of Anybank plc is actively
buying and selling Currency A. It expects good balance
of payments figures to be announced tomorrow.
The manager explains to a new recruit: ‘Everyone
expects that the figures will be good, we have already
bought Currency A on this expectation. The point is,
will it be better than the market expects or worse?
I don’t really know. The Prime Minister has been a bit
pessimistic on the economy of late, maybe the results
are very good and he is trying to lower our expectations
so that the results are a nice surprise.’ The recruit
replies: ‘Maybe the results aren’t really that good
and he is trying to avoid a big disappointment.’ The
manager responds: ‘Mmm . . . who knows . . . OK, we
haven’t really got any fresh information on this currency,
we will not make any further purchases or sales.’
Published information in the international arena is a matter for governments and international
institutions. Generally, we can expect that the officials of both types of institutions will not trade on
information before it is published. Nevertheless, we have said that markets need to be almost wholly
efficient in their processing of information. There clearly are instances of dishonest activities in the market.
Monitoring trades for suspicious activities is an important operational aspect of maintaining confidence in
the honesty of the price-setting process.
Efficient markets and exchange rate models and apparent contradiction. Much academic effort has been
expended on theories that seek to explain exchange rate movements. The problem is that the concept of
efficient markets appears to contradict such modelling. The efficient markets hypothesis maintains that
it is not the actual value of the variable but the difference between our expectations of that variable and
the actual value when announced. An explanatory variable13 such as the difference between interest rates
of the two currencies could be constant throughout the year, yet the exchange rate moves due to changes
in expectations. The volatility of the expectations, how they change, will affect the price of the currency.
Thus, models have the hidden expectation assumption that actual values when announced have not been
anticipated and that the expectation was that the value would be unchanged from the previous value. In
this way, an increase in an interest rate differential would lead to a devaluation of the higher rate currency
as the market was expecting no change. Obviously, this is not the case, so the compromise has to be
made that we expect our models to be inaccurate as we are unable to reliably measure expectations and
have instead to use actual values. Small changes and differences are likely to be swamped by changes in
expectations as well as changes in other unspecified variables relevant to the model that have not been
included.
Further apparent contradictions exist in the success of the large investors in the market. Normally
this is expressed in relation to shares, but large profits have been made in the currency markets, the most
noted example being George Soros and Black Wednesday on 16 September 1992 when the UK came out
of the Exchange Rate Mechanism – a forerunner to the euro. That was a case of shrewd anticipation of
an extremely unusual set of events. Many multinationals also withheld conversion of foreign currency
into UK pounds expecting the UK pound to devalue. In some respects, the Brexit vote (as below) was the
opposite: shrewd anticipation was for a vote to remain and for the pound to appreciate, the outcome on
both counts was the opposite.14 Generalizing from a few instances and reporting successes and not failures
proves little. Nevertheless, testing of the efficient markets hypothesis is not conclusive. We have already
noted the problem of fat tails. Another problem is that time periods in tests have been limited. A sample
of 30 separate five-year periods means a total span of 150 years. The longer-term efficiency of markets is
not well established. Thus the encouragement by Warren Buffett to invest for the long term: ‘If you aren’t
thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes’ may well
yield high profits. The time span for the financial manager over which performance is judged is little better
than 12 months, so such longer-term issues are not relevant.
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It is as well to conclude this section with a warning. Much of the language of business goes against
the analysis of efficient markets. For example, consider the example of the British pound which fell from
previous levels of $1.40 and above to below $1.30 following the surprise vote by the UK to leave the EU
on 23 June 2016. A financial manager who had not understood the contents of this section might think
that the pound was relatively cheap and commit to buying pounds with dollars at $1.30 that could include
compensating a counterparty for any values below $1.30 – large commitments are very easily made in the
derivative markets. Apart from a brief period in the following August, it was only the following May that
the pound recorded sustained periods above $1.30. Predicting the direction of a currency change is foolish
for all but the specialists in the market who spend millions on gathering information and interpreting it.
For them, it is a return for a considerable investment.
The extensive testing of the efficient markets hypothesis therefore provides strong evidence that a
financial manager cannot sensibly predict market prices.
Summary
●●
The existence of market imperfections prevents
markets from being completely integrated.
Consequently, investors and creditors can
attempt to capitalize on unique characteristics
that make foreign markets more attractive
than domestic markets. This motivates the
international flow of funds and results in the
development of international financial markets.
●●
The foreign exchange market allows currencies
to be exchanged in order to facilitate international
trade or financial transactions. Commercial banks
serve as financial intermediaries in this market.
They stand ready to exchange currencies on the
spot or at a future point in time with the use of
forward contracts.
●●
The convention of exchange rate quotation is
to quote the base first and then the term using
standard three letter identification. Thus GBPUSD
1.3 is read as ‘$1.3 to the £1’, but note that this
convention is not always followed.
●●
The international money markets are composed
of several large banks that accept deposits and
provide short-term loans in various currencies.
This market is used primarily by governments and
large corporations. The European market is a part
of the international money market.
●●
The international credit markets are composed
of the same commercial banks that serve
the international money market. These banks
convert some of the deposits received into loans
(for medium-term periods) to governments and
large corporations.
●●
The international bond markets facilitate
international transfers of long-term credit,
thereby enabling governments and large
corporations to borrow funds from various
countries. The international bond market
is facilitated by multinational syndicates of
investment banks that help to place the bonds.
●●
International stock markets enable firms to obtain
equity financing in foreign countries. Thus, these
markets have helped MNCs finance their
international expansion.
●●
Stock market prices on the world’s stock
exchanges on the whole agree with the efficient
markets hypothesis that share prices are driven
by information rather than speculation.
Critical debate
Should firms that go public engage in international
offerings?
Proposition. Yes. When a firm issues shares to the
public for the first time in an initial public offering (IPO),
it is naturally concerned about whether it can place all of
its shares at a reasonable price. It will be able to issue its
shares at a higher price by attracting more investors. It
will increase its demand by spreading the shares across
countries. The higher the price at which it can issue
shares, the lower is its cost of using equity capital. It can
also establish a global name by spreading shares across
countries.
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CHAPTER 3
International financial markets and portfolio investment
Opposing view. No. If a firm spreads its shares across
different countries at the time of the IPO, there will be less
publicly traded shares in the home country. Thus, it will
not have as much liquidity in the secondary market. Also,
foreign investors in the company may have very different
priorities and motives if they are from a substantially
different culture. There is a potential for conflicts over
strategy, green issues and ownership.
With whom do you agree? State your reasons. Use
InfoTrac or another search engine to learn more about
this issue. Which argument do you support? Offer your
own opinion on this issue.
Stock markets are inefficient
Proposition. I cannot believe that if the value of the euro
in terms of, say, the British pound increases three days in
a row, on the fourth day there is still a 50:50 chance that it
will go up or down in value. I think that most investors will
identify a trend and will buy, therefore the price is more
likely to go up. Also, if the forward market predicts a rise
in value, on average, surely it is going to rise in value. In
other words, currency prices are predictable. And finally,
if it were so unpredictable and therefore unprofitable to
103
the speculator, how is it that there is such a vast sum of
money being traded every day for speculative purposes –
there is no smoke without fire.
Opposing view. If this is your view, the simple answer
is, buy currencies that have increased three days
in a row and on average you should make a profit,
buy currencies where the forward market shows an
increase in value. The fact is that there are a lot of
investors with just your sort of view. The market
traders know all about such beliefs and will price the
currency so that such easy profit (their loss) cannot
be made. Look at past currency rates for yourself.
Check all fourth-day changes after three days of
rises, and any difference is going to be not enough
to cover transaction costs or trading expenses and
the slight inaccuracy in your figures which are likely to
be closing day midpoint of the bid/ask spread. No, all
currency movements are related to information and no
one knows if tomorrow’s news will be better or worse
than expected.
With whom do you agree? Could there be undiscovered
patterns? Could some movements not be related to
information? Could some private news be leaking out?
Self test
Answers are provided in Appendix A at the back of the
text.
1 Sunny Bank quotes a bid rate of £0.58 for the US
dollar and an ask rate of £0.60. What is the bid/
ask percentage spread?
2 Cloudy Bank quotes an ask rate of £0.12 for the
Peruvian currency (new sol) and a bid rate of £0.09.
Determine the bid/ask percentage spread. Briefly
give reasons for the difference between your
answer here and your answer to Q1. Why are they
not very similar?
3 Briefly explain how MNCs can make use of each
international financial market described in this
chapter.
Questions and exercises
For these questions:
●● Work to 4 decimal places.
●● Always show your workings using words and numbers.
●● Any number not in the question must be explained, even if it is just the addition or subtraction of two numbers.
1 Explain why someone holding dollars would expect the bid/ask spread for the SARUSD to be higher than for the
GBPUSD.
2 Express the following in standard notation:
a $1.25 = £1
b 15 ZAR = $1
c $0.27 = 1 SAR
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3 Taking the euro as the home currency:
a Write the following in direct form: EURUSD 1.37; GBPEUR 1.2; EURRUB 65; EURBTC 41,039.
b Write the following in indirect form: 0.14 CNYEUR, 0.00769 JPYEUR, EURUSD 0.8849.
c Which of your answers to a and b are likely to be quoted in the other format? Explain why.
4 Explain why a currency with more units to the dollar is not necessarily a weaker currency.
5 Go to the website tradingeconomics.com/currencies and calculate for an MNC wanting to acquire currency from
a bank:
a a 5 per cent increase in the dollar cost of the euro
b a 4 per cent fall in the dollar cost of the pound
c a 10 per cent fall in the euro cost of the Swiss franc (CHF).
Provide clear explanations of your calculations.
6 Go to the website tradingeconomics.com/currencies and calculate the GBPCNY cross exchange rate.
7 Using the following exchange rates convert $10,000 into the other currency: EURUSD 1.1371; JPYUSD 115.11;
USDRUB 74.7476; AUDUSD 0.72676.
8 From the site www1.oanda.com/currency/live-exchange-rates/ calculate the bid/ask spread for GBPUSD,
USDZAR and the ZARUSD. Suggest a reason for any difference.
9 A German MNC is thinking of investing in foreign government bonds to be held to maturity and is faced with yields
of India 6 per cent, Canada 1.43 per cent and Switzerland –0.14 per cent as opposed to its home alternative of
Germany –0.18 per cent.
For each of these foreign bonds, outline the key questions relevant to their selection as the best option.
10 If the dollar rises against the euro for three days in a row, what is the most likely rate on the fourth day? Explain your
answer.
11 If the standard deviation in an exchange rate is 0.5 per cent for one month, what is the estimate for one year and
what is the basis of this estimate?
12 How might a listing on the Lusaka stock exchange benefit an MNC and Zambia?
13 From the website tradingeconomics.com/currencies, list the major currencies in order of their movement against
the dollar, giving the percentage movement.
(Hint: the year to date (YTD) movement is the movement in the number, e.g. –5 per cent means that the number
being the exchange rate is 5 per cent lower than a year ago.)
14 Search for ‘Bank of England exchange rates’ online (www.bankofengland.co.uk/boeapps/database/Rates.
asp?into=GBP) and
a Download 1 year of daily exchange rates for one of the currencies listed (any will do).
b Calculate the daily percentage change (in decimal form i.e. 0.1 not 10 per cent), then use Excel to create a
frequency bar chart.
c Explain why the distribution is approximately normal.
d Calculate the percentage of observations outside the 95 per cent confidence interval and compare it with the
5 per cent predicted by the normal distribution and comment on the difference.
e Take an extreme outlier and try to find out on the internet a possible event that caused the extreme movement.
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CHAPTER 3
International financial markets and portfolio investment
105
15 Market information on the internet. Use your own institution’s currency database or search online for ‘Bank of
England Interest & exchange rates data’ to download at least one year of daily data in Excel.
Select a pattern, for example two days of consecutive falls, then select and check the movements on the
following day (the third day in this case). Are the following day movements unusual in any way? Evaluate the
significance of your results.
It is helpful to use nested If instructions in Excel. In this example two days of consecutive falls is the criteria for
selecting the third day’s price movement. An instruction placed in C4 and copied and pasted to C365 with exchange
rates from B1 to B365 would be:
5 IF(B3>B2, IF(B2>B1, B4, “ ”), “ ”), a run of 3 days would be:
5 IF(B4 > B3,IF(B3 > B2,IF(B2.B1,B5, “ ”), “ ”), “ ”)
Note that “ ”; is simply a double inverted comma, Excel ignores gaps so “ ” will also work. Once applied, choose
‘Data’ and ‘Sort’ from the toolbar to get rid of the blanks.
Note that the Excel formula can be varied so that for instance < may be used and other operands 5,1,2 and
so on. Formulas may also be incorporated so that if only large movements were of interest we could write:
5 IF(B4>B3*1.1,IF(B3>B2*1.1,IF(B2>B1*1.1, 2B5,“ ”),“ ”),“ ”)
Experiment with the fomula to obtain the desired pattern.
Discussion in the boardroom
Running your own MNC
This exercise can be found in the digital resources for this
book.
This exercise can be found in the digital resources for this
book.
Endnotes
1 Cohen, B. (1963) ‘The Eurodollar, the Common Market
and currency unification’, The Journal of Finance,
December, 605–21.
2 Rogoff, K. (2001) ‘Why not a global currency?’, American
Economic Review, Papers and Proceedings, 91(2), 243–7.
3 European Economic Community, Commission (1962)
Memorandum of the Commission on the Action
Programme for the Second Stage, Brussels.
4 Grabbe, J. O. (1982) ‘Liquidity creation and maturity
transformation in the Eurodollar market’, Journal of
Monetary Economics, 10, 39–72.
5 McGuire, P. (2004) ‘A shift in London’s Eurodollar market’,
BIS Quarterly Review, September, 67–77.
6 For a reflection on MNC issues within a currency area but
across countries refer to von Eije, H. and Westerman, W.
(2002) ‘Multinational cash management and conglomerate
discounts in the euro zone’, International Business Review,
11, 453–64.
7 This is in lognormal form changing what are multiplicative
movements – increasing or decreasing by percentages – into
additive movements which conforms with our additive
measures.
8 Statisticians normally content themselves with 1.96 s
(sigma) or 1.96 standard deviations. In business 6-sigma
9
10
11
12
13
14
management is founded on the need for far lower risk
tolerances due to the cost of errors and the non-normal
distribution of process outcomes.
For the technically minded, the relationship is derived from
a variance covariance matrix of time periods which are
independent of each other, so no covariance terms (refer
to the Appendix to this chapter). This just leaves the lead
diagonal of variance terms, all of which are assumed to
be the same. Two periods overall matrix variance is the
variance 3 2, three periods variance 3 3, and so on.
Fama, E. (1991) ‘Efficient capital markets: II’, The Journal
of Finance, 46(5), 1575.
For example, refer to Popovic, S. and Durovic, A. (2014)
‘Intraweek and intraday trade anomalies: Evidence
from FOREX market’, Applied Economics, 46(32),
3968–79.
Refer to Chandiok, A. (1996) ‘The impact of an unexpected
political resignation on exchange rates’, Applied
Economics, 28, 247–53.
In essence, the model has the change in the exchange rate
to the left of the equals sign and the explanatory variables
to the right.
Refer to the 2016 annual report of Rolls Royce.
Essays/discussion and articles can be found at the end of Part I.
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106
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
BLADES PLC CASE STUDY
Decisions to use international financial markets
As a financial analyst for Blades plc you are
reasonably satisfied with Blades’ current setup of
exporting ‘Speedos’ (rollerblades) to Thailand. Due
to the unique arrangement with Blades’ primary
customer in Thailand, forecasting the revenue to be
generated there is a relatively easy task. Specifically,
your customer has agreed to purchase 180,000 pairs
of Speedos annually, for a period of three years, at a
price of THB4,594 (THB 5 Thai baht) per pair. The
current direct quotation of the pound:baht exchange
rate is £0.016.
The cost of goods sold incurred in Thailand (due
to imports of the rubber and plastic components
from Thailand) runs at approximately THB2,871 per
pair of Speedos, but Blades currently only imports
materials sufficient to manufacture about 72,000
pairs of Speedos. Blades’ primary reasons for using
a Thai supplier are the high quality of the components
and the low cost, which has been facilitated by a
continuing depreciation of the Thai baht against the
pound. If the pound cost of buying components
becomes more expensive in Thailand than in the UK,
Blades is contemplating providing its UK supplier with
the additional business.
Your plan is quite simple – Blades is currently
using its Thai-denominated revenues to cover the
cost of goods sold incurred there. During the last
year, excess revenue was converted to pounds at the
prevailing exchange rate. Although your cost of goods
sold is not fixed contractually as the Thai revenues
are, you expect them to remain relatively constant in
the near future. Consequently, the baht-denominated
cash inflows are fairly predictable each year because
the Thai customer has committed to the purchase
of 180,000 pairs of Speedos at a fixed price. The
excess pound revenue resulting from the conversion
of baht is used either to support the UK production of
Speedos if needed or to invest in the UK. Specifically,
the revenues are used to cover the cost of goods sold
in the UK manufacturing plant.
Ben Holt, Blades’ Finance Director, notices that
Thailand’s interest rates are approximately 15 per
cent (versus 8 per cent in the UK). You interpret the
high interest rates in Thailand as an indication of
the uncertainty resulting from Thailand’s unstable
economy. Holt asks you to assess the feasibility
of investing Blades’ excess funds from Thailand
operations in Thailand at an interest rate of 15 per
cent. After you express your opposition to his plan,
Holt asks you to detail the reasons in a detailed report.
1 One point of concern for you is that there is a tradeoff between the higher interest rates in Thailand
and the delayed conversion of baht into pounds.
Explain what this means.
2 If the net bahts received from the Thailand operation
are invested in Thailand, how will UK operations be
affected? (Assume that Blades is currently paying
10 per cent on pounds borrowed and needs more
financing for its firm.)
3 Construct a spreadsheet to compare the cash
flows resulting from two plans. Under the first
plan, net baht-denominated cash flows (received
today) will be invested in Thailand at 15 per cent
for a one-year period, after which the baht will
be converted to pounds. The expected spot rate
for the baht in one year is about £0.0147 (Ben
Holt’s plan). Under the second plan, net bahtdenominated cash flows are converted to pounds
immediately and invested in the UK for one year
at 8 per cent. For this question, assume that all
baht-denominated cash flows are due today. Does
Holt’s plan seem superior in terms of pound cash
flows available after one year? Compare the choice
of investing the funds versus using the funds to
provide needed financing to the firm.
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CHAPTER 3
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107
SMALL BUSINESS DILEMMA
Developing a multinational sporting goods industry
Each month, the Sports Exports Company (an Irish
firm) receives an order for basketballs from a British
sporting goods distributor. The monthly payment for
the basketballs is denominated in British pounds, as
requested by the British distributor. Jim Logan, owner
of the Sports Exports Company, must convert the
pounds received into euros.
1 Explain how the Sports Exports Company could
utilize the spot market to facilitate the exchange of
currencies. Be specific.
2 Explain how the Sports Exports Company is
exposed to exchange rate risk and how it could
use the forward market to hedge this risk.
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APPENDIX 3
Portfolio Investment
A portfolio is an investment in a range of shares, bonds, etc. where the investor is concerned with the
overall return. The financial account in the balance of payments shows the increasing level of international
investments in most countries. The growth applies to both portfolio investment (less than a 10 per cent
interest in the ownership) and real investment (greater than 10 per cent ownership). Long-term investment
and loans by MNCs abroad to subsidiaries are real investments which we address in Parts IV and V. In
addition, MNCs holding cash in various currencies will make short-term portfolio investments. Pension and
insurance companies as well as hedge funds will hold portfolios that include shares in foreign companies.
Banks may hold foreign debt, shares and bonds in various currency denominations. In this section we consider
the investment process, the risk from investing in a portfolio, the international aspect of portfolio valuation
and methods of investing internationally.
Background on international stock exchanges
The international trading of shares has grown over time but has been limited by three barriers: transaction
costs, information costs and exchange rate risk. In recent years, however, these barriers have been reduced as
explained here.
USING THE WEB
Stock exchange information
It is best to use a search engine to find the home page of the stock exchange. For example, the London
stock exchange can be found at: www.londonstockexchange.com; go to the bottom of the page and
jump to statistics. Or choose the New York stock exchange at: www.nyse.com. In both cases pdf or
Excel files offer the best-quality data.
108
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APPENDIX 3
Portfolio Investment
109
Reduction in transaction costs
Most trades are undertaken by electronic trading platforms via the internet. The pre-computer age method
was by open outcry, that is traders gathered together in the ‘pit’ buying and selling via hand signals and
shouting – this was a surprisingly efficient method that is still used for occasional large or complex trades
on some exchanges (e.g. NYSE and CME). In recent years, electronic communications networks (ECNs)
have been created in many countries to match orders between buyers and sellers. ECNs do not have a
visible trading floor: the trades are executed by a computer network. Examples of popular ECNs include
Archipelago, Insti-net and Tradebook. With an ECN, investors can place orders on their computers that
are then executed by the computer system and confirmed through the internet to the investor. Therefore,
all parts of the trading process from the placement of the order to the confirmation that the transaction
has been executed are conducted by computer. The ease with which such orders can occur, regardless of
the locations of the investor and the stock exchange, is sure to increase the volume of international share
transactions in the future.
Impact of alliances. Several stock exchanges have created international alliances with the stock exchanges
of other countries, thereby enabling firms to more easily cross-list their shares among various stock
markets. This gives investors easier and cheaper access to foreign shares. The alliances also allow greater
integration between markets. At some point in the future, there may be one global stock market in which
any shares of any country can be easily purchased or sold by investors around the world. A single global
stock market would allow investors to easily purchase any shares, regardless of where the corporation
is based or the currency in which the share is denominated. The international alliances are a first step
towards a single global stock market. The costs of international share transactions have already been
substantially reduced as a result of some of the alliances.
Reduction in information costs
The internet provides investors with access to much information about foreign shares, enabling
them to make more informed decisions without having to purchase information about these shares.
Consequently, investors should be more comfortable assessing foreign shares. However, differences
in accounting rules still limit the degree to which financial data about foreign companies can be
interpreted or compared to data about firms in other countries. Over the years there has been a
convergence of standards. International Financial Reporting Standards comprise statements on various
aspects of accounting, e.g. the valuation of property, stock and so on. These statements are then usually
adopted by the national accounting bodies as set out in their national companies acts or equivalent.
Stock exchanges will also demand a certain degree of conformity with their own national accounting
standards additional to legal requirements (in the US this is known as Generally Accepted Accounting
Principles).
Exchange rate risk
When investing in a foreign share that is denominated in a foreign currency, investors are subject to the
possibility that the currency denominating the share may depreciate against the investor’s currency over time.
The depreciation in a currency may well outweigh the return from investing. For example, investing in an
Indian Government bond may offer a return of 4 per cent over the investment period, but if the value of
the rupee falls by more than 4 per cent over that period there will be an overall loss. Note that exchange
rate theories (refer to international Fisher effect in Chapter 9) state that a higher interest rate in a particular
currency is because a devaluation is expected. Hence the return to a UK investor from investing in a foreign
share is influenced by the return on the share itself, which includes the dividend and the percentage change in
the exchange rate, as shown here:
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110
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Rt, UK 5 (1 1 Rt)(1 1 et) 2 1
Where:
Rt, UK 5 overall return to the UK investor over period t. . .
et 5 percentage change in the value of the foreign currency over period t
Rt 5 return on the foreign investment itself over period t measured as:
Pt 2 Pt 2 1 1 Dt
Pt
Where:
Pt 5 price at the end of time t
Pt21 5 price at the end of time t21
Dt 5 dividend in time t
EXAMPLE
A year ago, Rob Grady invested in the shares of
Vopka, a Russian company. Over the last year, the
shares increased in value by 35 per cent. Over this
same period, however, the Russian rouble’s value
declined by 30 per cent. Rob sold the Vopka shares
today. His return is:
Even though the return on the shares was more
pronounced than the exchange rate movement, Rob
lost money on his investment. The reason is that the
exchange rate movement of 230 per cent wiped out
not only 30 per cent of his initial investment but also
30 per cent of the shares’ return.
RUK 5 (1 1 R)(1 1 e) 2 1
RUK 5 (1 1 0.35)(1 2 0.30) 2 1
5 20.055 or 2 5.5%
As the preceding example illustrates, investors should consider the potential influence of exchange rate
movements on foreign shares before investing in those shares. Foreign investments are especially risky in
developing countries, where exchange rates tend to be very volatile.
Reducing exchange rate risk of foreign shares. Although hedging the exchange rate risk of an international
share portfolio can be effective, it has three limitations. First, the number of foreign currency units to be
converted to the home currency at the end of the investment horizon is unknown as the exact price will
not be known. Nevertheless, though the hedge may not be perfect for this reason, investors normally
should be able to hedge most of their exchange rate risk.
A second limitation of hedging exchange rate risk is that the investors may decide to retain the
foreign shares beyond the initially planned investment horizon. Of course, they can reverse (or close
out) the existing position and create another forward sale for the extended period, but this would be at
a different rate.
A third limitation of hedging is that forward rates for currencies that are less widely traded may not exist
or may exhibit a large discount. Here protection can be gained thorough cross-hedging, that is hedging in a
currency whose movements are correlated with the less widely traded currency (Appendix 12).
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APPENDIX 3
Portfolio Investment
111
International share diversification
A substantial amount of research has demonstrated that investors in shares can benefit by diversifying
internationally. The philosophy of diversification is very simple. An investor will normally invest in a
portfolio, which is no more than saying that investment will be in the shares of more than one company.
A well-diversified portfolio will be made up of investments in shares whose performance is not well
correlated. If the value of one share in the portfolio falls there will be other shares in the portfolio that will
be increasing in value. Looking from the other point of view, there will be falls in the value of some shares
in the portfolio which will limit the effect of rises. So a well-diversified portfolio experiences lower overall
falls in value but less steep rises in value than a poorly diversified portfolio offering the same return.
Portfolio selection is a choice between risk (as measured by expected volatility measures such as
variance – as below) and return (as defined in the previous equation). Exhibit 3.11 outlines the choice
for an investor. In an efficient market (where goods are priced according to all available information)
the choice is between greater return and greater risk or lesser return but lesser risk. Portfolios C and E in
Exhibit 3.11 are mispriced in relation to portfolio A – we will assume that A is correctly priced.
Portfolio E should be offering a higher return. As the future value is a given estimate, the only way to
increase the return is to pay less for that future value – so portfolio E is overvalued with respect to A.
EXHIBIT 3.11
Risks return choice for an investor – a comparison of portfolios A, B, C, D and E
Return
C
B
Portfolio C is more
attractive than A
– higher return for
lower risk
D
Portfolio B may be
more attractive than A
– higher risk for higher
return
A
Portfolio D may be
more attractive than A
– lower return but
lower risk
E
Portfolio E is less
attractive than A
– higher risk for lower
return
Risk
Lowering the amount paid for E and hence raising the return would move it into the B quadrant. By
the same reasoning portfolio C is undervalued, so more should be paid for the given expected value – the
higher price of C would lower the return and move it down into the D quadrant. Portfolios B and D may
or may not be attractive to the holder of portfolio A depending on the holder’s level of risk aversion. A
risk-averse investor will prefer portfolio D to A and an investor wanting to take on more risk will prefer B
to A. When selecting portfolios, choice and value depend on risk and return.
Measuring portfolio risk and return. As shown in the previous equation, the return on an individual
share is measured by its movement in value plus any dividends all measured as a percentage return.
Because the value of the currency may have changed, the return must be multiplied by currency movement.
If the investment were in bonds, interest payments would replace dividends.
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112
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
EXAMPLE
Sunny investments plc, a UK company, purchased
150,000 euros worth of shares in Sensible SA, a French
company, when the exchange rate was €1.5:£1. At the
end of the year, Sunny receives €7,000 from Sensible
in dividend payments and sells its shares for €160,000.
Its returns are then converted at €1.4:£1.
The returns calculated in monetary terms are:
Original investment €150,000/1.5 5 £100,000
Converted sale price of shares €160,000/1.4 5
£114,285.71
Converted value of dividends €7,000/1.4 5 £5,000
Monetary return 5 £114,285.71 1 £5,000 2
£100,000 5 £19,285.71, which is a return in
percentage terms of £19,295.71/£100,000 5
0.1928571 or 19.29%
Or
Percentage return on investment in Sensible:
(€160,000 2 €150,000 1 €7,000)/€150,000 5
11.3333%
Percentage movement in currency value: opening
value of the euro: 1/1.5 5 £0.666666; closing value
of the euro: 1/1.4 5 £0.714285; percentage change
in value of the euro: (£0.714285 2 £0.666666)/
£0.666666 5 0.071428571 or 7.14286%
Overall return is RUK
5 (1 1 R)(1 1 e) 2 1
5 (1 1 0.113333)(1 1 0.0714286) 2 1
5 0.1928568 or 19.29%
Note that the difference between 0.1928571 and
0.1928568 of 0.0000003 is a rounding error.
EXAMPLE
If Investor Morse invests one-quarter of the initial sum
in share A offering a 20 per cent return and threequarters in share B offering a 10 per cent return,
the weights are 25 per cent and 75 per cent for
shares A and B respectively and the overall return
will be: 0.25 3 20% 1 0.75 3 10% 5 12.5% for the
portfolio.
Calculating portfolio return
In this section we use returns and standard deviations; support on these measures is given in Appendix B.
The expected return of a portfolio is a simple weighted average of the individual returns however calculated (it
could be from past data or simple business estimates, see Investor Morse example). The formula is therefore:
Portfolio return = wa × ra + wb × rb + wc × rc … wn × rn
Where:
a, b, c … n = Individual investments
w = Percentage of the value of the total portfolio investment as represented by a, b, c … n
r = Percentage return on the investment in terms of the home currency
Calculating portfolio risk
The risk of a portfolio is however very different. This is because when combining risks there is an
offsetting effect that differs depending on the shares. Where the investment is international, returns must
be converted into the home currency if using past data or simply estimated in terms of home currency.
If share A increases but share B typically decreases, then the overall risk of shares A and B in a portfolio
will be less than their weighted average. There is an offsetting effect.
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APPENDIX 3 Portfolio Investment
113
Only if share B always increased when A increased and always decreased when A decreased would
there be no offsetting effect and a portfolio of A and B would then be a weighted average, but this is never
the case in the real world.
The statistical approach to measuring portfolio risk is to calculate the standard deviation of the returns
of the individual investments in the portfolio and then to combine them to get the overall portfolio risk.
The returns are combined using correlations, which is our measure of how investments move together.
Once the portfolio standard deviation has been calculated we assume that the distribution of the
returns is normal and that we can work out probabilities of future returns, typically 95 per cent confidence
intervals (i.e. 1.96 standard deviations above and below the expected value). In practice, of course, we
know that there are outliers in the distribution but we will elaborate on that later.
The calculation of the standard deviation of a simple portfolio of two shares is illustrated in Exhibit 3.12.
It is based on a matrix that shows the weighted covariance of the returns of all two share combinations
in the portfolio, in this case AA, AB, BA and BB, AA and BB are the covariance of shares with themselves
which is, of course, its variance or individual risk. AB and BA are covariances or a measure of joint risk.
The following equation gives the standard deviation of the two share portfolio which is the square root of
the four elements of the matrix:
SDP 5
EXHIBIT 3.12
2 3 wA 3 wB SDA 3 SDB 3 Corr(A, B)
wB2 3 Var(B) 15
wA2 3 Var(A) 1 3
3
Top left
Bottom right
Top right and bottom left
Calculating the variance of a two share portfolio – the variance covariance matrix
Share A
Share B
Share A
wA2 3 Var(A)
wA 3 wB 3 Cov(A, B)
Share B
wB 3 wA 3 Cov(B, A)
wB2 3 Var(B)
Notes:
•
•
•
•
This is a variance (Var) and covariance (Cov) matrix of returns, where returns are defined as:
RUK 5 (1 1 R) (1 1 e) 2 1 (where RUK are the translated foreign returns (R) affected by currency changes (e) – as above).
wA and wB are weights, the percentage of original investment in share A and share B valued in the home currency.
The top right and bottom left values are the same, i.e. wA 3 wB 3 Cov(A, B) 5 wB 3 wA 3 Cov(B, A).
Covariances can be written using more familiar terms:
Cov(A, B) 5 SDA 3 SDB 3 Corr(A, B)
Where:
SDA, SDB 5 standard deviations of A and B
Corr (A, B) 5 correlation of A and B.
•
Cov(A, A) = Var(A).
•
The standard deviation of the portfolio is simply the square root of the total of all the values in the cells of the above matrix.
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114
EXHIBIT 3.13
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Calculating the variance of a portfolio of three or more international investments
International
investment A
International
investment B
International
investment C
International
investment D
International
investment E
International
investment A
W A2 3 Var(A)
WA 3 WB 3
Cov(A, B)
WA 3 Wc 3
Cov(A, C)
WA 3 WD 3
Cov(A, D)
WA 3 WE 3
Cov(A, E)
International
investment B
Wa 3 Wb 3
Cov(A, B)
W B2 3 Var(B)
Wb 3 Wc 3
Cov(B, C)
Wb 3 Wd 3
Cov(B, D)
Wb 3 We 3
Cov(B, E)
International
investment C
Wa 3 Wc 3
Cov(A, C)
Wb 3 Wc 3
Cov(B, C)
W C2 3 Var(C)
Wc 3 Wd 3
Cov(C, D)
Wc 3 Wd 3
Cov(C, E)
International
investment D
WA 3 WD 3
Cov(A, D)
WB 3 WD 3
Cov(B, D)
Wc 3 WD 3
Cov(C, D)
W D2 3 Var(D)
WD 3 WE 3
Cov(D, E)
International
investment E
WA 3 WE 3
Cov(A, E)
WB 3 WE 3
Cov(B, E)
Wc 3 WD 3
Cov(C, E)
WD 3 WE 3
Cov(D, E)
W E2 3 Var(E)
Notes:
•
•
•
•
The overall variance is simply the total value of all the cells in the matrix; for an explanation of the symbols refer to the previous Exhibit. Note that this
matrix simply extends the pattern of Exhibit 3.12.
The pattern can be extended to any number of investments, the lead diagonal is top left to bottom right (in bold), the values above the lead diagonal
are a mirror image (the same), as the values below the lead diagonal — hence the 2 in the equation above.
Note that the lead diagonal represents individual risk of the investments and will become progressively less important compared to their joint risk as
the portfolio grows — at present five cells compared to 20 covariance cells — hence the diversifying effect.
The order of the investments in the covariance term is the same, but note that the operation is commutative i.e. Cov(A, B) 5 Cov(B, A) and so on.
An example of an extended matrix is shown in Exhibit 3.13. Note that this powerful formula applies
to all types of investment: ADRs, Eurobonds, US Treasury bonds, etc. Although the value of the cash flows
in the foreign currency is almost certain for these particular instruments, the returns here are translated
into the home currency of the investor and will therefore be subject to changes in the value of the foreign
currency. Thus the formula applies to international investments in general.
Since stock markets partially reflect the current and/or forecasted state of their countries’ economies,
they do not move in tandem. Therefore, the returns of shares in different markets are not expected to be
highly correlated. In Exhibit 3.13 the off-diagonal values are therefore likely to be lower than for a purely
domestic portfolio – the diversification effect larger.
Crucial to the measurement of risk is an understanding of to how to predict variances and covariances
of shares. Also, as these investments are foreign, the variance and covariance of exchange rates as
well as shares is important. Sophisticated techniques such as Generalized Autoregressive Conditional
Heteroskedasticity (GARCH) can be employed to predict volatility (i.e. standard deviation). Predicting
covariances or correlations, however, is currently on the frontier of statistical modelling.
As an alternative to statistical modelling, businesses have to resort to subjective judgements on the
future value of these variables. Aids to such judgements can be gleaned from simply modelling volatilities
and correlations over time in Excel. Even in these circumstances, the model is useful in that it provides the
‘language’ for estimating portfolio risk.
The concept of an efficient market says that prices move randomly in response to news that is by
definition randomly better or worse than the expectations built into the current price; it may therefore
seem that any prediction is not possible. However, the randomness refers to the direction of movement,
variance is a non-directional statement and says nothing about whether the currency values will go up or
down. So predicting variances and indeed covariances and the derived measures of correlations, standard
deviations or volatilities does not mean that the markets are inefficient.
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APPENDIX 3
Portfolio Investment
115
EXAMPLE
Guess Investments plc wants to invest £100,000
in a portfolio of two foreign shares. The following
are estimates of their returns translated into British
pounds:
Investment in: share X £60,000; share Y £40,000
E xpected return: share X 15 per cent; share Y
45 per cent
Standard deviation: share X 10 per cent; share Y
50 per cent
Correlation share X with share Y: 0.25
The weights are: wX 5 60,000/100,000 5 0.60;
wY 5 40,000/100,000 5 0.40
The expected returns on the portfolio are: 0.60 3
15% 1 0.40 3 45% 5 27%
The standard deviation of the portfolio is:
0.602 3 0.102 1 0.402 3 0.502 1 2 3 0.40
3 0.60 3 0.10 3 0.50 3 0.2
5 0.22 or 22%
So, assuming that the returns are jointly normally
distributed (that is when their returns are considered
jointly the overall returns are normally distributed), the
95 per cent confidence interval (Appendix B) for the
expected portfolio returns is:
1.96 3 0.22 5 43%
243%
143%
216% a 27% a 70%
The Guess Director observes: ‘There isn’t much
of a diversification effect as the weighted average
of the standard deviations (i.e. assuming perfect
correlation and hence no diversification) is
0.6 3 10% 1 0.4 3 50% 5 26% a s oppose d t o
the 22% above.’ His bright young assistant replies:
‘True, but two investments hardly make a portfolio.
Now if you didn’t invest in X as your “safe” share, but
just looked for security in diversification and invested
only in four shares similar to Y, in four different stock
markets, with say a correlation of 0.1 between any
two, your overall standard deviation would be about
. . . 0.285 or 28.5 per cent. An expected return of
45 per cent with a standard deviation of 28.5 per cent
is not bad, certainly better than this expected
return of 27 per cent for a standard deviation of
22 per cent.’ (You may check this calculation on
the Portfolio Calculator.) The Guess Director replies:
‘And what if all the markets collapse together?’ It has
happened before.
Limitations of international diversification
The concern for building a portfolio is over the future correlation of investments within the portfolio. The
lower the correlation the lower the risk; the higher the correlation or co-movement the higher the risk. For
most periods the correlation is quite low. An exception is in times of crisis – refer to Exhibits 3.14a and b
and 3.15.
Statistics in many ways overstates its abilities with regard to measuring diversification. If there is a
major crisis as with the subprime crisis and global recession or COVID-19, all shares fall together and
there is suddenly no diversification effect. Such large events are precisely those for which protection
through diversification is most desirable.
If the past data does not contain a crisis, statistics will not predict one. This is known as the peso effect
or the ‘dog that didn’t bark’. Even if there is a crisis, its infrequency makes statistical prediction impossible.
Statistical measures are based on past numbers and their frequency. For this reason, subjective estimation
based on the well informed and intelligent analysis of relatively few past instances will always be needed
to supplement statistical estimates.
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116
PART I
EXHIBIT 3.14a
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Correlation of stock market returns on a 12-month rolling basis
US–UK
202
0
201
9
201
8
201
7
201
6
201
5
201
4
201
3
201
2
201
1
201
0
200
9
200
8
200
7
200
6
1
0.8
0.6
0.4
0.2
0
–0.2
–0.4
–0.6
–0.8
–1
US–South Africa
Notes:
•
•
•
The US–UK correlation for example is relevant to a US investor investing in the US and the UK, and a UK investor investing in the UK and the US.
Similarly so for US–South Africa.
The correlation varies greatly over time and hence the diversification effect is very variable.
Bearing in mind that these correlations are of a 12-month lookback, high correlation (e.g. 2016 for both measures) means low benefit from
­diversification; low correlation (e.g. late 2014 for US–UK) means high benefit from diversification.
EXHIBIT 3.14b
Stock market indices over the 2008/9 subprime crisis and global recession (rebased to Dec 2006 = 100)
Stockmarket index (Dec 2006 = 100)
180
160
140
Germany
120
Japan
100
UK
80
US
60
Egypt
40
South Africa
20
0
201
9
200
8
200
200
7
0
Notes:
•
•
Late 2008 is when all markets declined in unison, usually cited as the announcement by Paribas on 9 August 2007 of suspension of payments to
funds with exposure to subprime mortgages due to a ‘complete evaporation of liquidity’.
In September 2008 Lehman Brothers became bankrupt due to the subprime crisis (the biggest bankruptcy in history).
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APPENDIX 3
EXHIBIT 3.15
117
Portfolio Investment
Stock market indices over the outbreak of COVID-19 (rebased to 2018 = 100)
170
150
Germany
130
Japan
110
UK
US
90
Egypt
70
South Africa
201
9J
an
Feb
Ma
r
Ap
r
Ma
y
Jun
Jul
Au
g
Sep
Oc
t
No
v
D
202 ec
0J
an
Feb
Ma
r
Ap
r
Ma
y
Jun
Jul
Au
g
Sep
Oc
t
No
v
De
c
50
Notes:
•
•
First cases appeared in late 2019 in China.
Note the widening of returns between the markets after COVID-19 indicating a differential economic impact.
Valuation of foreign shares
When investors consider investing in foreign shares, they need methods for valuing those shares. The
methods are no different from the valuation of domestic shares except that there are added complications
from exchange rate movements.
Dividend discount model
One possibility is to use the dividend discount model with an adjustment to account for expected exchange
rate movements. Foreign shares pay dividends in the currency in which they are denominated. Thus, the
cash flow per period to European investors is the dividend (denominated in the foreign currency) converted
to euros. Because of exchange rate uncertainty, the value of the foreign shares from a home investor’s
perspective is subject to exchange rate uncertainty as well as uncertainty over dividends.
Price-earnings method
An alternative method of valuing foreign shares is to apply price-earnings ratios. The expected earnings
per share of the foreign firm are multiplied by the appropriate price-earnings ratio (based on the firm’s risk
and industry) to determine the appropriate price of the firm’s shares. Although this method is easy to use,
it is subject to some limitations when applied to valuing foreign shares. The price-earnings ratio for a given
industry may change continuously in some foreign markets, especially when the industry is composed of
just a few firms. Thus, it is difficult to determine the proper price-earnings ratio that should be applied
to a specific foreign firm. In addition, the price-earnings ratio for any particular industry may need to
be adjusted for the firm’s country, since reported earnings can be influenced by the firm’s accounting
guidelines and tax laws. Furthermore, even if investors are comfortable with their estimate of the proper
price-earnings ratio, the value derived by this method is denominated in the local foreign currency (since
the estimated earnings are denominated in that currency). Therefore, investors would still need to consider
exchange rate effects. Even if the share is undervalued in the foreign country, it may not necessarily
generate a reasonable return for investors if the foreign currency depreciates against the home currency.
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118
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Other methods
Some investors adapt these methods when selecting foreign shares. For example, they may first assess the
macroeconomic conditions of all countries to screen out those countries that are expected to experience
poor conditions in the future. Then, they use other methods such as the dividend discount model or the
price-earnings method to value specific firms within the countries that are appealing.
Why perceptions of share valuation differ between countries
A share that appears undervalued to investors in one country may seem overvalued to investors in another
country. Some of the more common reasons why perceptions of a share’s valuation may vary among
investors in different countries are identified here.
Required rate of return. Some investors attempt to value a share according to the present value of the
future cash flows that it will generate. The dividend discount model is one of many models that use
this approach. The required rate of return that is used to discount the cash flows can vary substantially
among countries. The rate is based on the prevailing risk-free interest rate available to investors, plus a
risk premium.
Do countries apply the same risk premium to identical projects? Are some investment communities
more risk averse than others? These are not settled questions. What can be said is that the riskier the
project the lower the value of its share as a higher discount rate is applied. A foreign investor may think
that the risk has been overpriced and that the share is a bargain and hence worth purchasing. Or the
investor may reap higher returns than are currently estimated for that share. Such judgements are the stuff
of investment. For international investment it is this risk plus exchange rate risk.
The other element of the discount rate used to discount future dividends is the risk-free rate. This
interest rate is the newspaper rate quoted as the market rate between large banks. The rate includes an
allowance for inflation and for the inconvenience of lending (sometimes called time preference). The rate
is risk-free in the sense that the investor is more or less guaranteed to receive the money as promised in the
investment, as banks rarely go bankrupt. This rate differs between currencies (not countries). Therefore,
there is a single rate for the euro and a single rate for the British pound and one rate for the dollar,
yen and so on. The rates differ: the one-year rate for the euro may be about 1.2 per cent, whereas it
could be 1.29 per cent for the British pound and 0.85 per cent for the US dollar. Given that these are
equilibrium rates in that they are determined by supply and demand in the marketplace, one might ask
why everyone does not invest in the UK rather than in the euro, dollar and so on? From the point of
view of the international investor, on balance the higher rates are offset by concern that the value of the
currency is less stable given that each interest rate requires the purchase of that particular currency.
Exchange rate risk. Returns are determined by the rate earned in the local currency and any changes in the
value of the currency between the investment date and the conversion back to the home currency date. The
conversion process is termed exchange rate risk. The relationship between currency values, interest rates
and inflation is explained further in Chapter 5. But for the moment one can identify that where a currency
is suffering high inflation its value may well fall in relation to other currencies over time – as one unit of
the currency buys less. A higher interest rate may well be needed to compensate for the expected loss in
value of the currency. Hence interest rates between currencies may differ.
Taxes. The tax effects of dividends and capital gains also vary between countries. The lower a country’s
tax rates, the greater the proportion of the pre-tax cash flows received that the investor can retain. Other
things being equal, investors based in low-tax countries should value shares more highly. Differences in
particular countries between the taxes levied on dividends and taxes on capital gains will create preferences
within that country for shares that pay high dividends or shares that pay low dividends but have higher
capital gains. A change in the tax laws of, say, the UK may make investments in that country more or less
attractive to the UK.
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APPENDIX 3
Portfolio Investment
119
Methods used to invest internationally
For investors attempting international share diversification, five common approaches are available:
1 direct purchases of foreign shares
2 invest in multinationals
3 American depository receipts (ADRs)
4 exchange-traded funds (ETFs)
5 international mutual funds (IMFs).
Each approach is discussed in turn.
Direct purchases of foreign shares
Foreign shares can be purchased on foreign stock exchanges. This requires the services of brokerage
firms that can contact floor brokers who work on the foreign stock exchange of concern. However, this
approach is inefficient because of market imperfections such as insufficient information, transaction costs
and tax differentials between countries.
An alternative method of investing directly in foreign shares is to purchase shares of foreign companies
that are sold on the local stock exchange. In the US, for example, Shell plc (UK/Netherlands), Sony (Japan)
and many other foreign shares are sold on US stock exchanges. Because the number of foreign shares listed
on any local stock exchange is typically quite limited, this method by itself may not be adequate to achieve
the full benefits of international diversification.
Invest in multinationals
If an investor wishes to take advantage of international diversification the question arises as to whether it
is better to invest in foreign companies or domestic companies that are internationally diversified. In theory
both should benefit from the diversification effect due to the different economic performance between
countries. A simple measure is to compare the beta of multinationals using differing stock market indices.
A beta is a measure of the covariance of a share’s returns with that of the stock market index, mapped
onto a scale where 1 is perfect synchronization. It has long been established that multinational shares
vary primarily with the stock market of their home economy (a beta near 1) and are not good sources of
international portfolio diversification.1
American depository receipts
Another approach is to purchase American depository receipts (ADRs), which are certificates representing
ownership of foreign shares. More than 1,000 ADRs are available in the US, primarily traded on the OTC
stock market. An investment in ADRs may be an adequate substitute for direct investment in foreign
shares, though only a limited number of ADRs are available.
USING THE WEB
ADR performance
The performance of ADRs is provided at: www.adr.com. Click on ‘Industry’ to review the share
performance of ADRs within each industry. The website provides a table that shows information about
the industry, including the number of ADRs in that industry, and the 6-month and 12-month returns.
Click on any particular industry of interest to review the performance of individual ADRs in that industry.
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120
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Exchange-traded funds (ETFs)
Exchange-traded funds (ETFs) represent funds that reflect composites of shares for particular countries;
they were created to allow investors to invest directly in a share index representing any one of several
countries. ETFs are sometimes referred to as world equity benchmark shares (WEBS) or as iShares.
International mutual funds
A final approach to consider is purchasing shares of international mutual funds (IMFs), which are
portfolios of shares from various countries. Like domestic mutual funds, IMFs are popular due to:
(1) the low minimum investment necessary to participate in the funds; (2) the presumed expertise of
the portfolio managers; and (3) the high degree of diversification achieved by the portfolios’ inclusion
of several shares. Many investors believe an IMF can better reduce risk than a purely domestic mutual
fund because the IMF includes foreign securities. An IMF represents a pre-packaged portfolio, so
investors who use it do not need to construct their own portfolios. Although some investors prefer to
construct their own portfolios, the existence of numerous IMFs on the market today allows investors
to select the one that most closely resembles the type of portfolio they would have constructed on
their own. Moreover, some investors feel more comfortable with a professional manager managing the
international portfolio.
Theoretical models of pricing international investments
All investments (whether shares, funds or bonds) seek to identify investments that are underpriced. An
investor considers an investment to be underpriced for two main reasons:
1 The investor expects returns to be greater than that anticipated by other investors.
2 The risk is not as great as anticipated by other investors.
The first reason is essentially a business decision and finance has little to say on the issue. If an investor
thinks that the returns of dot-com SMEs are going to be higher than offered by the market then that is a
business decision; finance offers no guidance. Most speculation about the price of investments is centred
on the first reason. The relationship is simple: the higher the expected returns the higher the price.
If the market is agreed on the expected returns then there is the remaining question as to how much
should be paid for those expected returns. The critical factor here is the risk, the possibility that the actual
returns may be very different from expectations. The relationship is inverse, the higher the risk the lower the
price. If I expect the value of a foreign share to have the home currency value of £100 in one year’s time give
or take £2, then I might be willing to pay £99 for that share given the low interest rates in the UK. If, due
to a risky foreign currency, the investment has a give or take estimate of £10, then clearly £99 would be too
high a price. I would only pay, say, £87 for such a prospect. The higher the risk the lower the price of the
investment.
Finance theory assumes rightly or wrongly that reason 1 is fixed and that the only remaining problem
is measuring and pricing the risk. Prices in theoretical models are assumed to vary not because of a
fundamental change in expectations but due to the uncertainty in the original expectation. Although this
might be thought of as unrealistic, as expectations are surely constantly changing, that is not the point. The
role of theory in finance is to abstract the problem and break it down into its constituent parts. A theory
might not work well in practice if taken literally, but it will have provided an insight into the problem.
The problem of pricing an investment in theoretical models is therefore to determine the price of risk
generally and the amount of risk of an individual investment. This is done in terms of returns. As we have
discussed, the price of an investment is linked to the return. If we can establish the appropriate return for
the risk of an investment then we can establish the price if we know the expected future cash flows.
The principal model is the capital asset pricing model (CAPM) and its international version (ICAPM).
These are single period models: in the case of a share, cash flows would be the value of the share in one year’s
time and the interim and final dividend and the discount rate would be the return as determined by the CAPM.
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APPENDIX 3
Portfolio Investment
121
In the CAPM model, the general price of risk is simply the market risk, the weighted average risk of
all investments. The risk of an individual investment (j) is measured in relation to the market risk and is
termed the beta (bj) of an investment:
Where:
If bj > 1 the risk is greater than the market risk
If bj = 1 the risk should be the same as the market risk
If bj < 1 the risk should be less than the market risk
If bj = 0 the return should be the risk-free rate (rf)
The model for the required return of an individual investment (rj) is:
E(rj) = rf + bj E(rm – rf)
Where (rm – rf) is termed the market risk premium being the extra return required by the market for its
‘average’ return.
Note that if b = 1 then rj = rm. As stated above, the risk of the investment should be the same as the
market risk; less than 1, then less than the market risk and so on.
The international version (ICAPM) adds currency risk in similar manner to market risk. In simple
form it is:
E(rj) = rf + bj E(rm – rf) + bcj (CRPj)
Where bcj (CRPj) is defined loosely as the risk due to the sensitivity of the investment to the currency risk
(how sensitive is the value of the investment value to the variability of the currency). A full model is more
complex as, if investments were in more than one currency and their exchange rates offset each other, then
the risk would be reduced. So interactions between currencies need to be considered.
The measurement problem
The concern of international financial management is the extent to which beta should be used in managing
portfolios. The measurement problem alone is sufficiently problematic to argue that it does not amount
to a practical measure of the appropriate return for the risk. Simply put although studies do find that a
higher beta is associated with higher return the prediction is not sufficiently accurate.2
The most notable attempt to improve on the beta model is the Fama three factor model that adds firm
size as a factor and the balance sheet value of the investment divided by the market value. This is purely
an empirical finding with no clear theoretical reason as to why these variables are found to be significant.
The main cause of the measurement problem is:
1 The market return (rm) should include all investment opportunities such as investment in land, gold, bonds,
derivatives and so on. For international investments it should also include all stock markets. Clearly this is
not measurable in practice and using the stock market index such as the FTSE100 is imprecise.
2 Finance markets are not sufficiently stable to take a statistical measure from past data for predicting up to
the medium term in the future; for example, betas based on monthly data differ greatly from betas based on
annual data. Exhibits 3.14 a and b illustrate the variability of the stock market index.
It should be understood that the models are intended not as a management tool in the first instance but
as an investigation into the workings of the market. Their practical value is best understood as part of the
‘language’ of estimation used as part of the subjective estimation of risk and return. Note that beta can be
thought of in a more intuitive way by noting that:
bi =
Cov(ri,rM)
Var(rM)
=
Correl(ri,rM)si
sM
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122
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
In other words, estimating beta as a subjective rather than a statistical measure can be seen as the
correlation with the market index multiplied by the ratio of the standard deviation of the investment
divided by that of the market. This helps give a more precise meaning to the risk of a portfolio investment
though clearly many other factors need to be taken into account such as regulatory risk and other factors
deemed important for particular investments.
Endnotes
1 Jacquillat, B. and Solnik, B. (1978) ‘Multinationals are poor
tools for diversification’, Journal of Portfolio Management,
4(2), 8–12.
2 Fama, E. F. and French, K. R. (1992) ‘The cross-section of
expected stock returns’, Journal of Finance, 47, 427–65.
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CHAPTER 4
International ethical
concerns: the Green
movement, Islamic
finance and globalization
LEARNING OBJECTIVES
The specific objectives of this chapter are to:
●●
Evaluate the importance of ethical issues.
●●
Describe the principles and practice of ethical investment.
●●
Describe the principles and practice of Islamic finance.
●●
Assess the arguments of globalization and its discontents.
Whether or not an MNC decides to invest in a particular country has important implications for particular locations,
organizations and for the country in general. As an unelected and hence undemocratic organization, an MNC is in
the difficult position of having considerable power without responsibility other than to its owners, for the most part
shareholders.
Understanding the issues and attitudes of sections in society that criticize the actions of MNCs is important for
understanding the financial environment within which MNCs operate. There have been sufficient scandals, court
cases and fines for financial management to be seen as more than just profit maximization. The concerns of other
123
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stakeholders need to be considered. Accordingly, this chapter examines alternative perspectives to the simple profit
maximization motive that underlies analysis in other chapters.
What are ethics?
Ethics are a set of directions or a code that acts as a guide to individual and social behaviour. Normally
the code is acknowledged by a significant group in society and will hence often form the basis of the legal
and regulatory framework. The code is sometimes partially written but never wholly described in this way.
What is ethical within a particular group is always subject to discussion and development in the face of
new challenges. In general though we can think of ethics as being a set of positive moral values.
The importance of ethical issues
Despite the focus on maximizing returns for owners, MNCs increasingly recognize that other sections
of society, sometimes organized pressure groups, can exert significant pressure on government and bring
about regulatory changes. Green issues, health issues and concerns over involvement in slavery are the
main current issues that can lead to regulation and decisions.
As the A.T. Kearney report confirms, the greatest concern of foreign investment in their 2018 survey – as
it is for most of their annual surveys – is: ‘Regulatory transparency and lack of corruption’ (Chapter 15).1
The threats of regulatory change and unclear application of regulations pose the greatest non-business
threat to investment and must be taken into account as an active constraint in any investment decision. The
debate for regulatory change has ethics as one of its driving forces. Regulatory transparency also relates
to the uncertain application of regulations and the problem of corruption. In this chapter we examine the
complex nature of ethical concerns and the problem of corruption as they might affect investment.
MANAGING FOR VALUE
Dieselgate
On reflection it is ironic that the head of the US-based
International Council on Clean Transport should be
called John German. As part of a report he decided
to compare car diesel emissions from lab reports with
emissions under real driving conditions. They chose
the Volkswagen Jetta and the VW Passat. After much
testing and retesting they had to conclude that nitrous
oxide emissions from Jetta’s tailpipe was 15 to 35 times
the regulatory limit and the Passat between 5 and 20
times the limit. On later testing, virtually all diesel cars
were found to be over the limit of regulations in both the
EU and the US. Volkswagens were not even in the top
half of offenders. The reason why cars passed the lab
test but not the road test was traced to cheat devices
in the car’s software that detected lab conditions and
turned on components that reduced emissions at the
expense of fuel consumption and performance.
Has the problem been solved? Both yes and no.
Yes, the latest models meet, we assume, performance
regulations. The answer is also no in that the
enforcement procedure is exceedingly weak in the EU.
The European Commission sets the standards and
then requires governments to enforce the rules and
certify compliance. The catch is that if one government
certifies a car then all the other governments must
honour the approval. Car makers will opt for a country
where they provide a lot of employment, where the
enforcement agencies are understaffed and poorly
funded, lacking technical expertise. You may be left
wondering how well any EU rules and regulations are
actually implemented.
Corruption is often thought of as breaking the rules,
but that is a naïve understanding. Complying with the
rules but not their intention is also corrupt. In this case,
the cars did, after all, pass the lab test rules.
Source: Gardner, B. (2019) ‘Dirty lies: How the car industry hid
the truth about diesel emissions’, The Guardian, 22 March.
Available at: www.theguardian.com/environment/2019/
mar/22/dirty-lies-how-the-carindustry-hid-the-truth-aboutdiesel-emissions [Accessed 30 August 2022]
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MANAGING FOR VALUE
Dutch court orders Shell to reduce carbon emissions
In May 2021 a Dutch court ordered Royal Dutch
Shell (now Shell plc) to increase its emissions
cuts in a ruling that is thought might set a global
precedent. The ruling required Shell to lower its
carbon emissions by 45 per cent in 2030 compared
to 2019. Shell had planned cuts of 20 per cent by
2030 compared with 2016 and to become net zero
by 2050. Shell’s response was that it would only
move in step with society. The judge responded
by saying that Shell should do more than just
complying with regulations in the countries where
it operated but added that Shell ‘has total freedom
to comply with its reduction obligations as it sees
fit’. Shell’s share price did not change following the
decision. Shell is due to appeal against the decision
in 2022. The lawyer who won the original case and
is preparing a response argues that: ‘One of the big
reasons for the judiciary to exist is to bring balance
in society and to protect us against human right
violations.’
Sources: Raval, A. (2021) ‘Dutch court orders Shell to
accelerate emissions cuts.’ Available at: www.ft.com/
content/340501e2-e0cd-4ea5-b388-9af0d9a74ce2
[Accessed 27 April 2022]; Wilson, T. (2021) ‘Lawyer who
defeated Shell predicts ‘avalanche’ of climate cases’.
Available at: www.ft.com/content/53dbf079-9d84-4088926d-1325d7a2d0ef [Accessed 27 April 2022]
MANAGING FOR VALUE
What do we mean by sustainability?
The EU is currently developing an EU taxonomy
for sustainable activities. It is seeking to develop a
sector by sector guide as to what can be claimed
as sustainable and what is not. This is obviously of
huge importance as, for example, there is already
disagreement between France and Germany as to
whether or not nuclear power is green. The 2021
COP26 meeting ended in failure to agree to anything
more than a reduction in fossil fuels following
intervention by India and China. There have been
calls from the WWF as well as the EU to regard
all fossil fuels as non-sustainable, although more
recently some consideration has been given as to
whether natural gas can be so classified if it is part
of a move away from brown coal. These current
problems are in the face of goals such as the EU
seeking all plastic packaging to be recyclable by
2030 and zero net CO2 emissions by 2050. They
also have a ‘do no harm’ principle so, for example,
windmills must not harm the local wildlife, though
harming the view is probably not included. As ever,
goals are announced and then delayed. Companies
in the EU were supposed to be reporting on ‘climate
mitigation’ and ‘climate adaptation’ by 2021, but this
has been delayed following lobbying from industry.
Although the EU is seeking to produce a manual
that is ‘comprehensive and watertight’ and on 21
April 2021 published the criteria of its taxonomy, it is
perhaps not fully appreciated by green lobbyists that
the consequences and costs of compliance are very
complex and hugely significant for MNCs, the debate
over natural gas being one such example.
Source: Veltmeijer, R. (2021) ‘Why the EU is working on
developing “An Oxford Dictionary of Sustainability” ’. Available
at: www.triodos-im.com/articles/2021/six-questions-aboutthe-eu-taxonomy [Accessed 27 April 2022]
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Just as companies have gained power through expanding and becoming multinational, so have the
pressure groups.
USING THE WEB
There are numerous instances of accusations of unethical activity by companies. One of the best
sources is www.corporatewatch.org.uk, which is part of a whole network of ‘watchers’ that can be
accessed by visiting the Corporatewatch website.
Other watchers include: Multinational Monitor, Corporate Europe Observatory, CorpWatch (US),
CounterCorp (US), BankWatch Network, BiofuelWatch, GeneWatch, GM Watch, IFIwatch, Media
Lens, Press Action, Oil Watch, PR Watch, Spin Watch, State Watch, Nor Watch (Norway).
Anti-corporate campaigns: Baby Milk Action, Compassion in World Farming, Boycott Nike, Boycott
Israeli Goods Campaign, Campaign Against Arms Trade, Coalition Against Bayer Dangers, Communities Against Toxics, Do or Die, Hands Off Iraqi Oil, Labour Behind the Label, McSpotlight, Mines
and Communities, No New Coal No Sweat, Shell Boycott, SmashEDO, Sprawl Busters, Stop Huntingdon Animal Cruelty (SHAC), Bretton Woods Project, Corporate Ethics Center for Corporate Policy,
Corporate Accountability, International Endgame, Research Services (US), Essential Information, New
Economics Foundation (NEF), Ultimate Holding Company.
Other grassroots campaigns and groups: Action for Solidarity, Equality, Environment & Development
(ASEED Europe), Banana Link, Down to Earth, Earth First! in Britain, ETC Group, Genetic Engineering
Network, GenetiX Snowball, Norfolk Genetic Information Network, Grassroots Action on Food and
Farming (GAFF), INQUEST, International Rivers Network, LetsLink UK, Pesticide Action Network,
Primal Seeds, Practical Action, Public Concern at Work, Reclaim The Streets, Radical Routes, Rainforest Action Network, Stop Deportation, Survival International, Sustain, The Land is Ours, Uncaged
Campaigns, WaterWatch, Women’s Environmental Network, Free Range Activism, Freedom to Care,
Action on Smoking & Health (ASH), Corner House, Friends of the Earth, Greenpeace UK, Iraq Occupation Focus, The Stop the War Coalition, People & Planet, Peoples Global Action PLATFORM, World
Development Movement, Women Working Worldwide.
Alternative media: Adbusters, Clearer Channel, Envirolink, Network Ethical Consumer, Earth First!,
Action Reports, Action Update (newsletter), Greenpepper, Indymedia, Indymedia UK, Information for
Action, New Internationalist, News Alternative, Peace News, Radical Activist Network, Red Pepper,
SchNEWS, The Ecologist, UKWatch, Undercurrents, VisionOnTV, ZNet.
Other: Banksy, George Monbiot, Naomi Klein.
A number of campaigns involve MNCs. There has been a long-standing campaign against genetically
modified crops. Campaigners see the development of seeds that do not reproduce as creating a dependence
of farming on large MNCs. Others object on the grounds of unforeseen consequences. Animal rights
organizations are against testing products and carrying out research on animals for ethical reasons – causing
pain and suffering. Multinationals have been accused of running sweatshops in developing countries and
of putting downward pressure on wages and standards in their own countries. Specific examples are easily
found on the internet. The Green agenda often comes into conflict with MNCs, not surprisingly since
green non-polluting technology is often more expensive.
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As an example, the efficient farming industry in the developed world is accused of destroying local
food production:
Cheap imports and food dumping create a vicious circle: they drive developing country farmers out
of their local markets because they can no longer compete, local production falls, farmers abandon
their land, the whole of the rural economy shrinks, people are forced to move to the cities for work
and more food must be imported.
www.corporatewatch.org.uk/?lid=2627 [Accessed 27/12/12]
For a recent example see YouTube ‘Tomatoes and greed – the exodus of Ghana’s farmers | DW
Documentary’. Available at www.youtube.com/watch?v=rlPZ0Bev99s [Accessed 21/12/21].
At the same time food is being imported from the developing world by the large food retailers. The
overall picture in this and many other instances is never that clear. MNCs and pressure groups typically
cite different evidence to support their cases with little by way of an overall assessment.
Even if MNCs wish to behave in an ethical manner there are difficulties. What is ‘right’ in one country,
for example child labour, is seen as unacceptable in another. Are MNCs to respect the customs and
practices of the country in which they operate or are they to adopt a rather vaguely defined concept of
global ethical standards? The latter approach is finding more favour among some MNCs but it is not a
general picture; for every MNC that adopts higher standards than strictly required by law, a cheaper rival
with no such standards will compete.
It may be argued that it is the law that is deficient and not the MNCs – if it is legal it is ‘right’. The
dilemma is highlighted by the revelations in the UK in 2013 that large MNCs such as Amazon, Google
and Starbucks were paying little or no corporation tax. Their defence was ‘we pay every penny we owe’,
which is indeed true. However, many hold the view that what is legal is not always ethical; hence the
proliferation of pressure groups, most of whom want to change the law in some aspect.
Poor regulation of markets
The permissiveness of legal frameworks across the world has a number of explanations. Generally,
politicians in developed countries are reluctant to regulate in any of the economic markets. The current
capitalist-based economic view is that regulations obstruct wealth creation in markets and that however
distasteful some of the consequences may be, it is to be preferred to over-regulated markets that stifle the
efficient use of capital.
A second rationale for the relatively poor regulation of markets is the technological change in markets
through the internet and greater financial sophistication. Markets are created at times with a view to
avoiding regulation. The rapid increase in the Eurodollar market in the 1960s was due in the main to
regulation Q restricting the lending of dollars in the US, so the markets simply traded dollars outside the
US. The newly created bitcoin market is an internet currency where payment is person to person (peer
to peer) over the internet and is beyond government control. These markets thrive because individual
governments cannot effectively legislate to regulate international markets – they do not have the authority
on an international scale. Furthermore, international regulatory bodies such as the International Monetary
Fund (IMF) require international agreement, and this is difficult to obtain.
A third reason for poor regulation is the rapid increase in communication that has led to
disintermediation – there is no market to regulate. Transactions are person to person. In the recent world
financial crisis, credit derivatives were sold largely over the counter and were not subject to market
scrutiny – mis-pricing was almost an inevitable consequence. Imposing some form of central clearing of
such instruments is seen by many (including the IMF) as an essential requirement.
Fourth, international non-governmental organizations are either committed to the economic argument of
reduced regulation, as is the case with the IMF, or are ineffective, as is often said of UNCTAD (United Nations
Conference on Trade and Development) incorporating UNCTC (United Nations Centre of Transnational
Corporations). This unfortunately is a reflection of the lack of common responsibility among nations.
Given the reluctance to regulate, MNCs are almost inevitably caught in a moral vacuum between
investors who want to maximize returns, governments that impose minimum regulations, international
organizations that appear ineffective and pressure groups that seek to further their own moral standards.
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MANAGING FOR VALUE
Banks face compensation claims over mis-selling
Deutsche Bank, it is claimed, may have mis-sold
foreign exchange derivatives (refer to Chapter 11) to
more than 50 Spanish companies. J Garcia-Carrion,
Europe’s largest wine exporter, was paid over €10m
by the bank following a claim. The company is also
involved in a similar claim with Goldman Sachs and
alleges misconduct over exchange rate transactions
by France’s BNP. The main trader involved, Amedeo
Ferri-Ricchi, who has left Deutsche Bank and denies
the claims, helped generate over €100m a year in
its currency trading division. He joined the bank in
2005, his doctoral thesis (PhD title ‘El Contrato de
swap como tipo de derivado’) at Spain’s Universidad
Complutense de Madrid included a study of swaps
and derivatives.
Sources: Storbeck, O., Morris, S. and Dombey, D. (2021)
‘Deutsche Bank’s Spanish mis-selling scandal widens’.
Available at: www.ft.com/content/9f38f81b-2fe4-4c11aa47-6d393cd2b6f2 [Accessed 27 April 2022]; Arons, S.,
Griffin, D. and Spezzati, S. (2021) ‘Deutsche Bank’s FX probe
puts spotlight on former star salesman’. Available at: news.
bloomberglaw.com/banking-law/deutsche-banks-fx-probeputs-spotlight-on-former-star-salesman?context=articlerelated [Accessed 27 April 2022]
In the following sections we look at three examples of concern over ethical standards. The first is the Green
movement founded on sustainability and respect for the environment. The second is a continuation of the long
history of religious objections to commerce in the form of Islamic finance, which embraces a code of ethics
that gives some assurance of ethical standards. The third example is entitled globalization and its discontents,
which is a concern for the ethical and social consequences of the existing form of the global economy.
Financial management, orientated as it is towards profit maximization, needs to be aware of these
increasingly important constraints on its actions – more so in an international environment where good
relations with a host country are a priority.
The Green movement
The Green movement is a pressure group in some countries and a political party in others. It is certainly
less economically orientated than traditional political parties and is less focused on furthering the interests
of any particular faction in society. The most recent expression of those values (the Global Greens Charter)
is the following six principles:
1 ecological wisdom
2 social justice
3 participatory democracy
4 non-violence
5 sustainability
6 respect for diversity.
A green policy is generally understood to include the following elements:
1 Waste reduction – encourage re-use and recycling. Use resources such as water as sparingly as possible.
2 Purchasing – consider the resources used in production: is it an item shipped across the world when it could
have been made locally? Could the resources be shared? Is there a commitment to the community that has
produced the item? Does the purchase price allow a fair wage for workers including adequate social and
pension provisions?
3 Energy – as far as possible use renewable energy; create as little pollution as possible by reducing
consumption.
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4 Travel – are journeys necessary? Are there alternatives to arranging meetings? Can the journey be arranged
such that the pollution it causes is minimized?
5 Can carbon credits be purchased to offset consumption?
6 Is the worker provided with an acceptable working environment?
Most of these policies imply higher costs. In some cases, such as importing cheap clothes from
developing countries with poor conditions for workers and no social security or health system, the whole
business model would fail if it had to conform to an ethical code.
MANAGING FOR VALUE
Ethical statements
These can be found in most of the annual reports
of major companies. For instance from M&S’s NonFinancial Information Statement Strategic Report:
The statements below reflect our commitment
to, and management of, people, communities,
the environment, human rights, anti-bribery and
anti-corruption in the last 12 months. Full details
of all our policies on these matters can be found
at marksandspencer.com/thecompany.
M&S Annual Report, 2021, p. 33
And:
Al Yamamah Steel Industries Company is one
of the listed companies in the Kingdom of Saudi
Arabia, listed in Saudi Stock Market ‘Tadawul’.
The company is constantly keen to perform
its duty towards the young Saudis who are
the backbone of the society and to carry out
responsibilities towards them in a way that serves
their interests and develops their contribution
in the society, depends on them to achieve the
future goals and development in the country. The
company actively participated in the year 2021 in
community service, as it carried out the following
actions (...).
Al Yamamah Steel Industries Annual Report,
2021, p. 36
MANAGING FOR VALUE
Can finance help climate change?
There is an increasing carbon credit market whereby
one carbon credit represents the purchase of one
ton of carbon-reducing activity (such as planting
trees). In this way companies are able to purchase
their green credentials in the marketplace. The price
depends somewhat on the issuer in what is a poorly
regulated market. One of the better examples is the EU
carbon permit, and the market price is available at the
tradingeconomics.com site. Whether or not this is ethical
practice is highly debatable, especially when purchased
from developing countries, given that development can
imply the use of lower, cheaper and dirtier technologies.
Could the unintended consequence be restraining
development, planting trees instead of growing industry?
It may seem environmentally absurd to be importing goods such as shirts and woolly hats from the other side
of the world when they could have been made within a short distance of the consumer; but there is an ethical
counter argument. Buying a country’s goods is arguably more generous than giving aid. Giving aid provides
little incentive to improve and if the aid is in the form of goods, food, clothing, etc. it can harm local businesses.
In the form of cash, it can end up in the wrong hands. Buying a country’s produce helps the society to organize
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itself, develop and administer an adequate legal framework to enforce contracts and honour agreements and
pay ordinary people. The evidence is that national wealth increases faster through trade than through aid.
The Green movement is also vulnerable to the argument that it is a form of cultural imperialism. The
West has developed economies that were as environmentally polluting as the developing economies of today,
and to ask developing economies of today to reduce their carbon footprint is to an extent hypocritical. The
Green movement’s opposition to nuclear power has also been subject to criticism as it is cleaner than other
alternative energy sources and is more able to fill the gap left by the reduction in the use of fossil fuels
than wind, wave and other such sources. Such is the international confusion over policy that Germany is
considering closing its nuclear power stations while the UK is planning to build mini nuclear power stations.
MANAGING FOR VALUE
The UN sponsored a conference on climate change
in 2021 which was held in Glasgow (referred to
as COP26). The conference failed to limit global
temperatures to 1.5°C above pre-industrial measures
as promised in the 2015 conference. The process
required countries to make improved targets every
five years in a process referred to as ratcheting up.
For the first time there was specific mention of fossil
fuels, namely oil, coal and gas. There was much
disappointment in the intervention by China and
India to weaken the wording of the final agreement
from ‘phasing out’ coal power to ‘phasing down’ coal
power which is without CO2 capture, a process that
is overly costly. A more successful international effort
has been about the hole in the ozone layer. This was
caused by certain gases notably CFCs being released
into the atmosphere. The problem was officially
acknowledged in 1985. Since then, the use of CFCs
and other gases has been reduced drastically though
it is still reckoned that it will take decades for the
hole to finally close. Nevertheless, this has been a
successful international cooperation, though it must
be said that in this case there were ready alternatives.
The flaws in the Green agenda however do not justify ignoring the issues they raise. MNCs are keen
to comply with an ethical agenda close to the requirements of the Green movement. Minimizing costs
as the only criteria is clearly an overly simplistic approach, as illustrated in the IKEA ‘Managing for
Value’ below.
MANAGING FOR VALUE
Unethical procurement
IKEA apologises for benefiting from forced prison
labour in communist East Germany 30 years ago
●●
East German prisoners, including many political
dissidents, were involved in the manufacture of
goods supplied to IKEA, 25 to 30 years ago
●●
Swedish furniture giant has said it ‘deeply
regrets’ its use of suppliers involved in forced
prison labour
... The Swedish furniture giant released a report showing
that East German prisoners, among them many political
dissidents, were involved in the manufacture of goods
that were supplied to IKEA, 25 to 30 years ago. The
report concluded that IKEA managers were aware
of the possibility that prisoners would be used in the
manufacture of its products and took some measures to
prevent this, but they were insufficient.
Daily Mail (2012) ‘IKEA apologises for benefitting from
forced prison labour in communist East Germany 30 years
ago’ (28 December). Available at: www.dailymail.co.uk/
news/article-2234050/IKEA-apologises-benefitting-forcedprison-labour-communist-East-Germany-30-years-ago.html
[Accessed 15 August 2022]
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In conclusion, MNCs are part of a world economy that operates without a world government. Instead
there are pressure groups such as the Green movement, international organizations that operate by agreement
and world public opinion as evidenced on the internet. In this smaller world of the ‘global village’ MNCs
are having to realize that profit maximization to be anything other than purely short term, has to have
self-regulation guided by an ethical code.
Islamic finance
The second ethical construct that has international prominence is Islamic finance. The best-known feature
is the prohibition on interest or ‘riba’, which in past times has also been banned in the Jewish faith (among
Jewish people themselves) and Christianity, where it was seen as usury.
EXAMPLE
Compound interest is the eighth wonder of the
world... He who understands it, earns it... He
who doesn’t, pays it.
Attributed to Albert Einstein
If you borrowed £1 at 1 per cent compound in
Shakespeare’s time you would owe £65 today
(1 x 1.01420) but if the interest rate were 2 per cent you
would owe £4,093, 3 per cent £246,396, 4 per cent
£14.3 million and 5 per cent £793.4 million!
The reason for the dislike of interest in the Muslim faith is that money is regarded not as an asset but
only a measure. The ancient Greek philosopher Aristotle expressed similar views as follows:
Usury is most reasonably hated because its gain comes from money itself and not from that for
the sake of which money was invented. For money was brought into existence for the purpose of
exchange, but interest increases the amount of the money itself (poiei pleon); (and this is the actual
origin of the Greek word: offspring resembles parent, and interest is money born of money); consequently this form of the business of getting wealth is of all forms the most contrary to nature (para
phusin).
Aristotle (350 bc), Politics 1, iii, 23 quoted in Usury and the Church of England
by Rev. Henry Swabey (2008) p. 3, Cesc publications
The somewhat cynical view expressed by non-users of Islamic finance (which is open to non-Muslims) is
that the Islamic alternatives are really the same as paying interest. This is not true in that interest is only
part of the Islamic finance structure and taken together amounts to a different approach to lending. It
may be true for those organizations who wish only to appear to conform to Islamic principles; but Islamic
finance should be entered into willingly by both parties and therefore provide little incentive to those
who may only want to borrow in the capitalist manner – that option is open to Muslims and of course all
others.
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The ethical arguments of capitalist interest rates
The ethical foundation of capitalist interest rates should perhaps be stated, in order to understand the
contrast with Islamic finance. The Fisher analysis is that interest consists of three elements:
1 Time preference: the reward for non-consumption
2 Inflation: the maintenance of the purchasing power of the loan
3 Risk: the possibility of non-repayment.
Thus, for example, if time preference is 1 per cent and estimate of inflation 3 per cent and risk at
5 per cent then the overall interest rate will be approximately the sum of these elements, i.e. 9 per cent.
Many banking operations have through the ages regarded money lending, in particular, as a form of
exploitation. Borrowing at one rate and lending at a higher rate is seen as ‘making money’. The margin
is justified on four principal grounds. First, the process is one of maturity transformation: short-term
lenders (those holding current accounts for the most part) are lending to long-term borrowers. The
banking operation is taking on a risk that it will not be able to meet the demands of the depositors when
they wish to withdraw their money. Second, risk transformation: in a banking operation a lot of small
deposits are being lent out to relatively fewer large borrowers. Third, liquidity: borrowers are able to go
to one lender who has amassed the savings of many lenders to provide the large loan. Finally, allocative
efficiency: the lending operation is deciding what are the worthy or profitable operations and what are
not worth pursuing. These it can be argued are significant services to society justifying the use of an
interest rate.
If the interest rate is helping to fund all these operations, then why is it seen as unworthy? Aristotle’s
view that using money to make a profit with no substantive service being provided is not really the case –
the services of maturity and risk transformation, and liquidity and allocative efficiency, are vital to wealth
creation. Furthermore, who would lend money and take the risk of non-repayment for no interest? Given that
there are always loans that are never repaid, how is that financial shortfall going to be filled? Nevertheless,
MNCs have to accept that finance is held in low esteem in many parts of the world. Although MNC
operations do not usually involve banking operations, any form of financial decision-making that involves
negative social consequences is likely to incur social opprobrium from quarters of society. A clear ethical
defence is important.
Islamic finance principles2
For Islamic finance the apparent unethical nature of free market finance is a matter of religious conviction.
There are five guiding principles based on the Koran:
1 Belief in divine guidance. The Muslim faith is not restricted to worship but provides guidance for almost every
aspect of life including financial transactions. This is part of the debate as to whether government should
be secular (independent of religion) or non-secular, abiding, in this case, by the Islamic faith in its actions,
including tolerance of other religions.
2 The charging of interest (riba) is prohibited. This does not mean that money is lent free of charge. Typically,
the loan will be linked with the underlying transaction and payment will be made from a combination of fees
and profit sharing. Interest is trading money for money, and generally there is a ban on profiting from buying
and selling the same asset, which is also the essence of speculation. In this sense, a loan can be thought
of as selling money in return for even more money at a later date. Any form of delay in a contract that is
artificial in the sense of not physically necessary is also banned, as this could easily form the basis of an
interest-based contract.
3 Banned (‘haram’) investments. In similar fashion to the Green movement, investment in products deemed to
be physically or socially harmful are banned. Thus tobacco, alcohol, arms, pornography are banned.
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4 Risk sharing is to be encouraged. This is an important element of the general distancing from the Western
concept of an ‘arm’s length transaction’. In a finance context in the UK, for instance, a bank charges interest
based on the risk that it perceives to its loan. If the borrower can offer security in the form of assets, land
and buildings, for example, then the bank will not be especially concerned with the purpose of the loan. If
it is successful, the borrower stands to gain significant profits, but the bank’s involvement will be limited
to the interest charged. If the project is unsuccessful then the bank can claim the assets to help repay the
loan. In this way, the bank need have little involvement in the activities of the borrower. This has been a­
much-criticized aspect of finance as it also implies that there is little knowledge transfer between the parties.
The banks’ financial skills are not transferred.
In making risk sharing part of the contract the lender now has to take an interest in the purpose of the
loan as well as the security of the borrower. The intention is to promote sharing and to avoid excessive
profiteering by either party at the expense of the other. Risk sharing on its own does not achieve this and
indeed it would be easy to construct a risk sharing contract that favours banks even more than an arm’s
length transaction. Risk sharing does no more than create a structure within which mutual co-operation and
trust can be enhanced more easily.
5 Financing should be based on real assets. A loan should be for the purposes of buying real assets rather
than, say, purchasing shares. Borrowing to buy shares is a form of speculation that leads to share values
rising at a faster rate than economic growth – a situation that in the long run is unsustainable.
These five principles form the basis of what is termed Shariah-compliant investment. Whether or not
a transaction is Shariah-compliant is a matter of scholarly debate and standards vary across countries.
Regulatory bodies have evolved, notably the Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI), the Islamic Financial Services Board (IFSB) and the International Islamic Financial
Market (IIFM).
The lack of clear definition is in many ways a strength of the system. Hard targets introduce game
playing and it seems right that, apart from the most basic of arrangements, no one scheme should be
assured of being Shariah-compliant.
Prohibitions and encouraged practices
The first prohibition is ‘riba’ or interest, which is discussed above as one of the five principles.
The second is ‘gharar’ or uncertainty. Whereas risk is to be shared, it should not be excessive. Excessive
risk is not clearly defined, but it should not be due to extreme complexity of an agreement, which amounts
to deceit or fraud. Neither, as in moral hazard, should uncertainty be caused by the withholding of
information; for example, an employee withholding information from their superior. Outcomes must as
far as possible be ascertainable. Thus, for instance, the sale of fish not yet caught would be deemed to be
gharar or excessively risky, but paying someone to fish for five hours in return for the catch would not be
anything other than taking on unavoidable risk and therefore permitted.
Third, ‘maysir’ or gambling is prohibited. Closing out derivatives in particular futures and option
contracts are seen as a form of gambling as there is no actual delivery (Chapter 11). However, derivatives
where there is a clear underlying asset with a risk that the company wishes to insure would ordinarily be
permissible.
In addition, practices that are forbidden or discouraged include:
●●
Price manipulation. Prices should be determined by fair and open trading in the market, i.e. an efficient
market.
●●
There should be equal access to information on both sides of the contract. The sale of land and buildings
where the seller fails to reveal significant defects would not be Shariah-compliant.
●●
Mutual co-operation should be encouraged. This is evidenced in the profit-sharing schemes and the sharing
of information. Also, Muslims are obligated to give a portion of their wealth to the less well off in what is
known as ‘zakat’.
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Islamic financial transactions
Bai bithaman ajil (BBA). This is a loan to meet long-term financing. Note the role of the real asset. In the
case of, for example, a house purchase:
1 The house is identified by the buyer.
2 The bank agrees to finance the purchase.
3 The bank purchases the asset and sells it to the buyer for the cost plus a mark-up. The bank may previously
have appointed the buyer as an agent thus ensuring an obligation to buy.
4 The buyer pays the price to the bank over an agreed time period.
Note that the asset and the mark-up are evident in this transaction. In the case of a variable rate
mortgage the interest element would not be as clear. There are variable rate products but with limitations
to differentiate between risk and gharar.
Murabaha(h). This is very similar to a BBA except that it is normally for shorter periods and used for
example for financing working capital, for example:
1 The buyer wishes to purchase raw material for a business.
2 The bank purchases the goods.
3 The bank sells the goods to the buyer for an agreed mark-up price.
4 Payment is made in 30 days’ time by the buyer to the bank.
As with BBA the customer may be appointed as an agent.
Ijara(h). An operating lease (a lessor lends an asset – a car for example – to a lessee who leases the asset for
an extended period) in which a typical configuration might be:
1 The bank appoints the lessee as an agent, giving ownership responsibilities to the lessee.
2 The lessee identifies the asset and buys it on behalf of the bank.
3 Ownership is transferred to the bank.
4 The lessee then uses the asset.
5 At the end of the lease period the asset is returned to the bank.
6 The bank may lease the asset to another customer or sell the asset.
Note that contracts are not allowed to run in parallel, thus the agency contract terminates when the
lease contract begins.
A financial lease ends with the lessee having the right to purchase the asset. This is termed Al-IjarahThemmal Al-Bai (AITAB) or Ijarah Muntahia Bittamleek (IMB). This is the same as the operating lease
with the addition of a sales contract at the end of the lease period.
Mudharaba(h). This is a joint venture between the borrower and the bank, where the bank provides the
funding and the borrower the expertise. The borrower runs the business. Payment to the bank is by an
agreed profit-sharing ratio. If there is a loss, the bank is solely responsible unless there is negligence or
other form of wrongdoing by the borrower. The bank’s liability is limited to the capital it has provided.
Any further liability is due to the borrower who has incurred the extra debt as a result of managing the
enterprise.
Note that this is almost the exact opposite of the Western approach to a financing arrangement where
the borrower takes on the unsecured risk in the event of failure.
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Musharaka(h). Similar to the Mudharabah except that losses are shared in proportion to the amount of
capital contributed by each party. The business is run jointly by the borrower and the bank. Each party has
unlimited liability.
A variant is diminishing Musharakah whereby the borrower can use some of the profits to repay the
capital that the bank has contributed. Therefore the bank’s share of the profits gradually diminishes in
line with the diminished share of the capital. This process can, for example, be used for a house purchase
where the borrower’s deposit and the bank’s contribution form the initial capital sharing and the borrower
gradually over time buys out the bank’s contribution.
Sukuk. The Islamic bond is known as a sukuk. The bondholders appoint a manager to oversee the
underlying assets which are assigned to the bondholders as the owners. The sukuk holder participates in
the profit generated by the bond and also the potential losses. This arrangement adheres to the principles
of no interest being paid and the need to have underlying assets to support financial transactions.
Scholars who are seen as the judges of Shariah compliance actively debate these Islamic financial
transactions and contracts and their many and growing variations. From the ethical perspective, their
interest is in the way in which they attempt to express the principles of Islamic finance. The process
is not easy as there is often a small but important distinction between a profit that exploits a business
opportunity and one that exploits other people or encourages unproductive behaviour.
The two ethical codes of Green economics and Islamic finance offer widely differing views on ethical
behaviour. The essentially scientific orientation of the Green movement is focused on the object of expenditure;
the Islamic code more on social behaviour. An MNC needs to be aware that the perspective of these stakeholders
and others in society have an important voice in the regulation of business in different countries. It cannot be
assumed in any society that financial management can be guided solely by profit maximization.
Globalization and its discontents
The final area of ethical concern is from those who accept the profit maximization philosophy but are
concerned that it is leading to a catastrophic end, chiefly as a result of globalization. Such advocates seek
modification in the form of greater regulation to international trade and the investment process.
Globalization
Globalization was described by the economist and diplomat Peter Jay as:
Any entrepreneur anywhere can draw on savings accumulated anywhere and on technologies and
managerial skills located anywhere to create a productive unit anywhere, employing local labour,
and selling its products anywhere to everyone.3
Although this definition is not yet literally true, it is this scenario that is implied by the free market
philosophy of the IMF and major nations of the developed world. For many, this apparent ideal brings
with it national and international problems in the form of significant social and economic change that is
so disruptive as to imply a general lowering rather than increase in wealth. A recent study of US imports
from China concluded:
Our analysis finds that exposure to Chinese import competition affects local labour markets not just
through manufacturing employment, which unsurprisingly is adversely affected, but also along numerous
other margins. Import shocks trigger a decline in wages that is primarily observed outside of the manufacturing sector. Reductions in both employment and wage levels lead to a steep drop in the average earnings
of households. These changes contribute to rising transfer payments through multiple federal and state
programs (elsewhere referred to as unemployment and social security payments by governments), revealing an important margin of adjustment to trade that the literature has largely overlooked.4
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Ricardo’s law of comparative advantage (Chapter 2) underwrites the rationale for free trade. This is, in
essence, showing that where countries have differing productivities, the world economic output can be
increased by allowing a degree of specialization and then trading the surpluses. In this way, all countries
can be better off, even those who are less productive in all aspects but relatively less unproductive in
some. The price mechanism should support this process, the lower cost resources being those of the more
productive processes. However, there is a growing problem with this rationale. The benefits reduce as the
productivity differences reduce between countries.
In the extreme example of equal productivity everywhere, there would be no benefit through
international trade. The free market and technology are achieving such an equalization of technology
for many products and services. Production can indeed be as productive anywhere and services can be
provided from widely dispersed locations due to the internet. In such cases, advantage is gained not through
being more productive but rather through less rigorous regulations and less expensive employment.
Countries with no pension provision, poor hospital services and no social security attract investment to
take advantage of the lower employment costs. These goods are then exported to countries where these
costs cannot be competed with other than through lowering their own employment conditions.
MNCs, by importing and engaging in foreign direct investment are directly responsible for the
operational aspects of globalization. Clearly, they do not want to be involved in the moral argument. The
original defence of MNCs’ behaviour when challenged by pressure groups was, in general terms, that
‘we comply with the laws in every country where we operate’ (sometimes termed relativism). But where
the legal standards and practices in those countries are being questioned, then clearly this is not enough.
Increasingly, MNCs are devising their own set of standards – a move from relativism to absolutism.
Discontent
The discontent of analysts is due to the view that this is not a stable or desirable scenario.
Race to the bottom. The large movement of production out of the developed world reduces the national
income in those countries that are then unable to fund pensions and social services. To compete, firms in
the developed world must lower their standards – a process known as the ‘race to the bottom’. MNCs
find themselves in the difficult position of implementing these developments: more part-time work, fewer
apprenticeships, closing factories and moving to the Far East.
This lowering of standards is not a new phenomenon. The Industrial Revolution replaced the old
guild and mercantilist economies, leading to a worsening of conditions. Many see the current changes as
dismantling social structures that have taken over 100 years to achieve.
The counter argument is that such transfer of production releases resources for activities that are more
productive than can be achieved in the developing world. This is obviously true in certain areas such as
research and development, but technological equalization limits those opportunities and employment in
the developed world increasingly moves to non-exportable activities such as take-aways and delivery.
The liberalization of exchange controls and investment. Restrictions on foreign-owned shares and foreign
investment have largely been lifted. This has led to huge increases in portfolio and real investment. The
volume of trade on the foreign exchanges in one day is larger than the UK gross national income. This
increase has enabled countries to borrow on the international exchanges, issuing bonds to foreign investors
to fund domestic spending promises. For many years the US national debt (government bonds) has had
significant ownership from Japan and more recently China as well. About 30 per cent of US equity and
38 per cent of US government bonds are foreign owned. This phenomenon is not confined to the US; in
Australia, for instance, about half the equities and bonds are foreign owned.
If foreign investors were to sell their bonds, interest rates would rise in the country concerned, resulting
in a reduction in the growth of economic activity. Generally, this does not happen as the lender will lose
from a fall in the value of the bonds caused through selling (they cannot be sold all in one go). Therefore
there is a dependency between the lender and the borrower. There is also a dependency created between
the borrowing country and the financial markets. Government actions and policy are actively constrained
by concern over the views of the market; ‘what the market will think’ is now an active political concern
for most countries. One of the more easily observed sources of market views are the credit agencies such
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CHAPTER 4
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as S&P’s, Fitch or Moody’s. Politicians feel that they are being judged, as indeed they are, by an unelected
unaccountable organization that is making essentially political judgements. The market, however, is free to
ignore the judgements of the credit agencies, as indeed was the case when the US was downgraded – there
was no effect on interest rates.
As a result of government borrowing, there has been a loss of national sovereignty to the financial
markets. The lack of democratic accountability and indeed any clear governing structure of the markets
represent a worrying loss of control from the point of view of the discontents.
MANAGING FOR VALUE
Ghana’s sovereign dollar bonds tumbled on Monday
after Moody’s slashed the country’s credit rating …
Moody’s cut its rating from B3 to CAA1 late on Friday,
saying Ghana’s debt was subject to “very high credit
risk”, and estimating that interest payments would
absorb more than half of government revenues for
the foreseeable future … Ghana, one of West Africa’s
largest economies, slammed Moody’s action …
the finance ministry said it had appealed against
downgrade and said the rating agency’s concerns
were largely addressed by fiscal consolidation
measures outlined recently in its 2022 budget
‘anchored on debt sustainability and a positive
primary balance’.
Strohecker, K. (2022) ‘Moody’s downgrade whacks
Ghana dollar bonds’ (7 February). Available at: www.reuters.
com/world/africa/moodys-downgrade-whacks-ghanadollar-bonds-2022-02-07/ [Accessed 4 March 2022]
The internet. Discontent also arises as a result of the communications revolution caused by the internet.
International legislation at present does little to prevent these developments. Business models as a result are
uncertain; the publishing industry, the music industry and services either are, or could be, radically changed
by the internet. Copyright infringement has been a big issue. Currently the EU Directive on Copyright in
the Digital Single Market Articles 11 and 13 seeks to make platforms such as YouTube liable for copyright
infringement by contributors to its content. EU members have two years to include this in their laws.
Labour. The freeing up of markets has led to a concern over the huge labour force in South America,
Indonesia, India, China and the rest of South East Asia with approximately 1.7 billion workers willing
to work for a fraction of the wages in the developed world. 5 This factor combined with the reduction
in the technological advantage of the developed world due to the ease with which technology can be
exported, combined with the internet and international financial markets, is enabling MNCs to produce
efficiently anywhere. The problem that this creates is that in taking production away from the developed
world, demand is also being removed. A wage cost for one company is a source of demand for another.
Eventually, of course, the developing world itself will become a source of demand, but there are two
major problems. The first is that the demand on which the exporting nations depend may be disrupted
by the failure of the economies in the developed world to adapt. The debt crisis of a number of developed
countries is evidence of this possibility. The second is that the political and social changes that are likely to
accompany the increasing wealth of the developing (producing) countries may also be disruptive.
Population growth. A final concern is the argument of what might be called the ‘New Malthusians’. In
1798 Thomas Malthus published his treatise: ‘An Essay on the Principle of Population’. His concern was
that the growth in population would outstrip their means of support, leading to widespread poverty. For
many years this argument was discounted. Huge advances in technology in the nineteenth and twentieth
centuries meant that the means of support grew at a faster rate than Malthus thought possible. Also,
populations showed a natural tendency to restrict growth as they became wealthier. The New Malthusians
attack both these points.
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The once almost free energy of oil and gas is rapidly becoming more expensive as sources are harder
to exploit. Scientific breakthroughs are not reliable and if present trends continue, resources will become
increasingly expensive. Developing countries in such an event would find it difficult to support their
populations. Sub-Saharan Africa is already suffering increased poverty due to rising food prices.
With regard to population, there have indeed been dramatic reductions in the rate of growth of
populations. China’s growth rate is only 0.5 per cent and Japan, Russia, Germany and many other countries
have negative growth rates. Countering these trends, however, is the growth in the consumer population.
The move away from agrarian subsistence to urban consumerism lifestyles in China is producing rapidly
increasing demands for wheat, oil, coal and other resources similar to the effect of population growth. A
future scenario of a decline in living standards along with social unrest based on a shortage of resources is,
according to the New Malthusians, the inevitable result.
This is a pessimistic view of the future and is deepened by the fact that there appears to be little control
over this process. There is no effective international government. Furthermore, the international nature of
financial markets has made them remarkably difficult to regulate being beyond the control or influence
of any one government. MNCs are also poorly regulated. The recent revelation that Amazon, Google and
Starbucks paid almost no UK tax illustrates how control is difficult, even for a developed nation. It is
ironic that free trade and movement of capital that have been the source of wealth, are the very features
that appear to be the cause of much of the ‘discontent’.
MNCs in responding to governments, pressure groups and the press need to be aware of these
international concerns as the MNCs themselves are often blamed unfairly for being the cause of the
problem. Their first duty, however, is to maximize returns for their shareholders and in doing so appear as
helpless to influence many of these trends as any other party.
Corporate Social Responsibility (CSR) and Socially Responsible Investment (SRI)
The dilemma facing MNCs is that they wish simply to avoid transgressing the ethical values of any country
that they invest in and want to appear socially responsible. CSR is a constraint to their main purpose of
generating wealth. For an MNC to impose its own values counter to that of the country it is operating in
could well be interpreted as arrogance and seen as an ethical crusade. Yet that is what is implied when it is
argued that MNCs should adopt an ethical code across all their activities on a worldwide basis. This would
mean, for example, applying the ethical values of the UK to an investment in a country where child labour
is regarded as normal and a valuable income to a family. It is this absolute approach that has become the
accepted philosophy of the developed countries, where child labour is regarded as unacceptable under any
circumstances, not only for the MNC but also throughout its supply chain. This is not easy to regulate as the
quote from Next plc’s Annual Report demonstrates (refer to ‘CSR governance’ Managing for Value box).
Suppliers have suppliers of their own and so on. The counter argument to this approach is that it is virtue
signalling in that the company is imposing its version of ethics for the approval of investors and customers
but not taking responsibility for the negative consequences of its actions in the country where it operates.
There are no clear dividing lines. For example, should the holiday entitlements of a developed economy be
imposed on the foreign operations of an MNC? How ethical is it to close down an operation in one country
and move to another to exploit lower pay and conditions? If that is unethical you might question the huge
relocation of manufacturing from developed countries to developing countries since the 1970s.
An important motive for MNCs to include CSR in their governance structure is to attract SRI. Funds
offer varying interpretations of ethical investment: some will avoid harmful products such as smoking
or alcohol, others invest in companies that are improving the environment such as wind farms or solar
panels. There is again no clear ethical pathway for MNCs. Should an MNC forgo an investment due
to SRI concerns and thereby deprive investors, some of whom are pension funds, of much needed
dividends?
Despite the ambiguities posed by CSR and SRI, it is undoubtedly the case that there is an ever greater
coming together of trade and ethics. Companies now have extensive statements on ethical concerns and
are very sensitive to transgressions, wary no doubt of the power of social media and the real social and
ethical problems as the following quotes illustrate.
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MANAGING FOR VALUE
CSR and child labour
Child labour should never be taken lightly, but there
is a widespread assumption that a bit of work in the
fields is a normal part of growing up in developing
countries such as Malawi, Bangladesh or Mexico.
This notion of some sort of cultural acceptability
serves to draw a veil over what is, frankly, abuse
and the wrecking of children’s life chances. Child
labour is never OK. But when children working
boosts the profits of wealthy multinational tobacco
corporations, it is an outrage.
Boseley, S. (2018) ‘Child labour is never OK. But for
multinationals it is an outrage’. Available at: www.
theguardian.com/commentisfree/2018/jun/26/child-labourtobacco-fields-multinationals-life-chances-destroyed
[Accessed 27 April 2022]
MANAGING FOR VALUE
CSR governance
Our in-house global Code of Practice team carries
out regular audits of our product-related suppliers’
operations to ensure compliance with the
standards set out in our Code. These standards
cover supplier production methods, employee
working conditions, quality control and inspection
p r o c e s s e s … We t r a i n r e l e v a n t e m p l o y e e s
and communicate with suppliers regarding our
expectations in relation to responsible sourcing,
anti-bribery, human rights and modern slavery …
The Audit Committee receives modern slavery and
anti-bribery training progress updates together
with whistleblowing reports at each meeting.
Significant matters are reported to the Board.
Next plc Annual Report, 2021, p. 73
International corporate governance6
Increasing concern over the way in which companies are managed has been motivated by financial scandals
such as Enron, Arthur Andersen and WorldCom and earlier corporate scandals in the 1990s. Of particular
concern has been the unethical behaviour of company directors who have benefited themselves at the
expense of shareholders. The result has been legislation and codes of conduct around the world designed
to increase the power of the shareholder and limit the influence of individual directors – the relationship,
however, is not uniform. International corporate governance is concerned with the differing governance
regimes within companies around the world and why there are differences. From a financial management
perspective, joint ventures and partnerships require an appreciation of the differing control structures of
foreign companies to be effective.
Corporate governance and outside parties
Corporate governance is questioned particularly by the Green movement over issues such as the
environment and child labour. Also, MNCs are accused of regulation arbitrage, moving to countries where
the tax or environmental or employment or other legislation is particularly favourable. Examples quoted
earlier in this chapter provide ample evidence of the dilemma these MNCs face.
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Differing control structures7
The basic common format for ownership is of shareholding in a legal entity that engages in commercial
activities. One of the main international differences is in the nature of the relationship between the owner
and the managers or directors. In this regard, the UK along with the US are markedly different from other
major industrialized countries. The influence of shareholders on managers depends in large measure on
the size of the shareholding. A small shareholding has little influence in voting and hence cannot influence
decisions. This is generally the case in both the UK and the US. Fewer than 5 per cent of listed firms
have majority shareholders in these countries. This is in sharp contrast to the rest of the world where the
percentages are much higher. In Austria, Belgium and Germany there is a majority shareholder in over
60 per cent of listed companies. Control can be exercised by shareholders with blocking power set usually
at 25 per cent. This is true of over 80 per cent of companies in these three countries plus the Netherlands,
with Spain, Italy and Sweden at over 60 per cent. By contrast, in the UK, 15 per cent of companies have
blocking shareholders and in the US it is below 10 per cent. The situation is even more extreme in East
Asia, with the exception of Japan, and similarly so in Eastern Europe. In other words, apart from the UK
and the US there is a much closer relationship between ownership and control.
The advantage of having majority or large shareholdings is that information asymmetry is far less. The
investors will have access to the detailed accounts of the company in that they will be able to nominate
directors to the board. Where the major shareholder is a bank or financial institution the company may
benefit from its financial expertise. The disadvantages are that major shareholders reduce the flexibility of
the company. A major shareholder will be reluctant to increase the shareholding and dilute its influence or
in any way damage its interests elsewhere.
In addition, the benefit of a major shareholder depends in part on their identity. Here again research
reveals large differences. In Italy, for example, a survey found that 69 per cent of shareholders holding over
5 per cent were individuals or families; in the UK the figure was 2 per cent. Banks in France and Germany
(through proxy votes) are particularly influential. In East Asia families are also the predominant influence.
There are also links between firms through cross holding of shares and bank investments. In Japan such
structures are termed keiretsus and in Korea chaebols. China similarly displays a narrow shareholder
ownership; a study found that the largest shareholder held on average 43 per cent of the shares and in 67
per cent of such cases the largest shareholder was the government. An MNC seeking to go into partnership
with a company or even to purchase the company is therefore likely to be dealing with a family or other
large shareholder rather than the directors as the ultimate influence.
Why do governance structures differ?
Researchers have sought to explain the cause of the large differences in corporate governance. Of particular
interest is the large difference between the ‘Anglo-Saxon’ model of the US and the UK where there is a
strong division between shareholders and directors, and the ‘Continental’ model where the division is
far less. The question of interest is whether or not this difference is a symptom of other features of the
societies to which they belong.
A number of distinguishing features have been suggested as causal factors of the differences. An early
study sought to distinguish between bank-based and market-based economies. The UK and the US have the
most highly developed stock markets and are therefore attractive to a range of investors, thus widening the
ownership base. The bank offers an alternative source, performing much the same functions as the market
providing risk and maturity transformation, diversification and liquidity but not diversity of ownership.
Other researchers have pointed to the very large difference in the legal structures. The UK and the US are
governed by common law, which is case based. Judges’ decisions set a legal precedent, which is to say that
they add to the law passed by parliament. The alternative is civil law based on Roman law, which is rule- or
principles-based. The argument is that common law is more flexible and hence more attractive to investors
as it adapts more quickly to changing circumstances. The civil law system with its lesser concern with the
concept of fairness and greater adherence to the letter of the law is deemed less reassuring. Judges’ rulings
under common law are lengthy as the judge wrestles with the concepts of fairness and conformity with
precedents, whereas the civil law judgements are briefer, concerned solely with the application of the law.
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CHAPTER 4
INTERNATIONAL ETHICAL CONCERNS
141
Evidence that common law is more flexible is also in the larger number of measures restricting the
power of directors in a company. The concern of corporate governance is over the misuse of company
resources by directors. So evidence that common law countries protect ordinary shareholders to a much
greater extent would support the more widely held shareholding.
In sum, ownership and control varies greatly between countries and between companies. In
general, shareholder protection and sensitivity to Green issues is greater in countries with low average
shareholdings as evidenced in the annual reports. There are also other factors that seem relevant. For
example, suggestions of religious and geographic causes. The corruption perception index (CPI) is
dominated at the top by northern countries, also, the highest country that is mainly Catholic is Austria
currently ranked 15th. Such associations are however difficult to establish in what is an under-researched
area of governance.
Summary
●●
MNCs have to be aware of the potential regulatory
threat posed indirectly by pressure groups and
directly by governments who feel threatened by
the actions of MNCs.
●●
There are a number of alternative views of
business that can potentially conflict with
the profit maximization process including
concern for the environment, animal rights
and employment.
●●
●●
MNCs need to develop a response to the
alternative views of business and develop codes
or statements of ethical behaviour.
The Green movement offers a detailed agenda
as to what is ethical expenditure. The actions
of MNCs are scrutinized by a large number of
international pressure groups.
●●
Islamic finance presents an alternative model of
financial transactions according to a set of
principles based on the Koran. Business
conducted according to these principles is
becoming increasingly popular.
●●
Advocates of the free market and capitalism
are also concerned that free trade is going to
create huge disruptions due to the international
transferability of technology, production and
finance. MNCs are sometimes accused of being
the cause of the disruption.
●●
Ethics is also an important element of corporate
governance. Differences in governance between
countries have a number of possible causes that
may help to explain the differences such as the
use of the bank or the stock market as a source
of finance.
Critical debate
Importing
Proposition. MNCs should seek to obey the laws of
each country within which they operate. To do more
would mean that they are not maximizing profits and
potentially lead them into appearing as a political force in
a particular country.
Opposing view. MNCs should have a single set of
values to guide their investments. Otherwise they will
appear to be hypocritical and exploitative.
With whom do you agree? Remembering that an MNC
is bound to maximize returns for its shareholders, should
their actions be guided by the law or an independent set
of ethical standards?
Proposition. When buying goods produced in another
country you are in effect sponsoring their social, ethical,
political and environmental standards. To claim to be
‘green’ and a believer in ‘democracy’, yet stand in
clothes made by countries that are anything but green
or democratic is an act of pure hypocrisy. Worse still,
you are depressing standards in your own country as,
to compete, home companies have to reduce their own
standards.
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142
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
Opposing view. One must be dispassionate about
such matters. Of course there are bad examples but
you cannot base policy on one or two examples. More
generally, countries have been lifted out of poverty
through trade. Trade teaches developing countries
to honour contracts and have a fair and just legal
structure to attract investment. MNCs in having green
policies and ethical employment standards are helping
to spread good practices. Business, in encouraging
individual initiative and rewarding it with individual
wealth, is spreading control away from previously
dictatorial regimes and nurturing the principles of
democracy. Home countries should not compete with
developing countries but move to higher level activities
such as research or activities that are not importable
such as much of the service sector.
With whom do you agree? Is there a workable
middle way? If countries operating as dictatorships
are commercially more successful than democratic
countries, what then?
Self test
Answers are provided in Appendix A at the back of the
text.
1 Define globalization for an MNC.
2 Give three examples of the application of Green
movement principles that have financial consequences.
3 Outline the principles of Islamic finance.
Questions and exercises
1 Can ethical behaviour be fully defined or does it clash with cultural behaviour and development (child labour, land
clearance and levels of social security being relevant examples)?
2 Are carbon permits ethical or, like the COP26 disagreement, merely another way of disadvantaging developing
countries? Discuss.
3 What is the ethical argument for and against MNCs moving to countries because of lower labour and energy
costs? Recent movements out of China to Asian and South East Asian countries are one such example.
4 Describe a Murabaha contract and explain why it is ethically superior according to Islamic finance.
5 What are the justifications for charging 2,000 per cent?
6 How does a sukuk differ from an ordinary bond?
7 What is the role of profit sharing in Islamic finance contracts?
8 How green are electric vehicles and nuclear fuel? Use the arguments on the internet to form a reasoned opinion.
9 Why is the law of comparative advantage less effective in the current business environment?
10 Rank the five areas of discontent in terms of their ethical implications and justify your choice.
11 ‘It is not the rating agencies that dictate the policies of France’. Is this true? Does the marketplace rule
governments?
12 Rank the Green movement’s set of principles in order of their solvability and justify your choice.
13 Is Islamic finance just a matter of engaging in Islamic contracts or does it offer lessons for MNCs who engage in
ordinary financial contracts?
14 ABC plc seeks to move production to the Far East. What ethical considerations if any should it take into account
in assessing the profitability of the exercise?
15 Is trade better than aid? Discuss.
16 To what extent is the law of comparative advantage undermined by technology and ethical standards making
free trade no longer the foundation of developed economies?
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CHAPTER 4
INTERNATIONAL ETHICAL CONCERNS
143
Endnotes
1 A.T. Kearney (2018) ‘The 2018 Kearney FDI Confidence
Index®’. Available at: www.kearney.com/foreign-directinvestment-confidence-index/2018-full-report [Accessed
25 July 2022].
2 Abdullah, D. V. and Chee, K. (2010) Islamic Finance:
Understanding its Principles and Practices, Marshall
Cavendish.
3 Kennedy, P. and Jay, P. (1996) ‘Globalization and
its discontents’, BBC Analysis Lecture tape No.
SLN621/96VT1022. This section is based on the arguments
of this prescient programme.
4 Autor, D., Dorn, D. and Hanson, G. (2013) American
Economic Review, October, 103(6), 2121–68, at p. 2159.
5 WorldBank.org (2022) ‘Labor force, total - Latin America &
Caribbean, India, China, Indonesia, Philippines’. Available
a t : d a t a . w o r l d b a n k . o r g / i n d i c a t o r / S L . T L F. TOT L .
IN?locations=ZJ-IN-CN-ID-PH [Accessed 25 July 2022].
6 Goergen, M. (2012) International Corporate Governance,
Pearson.
7 Barca, F. and Becht, M. (2001) The Control of Corporate
Europe, Oxford University Press.
Essays/discussion and articles can be found at the end of Part I.
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144
PART I
THE INTERNATIONAL FINANCIAL ENVIRONMENT
BLADES PLC CASE STUDY
Ethical debate
In a conference call by investors, after publishing the
year-end figures, Ben Holt is accused of exploiting the
workforce in Thailand. He explains that they do not
produce goods in Thailand. The caller who he later
learns is from a British trade union says that this is not
the case. Although Blades technically does not own
the suppliers, Blades is by far and away the biggest
customer of the suppliers. The caller quotes an
email from Blades complaining about the cost of the
components imported and threatening to transfer the
order to Cambodia. The caller quotes the conditions
in one of the major suppliers of rubber and plastic
components in Cambodia and says that they are
considerably worse than in Thailand. This the caller
explains was by British standards already low. Thai
workers did not enjoy anything like the real value of
pay compared with British workers, pension schemes
in the Thai factory were also very poor and in some
cases non-existent. The caller further states that the
poor conditions are poor by Thai standards as well
and that the company is regarded as a poor employer
in Thailand.
Ben Holt is surprised by the call and is worried
that other investors who are sensitive to pressure
gro u p s a n d s om e o f wh o m h a v e a n e t h i c a l
investment policy might be concerned about these
accusations. He therefore decides to make a
reasonably robust defence. First, he says that he
had no idea that Blades was the main customer of
the company and stressed that it had no shares
or other interests other than being a customer.
Second, being the main customer did not mean
that they were the problem; it may be that the other
customers were getting even lower prices. Third,
that he had a duty to shareholders to maximize
returns and obtaining the best value for money
from suppliers was part of that process. One of
the larger investors then responds asking Ben if he
has an ethical purchasing policy. Ben is caught off
guard by this but decides that he had better sound
a bit more sympathetic. He responds that they do
not have an ethical policy per se, but were they to
have matters brought to their attention regarding
the conditions in the factories of their suppliers,
they would certainly look into the matter. The
investor replies that they have recently come under
pressure to ensure that their investments were
ethical and conformed with Islamic principles. He
asks Ben whether he engaged in any form of Islamic
finance. Ben has to be direct with this question and
admits that he does not, though he argues that
he would be sympathetic to any concerns that
their company engaged in practices that might be
considered unacceptable under Islamic principles.
The unionist responds saying that Mr Holt seems
to be sympathetic to a lot of things but only when
they are brought to his attention in a conference
call. His sympathy seems to fade rapidly when
the call is over. He then asked whether he had
any sympathy for the workers and the families
of the workers who had had their employment
terminated at their former UK suppliers. Also
whether he had any sympathy for the Thai workers
and their conditions which were poor even by Thai
standards. Ben Holt replies that the company is
not in a position to rectify these issues and that
it is a matter for governments. He adds that he is
in competition and if he did not seek the lowest
price then a competitor would do so and take
market share away from Blades. He then presses
the point by saying that perhaps the caller should
educate the customers and encourage them not to
purchase goods on the basis of value for money. If
the customer took into account the conditions of
the workers who produced the goods then it would
be a lot easier for Blades to take these issues into
account as well.
After the call Ben Holt asks you as the company
financial analyst to report on the following concerns:
1 Draft out an ethical purchasing policy for Blades
and identify the key cost areas.
2 Ben Holt remembers that on a trip to Thailand the
factory, which is in the south, has mainly Muslim
employees. He asks you whether there is anything
that can be done to make the relationship more
sympathetic to the Muslim faith.
3 Ben Holt is also wondering whether or not it would
be a good idea to have a clear ethical policy that
might combine all of the concerns of the callers.
He is nevertheless concerned about the cost
implications and asks you to investigate the matter.
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CHAPTER 4
INTERNATIONAL ETHICAL CONCERNS
145
SMALL BUSINESS DILEMMA
Obtaining finance
Jim Logan is aware that he might have problems
in refinancing his working capital from his existing
bank as they are now very reluctant to take on any
risky investment. He also knows from a friend that
they have recently been refusing requests to renew
arrangements with firms that Jim thought were
perfectly sound. He notes that an Islamic bank has
recently opened near the Sports Exports Company
and he is wondering whether or not they might be
a future source of funds. The literature they give him
is very similar to his existing bank, but he wonders
whether or not they might be more sympathetic to
an Islamic type loan or financial arrangement. To get
a better idea as to whether Islamic-based finance
would be a possibility or not he asks you to identify
how Islamic finance could help him and his business.
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Part I Integrative problem
The international financial environment
Neptune Ltd, a UK company, exports water pumps to the US. The financial manager, Mr A, reads in the
newspaper that the US intends to raise tariffs on manufactured goods that would include their products.
He suggests that the value of the dollar is likely to fall as a result and hence their products sold in dollars
will convert to fewer UK pounds. To back his hunch, he suggests to the management board that Neptune
take out futures or option contracts to profit from the fall in the dollar and recover some of the reduction
in the UK pound value of their earnings. A member of the board (Ms B) remarks that import elasticity
is remarkably low for these sorts of products and that we should therefore raise our prices immediately.
Finally, Mr C argues that this sort of issue is common and that he agrees with Ms B that the pass through
would not be that great. As they export across the world he suggests that any problem with US tariffs is
likely to be offset by events in other countries and should be ignored.
Questions
1 Explain and discuss the relevance of the efficient markets hypothesis to Mr A’s remarks.
2 What does Ms B mean by import elasticity and how is pass through relevant?
3 How is the concept of a portfolio and the variance covariance matrix relevant to Mr C’s argument?
4 Write a short response to the arguments put forward by A, B and C that offers an overall view and a suggestion
as how the company should react to the threat of tariffs.
146
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Part I Essays/discussion and academic articles
1 Goergen, M., Martynove, M. and Renneboog, L. (2005) ‘Corporate governance: Convergence evidence from
take over regulation reforms in Europe’, Oxford Economic Review, 20(2), 243–68.
Q Evaluate the advantages and disadvantages of the two corporate governance models outlined by Goergen
et al.
2 Woods, N. (2000) ‘The challenge of good governance for the IMF and the World Bank themselves’, World
Development, 28(5), 823–41. A discussion of the problems facing these institutions.
Q From a reading of the Woods article, outline the pressures for reform of the IMF and World Bank. Discuss the
advantages and disadvantages of democratizing decisions.
3 Critin, D. and Fischer, S. (2000) ‘Strengthening the international financial system: Key issues’, World Development,
28(6), 1133–42. The role of the IMF, capital flows and exchange rate regimes.
Q Private sector involvement is essential to economic development, but exchange rate volatility, moral hazard
and capital flow restrictions limit its contribution. Explain and discuss possible solutions.
4 Conway, P. (2006) ‘The International Monetary Fund in a time of crisis: A review of Stanley Fisher’s essays from a
time of crisis – The international financial system and development’, Journal of Economic Literature, 44, 115–44.
Q Reviewing the crises of the 1990s, is the IMF part of the problem? Discuss.
5 Morgan, R. E. and Katsikeas, C. S. (1997) ‘Theories of international trade, foreign investment and firm
internationalization: A critique’, Management Decision, 35(1), 68–78. A clear and relatively brief tour around the
area.
Q What can we reasonably expect from trade and investment theories? Outline and discuss.
6 Cyr, A. I. (2003) ‘The euro: Faith, hope and parity’, International Affairs, 75(5), 979–92. An excellent historical
context and analysis.
Q Consider and evaluate possible future scenarios for the euro.
7 Zoffer, J. (2012) ‘Future of dollar hegemony’, Harvard International Review, 34(1), 26–9.
Q Is the dominance of the dollar good or bad for international development?
8 Rosenthal, J. (2012) ‘Germany and the euro crisis’, World Affairs, May/June, 175(1), 53–61.
Q Has the euro crisis helped in the stated goal of the Maastricht Treaty to promote economic and social cohesion
within the EU?
147
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PART II
Exchange rate
behaviour
A change in exchange rates affects the price of all exports and imports, hence its central role in international finance.
Chapter 5 looks at the practical implications for economies of changes in the exchange rate. As there is no model to fully
explain and predict exchange rate behaviour, it is important to examine the history of exchange rates to show what actually
happened and what can happen in the future; very little in finance is new and this we do in Chapter 6. In Chapter 7 we
examine the models that attempt to predict changes in the exchange rate with the understanding that in an efficient market
such models will always be approximate. Chapter 8 focuses on an important consequence of efficient markets, namely
arbitrage. There should be no certain profits in the exchange rate market and indeed in any market that is efficient, be it
for currencies, bonds, shares or commodities. In Chapter 9 we tease out a further implication of our analysis, namely the
­relationship between exchange rates and inflation (purchasing power parity) and interest rates (international Fisher effect or
uncovered interest rate parity). Again, we point out that in practice the behaviour of exchange rates can be very different.
Relationship enforced by covered interest arbitrage
Existing spot
exchange rate
Relationship enforced by locational arbitrage
Relationship enforced by triangular arbitrage
Existing spot
exchange rate at
other locations
Existing cross
exchange rate
of currencies
Existing
inflation rate
differential
Existing forward
exchange rate
Relationship suggested
by purchasing
power parity
Existing interest
rate differential
Relationship suggested by the
Fisher effect
Relationship suggested by the international Fisher effect
Future
exchange
rate movements
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CHAPTER 5
Exchange rate changes
LEARNING OBJECTIVES
The specific objectives of this chapter are to:
●●
Explain how exchange rate movements are measured.
●●
Explain the effect of demand and supply on exchange rates.
●●
Examine a range of economic factors which may explain changes in the exchange rate from a market
perspective. Theoretical models are developed later in Chapters 8 and 9.
Financial managers of MNCs must continuously monitor exchange rates because their cash flows are highly dependent
on changes in the rates. In a matter of days the value of a currency can fall by 5 per cent, 10 per cent or more. As
a result, a potentially profitable contract or transaction can become unprofitable unless the risk has been managed
in some way so that the effect is lessened without making the underlying business unprofitable. Financial managers
therefore need to understand what factors influence exchange rates so that they can anticipate how exchange rates
may change in response to specific conditions. This chapter provides a foundation for understanding how exchange
rates are determined.
150
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CHAPTER 5
Exchange rate changes
151
Measuring exchange rate movements
The actual exchange rate, be it 100 Japanese yen to the UK pound or $1.5 dollars to the UK pound, is
of itself not significant. An analogy is whether you measure your height in millimetres or inches or your
weight in pounds or kilos: the different measures represent the same height and the same weight. So it is
with currencies; the different units do not make things more or less valuable. The Japanese like to measure
value in pennies approximately and the dollar in units of about 66 pence. What matters is the change in
value of the currency because this means that all the goods being sold in that currency will become either
more or less expensive. For that reason we focus in this chapter on the change in exchange rates and by
implication the change in the value of foreign currency.
The home currency price of all imports, exports and international investments being sold in a foreign
currency is subject to the change in value of the foreign currency itself. As is often forgotten by students,
such transactions are subject to two prices that can potentially change:
1 The price of the investment or import in foreign currency terms.
2 The ‘price’ of the currency as determined by the exchange rate.
For exports denominated in home currency, as when a UK company sells goods priced in UK pounds,
items 1 and 2 will apply to the foreign importer. If the UK company denominates the exports in the
currency of the foreign importer, for example pricing its goods in euros if selling to France, then the UK
exporter is taking on the risk of a change in the exchange rate.
In general, the exchange rate changes far more over time than the price of goods in the local currency.
Hence exchange rate movements are central to international finance.
EXAMPLE
Blue UK Ltd sells apples to France at £10.50 per 100
apples. A regular order from a French supermarket
is for 5,000 a week over the season and is priced
at £525. The exchange rate in the first week is
£0.88:€1 and therefore costs the French supermarket
£525/0.88 = €596.59. The next week the exchange
rate is £0.85:€1, so the cost to the French
supermarket is now £525/0.85 = €617.65 an increase
of 617.65/596.59 –1 = 0.0353 or 3.53 per cent. Blue
UK Ltd therefore thinks about lowering its selling
price to £10.20 per 100 apples. The order would then
cost £510 and in euros would be £510/0.85 = €600,
an increase in the French supermarket’s bill of €3.41
as opposed to €21.06 if Blue UK Ltd did not lower
its price. The net effect of the change is sometimes
referred to as pass through.
A decline in a currency’s value is often referred to as depreciation or devaluation. When the British pound
depreciates against the US dollar, this means that the US dollar is strengthening relative to the pound. More
pounds will be needed to buy a dollar. The increase in a currency value is often referred to as appreciation.
Unless stated otherwise, exchange rates will always be considered as direct quotations (Chapter 3), that is,
how many units of home currency to one unit of foreign currency. Thus the exchange rate is a price of foreign
currency and is in that way much like any other price. When a foreign currency’s spot rates are compared at
two specific points in time, the spot rate at the more recent date is denoted as St and the spot rate at the earlier
date is denoted as St21. The percentage change in the value of the foreign currency is computed as follows:
Percentage change in a foreign currency value 5
St 2 St 2 1
3 100
St 2 1
St
St 2 1
St
2
5
2 1. This formulation is better in that no brackets are
St 2 1
St 2 1
St 2 1
needed when using a calculator – a common mistake being to forget the brackets.
which breaks down into
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152
PART II
EXCHANGE RATE BEHAVIOUR
Using direct exchange rates a positive percentage change indicates that the foreign currency has
appreciated, while a negative percentage change indicates that it has depreciated. As has been indicated,
the values of currencies can vary greatly over a short time. For popular currencies there will be changes
every day, indeed every hour on the foreign currency exchanges. Taking the dollar as an example, on some
days, most foreign currencies appreciate against the dollar, although by different degrees. On other days,
most currencies will depreciate against the dollar, but by different degrees. There are also days when some
currencies appreciate while others depreciate against the dollar; the media describe this scenario by stating
that ‘the dollar was mixed in trading’.
Exhibit 5.1 shows the dollar (USD) changing against the euro (EUR), the Japanese yen (JPY) and the
British pound (GBP) and how it might be described in the markets.
EXHIBIT 5.1
Daily percentage changes in the value of the UK pound (GBP) for 20 trading days in 2021
0.6
0.4
0.2
0
-0.2
-0.4
-0.6
-0.8
-1
-1.2
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21
a
c
b
GBPJPY
GBPEUR
GBPUSD
Notes:
a = a sharp rise in the value of the UK pound (a 0.4 per cent rise in one day is approximately 171 per cent in a year).
b = mixed trading.
c = a sharp fall in the value of the UK pound.
EXAMPLE
Suppose a South African family on 21 August prepaid
their €2,000 winter holiday in France. That would have
cost the family 41,160 Rand, given an exchange rate
of EURZAR 20.58. One year later the same bill would
have cost 35,800 rand, the value of the euro having
fallen to 17.90 rand. This represents a reduction of
13 per cent (35,800/41,160 – 1) solely due to the
exchange rate.
It is important to understand the forces that can cause an exchange rate to change over time – the
example illustrates some of the issues. MNCs that understand how currencies might be affected by existing
forces can prepare for possible adverse effects on their expenses or revenue and may be able to reduce the
impact on their profits.
Exchange rate movements – an overview
Although it is easy to measure the percentage change in the value of a currency, it is more difficult to
explain why the value changed or to forecast how it might change in the future. In this chapter we take
a practical approach; in Chapters 8 and 9 we review the academic models of exchange rate movements.
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Before we consider motives, it is helpful just to think of the demand and supply for a foreign currency and
the relationship of that demand and supply to the exchange rate. In this respect it is much like any other
price with the important exception that the supply of a currency is potentially infinite; ‘printing’ money is
not expensive.
Demand for a currency
The UK demand for the US dollar is used here to explain exchange rate equilibrium. Exhibit 5.2
shows a hypothetical number of dollars that would be demanded under various possibilities for the
exchange rate. At any one point in time, there is only one exchange rate. The exhibit shows the
quantity of dollars that would be demanded by UK pounds at various exchange rates. The demand
schedule is downward sloping because UK corporations will be encouraged to purchase more US
goods when the dollar is worth less, as it will take fewer British pounds to obtain the desired amount
of dollars.
EXHIBIT 5.2
UK demand schedule for US dollars
Price of dollar
Dollar expensive – low demand for dollars
to buy US goods and invest in the US
£0.625
£0.600
Demand curve
£0.575
Dollar cheap – high demand for dollars
to buy US goods and invest in the US
Quantity of dollars
demanded by pounds
Note:
• Moving from an exchange rate of £0.625:$1 to £0.575:$1, US goods are (0.575 ] 0.625)/0.625 5 ]0.08, or 8 per cent, cheaper.
Supply of a currency for sale
Up to this point, only the UK demand for dollars has been considered, but the US demand for British pounds
must also be considered. From the UK perspective, the US demand for the British pound results in a supply
of dollars for sale, since dollars are supplied in the foreign exchange market in exchange for British pounds.
A supply schedule of dollars for sale in the foreign exchange market can be developed in a manner
similar to the demand schedule for dollars. Exhibit 5.3 shows the quantity of dollars for sale (supplied
to the foreign exchange market in exchange for pounds) corresponding to each possible exchange rate.
Notice from the supply schedule in Exhibit 5.3 that there is a positive relationship between the value of the
US dollar in British pounds and the quantity of US dollars for sale (supplied), which can be explained as
follows. When the dollar is valued highly, US consumers and firms are more likely to purchase UK goods.
Thus, they supply a greater number of dollars to the market, to be exchanged for pounds. Conversely,
when the dollar is valued low, the supply of dollars for sale is smaller, reflecting less US desire to obtain the
relatively more expensive UK goods.
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EXHIBIT 5.3
EXCHANGE RATE BEHAVIOUR
US supply schedule for British pounds
Dollar expensive, so one dollar buys more
British pounds. UK goods therefore cheap –
high supply of dollars to purchase UK goods
Price of dollar
£0.625
Supply curve
£0.600
£0.575
Dollar cheap, so one dollar buys fewer
British pounds. UK goods therefore expensive –
low supply of dollars to purchase UK goods
Quantity of dollars
supplied for pounds
Notes:
• Adding some figures to the relationship, moving from an exchange rate of £0.625:$1 to £0.575:$1 means that for holders of US dollars the British pound will
have increased in cost from $1.60:£1 to $1.74:£1, an increase of (1.74 2 1.60)/1.60 ≈ 0.0875 or 8.75 per cent, hence a low supply of dollars (note that these
rates are the inverse of the $ rates, i.e. £0.625:$1 implies $1.60:£1 as 1/0.625 5 1.60 and 1/0.575 ≈ 1.74; refer to direct and indirect rates in Chapter 3).
• Compare these notes with the note in Exhibit 5.2. For exactly the same change in exchange rates from £0.625:$1 to £0.575:$1, US goods have
become 8 per cent cheaper for holders of British pounds; whereas UK goods have become 8.75 per cent more expensive for holders of US dollars.
Surely the percentage changes should be the same? In fact they are not, and the difference is known as Siegal’s Paradox and is currently thought
to be of little consequence other than in explaining differences between calculations of the same events but viewed from differing home currencies.
Equilibrium
The demand and supply schedules for pounds by US dollars are combined in Exhibit 5.4. At an exchange
rate of £0.575:$1, the quantity of dollars demanded would exceed the supply of dollars for sale.
Consequently, banks providing foreign exchange services would experience a shortage of dollars at that
exchange rate. At an exchange rate of £0.625:$1, the quantity of dollars demanded would be less than
the supply of dollars for sale. Therefore, banks providing foreign exchange services would experience
a surplus of dollars at that exchange rate. According to Exhibit 5.4, the equilibrium exchange rate is
£0.600:$1 because this rate equates the quantity of dollars demanded with the supply of dollars for sale.
EXHIBIT 5.4
Equilibrium exchange rate determination
Dollar price
Supply curve
£0.625
£0.600
£0.575
Demand curve
Quantity of dollars
Note:
• The quantity of dollars now represents dollars demanded by British pounds and dollars offered or supplied for British pounds.
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Impact of liquidity. For all currencies, the equilibrium exchange rate is reached through transactions in
the foreign exchange market, but for some currencies, the adjustment process is more volatile than for
others.
If the currency’s spot market is liquid, its exchange rate will not be highly sensitive to a single large
purchase or sale of the currency; such markets are termed ‘deep’. Therefore, the change in the equilibrium
exchange rate will be relatively small and the currency movement will not be volatile. With many willing
buyers and sellers of the currency, transactions can be easily accommodated at the given rate. Conversely,
if the currency’s spot market is illiquid, its exchange rate may be highly sensitive to a single large purchase
or sale transaction. There are not sufficient buyers or sellers to accommodate a large transaction, which
means that the price of the currency must change to attract sufficient buyers and sellers to rebalance
the supply and demand for the currency. Consequently, illiquid currencies tend to exhibit more volatile
exchange rate movements, as the equilibrium prices of their currencies adjust to even minor changes in
supply and demand conditions. Ideally, markets should be deep and broad. A deep market is liquid and
can cope with large transactions. A broad market has many different views as to the correct market price
and is not going to overreact to information. Therefore, breadth is also important to stability.
Factors that influence exchange rates
In the short run relatively little is known as to why exchange rates change beyond journalistic type
speculation as to the reasons – often delivered in an authoritative manner! The truth is that there is no
reliable systematic means of explaining short-run movements. This state of affairs is sometimes referred to
as the real exchange rate puzzle or the purchasing power puzzle. Why is it that the exchange rate changes
so often when information about a change in the explanatory variables such as inflation and interest rates
is far less frequent?
The equilibrium exchange rate will change over time as supply and demand schedules change; in fact
the equilibrium changes every day and every second of every day. As our understanding of the causes does
not explain actual movements very well, we should not think of equilibrium as a kind of steady state. All
that can be achieved with the current state of knowledge is a set of candidate causes, most of which are
medium to long term. The following equation summarizes the factors that can influence a currency’s spot
rate:
e 5 f(DINF, DINT, DINC, DGC, DEXP)
Where:
5 percentage change in the spot rate
5 Greek letter for delta where ‘d’ stands for difference or change
5 change in the differential between UK inflation and the foreign country’s inflation
5 change in the differential between the UK interest rate and the foreign country’s interest rate
5 change in the differential between the UK income level and the foreign country’s income
level
∆GC 5 change in government controls
∆EXP 5 change in expectations of future exchange rates
e
∆
∆INF
∆INT
∆INC
Relative inflation rates
The main explanation offered for exchange rate changes is due to differences in inflation. It is a flawed
explanation as it is clear from Exhibit 5.1 that inflation does not move like that on a daily basis, neither
as we have said do expectations about exchange rates. Nevertheless, changes in relative inflation rates can
affect international trade activity, which influences the demand for and supply of currencies and therefore
influences exchange rates.
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EXAMPLE
Consider how the demand and supply schedules
displayed in Exhibit 5.4 would be affected if UK inflation
suddenly increased substantially while US inflation
remained the same. (Assume that both British and US
firms sell goods that can serve as substitutes for each
other.) The sudden jump in UK inflation should cause
an increase in the UK demand for US goods, as they
would be cheaper at the original exchange rate, leading
to an increase in the UK demand for US dollars.
In addition, the jump in UK inflation should reduce
the US desire for British goods and therefore reduce
the supply of dollars wanting British pounds. These
market reactions are illustrated in Exhibit 5.5. The
increased UK demand for dollars and the reduced
supply of dollars for sale place upward pressure on
the value of the dollar. According to Exhibit 5.5, the
new equilibrium value is £0.610:$1.
EXHIBIT 5.5
If US inflation increased (rather than UK inflation),
the opposite forces would occur. Assume there is a
sudden and substantial increase in US inflation while
UK inflation is low. Based on this information, answer
the following questions: (1) How is the demand
schedule for dollars affected? (2) How is the supply
schedule of dollars for sale affected? (3) Will the new
equilibrium value of the pound increase, decrease
or remain unchanged? Based on the information
given, the answers are (1) the demand schedule for
dollars should shift inward, (2) the supply schedule
of dollars for sale should shift outward, and (3) the
new equilibrium value of the dollar will decrease. Of
course, the actual amount by which the dollar’s value
will decrease depends on the magnitude of the shifts.
There is not enough information to determine their
exact magnitude.
Impact of rising UK inflation on the equilibrium value of the US dollar
Dollar price
Supply curve 2
Supply curve 1
£0.625
£0.610
£0.600
£0.575
Demand curve 2
Demand curve 1
Quantity of dollars
Note:
• The equilibrium rate changes from £0.600:$1 to £0.610:$1.
In reality, the actual demand and supply schedules, and therefore the true equilibrium exchange rate, will
reflect several factors simultaneously. The point of the preceding example is to demonstrate how to logically
work through the mechanics of the effect that higher inflation in a country can have on an exchange rate. Each
factor is assessed one at a time to determine its separate influence on exchange rates, holding all other factors
constant. Then, all factors can be tied together to fully explain why an exchange rate moves the way it does.
Relative interest rates
Changes in relative interest rates affect investment in foreign securities, which influences the demand for
and supply of currencies and therefore influences exchange rates.
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EXAMPLE
Assume that UK interest rates rise while US interest
rates remain constant. In this case, UK investors are
likely to reduce their demand for dollars, since UK
rates are now more attractive relative to US rates, and
there is therefore less desire for US bank deposits.
Because UK rates will now look more attractive to US
investors with excess cash, the supply of dollars for
sale by US investors should increase as they establish
more bank deposits in the UK. Due to an inward shift
in the demand for dollars and an outward shift in the
EXHIBIT 5.6
supply of dollars for sale, the equilibrium exchange
rate or the value of the dollar should decrease. This
is graphically represented in Exhibit 5.6. If UK interest
rates decreased relative to US interest rates, the
opposite shifts would be expected. This movement
assumes that the expected change in the exchange
rate would not wholly offset the higher interest rate. In
effect the assumption is that the International Fisher
Effect (Uncovered Interest Parity) does not hold. This
form of trading is known as the carry trade.
Impact of rising UK interest rates on the equilibrium value of the US dollar in terms of British pounds
Dollar price
Supply curve 1
£0.625
Supply curve 2
£0.600
£0.575
Demand curve 1
Demand curve 2
Quantity of dollars
Notes:
• Demand and supply curves move from curve 1 to curve 2.
• Demand for dollars falls as home investments now seem relatively more attractive.
• Dollars supplied for British pounds increases in order to purchase UK securities offering the higher interest rate.
In some cases, an exchange rate between two countries’ currencies can be affected by changes in
a third country’s interest rate, again assuming that the International Fisher Effect (Uncovered Interest
Parity) does not hold.
EXAMPLE
When the euro interest rate increases, it can become
more attractive to UK investors than the US rate. This
encourages UK investors to purchase fewer dollardenominated securities. Thus, the demand for dollars
would be smaller than it would have been without the
increase in euro interest rates for all given exchange
rates, which places downward pressure on the value
of the dollar in terms of the British pound.
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It must be remembered that portfolio investment flows are very large in the international money
markets, so interest rates will therefore be an important part in determining the value of a currency.
Real interest rates. High interest rates on their own cannot be the only factor in determining the value
of a currency, otherwise the currency offering the highest interest rate would attract all investment. So
there must be factors that make a manager of a portfolio refrain from investing all funds in the currency
offering the highest interest rate. That factor is a concern since although the interest rate is higher, there
could well be an offsetting fall in the value of the currency with the higher interest rate. So if the UK is
offering a risk-free rate of 5 per cent on the British pound and the US is offering a rate of 3 per cent on
the US dollar, a US portfolio manager who decides not to invest in the UK must be expecting the British
pound to lose value against the dollar by at least 2 per cent (calculated as 5% 2 3% 5 2%), so that the net
returns from investing in the UK would be the 5 per cent from the investment less at least the 2 per cent
loss in the value of the British pound. The net return would therefore be no more than 5% 2 2% 5 3%,
the same as investing in the US. So a higher interest rate would not attract all international investments
as many investors would think that there is likely to be an even greater offsetting fall in the value of the
currency.
Such reasoning leads to the question as to why the value of the British pound should be expected to
fall if interest rates are higher? US economist Irving Fisher suggested that interest rates were compensation
for three elements: time, risk and inflation. Time and risk elements of the interest rate (known as the
real interest rate) should be the same between the US and the UK; the only rationale for a difference
according to Fisher is therefore inflation. If, for example, interest rates are expected to be higher in the
UK after adjustment for inflation (i.e. higher expected real interest rates), there will be an increased supply
of dollars for British pounds and a reduced demand for dollars by British pounds as investment prefers
the UK to the US. As shown in Exhibit 5.6 there would be a consequent leftward shift in the demand for
dollars and a rightward shift in the supply of dollars for British pounds resulting in a fall in the value of
the dollar – the details are discussed in Chapter 8.
The US portfolio manager should, by this reasoning, only invest in the UK if they feel that the interest
rate less inflation (or real interest rate) is going to be higher in the UK than in the US. For the US portfolio
manager, countries with higher expected real interest rates are offering a higher return after allowing
for loss in currency value due to higher expected inflation. The currencies of such countries should
be attractive and increase in value, though not all managers will agree, so the rise will be limited. But
where a higher interest rate does not offset an expected fall in the currency value due to inflation, the
overall return will be less than home investment. Note that purchasing power parity theory (Chapter 9)
argues that exchange rates should exactly offset differences in inflation. The differences in inflation should
in turn reflect differences in interest rates, so in theory this form of trading should not result in profits.
The evidence is, however, that exchange rate movements are poorly correlated with differences in interest
and inflation rates. Exceptions to this finding are, first, in the long term, longer trading periods than those
being considered here and, second, in extreme cases of hyperinflation where economic instability becomes
a dominating concern.
We can say that exchange rates should adjust to inflation and interest rate differences but, as we have
pointed out, simply a change in expectations about these values without any actual change can bring
about a change in the rate. Unsurprisingly, in practice, there is a large trade on the financial markets
known as the carry trade, whereby traders borrow in low interest countries and invest in higher interest
countries in the belief that currency movements will not offset interest rate differences. Borrowing in
yen and investing in US dollars has been quite a frequent direction of trade. The trade is risky, however,
in that the investment is converted back at the prevailing spot rate at the time and losses as well as
profits can be made. But whenever governments attempt to manage interest rates or exchange rates they
will indirectly fund the profits of financial institutions that identify the misalignment and engage in the
carry trade.
Relative income levels
A third factor affecting exchange rates is relative income levels. Because income can affect the amount of
imports demanded, it can affect exchange rates.
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EXAMPLE
Assume that the UK income level rises substantially
while the US income level remains unchanged.
Consider the impact of this scenario on: (1) the
demand schedule for dollars, (2) the supply schedule
of dollars for sale and (3) the equilibrium exchange
rate. First, the demand schedule for dollars will shift
EXHIBIT 5.7
rightwards, reflecting the increase in UK income and
therefore increased demand for US goods. Second,
the supply schedule of dollars for sale is not expected
to change as the US income level is constant.
Therefore, the equilibrium exchange rate and value of
the dollar are expected to rise, as shown in Exhibit 5.7.
Impact of rising UK income levels relative to the US on the equilibrium value of the US dollar
Dollar price
Supply curve
£0.625
£0.600
£0.575
Demand curve 2
Demand curve 1
Quantity of dollars
Note:
• Increase in UK income increases demand for goods generally including US imports, hence the higher demand for dollars.
Changing income levels can also affect exchange rates indirectly through effects on interest rates. When
this effect is considered, the impact may differ from the theory presented here, as will be explained shortly.
Government controls
A fourth factor affecting exchange rates is government controls. The governments of foreign countries can
influence the equilibrium exchange rate in many ways, including: (1) imposing foreign exchange barriers,
(2) imposing foreign trade barriers, (3) intervening (buying and selling currencies) in the foreign exchange
markets, and (4) affecting macro variables such as inflation, interest rates and income levels. Chapter 6
covers these activities in detail.
EXAMPLE
Suppose US real interest rates rose relative to British
real interest rates. The expected reaction would be
an increase in the British supply of pounds for sale
to obtain more US dollars (in order to capitalize on
high US money market yields). Yet, if the British
government placed a heavy tax on interest of
income earned from foreign investments, this could
discourage the exchange of pounds for dollars.
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Expectations
A fifth factor affecting exchange rates is market expectations. Like other efficient financial markets,
foreign exchange markets react immediately to any news that may have a future effect on demand
and supply. By definition in finance, news is information that differs from expectations. This further
complicates relationships in that an announcement of high inflation in the US, if unexpected, may cause
currency traders to sell dollars, anticipating a future decline in the dollar’s value. But if the high inflation
was less than expected then traders may buy dollars because the situation is better than at first thought.
If in line with expectations, there may be no movement. So, an announcement of high inflation could
have a positive, negative or no effect on the value of the dollar. The solution is that when analyzing the
effect of factors on the value of a currency, the ‘measure’ should always be the difference between actual
and expectations. Unfortunately, as we have stated previously, expectations are hard to measure and
for the most part academic models in using actual values implicitly assume that any actual change was
unexpected. This is therefore a source of further inaccuracy in academic models, as we do not really know
whether or not an actual change in causal factors (interest rates, inflation rates, exports, imports, etc.) was
expected.
EXAMPLE
Investors may temporarily invest funds in France if
they expect euro interest rates to increase. Such a
rise may cause further capital flows into the euro area,
which could place upward pressure on the euro’s
value. By taking a position based on expectations,
investors can fully benefit from the rise in the euro’s
value because they will have purchased euros before
the change occurred. Although the investors face the
obvious risk that their expectations may be wrong,
the point is that expectations can influence exchange
rates because they commonly motivate institutional
investors to take foreign currency positions.
Impact of signals on currency speculation. Day-to-day speculation on future exchange rate movements is
commonly driven by signals of future interest rate movements, but it can also be driven by other factors.
Signals of the future economic conditions that affect exchange rates can change quickly, so the speculative
positions in currencies may adjust quickly, causing unclear patterns in exchange rates. It is not unusual for
the dollar to strengthen substantially on a given day, only to weaken substantially on the next day. This can
occur when speculators overreact to news on one day (causing the dollar to be overvalued), which results in
a correction on the next day. Overreactions occur because speculators are commonly taking positions based
on signals of future actions (rather than the confirmation of actions), and these signals may be misleading.
When speculators speculate on currencies in emerging markets, they can have a substantial impact on
exchange rates. Those markets have a smaller amount of foreign exchange trading for other purposes
(such as international trade) and therefore are less liquid than the larger markets.
The abrupt decline in the Russian rouble on some days during 1998 was partially attributed to
speculative trading (although the decline might have occurred anyway over time). The decline in the
rouble also created a lack of confidence in other emerging markets and caused speculators to sell off other
emerging market currencies, such as those of Poland and Venezuela. The market for the rouble is not very
active, so a sudden shift in positions by speculators can have a substantial impact. In June 2012 hedge
funds were reported as taking out large short positions on the euro (borrowing in euros, selling them for,
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say, dollars, then repaying the euro loan at the expected lower euro rate). In fact, the euro increased in
value against the dollar over the next six months, as much due to problems with the dollar.
Speculation
If as Eugene Fama states that ‘security prices fully reflect all available information’1 (note that a currency
is a security, as it is a promise of value), then it could be that the information might be what other
investors are doing. John Maynard Keynes famously referred to this as analogous to a beauty contest
where votes are cast on the basis of what other people think is beauty rather than what they think. This
form of social self-referencing is the basis of speculation. If you believe that other people believe that
bitcoins are a good investment, then you might invest purely on that belief, even though your views may
differ. The price can consequently rise based on social behaviour rather than economic value. In the case
of shares, the term meme stocks refers to stocks whose share price varies wildly due to rumours among
retail (non-professional) investors. Such behaviour can also be found among some currency traders who,
for example, believe that a currency that rises three days in a row will fall the next day purely because it
rose on consecutive days. There is no evidence that this is consistently the case, in fact the more common
finding is that on the fourth day the currency is as likely to go up in value as to go down. This finding
agrees with the expectations view of prices and the efficient markets hypothesis – expectations for a
future point in time are randomly better or worse than the actual outcome. Nevertheless, there is a whole
investment community that indulges in what is termed technical analysis based on this form of social
psychology and is part of the more general approach termed behavioural finance. In general we can say
that purely speculative changes in price based on no economic information obviously does happen but
not on a consistent basis. There is no doubt a continuing small proportion of speculative buying and
selling, but the main part of any trading movement is based on economic data leading to a change in
expectations.
Order flow models
Traditional models assume that information affects the market instantaneously and that the market
is of one judgement or opinion; this is termed homogenous expectations. Thus, using an example in
Evans and Lyons (2008),2 suppose that a scheduled announcement on US growth is generally seen as
better than expected. Traditional models assume that the market will agree that the value of the dollar
should increase by x per cent and there will be instantaneous adjustment and no more. The homogenous
expectations mean that there is in effect only one opinion in the market and hence that there should be
only one adjustment, this is obviously an oversimplification.
Order flow models take a closer look at the market participants. First, however, it is worthwhile
taking a more general overview. The Bank for International Settlements in its most recent Triennial
Survey at the time of writing reported spot market participants samples in April 2019 as: dealers
18 per cent, other financial institutions 38 per cent, non-reporting banks 14 per cent, institutional
investors 10 per cent, hedge funds 8 per cent, official sector 1 per cent, others 6 per cent and nonfinancial 5 per cent. 3 Note the very small quantitative role of governments. Participants by motive
can be divided into spot traders, hedgers, speculators, arbitrageurs and governments. MNCs can be
classified as spot traders and hedgers. As spot traders, they are converting currencies to support trading
and investing activities; as hedgers, they are buying and selling derivatives to protect against adverse
currency movements. MNCs typically buy derivatives and need a counterparty to sell derivatives;
speculators can fill that role.
Order flow models classify these market traders into three types: dealers who are simply acting as
intermediaries between buyers and sellers in the manner of any dealer, informed traders and uninformed
traders. There will be traders who think that the adjustment in the value of the dollar was too big and some
that it was not big enough. Uninformed traders may react to the buying and selling of the informed traders.
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Dealers may find themselves temporarily short of a currency and so improve their bid price. Taken together,
you can expect secondary movements in the price of the dollar reacting to the original movement. This
creates an order flow as the demands to buy and sell arrive on the screens. This in turn is seen by traders
along with the names of the buyers and sellers. As we have said, some of these parties may be regarded as
being very knowledgeable and may even have insider information (or at least may be suspected of having
such information). The actions of a central bank would be one such example. Their actions would unleash
a further round of adjustments that is a reaction to the market reaction to the original price movement. In
some respects this begins to look like a Keynesian beauty contest.4 Uninformed traders may react to the
way they think the market reacts, such as ‘the market always overreacts to these types of rallies’; behaviour
as well as information affects the price. A single adjustment is an over-simplification of the actual process.
This more detailed analysis of the market microstructure means that many more of the movements in a
currency value can be attributed to a piece of news. Traditional models looking at the impact of news on
currency values5 really only established that news did have an impact, but failed to account for all but a
small percentage of the changes in value. That the changes were so much more than could be accounted
for by assuming a single adjustment was deemed to be a puzzle.6 This analysis offers an explanation
of more of the changes than previously. Using intraday data, that is trades within the day at 5 minute
intervals, Evans and Lyons conclude that about 36 per cent of the variations of intraday data, being
both the direct and the indirect effects, can be accounted for by macro news, a much greater figure than
previous studies.
Order flow can be news in itself and it is said that banks regularly trade on such information as large
orders for a particular currency.7 Dealers are also not all equally informed. Those in financial centres
appear to do better than elsewhere, the suspicion being that they are using private information. 8
Intriguingly, corporate order flows have been found to be more predictive of longer-term movements and
financial order flow more predictive of movements in high frequency trading.9
There are also non-news effects such as temporary illiquidities in the market that can change prices;
thus there are some small elasticity effects (changes in order quantities driving the price). Whether this
approach can explain further issues such as bubbles and crashes remains to be seen.
Interaction of factors
Transactions within the foreign exchange markets facilitate either trade or financial flows. Trade-related
foreign exchange transactions are generally less responsive to news. Financial flow transactions are very
responsive to news, however, because decisions to hold securities denominated in a particular currency are
often dependent on anticipated changes in currency values. Sometimes trade-related factors and financial
factors interact and simultaneously affect exchange rate movements.
It is important to note that it is better to measure the effect of changes in explanatory variables rather
than their absolute value. This is a subtle but important point termed detrending in statistics (Chapter 9).
Inflation and interest rates are changes and so do not need any further adjustment. However, many other
factors such as GDP, the stock market index and the volume of trade tend to move in line with each
other, typically increasing over time. Unsurprisingly, statistics find it very difficult to separate these values
in any multiple regression type modelling. To overcome this problem you should look at changes in the
explanatory variables. Therefore, the change in GDP and the change in the market index should be used in
assessing their effect on changes in the value of a particular currency, not their absolute value.
An increase in income levels sometimes causes expectations of higher interest rates. So, even though
a higher income level can result in more imports, it may also indirectly attract more financial inflows
(assuming interest rates increase). Because the favourable financial flows may overwhelm the unfavourable
trade flows, an increase in income levels is frequently expected to strengthen the local currency.
Exhibit 5.8 separates payment flows between countries into trade-related and finance-related flows and
summarizes the factors that affect these flows. Over a particular period, some factors may place upward
pressure on the value of a foreign currency while other factors place downward pressure on the currency’s
value. The exact relationship between factors in practice is unclear, allowing subjective processes such as
market judgement to be significant in estimating future currency values.
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CHAPTER 5
EXHIBIT 5.8
163
Exchange rate changes
Summary of factors affecting exchange rates
Trade-related factors
Inflation differential
UK demand for
foreign goods
UK demand for
the foreign
currency
Foreign demand
for UK
substitutes
Supply of the
foreign currency
for sale
Income differential
Government trade
restrictions
Exchange rate
between the
foreign currency
and the pound
Financial factors
Interest rate differential
Capital flow restrictions
Market factors
Information
UK demand for
foreign securities
UK demand for
the foreign
currency
Foreign demand
for UK
securities
Supply of the
foreign currency
for sale
Dealers,
informed
traders,
uninformed
traders
Order flow
The sensitivity of an exchange rate to these factors is dependent on the volume of international transactions
between the two countries. If the two countries engage in a large volume of international trade but a very
small volume of international capital flows, the relative inflation rates will likely be more influential. If the two
countries engage in a large volume of capital flows, however, interest rate fluctuations may be more influential.
EXAMPLE
Assume the simultaneous existence of: (1) a sudden
increase in UK inflation and (2) a sudden increase in UK
interest rates. If the US economy is relatively unchanged,
the increase in UK inflation will place upward pressure
on the dollar’s value while the increase in UK interest
rates places downward pressure on the dollar’s value.
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164
PART II
EXCHANGE RATE BEHAVIOUR
EXAMPLE
Assume that Morgan AG, a German-based MNC,
commonly purchases supplies from Venezuela and
Bahrain and therefore desires to forecast the value
of the Venezuelan bolivar and the Bahrainian dinar in
terms of euros.
Assume that Germany and Venezuela conduct
a large volume of international trade but engage in
minimal capital flow transactions. Venezuelan inflation
is expected to be 5 per cent higher than in Germany.
Also, assume that Germany and Bahrain conduct
very little international trade but frequently engage in
capital flow transactions. Interest rates are expected
to be 2 per cent higher in Germany than in Bahrain.
What should Morgan expect regarding the future
value of the Venezuelan bolivar and the Bahrainian dinar?
The bolivar should be influenced most by traderelated factors because of Venezuela’s assumed
heavy trade with Germany. The expected inflationary
changes should place downward pressure on the
value of the bolivar. Interest rates are expected to
have little direct impact on the bolivar because of the
assumed infrequent capital flow.
The Bahrainian dinar should be most influenced
by interest rates because of Bahrain’s assumed
heavy capital flow transactions with Germany. The
expected interest rate changes should place upward
pressure on the value of the euro in terms of the dinar.
The inflationary changes are expected to have little
direct impact on the dinar because of the assumed
infrequent trade between the two countries.
Capital flows, being in the main the international buying and selling of shares and bonds, have become
larger over time and can easily overwhelm trade flows. For this reason, the influence of factors such as
inflation on interest rates has become increasingly important.
An understanding of exchange rate equilibrium does not guarantee accurate forecasts of future exchange
rates because that will depend in part on how the factors that affect exchange rates will change in the future.
Even if analysts fully realize how factors influence exchange rates, they may not be able to predict how
those factors will change. Even if they can predict factors such as future economic growth and inflation, the
effect on the exchange rate is not clear in that it is the difference with market expectations that affects the
exchange rate. A high growth prediction may have a negative effect on the value of the currency if the
growth rate is lower than existing expectations. Estimating whether or not economic growth is higher or
lower than market expectations is even harder than trying to predict those variables on their own.
USING THE WEB
Impact of exchange rates on the accounts of Danone
Search online for ‘Danone Consolidated financial statements and related notes Year ended December
31, 2020’ and use the search term ‘exchange’ to gauge the effect of exchange rates on translating foreign
valuations, the use of derivatives and financing.
Speculating on anticipated exchange rates
Many commercial banks attempt to capitalize on their forecasts of anticipated exchange rate movements
in the foreign exchange market, as illustrated in this example.
1 The European Bank expects the exchange rate of the New Zealand dollar (NZ$) to appreciate from its
present level of €0.50 to €0.52 in 30 days. This is an increase in the value of the New Zealand dollar of
4 per cent (i.e. 0.52/0.5 2 1 5 0.04) over 30 days or an annualized increase of 60 per cent (i.e. using the
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CHAPTER 5
165
Exchange rate changes
exact method, 1.04360/30 2 1 5 0.601; note that for large interest rates the simple method and exact method
give widely differing rates). This is greatly in excess of the difference in interest rates, so the strategy is clear:
buy into the New Zealand dollar and gain from the expected increase in value.
2 The European Bank is able to borrow $20 million on a short-term basis from other banks.
3 Present short-term interest rates (annualized) in the interbank market are as follows:
Currency
Lending rate
Borrowing
Euro
6.72%
7.20%
New Zealand dollar (NZ$)
6.48%
6.96%
Because brokers sometimes serve as intermediaries between banks, the lending rate differs from the
borrowing rate. Given this information, the European Bank could:
1 Borrow €20 million.
2 Convert the €20 million to NZ$40 million (computed as €20,000,000/0.50).
3 Lend the New Zealand dollars at 6.48 per cent annualized, which represents a 0.54 per cent return over the
30-day period [computed as 6.48 per cent 3 (30/360)]. After 30 days, the bank will receive NZ$40,216,000
[computed as NZ$40,000,000 3 (1 1 0.0054)].
4 Use the proceeds from the New Zealand dollar loan repayment (on day 30) to repay the euros borrowed.
The annual interest on the euros borrowed is 7.2 per cent, or 0.6 per cent over the 30-day period [computed
as 7.2 per cent 3 (30/360)]. The total New Zealand dollar amount necessary to repay the loan is therefore
NZ$38,692,308 [computed as €20,000,000 3 (1 1 0.006)/0.52].
5 Given that the bank accumulated NZ$40,216,000 from its New Zealand dollar loan, it would earn a speculative
profit of NZ$1,523,692 (being NZ$40,216,000 2 NZ$38,692,308) or convert it to €792,320 (given a spot rate
of €0.52 per New Zealand dollar on day 30 5 €792,320 3 0.52). The bank would earn this speculative profit
without using any funds from deposit accounts because the funds would have been borrowed through the
interbank market.
A simple schema of the above events is shown below.
1
European Bank
borrows €20m
Interest
at 0.60%
2
Converts 20m/0.50
4
To repay loan needs NZ$38,692,308
at €0.52: NZ$1
€20,120,000 owing
Profit €792,320
5
New Zealand
NZ$40m
3
Invests at
0.54% return
NZ$40,216,000
less NZ$38,692,308
Profit NZ$1,523,692
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PART II
EXCHANGE RATE BEHAVIOUR
If instead the European Bank expects that the New Zealand dollar will depreciate, it can attempt
to make a speculative profit by taking positions opposite to those just described. To illustrate, assume
that the bank expects an exchange rate of €0.48 for the New Zealand dollar on day 30. It can borrow
New Zealand dollars, convert them to euros and lend the euros out. On day 30, it will close out
these positions. Using the rates quoted in the previous example, and assuming the bank can borrow
NZ$40 million, the Bank could take the following steps:
1 Borrow NZ$40 million.
2 Convert the NZ$40 million to €20 million (computed as NZ$40,000,000 3 €0.50).
3 Lend the euros at 6.72 per cent, which represents a 0.56 per cent return over the 30-day period. After
30 days, the bank will receive €20,112,000 [computed as €20,000,000 3 (1 1 0.0056)].
4 Use the proceeds of the euro loan repayment (on day 30) to repay the New Zealand dollars borrowed. The
annual interest on the New Zealand dollars borrowed is 6.96 per cent, or 0.58 per cent over the 30-day
period [computed as 6.96 3 (30/360)]. The total New Zealand dollar amount necessary to repay the loan is
therefore NZ$40,232,000 [computed as NZ$40,000,000 3 (1 1 0.0058)].
5 Assuming that the exchange rate on day 30 is €0.48 per New Zealand dollar as anticipated, the number
of euros necessary to repay the NZ$ loan is €19,311,360 (computed as NZ$40,232,000 3 €0.48 per New
Zealand dollar). Given that the bank accumulated €20,112,000 from its euro loan, it would earn a speculative
profit of €800,640 without using any of its own money (computed as €20,112,000 2 €19,311,360).
Most banks continue to take some speculative positions in foreign currencies. In fact, some banks’
currency trading profits have exceeded $100 million per quarter.
The potential returns from foreign currency speculation are high for banks that have large borrowing
capacity. Nevertheless, foreign exchange rates are very volatile and a poor forecast could result in a large
loss. One of the best-known bank failures, Franklin National Bank, in 1974, was primarily attributed to
massive speculative losses from foreign currency positions.
Summary
●●
The significance of an exchange rate is in its
movement, that is why trade and investment
become more or less expensive. Exchange
rate movements are commonly measured by
the percentage change in their values over a
specified period, such as a month or a year.
MNCs closely monitor exchange rate movements
over the period in which they have cash flows
denominated in the foreign currencies of concern.
●●
The equilibrium exchange rate between two
currencies at any point in time is based on
the demand and supply conditions. Changes
in the demand for a currency or the supply of
a currency for sale will affect the equilibrium
exchange rate.
●●
The key economic factors that can influence
exchange rate movements through their
effects on demand and supply conditions
are relative inflation rates, interest rates and
income levels, as well as government controls.
As these factors cause a change in international
trade or financial flows, they affect the
demand for a currency or the supply of currency
for sale and therefore affect the equilibrium
exchange rate.
●●
The two factors that are most closely monitored
by foreign exchange market participants are
relative inflation and interest rates.
If a country experiences higher inflation than
other countries, its exports should decrease
(demand for its currency decreases), its imports
should increase (supply of its currency increases),
and there is downward pressure on its currency’s
equilibrium value.
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CHAPTER 5
If a country experiences higher real interest
rates (i.e. interest rate returns less expected loss in
currency value due to inflation), the inflow of funds
to purchase its securities should increase (demand
for its currency increases), the outflow of its funds
to purchase foreign securities should decrease
(supply of its currency to be exchanged for foreign
currency decreases), and there is upward pressure
on its currency’s equilibrium value.
●●
Exchange rate changes
167
All relevant factors must be considered
simultaneously to assess the likely movement in a
currency’s value. As well as inflation and interest
rates, economic news, business news and also
differences of opinion in the market as well as
technical factors such as the need for liquidity
also have been shown through order flow models
to affect the price of currencies.
Critical debate
The currencies of some Latin American countries
depreciate against other currencies on a
consistent basis. How can persistently weak
currencies be stabilized?
Proposition. The governments of these countries need
to increase the demand for their currency by attracting
more capital flows. Raising interest rates will make their
currencies more attractive to foreign investors. They also
need to insure bank deposits so that foreign investors
who invest in large bank deposits do not need to worry
about default risk. In addition, they could impose capital
restrictions on local investors to prevent capital outflows.
Opposing view. The governments of these countries
print too much money because they make too many
promises to the electorate that would otherwise have to
be funded by higher taxes or borrowing at high interest
rates. Printing money is the easy way out; but prices
rise, exports decrease and imports increase. Thus,
these countries could relieve the downward pressure
on their local currencies by printing less money and
thereby reducing the money supply and hence inflation.
The outcome is likely to be a temporary reduction in
economic growth and business failures. Higher interest
rates would merely increase inflation.
Reply. Solutions that cause riots are not very clever.
With whom do you agree? Which argument do you
support? Offer your own opinion on this issue.
Self test
Answers are provided in Appendix A at the back of
the text.
UK and Country B had no effect on the value of
Currency B. Explain why the effects may vary.
1 Briefly describe how various economic factors
can affect the equilibrium exchange rate of the
Japanese yen’s value with respect to that of the
pound.
3 Smart Banking plc can borrow £5 million at
6 per cent annualized. It can use the proceeds to
invest in US dollars at 9 per cent per year over a
six-day period. The US dollar is worth £0.60 and is
expected to be worth £0.59 in six days. Based on
this information, should Smart Banking plc borrow
pounds and invest in US dollars? What would be
the gain or loss in pounds?
2 A recent shift in the interest rate differential
between the UK and Country A had a large effect
on the value of Currency A. However, the same
shift in the interest rate differential between the
Questions and exercises
1 From the tradingeconomics.com/currencies site calculate the top three largest increases and decreases against
the dollar (hint: take care over direct and indirect quotes, a graph can be obtained by clicking on the exchange
rate). Provide clear calculations.
2 What is meant by mixed trading and what are the implications for an MNC trading in a number of currencies?
3 If the dollar becomes relatively expensive what are the implications for a UK importer from the US and a US
investor holding bonds in the UK and thinking about investing further in the UK?
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168
4
PART II
EXCHANGE RATE BEHAVIOUR
Why is it important that markets are deep?
5Estimate the effect on the SEKINR exchange rates if Swedish inflation is (1) higher, (2) the same and (3) lower
than India. What would be the effect on exchange rates of the Swedish krona with other currencies?
6If interest rates are higher in Bahrain than in Switzerland, what effect will this have on the exchange rate between
the Bahraini dinar and the Swiss franc for investors in each of the countries?
7What do you expect will be the pressure on an exchange rate between countries if one country has a higher
income level than the other country?
8
a List three ways in which the government can affect exchange rates and evaluate these methods in terms of
their effect on the exchange rate and the cost of the interventions.
b Go on the internet, search for ‘tariffs and quotas’ and click on ‘news’. Find an example of government actions
concerning tariffs and quotas, describe it and comment on the effect on the value of the currency.
9How can the release of statistics showing an improvement in the economic outlook of a country leading to a fall
in the value of the currency?
10 Assume that the UK invests heavily in government and corporate securities of Country K. In addition, residents
of Country K invest heavily in the UK. Approximately £10 billion worth of investment transactions occur between
these two countries each year. The total value of trade transactions per year is about £8 million. This information
is expected to also hold in the future. Because your firm exports goods to Country K, your job as international
cash manager requires you to forecast the value of Country K’s currency (the ‘krank’) with respect to the pound.
Explain how each of the following conditions will affect the value of the krank, holding other things equal. Then,
aggregate all of these impacts to develop an overall forecast of the krank’s movement against the pound.
a UK inflation has suddenly increased substantially, while Country K’s inflation remains low.
b UK interest rates have increased substantially, while Country K’s interest rates remain low. Investors of both
countries are attracted to high interest rates.
c The UK income level has increased substantially, while Country K’s income level has remained unchanged.
d The UK is expected to impose a small tariff on goods imported from Country K.
e Combine all expected impacts to develop an overall forecast.
11 What is meant by homogenous expectations, and what is the relevance of this concept in understanding
exchange rates?
12 Who are the differing ‘players’ in the exchange market and what is their effect on the exchange rate?
13 Why might a country with higher interest rates not attract foreign investors?
14 If an exchange rate does not change between two countries, what happens to the buying power of the country
experiencing higher inflation?
15 Summarize (using the internet) Venezuela’s or Turkey’s hyperinflation, government attempts to control it and the
behaviour of the exchange rate.
Discussion in the boardroom
Running your own MNC
This exercise can be found in the digital resources for
this book.
This exercise can be found in the digital resources for
this book.
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CHAPTER 5
Exchange rate changes
169
Endnotes
1 Fama, E. (1991) ‘Efficient capital markets: II’, The Journal
of Finance, 46(5), 1575.
2 Evans, M. D. D. and Lyons, R. K. (2008) ‘How is macro
news transmitted to exchange rates?’, Journal of Financial
Economics, 88, 26–50.
3 BIS (2019) ‘Triennial Central Bank Survey of Foreign
Exchange and Over-the-counter (OTC) Derivatives
Markets in 2019’. Available at: www.bis.org/statistics/
rpfx19.htm?m=2617 [Accessed 25 July 2022].
4 Buyers and sellers are reacting to the actions of other
buyers and sellers rather than reacting to economic news.
5 Andersen, T., Bollerslev, T., Diebold, F. and Vega, C.
(2003) ‘Micro effects of macro announcements: Real-time
price discovery in foreign exchange’, American Economic
Review, 93, 38–62.
6 Obstfeld, M. and Rogoff, K. (2000) ‘The six major puzzles
in international microeconomics: Is there a common cause?’
in B. Bernanke and K. Rogoff (eds) NBER Macroeconomics
Annual 2000, MIT Press, 339–90.
7 King, M., Osler, C. and Rime, D. (2013) ‘The market
microstructure approach to foreign exchange: Looking
back and looking forward’, Journal of International Money
and Finance, 38, 95–119.
8 Menkhoff, L. and Schmeling, M. (2010) ‘Whose trades
convey information? Evidence from a cross-section of
traders’, Journal of Financial Markets, 13(1), 101–28.
9 Frommel, M., Mende, M. and Menkhoff, L. (2008)
‘Orderflows, news, and exchange rate volatility’, Journal
of International Money and Finance, 27(6), 994–1012 and
Evans, M. D. D. (2010) ‘Order flows and the exchange rate
disconnect puzzle’, Journal of International Economics,
80(1), 58–71.
Essays/discussion and articles can be found at the end of Part II.
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170
PART II
EXCHANGE RATE BEHAVIOUR
BLADES PLC CASE STUDY
Assessment of future exchange rate movements
As the Finance Director of Blades plc, Ben Holt is
pleased that his current system of exporting ‘Speedos’
to Thailand seems to be working well. Blades’ primary
customer in Thailand, a retailer called Entertainment
Products, has committed itself to purchasing a fixed
number of Speedos annually for the next three years
at a fixed price denominated in baht, Thailand’s
currency. Furthermore, Blades is using a Thai supplier
for some of the components needed to manufacture
Speedos. Nevertheless, Holt is concerned about
recent developments in Asia. Foreign investors from
various countries had invested heavily in Thailand to
take advantage of the high interest rates there. As
a result of the weak economy in Thailand, however,
many foreign investors have lost confidence in
Thailand and have withdrawn their funds.
Ben Holt has two major concerns regarding these
developments. First, he is wondering how these
changes in Thailand’s economy could affect the value
of the Thai baht and, consequently, Blades. More
specifically, he is wondering whether the effects on
the Thai baht may affect Blades, even though its
primary Thai customer is committed to Blades over
the next three years.
Second, Holt believes that Blades may be able to
speculate on the anticipated movement of the baht,
but he is uncertain about the procedure needed to
accomplish this. To facilitate Holt’s understanding
of exchange rate speculation, he has asked you,
Blades’ financial analyst, to provide him with detailed
illustrations of two scenarios. In the first, the baht
would move from a current level of £0.0147 to
£0.0133 within the next 30 days. Under the second
scenario, the baht would move from its current level
to £0.0167 within the next 30 days.
Based on Holt’s needs, he has provided you with
the following list of questions to be answered:
assuming a change in the Thai baht’s value from a
value of £0.0147 to £0.0173.
2 What are the basic factors that determine the
value of a currency? In equilibrium, what is the
relationship between these factors?
3 How might the relatively high levels of inflation and
interest rates in Thailand have affected the baht’s
value? (Assume a constant level of UK inflation and
interest rates.)
4 How do you think the loss of confidence in the
Thai baht, evidenced by the withdrawal of funds
from Thailand, affected the baht’s value? Would
Blades be affected by the change in value, given
the primary Thai customer’s commitment?
5 Assume that Thailand’s Central Bank wishes to
prevent a withdrawal of funds from its country in
order to prevent further changes in the currency’s
value. How could it accomplish this objective using
interest rates?
6 Construct a spreadsheet illustrating the steps
Blades’ Treasurer would need to follow in order
to speculate on expected movements in the
baht’s value over the next 30 days. Also show the
speculative profit (in pounds) resulting from each
scenario. Use both of Ben Holt’s examples to
illustrate possible speculation. Assume that Blades
can borrow either £7 million or the baht equivalent
of this amount. Furthermore, assume that the
following short-term interest rates (annualized) are
available to Blades:
Currency
British pounds
Thai baht
Lending rate
Borrowing rate
8.10%
8.20%
14.80%
15.40%
1 How are percentage changes in a currency’s value
measured? Illustrate your answer numerically by
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CHAPTER 5
Exchange rate changes
171
SMALL BUSINESS DILEMMA
Assessment by the Sports Exports Company of factors
that affect the British pound’s value
Because the Sports Exports Company (an Irish firm)
receives payments in British pounds every month and
converts those pounds into euros, it needs to closely
monitor the value of the British pound in the future.
Jim Logan, owner of the Sports Exports Company,
expects that inflation will rise substantially in the
UK, while inflation in Ireland will remain low. He also
expects that the interest rates in both countries will
rise by about the same amount.
1 Given Jim’s expectations, forecast whether the
pound will appreciate or depreciate against the
euro over time.
2 Given Jim’s expectations, will the Sports Exports
Company be favourably or unfavourably affected
by the future changes in the value of the pound?
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CHAPTER 6
Exchange rate
history and the role
of governments
LEARNING OBJECTIVES
The specific objectives of this chapter are to:
●●
Describe the exchange rate systems used by various governments.
●●
Explain how governments can use direct and indirect intervention to influence exchange rates.
●●
Explain the relationship between exchange rates and economic monetary and fiscal policies.
●●
Outline the history of government and intergovernmental organizations in the management of exchange rates.
An understanding of what actually happened in the past helps us to understand what might happen in the future. This
is an alternative approach to economic theories which, unlike the sciences, are only very approximate and uncertain in
their predictions. As a generalization, the history of exchange rates has been a story of ‘tension’ between government
decisions and the market. The financial manager needs to understand this relationship and how it has worked out in
the past in order to interpret the macro environment.
172
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CHAPTER 6
Exchange rate history and the role of governments
173
Exchange rate systems
Exchange rates can be viewed as a kind of financial border to a country. Where the exchange rate is fixed
to another currency it is similar to having a common currency. Interest rates and ultimately inflation rates
cannot be too different. The trading and investment forces are the same as those that make interest rates
and inflation within a country very similar – the detailed implications are spelled out in the examples.
Where exchange rates are free to vary we will see that this enables countries to have their own economic
policies. The cost of a freely floating exchange rate is the uncertainty that it introduces to business
transactions. The choice of system is a political one and is essentially a trade off between the stability of
a fixed exchange rate and the independence of a freely floating rate. Of course, the temptation is to try to
benefit from both regimes, hence the following categories have emerged over time:
1 fixed
2 managed float
3 pegged
4 freely floating.
Each of these exchange rate systems is discussed in turn.
Fixed exchange rate system
In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within
very narrow boundaries. If an exchange rate begins to move too much, governments, via their central
banks, intervene to maintain it within the boundaries. In some situations, a government will devalue or
reduce the value of its currency against other currencies. In other situations, it will revalue or increase the
value of its currency against other currencies. A central bank’s actions to devalue a currency are referred
to as devaluation. Devaluation refers to a downward adjustment of the value of a currency by the central
bank. A similar term, depreciation, refers to a loss in value of a currency caused by exchange rate markets.
Revaluation refers to an upward adjustment in the value of a currency by the central bank. An upward
adjustment by the market is referred to as an appreciation in the value of the currency. Remember always
to refer to movement in the value of a currency and not to movement in the exchange rate. Saying that the
exchange rate went up or down has two meanings depending on whether the rate is direct or indirect and
so is confusing.
USING THE WEB
Visit the EU site at: europa.eu for access to the server of the EU’s Parliament, Council, Commission,
Court of Justice and other bodies. It includes basic information on all related political and economic
issues.
Advantages of a fixed exchange rate system. In a fixed exchange rate environment, MNCs can engage in
international trade without worrying about the future exchange rate. Consequently, the managerial duties
of an MNC are less difficult.
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EXAMPLE
When UK companies imported materials from abroad
during the fixed exchange rate era after the Second
World War (history below), they could anticipate the
amount of British pounds they would need to pay for
the imports. When the British pound devalued in the
late 1960s, however, UK companies needed more
British pounds to purchase imports. A fixed exchange
rate is therefore useful to business in the short run
but over a longer period is likely to include large
adjustments that can be as damaging as a freely
floating system of smaller changes – it can dam up
changes rather than avoid them.
A second effect of fixed exchange rates is that
where the currency of a small economy with high
inflation fixes its exchange rate to a large currency
with low inflation, the inflation in the small currency
is restrained. Prices in the small currency are now in
direct competition with imports that are not increasing
in price as they would do if the currency of the small
economy were allowed to devalue. As the rates are
fixed, extra demand for imports by the small economy
from the large economy will not affect the price of
imports. Initially this will seem to be an advantage but
in the long run will lead to severe economic difficulties.
This effect was seen in Italy and Greece on joining
the euro (1999 and 2001 respectively), which was
and still is a low inflation currency dominated by
conservative German economic policies. In the past,
the Greek and to a lesser extent the Italian governments
financed government commitments by printing money
(creating credit) and the resulting inflation was in effect
a regressive tax. Your income was worth less due to
inflation rather than tax. Now that they were not able
to ‘print euros’, their only recourse was to borrow to
finance their expenditure and encourage their citizens
to pay tax! Eventually, the level of borrowing was such
that bond defaults became a real possibility. The Greek
government, in particular, was forced to make huge
cuts in its spending and introduce general austerity
measures that led to negative growth. Italian and
Greek GDP in 2020 (the latest data as of 2022) is still
well below 2009 levels, unlike the German economy
which grew by 13 per cent over the same period, a
sobering experience.
Disadvantages of a fixed exchange rate system. Although an MNC is not exposed to continual movements
in an exchange rate, it does continuously face the possibility that the government will devalue or revalue
its currency. In this respect the difference from a variable exchange rate system is not so great.
A second disadvantage is that from a macro viewpoint, a fixed exchange rate system may make each
country more vulnerable to economic conditions in other countries.
EXAMPLE
Assume that there are only two countries in
the world: the US and the UK. Also assume a
fixed exchange rate system, and that these two
countries trade frequently with each other. If the US
experiences a much higher inflation rate than the
UK, US consumers should buy more goods from
the UK and British consumers should reduce their
imports of US goods (due to the high US prices).
This reaction would force US production down
and unemployment up. It could also cause higher
inflation in the UK due to the excessive demand for
British goods relative to the supply of British goods
produced. Thus, the high inflation in the US could
cause high inflation in the UK. In the mid- and late
1960s, the US experienced relatively high inflation
and was accused of ‘exporting’ that inflation
to some European countries due to the fixed
exchange rate.
Alternatively, a high unemployment rate in the
US will cause a reduction in US income and a
decline in purchases of British goods in the US.
Consequently, productivity in the UK may decrease
and unemployment may rise. In this case, the US
may ‘export’ unemployment to the UK.
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CHAPTER 6
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175
However, if a fixed exchange rate is accompanied by appropriate policies, good rather than bad
economic conditions may spread (refer to the examples); indeed, this is the hope of the EU.
EXAMPLE
Rerun the previous example and assume that there
are only two countries: the US and the UK. The
much higher inflation in the US causes the demand
for British pounds to rise and the exchange rate to
move outside its set limits. Initially, the US will use
its reserves of British pounds to meet the demand
in the marketplace; but reserves of British pounds
are bound to run low. Subsequently, the US raises
interest rates to make the dollar more attractive.
The higher interest rates reduce spending in the
US as consumers lower their credit card debt and
companies borrow less and defer investment
spending plans. Demand decreases in the US,
inflation slows down and as a result unemployment
increases temporarily. Financial stability is restored;
some may say at the expense of economic activity.
Where different countries share the same currency, as in the EU, it is very clearly the case that members
are subject to the economic conditions in each other’s countries. If a member government such as Italy
decided to borrow excessively to promote its own economy, interest rates may well increase. As a common
currency area can only support one interest rate for a given level of risk, it would mean that people in
France could be paying more on their borrowing for credit cards and houses etc. due to the excessive
borrowing in Italy. The solution in the EU is to harmonize economic policies. To this end, member states
signed up to the Growth and Stability Pact in 1997. The main terms are that government budgets must
balance in the medium term and that there are penalties for excessive annual borrowing (more than
3 per cent of GDP) and excessive total government debt (more than 60 per cent of GDP). At the time of
writing German government debt as a percentage of GDP was 59.8 per cent, France 98.1 per cent and
Italy 134.8 per cent.
Therefore a fixed currency implies interdependency of the economic systems. It is possible for good economic
conditions such as low inflation to spread, or bad conditions such as high inflation and unemployment
to spread. The relative size of the countries, or rather currency areas, is an important factor, as well as the
economic policies of the countries concerned and the nature of the cooperation between the policies.
We should not, however, be too simplistic in this distinction. In the past many countries declaring
themselves to have a fixed exchange rate have in fact had more than one ‘fixed’ rate, referred to as parallel
markets.1 Black market rates are also a common phenomenon. As Reinhart and Rogoff point out, these
markets can be significant and the differences great. They quote the extreme example of Myanmar with a
premium of 700 per cent in the parallel foreign currency market.2
Managed float exchange rate system
The exchange rate system that exists today for the major currencies lies somewhere between fixed and
freely floating. It resembles the freely floating system in that exchange rates are allowed to fluctuate on a
daily basis and there are no official boundaries. It is similar to the fixed rate system in that governments
can and sometimes do intervene to prevent their currencies from moving too far in a certain direction. This
type of system is known as a managed float or ‘dirty’ float (as opposed to a ‘clean’ float where rates float
freely without government intervention).
Criticism of a managed float system. The main problem of a managed float is whether or not it is in fact
possible to manage a currency. Accepting that market volumes greatly exceed reserves of foreign exchange
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held by governments, their role would seem limited. Rather like the IMF though, a government’s ‘voice’
in the market is authoritative and has the status of an informed trader, its influence is probably greater
than its financial reserves. The difficulty for researchers investigating the effectiveness of government
intervention is the lack of data. Interventions are for the most part unannounced, and as Sarno and Taylor
(2001) point out this rather conflicts with the view that governments are signalling to the market.3
Pegged exchange rate system
Some countries use a pegged exchange rate arrangement, in which their home currency’s value is pegged
to a foreign currency or a basket of foreign currencies. While the home currency’s value is fixed in terms
of the foreign currency to which it is pegged, it moves in line with that currency against other currencies.
Where it is a basket of currencies, the movement of the basket’s value will be an average of the movement
of the currencies that make up the basket. The basket may be thought of as literally a basket with so many
dollars, yen and so on. Its value in any one currency is all the currencies in the basket converted at the spot
rate to the desired currency.
Some Asian countries such as Malaysia and Thailand had pegged their currency’s value to the dollar.
During the Asian crisis (1997), they were unable to maintain the peg and allowed their currencies to float
against the dollar. A suggestion is that as countries liberalize their financial accounts and allow foreign
investment, so pressure mounts to move to a flexible exchange rate.4
Currency boards
A currency board is a system for pegging the value of the local currency to some other specified currency.
The board must maintain currency reserves (usually near 100 per cent) of the specified currency for all
the local currency that it has issued. In one sense it may appear that the currency value is safe in that the
currency board can replace the currency it has issued with the foreign currency. Cash is, however, only a
small part of the total ‘money’ or credit in an economy. Banks hold only about 10 per cent of deposits in
the form of cash. The currency board could therefore only convert 10 per cent of bank balances into the
chosen foreign currency. This would not affect credit greatly if there were to be an orderly conversion, but
in a crisis scenario it is likely that banks would need more than 10 per cent.
EXAMPLE
Hong Kong has tied the value of its currency (the
Hong Kong dollar) to the US dollar (HK$7.80 5 $1.00)
since 1983. Every Hong Kong dollar in circulation is
backed by a US dollar in reserve.
A currency board can stabilize a currency’s value. This is important because investors generally avoid
investing in a country if they expect the local currency will weaken substantially. If a currency board is
expected to remain in place for a long period, it may reduce fears that the local currency will weaken and
thus may encourage investors to maintain their investments within the country. However, a currency board is
worth considering only if the government can convince investors that the exchange rate will be maintained.
If investors expect that market forces will prevent a government from maintaining the local currency’s
exchange rate, they will attempt to move their funds to other countries where they expect the local
currency to be stronger. When foreign investors withdraw their funds from a country and convert the
funds into a different currency, they place downward pressure on the local currency’s exchange rate. If the
supply of the currency for sale continues to exceed the demand, the government will be forced to devalue
its currency.
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CHAPTER 6
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177
EXAMPLE
In 1991, Argentina established a currency board
that pegged the Argentine peso to the US dollar
at a rate of one dollar to one peso. By the end of
the 1990s and early 2000s Argentina faced an
increasing value of the dollar, a consequent current
account deficit and foreign currency borrowing,
and a currency board that was failing to fully align
its financial management with the US. As a result,
in 2002 Argentina suspended its payment of foreign
debt and in January unpegged the peso from the
dollar. To make matters worse, the government
engaged in ‘pesification’: converting bank account
dollars to pesos on a one-to-one basis. This caused
a further loss in confidence in the peso which over
the following months lost 75 per cent of its value – a
massive devaluation.
The dominance of the markets over government management is evident. Where the market takes the
view that the currency is overvalued, the volume of selling of that currency is such that governments are
unable to resist the pressure for a devaluation.
Exposure of a pegged currency to interest rate movements. A country that uses a currency board does not
have complete control over its local interest rates because its rates must be aligned with the interest rates
of the currency to which it is tied.
Recall that the Hong Kong dollar is pegged to the US dollar. If Hong Kong lowers its interest rates
to stimulate its economy, its interest rate would then be lower than US interest rates. Investors based in
Hong Kong would be enticed to exchange Hong Kong dollars for US dollars and invest in the US where
interest rates are higher. Since the Hong Kong dollar is tied to the US dollar, the investors could exchange
the proceeds of their investment back to Hong Kong dollars at the end of the investment period without
concern about exchange rate risk because the exchange rate is fixed. If the US raises its interest rates, Hong
Kong would therefore be forced to raise its interest rates.
Even though a country may not have control over its interest rate when it establishes a currency board,
its interest rate may be more stable than if it did not have a currency board. Its interest rate will move
in tandem with the interest rate of the currency to which it is tied. The interest rate may include a risk
premium that could reflect either default risk or the risk that the currency board will be discontinued.
EXAMPLE
While the Hong Kong interest rate moves in tandem
with the US interest rate, specific investment
instruments may have a slightly higher interest rate in
Hong Kong than in the US. For example, a Treasury
bill may offer a slightly higher rate in Hong Kong than
in the US. While this allows for possible arbitrage by
US investors who wish to invest in Hong Kong, they
will face two forms of risk.
First, some investors may believe that there is
a slight risk that the Hong Kong government could
default on its debt. Second, if there is sudden
downward pressure on the Hong Kong dollar, the
currency board could be discontinued. In this case,
the Hong Kong dollar’s value would be reduced, and
US investors would earn a lower return than they
could have earned in the US.
Exposure of a pegged currency to exchange rate movements. A currency that is pegged to another currency
cannot be pegged against all other currencies. If it is pegged to the US dollar, it is forced to move in tandem
with the dollar against other currencies. In 2005 the Chinese announced that the yuan would no longer be
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pegged to the dollar but to a basket of currencies. This action reduces the yuan’s exposure to the interest
rates of any one country as it is exposed only to the average interest rate of the currencies in the basket.
As well as the dollar, the euro, the yen and the South Korean won, the basket includes the Australian,
Canadian and Singapore dollars, the British pound, the Malaysian ringgit, the Russian rouble and the
Thai baht. The weights in the basket have not been disclosed, other than to say that the weights in general
reflect the level of trade with those currencies. In effect, the yuan will only be presenting a soft target to
the foreign exchange market. Traders will not know exactly what value the Bank of China seeks against
any one currency. Such a strategy is designed to deter speculators in the manner of the soft targets in the
Exchange Rate Mechanism (discussed below).
EXAMPLE
As mentioned earlier, from 1991 to 2002 the
Argentine peso’s value was set to equal 1 US
dollar. Thus, if the dollar strengthened against the
Brazilian real by 10 per cent in a particular month,
the Argentine peso strengthened against the
Brazilian real by the exact same amount. During the
1991–2002 period, the dollar commonly strengthened
against the Brazilian real and some other currencies
in South America; therefore, the Argentine peso
also strengthened against those currencies. Many
exporting firms in Argentina were adversely affected
by the strong Argentine peso because it made their
products too expensive for importers. Now that
Argentina’s currency board has been eliminated, the
Argentine peso is no longer forced to move in tandem
with the dollar against other currencies.
Pressures can also exist for appreciation. The Chinese central bank revalued the yuan against the dollar
(to which it was then pegged) in July 2005. The Chinese government faced speculative purchase of Chinese
securities to profit from an expected further appreciation in the value of the yuan. Exporters will also find
that their products cost more and must decide whether to compensate by lowering their prices or passing
the higher cost on to the foreign importer. The net effect of a devaluation and a price change is referred to
as the pass through.
Dollarization
Dollarization in its literal form is the replacement of a foreign currency with US dollars. This process is
a step beyond a currency board, because it forces the local currency to be replaced by the US dollar. The
decision to use US dollars as the local currency cannot be easily reversed because the country no longer
has a local currency.
From 1990 to 2000, Ecuador’s currency (the sucre) depreciated by about 97 per cent against the dollar.
The weakness of the currency caused unstable trade conditions, high inflation and volatile interest rates.
In 2000, in an effort to stabilize trade and economic conditions, Ecuador replaced the sucre with the US
dollar as its currency. By November 2000, inflation had declined and economic growth had increased.
Thus, it appeared that dollarization had favourable effects. Dollarization is also used as a more general
term to refer to the use of a foreign currency for domestic transactions.
Freely floating exchange rate system
In a freely floating exchange rate system, exchange rate values are determined by market forces without
intervention by governments. Whereas a fixed exchange rate system allows no flexibility for exchange rate
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CHAPTER 6
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179
movements, a freely floating exchange rate system allows complete flexibility. A freely floating exchange
rate adjusts on a continual basis in response to demand and supply conditions for that currency.
Advantages of a freely floating exchange rate system. One advantage of a freely floating exchange rate
system is that a country is more insulated from the inflation of other countries.
EXAMPLE
Return to the previous example in which there are
only two countries, but now assume a freely floating
exchange rate system. If the US experiences a high
rate of inflation, the increased US demand for British
goods will place upward pressure on the value of
the British pound. As a second consequence of the
high US inflation, the reduced British demand for US
goods will result in a reduced supply of pounds for
sale (exchanged for dollars), which will also place
upward pressure on the British pound’s value. The
pound will appreciate due to these market forces.
This appreciation will make British goods more
expensive for US consumers, even though British
producers have not raised their prices. The higher
prices will simply be due to the pound’s appreciation;
that is, a greater number of US dollars is required to
buy the same number of pounds as before. From
the US perspective, imported goods will increase in
terms of the dollar price in much the same way as
their domestic (US) equivalents.
In the UK, the actual price of the goods as
measured in British pounds may be unchanged. Even
though US prices have increased, British consumers
will continue to purchase US goods because they
can exchange their pounds for more US dollars (due
to the British pound’s appreciation against the US
dollar). Imported goods, although bearing a higher
dollar price, will not therefore have increased in terms
of their UK pound cost.
In this way, due to the adjustment of the
exchange rate, a high inflation country does not
affect the inflation rates in other countries due to the
depreciation of its currency. This is the argument of
purchasing power parity (refer to Chapter 9).
Another advantage of freely floating exchange rates is that a country is more insulated from
unemployment problems in other countries.
EXAMPLE
Under a floating rate system, the decline in
US purchases of British goods caused by US
unemployment will reflect a reduced US demand for
British pounds. Such a shift in demand can cause
the pound to depreciate against the dollar (under the
fixed rate system, the pound would not be allowed
to depreciate). The depreciation of the pound will
make British goods look cheap to US consumers,
offsetting the possible reduction in demand for these
goods resulting from a lower level of US income.
As was true with inflation, a sudden change in
unemployment will have less influence on a foreign
country under a floating rate system than under a
fixed rate system.
As these examples illustrate, in a freely floating exchange rate system, problems experienced in one
country will not necessarily be contagious. The exchange rate adjustments serve as a form of protection
against ‘exporting’ economic problems to other countries.
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An additional advantage of a freely floating exchange rate system is that a central bank is not required
to constantly maintain exchange rates within specified boundaries. It can therefore hold lower levels of
foreign exchange than would be needed under a fixed rate regime to meet surplus demand for foreign
currency at the fixed rate. It also need not adjust interest rates and the money supply just to control
exchange rates. In effect, a freely floating currency allows a country to implement its own economic policy.
Disadvantages of a freely floating exchange rate system. In the previous example, the UK was somewhat
insulated from the problems experienced in the US due to the freely floating exchange rate system.
Although this is an advantage for the country that is protected (the UK), it can be a disadvantage for a
country that experiences economic problems.
EXAMPLE
If the UK experiences a weak pound due to monetary
factors such as interest rates, a weaker UK British
pound causes import prices to be higher. This can
increase the price of UK materials and supplies,
causing ‘cost push’ inflation. In addition, higher
foreign prices (from the UK perspective) can force
UK consumers to purchase domestic products. As
UK producers recognize that foreign competition
has been reduced due to the weak British pound,
they can more easily raise the prices of their finished
goods without losing their customers to foreign
competition.
In a similar manner, a freely floating exchange rate system can adversely affect a country that has high
unemployment.
EXAMPLE
If the UK unemployment rate is rising, UK demand
for imports will decrease. As a result, the reduced
supply of British pounds on the foreign exchange
will place upward pressure on the value of the British
pound. A stronger British pound will then cause UK
consumers to purchase foreign products rather than
UK products because the foreign products can be
purchased cheaply. Yet, such a reaction can actually
be detrimental to the UK during periods of high
unemployment.
As these examples illustrate, a country’s economic problems can sometimes be compounded by freely
floating exchange rates. Under such a system, MNCs will need to devote substantial resources to measuring
and managing exposure to exchange rate fluctuations. Thus although cheaper for governments, variable
rates can be more expensive for industry.
Comparing fixed and floating rates in outline, governments want the certainty of fixed rates with the
low cost and greater independence of variable rates. Managed floats offer the prospect of benefiting from
both systems – refer to the trilemma (below).
The concept of an optimal currency area*
It is often the case that issues which have caused people to march in the streets have been the subject
of academic debate for many years previously. A case in point is the euro effectively imposing a fixed
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CHAPTER 6
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181
exchange rate between the member countries and forcing low inflation policies of Germany on countries
that traditionally had higher levels, such as Italy and Greece. In 1961 Robert Mundell wrote a famous
paper entitled ‘A theory of optimum currency areas’. 5 This is now referred to as the endogeneity of
exchange rate regimes. In other words, to what extent can we identify the factors that delineate an ideal
exchange rate area, namely those factors that are endogenous or internal to an ideal area. The issue is not
just relevant to the euro, a currency that is at present actively in the process of defining its jurisdiction, but
also other trading blocs such as the North American Free Trade Association and the African Union.
With no small percipience, Mundell observes in relation to unemployment that only a single policy can
be set by central authorities in a single currency area, whereas in a multicurrency area it is possible for
successful areas to have an appreciating currency (making their prices relatively higher), and less successful
areas to have a depreciating currency (making their prices relatively cheaper). A single policy will likely
not suit all countries in a single currency area. With regard to the EU, in 2021 Italy and Greece had
unemployment rates of 15 per cent, France 7 per cent and Germany 4 per cent.
Mundell raises an objection to the law of comparative advantage, namely that it assumes that the
factors of production are immobile internationally (a point we have made above). Only if labour and
machinery do not move to successful areas will there be benefits for less productive currencies. Currently,
it seems that the movement of labour and machinery is in danger of asset stripping poorer countries by the
wealthier countries.
An exchange rate area that is the same as a country allows the country to pursue its own interest
rate policy and inflation policy. For example, the country might want to promote a higher level of
inflation through increasing the money supply. A devaluation of the currency due to inflation means that
the real value of exports remains the same, the price goes up with inflation but is offset by a devaluing
currency. Within a currency area such as the euro, it is not possible for all countries to inflate and devalue
their currency for the sake of one country. Instead, the same adjustment can only be made through an
adjustment to the money wage of the depressed country. We have advanced this argument in relation to
Greece. In early 2016 the country accepted reductions in pensions and other remuneration; Ireland also
suffered wage reductions of typically 10 per cent.6 This can be said to have worked for Ireland, which had
an unemployment rate of 5 per cent in 2021.
The issues raised by Mundell have since moved on to a consideration as to what is an appropriate
exchange rate regime for a country. The second half of the twentieth and early twenty-first century
saw a whole range of exchange rate regimes and the disastrous consequences of inappropriate policies,
with the UK’s Black Wednesday in 1992, Mexico in 1994 and Argentina in 2001 all being examples of
inappropriate pegging. Clearly there is no one-size-fits-all in the question of regime choice. In theory,
flexible exchange rates should provide greater independence. Academic papers review this in the context
of shocks to the terms of trade, which is the ratio of export to import prices. For a developing country,
such shocks would manifest as a sudden fall in the demand for a commodity that is a significant part of
their exports. A flexible exchange rate would allow for currency devaluation to lower the foreign price. 7
Despite this argument a number of papers find a preference for fixed regimes for developing countries an
important factor, taking into account the fact that the countries have borrowed in foreign currency.8 In
such cases a devaluation would make repayments more expensive. In a comprehensive study, Levi-Yeyati
et al.9 conclude that: ‘The probability of choosing a peg is higher in small open economies with high
levels of foreign liabilities and financial integration, poor institutional quality and strong governments’
(p. 668). On the capital side, developed countries that allow free movement of portfolio and real investment
tend to have flexible regimes, whereas developing economies tend to have fixed regimes. The choice of
regime is found to depend on geographical, financial and political variables (a government’s years in office
positively related to a more flexible regime). Fixed exchange rate regimes can appear to offer stability but
have been the source of catastrophic devaluations; variable rate regimes are more disruptive but can offer
better adjustment. The choice is complex.10
Classification of exchange rate arrangements
Exhibit 6.1 identifies the currencies and exchange rate arrangements used by various countries. Many
countries allow the value of their currency to float against others but intervene periodically to influence its
value. Several small countries peg their currencies to the US dollar.
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EXHIBIT 6.1
EXCHANGE RATE BEHAVIOUR
Examples of exchange rate arrangements 2020
Exchange rate regime
Country
No separate legal tender
Using the US dollar: Ecuador, El Salvador. To the euro: Kosovo, San Marino
Currency board
Pegged to the dollar: Hong Kong, Djibouti. To the euro: Bulgaria
Conventional peg
To the dollar: Barbados, Jordan, UAE. To the euro: Senegal, Cameroon,
Republic of the Congo. Iraq, Jordan, Saudi Arabia
Floating with inflation target
Brazil, India, South Africa.
Free floating with an inflation target
Canada, Japan, Sweden, UK
Free floating with no specific target
US dollar, euro
Source: IMF (2020) Annual Report on Exchange Rate Arrangements and Restrictions
The Mexican peso has a controlled exchange rate that applies to international trade and a floating
market rate that applies to tourism. The floating market rate is influenced by central bank intervention.
Chile intervenes to maintain its currency within 10 per cent of a specified exchange rate with respect to
major currencies. Venezuela intervenes to limit exchange rate fluctuations within wide bands.
EXAMPLE
In February 2017 the Mexican central bank offered
$20 billion in currency hedges as a means of taming
currency volatility in line with other central banks of
emerging economies, such as Brazil. The hedge was
in the form of an auction of non-deliverable forward
contracts (NDFs, refer to Chapter 11) that pay in
pesos. This was considered as a less expensive way
of supporting the peso, compared to its 2015 policy of
selling dollars for pesos (i.e. creating an artificial demand
for pesos) using its reserves of dollars. The NDF hedge
will offer price stability to traders. Speculators will in
effect be betting against the government.
Some Eastern European countries that recently opened their markets have tied their currencies to a single
widely traded currency. The arrangement was sometimes temporary, as these countries were searching for
the proper exchange rate that would stabilize or enhance their economic conditions. For example, in 1998
when the current account deficit of the Slovakian balance of payments exceeded 10 per cent of GDP, the
government unpegged from a currency and allowed it to devalue in an attempt to reduce demand for
foreign goods and increase foreign demand for its own goods.
Many governments attempt to impose exchange controls to prevent their exchange rates from
fluctuating. When these governments remove the controls, however, the exchange rates abruptly adjust
to a new market-determined level. For example, in October 1994, the Russian authorities allowed the
Russian rouble to fluctuate, and the rouble depreciated by 27 per cent against the dollar the day it was
unpegged. In April 1996, Venezuela’s government removed controls on the bolivar (its currency), and the
bolivar depreciated by 42 per cent that very day.
After the 2001 war in Afghanistan, an exchange rate system was needed. In October 2002, a new
currency, called the new afghani, was created to replace the old afghani. The old currency was exchanged
for the new money at a ratio of 1,000 to 1. Thus, 30,000 old afghanis were exchanged for 30 new afghanis.
The new money was printed with watermarks to deter counterfeits.
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183
At the end of the 2003 war in Iraq, an exchange rate system was also needed. At that time, three
different currencies were being used in Iraq. The Swiss dinar (so called because it was designed in
Switzerland) was created before the Gulf War but had not been printed since then. It traded at about
eight dinars per dollar and was used by the Kurds in northern Iraq. The Saddam dinar, which was
used extensively before 2003, was printed in excess to finance Iraq’s military budget and was easy to
counterfeit. Its value relative to the dollar was very volatile over time. The US dollar was frequently
used in the black market in Iraq even before the 2003 war. Just after the war, the dollar was used
more frequently, as merchants were unwilling to accept Saddam dinars out of fear that their value was
declining.
Although Iraq is not the best example, mention should be made of the possibility of multicurrency
arrangements. In 1989 the UK government proposed a ‘hard ecu’, a European currency to be used as
an alternative alongside the domestic currencies that made up the European Currency Unit (ECU).
Indeed, in the UK and in most other countries there is nothing to stop MNCs and individuals settling
their debts in any currency, providing that both parties are agreed. A number of retail chains in the
UK will accept euros though this is less likely following Brexit. The process is known as dollarization,
a term loosely used to refer to the use of foreign currency for domestic transactions. The danger of
such arrangements is that individuals become exposed to currency fluctuations in their own personal
finances, for example earning in one currency and borrowing in another. This was the case in the
Argentinian crisis of 2001–02 where some 70 per cent of loans were denominated in dollars and
earnings were in pesos.
Government intervention – the process
Each country has a central bank that may intervene in the foreign exchange markets to control its
currency’s value. In the US, for example, the central bank is made up of a network of major banks
referred to as the Federal Reserve System (the Fed). In Europe, the European Central Bank (ECB) is a
separate bank situated in Frankfurt, Germany. The main decision-making body, the Governing Council,
includes the governors of all the national central banks from the euro area countries. Central banks
have other duties besides intervening in the foreign exchange market. In particular, they control interest
rates and attempt to control the growth of the money supply. The central bank is in charge of printing
the money and controlling the amount of lending in the currency. The immediate objectives are to
maintain stable prices, economic growth and low unemployment. The precise nature of government
spending is, of course, the responsibility of governments. The central bank’s role is to control the
overall levels.
USING THE WEB
Central bank website links
The Bank for International Settlements website www.bis.org/cbanks.htm provides links to websites of
central banks around the world.
Reasons for government intervention
The degree to which the home currency is controlled, or ‘managed’, varies among central banks. Central
banks commonly manage exchange rates for three reasons:
1 to smooth exchange rate movements
2 to establish implicit exchange rate boundaries
3 to respond to temporary disturbances.
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Smooth exchange rate movements. If a central bank is concerned that its economy will be affected by
abrupt movements in its home currency’s value, it may attempt to smooth the currency movements
over time. Its actions may keep business cycles less volatile. The central bank may also encourage
international trade by reducing exchange rate uncertainty. Furthermore, smoothing currency movements
may reduce fears in the financial markets and speculative activity that could cause a major decline in a
currency’s value.
Establish implicit exchange rate boundaries. Some central banks attempt to maintain their home currency
rates within some unofficial, or implicit, boundaries. Analysts are commonly quoted as forecasting that a
currency will not fall below or rise above a particular benchmark value because the central bank would
intervene to attempt to prevent that. It should be remembered that the volumes of transactions on the
international financial markets are very much greater than the reserves of the central banks. Any attempt
by central banks to influence the value of its currency may well fail.
Respond to temporary disturbances. In some cases, a central bank may intervene to insulate a currency’s
value from a temporary disturbance. Because of the size of the international currency markets, central
banks will often act in unison. The ECB may therefore use its reserves of euros to buy British pounds to
support the value of the pound at the request of the Bank of England.
EXAMPLE
News that oil prices might rise could cause
expectations of a future decline in the value of the
Japanese yen because Japan exchanges yen for
dollars to purchase oil from oil-exporting countries (oil
was always paid for in dollars – this is still generally
the case). Foreign exchange market speculators
may exchange yen for dollars in anticipation of this
decline. Central banks may therefore intervene to
offset the immediate downward pressure on the yen
caused by such market transactions.
Several studies have found that government intervention does not have a permanent impact on
exchange rate movements. In many cases, intervention is overwhelmed by market forces. In the absence of
intervention, however, currency movements would be even more volatile.
Direct intervention
To force the British pound to depreciate, the Bank of England can intervene directly by exchanging pounds
that it holds as reserves for other foreign currencies in the foreign exchange market at attractive exchange
rates. By ‘flooding the market with pounds’ in this manner, the Bank of England puts downward pressure
on the pound. To strengthen the pound’s value, the Bank of England draws on its reserves of foreign
currency (an item in the balance of payments account) to buy British pounds.
In terms of demand and supply curves, to increase the value of the pound, there is an outward shift
in the demand for pounds in the foreign exchange market (as in Exhibit 6.2, the graph on the left).
Conversely, to weaken the pound’s value, the Bank of England sells pounds for foreign currency, which
causes an outward shift in the supply of pounds for sale in the foreign exchange market (as shown in the
graph on the right).
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CHAPTER 6
EXHIBIT 6.2
185
Exchange rate history and the role of governments
Effects of direct central bank intervention in the foreign exchange market
Bank of England exchanges reserves of
foreign currency for £s thereby increasing
the demand for £s by foreign currency
Bank of England exchanges £s for
foreign currency thereby increasing the
supply of £s for foreign currency
Value
of £
Value
of £
Supply of £s
V2
V1
V1
V2
Demand for £s
Quantity of £s
Supply of £s
Demand for £s
Quantity of £s
EXAMPLE
By October of the fiscal year 2021/22 the Bangladeshi
Bank had sold $1.38bn in exchange for its own
currency the taka (Tk). This kept the value of the US
dollar from rising which was caused in part by a surge
in imports giving rise to fears of inflation. The IMF
advised, as it often does, not to intervene in the foreign
exchange market. The government response was to
comment that the IMF only had an advisory role. In
November 2021 the Bangladeshi Daily Star reported
the official interbank rate as 85.65Tk:$1, up from
84.8Tk the previous year. However, private banks were
reported as selling the US dollar for 88Tk to 89Tk with
one trader reporting 90Tk to the dollar. Despite the
government intervention, the US dollar was becoming
more and more expensive. This illustrates the struggle
that governments have in trying to control currency
by market intervention. The market is far bigger than
government resources and usually wins!
Direct intervention is usually most effective when there is a coordinated effort among central banks.
If all central banks simultaneously attempt to strengthen or weaken the currency in the manner just
described, they can exert greater pressure on the currency’s value.
Reliance on reserves. The effectiveness of a central bank’s direct intervention depends on the amount of
reserves it can use. If the central bank has a low level of reserves, it may not be able to exert much pressure
on the currency’s value. Market forces are likely to overwhelm its actions.
As foreign exchange activity has grown, central bank intervention has become less effective. The volume
of foreign exchange transactions on a single day now exceeds the combined values of reserves at all central
banks. Consequently, the number of direct interventions has declined. In 1989, for example, the Fed (the
US central banking system) intervened on 97 different days. Since then, the Fed has not intervened on
more than 20 days in any year.
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Non-sterilized versus sterilized intervention. When central banks intervene in the foreign exchange market
without adjusting for the change in the money supply, they are engaging in a non-sterilized intervention.
For example, if the Bank of England sells pounds for foreign currencies in the foreign exchange markets in
an attempt to weaken the pound, the pound money supply increases. Effectively, the Bank of England, as
the printer of the currency, has created the reserve of pounds to use on the exchange markets.
In a sterilized intervention, the central bank intervenes in the foreign exchange market and simultaneously
engages in offsetting transactions in the treasury securities markets. As a result, the money supply is
unchanged. When intervening in the foreign exchange market, the central bank can either buy its own
currency with its reserves of foreign currency, or sell its currency from the reserves that it creates, by virtue of
being the issuer of the currency.
If the central bank buys its own currency, it creates an artificial demand for its own currency that will help to
maintain its value. There will also be a reduction in the money supply as the central bank in effect ‘buys back’ its
own currency in exchange for its reserves of foreign currency. This effect can be negated by using the money it
has bought back to purchase its own treasury securities from commercial banks. Redeeming Treasury securities
in this way increases the money supply in the economy as money is paid by the central bank to the commercial
banks for the securities. The increased holding of cash on the banks’ balance sheets will then encourage banks
to lend. It is a kind of ‘loans push’ policy that is in effect asking banks to seek out profitable projects rather than
the government alternative of financing grand infrastructure schemes (typically updating roads and railways).
If the central bank, in simple terms, prints money and sells it for foreign currency, the effect is to
increase the money supply. This effect can be negated by issuing Treasury securities. Payment for securities
by banks will reduce the money supply as banks pay the central bank for the securities. The central bank
can then retire the payments it receives from circulation.
EXAMPLE
If the Bank of England desires to strengthen the
British pound without affecting the pound money
supply, it: (1) buys pounds with foreign currency, thus
maintaining the foreign currency demand for pounds
and hence the pound’s value, and (2) with the pounds
it receives for foreign currency buys or redeems its
own Treasury bills (securities). Thus there will be no
net change in the holding of pounds in the economy
(Exhibit 6.3, top right-hand section).
The balance of payments would show a reduction
in the Bank of England’s reserves of foreign currency.
This would be noted with a plus sign indicating the
resulting demand for pounds (similar to the effect of
exports).
The difference between non-sterilized and sterilized intervention is illustrated in Exhibit 6.3. In the
top half of the exhibit, the Bank of England attempts to strengthen the British pound, and in the bottom
half, the Bank of England attempts to weaken or lower the value of the pound. For each scenario, the
right-hand side shows a sterilized intervention involving an exchange of Treasury bills for British pounds
that offsets the pound flows resulting from the exchange of currencies. Thus, the sterilized intervention
achieves the same exchange of currencies in the foreign exchange market as the non-sterilized intervention,
but it involves an additional transaction to prevent changes to the pound money supply.
Speculating on direct intervention. Some traders in the foreign exchange market attempt to determine
when central bank intervention is occurring and the extent of the intervention, in order to capitalize on the
anticipated results of the intervention effort. Normally, the central banks attempt to intervene without being
noticed. However, dealers at the major banks often pass the information to other market participants. Also,
when central banks deal directly with the numerous commercial banks, markets are well aware that the
central bank is intervening. To hide its strategy, a central bank may pretend to be interested in selling when it
is actually buying, or vice versa. It contacts commercial banks to obtain both bid and ask quotes on currencies,
so the banks will not know whether the central bank is considering purchases or sales of these currencies.
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CHAPTER 6
EXHIBIT 6.3
187
Exchange rate history and the role of governments
Forms of central bank intervention in the foreign exchange market
Non-sterilized intervention:
Bank of England . . .
Sterilized intervention:
Bank of England . . .
to strengthen the pound,
buys pounds
to strengthen the pound, buys pounds then buys Treasury bills
Bank of England
£ in
Bank of England
Bills
£ out
Foreign
currency
Banks participating
in the foreign
exchange market
to weaken the pound,
sells pounds
Bank of England
£ out
Foreign
currency
Banks participating
in the foreign
exchange market
to weaken the pound, sells pounds then sells
Treasury bills
£ out
Bank of England
Bills
£ in
Foreign
currency
Banks participating
in the foreign
exchange market
£ in
Foreign
currency
Banks receive
pounds from
Bank of
England for
their
Treasury
bills
Banks pay
pounds to
Bank of
England
for their
Treasury bills
Banks participating
in the foreign
exchange market
Notes:
• £ out 5 £s taken out of circulation and held by the Bank of England.
• £ in 5 £s put into circulation by the Bank of England.
Intervention strategies vary among central banks. Some arrange for one large order when they intervene;
others use several smaller orders equivalent to €5 million to €10 million. Even if traders determine the extent
of central bank intervention, they still cannot know with certainty what impact it will have on exchange rates.
Indirect intervention
A central bank can also affect its currency’s value indirectly by influencing the factors that determine it.
Recall that the change in a currency’s spot rate is influenced by the following factors in the case of the UK
and the British pound:
DINF 5 change in the differential between UK inflation and the foreign country’s inflation
DINT 5 change in the differential between the UK interest rate and the foreign country’s interest rate
DINC 5 change in the differential between the UK income level and the foreign country’s income level
DGC 5 change in government controls
DEXP 5 change in expectations of future exchange rates
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The central bank can influence all of these variables, which in turn can affect the exchange rate. Since these
variables are likely to have a more lasting impact on a spot rate than direct intervention, a central bank
may use indirect intervention by influencing these variables. Although the central bank can influence all
of these variables, it is likely to focus on interest rates or government controls since these can be changed
directly by the central bank.
Government adjustment of interest rates. When countries experience substantial net outflows of funds
(which places severe downward pressure on their currency), they commonly intervene indirectly by raising
interest rates to discourage excessive outflows of funds and therefore limit any downward pressure on the
value of their currency. However, this strategy adversely affects local borrowers (government agencies,
corporations and consumers) and may weaken the economy.
The central bank can attempt to lower interest rates by increasing the money supply (assuming that
inflationary expectations are not affected). Lower interest rates tend to discourage foreign investors from
investing in home securities, thereby placing downward pressure on the value of the home currency. Or,
to boost a currency’s value, the central bank can attempt to increase interest rates by reducing the money
supply.
In the UK, interest rates are set by the Bank of England’s Monetary Policy Committee. The minutes
of the meeting, including the vote of whether the interest rates should rise, fall or stay the same, are
published. Markets can include expectations in their interest rate-sensitive prices (the price of the currency
and shares) thus discouraging speculation.
EXAMPLE
In May 1998, the Russian currency (the rouble)
declined, and Russian stock prices fell by more
than 50 per cent from their level four months earlier.
Fearing that the lack of confidence in Russia’s
currency and stocks would cause massive outflows
of funds, the Russian central bank attempted to
prevent further outflows by tripling interest rates
(from about 50 per cent to 150 per cent). The
rouble was temporarily stabilized, but stock prices
continued to decline because investors were
concerned that the high interest rates would reduce
economic growth.
Government use of foreign exchange controls. Some governments attempt to use foreign exchange controls
(such as restrictions on the exchange of the currency) as a form of indirect intervention to maintain the
exchange rate of their currency. A control exists where a resident has to obtain permission to buy foreign
currency and where a foreign national needs permission to buy a currency. Exchange controls tend to
affect the financial account rather than the current account. China, for example, allowed its currency to be
bought and sold for current account transactions involving goods and services in 1996. But only in 2001
were Chinese residents allowed to purchase foreign exchange to pay for their own studies abroad. In 2002
the Qualified Foreign Investor Initiative was introduced in China to allow non-residents, under certain
conditions, to invest in the Chinese stock market.
Exchange rate controls require government permission to exchange the domestic currency for foreign
currency. Sometimes the rates may differ depending on the purpose of the transaction. Under severe
pressure, however, governments tend to let the currency float temporarily towards its market-determined
level and set new bands around that level.
Exchange rate target zones
In recent years, many economists have criticized the present exchange rate system because of the wide
swings in exchange rates of major currencies. Some have suggested that target zones be used for these
currencies. An initial exchange rate would be established, with specific boundaries surrounding that rate.
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CHAPTER 6
Exchange rate history and the role of governments
189
Such a target zone is similar to the bands used in a fixed exchange rate system but would likely be wider.
Proponents of the target zone system suggest that it would stabilize international trade patterns by
reducing exchange rate volatility.
Implementing a target zone system could be complicated, however. First, what initial exchange rate
should be established for each country? Second, how wide should the target zone be? The ideal target zone
would allow exchange rates to adjust to economic factors without causing wide swings in international
trade and arousing fear in financial markets.
If target zones were implemented, governments would be responsible for intervening to maintain
their currencies within the zones. If the zones were sufficiently wide, government intervention would
rarely be necessary; however, such wide zones would basically resemble the exchange rate system as
it exists today. Governments tend to intervene when a currency’s value moves outside some implicitly
acceptable zone. Unless governments could maintain their currency’s value within the target zone, this
system could not ensure stability in international markets. A country experiencing a large balance
of trade deficit might intentionally allow its currency to float below the lower boundary in order to
stimulate foreign demand for its exports. Wide swings in international trade patterns could result.
Furthermore, financial market prices would be more volatile because financial market participants
would expect some currencies to move outside their zones. The result would be a system no different
from what exists today.
Intervention as a policy tool
The government of any country can implement its own fiscal and monetary policies to control its economy.
In addition, it may attempt to influence the value of its home currency in order to improve its economy,
weakening its currency under some conditions and strengthening it under others. In essence, the exchange
rate becomes a tool, like tax laws and the money supply, that the government can use to achieve its desired
economic objectives.
Influence of a weak (relatively low value) home currency on the economy
A weak home currency can stimulate foreign demand for products as the currency becomes cheaper.
A weak euro, for example, can substantially boost eurozone exports and eurozone jobs. By contrast,
foreign currency becomes more expensive so imports are likely to reduce.
Though a weak currency can reduce unemployment at home as a result of increased exports, it can
also lead to higher inflation. In the early 1990s, the US dollar was weak, causing US imports from foreign
countries to be highly priced. This situation priced firms such as Bayer, Volkswagen and Volvo out of
the US market. Under these conditions, US companies were able to raise their domestic prices because
it was difficult for foreign producers to compete. In addition, US firms that are heavy exporters, such as
Goodyear Tire & Rubber Co., Litton Industries, Merck and Maytag Corp., also benefit from a weaker
dollar.
Influence of a strong home currency on the economy
A strong home currency can encourage consumers and corporations of that country to buy goods from
other countries. This situation intensifies foreign competition and forces domestic producers to refrain
from increasing prices. Therefore, the country’s overall inflation rate should be lower if its currency is
stronger, other things being equal. This has been interpreted as a government policy by pegging a currency
and preventing it from devaluing, thus forcing home prices to compete with foreign imports whose prices
remain stable. Brazil was a notable example of this policy in the 1990s that was judged on the whole to
have failed to change fundamentals.11
Though a strong currency is a possible cure for high inflation, it may cause higher unemployment due
to the attractive foreign prices that result from a strong home currency. The ideal value of the currency
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190
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depends on the perspective of the country and the officials who must make these decisions. The strength or
weakness of a currency is just one of many factors that influence a country’s economic conditions.
The interaction between exchange rates, government policies and economic factors is illustrated in
Exhibit 6.4. As already mentioned, factors other than the home currency’s strength affect unemployment
and/or inflation. Likewise, factors other than unemployment and the inflation level influence a currency’s
strength. The cycles that have been described here will often be interrupted by these other factors and
therefore will not continue indefinitely.
EXHIBIT 6.4
Impact of government actions on exchange rates
Government monetary
and fiscal policies
Relative interest rates
Relative inflation
rates
Relative national
income levels
International capital
flows
Exchange rates
International trade
Government purchases
and sales of currencies
Tax laws etc.
Government intervention in
foreign exchange market
Quotas, tariffs, etc.
Balassa Samuelson effect
This is sometimes referred to as the Harrod Balassa Samuelson effect. The effect is that countries with
more productive economies tend to have a high valued currency in the sense that a hamburger will
cost more when translated to a common currency. The argument is that a more productive economy
will export goods and services, creating a demand for its currency and higher salaries in those areas of
the productive economy directly benefiting from exports such as the German manufacturing industry.
This in turn leads to a demand for higher salaries by the non-productive sectors of that economy, such
as the German hairdressing sector and hamburger producing sector!12 As the currency value is largely
determined by traded goods and services whose price has not changed owing to the productivity of the
economy, the currency does not devalue to offset the higher salaries as predicted by purchasing power
parity (refer to Chapter 9). Prices therefore go up due to the higher salaries but the exchange rate is
not affected. Therefore the price of the hamburger in another currency will be more than the local
price. Similarly within a country, houses and hamburgers cost more in wealth producing areas.
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CHAPTER 6
Exchange rate history and the role of governments
191
The law of comparative advantage?
In June 2016 the UK voted in a referendum by 52 per cent to 48 per cent, a majority of some 1.3 million,
to leave the European Union (EU). This result was described as stunning and amazing by leaders across
the world. This piece of history is included here because, as we have discussed, the law of comparative
advantage holds that by specializing in production and services and trading surplus production, all
countries will benefit providing that there are no obstructions to free trade such as tariffs. Given that the
EU is a free trade area, it appeared to the world to be against the interests of the UK to be advocating
leaving the union and incurring tariffs as a result.
One of the aims of the EU is to promote unity among its members, termed ‘social cohesion’ in the
preamble to the Maastricht Treaty, part of that policy being the free movement of labour. A student
exchange scheme such as Erasmus is an example. To be dispassionate about the issue, suppose Country
B is less productive in all aspects compared to Country A. Comparative advantage still offers growth for
Country B as it specializes in its least worse activity and trades its surplus. Adding the free movement
of labour combined with the Harrod Balassa Samuelson (HBS) effect means that the higher wages in
Country A will encourage labour to move from Country B to Country A for all activities. This effect
is well known and was termed the ‘brain drain’, initially in relation to UK academics going to the US;
however, the HBS effect spreads to all activities, another example being the highly skilled Polish workers
across Western Europe.
Country B can nevertheless be expected to attract companies from type A countries; again there are
plenty of anecdotal stories to illustrate, such as the Italian factory (refer to the example below). So from
Country B’s position the closer union has both losses and gains. It is likely to lose its more skilled labour
but gain industry that takes advantage of its cheaper labour. Deskilling of areas and countries in this way
is treated as secondary to the right of free movement of skilled labour, not only in the EU but worldwide.
This has led to growing calls from Country B-type areas for greater national identity and discontent with
policies based on ever-growing international trade. Both in theory and practice international trade does
not bring wealth to all when coupled with the free movement of the factors of production, neither in
the short run nor the long run. It remains to be seen in the case of Brexit whether the benefits of less
movement of machinery and labour will outweigh the loss, due to more restricted international trade with
the EU. This is, of course, apart from the social, political and even economic benefits of having greater
self-determination.
EXAMPLE
It became a cause célèbre and subject to judicial
investigation. In August 2013 Fabizio Pedroni, the
owner of an electrical component factory (Firem),
sent all his employees off on their annual holiday.
Unbeknown to the workers he had hired a fleet of
some 20 lorries to move the whole factory to Poland
during their break. By the time they found out what
was happening they managed to block the last
load but the rest had gone. He justified his move
citing not only the higher wages in Italy but also the
higher social costs, making the total cost some two
and a half times higher than labour in Poland. His
competitors in Poland and Romania offered much
lower prices for their products, so he claimed his
choice was either to move the factory, close it down
or shoot himself. He added that following death
threats he would not be returning to Italy any time
soon.
The trilemma of government policy choice
Normally we think of a dilemma as a choice between two attractive options. In this case, governments are
said to face a trilemma with regard to policies. A choice has to be made of two out of three attractive options.
The trilemma is also referred to as the impossibility theorem.13 Those options are illustrated in Exhibit 6.5.
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192
EXHIBIT 6.5
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Policy trilemma
Free capital movements
into and out of the country
A
B
Fixed exchange rate
C
Own monetary policy and
hence influence over
interest and inflation rates
Fixed exchange rate
A: You can have fixed exchange rates and free capital movements but that will mean that you have to set interest rates to control the flow of capital – it
is not a free choice. If, for example, capital starts flowing out of the country putting downward pressure on the value of the currency, then you have to
increase interest rates to stem the flow and hence maintain the fixed exchange rate – there is no choice.
B: If you have free capital movement and a free choice over interest rates then you have to accept that if foreign investors holding home investments do
not like the interest rate, then they will convert their investments to a foreign currency, putting downward pressure on the exchange rate. A fixed rate
cannot be maintained.
C: If you have fixed exchange rates and a free choice over interest rates then you are guaranteeing a return for foreign investment. If that rate is, for
example, better than elsewhere, then you will have to control the money coming into the country.
Whether the currency is fixed or whether there are rather too frequent adjustments means that it is not that
clear whether the de jure position (the official position, usually taken as the classification by the IMF) is the
same as the de facto (actual) position. In fact Klein and Shambaugh report that over the years 1973–2004
the IMF classified 41 per cent of its observations as pegged whereas Reinhart and Rogoff classified only
33 per cent as pegged.14 They used degrees of pegging being ‘no separate legal tender’, ‘preannounced peg
for currency board arrangement’, ‘preannounced horizontal band that is narrower than or equal to 1/2 2%’
and ‘de facto peg’ (p. 25). There can also be black markets for exchange rates and dual exchange rates. To
cope with these finer distinctions Aizenman and Ito15 developed a divergence index being a measure of the
degree to which countries did not observe the trilemma. They found that countries which had experience of
crises did tend to observe to a greater degree the need for aligned policies as determined by the trilemma.
A brief history of exchange rates
The history of exchange rates is mainly an account of the attempt by governments to manage exchange rates
in increasingly free market economies. Exchange rates are primarily affected by economic developments.
The exchange rate accompanies these developments, but on occasion can be the cause when there is a
financial crisis. For financial managers, knowledge of the history of exchange rates is important in that it
shows in a way what theory does not and what can happen to exchange rates. Although transactions have
become increasingly sophisticated over the years, the role of money in the economy has little changed.
Solutions in the past are therefore still relevant today. Also, history includes social and political dimensions
to exchange rate behaviour that is not reflected in the primarily economic exchange rate models we
address later.
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CHAPTER 6
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193
The social and political dimensions. It is first important to appreciate that the motive behind the
management of exchange rates lies in the consequences for the economy that extend beyond trade.
Assuming a commitment to the free movement of capital, a fixed exchange rate regime would mean a
loss of control over interest rates and inflation and as a result a loss over economic independence. This is
too high a price to pay for many countries. Britain’s exit from the European exchange rate mechanism in
1992 was just such an example (the UK was in the ‘Exchange Rate Mechanism’, a near fixed rate system).
Higher interest rates caused by German unification would have meant much higher mortgage payments
in the UK due to the tradition of house purchasing in the UK, whereas on the Continent renting is more
common. Protests in 2016 over Greek pensions were again due to the euro acting as a single currency. The
EU troika (as below) ordered that Greece reduce its pension payments. If Greece had its own currency (the
drachma) then it would be able to pay its ‘over-generous’ pensions by increasing the money supply, which
would in turn incur inflation. The value of pensions would reduce due to inflation but the burden would
be spread over the whole population rather than just the pensioners. It is these type of events that are the
cost of a single currency – one size does not fit all.
A fixed exchange rate is desirable to avoid the negative effects of devaluation and revaluation and
to encourage trade and economic stability. Whether this has actually been the case with the adoption of
the euro is, however, disputable. Early evidence suggested that this was the case.16 However, more recent
papers have cast doubt on this conclusion, finding that there was no discernible effect of the euro when
a longer time frame was taken17 and even that the increased trade effect was greater among EU members
who did not adopt the euro.18
There is also a political dimension in that a variable rate means the government is under the constant
scrutiny of the exchange rate markets. If the markets are displeased with government policy, the value of the
currency will fall on the foreign currency markets, causing a loss of economic confidence. Governments, no
matter how autocratic, are unable to control the financial markets any more than democratic governments.
Russia and China are sometimes cited as autocratic governments who have been unable to prevent stock
market crashes. The cost of maintaining a fixed exchange rate, as the trilemma highlights, is either to regulate
the conversion of the currency, as in the post-Second World War era (as below), or to lose sovereignty
over economic policy, which is the experience of countries within the eurozone (again discussed below).
Unsurprisingly, it has been shown that autocracies are more likely to have a fixed exchange rate regime than
democracies.19 Within democracies, countries that have weak opposition are more likely to have flexible rates,
presumably because the political cost of adverse movements in the exchange rates is less; more intriguingly,
countries with fixed election dates are more likely to have flexible exchange rates, the suggestion being that it
allows the central bank to influence the exchange rate should the economy suffer at election time.20
The literature has also sought to ask managers about their preferences for exchange rate regimes given
that their voice is influential in government decision-making. There is evidence that companies which
trade in goods are more strongly in favour of fixed regimes and businesses show concern over the real
exchange rate increasing, making exports more expensive.21 This is very much as you would expect. What
is surprising in these studies is that as industries are very much a mix of exporting and non-exporting
businesses, there is not necessarily any industry pressure.22
That politics and the social implications are important in the choice of exchange rate is undeniable.
There is no clear model in the literature, but in general the findings are guided by the need for control and
the costs of not being in control: the essence of government you would suspect.
Pre-First World War – the gold standard. The gold standard is the earliest fixed rate system of the developed
world. Currencies under a full gold standard are convertible into a fixed weight of gold of a defined
fineness (quality). Before the First World War, the Bank of England sold gold at £3 17s 10½d (£3.89375)
per ounce (28.35 grammes). Gold could serve as an alternative currency: if businesses feared that their
paper money would buy less gold in future (a devaluation), they could always convert their money into
gold now. The gold standard was an insurance against the temptation by central banks to print too much
money – the main cause of a devaluation. As all currencies adopting the gold standard were convertible
into an ounce of gold at a set price, the exchange rate between these currencies was also fixed. As stated in
an earlier chapter, a currency unit that could buy twice as much gold as a unit of another currency had to
be worth twice as much as the other currency unit.
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PART II
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The UK adopted the gold standard in 1816 and the US and Europe converted in the 1870s. This was a
period of great financial stability, although there were large fluctuations in economic activity trade cycles.
As exchange rates were fixed and free trade was actively encouraged, an excess of imports could only
be corrected by reducing the level of economic activity in order to reduce imports. This was achieved
automatically in that excess imports meant money and gold flowing out of the economy to pay for the
imports. The consequent reduction in the money supply led directly to a reduction in economic activity. On
the plus side, exchange rate stability encourages international investment, and it is one of the surprising
facts that nearly 50 per cent of the savings of the developed world before the First World War were invested
in the developing world. The ratio nowadays is about a tenth of that figure, i.e. 5 per cent.
The interwar period. Economic disruption after the First World War caused intermittent periods of free
floating exchange rates and fixed gold standard rates for the major currencies. Germany experienced
hyperinflation, caused in part by unrealistic reparation payments after the War. In 1919 there were
8.9 German marks to the dollar; by October 1922, that figure had risen to 4,500 and in 1923 reached
4.2 trillion marks to the dollar! Inflation rose by the hour; a meal was more expensive by the end than
at the beginning. A loaf of bread cost 200 billion marks. In 1923 a new currency, the rentenmark, was
introduced, supposedly backed by property (it could be exchanged for a small piece of land). In 1924 the
reichsmark replaced the rentenmark and was backed 30 per cent by gold (i.e. gold reserves amounted to
30 per cent in value of notes in circulation). Inflation came to an abrupt end; gold had brought currency
stability. The legacy today of German hyperinflation in Europe is great caution on the part of the German
government with regard to monetary policy (government borrowing and lending). The conservatism of the
Growth and Stability Pact (1997 – as below) is in part due to this experience.
In the mid-1920s there was an attempt by European countries to return to the gold standard. In the
UK the return to the gold standard in 1925 limited the money supply and hence government spending.
This and the overvalued rate of the pound were in part responsible for the general strike of 1926 and the
Great Depression, resulting in high unemployment. Deflationary pressures and rising unemployment forced
governments to spend more, hence increasing the money supply. The consequence was devaluation on the
international exchange markets and/or shortage of gold as confidence was lost in the currency. The 1930s
saw competitive devaluations and suspension of convertibility into gold. The fixed exchange rate regime
was incompatible with the need for governments to control their money supply and thereby manage their
economies. The US dollar floated in 1933 and generally there was a reduced commitment to gold.
Bretton Woods Agreement. Towards the end of the Second World War, there was a desire to establish a
stable exchange rate system. In particular, countries wanted to avoid the financial chaos after the First
World War. The Bretton Woods Conference resulted in the setting up of the International Monetary Fund
(IMF) and the International Bank for Reconstruction and Development (now the World Bank). The IMF
was charged with overseeing a fixed exchange rate with the dollar. From 1944 to 1971, exchange rates
were typically fixed to within 1 per cent of the dollar, which alone was redeemable into gold at 35 dollars
an ounce. Governments intervened in the foreign exchange markets to ensure that the exchange rates
remained within the 1 per cent band. As with the gold standard, a fixed exchange rate with the dollar
implies a fixed exchange rate with all other currencies in the system. In addition to the fixed exchange rate
there were also restrictions on the amount of currency that could be used in international transactions.
These restrictions on convertibility helped to support the currency in the marketplace. For example, until
1967, foreign investors in the UK were allowed to sell their stocks and shares to other foreign investors
but not to UK residents. Such a sale would have created a demand for foreign currency to pay the foreign
investors. There were also restrictions on investments abroad that were only lifted in 1979.
Smithsonian Agreement. The problem with the Bretton Woods Agreement was that all currencies except
the dollar were pegged or fixed in a way that was tested by market trading each day. The dollar’s peg was
with gold, and that link was not tested, as few in the immediate post-War era wanted to change dollars
for the far less easily handled commodity, gold. The Fed (Federal Reserve Board) in the US, charged with
managing monetary policy, was constrained by the need to ensure that there were sufficient gold reserves
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CHAPTER 6
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195
to meet any demands to convert dollars into gold. In 1958 their reserves of gold were more than the rest
of the world’s banks put together and were ample, though the reserves were not sufficient to change all
dollars into gold. But as there were very few demands to convert dollars into gold, the Fed found that in
practice the dollars could be issued without increasing the reserves of gold, and that the gold to dollar
ratio could be allowed to fall. The resulting increase in the money supply was needed to finance large
current account deficits and the Vietnam War.
In effect, the US was benefiting from international seigniorage, a situation that still exists today. In other
words, the dollar was becoming a world currency and the US was able to profit from issuing the currency.
In very simple terms, the US could print dollars and spend the money and associated credit created
on imports. For other currencies this would have resulted in an oversupply of domestic currency and
devaluation. But the US position was different. Because international trade needed accounts denominated
in a stable, acceptable currency, the dollars offered for imports were deposited back in the US in the
form of short-term deposits. The current account deficits therefore did not appear to lead to devaluation
pressures. Increased supply for imports was met by increased demand for dollar deposits (investments), a
situation described as co-dependency.23 The deficit on the current account was met by a surplus on the
financial or capital account due to the demand for deposits in the US.24
When the IMF was set up at Bretton Woods, a plan by the British economist J. M. Keynes wanted to
create a world currency, the bancor. It was intended that the benefits from issuing the bancor would go to
developing countries. In the event this plan was rejected and the numeraire currency of the SDR (Special
Drawing Right) was created which did not have a separate seigniorage effect.
The role of a world currency was taken by the dollar. Such was the confidence in the dollar that the
US government could increase the supply of dollars, which foreign exporters exchanged with their central
banks into local currency, that the central banks then invested back into the US by buying US government
bonds as part of their reserves – a situation that still exists today. Hence imports did not affect the
exchange rate, the supply of dollars was met by the demand for dollars to invest in the US. Large current
account deficits ensued but eventually the US current account deficits and evident overissuing of dollars
led to a loss of confidence in its value and two European countries, Germany and France, began to prefer
gold as a reserve to dollars. The resulting loss of confidence ending the long period of relative calm in
exchange rates came to an abrupt end on 14 March 1968, when President Johnson suspended the ‘gold
pool operation’ as it was known. Some $2.8 billion had been converted into gold in the previous six
months. The price of gold was allowed to float freely, though central banks continued to trade gold at
$35 an ounce.
Eventually, the US, on 15 August 1971, suspended convertibility into gold, imposed a 10 per cent
surcharge on imports and limited tax relief on imported machinery. Unfortunately, these measures
prompted restrictions on the international flow of investments, as investment institutions sought to move
their funds out of dollars in anticipation of a devaluation of the dollar. A meeting was called of the ten
largest economies at the Smithsonian Institute in Washington. As a result, the dollar was devalued against
the yen by 17 per cent, the German mark by 14 per cent, and the French franc and the UK pound by
8 per cent. The margin of variation around the dollar was increased to 2.25 per cent from 1 per cent. The
official price of gold was raised to $38 an ounce. This move was of little significance as the market price
was well above this rate – newly mined gold went on to the non-bank market, and banks were unwilling
to use gold at this rate to settle accounts. Finally, in August 1971, with much depleted gold reserves,
convertibility of the dollar into gold between central banks was suspended.
The fixed exchange rates between currencies continued in this now weakened form. However, there
was still an excessive demand by dollar holders for foreign currency. As of February 1973, the dollar was
again devalued. By March 1973, most governments of the major countries were no longer attempting to
maintain their home currency values within the boundaries established by the Smithsonian Agreement.
The world financial system had changed from a fixed rate regime to a freely floating exchange rate system
between the major currencies.
The members of what is now termed the EU, at this point, set up a system of managing exchange rates
between their currencies in what proved to be the start of the long road that led to the creation of the
euro (as below). Their reasons were simply that a fixed exchange rate between members was considered
necessary to promote free trade.
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PART II
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Creation of Europe’s snake arrangement. In the late 1960s it became evident that the gold exchange
standard was not going to last in its present form. The European Economic Community (EEC, now the
EU) commissioned the Werner report, which came out in 1970. The report recommended a process of
monetary union within Europe by means of a parity grid system. By narrowing the band of variation,
a single currency was planned to be achieved by 1980 – some 19 years before the actual achievement
of fixed rates on 1 January 1999. In the spirit of the Werner plan, and in response to the Smithsonian
arrangements, the EEC set up what came to be known as the ‘snake in the tunnel’ or simply, the ‘snake’
system. Currencies, as under the Smithsonian Agreement, were allowed to vary 2.25 per cent either side
of the dollar, allowing currencies to rise or fall a total of 4.5 per cent. If a currency moved from its ceiling
to its floor while another currency went from the floor to the ceiling, the total movement between the
two currencies would be 2 × 4.5% 5 9 per cent. Such potential variation was considered to be too much
between members of the EEC. They therefore agreed in addition that they would maintain a 2.25 per cent
(half the Smithsonian band) with each other. When one currency rose to the top of its band with the
dollar, it would buy the weakest of the currencies. The snake came into operation in March 1972; the UK,
Denmark and Ireland joined in May 1972. The UK left the following month when the pound was floated.
Italy left in 1973 and France in 1976. When the European monetary system was established in 1979 (as
below), members of the snake were Germany, Benelux, Denmark and Norway.
The failure to develop a stable system in the 1970s was in no small part due to the large increases in oil
prices. In response to the Arab–Israeli war in October 1973 oil prices were increased by the Arab-dominated
Organization of the Petroleum Exporting Countries (OPEC). Prices increased in real terms (after adjusting
for inflation) by 126 per cent in 1974. Over the 1970s oil prices increased by 300 per cent, again in
real terms. Oil is paid for in dollars, therefore the devaluation of the dollar helped to offset the oil price
changes. Being linked to the dollar, however, meant that the beneficial effect of dollar devaluation was less
than if currencies floated freely against the dollar.
Creation of the European Monetary System (EMS). Despite the gradual disintegration of the snake, the UK
President of the European Commission, Roy Jenkins, relaunched the monetary union project by initiating
the European Monetary System in March 1979. This was a parity grid system that did not include the
dollar. Thus each country faced a central rate, and upper and lower rates with each other member of the
system. Originally, the currencies were allowed to diverge by 2.25 per cent above and below the central
rate and a wider band of 6 per cent for the Italian lira. The system became known as the Exchange Rate
Mechanism or ERM. In addition, a numeraire currency (a weighted basket of currencies) was created
known as the ECU. The new currency, later to become the euro, was used in the parity system as a measure
for determining intervention and also served to measure expenditure of the EEC.
A weighted basket of currencies can be thought of literally as a basket containing currencies. In this case
there were 1.15 French francs, 109 Italian lira, 0.82 of a German mark and so on. The value of the ECU
could be translated into any one currency simply by converting the currencies in the basket at the market
exchange rates to the desired currency. The amount of each currency in the basket was determined by the
level of trade undertaken by each country within the community. The lira had a low value, so 109 lira
amounted to less than 10 per cent of the value of the ECU in 1979. The German mark had a high value
and was about 33 per cent of the value of the ECU. The currency values in the basket were periodically
readjusted. The Special Drawing Right (SDR) is also a numeraire currency and serves a similar purpose for
the IMF. The value of the ECU was originally set at 1SDR, and the value of the euro was set at the then
value of an ECU in 1999.
Managed float. This system is usually dated from the Plaza Accord (September 1985) between the US,
France, Germany and the UK. The view was expressed at the meeting that the dollar was overvalued, but
no specific targets or timetable were offered to revise this. By early 1987 the dollar had lost more than
40 per cent from its highs in 1985 against the German mark and the Japanese yen. In February 1987 there
was another meeting in Paris (the Louvre Accord, this time including Canada) where it was jointly agreed
that the value of the dollar should be stabilized, but giving no indication as to how this was to be achieved.
The dollar continued to fall and only began to stabilize following a further meeting among the major
nations that Christmas (the ‘Telephone Accord’). Unlike previous attempts to influence the exchange rate,
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no specific targets were given to the market. The concept of soft targets was born. The advantage was that
the very large funds on the foreign exchange markets had no targets against which to speculate. Intervention
by the central banks initially sought to oppose market movements but later was refined to move rates in
relatively quiet periods with market trends that they approved of, rather than contest bouts of speculation.
The technique was later adopted by the Exchange Rate Mechanism of the EU to good effect.
Demise of the European Monetary System. At first the system worked well. Between 1979 and 1983 there
were 27 realignments averaging 5.3 per cent and between 1984 and 1987, 12 realignments averaging
3.8 per cent. The UK joined the ERM on 8 October 1990 after a period of high interest rates in order
to maintain the value of the British pound. The consensus was that the British pound was overvalued in
the parity grid. This was, in fact, a deliberate policy designed to keep inflation low. The reason was that
by making the British pound relatively expensive, prices in the UK would have to compete with imports
that were at an artificially low price. France had taken much the same action when it joined in 1979 and
had successfully reduced its inflation. The stratagem was nevertheless vulnerable. Measures needed to
protect the value of the British pound would now have to be much stronger given that the starting point
was already one of overvaluation. Needless to say, the market tested this vulnerability in 1992. A major
difference between 1979 and 1992 was that the international financial markets were much larger and
hence powerful, boosted in part by the relaxation of restrictions on portfolio investment. The breaking
point came as a result of German unification following the fall of the Berlin Wall in 1989. East Germany
was allowed to convert its currency to West German marks at a very favourable rate causing a 20 per cent
jump in the money supply. Growth was insufficient to absorb this increase. Government borrowing in
Germany was also higher to help finance the rebuilding of East Germany following years of neglect under
communist rule. As a result, the German government increased its interest rates. In order to prevent the
value of the British pound falling against the other currencies in the ERM, it was necessary to increase UK
interest rates as well. The currencies in the ERM were having to pay higher interest rates for reasons that
were purely concerned with the German economy.
The effect of an interest rate rise in the UK is very different from other member countries, due to the
tradition of borrowing to purchase houses in the UK. On the Continent, renting is the norm. Householders
in the UK typically borrow an amount equivalent to a limit of 5 years’ income to purchase their house
on variable interest loans (mortgages). A 1 per cent increase in a 6 per cent 25-year loan of £100,000 to
buy a house (i.e. a mortgage) is a rise of approximately £64 per month, a 2 per cent increase is a rise of
£129 per month. An increase in interest rates directly affects householders far more in the UK than in
the rest of Europe. Against this background, the market came to believe that UK politicians would prefer
to devalue the British pound rather than raise interest rates. The trial of strength with the markets came
on 16 September 1992 (‘Black Wednesday’). Speculators, treasurers of MNCs and investors all converted
British pounds into foreign currency in the belief that the pound was about to devalue. At 2.15pm, interest
rates were raised to 15 per cent from 10 per cent that morning. By 5.15pm, after using over £8 billion from
the foreign currency reserves of the Bank of England and other European central banks to support the
value of the pound, the pound was suspended from the ERM and allowed to devalue. The British pound
devalued by over 5 per cent in one day and by a further 5 per cent over the next month. The Italian lira
suffered a similar fate (Italy had also followed the UK out of the snake system). An attempt was then made
to speculate on a fall in the value of the French franc. The attempt failed, though at 30 January 1993 central
bank interest rates were: France 10 per cent, Germany 8.25 per cent and the UK 6.0625 per cent. The
fluctuation margins were increased to 15 per cent in August 1993, effectively ending the rigid form of the
ERM. Italy later rejoined the ERM. However, for the British pound, Black Wednesday marked the end of
formal participation in the European currency project – a position that is little changed today.
USING THE WEB
The website www.ecb.int/home/html/index.en.html provides information on the euro and monetary
policy conducted by the ECB.
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After 1992, greater variation of currencies in the looser form of the ERM did not ensue. A policy of soft
exchange rate targets was pursued. Occasional variations were not contested by the central banks; when
the market was quieter, intervention was made to encourage the markets to move in the approved direction.
The relative calm among European currencies after 1992 was in part due to the clear commitment to
create a single European currency by the end of the decade. The Maastricht Treaty was signed in February
1992 and among other provisions, ‘Resolved to achieve the strengthening and the convergence of their
economies and to establish an economic and monetary union including, in accordance with the provisions
of this Treaty, a single and stable currency.’ By stressing economic convergence, the lesson had been learnt
that exchange rate policy had to reflect economic realities.
Unlike many previous exchange rate agreements, the ERM came to an orderly end with the creation of
the euro in 1999.
European Monetary Union. The creation of the euro on 1 January 1999 meant the fixing of exchange
rates of the then 11 participating nations: Austria, Belgium, Finland, France, Germany, Ireland, Italy,
Luxembourg, the Netherlands, Portugal, Spain and later, Greece. Subsequently, in January and early
February 2002 these nations withdrew their national currencies and issued a common currency.
Together, the participating countries in the euro comprise almost 20 per cent of the world’s gross
domestic product – a proportion similar to that of the US. Three countries that were members of the EU
in 1999 (the UK, Denmark and Sweden) decided not to adopt the euro at that time. The ten countries in
Eastern Europe (including the Czech Republic and Hungary) that joined the EU in 2004 were be eligible
to participate in the euro in the future if they met specific economic goals. Countries that participate in
the EU are supposed to abide by the Growth and Stability Pact before they adopt the euro. This pact
requires, as mentioned earlier that the country’s annual budget deficit be less than 3 per cent of its gross
domestic product and government total borrowing be less than 60 per cent. These targets have, however,
not generally been met since the 2008–09 recession.
To join the euro, a country must restrict the movements of the euro relative to its home currency within
a range of plus or minus 15 per cent from an initially set exchange rate. This will allow it to convert
to euros at a particular exchange rate with some assurance of stability. Assuming that the country also
complies with other specified macroeconomic conditions, such as limiting inflation and its budget deficit,
a member state will be allowed to join the euro. Currently the euro is the official currency in 19 of the
member states of the EU, being: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece,
Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and
Spain. Countries in the EU but not part of the euro are the Czech Republic, Hungary, Sweden, Denmark,
Croatia, Romania, Bulgaria and Poland.
We might assume that countries within the EU would be charged the same interest rate given that
the currency is underwritten by all member states. This is not the case, in other words the market
prices investments in the respective government bonds, taking into account the possibility that a member
of the euro might default separately in the manner of a firm becoming bankrupt and not have debts
guaranteed by other members. Greece has been an example of this separate risk that is special to members
of the euro. This is a realistic prospect in that banks have had to write off loans to the Greek government,
but this has not been part of a general government insolvency. The degree of risk sharing within the
eurozone is therefore limited. In 2022 it is clear that bond yields (the annual return from buying a bond
at the current market price and holding it to maturity) reflect the difference in risk from investing in
the various members of the EU (Exhibit 6.6). Italy and Greece have been the main concerns and have
the highest bond yields. Clearly the market does not believe in collective responsibility among the EU
members just yet. The generally higher rates in non-euro countries reflects higher inflation particularly
with Romania, Russia and Turkey, but there are also sovereign debt worries as well.
As a historical note suggesting that little is new in finance, a similar form of standardization was attempted
in 1865 with the formation of the Latin Monetary Union. The principal members were France, Belgium,
Switzerland, Italy and Greece. Each member issued standard coins that were allowed to circulate freely
throughout the Union. Later, other countries, in particular, Austria, Bulgaria, Romania, Spain and Venezuela
issued coins of similar denomination and value without formally joining. The UK decided not to join, Greece
left the Union due to diluting the gold content of the coins but was readmitted two years later after adjusting
their monetary policy.25 Unsurprisingly, the euro suffers similar problems to previous monetary unions.
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CHAPTER 6
10-year bond yields for euro and non-euro European countries (2022)
22.5
EXHIBIT 6.6
199
Exchange rate history and the role of governments
G
N erm
et a
he ny
rla
-0.1
Fi nds
0.0
nl
a
Au nd 0.2
s
Sl tria
ov
0.2
B e a k ia
0.2
lg
iu
Fr m 0.2
an
Ire ce 0.3
Sl land
ov
0.3
Po eni
rtu a 0.3
g
L al
0.5
Li atv
t h ia
ua
0.5
ni
Sp a
0.6
Cr ain
0.6
oa
t ia
0.7
Ita
G ly
1.3
Sw ree
itz ce
er
1.5
D la
en nd
m
0.0
Sw ark
0.1
ed
Bu en
lg
0.3
ar
ia
0.7
Cz N U
ec o K
1.1
h rw
Re ay
pu
1.8
b
Po lic
3.2
lan
Ic d
ela
4.0
H nd
un
4.2
Ro gar
m y
4.7
an
Ru ia
5.5
s
Tu sia
rk
ey
9.4
Percentage
10-year bond yields
Euro and non-euro countries in interest rate order
Source: tradingeconomics.com
USING THE WEB
One of the best sources of the events of the EU debt crisis is Wikipedia. Follow ‘Greek governmentdebt crisis’ and subsequent links.
The eurozone crisis, 2010 onwards. In retrospect, the eurozone crisis seems little more than an introduction
to the new financial era of heavily indebted economies. At the time though, low government borrowing
and control of the money supply was seen as essential to good economic management. The EU Maastricht
Treaty commitments were that government borrowing should amount to no more than 60 per cent of GDP
and government deficits on its income less expenditure account should be no more than 3 per cent of GDP.
Following the 2008–9 global recession, a number of countries, including Greece and Italy in particular,
experienced deficit problems. To put the crisis into context, it is noteworthy that the GDP of Greece in 2019
since 2010 (i.e. excluding COVID-19) was the equivalent of –1.8 per cent, Italy 0.09 per cent per annum
growth, whereas Germany experienced 1.7 per cent and France 1.4 per cent per annum growth. In other
words, there are large differences that have persisted beyond the eurozone crisis. The crisis itself revolved
around government debt; again the figures in 2020 add some perspective: the debt-to-GDP ratios were
Germany 79 per cent, France 146 per cent, Greece 238 per cent and Italy 184 per cent. In 2009 Greece’s
borrowing was 113 per cent of GDP and in 2010 its spending deficit was 12.7 per cent, greatly in excess of the
60 per cent and 3 per cent Maasrticht guidelines.
This was further exacerbated by accounting irregularities. The fear was that Greece’s problems could
create a sovereign debt crisis that would spread throughout the eurozone. Greece became the recipient
of bailout funds with what is termed conditionality, that is requirements to reduce government spending.
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These demands were made by a ‘troika’, being a tripartite board of the IMF, European Commission
and the European Central Bank. Portugal and Ireland were also subject to bailout funds and concerns
were raised over Italy and Spain. The European Central Bank made loans to banks throughout these
countries to support the financial system. Countries themselves devalued by lowering wages to curtail
spending; Greek salaries were cut to the level in the late 1990s and Italy to 1986 levels. In 2011 the
eurozone ministers set up a permanent fund to lend to member countries in repayment difficulties
termed the European Stability Mechanism. The euro fell against the dollar, a fact that benefited Germany
in particular, as at the time it was the world’s largest exporter. These differences were, and still are,
reflected in the very large differences in GDP per head of population. In 2022, Greece with borrowing
already in excess of 200 per cent, is reported as demanding a relaxation of the EU debt rules for green
infrastructure investments, even though the 60 per cent, 3 per cent rule has been suspended until 2023
and seems unlikely to return.
Overall, the eurozone crisis was the first major test of the euro in that countries were being asked
to make significant sacrifices to remain members. As well as the negative overall economic data,
the impact on peoples’ lives was significant and there were riots in the streets, but there was never
sufficient support for leaving the euro – even though there would almost certainly have been economic
gains for some of the indebted countries. The crisis was also the emergence of a higher degree of joint
responsibility between member countries in the formation of the troika and the stability fund and a
certain degree of convergence between economic policies. At the time the reluctance of the ECB to bail
out indebted members was seen as the dominance of the northern countries’ economic conservatism
to which the traditionally more inflationary economies had to conform. The pandemic has altered
this balance. As stated above, the current ratios make the concerns of the crisis seem trivial. Now, the
prospect is of the ECB and the European Commission moving more to the looser monetary policies of
the Mediterranean states.
What are the lessons for those outside the eurozone? First, it demonstrates the severe economic and
political consequences of any form of monetary union. The reluctant acceptance of the severe economic
measures showed the level of social cohesion required. Second, when the euro was formed, the main
argument was on the reduction of transaction costs and exchange rate risk between the member states. The
crisis showed the significant impact that sharing a currency has on peoples’ lives, the business argument
being relatively trivial. Economically the euro does not appear to be an optimal currency area. The UK is
not in the euro and even the EU experienced growth from 2010 to 2019 of 2.0 per cent per annum, higher
than either France or Germany. Nevertheless, the crisis demonstrated the strong social cohesion among
member states in spite of the economic consequences. It is clearly a marriage that has survived the worst
and looks set to continue for a long time.
Case study: How Mexico’s pegged system led to the Mexican peso crisis. In 1994, Mexico’s central bank
used a special pegged exchange rate system that linked the peso to the US dollar but allowed the peso’s
value to fluctuate against the dollar within a band. The Mexican central bank enforced the link through
frequent intervention. In fact, it partially supported its intervention by issuing short-term debt securities
denominated in dollars and using the dollars to purchase pesos in the foreign exchange market. Limiting
the depreciation of the peso was intended to reduce inflationary pressure that can be caused by a very weak
home currency. The argument is that a weak home currency leads to more expensive imports creating a
cost push effect, thereby increasing inflation. Keeping the price of imports down, however, led in part to
a large balance of trade deficit in 1994. Because the peso was stronger than it should have been, Mexican
firms and consumers were encouraged to buy an excessive amount of imports.
Many speculators based in Mexico recognized that the peso was being maintained at an artificially high
level, and they speculated on its potential decline by investing their funds in the US. They planned to sell their
US investments if and when the peso’s value weakened, so that they could convert the dollars from their US
investments into pesos at a favourable exchange rate. As with the speculation against the British pound on
Black Wednesday, the selling of the peso for the dollar put even more downward pressure on the peso.
On 20 December 1994, Mexico’s central bank devalued the peso by about 13 per cent. Mexico’s stock
prices plummeted, as many foreign investors sold their shares and withdrew their funds from Mexico in
anticipation of further devaluations. On 22 December the central bank allowed the peso to float freely,
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201
and it declined by 15 per cent. This was the beginning of the so-called Mexican peso crisis. In an attempt
to discourage foreign investors from withdrawing their investments in Mexico’s debt securities, the central
bank increased interest rates. However, the higher rates increased the cost of borrowing for Mexican firms
and consumers, thereby slowing economic growth.
As Mexico’s short-term debt obligations denominated in dollars matured, the Mexican central bank
used its weak pesos to obtain dollars and repay the debt. Since the peso had weakened, the effective cost
of financing with dollars was very expensive for the central bank. Mexico’s financial problems caused
investors to lose confidence in peso-denominated securities, so they liquidated their peso-denominated
securities and transferred their funds to other countries. These actions put additional downward pressure
on the peso. In the four months after 20 December 1994, the value of the peso declined by more than
50 per cent. Over time, Mexico’s economy improved, and the paranoia that had led to the withdrawal
of funds by foreign investors subsided. The Mexican crisis might not have occurred if the peso had been
allowed to float throughout 1994, because the peso would have gravitated towards its natural level. The
crisis illustrates that central bank intervention will not necessarily be able to overwhelm market forces;
thus, the crisis may serve as an argument for letting a currency float freely.
Case study: The end of Argentina’s pegged system. In 1991 Argentina set up a currency board which linked
the peso to the dollar on a one-to-one basis. The money supply was limited to purchasing dollars. Strong
economic growth was checked in 1994 by the Mexican crisis and a decline in Argentina’s GDP. Growth
subsequently resumed but at the cost of increasing indebtedness. In 1998, Argentina was in recession, made
worse by the devaluation of the Brazilian real. About a third of Argentina’s exports were to Brazil. In 2001
Argentina defaulted on its international loan repayments. As many loans were denominated in dollars
and earnings were in pesos, loss of confidence in the peso led to a run on the banks. Withdrawals were
limited to $1,000 per month. In early 2002 the currency board was terminated and the peso was allowed
to devalue; by March the peso had lost nearly 70 per cent of its value. The government implemented
legislation on the conversion rate to be used in converting dollar debts to pesos. The burden of devaluation
was mainly placed on the lender, especially for the smaller debts.
In many ways the Argentina crisis is an illustration of Tobin’s proposition that a fixed exchange rate
is incompatible with free convertibility and an independent money supply, and hence borrowing policy.
It also illustrates the risk involved of a supposedly riskless fixed exchange rate. As noted above, inflation
has returned to Argentina and the country appears to be returning to the hyperinflation that the currency
board was designed to cure. Pegging a currency to reduce inflation is, however, an attempt to treat the
symptoms only, while the cause undoubtedly lies in the social and political tensions within societies.
Unfortunately, mainstream economic modelling offers little by way of such analysis.
Case study: The Asian crisis. From 1990 to 1997, Asian countries achieved higher economic growth than
any other countries. They were viewed as models for advances in technology and economic improvement.
In the summer and autumn of 1997, however, they experienced financial problems, leading to what is
commonly referred to as the ‘Asian crisis’, and resulting in bailouts of several countries by the IMF.
Much of the crisis is attributed to the substantial depreciation of Asian currencies, which caused severe
financial problems for firms and governments throughout Asia, as well as some other regions. This crisis
demonstrated how exchange rate movements can affect country conditions and therefore affect the firms
that operate in those countries.
Crisis in Thailand. Until July 1997, Thailand was one of the world’s fastest-growing economies. In fact,
Thailand grew faster than any other country over the 1985–94 period. Thai consumers spent freely, which
resulted in lower savings compared to other South East Asian countries. The high level of spending and
low level of saving put upward pressure on prices of real estate and products, and on the local interest rate.
Normally, countries with high inflation tend to have weak currencies because of forces from purchasing
power parity. Prior to July 1997, however, Thailand’s currency was linked to the dollar, which made
Thailand an attractive site for foreign investors; they could earn a high interest rate on invested funds
while being protected (until the crisis) from a large depreciation in the baht.
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Normally, countries desire a large inflow of funds because it can help support the country’s growth.
In Thailand’s case, however, the inflow of funds provided Thai banks with more funds than the banks
could use for making loans. Consequently, in an attempt to use all the funds, the banks made many very
risky loans. Commercial developers borrowed heavily without having to prove that the expansion was
feasible.
Lenders were willing to lend large sums of money based on the previous success of the developers.
The loans may have seemed feasible based on the assumption that the economy would continue its high
growth, but such high growth could not last forever. The corporate structure of Thailand also led to
excessive lending. Many corporations are tied in with banks, such that some bank lending is not an ‘arm’s
length’ business transaction, but a loan to a friend that needs funds.
In addition to the lending situation, the large inflow of funds made Thailand more susceptible to a
massive outflow of funds if foreign investors ever lost confidence in the Thai economy. Given the large
amount of risky loans and the potential for a massive outflow of funds, Thailand was sometimes described
as a ‘house of cards’, waiting to collapse.
While the large inflow of funds put downward pressure on interest rates, the supply was offset by a
strong demand for funds as developers and corporations sought to capitalize on the growth economy by
expanding. Thailand’s government was also borrowing heavily to improve the country’s infrastructure.
Thus, the massive borrowing was occurring at relatively high interest rates, making the debt expensive to
the borrowers.
During the first half of 1997, the dollar strengthened against the Japanese yen and European currencies,
which reduced the prices of Japanese and European imports. Although the dollar was linked to the baht
over this period, Thailand’s products were not priced as competitively to US importers.
Pressure on the Thai baht. The baht experienced downward pressure in July 1997 as some foreign
investors recognized its potential weakness. The outflow of funds expedited the weakening of the baht,
as foreign investors exchanged their baht for their home currencies. The baht’s value relative to the dollar
was pressured by the large sale of baht in exchange for dollars. On 2 July 1997, the baht was detached
from the dollar. Thailand’s central bank then attempted to maintain the baht’s value by intervention.
Specifically, it swapped its baht reserves for dollar reserves at other central banks and then used its
dollar reserves to purchase the baht in the foreign exchange market (this swap agreement required
Thailand to reverse this exchange by exchanging dollars for baht at a future date). The intervention was
intended to offset the sales of baht by foreign investors in the foreign exchange market, but market forces
overwhelmed the intervention efforts. As the supply of baht for sale exceeded the demand for baht in the
foreign exchange market, the government eventually had to surrender in its effort to defend the baht’s
value. In July 1997, the value of the baht plummeted. Over a five-week period, it declined by more than
20 per cent against the dollar.
Thailand’s central bank used more than $20 billion to purchase baht in the foreign exchange market
as part of its direct intervention efforts. Due to the decline in the value of the baht, Thailand needed more
baht to be exchanged for the dollars to repay the other central banks.
Thailand’s banks estimated the amount of their defaulted loans at over $30 billion. Meanwhile, some
corporations in Thailand had borrowed funds in other currencies (including the dollar) because the
interest rates in Thailand were relatively high. This strategy backfired because the weakening of the baht
forced these corporations to exchange larger amounts of baht for the currencies needed to pay off the
loans. Consequently, the corporations incurred a much higher effective financing rate (which accounts
for the exchange rate effect to determine the true cost of borrowing) than they would have paid if they
had borrowed funds locally in Thailand. The higher borrowing cost was an additional strain on the
corporations.
On 5 August 1997, the IMF and several countries agreed to provide Thailand with a $16 billion rescue
package. Japan provided $4 billion, while the IMF provided $4 billion. At the time, this was the second
largest bailout plan ever put together for a single country (Mexico had received a $50 billion bailout in
1994). In return for this monetary support, Thailand agreed to reduce its budget deficit, prevent inflation
from rising above 9 per cent, raise its value-added tax from 7 per cent to 10 per cent, and clean up the
financial statements of the local banks, which had many undisclosed bad loans.
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Exchange rate history and the role of governments
203
The rescue package took time to finalize because Thailand’s government was unwilling to shut down
all the banks that were experiencing financial problems as a result of their overly generous lending
policies. Many critics have questioned the efficacy of the rescue package because some of the funding was
misallocated due to corruption in Thailand.
Spread of the crisis throughout South East Asia. The crisis in Thailand was contagious to other countries
in South East Asia. The South East Asian economies are somewhat integrated because of the trade between
countries. The crisis was expected to weaken Thailand’s economy, which would result in a reduction in
the demand for products produced in the other countries of South East Asia. As the demand for those
countries’ products declined, so would their national income and their demand for products from other
South East Asian countries. Thus, the effects could perpetuate. Like Thailand, the other South East Asian
countries had had very high growth in recent years, which had led to overly optimistic assessments of future
economic conditions and thus to excessive loans being extended for projects that had a high risk of default.
These countries were also similar to Thailand in that they had relatively high interest rates, and their
governments tended to stabilize their currencies. Consequently, these countries had attracted a large
amount of foreign investment as well. Thailand’s crisis made foreign investors realize that such a crisis
could also hit the other countries in South East Asia. Consequently, they began to withdraw funds from
these countries.
In July and August 1997, the values of the Malaysian ringgit, Singapore dollar, Philippine peso and
Indonesian rupiah also declined. The Philippine peso was devalued in July. Malaysia initially attempted
to maintain the ringgit’s value within a narrow band but then surrendered and let the ringgit float to its
market-determined level. In August 1997, Bank Indonesia (the central bank) used more than $500 million
in direct intervention to purchase rupiah in the foreign exchange market in an attempt to boost the value
of the rupiah. By mid-August, however, it gave up its effort to maintain the rupiah’s value within a band
and let the rupiah float to its natural level. This decision by Bank Indonesia to let the rupiah float may
have been influenced by the failure of Thailand’s costly efforts to maintain the baht. The market forces
were too strong and could not be offset by direct intervention. On 30 October 1997, a rescue package
for Indonesia was announced, but the IMF and Indonesia’s government did not agree on the terms of the
$43 billion package until the spring of 1998. One of the main points of contention was that President
Suharto wanted to peg the rupiah’s exchange rate, but the IMF believed that Bank Indonesia would not
be able to maintain the rupiah’s exchange rate at a fixed level and that it would come under renewed
speculative attack.
As the South East Asian countries gave up their fight to maintain their currencies within bands, they
imposed restrictions on their forward and futures markets to prevent excessive speculation. For example,
Indonesia and Malaysia imposed a limit on the size of forward contracts created by banks for foreign
residents. These actions limited the degree to which speculators could sell these currencies forward, based
on expectations that the currencies would weaken over time. In general, efforts to protect the currencies
failed because investors and firms had no confidence that the fundamental factors causing weakness in the
currencies were being corrected. Therefore, the flow of funds out of the Asian countries continued; this
outflow led to even more sales of Asian currencies in exchange for other currencies, which put additional
downward pressure on the values of the currencies.
As the values of the South East Asian currencies declined, speculators responded by withdrawing more
of their funds from these countries, which led to further weakness in the currencies. As in Thailand, many
corporations had borrowed in other countries (such as the US) where interest rates were relatively low.
The decline in the values of their local currencies caused the corporations’ effective rate of financing to be
excessive, which strained their cash flow situation.
Due to the integration of South East Asian economies, the excessive lending by the local banks
across the countries, and the susceptibility of all these countries to massive fund outflows, the crisis
was not really focused on one country. What was initially referred to as the Thailand crisis became the
Asian crisis.
Impact of the Asian crisis on Hong Kong. On 23 October 1997, prices in the Hong Kong stock market
declined by 10.2 per cent on average; considering the three trading days before that, the cumulative
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204
PART II
EXCHANGE RATE BEHAVIOUR
four-day effect was a decline of 23.3 per cent. The decline was primarily attributed to speculation that
Hong Kong’s currency might be devalued and that Hong Kong could experience financial problems
similar to the South East Asian countries. The fact that the market value of Hong Kong companies
could decline by almost a quarter over a four-day period demonstrated the perceived exposure of
Hong Kong to the crisis.
During this period, Hong Kong maintained its pegged exchange rate system with the Hong Kong dollar
tied to the US dollar. However, it had to increase interest rates to discourage investors from transferring
their funds out of the country.
Impact of the Asian crisis on Russia. The Asian crisis caused investors to reconsider other countries where
similar effects might occur. In particular, they focused on Russia. As investors lost confidence in the Russian
currency (the rouble), they began to transfer funds out of Russia. In response to the downward pressure
this outflow of funds placed on the rouble, the central bank of Russia engaged in direct intervention by
using dollars to purchase roubles in the foreign exchange market. It also used indirect intervention by
raising interest rates to make Russia more attractive to investors, thereby discouraging additional outflows.
In July 1998, the IMF (with some help from Japan and the World Bank) organized a loan package
worth $22.6 billion for Russia. The package required that Russia boost its tax revenue, reduce its budget
deficit and create a more capitalist environment for its businesses.
During August 1998, Russia’s central bank commonly intervened to prevent the rouble from declining
substantially. On 26 August, however, it gave up its fight to defend the rouble’s value, and market forces
caused the rouble to decline by more than 50 per cent against most currencies on that day. This led to fears
of a new crisis, and the next day (called ‘Bloody Thursday’), paranoia swept stock markets around the world.
Some stock markets (including the US stock market) experienced declines of more than 4 per cent.
Lessons about exchange rates and intervention from the Asian crisis. The Asian crisis demonstrated the
degree to which currencies could depreciate in response to a lack of confidence by investors and firms
in a central bank’s ability to stabilize its local currency. If investors and firms had believed the central
banks could prevent the free fall in currency values, they would not have transferred their funds to other
countries, and South East Asian currency values would not have experienced such downward pressure.
The Asian crisis demonstrates how integrated country economies are, especially during a crisis. Just as
the US and European economies can affect emerging markets, they are also susceptible to conditions in
emerging markets. Even if a central bank can withstand the pressure on its currency caused by conditions
in other countries, it cannot necessarily insulate its economy from other countries that are experiencing
financial problems.
USING THE WEB
The Trading Economics website at: tradingeconomics.com is an easily accessible source of national
statistics collected for the most part by the IMF.
The Global Financial Crisis 2007–9. The global financial crisis had as a catalyst the mispricing of financial
instruments due to the overestimation of the effect of diversification. The Third World debt crisis in
1982 had a similar cause. The actual reduction in risk through diversification in a new form of lending
(collateralized debt obligations or CDOs) was greatly overestimated, and too much credit was being
created by the dollar – a condition that persists.
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CHAPTER 6
Exchange rate history and the role of governments
205
The first phase of the crisis (June 2007 to mid-March 2008) was caused by a housing boom in the
US. Rising house prices and low interest rates enabled borrowers to borrow ever-increasing amounts
for a house purchase. A new form of lending, subprime mortgage-backed securities often in the form
of bonds, enabled investors, typically foreign banks, to engage in lending to this market without a
great knowledge of the actual loans. There are obvious comparisons with the Asian crisis also fuelled
by foreign investment. Mortgages were pooled into bonds and then securitized in the form of CDOs.
Although the mortgages were subprime, meaning that the borrowers were a poor risk, by dividing the
debt pool into tranches (slices), low risk paper (AAA credit rating) could be created. The top or senior
tranche (AAA) would only have to start suffering bad debts if more than 24 per cent of loans went bad
(in a typical arrangement). The bottom or equity tranche would take on all of the first 8 per cent of
the bad loans and was held by the originating bank. Typically, this tranche would not receive a credit
rating. A huge moral hazard problem was created in the sense that those offering the mortgages were
not going to be responsible for the risk; it was sold on in the form of the CDOs. Compounding the
problem was the fact that those taking on the risk assumed that the loans were being issued responsibly
and underestimated the riskiness of the CDOs. Low interest rates at the time enabled estate agents
and banks with breathtaking indifference to their ‘customers’ to sell houses to people who were highly
unlikely to be able to repay the mortgage – this is an instance of what is termed predatory lending.
An increase in interest rates and a surplus of houses led to a decline in house prices and difficulty
in repaying the mortgages. The collateralized mortgage obligations were suddenly seen as being far
riskier. Although the AAA tranche went up in risk relatively moderately, the rate of return on the lower
tranches went up to rates that were difficult to estimate but were around 30 per cent – that is, the price
of the securities for the lower tranches fell dramatically as investors realized that the bad debts once
thought to be unlikely were now a real prospect due to the fact that the mortgages (the source of the
returns to the securities) were being sold to borrowers who could not afford to repay. Of particular note
was the prevention of withdrawals from funds managed by BNP Paribas in August 2007 as they warned
that: ‘The complete evaporation of liquidity in certain market segments of the US securitization market
has made it impossible to value certain assets fairly regardless of their quality or credit rating.’ BNP
was holding AAA paper and higher risks that they were unable to sell and hence unable to value. This
was the start of concerns over bank liquidity, leading ultimately to the collapse of Lehman Brothers in
September 2008. Only direct government intervention and guarantees of support prevented a complete
collapse. The UK government became majority shareholders in Lloyds Bank, HBOS and RBS, appointing
directors to the board. October 2008 to March 2009 saw the second phase as the market adjusted to
gloomy growth prospects.
The third phase from March 2009 to the present has seen some signs of recovery as countries report
growth in output. But also there are concerns as to how countries are going to repay the government
borrowing needed to rescue the banking system and, more generally, borrowing undertaken in the
early years of this century when it was assumed that repayment would be financed by economic
growth. Riots in Greece in February 2010 at the prospect of cutting government services illustrate the
dangers.
Generally, government borrowing in the developed countries has increased in recent years
(Exhibit 6.7); the problem of the Greek deficit is not so different from the problem facing many
developed countries. Governments are attempting to reduce the deficit by increasing taxes and reducing
government spending, but in doing so they risk a continuation of slow economic growth that threatens
to increase government spending to meet social security commitments (unemployment pay etc.). In
addition, therefore, social security rights are being reduced, including pensions and welfare payouts,
and pensionable ages increased, in the developed world. To some this may appear to be part of the ‘race
to the bottom’; ultimately you cannot compete with developing countries without having to adopt their
lower standards of social care. To others it is a necessary rebalancing of government spending promises
that were always unrealistic – the financial system is calling countries to account. Both views have
considerable empirical support.
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206
PART II
EXHIBIT 6.7
EXCHANGE RATE BEHAVIOUR
Debt to national income ratios >60% for countries with populations greater than 20m (2019)
250%
200%
150%
100%
50%
J
Ve apa
ne n
zu
e
Gr l a
ee
c
Su e
da
n
M
oz Ita
am ly
bi
qu
e
U
Fr S
an
ce
Sp
ain
An
go
la
Br
a
Ca zil
na
da
Eg
yp
t
Sr UK
iL
an
Pa ka
ki
Ar sta
ge n
nt
in
a
In
M dia
or
oc
U co
kr
ain
e
Gh
an
a
0%
Source: worldpopulationreview.com
The Gobal Financial Crisis has been a crisis of the developed world rather than the developing world.
As with the Third World Debt Crisis, high risk innovative lending was thought to be low risk. The cause
of the misestimating of the risk of these international investments is not clear. Poor market regulation,
poor accounting practices and excessive employee bonuses for short-term lending have all been cited. The
Third World Debt Crisis gave rise to the Basel agreements on bank reserves designed to curb excessively
risky portfolios. Basel III is a continuation of that process only this time informed by the Global Financial
Crisis. How does the world rein back on a culture of innovation and risk taking without damaging the
international financial system itself? How do countries repay debt without damaging the economic ‘engine’
that will repay that debt? There is no clear answer to these questions.26
China. China’s exchange rate policy has been described as one of the most controversial financial issues
in recent times.27 What is regarded as the artificially low value of the yuan (CNY), it has been estimated,
has resulted in a decline of a third in US manufacturing employment from 1990 to 2007.28 Chinese prices
have also been estimated as having a disproportionate effect on the import price index for the US: a
1 per cent movement of the yuan is estimated to have about the same effect on the import price index as
a 1 per cent movement in all other currencies. In July 2005 the Chinese government reacted to pressure to
allow the yuan to float against the dollar. It was announced that the currency would in future be pegged
to a basket of currencies and be allowed to move around that rate and over time to adjust to cumulative
changes. The composition of the basket was, however, not revealed. In early 2006 the rate was a little over
USDCNY 8 and in late 2021 it was 6.39. In other words the yuan has appreciated by only 15 per cent
over a period where it has become a major exporter.
The US government has called for China to revalue its currency between 20 and 40 per cent. The
consequences would obviously be a reduction in Chinese exports but also an increase in US inflation.
Auer29 estimates that an appreciation of 2.5 per cent a month over ten months would add 4 percentage
points to US inflation. If nothing else, this demonstrates the close interdependence of international trade
and domestic economies that is inevitable when one in six of the goods in the average US consumer’s
shopping basket comes from China. 30 The large surplus on the Chinese current account is met by net
outward investment on the financial account. Here China has been bundling its trade with investment,
often in the form of bilateral swaps and lending with in-kind repayments to emerging economies and
commodity countries.31 This has led to a greater risk of default with lending to countries with a default
history such as Argentina, Venezuela and Zimbabwe, which could in turn affect the value of the currency.
In 2018 the US imposed tariffs on $250 billion worth of goods on Chinese exports with threats to
include virtually all Chinese exports to the US. The US imports over 20 per cent by value from China. It is
estimated that the supply chain can absorb most of the tariff. In other words, the pass through (net effect)
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CHAPTER 6
Exchange rate history and the role of governments
207
will be less than 25 per cent. Chinese retaliation could be significant in that China holds some 14 per cent
of US Treasury bonds. If they were to sell these, the US interest rate may have to increase, which could
reduce economic activity. This is at best an uneasy relationship.
COVID-19. At the time of writing the COVID-19 pandemic has not caused a financial crisis. There is
nevertheless much anticipation that the high levels of government borrowing (Exhibit 6.7) coupled with
high inflation rates (eurozone average of 5 per cent), an uncertain economic recovery and negative real
saving rates (i.e. interest rate less than inflation) will lead to a global recession. Exchange rates have not
been central to this scenario owing to the relatively even spread of uncertainty across the world. MNCs
have nevertheless experienced severe disruptions to trade owing to COVID-19 restrictions, but shortages
have been far less than anticipated. Existing currency crises in Turkey and Venezuela are unrelated to
the pandemic. It is worth noting that a pandemic risk was recognized by the UK government in a risk
assessment exercise prior to the pandemic but there was no preparation. Perhaps there is a class of extreme
events for which the consequences are so great and so uncertain that preparation is impossible. Could the
same also be said of the 2008 global recession or indeed the Third World Debt Crisis?
Summary
●●
●●
Exchange rate systems can be classified as fixed
rate, freely floating, managed float and pegged. In
a fixed exchange rate system, exchange rates are
either held constant or allowed to fluctuate only
within very narrow boundaries. In a freely floating
exchange rate system, exchange rate values are
determined by market forces without intervention.
In a managed float system, exchange rates are
not restricted by boundaries but are subject to
government intervention. In a pegged exchange
rate system, a currency’s value is pegged to a
foreign currency or a unit of account and moves
in line with that currency (or unit of account)
against other currencies.
Governments can use direct intervention by
purchasing or selling currencies in the foreign
exchange market, thereby affecting demand
and supply conditions and, in turn, affecting the
equilibrium values of the currencies. When a
government purchases a currency in the foreign
exchange market, it puts upward pressure on the
currency’s equilibrium value. When a government
sells a currency in the foreign exchange market,
it puts downward pressure on the currency’s
equilibrium value.
●●
Governments can use indirect intervention by
influencing the economic factors that affect
equilibrium exchange rates.
●●
History shows a continuing narrative of
international economic crises for which there is
no explicit predictive model.
●●
Some insight is gained by the impossibility
theorem of the trilemma that a fixed exchange
rate (desirable for stability), free capital movement
(implying free interest rates) and sovereign
monetary policy (affecting inflation and interest)
cannot all exist at the same time. The relative
importance of these factors constantly varies
over time creating financial crises.
Critical debate
To join or not to join ...
Proposition. The UK should rejoin the EU. The Financial
Times (26 April 2022) reported on a survey by the LSE
Centre for Economic Performance that found that exports
to the EU have returned to the pre-pandemic levels but
the post Brexit number of buyer–seller links has fallen by
a third, having a particular effect on smaller businesses.
Customs controls, VAT and regulatory red tape were
identified as the principal reasons for such firms deciding
not to trade with the EU. In addition, it appears to be
difficult to have no border controls with Northern Ireland
and implement import and export regulations. There have
also been significant labour shortages in services and
farming with the reduced numbers from the EU, again
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208
PART II
EXCHANGE RATE BEHAVIOUR
due to regulatory barriers. Finally, European security is
enhanced through greater union.
Opposing view. Brexit was as much about sovereignty
and democracy as it was about short-term economics.
Vital economic policies developed and decided upon
by the Council of Ministers, Commissioners and the
European Central Bank gave the UK minimal influence
over the future of its economy. The European courts
take precedence over UK courts, the UK government
has to implement EU law over which it has minimal
influence; this is the creation of an authoritarian state
by the back door. The labour shortages merely show
the ‘taking our jobs’ argument, particularly among the
lower income groups, had indeed some substance.
There will no doubt be further economic disruption
as society adjusts to improving its own labour force
rather than importing and to an extent stealing skills
from abroad – but this will be worthwhile.
With whom do you agree?
1 Is a single currency necessary for further EU
integration?
2 Does the UK economy necessarily need a separate
currency?
3 Is a separate currency really the cause of the
spread of the Anglo-Saxon model; what other
factors underlie the Anglo-Saxon model?
The gold standard
Proposition. Developing countries should adopt the
gold standard. History shows that a lack of confidence
in the currencies of developing countries is the major
cause of the financial crises. Under the gold standard,
currencies would be convertible into gold. Currency
value would be more stable; countries would be less
likely to borrow excessively. More investment would
be attracted to developing countries as in the pre–First
World War era. Should developing countries adopt
the gold standard? How else might a country create
confidence in its currency?
Opposing view. Credit would be restricted to the
reserves of gold and would arrest development.
Alternatively, convertibility would be limited. The large
level of imports needed for a developing country would
lead to balance of payments difficulties which in turn
would lead to a reduction in the money supply as sterilized
intervention would not be possible. The consequent
deflation would be disastrous for a developing country.
Self test
Answers are provided in Appendix A at the back of
the text.
1 Explain why it would be difficult to maintain a
fixed exchange rate between the euro and the
dollar.
2 Assume the European Central Bank (ECB) believes
that the dollar should be weakened against the
euro. Explain how the ECB could use direct and
indirect intervention to weaken the dollar’s value
with respect to the euro. Assume that future
inflation in the EU is expected to be low, regardless
of the ECB’s actions.
3 Briefly explain why a central bank may wish to
weaken the value of its currency.
Questions and exercises
1 Explain what is meant by each of a fixed, managed float, pegged and freely floating exchange rate policy.
2 Explain the advantages and disadvantages of each of the fixed, managed float, pegged and freely floating
exchange rate systems.
3 What is a currency board and what is its purpose?
4 How is a pegged system exposed to interest rate movements?
5 Does the euro represent an optimal currency area?
6 Compare and contrast Black Wednesday (1992) with the eurozone crisis using the concept of an optimal
currency area.
7 Why would a government seek to unpeg its currency and what examples are there in history of this being done?
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CHAPTER 6
Exchange rate history and the role of governments
209
8 What is the difference between sterilized and non-sterilized intervention?
9 What is meant by indirect intervention?
10 What effect does a strong and a weak currency have on an economy?
11 What is the Balassa Samuelson effect?
12 What is the trilemma of government policy choice?
13 Why do free capital movements and fixed exchange rates dictate monetary policy?
14 Summarize the interwar period: what effect does it have today?
15 Consider whether or not the euro borrowing requirements should be relaxed as demanded by Greece (use data
from data.worldbank.org/ to support your argument.
Discussion in the boardroom
Running your own MNC
This exercise can be found in the digital resources for
this book.
This exercise can be found in the digital resources for
this book.
Endnotes
1 In the transferrable account system after the Second World
War, Britain was said to have 57 varieties of pound (as
with Heinz soup). Allen, W. (2014) Monetary Policy and
Financial Repression in Britain, 1951–59, Palgrave, 258.
Even in the early 1970s in the UK there was one rate for
current account transactions and another rate for capital
transactions where foreign currency was auctioned off at
a premium.
2 Reinhart, C. and Rogoff, K. (2004) ‘The modern history
of exchange rate arrangements: A reinterpretation’, The
Quarterly Journal of Economics, 119(1), 1–48.
3 Refer to Sarno, L. and Taylor, M. P. (2001) ‘Official
intervention in the foreign exchange markets: Is it effective
and, if so, how does it work?’, Journal of Economic
Literature, 34(3), 839–68; and Menkhoff, L. (2013) ‘Foreign
exchange intervention in emerging markets: A survey of
empirical studies’, The World Economy, 1187–208.
4 Eichengreen, B. (1999) ‘Kicking the habit: Moving from
pegged exchange rates to greater exchange rate flexibility’,
The Economic Journal, March, C1–C14; and Eichengreen,
B. (2000) ‘Taming capital flows’, World Development,
28(6), 1105–16.
5 Mundell, R. (1961) ‘A theory of optimum currency areas’,
American Economic Review, 51(4), 657–65.
6 Eurofound (2012) ‘Ireland: Evolution of wages during
the crisis’. Available at: www.eurofound.europa.eu/
publications/report/2012/ireland-evolution-of-wagesduring-the-crisis [Accessed 21 October 2019].
7 Willett, T. (1998) ‘Credibility and discipline effects of
exchange rates as nominal anchors: The need to distinguish
temporary from permanent pegs’, World Economy,
21(6), 803–26.
8 Eichengreen, B., Hausmann, R. and Panizza, U. (2002)
‘Original sin: The pain, the mystery, and the road to
redemption’, Paper prepared for the conference Currency
9
10
11
12
13
14
15
16
17
and Maturity Matchmaking: Redeeming Debt from Original
Sin, Inter-American Development Bank, Washington,
DC. Available at: www.financialpolicy.org/financedev/
hausmann2002.pdf [Accessed 1 October 2019].
Levy-Yeyati, E., Sturzenegger, F. and Reggio, I. (2010)
‘On the endogeneity of exchange rate regimes’, European
Economic Review, 54, 659–77.
Klein, M. and Shambaugh, J. (2010) Exchange Rate
Regimes in the Modern Era, MIT, chapter 5.
Amann, E. and Baer, W. (2000) ‘The illusion of stability: The
Brazilian economy under Cardoso’, World Development,
28(10), 1805–19.
Haircuts are often used as an example of a non-exportable
service.
Tobin, J. (2000) ‘Financial globalization’, World
Development, 28(6), 1101–04.
Klein, M. and Shambaugh, J. (2010) Exchange Rate
Regimes in the Modern Era, MIT, 47; and Reinhart, C. and
Rogoff, K. (2004) ‘The modern history of exchange rate
arrangements: A reinterpretation’, Quarterly Journal of
Economics, 119(1), 1–48.
Aizenman, J. and Ito, H. (2014) ‘Living with the trilemma
constraint: Relative trilemma policy divergence, crises,
and output losses for developing countries’, Journal of
International Money and Finance, 49, 28–51.
Rose, A. (2000) ‘One money, one market: The effect
of common currencies on trade?’, Economic Policy: A
European Forum, (April), 30, 7–33. Also refer to Baldwin,
R. (2006) ‘The Euro’s trade effects’, ECB Working Paper
No. 594; and Klein, M. and Shambaugh, J. (2006) ‘Fixed
exchange rates and trade’, Journal of International
Economics, 70(2), 359–83.
Berger, H. and Nitsch, V. (2008) ‘Zooming out: The trade
effect of the euro in historical perspective’, Journal of
International Money and Finance, 27, 1244–60.
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210
PART II
EXCHANGE RATE BEHAVIOUR
18 Willett, T., Permpoon, O. and Wihlborg, C. (2010)
‘Endogenous OCA analysis and the early euro experience’,
World Economy, 33(7), 851–72.
19 Broz, J. L. (2002) ‘Political system transparency and
monetary commitment regimes’, International Organization,
56(4), 861–7.
20 Bernhard, W. and Leblang, D. (1999) ‘Democratic
institutions and exchange rate commitments’, International
Organization, 53(1), 71–97.
21 Levy-Yeyati, E. and Sturzenegger, F. (2005) ‘Classifying
exchange rate regimes: Deeds vs. words’, European Economic
Review, 49(6), 1603–35; and Broz, L., Freiden, J. and
Weymouth, S. (2008) ‘Exchange rate policy attitudes: Direct
evidence from survey data’, IMF Staff Papers, 55(3), 417–44.
22 Klein, M., Schuh, S. and Triest, R. (2003) ‘Job creation,
job destruction and the real exchange rate’, Journal of
International Economics, 59(2), 239–65.
23 Mann, C. (2004) ‘Managing exchange rates: Achievement
of global rebalancing or evidence of co-dependency?’,
Business Economics, July, 20–9.
24 Ivanova, M. N. (2010) ‘Hegemony and seigniorage: The
planned spontaneity of the US current account’, International
Journal of Political Economy, 39(1), 93–130.
25 Refer to Bennhold, K. (2012) When Greece Exited from
Latin Monetary Union in 1908…[Blog] Mostly Economics.
Available at: mostlyeconomics.wordpress.com/2012/05/24/
when-greece-exited-from-latin-american-union-in-1908/
[Accessed 1 October 2019].
26 Also refer to Issing, O. (2009) ‘Some lessons from the
financial market crisis’, International Finance, 12(3), 431–44.
27 Frankel, J. (2010) ‘The renminbi since 2005’. Available
at: scholar.harvard.edu/frankel/publications/remnibi-2005
[Accessed 1 October 2019].
28 Autor, D., Dorn, D. and Hanson, G. (2013) ‘The
China Syndrome: Local labor market effects of import
competition in the United States’, American Economic
Review, 103, 2121–68.
29 Auer, R. (2015) ‘Exchange rate pass-through, domestic
competition, and inflation: Evidence from the 2005–08
revaluation of the renminbi’, Journal of Money, Credit and
Banking, 47(8), 1617–50.
30 Rynn, J. (2005) ‘Why manufacturing and the infrastructure
are central to the economy: A global vision of peace, prosperity,
democracy, and ecological sustainability’. Available at:
economicreconstruction.org/sites/economicreconstruction.
com/static/JonRynn/WhyManufacturingIsCentral.pdf
[Accessed 1 October 2019]
31 Garcia-Herrero, A. and Xia, L. (2015) ‘China’s RMB bilateral
swap agreements: What explains the choice of countries?’,
BOFIT Discussion Papers 5/30/2013, Issue 12, 1–22.
Essays/discussion and articles can be found at the end of Part II.
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CHAPTER 6
Exchange rate history and the role of governments
211
BLADES PLC CASE STUDY
Assessment of government influence on exchange rates
Recall that Blades, the UK manufacturer of
rollerblades, generates most of its revenue and
incurs most of its expenses in the UK. However, the
company has recently begun exporting rollerblades
to Thailand. The company has an agreement with
Entertainment Products, Inc., a Thai importer, for
a three-year period. According to the terms of the
agreement, Entertainment Products will purchase
180,000 pairs of ‘Speedos’, Blades’ primary product,
annually at a fixed price of 4,594 Thai baht per pair.
Due to quality and cost considerations, Blades is also
importing certain rubber and plastic components
from a Thai exporter. The cost of these components
is approximately 2,871 Thai baht per pair of Speedos.
No contractual agreement exists between Blades
plc and the Thai exporter. Consequently, the cost
of the rubber and plastic components imported
from Thailand is subject not only to exchange rate
considerations but to economic conditions (such as
inflation) in Thailand as well.
Shortly after Blades began exporting to and
importing from Thailand, Asia experienced weak
economic conditions. Consequently, foreign
investors in Thailand feared the baht’s potential
weakness and withdrew their investments, resulting
in an excess supply of Thai baht for sale. Because
of the resulting downward pressure on the baht’s
value, the Thai government attempted to stabilize
the baht’s exchange rate. To maintain the baht’s
value, the Thai government intervened in the
foreign exchange market. Specifically, it swapped
its baht reserves for dollar reserves at other
central banks and then used its dollar reserves to
purchase the baht in the foreign exchange market.
However, this agreement required Thailand to
reverse this transaction by exchanging dollars
for baht at a future date. Unfortunately, the Thai
government’s intervention was unsuccessful, as it
was overwhelmed by market forces. Consequently,
the Thai government ceased its intervention efforts,
and the value of the Thai baht declined substantially
against the dollar over a three-month period.
When the Thai government stopped intervening
in the foreign exchange market, Ben Holt, Blades’
Finance Director, was concerned that the value of
the Thai baht would continue to decline indefinitely.
Since Blades generates net inflow in Thai baht,
this would seriously affect the company’s profit
margin. Furthermore, one of the reasons Blades
had expanded into Thailand was to appease the
company’s shareholders. At last year’s annual
shareholder meeting, they had demanded that
senior management take action to improve the
firm’s low profit margins. Expanding into Thailand
had been Holt’s suggestion, and he is now afraid
that his career might be at stake. For these
reasons, Holt feels that the Asian crisis and its
impact on Blades demands his serious attention.
One of the factors Holt thinks he should consider
is the issue of government intervention and how
it could affect Blades in particular. Specifically, he
wonders whether the decision to enter into a fixed
agreement with Entertainment Products was a
good idea under the circumstances. Another issue
is how the future completion of the swap agreement
initiated by the Thai government will affect Blades.
To address these issues and to gain a little more
understanding of the process of gover nment
intervention, Holt has prepared the following list
of questions for you, Blades’ financial analyst,
since he knows that you understand international
financial management.
1 Did the intervention effort by the Thai government
constitute direct or indirect intervention? Explain.
2 Did the intervention by the Thai government
constitute sterilized or non-sterilized intervention?
What is the difference between the two types
of intervention? Which type do you think would
be more effective in increasing the value of the
baht? Why? (Hint: think about the effect of nonsterilized intervention on UK interest rates.)
3 If the Thai baht is effectively fixed with respect
to the dollar, how could this affect UK levels of
inflation? Do you think these effects on the UK
economy will be more pronounced for companies
such as Blades that operate under trade
arrangements involving commitments or for firms
that do not? How are companies such as Blades
affected by a fixed exchange rate?
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PART II
EXCHANGE RATE BEHAVIOUR
4 What are some of the potential disadvantages
for Thai levels of inflation associated with the
floating exchange rate system that is now used
in Thailand? Do you think Blades contributes to
these disadvantages to a great extent? How are
companies such as Blades affected by a freely
floating exchange rate?
5 What do you think will happen to the Thai baht’s
value when the swap arrangement is completed?
How will this affect Blades?
SMALL BUSINESS DILEMMA
Assessment of central bank intervention by the Sports Exports Company
Jim Logan, owner of the Sports Exports Company, is
concerned about the value of the British pound over
time because his firm receives pounds as payment
for basketballs exported to the UK. He recently read
that the Bank of England (the central bank of the UK)
is likely to intervene directly in the foreign exchange
market by flooding the market with British pounds.
1 Forecast whether the British pound will weaken or
strengthen based on the information provided.
2 How would the performance of the Sports Exports
Company be affected by the Bank of England’s
policy of flooding the foreign exchange market with
British pounds (assuming that it does not hedge its
exchange rate risk)?
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CHAPTER 7
Forecasting exchange
rates
LEARNING OBJECTIVES
The specific objectives of this chapter are to:
●●
Explain how firms can benefit from forecasting exchange rates.
●●
Describe the common techniques used for forecasting.
●●
Explain how forecasting performance can be evaluated.
Many decisions of MNCs are influenced by exchange rate projections. Financial managers must understand the
problems and methods of forecasting exchange rates so that they can make decisions that maximize the value of
their MNCs.
213
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PART II
EXCHANGE RATE BEHAVIOUR
Why firms forecast exchange rates
While the academic models of purchasing power parity (PPP), the international Fisher effect (IFE) also
termed uncovered interest rate parity (UIP), provide powerful rationales for explaining changes in
exchange rates, in practice, their predictive power is poor. Typically, statistical models based on PPP or IFE
will explain 10 per cent or less of the variation in exchange rates. Statements such as ‘invest in a country
with a high interest rate’ are therefore allowable as long as it is understood that this consideration must
include any offsetting devaluation in the currency.
Even if models were to explain actual movements much better, there would still be the problem of
‘fat tails’. This is the finding that the normal distribution, on which statistical models are based, tends
to underestimate extreme movements. Actual distributions tend to have a higher frequency of very high
and very low movements, hence the high and low values (tails) of the normal distribution are ‘fatter’ than
would be predicted by a normal distribution. This is unfortunate because predicting large movements in
exchange rates is much more valuable to an MNC than predicting small movements.
Virtually every operation of an MNC can be influenced by changes in exchange rates. The following are
some of the corporate functions for which exchange rate forecasts are necessary:
●●
Hedging decision. MNCs constantly face the decision as to whether to hedge future payments and receipts
in foreign currencies. Whether a firm hedges may be determined by its forecasts of foreign currency values.
EXAMPLE
Pierre SA, based in France, plans to pay for clothing
imported from Mexico in 90 days. If the forecasted
value of the peso in 90 days is sufficiently below the
90-day forward rate, the MNC may decide not to
hedge. In other words, it will not have to pay insurance
●●
(hedge) to protect against the possibility of a price rise.
Forecasting may therefore enable the firm to make a
successful forecast that will reduce expenditure for
the firm and increase its cash flows.
Short-term financing decision. When large corporations borrow, they have access to several different
currencies. The currency they borrow will ideally: (1) exhibit a low interest rate, and (2) decline in value
over the financing period and therefore be cheaper to repay.
EXAMPLE
Luigi SpA, an Italian-based company, considers
borrowing Japanese yen to finance its European
operations because the yen has a low interest
rate. If the yen depreciates against the euro over the
financing period, the firm can pay back the loan with
●●
fewer euros (when converting those euro in exchange
for the amount owed in yen). The decision as to
whether to finance with yen or euro is dependent on a
forecast of the future value of the yen.
Short-term investment decision. Corporations sometimes have a substantial amount of excess cash
available for a short time period. Large deposits can be established in several currencies. The ideal
currency for deposits will: (1) exhibit a high interest rate, and (2) strengthen in value over the investment
period.
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CHAPTER 7
Forecasting exchange rates
215
EXAMPLE
Roar ASA, a Norwegian-based company, has excess
cash and considers depositing the cash into a British
bank account. If the British pound appreciates against
the Norwegian krone by the end of the deposit period
when pounds will be withdrawn and exchanged
●●
for krone, more krone will be received than was
invested. Thus, the firm can use forecasts of the
pound’s exchange rate when determining whether to
invest the short-term cash in a British account or a
Norwegian account.
Capital budgeting decision. When an MNC’s parent assesses whether to invest funds in a foreign project,
the firm takes into account that the project may periodically require the exchange of currencies. The
capital budgeting analysis can be completed only when foreign payments to the parent company are
measured in terms of its home currency.
EXAMPLE
Decker BV from Belgium wants to determine whether
to establish a subsidiary in Thailand. Forecasts of
the future cash flows used in the capital budgeting
process will be dependent on the future exchange
rate of Thailand’s currency (the baht) against the euro.
This dependency can be due to (1) future inflows
●●
denominated in baht that will require conversion to
euros, and/or (2) the influence of future exchange
rates on demand for the subsidiary’s products.
Accurate forecasts of currency values will improve the
estimates of the cash flows and therefore enhance
the MNC’s decision-making.
Earnings assessment. The parent’s decision about whether a foreign subsidiary should reinvest earnings
in a foreign country or remit earnings back to the parent may be influenced by exchange rate forecasts.
If a strong foreign currency is expected to weaken substantially against the parent’s currency, the parent
may prefer to convert the foreign earnings before the foreign currency weakens.
Exchange rate forecasts are also useful for forecasting an MNC’s earnings. When earnings of an MNC
are reported, subsidiary earnings are consolidated and translated into the currency representing the parent
firm’s home country.
EXAMPLE
Monroe Ltd has its home office in the UK and
subsidiaries in Canada and the US. It must decide
whether its Canadian and US subsidiaries should
remit their earnings. This involves comparing the
amount of dollar cash flows that would be received
today (if the subsidiaries remit the earnings) to the
potential dollar cash flows that would be received in
the future (if the subsidiaries reinvest the earnings).
The decision is influenced by Monroe’s forecast of the
value of the Canadian dollar and the US dollar at the
time when the future earnings of the subsidiaries
would be remitted.
(Continued )
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For accounting purposes, the Canadian subsidiary’s
earnings in Canadian dollars must be measured
by translating them to British pounds. The US
subsidiary’s earnings in dollars must also be measured
by translation to pounds. ‘Translation’ does not mean
that the earnings are physically converted to British
pounds. It is simply a periodic recording process so
●●
that consolidated earnings can be reported in a single
currency. In this case, appreciation of the Canadian
dollar will boost the Canadian subsidiary’s earnings
when they are reported in (translated to) pounds.
Forecasts of exchange rates thus play an important
role in the overall forecast of an MNC’s consolidated
earnings.
Long-term financing decision. Corporations that issue bonds to secure long-term funds may consider
denominating the bonds in foreign currencies. They prefer the currency borrowed to depreciate over time
against the currency they are receiving from sales. To estimate the cost of issuing bonds denominated in a
foreign currency, forecasts of exchange rates are required.
EXAMPLE
Harold plc, a UK-based company, needs long-term
funds to support its UK business. It can issue
10-year bonds denominated in Japanese yen at
a 1 per cent coupon rate, which is 5 percentage
points less than the prevailing coupon rate on British
pound-denominated bonds. However, Harold will
need to convert pounds to yen to make the coupon
or principal payments on the yen-denominated bond.
So if the yen’s value rises, the yen-denominated bond
could be costlier to Harold than a pound-denominated
bond. Harold’s decision to issue yen-denominated
bonds versus pound-denominated bonds will be
dependent on its forecast of the yen’s exchange rate
over the 10-year period.
Although most forecasting is applied to currencies whose exchange rates fluctuate continuously,
forecasts are also relevant for currencies whose exchange rates are fixed at the time of investigation.
The likelihood of a change in the fixed rate is an important risk.
EXAMPLE
Even though the Argentine peso’s value was still
pegged to the US dollar in 2001, some MNCs
anticipated that it would be devalued. They therefore
made forecasts of its unpegged value. The peso was
unpegged with the dollar in January 2002 going from
1 peso to the dollar to 1.4 peso and by the end of the
year 3.4 peso to the dollar! In the UK the exit from the
ERM (exchange rate mechanism, a form of fixed rate)
on 16 September 1992, ‘Black Wednesday’, led to
a fall in the value of the pound by 25 per cent at the
end of the year. It was said at the time that a number
of multinational companies engaged in leading
and lagging, that is they delayed converting foreign
currency into UK pounds and advanced payments
before the fall in value of the UK pound.
An MNC’s motives for forecasting exchange rates are summarized in Exhibit 7.1. The motives are
distinguished according to whether they can enhance the MNC’s value by influencing its cash flows or its
cost of capital. The need for accurate exchange rate projections should now be clear. The following section
describes the forecasting methods available.
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CHAPTER 7
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Forecasting exchange rates
EXHIBIT 7.1 Corporate motives for forecasting exchange rates
Decide whether
to hedge foreign
currency cash
flows
Decide whether
to invest in
foreign projects
Cash
flows
Forecasting
exchange rates
Decide whether
foreign
subsidiaries should
remit earnings
Decide whether
to obtain
financing in
foreign currencies
Value of the
firm
Cost of capital
Forecasting techniques
The numerous methods available for forecasting exchange rates can be categorized into four general
groups: (1) technical, (2) fundamental, (3) market-based and (4) mixed. The concept of market efficiency
puts these methods in to context.
Market efficiency
The efficiency of the foreign exchange market has implications for the approach to predicting movements
as the efficient markets hypothesis (often referred to as EMH) attempts to answer the question: why do
prices change? If the reason for a price change is established, then it will be possible to select which models
should perform better.
The simple idea behind the efficient markets hypothesis is that prices change as a result of news. If the
news is good, the price goes up; if the news is bad, the price goes down. What is meant by news, however,
needs to be clearly understood. In the ordinary meaning of the word, news means information. In this
context, however, news is taken to mean the unexpected, literally what is new. We can therefore write:
News 5 ‘Actual information’ 2 ‘Expected information’
This simple formula has important implications in understanding markets. For example, to say that the
publication of a positive balance of payments is good news and the exchange rate should as a result
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PART II
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increase is in itself a misunderstanding, as a positive balance of payments could be good or bad news.
To illustrate:
Good news 5 Published current account balance $10bn positive 2 Market expectation $6bn
Bad news 5 Published current account balance $10bn positive 2 Market expectation $12bn
The impact of any single piece of information can therefore be positive or negative. This means that in
times of economic hardship the exchange rate is still likely to go up or down. Although the news in
absolute terms may be bad, it may yet be better or worse than expected, depending on expectations. The
argument is therefore that in a market context it is news that is the driving force behind a change in the
market price. The logic of this reasoning is very attractive.
With this understanding of news, the efficient markets hypothesis is traditionally divided into ‘weak’,
‘semi-strong’ and ‘strong’. These rather odd terms refer to the degree to which news is identified in testing.
If the foreign exchange market is weak-form efficient, the price reflects estimates of the future value
of the currency. All known information about the future is discounted into the current price. This implies
that historical information has no role to play in explaining a change in price. Such information whether
it is about past events or future expected events is already included in the current expectation (the current
price) and therefore cannot be news. This has three implications.
First, technical analysis has no role to play in estimating changes in the exchange rate. Technical
forecasting attempts to find patterns in exchange rates, and a pattern over time by its very definition is
determined by movements in the past as the pattern unfolds. A head and shoulder pattern predicts a fall
when past movements indicate that the exchange rate has reached the top of the head and so on. So a
pattern is inherently backward looking.
The second implication is that the movement of the exchange rate should be random as there can, by
definition, be no pattern. Weak form tests are confined to establishing that the movements of market prices
such as shares and exchange rates are random and without a pattern. Randomness is therefore the ‘footprint’
of a price that is reacting to news but the tests do not identify any piece of news as such, hence the term ‘weak’.
Generally, in the scientific and natural world structures such as DNA that are rich in information tend
to be random; the stock market is also rich in information. The following extract from Davies (2015)
illustrates the link: ‘Consider the binary sequence 101010101010101010 … This can be generated by
the simple command “Print 10 n times” … the output has very little information content. By contrast an
apparently random sequence such as 110101001010010111… cannot be condensed into a simple set
of instructions, so it has a high information content’ (p. 17).1 We should not be surprised that the high
information content that is the stock market should produce price movements that are random.
The third implication is that if the movement is random, the changes should be normally distributed.
If there is an equal chance of a rise or fall over successive days, the probabilities of the price changes
over time evolve into a normal distribution. Demonstrations from repeated lots of two flips of a coin
representing two days (with heads as a rise and tails as a fall) will show that on average two flips will
result in a 25 per cent chance of two rises, 25 per cent of two falls in value and a 50 per cent chance of a
rise and a fall. A histogram of this result already has the basic shape of a normal distribution and as the
number of flips (days) is extended so the results look closer and closer to that of a normal distribution. 2
Reversing the argument, the assumption that changes in the exchange rate are normally distributed relies
on the assumption that the market is efficient.
If the foreign exchange market is semi-strong form efficient, then the exchange rate reacts in an
immediate and unbiased way to all publicly available information. This builds on the notion of news
being a possible explanation in the weak form. With a semi-strong test, the piece of news is identified and
attempts are made to gauge the effect, if any, on the exchange rate. In the case of currencies, a typical piece
of news would be the announcement of the balance of payments. If it is unexpected, does the exchange
rate react immediately? It would be very unusual if it did not, and we do not have to look far to see that
the exchange rate is constantly being scrutinized in the press. Markets are regulated to try to ensure that
they are semi-strong form efficient. That is, everyone has equal access to information. Price movements are
reactions to new information available to all or are revised interpretations of existing information.
If foreign exchange markets are strong-form efficient, then all relevant public and private information
is already reflected in today’s exchange rates. This form of efficiency is difficult to test with regard to
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CHAPTER 7
Forecasting exchange rates
219
exchange rates as it is difficult to clearly define private information, unlike say shares where private
information becomes public on specified announcement dates. This is an undesirable form of efficiency
as some traders (referred to as ‘insider traders’) in this market know more than others and the price at
any given time will not reflect all that is knowable about the currency, interest rate or MNC share price.
The picture is less clear when we focus on the detail of price setting in the marketplace where there
are informed traders and uninformed traders.3 The extent to which an informed trader is in possession
of information that should be known to all is unclear. If a bank acts on orders from a well-respected
industrial company, is this insider trading?
Direct semi-strong efficiency tests show that prices react to information almost immediately. Often,
however, an unusual movement in a price will occur before an announcement. Whether this is because of
insider trading or clever anticipation is very difficult to distinguish. Direct strong-form tests are difficult
as private information by its nature is difficult to collect. However, prosecutions of insider traders have
revealed alarming levels of contacts with major multinationals, as in the case of Raj Rajaratnam. He
was found guilty in 2011 of insider trading, profiting by over $50 million from illegally obtained insider
information from major multinationals including Google, Hilton and Goldman Sachs.
Tests of market efficiency generally show that markets are, as desired, semi-strong efficient in the sense
that they react quickly to published information and do not react to the information before it becomes
public. There are exceptions and court cases where traders are found to have links with major companies in
an effort to use private information for trading. Such activity appears to be not sufficient for traders to
lose confidence in the market. Weak-form tests confirm that the movement in market prices over the short
to medium term do not display consistent patterns. This is not evidence against insider trading and is not
strictly evidence that the market reacts to information, but if information or news is causing the market
price to change and not something else then, as explained above, we would expect the price to move
randomly – hence information may be the cause.4
As a note of caution, tests of market efficiency in the academic literature are in danger of overstating
the case for efficiency. With regard to weak form testing, the set of patterns is infinite so all that is
being found is that there is little evidence of the existence of the patterns being tested – the tests say
nothing about untested patterns. Semi-strong and strong form tests are only tests of particular items of
information. The tests do not of themselves imply that prices only react to news, and insider trading is
not ruled out.
A few further general points are relevant about market efficiency. The hypothesis is probably the most
fundamental in all finance. Without market efficiency being generally true, the whole price mechanism
would fail. The price must represent all that is knowable about the product’s future value and this is
true for the efficiency of all markets, cars, food as well as financial instruments. The reason why it is so
important in finance is that news about the product (a share, currency, etc.) changes every day, every hour.
For cars, food, etc. the information set is very much more stable.
A second general implication is market efficiency implies that how the information is disclosed does not
greatly matter. Tests show that the market is good at interpreting information from whatever source and
however presented. Arguments about the manner in which accounts are presented in the annual report are
therefore of no great economic significance.
Third, market efficiency does not mean that the estimate is necessarily accurate. The market may be
wrong in its estimation of the effect of any piece of news. but it is not wrong in any consistent way. It
does not consistently underestimate the value of any particular currency – that would create a pattern.
Statements that the market is undervaluing a share or a currency should therefore be treated as probably
incorrect. It may be true in retrospect that a share was underpriced but that is to assume information not
known at the time of setting the price.
Finally, the definition of information as news does much to explain why academic models can be
inaccurate. As has been shown above, a piece of information on its own is not necessarily good or bad
news; it depends on what was expected. Therefore if a model is built on actual values it is not including
expectations unless we assume that all changes in values were unexpected. This is patently not true, indeed
no change in a variable can be unexpected. So from the outset we must expect that models based on what
actually happened are going to be inaccurate unless there is some arbitrage process to justify the particular
value as, say, in cross exchange rates.
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PART II
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Technical forecasting
Technical forecasting involves the use of historical exchange rate data to predict future values based on
patterns in past prices. Academics in general do not support this approach to forecasting. Prices move in
reaction to information about the future and not past price movements. Weak form testing generally finds
no evidence that past prices affect future movements, the essence of a pattern. Yet in the press there are
often comments that appear to support the view that prices are following a pattern of sorts. For example,
a comment such as: ‘the exchange rate has fallen back as a result of three days of increases’ suggests that
it has done so because it has risen for three days in a row in the past. The movement of the next day’s
exchange rate is not known and a pattern that suggests that after every three days of increases a reduction
is more likely can be tested and is almost certainly not present. However, there is no doubt that technical
forecasting is popular in practice. A survey by Taylor and Allen (1992)5 showed that over the short term
at least, analysis by chartists (a form of technical analysis) was seen by dealers as being as important as
fundamental analysis; this was less so over the longer term. Despite the strength of the arguments against
technical analysis, studies have found that there are gains to be made. For a comprehensive review refer to
Menkhoff and Taylor (2007).6
EXAMPLE
Tomorrow Freeda GmbH (Austria) has to pay
10 million Brazilian real for supplies that it recently
received from Brazil. Today, the real has appreciated
by 3 per cent against the euro. Freeda could send
the payment today so that it would avoid the effects
of any additional appreciation tomorrow. Based
on an analysis of historical time series, Freeda has
determined that whenever the real appreciates against
the euro by more than 1 per cent, it experiences a
reversal of about 60 per cent of that amount on the
following day. That is:
Applying this tendency to the current situation in
which the peso appreciated by 3 per cent today,
Freeda forecasts that tomorrow’s exchange rate will
change by:
et 1 1 5 et 3 (260%)
5 (3%) 3 (260%)
5 21.8%
Given this forecast that the real will depreciate
tomorrow, Freeda decides that it will make its
payment tomorrow instead of today.
et 1 1 5 et 3 (260%) when et 7 1%
USING THE WEB
www.newyorkfed.org/markets/international-market-operations/foreign-exchange-operations and
www.oanda.com provide historical exchange rate data that may be used to create technical forecasts
of exchange rates.
Technical factors are often cited in the financial press as the main reason for changing speculative
positions that cause an adjustment in a currency’s value. Typical examples are:
1 Technical factors overwhelmed economic news.
2 Technical factors triggered sales of pounds.
3 Technical factors indicated that euros had been recently oversold, triggering purchases of euros.
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CHAPTER 7
Forecasting exchange rates
221
As these examples suggest, technical forecasting appears to be widely used by speculators who attempt
to capitalize on day-to-day exchange rate movements.
There is no clear rationalization of technical forecasting, especially when it is implying simple patterns
of trade. Nevertheless, much of the discussion concerns market behaviour and market sentiment and that
is relevant. The academic models in the main assume homogeneous expectations, that is to say that in the
investment community there are no differences of opinion concerning the risk and expected value of, in
this case, a currency. That is clearly an unrealistic assumption. Investors do disagree and market opinion
does change as a result of discussion and differences. Predictions based on such behavioural factors clearly
have a place in understanding future exchange rates. Nevertheless, much of the language of technical
forecasting is short term and is unlikely to be relevant to an MNC.
MANAGING FOR VALUE
How MNCs’ earnings depend on currency values
Like many publicly traded companies, Renault SA, the
French vehicle manufacturer, analyzes their exposure to
currency changes in their accounts. The calculation is
not easy. In some countries or, more relevantly, in some
currency areas, Renault will produce as well as sell
cars and lorries. Devaluation in such a currency would
reduce the value of the revenues in terms of Renault’s
home currency, the euro, but also there would be an
offsetting reduction in the value of the costs. So the
exposure is the net of the revenue figure less the costs
in the foreign currency. In other currency areas there
may be an excess of purchases and in yet others,
an excess of sales. To help investors appreciate how
currency changes affect earnings, Renault in their
2021 annual report describes the effect on profits as:
In 2021, the operating income includes a
net foreign exchange expense of €68 million,
mainly related to movements in the Argentinian
peso, Brazilian real and Turkish lira (compared
to a net foreign exchange expense of €125
million in 2020 mainly related to movements
in the Argentinian peso, Brazilian real and
Turkish lira).
Renault (2021) Annual Report, p. 29
With costs mainly in euros and revenues in other
currencies, the fall in value of the other currencies
will adversely affect sales measured in euros. How
much of this is realized as a loss depends on the
cash flow transactions. The consolidated cash flow
statement refers rather vaguely to an increase in cash
flows of some €57 million due to ‘effect of changes
in exchange rate and other changes’ so clearly there
have been offsetting gains.
Fundamental forecasting
Fundamental forecasting is based on fundamental relationships between economic variables and exchange
rates. Recall from Chapter 5 that a change in a currency’s spot rate is influenced by the following factors:
e 5 f(DINF, DINT, DINC, DGC, DEXT)
Where:
e 5 percentage change in the spot rate
DINF 5 the difference between home inflation and the foreign country’s inflation
DINT 5 the difference between the home interest rate and the foreign country’s interest rate
DINC 5 the difference between the home income level and the foreign country’s income level
DGC 5 change in government controls
DEXT 5 change in expectations of future exchange rates
Given current values of these variables along with their historical impact on a currency’s value, corporations
can develop exchange rate projections.
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A forecast may arise simply from a subjective assessment of the degree to which general movements
in economic variables in one country are expected to affect exchange rates. MNCs typically use in-house
economists to make such projections. From a statistical perspective, a forecast would be based on
quantitatively measured impacts of factors on exchange rates. Pure statistical models are highly unlikely to
be accurate. They are nevertheless useful in informing the subjective estimates of managers. The following
example illustrates the nature of statistical modelling, but without a high R2 and high T-scores for the
explanatory variables such models have little value on their own.
EXAMPLE
The focus here is on only two of the many factors
that affect currency values. Before identifying them,
consider that the corporate objective is to forecast
the percentage change (rate of appreciation or
depreciation) in the US dollar with respect to the
British pound during the next quarter. For simplicity,
assume the firm’s forecast for the dollar is dependent
on only two factors that affect the dollar’s value:
1 Inflation in the US relative to inflation in the UK.
2 Income growth in the US relative to income
growth in the UK (measured as a percentage
change).
The first step is to determine how these variables
have affected the percentage change in the dollar’s
value based on historical data. This is commonly
achieved with regression analysis. First, quarterly
data are compiled for the inflation and income growth
levels of both the UK and the US. The dependent
variable (the left-hand side of a regression) is the
quarterly percentage change in the dollar value.
The independent variables (the right-hand side of a
regression) may be set up as follows:
1 Previous quarterly percentage inflation differential
(British inflation rate minus US inflation rate),
referred to as INFt ]1.
2 Previous quarterly percentage income growth
differential (British income growth minus US
income growth), referred to as INCt ]1.
The regression equation can be defined as:
e$,t 5 b0 1 b1INFt 2 1 1 b2 INCt21 1 mt
Where:
INFt ]1 5 British inflation less US inflation for time
t ] 1, the previous period to time t
INCt ]1 5 British income growth less US income
growth for time t ] 1, the previous period
to time t
e$,t 5 percentage change in the value of the
dollar over time t
b0 5 a constant
b1 5 the sensitivity of e$,t to changes in INFt ]1
b2 5 the sensitivity of e$,t to changes in INCt ]1
mt 5 the error term
A set of historical data is used to obtain previous
values of dollar, INF and INC. Using this data set,
regression analysis will generate the values of
the regression coefficients (b0, b1 and b2). That is,
regression analysis determines the direction and
degree to which changes in the dollar are affected
by each independent variable over the sample. The
coefficient b1 will exhibit a positive sign if and when
INF t ]1 and per cent change in the same direction
over time (other things held constant). A negative
sign indicates that per cent and INF t ]1 move in
opposite directions. In the equation given, b 1 is
expected to exhibit a positive sign because when
UK inflation increases relative to inflation in the US,
upward pressure is exerted on the dollar’s value
(dollar goods appear cheaper leading to a greater
demand for dollars).
The regression coefficient b2 (which measures the
impact of INC t ]1 on e$t) is expected to be positive
because when British income growth exceeds US
income growth, there is upward pressure on the
dollar’s value. These relationships have already been
thoroughly discussed in Chapter 5.
Once regression analysis is employed to generate
values of the coefficients, these coefficients can
be used in the forecast. To illustrate, assume the
following values: b0 5 0.002, b1 5 0.8 and b2 5 1.0.
The coefficients can be interpreted as follows.
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CHAPTER 7
For a one-unit percentage change in the inflation
differential, the dollar is expected to change by 0.8
per cent in the same direction, other things held
constant. For a one-unit percentage change in the
income differential, the dollar is expected to change
by 1.0 per cent in the same direction, other things
held constant. To develop forecasts, assume that the
most recent quarterly percentage change in INF t ]1
(the inflation differential) is 4 per cent, and that INCt ]1
(the income growth differential) is 2 per cent. Using
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Forecasting exchange rates
this information along with our estimated regression
coefficients, the forecast for e$t is:
e$,t 5 b0 1 b1INFt 2 1 1 b2INCt 2 1 1 mt
5 0.002 1 0.8(4%) 1 1(2%)
5 0.2% 1 3.2% 1 2%
5 5.4%
Thus, given the current figures for inflation rates
and income growth, the dollar should appreciate by
5.4 per cent during the next quarter.
This example is simplified to illustrate how fundamental analysis can be implemented for forecasting.
A full-blown model might include many more than two factors, but the application would still be similar.
Unfortunately, a relationship that held in the past is not necessarily going to hold in the future. Models
that have in a sense ‘thrown in’ all relevant variables into the right-hand side of the equation are likely
to produce a reasonably good prediction, given that the model chooses the parameters b1, b2, etc. that
offer the best fit as measured by the adjusted R2. But the more variables included in the right-hand side,
the weaker the rationale and the greater the statistical problem of multicollinearity (correlation among
the explanatory variables). You can have little confidence in the longevity of a model that has no clear
justification other than that it worked well over a particular time period.
Use of sensitivity analysis for fundamental forecasting. When a regression model is used for forecasting,
and the values of the influential factors have a lagged impact on exchange rates, the actual values of those
factors can be used as inputs for the forecast. For example, if the inflation differential has a lagged impact
on exchange rates, the inflation differential in the previous period may be used to forecast the percentage
change in the exchange rate over the future period. Some factors, however, have an instantaneous influence
on exchange rates. Since these factors obviously cannot be known, forecasts must be used. Firms recognize
that poor forecasts of these factors can cause poor forecasts of the exchange rate movements, so they
may attempt to account for the uncertainty by using sensitivity analysis, which considers more than one
possible outcome for the factors exhibiting uncertainty.
EXAMPLE
Phoenix GmbH (Germany) develops a regression
model to forecast the percentage change in the
Mexican peso’s value. It believes that the real interest
rate differential and the inflation differential are the
only factors that affect exchange rate movements, as
shown in this regression model:
eP,t 5 a0 1 a1INTt 1 a2INFt21 1 mt
Where:
INTt 5 euro interest rate less Mexican interest
rate for time t
INFt21 5 euro inflation rate less Mexican inflation
rate for the previous period time t ] 1
ep,t 5 percentage change in the value of the
peso over time t
a0 5 a constant
a1 5 the sensitivity of ep,t to changes in INTt
a2 5 the sensitivity of ep,t to changes in INFt ]1
mT 5 the error term
Historical data are used to determine values for eP,t
along with values for INTt and INFt 2 1 for several
periods (preferably 30 or more periods are used to
build the database). The length of each historical
period (quarter, month, etc.) should match the length
of the period for which the forecast is needed. The
(Continued )
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historical data needed per period for the Mexican
peso model are: (1) the percentage change in the
peso’s value, (2) the euro real interest rate minus the
Mexican real interest rate and (3) the euro inflation
rate in the previous period minus the Mexican inflation
rate in the previous period. Assume that regression
analysis has provided the following estimates for the
regression coefficients and that the model has a high
R2 and the coefficients have a high T-score:
Regression
coefficient
a0
Estimate
0.001
a1
]0.7
a2
0.6
The negative sign of a1 indicates a negative
relationship between INTt and the peso’s movements,
while the positive sign of a2 indicates a positive
relationship between INFt 2 1 and the peso’s movements.
To forecast the peso’s percentage change over
the upcoming period, INTt 2 1 and INFt 2 1 must be
estimated. Assume that INFt 2 1 was 1 per cent.
However, INTt is not known at the beginning of the
period and must therefore be forecasted. Assume
that Phoenix GmbH has developed the following
probability distribution for INTt:
Probability
Possible outcome
20%
23%
50%
24%
30%
]5%
100%
A separate forecast of et can be developed from
each possible outcome of INTt as follows:
Forecast of INT
Forecast of et
Probability
]3%
0.1% 1 (]0.7)(]3%) 1
0.6(1%) 5 2.8%
20%
]4%
0.1% 1 (]0.7)(]4%) 1
0.6(1%) 5 3.5%
50%
]5%
0.1% 1 (]0.7)(]5%) 1
0.6(1%) 5 4.2%
30%
If the firm needs forecasts for other currencies, it can
develop the probability distributions of their movements
over the upcoming period in a similar manner.
As a note of caution, it should be remembered
that most statistical based models have a low R2 and
poor T-scores and therefore make poor forecasts.
Use of PPP for fundamental forecasting. The theory of PPP specifies the fundamental relationship
between the inflation differential and the exchange rate. In simple terms, PPP states that the currency of
the country with higher inflation will depreciate by an amount that reflects the difference. A currency
with a 2 per cent higher inflation should therefore fall in value by 2 per cent thus canceling the effect
of its higher prices for foreign buyers. Hence a future rate is implied by the inflation differential (for
more details refer to Chapter 9).
EXAMPLE
The UK inflation rate is expected to be 1 per cent over the
next year, while the Australian inflation rate is expected to
be 6 per cent. According to PPP, the Australian dollar’s
exchange rate should change as follows:
(1 1 IUK)
21
(1 1 IA)
(1.01)
5
21
(1.06)
^ 2 4.7%
ef 5
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CHAPTER 7
This forecast of the percentage change in the
Australian dollar can be applied to its existing spot
rate to forecast the future spot rate at the end of one
year. If the existing spot rate (St) of the Australian
dollar is £0.40, the expected spot rate at the end of
1 year, e(St11), will be about 0.3812:
Forecasting exchange rates
225
e(St 1 1) 5 St(1 1 ef)
5 £0.40(120.047)
5 £0.3812
In reality, the inflation rates of two countries over an upcoming period are uncertain and therefore
would have to be forecasted when using PPP to forecast the future exchange rate at the end of the
period. This complicates the use of PPP to forecast future exchange rates. Even if the inflation rates in the
upcoming period were known with certainty, PPP might not be able to forecast exchange rates accurately.
If the PPP theory were accurate in reality, there would be no need to even consider alternative forecasting
techniques. However, using the inflation differential of two countries to forecast their exchange rate is not
always accurate. Problems arise for several reasons:
1 The timing of the impact of inflation fluctuations on changing trade patterns, and therefore on exchange
rates, is not known with certainty.
2 Data used to measure relative prices of two countries may be somewhat inaccurate.
3 Barriers to trade can disrupt the trade patterns that should emerge in accordance with PPP theory.
4 Other factors, such as the interest rate differential between countries, can also affect exchange rates.
For these reasons, the inflation differential by itself is not sufficient to accurately forecast exchange rate
movements. Nevertheless, it should be included in any fundamental forecasting model.
Limitations of fundamental forecasting. Although fundamental forecasting accounts for the expected
fundamental relationships between factors and currency values, the following limitations exist:
1 The precise timing of the impact of some factors on a currency’s value is not known. It is possible that the
full impact of inflation on exchange rates will not occur until two, three or four quarters later. The regression
model would need to be adjusted accordingly.
2 As mentioned earlier, some factors exhibit an immediate impact on exchange rates. They can be usefully
included in a fundamental forecasting model only if forecasts can be obtained for them. Forecasts of these
factors should be developed for a period that corresponds to the period for which a forecast of exchange
rates is necessary. In this case, the accuracy of the exchange rate forecasts will be somewhat dependent on
the accuracy of these factors. Even if a firm knows exactly how movements in these factors affect exchange
rates, its exchange rate projections may be inaccurate if it cannot predict the values of the factors.
3 Some factors that deserve consideration in the fundamental forecasting process cannot be easily quantified.
For example, what if large Australian exporting firms experience an unanticipated labour strike, causing
shortages? This will reduce the availability of Australian goods for British consumers and therefore reduce
British demand for Australian dollars. Such an event, which would put downward pressure on the Australian
dollar value, normally is not incorporated into the forecasting model.
4 Coefficients derived from the regression analysis will not necessarily remain constant over time. In the
previous example, the coefficient for INF t21 (a 2) was 0.6, suggesting that for a 1 per cent change in
euro inflation less inflation in Mexico, the Mexican peso would appreciate by 0.6 per cent. Yet, if the
Mexican government or the European Union imposed new trade barriers, or eliminated existing barriers,
the impact of the inflation differential on trade (and therefore on the Mexican peso’s exchange rate)
could be affected.
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These limitations of fundamental forecasting have been discussed to emphasize that even the most
sophisticated forecasting techniques (fundamental or otherwise) cannot provide consistently accurate
forecasts. MNCs that develop forecasts must allow for some margin of error and recognize the possibility
of error when implementing corporate policies.
Market-based forecasting
The process of developing forecasts from market indicators, known as market-based forecasting, is usually
based on either: (1) the spot rate or (2) the forward rate.
Use of the spot rate. Today’s spot rate may be used as a forecast of the spot rate that will exist on a
future date. Using the spot rate is the same as forecasting that there will be no change in the exchange
rate. To see why the spot rate can serve as a market-based forecast, assume the dollar was expected to
appreciate against the pound in the very near future. This expectation will have encouraged speculators
to buy the dollar with pounds today in anticipation of its appreciation, and these purchases will have
forced the dollar’s value up immediately. So the current price of the dollar will include the expectation
that the value of the dollar will rise.
Conversely, if the dollar was expected to depreciate against the pound, speculators will have sold
off dollars hoping to purchase them back at a lower price after their decline in value. Such actions will
have forced the dollar to depreciate immediately. Thus, the current value of the dollar should reflect
the expectation of the dollar’s decline in value. Corporations can use the spot rate to forecast, since it
represents the market’s expectation of the spot rate in the near future. In an efficient market there is a
50 per cent chance of a rise or a fall making the spot the best estimate.
Use of the forward rate. As we will discuss in Chapter 8, the information set that informs the forward
rate is the same as the information set that informs the spot. The only difference between the two rates is
time and that is accounted for by the difference between the foreign and home interest rates. Where there
is a large difference in inflation (a time-related effect), the interest rate difference is likely to be significant.
The forward rate will capture this information and quote a discount in the value of the currency with the
higher inflation. In such circumstances, the forward estimate should be better than the spot. Nevertheless,
in the far more common instances where the interest rate differences are small, inflation will not be a
factor and the forward rate will be no better than the spot rate.
Despite this reasoning, tests show that the forward rate is, unlike the spot, not an unbiased predictor
of the future spot. That is to say the errors are not randomly distributed around that future spot,
instead they tend to overshoot or undershoot on a basis that varies over time, termed time varying
risk premiums. This is known as the forward rate puzzle and has become a problem subject to much
statistical analysis which we leave as simply an issue that is undecided. For a reasonably accessible
analysis refer to Al-Zoubi (2011).7
EXAMPLE
Assume that the spot rate of the dollar is currently
1.20 euros, while the five-year forward rate of the
dollar is 1.02 euros. This forward rate can serve as
a forecast of 1.02 euros for the dollar in five years,
which reflects a 15 per cent depreciation in the dollar
over the next five years.
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CHAPTER 7
Forecasting exchange rates
227
EXAMPLE
Raymond plc, a UK company, is expecting to have to
make a large contract payment in dollars in five years’
time. The company has been quoted a five-year
forward ask rate on dollars of £0.70 and a bid rate
of £0.52 by a UK bank. Interest rates in the US are
quoted at 30 per cent over the five years and in the
UK a rate of 40 per cent has been quoted (note that
this is not a per year interest rate but the total interest
rate charge over the five years). The current spot rate
is £0.59 to the dollar.
Raymond notes that £100 would convert now to
$169 (£100/0.59) and be worth $220 at the end of the
five-year investment period in the US (£169 3 1.30);
the investment would then convert back to
£114 ($220 3 0.52), a return of only 14 per cent and
considerably less than investing in the UK.
Also, $100 would convert to £59 ($100 3 0.59)
and be worth £83 (£59 3 1.4) at the end of the fiveyear investment period in the UK. The investment
would then convert back to $119 at the end of
the period (£83>0.70), a return of only 19 per cent
and considerably less than investing in the US. So
covered interest rate arbitrage is not possible.
Raymond, however, is thinking of taking out a
forward contract to sell dollars at the bank bid rate
of £0.52 for a dollar as the discount on the current
spot rate of 12 per cent (3£0.52 2 £0.594 >£0.59)
is considered worthwhile to protect against an
even further possible fall in the value of the dollar.
Raymond’s Financial Manager predicts that such a fall
might well be possible and that the company should
insure its returns in this way.
USING THE WEB
Forward rates as forecasts
Forward rates for the euro, British pound, Canadian dollar and Japanese yen for one-month, threemonth, six-month and one-year maturities are available on the Financial Times website at: www.ft.com/
by following the market data tab. These rates are determined by the spot and interest rates.
EXAMPLE
Alvi SpA is an Italian firm that trades in Brazil, and it
needs to forecast the exchange rate of the Brazilian
real for one year ahead. It considers using either the
spot rate or the forward rate to forecast the real.
The spot rate of the Brazilian real is 0.30 euros.
The one-year interest rate in Brazil is 20 per cent,
versus 5 per cent in Italy. The one-year forward
rate is 0.2625 euros, which reflects a discount to
offset the interest rate differential according to IRP
(check this yourself using the exact method). Alvi
believes that the future exchange rate of the real
will be driven by the inflation differential between
Brazil and Italy. It also believes that the real rate of
interest (i.e. without inflation rate) in both Brazil and
Italy is 3 per cent. This implies that the expected
inflation rate for next year is 17 per cent in Brazil
and 2 per cent in Italy. The forward rate discount is
based on the interest rate differential, which in turn
is related to the inflation differential. In this example,
the forward rate of the Brazilian real reflects a large
discount, which means that it implies a forecast
of substantial depreciation of the real against the
euro. Conversely, using the spot rate of the real as
a forecast would imply that the exchange rate at
the end of the year will be what it is today. Since
the forward rate forecast indirectly captures the
differential in expected inflation rates, it is a more
appropriate forecast method than the spot rate.
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Mixed forecasting
Because no single forecasting technique has been found to be consistently superior to the others, some
MNCs prefer to use a combination of forecasting techniques. This method is referred to as mixed
forecasting. Various forecasts for a particular currency value are developed using several forecasting
techniques. The techniques used are assigned weights in such a way that the weights total 100 per cent,
with the techniques considered more reliable being assigned higher weights. The actual forecast of the
currency is a weighted average of the various forecasts developed.
EXAMPLE
Pergreen plc needs to assess the value of the
Mexican peso because it is considering expanding
its business in Mexico. The conclusions drawn from
each forecasting technique are shown in Exhibit 7.2.
Notice that, in this example, the forecasted direction
of the peso’s value is dependent on the technique
EXHIBIT 7.2
used. The fundamental forecast predicts the peso will
appreciate, but the technical forecast and the marketbased forecast predict it will depreciate. Also, notice
that even though the fundamental and market-based
forecasts are both driven by the same factor (interest
rates), the results are distinctly different.
Forecasts of the Mexican peso drawn from each forecasting technique
Factors considered
Situation
Forecast
Technical forecast
Recent movement in
peso
The peso’s value declined below a
specific threshold level in the last few
weeks.
The peso’s value will continue to fall
now that it is beyond the threshold
level.
Fundamental
forecast
Economic growth,
inflation, interest rates
Mexico’s interest rates are high and
inflation should remain low.
The peso’s value will rise as euro
investors capitalize on the high
interest rates by investing in Mexican
securities.
Market-based
forecast
Spot rate, forward rate
The peso’s forward rate exhibits
a significant discount which is
attributed to Mexico’s relatively high
interest rates.
Based on the forward rate, which
provides a forecast of the future spot
rate, the peso’s value will decline.
EXAMPLE
During the Asian crisis (1997–98), the Indonesian
rupiah depreciated by more than 80 per cent against
the dollar within a nine-month period from August
1997. Before the rupiah’s decline, neither technical
factors, nor fundamental factors, nor the forward rate
indicated any potential weakness. The depreciation
of the rupiah was primarily attributed to concerns
by institutional investors about the safety of their
investments in Indonesia, which encouraged them to
liquidate the investments and convert the rupiah into
other currencies, putting downward pressure on the
rupiah.
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CHAPTER 7
Forecasting exchange rates
229
Weakness in some currencies may best be anticipated by a subjective assessment of conditions in
a particular country and not by the quantitative methods described here. We have noted already that
outlying rare events occur more frequently than would be predicted by statistics. Subjective estimation
of events such as a default, the passing of limiting regulations and civil unrest in many contexts may be a
necessary additional consideration for which there is no statistical predictive tool.
Forecasting services
The corporate need to forecast currency values has prompted the emergence of several forecasting service
firms, including Business International, Conti Currency, Predex and Wharton Econometric Forecasting
Associates. In addition, large investment banks offer forecasting services. Many consulting services use
at least two different types of analysis to generate separate forecasts and then determine the weighted
average of the forecasts. Some forecasting services focus on technical forecasting, while others focus on
fundamental forecasting.
USING THE WEB
Exchange rate forecasts
A useful source for the type of data used in making forecasts can be found at: www.fxstreet.com but
beware of the mixture of technical and fundamental approaches to forecasting.
Forecasts are even provided for currencies that are not widely traded. Forecasting service firms
provide forecasts on any currency for time horizons of interest to their clients, ranging from 1 day to
10 years from now. In addition, some firms offer advice on international cash management, assessment
of exposure to exchange rate risk and hedging. Many of the firms provide their clients with forecasts and
recommendations monthly, or even weekly, for an annual fee.
Performance of forecasting services
Given the recent volatility in foreign exchange markets, it is quite difficult to forecast currency values. One
way for a corporation to determine whether a forecasting service is valuable is to compare the accuracy of
its forecasts to that of publicly available and free forecasts.
Some studies have compared several forecasting services’ predictions for different currencies to the
forward rate and found that the forecasts provided by services are no better than using the forward rate.
Such results are frustrating for the corporations that have paid substantial amounts for expert opinions.
Perhaps some corporate clients of these forecasting services believe the fee is justified even when
the forecasting performance is poor, if other services (such as cash management) are included in the
package. Alternatively, you may argue that the value of the services is not in necessarily being able to
predict exchange rates on a day-to-day basis, but rather being able to anticipate high-risk situations and
predict large changes in the exchange rate, as with Black Wednesday 1992 in the UK, or the unpegging
of the Argentine peso with the dollar in 2002 (Chapter 6). It is also possible that a corporate treasurer, in
recognition of the potential for error in forecasting exchange rates, may prefer to pay a forecasting service
firm for its forecasts. Then the treasurer is not directly responsible for corporate problems that result from
inaccurate currency forecasts. Not all MNCs hire forecasting service firms to do their forecasting; some
may have in-house economists, others may hedge as a matter of policy.
Evaluation of forecast performance
An MNC that forecasts exchange rates must monitor its performance over time to determine whether the
forecasting procedure is satisfactory. For this purpose, a measurement of the forecast error is required.
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There are various ways to compute forecast errors. One popular measurement will be discussed here
and is defined as follows:
Absolute forecast error as a fraction of the realized value 5
u Forecasted value 2 Realized value u
Realized value
The error is computed using an absolute value because this avoids a possible offsetting effect when
determining the mean forecast error. If the forecast error is 0.05 in the first period and 20.05 in the
second period (if the absolute value is not taken), the mean error is zero. Yet, that is misleading because the
forecast was not perfectly accurate in either period. The absolute value avoids such a distortion.
EXAMPLE
Consider the following forecasted and realized values
by Old Hampshire plc during one period:
Forecasted value
Absolute forecast error as a
£0.060 2 £0.058
£0.058
5 3.4%
percentage of the realized value 5
Realized value
US dollar
£0.60
£0.58
Japanese yen
£0.005
£0.006
In this case, the difference between the forecasted
value and the realized value is £0.02 for the dollar and
£0.001 for the yen. This does not necessarily mean
that the forecast for the yen is more accurate. When
the relative size of what is forecasted is considered
(by dividing the difference by the realized value), you
can see that the dollar has been predicted with more
accuracy on a percentage basis. With the data given,
the forecasting error (as defined earlier) of the British
pound is:
In contrast, the forecast error of the Japanese yen is:
Absolute forecast error as a
£0.005 2 £0.006
£0.006
5 16.7%
percentage of the realized value 5
It is the percentage difference between actual and
forecast that matters when translating large sums of
money, not the absolute amount. Thus, the yen has
been predicted with less accuracy as a percentage,
even though the absolute error in the exchange rate
is a smaller number. Translating yen into pounds
would differ from expectations by 16.7 per cent, as
opposed to only 3.4 per cent if translating the US
dollar into pounds.
Forecast accuracy over time
The efficient markets hypothesis has the rather hidden assumption that the best forecast of a future
exchange rate is the current one, the spot rate. In effect this is a prediction of no change. If an MNC
uses the current spot to predict the rate 30 days forward, the implication is that there will be no change
between the current spot and the actual 30 days. Hence, why should this prediction be accurate? Surely all
the discussion in the newspapers about a currency strengthening and another weakening etc. implies that
the market is predicting future movements and a one-month forward rate would include such a prediction.
But the efficient markets hypothesis says that all information about a product is included in the current
price. That information is about the future not the past. Therefore, any expectations about a rise in the
value of the dollar should be included in the current price. The only difference between the spot rate and
our prediction now of some future rate is the relative cost of time between the two currencies. That ‘cost of
time’ is the interest rate by any other name. This is the basis of the forward rate (refer to covered interest
rate parity), but unfortunately unpredicted events too often overtake the spot rate such that on average the
forward rate is not a good predictor for practitioners having to make an estimate of the actual spot rate at
the forward date.
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CHAPTER 7
Forecasting exchange rates
231
Exhibit 7.3 examines the euro-dollar exchange rate. This is over a past period but would be the same for
more recent periods. The two lines that are close to each other are the forward rate at its predicted forward
date and the spot rate at the time of the prediction (the date of the quote). As is clear, the differences with the
actual spot are far greater than the differences between using the spot as a predictor and using the forward
rate. In fact, the mean absolute forecast error as a percentage of the realized value is 2.3 per cent using the
forward prediction and 2.4 per cent using the no change or spot prediction. Not only are the errors similar,
Exhibit 7.3 shows that they are highly correlated. This is what we would expect because the efficient markets
hypothesis tells us that all the information in the spot should be in the forward and all the information in
the forward should also be in the spot. Only in cases of hyperinflation and consequently large difference in
interest rates might the forward rate be better than the spot, as the forward is determined by the difference
in interest rates. Such scenarios are nevertheless likely to be chaotic, making subjective estimation preferable.
EXHIBIT 7.3
Forward prediction, no change prediction and actual spot
1.55
Actual spot
Value of dollar in euros
1.5
1.45
Forward prediction
1.4
1.35
1.3
1.25
No change prediction
02
.0
2.
2
24 009
.0
2.
20
09
18
.0
3.
2
09 009
.0
4.
2
01 009
.0
5.
2
25 009
.0
5.
2
16 009
.0
6.
2
10 009
.0
7.
2
30 009
.0
7.
2
21 009
.0
8.
2
14 009
.0
9.
2
06 009
.1
0.
2
28 009
.1
0.
2
19 009
.1
1.
20
09
11
.1
2.
20
09
1.2
Statistical test of forecasts – the de-trending problem
A wrong method of testing a forecast is to apply the following regression model to historical data:
St 5 a0 1 a1Ft 2 1, t 1 mt
Where:
St 5 the spot rate in direct form (i.e. per unit of foreign currency) at time t
Ft 2 1, t 5 the forward rate prediction, again in direct form, for time t made at time t 2 1
mt 5 error term for period t
a0 5 the intercept
a1 5 the regression coefficient
The problem with this model as a prediction is that it is not de-trended. The results appear to produce
in most instances a regression model of very high significance and therefore good prediction with a
high R2. Do not be fooled. The model is measuring error from using the model prediction compared to the
error made by no prediction at all. The no prediction model is simply to use the average rate over the period
ignoring the fact that exchange rates move from their previous observation and not from the average.
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For example, if the average exchange rate was $1.2:£1 over the whole period but the previous
observation to point A in that period was $1.3:£1, then point A should be modelled as a movement from
$1.3:£1 and not $1.2:£1. The average over the whole period contains exchange rates reacting to future
events not known at point A and makes no sense. That the model is better than a nonsensical average over
the whole period is not in any way surprising and the high R2 is therefore misleading. For this reason we
should not use actual rates (spot or forward) but the movement from the previous observation. This is a
difficult point that students conducting projects can get wrong. The message is however simple, only the
change not the actual rate.
Looking at change is termed de-trending, a de-trended model appears thus:
Ft 2 1,t 2 St
St 2 St 2 1
5 ef 5 a0 1 a1
1 mt
St
St
(actual change)
(change predicted by
the forward rate)
where S is the spot rate and F the forward rate and t, t−1, is the forward rate quoted at time t-1 for
exchange at time t. On the left-hand side is ef the percentage change in the actual spot over the t-1 to t
period (this is the figure that businesses want to know). On the right-hand side is the predicted change
made by the forward rate (the premium or discount over the spot). Both are presented as fractional
changes in relation to St the actual spot rate at time t (0.1 = 10% and so on). So the model tests how good
the forward rate is at predicting the change in the actual future spot. If the model is a good predictor of
the actual change then the error (µt) as measured by R2 should be high. It will almost certainly not be high
and shows that the forward rate in its proper premium or discount measure is not a good predictor of the
future spot. Further studies ask whether the forward rate systematically over or underestimates the change
in the spot, that is whether a0 ≠ 0 and a1 ≠ 1 with inconclusive results.
Now let us suppose that we have a regression model to predict changes in the exchange rate (ef) that is:
ef 5 a0 1 a X1 1 a2 X2 1 c
The explanatory variables X1 X2, c could be differences in the money supply, changes in current account
balances and so on. Note that we are still measuring changes, not the absolute figures, for the same
reasons that we measure only the change in exchange rates as explained above. These are known as news
models or mixed models as there is no underlying philosophy apart from the assertion of the efficient
markets hypothesis that prices react to new relevant information. Since market expectations are not easily
measured the simplifying assumption is that any change is unexpected. It is not a surprise that these models
perform poorly leading to the conclusion that variables are not consistently relevant and expectations are
not generally of no change. The real world is more complicated than these relatively simple models.
Should MNCs make exchange rate forecasts?
The answer to this question is both yes and no. In what is a reasonably efficient market, expecting an MNC
to make regular forecasts of the exchange rate and to act on those predictions would be misleading. On
occasions the company would profit and at other times make a loss. On average, however, the MNC will
not be able to ‘beat the market’ and should not be engaging in what are essentially speculative activities.
On the other hand, monitoring exchange rates because of the risk of changes in the exchange rate is
sensible. Actual changes do not occur in quite the way that theory predicts. The difference is apparent
when comparing Exhibit 7.4a with Exhibit 7.4b. The first shows seven years of actual changes in the
£:$1 exchange rate and the second shows the changes that would be predicted by a random walk – the
theoretical basis of the price movements. The actual years are not relevant as this result would obtain over
any time period.
Two differences are immediately apparent. The first is that the percentage change in Exhibit 7.4b occurs
evenly throughout the range whereas in Exhibit 7.4a the changes are quite irregular. Not only are there
periods of heightened movement during the Global Financial Crisis but also there are periods of extremely
low movement before the crisis. The variation is uneven, a phenomenon referred to as ‘bunching’.
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CHAPTER 7
EXHIBIT 7.4a
233
Forecasting exchange rates
$ to UK £ percentage daily change in exchange rate of the UK £ value of $1
% Change in the value of the dollar
0.05
0.04
0.03
0.02
0.01
0
–0.01
–0.02
–0.03
20
2.
.1
31
01
.0
1.
20
12
12
11
01
.0
1.
20
20
1.
.0
01
01
.0
1.
20
10
09
08
20
1.
.0
.0
1.
20
02
02
02
.0
1.
20
06
07
–0.04
EXHIBIT 7.4b Percentage change from a random walk with the same mean and standard deviation as Exhibit 7.4a –
the theoretical model of exchange rate changes
0.05
0.04
0.03
% Change
0.02
0.01
0
–0.01
–0.02
–0.03
–0.04
The second very apparent difference is that in practice (Exhibit 7.4a) there are extreme changes that
are not predicted by theory. Of the 2,556 observations there are 19 with a probability of less than three in
a million of occurring. This is sometimes referred to as ‘sigma events’, in this case four-sigma events and
above, i.e. four standard deviations from the mean. This phenomenon is known as ‘fat tails’ in that there
are more observations in the extreme ends of the distribution than would be predicted from a normal
distribution.
The random walk of Exhibit 7.4b implies a normal distribution (refer to Exhibit 3.8a). In Exhibit
7.4c, the actual distribution does appear approximately normal but with the aforementioned outliers, the
extreme 4-sigma events. Unfortunately these are the really significant events for an MNC, a financial crisis
or an economic downturn.
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234
PART II
EXHIBIT 7.4c
EXCHANGE RATE BEHAVIOUR
Distribution of monthly changes in the exchange rate 1993 to 2018
80
Number of changes
70
60
50
40
30
20
10
]
11%
%]
(10
%,
]
, 10
, 8%
(8%
]
(7%
, 7%
]
(6%
, 6%
]
(5%
, 5%
]
(3%
, 3%
]
(2%
, 2%
(1%
1%
]
]
%,
(–1
–1%
]
%,
–2%
(–2
]
%,
–3%
(–3
]
%,
–5%
(–5
]
%,
–6%
(–6
%,
(–7
[–8
%,
–7%
]
0
Note:
• ‘[’ means ‘including’ and ‘(’ means ‘not including’.
Source: EIU
This mixture of excessively quiet periods mixed with extreme variation, neither of which were predicted
by the normal distribution, is difficult to manage. For some periods, protection in the form of derivatives
may seem unnecessary and risk taking may seem profitable. In the very short term this may well be true;
but where it is not true, large losses will be made. Certainly, you cannot rely on statistics (the analysis of
past data) and the ergodic assumption (the future will replicate the past). To understand surprises in the
market, more must be understood about the driving force of the exchange rate changes. This requires being
able to understand the nature of a crisis and its implications through interpreting the newspapers and other
news sources. Fortunately for the reader, MNCs need managers who understand international financial
management.
EXAMPLE
Harp plc is based in Shropshire and imports
products from Canada. It uses the spot rate of
the Canadian dollar (valued at £0.70) to forecast
the value of the Canadian dollar one month from
now. It also specifies a range around its forecasts,
based on the historical volatility of the Canadian
dollar. The more volatile the currency, the more
likely it is to wander far from the forecasted value
in the future (the larger is the expected forecast
error). Harp determines that the standard deviation
of the Canadian dollar’s movements over the
last 12 months is 2 per cent. Thus, assuming the
movements are normally distributed, it expects that
there is a 68 per cent chance that the actual value
will be within one standard deviation (2 per cent) of
its forecast, which results in a range from £0.686
to £0.714. In addition, it expects that there is a
95 per cent chance that the Canadian dollar will
be within two standard deviations (4 per cent) of
the predicted value, which results in a range from
£0.672 to £0.728. By specifying a range, Harp can
more properly anticipate how far the actual value
of the currency might deviate from its predicted
value. If the currency was more volatile, its standard
deviation would be larger, and the range surrounding
the forecast would also be larger.
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CHAPTER 7
Forecasting exchange rates
235
Methods of forecasting exchange rate volatility
The volatility of exchange rate movements for a future period can be forecast using: (1) recent exchange
rate volatility, (2) historical time series of volatilities and (3) the implied standard deviation derived from
currency option prices.
Use of short-term volatility to predict long-term volatility. The volatility of historical exchange rate
movements over a recent period can be used to forecast the short-, medium- and long-term future. In our
example, the standard deviation of monthly exchange rate movements in the Canadian dollar during the
previous 12 months could be used to estimate the future volatility of the Canadian dollar over the next
month. If the volatility conditions of the monthly figures in the 12-months’ sample is thought to be typical
for the next year, the predicted monthly standard deviation can be converted to an annual predicted
standard deviation by the simple formula:
Where:
s.d.t 5 s.d.m 3 !(t>m)
s.d. 5 standard deviation
t, m 5 time periods in the same unit of time where t is the longer time period and m the shorter time
period (so a monthly prediction converted to a prediction of the standard deviation for a year
can be calculated by setting t 5 12 months and m 5 1 month)
This measure assumes that the exchange rates follow a random walk (Chapter 3).
EXAMPLE
The standard deviation of monthly changes in
the value of currency Y for the last 12 months has
been 1 per cent. Winston Ltd estimates that these
conditions will last for at least one year and wants
to know the estimated standard deviation for the
exchange rate one year hence rather than one month
hence. Using the above equation, t 5 12 months and
m 5 1 month.
So the implied annual standard deviation of the oneyear estimate is:
s.d.t 5 s.d.m 3 !(t>m)
3.46% 5 1% 3 !(12>1)
Assuming a random walk and a current spot of
£0.50:1 Y, the 95 per cent confidence interval for Y
will be:
1.96 standard deviations 3 3.46% 5 6.78% of the expected value, so:
£0.50 3 (1 2 6.78%) 6 £0.50 6 £0.50 3 (1 1 6.78%)
£0.4661 6 £0.50 6 £0.5339
Use of a historical pattern of volatilities. Since historical volatility can change over time, the standard
deviation of monthly exchange rate movements in the last 12 months is not necessarily an accurate
predictor of the volatility of exchange rate movements in the next month. To the extent that there is
a pattern to the changes in exchange rate volatility over time, a series of time periods may be used to
forecast volatility in the next period. Being able to predict stock market volatility does not violate weakform efficiency. The actual value of a currency may not follow a pattern or be predictable, but the variance
can be predictable. Just as with a lottery, knowing the range of outcomes and their equal probability does
not (alas) help to predict the actual number.
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236
PART II
EXCHANGE RATE BEHAVIOUR
EXAMPLE
The standard deviation of monthly exchange rate
movements in the dollar can be determined for
each of the last several years. A time series trend
of these standard deviation levels can be used to
form an estimate for the volatility of the dollar over
the next month. The forecast may be based on
a weighting scheme such as 60 per cent times
the standard deviation in the last year, plus 30 per
cent times the standard deviation in the year before
that, plus 10 per cent times the standard deviation
in the year before that. This scheme places more
weight on the most recent data to derive the
forecast but allows data from the last three years
to influence the forecast. Normally, the weights that
achieved the most accuracy (lowest forecast error)
over previous periods and the number of previous
periods (lags) would be used when applying this
method.
Implied standard deviation. A third method for forecasting exchange rate volatility is to derive the
exchange rate’s implied standard deviation from the currency option pricing model. This is measured by
the VIX index (Chapter 11). A high rate indicates high future (30 day normally) volatility and a low
number low volatility. From the MNC perspective the financial press and its references to the VIX index is
preferable to a direct measure and to understand it as part of the ‘language of finance’.
Subjective estimation. In many ways even advanced statistical models are naive in trying to find a
systematic relationship across time. The real world is more chaotic. A ‘score’, be it a negative current
account or an increase in interest rates, will be significant in one period but not in another, for reasons that
are difficult to predict on any systematic basis. Financial behaviour is unpredictable and, in many ways,
more complex than advanced physics. Whereas in science, equations and theories can make incredibly
accurate predictions, finance equations are trying, in most cases, to find a variable that is relevant to topics
such as exchange rate changes. The finding that a variable is relevant (the term used is significant) is very
far from it being a useful predictor. Subjective judgement, the undefined estimation based on ‘knowledge
of the situation’ and ‘informed by analysis’ (as presented here) should always be the final part of any
prediction of the future.
Summary
●●
MNCs need exchange rate forecasts to make
decisions on hedging payables and receivables,
short-term financing and investment, capital
budgeting and long-term financing.
●●
The most common forecasting techniques can
be classified as: (1) technical, (2) fundamental,
(3) market-based and (4) mixed. Each technique
has limitations, and the quality of the forecasts
produced varies. Yet, due to the high variability in
exchange rates, it should not be surprising that
forecasts are not always accurate.
●●
Forecasting methods can be evaluated by
comparing the actual values of currencies to
the values predicted by the forecasting method.
To be meaningful, this comparison should be
conducted over several periods. Two criteria
used to evaluate performance of a forecast
method are bias and accuracy. When comparing
the accuracy of forecasts for two currencies,
the absolute forecast error should be divided by
the realized value of the currency to control for
differences in the relative values of currencies.
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CHAPTER 7
Forecasting exchange rates
237
Critical debate
What should an MNC use to forecast when
budgeting?
Proposition: use the spot rate to forecast. When an
MNC firm conducts financial budgeting, it must estimate
the values of its foreign currency cash flows that will be
received by the parent. Since it is well documented that
firms cannot accurately forecast future values, MNCs
should use the spot rate for budgeting. Changes in
economic conditions are difficult to predict, and the spot
rate reflects the best guess of the future spot rate if there
are no changes in economic conditions.
Opposing view: use the forward rate to forecast.
The spot rates of some currencies do not represent
accurate or even unbiased estimates of the future spot
rates. Many currencies of developing countries have
generally declined over time. These currencies tend
to be in countries that have high inflation rates. If the
spot rate had been used for budgeting, the dollar cash
flows resulting from cash inflows in these currencies
would have been highly overestimated. The expected
inflation in a country can be accounted for by using the
nominal interest rate. A high nominal interest rate implies
a high level of expected inflation. Based on interest rate
parity, these currencies will have pronounced discounts.
Therefore, the forward rate captures the expected
inflation differential between countries because it is
influenced by the nominal interest rate differential. Since
it captures the inflation differential, it should provide a
more accurate forecast of currencies, especially those
currencies in high-inflation countries.
With whom do you agree? Use InfoTrac or some other
search engine to learn more about this issue. Which
argument do you support? Offer your own opinion on
this issue.
Self test
Answers are provided in Appendix A at the back of
the text.
1 Assume that the annual UK interest rate is
expected to be 7 per cent for each of the next
four years, while the annual interest rate in India
is expected to be 20 per cent. Determine the
appropriate four-year forward rate premium or
discount on the Indian rupee which could be used
to forecast the percentage change in the rupee
over the next four years.
2 Consider the following information:
Currency
90-day
forward
rate
Spot rate that
occurred 90-days
later
Canadian dollar
€0.80
€0.82
Japanese yen
€0.012
€0.011
Assuming the forward rate was used to
forecast the future spot rate, determine whether
the Canadian dollar or the Japanese yen was
forecasted with more accuracy, based on the
absolute forecast error as a percentage of the
realized value.
3 An analyst has stated that the British pound
seems to increase in value over the two weeks
following announcements by the Bank of England
(the British central bank) that it will raise interest
rates. If this statement is true, what are the
inferences regarding weak-form or semi-strong
form efficiency?
4 Assume that Russian interest rates are much
higher than UK interest rates. Also assume that
interest rate parity (discussed in Chapter 8) exists.
Would you expect the rouble to appreciate or
depreciate? Explain.
5 Warden plc is considering a project in Venezuela,
which will be very profitable if the local currency
(bolivar) appreciates against the British pound.
If the bolivar depreciates, the project will result in
losses. Warden plc forecasts that the bolivar will
appreciate. The bolivar’s value historically has been
very volatile. As a manager of Warden plc, would
you be comfortable with this project? Explain.
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238
PART II
EXCHANGE RATE BEHAVIOUR
Questions and exercises
1 Why would an MNC seek to make its own forecast rather than rely on PPP or IFE or any other model?
2 What MNC decisions would be affected by a currency forecast?
3 A fellow manager notes that the recent government announcement of a current account deficit is good news.
Explain how this might be true.
4 Why would you expect random movements to be a sign of a share reacting to information?
5 What is the relationship between random movement and a normal distribution?
6 Outline the meaning of weak, semi-strong and strong form efficiency in the context of exchange rate behaviour.
7 From the internet:
GBP/JPY Price Analysis: Weekly W-formation remains in play
●●
●●
GBP/JPY bears engaging in a phase of distribution.
Bears to target the neckline of the weekly W-formation.
As per the prior analysis, GBP/JPY Price Analysis: Bears move in following bull rally, weekly W-formation eyed,
the price is indeed making progress as per the W-formation. The following illustrates the market structure on a
weekly time frame and prospects for a setup on the lower time frames.
Ross J. Burland (11 January 2022), FX Street
Is this valuable information? Examine the arguments for and against.
8 a W
hat is meant by technical forecasting and why is it subject to relatively few academic papers compared to
other approaches to modelling?
b Determine whether the following excerpts from the press are based on technical analysis or fundamental
analysis.
‘The Pound (GBP) dropped on Monday afternoon as media headlines suggested that England would not be
reinstating new restrictions in spite of a rise in Coronavirus cases, causing tension for investors.’
‘New Zealand’s Dollar opened the new year on the defensive as the late December rally in NZD/USD began
to reverse, with the main Kiwi exchange rate slipping back toward last month’s lows near to the round number
of 0.67.’
‘If Bitcoin falls below that, it could drop back to last September’s lows around $39,500, while a move above
$49,000 would be needed for a “larger bounce” to take hold, Fundstrat says.’
‘The spot’s daily closing above the 50-Daily Moving Average (DMA) resistance, now at 11.78, on Tuesday,
prompted a fresh upswing beyond 12.00. having bounced off the critical 100-DMA support in the previous week.’
9 What is meant by homogeneous expectations and how is it relevant to technical forecasting?
10 What is meant by a lagged impact on exchange rates and why might inflation be one example?
11 You develop a model based on PPP but you find that the results are not that good. Explain possible reasons for
the poor model.
12 What is mixed forecasting and why might it be better than other methods?
13 An MNC might want to access forecasting services. What are the arguments for and against such a move?
14 Explain why the forward rate as a predictor of the future spot is generally no better than the current spot.
15 What is the difference between the random movement of exchange rates and the actual movements of exchange
rates over time?
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CHAPTER 7
Forecasting exchange rates
239
Discussion in the boardroom
Running your own MNC
This exercise can be found in the digital resources for
this book.
This exercise can be found in the digital resources for
this book.
Endnotes
1 Davies, P. (2015) ‘The algorithm of life’, in M. Brooks (ed.)
Chance, New Scientist, Profile.
2 The emerging normal distribution is the same as
histograms of successive layers of Pascal’s triangle, each
level representing an extra day starting from the top.
3 Peiers, B. (1997) ‘Informed traders, intervention, and price
leadership: A deeper view of the microstructure of the
foreign exchange market’, The Journal of Finance, LII(4),
1589–642.
4 Long-term tests are almost impossible to sample and
panel testing (for example, five-year movements in a price
across a range of countries) is still a developing area in
statistics.
5 Taylor, M. and Allen, H. (1992) ‘The use of technical
analysis in the foreign exchange market’, Journal of
International Money and Finance, 11(3), 304–14.
6 Menkhoff, L. and Taylor, M. (2007) ‘The obstinate passion
of foreign exchange professionals: Technical analysis’,
Journal of Economic Literature, 45, 936–72.
7 Al-Zoubi, H. A. (2011) ‘A new look at the forward
premium “puzzle”’, The Journal of Futures Markets, 31(7),
599–628.
Essays/discussion and articles can be found at the end of Part II.
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240
PART II
EXCHANGE RATE BEHAVIOUR
BLADES PLC CASE STUDY
Forecasting exchange rates
Recall that Blades plc, the UK-based manufacturer
of rollerblades, is currently both exporting to and
importing from Thailand. Ben Holt, Blades’ Finance
Director, and you, a financial analyst at Blades plc, are
reasonably happy with Blades’ current performance in
Thailand. Entertainment Products, Inc., a Thai retailer
for sporting goods, has committed to purchasing a
minimum number of Blades’ ‘Speedos’ annually. The
agreement will terminate after three years. Blades also
imports certain components needed to manufacture
its products from Thailand. Both Blades’ imports and
exports are denominated in Thai baht. Because of
these arrangements, Blades generates approximately
10 per cent of its revenue and 4 per cent of its cost of
goods sold in Thailand.
Currently, Blades’ only business in Thailand
consists of this export and import trade. Ben Holt,
however, is thinking about using Thailand to augment
Blades’ UK business in other ways as well in the
future. For example, Holt is contemplating establishing
a subsidiary in Thailand to increase the percentage
of Blades’ sales to that country. Furthermore, by
establishing a subsidiary in Thailand, Blades will have
access to Thailand’s money and capital markets. For
instance, Blades could instruct its Thai subsidiary to
invest excess funds or to satisfy its short-term needs
for funds in the Thai money market. Furthermore, part
of the subsidiary’s financing could be obtained by
utilizing investment banks in Thailand.
Due to Blades’ current arrangements and
future plans, Ben Holt is concerned about recent
developments in Thailand and their potential impact
on the company’s future in that country. Economic
conditions in Thailand have been unfavourable
recently. Movements in the value of the baht have
been highly volatile, and foreign investors in Thailand
have lost confidence in the baht, causing massive
capital outflows from Thailand. Consequently, the
baht has been depreciating.
When Thailand was experiencing a high economic
growth rate, few analysts anticipated an economic
downturn. Consequently, Holt never found it
necessary to forecast economic conditions in Thailand
even though Blades was doing business there. Now,
however, his attitude has changed. A continuation
of the unfavourable economic conditions prevailing
in Thailand could affect the demand for Blades’
products in that country. Consequently, Entertainment
Products may not renew its commitment for another
three years.
Since Blades generates net cash inflows
denominated in baht, a continued depreciation of
the baht could adversely affect Blades, as these
net inflows would be converted into fewer pounds.
Thus, Blades is also considering hedging its
baht-denominated inflows.
Because of these concerns, Holt has decided
to reassess the importance of forecasting the
baht-pound exchange rate. His primary objective
is to forecast the baht-pound exchange rate for the
next quarter. A secondary objective is to determine
which forecasting technique is the most accurate and
should be used in future periods. To accomplish this,
he has asked you, a financial analyst at Blades, for
help in forecasting the baht-pound exchange rate for
the next quarter.
Holt is aware of the forecasting techniques
available. He has collected some economic data
and conducted a preliminary analysis for you to use
in your analysis. For example, he has conducted
a time series analysis for the exchange rates over
numerous quarters. He then used this analysis to
forecast the baht’s value next quarter. The technical
forecast indicates a depreciation of the baht by 6 per
cent over the next quarter from the baht’s current
level of £0.015 to £0.014. He has also conducted a
fundamental forecast of the baht–pound exchange
rate using historical inflation and interest rate data.
The fundamental forecast, however, depends on what
happens to Thai interest rates during the next quarter
and therefore reflects a probability distribution. There
is a 30 per cent chance that Thai interest rates will
be such that the baht will depreciate by 2 per cent,
a 15 per cent chance that the baht will depreciate by
5 per cent, and a 55 per cent chance that the baht
will depreciate by 10 per cent.
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CHAPTER 7
Ben Holt has asked you to answer the following
questions:
1 Considering both Blades’ current practices and
future plans, how can it benefit from forecasting the
baht-pound exchange rate?
2 Which forecasting technique (i.e. technical,
fundamental, or market-based) would be easiest to
use in forecasting the future value of the baht? Why?
3 Blades is considering using either current spot
rates or available forward rates to forecast the
future value of the baht. Available forward rates
currently exhibit a large discount. Do you think the
spot or the forward rate will yield a better marketbased forecast? Why?
4 The current 90-day forward rate for the baht is
£0.014. By what percentage is the baht expected
to change over the next quarter according to a
market-based forecast using the forward rate?
What will be the value of the baht in 90 days
according to this forecast?
Forecasting exchange rates
241
5 Assume that the technical forecast has been more
accurate than the market-based forecast in recent
weeks. What does this indicate about market
efficiency for the baht–pound exchange rate? Do
you think this means that technical analysis will
always be superior to other forecasting techniques
in the future? Why or why not?
6 What is the expected percentage change in
the value of the baht during the next quarter
based on the fundamental forecast? What is the
forecasted value of the baht using this forecast? If
the value of the baht 90 days from now turns out
to be £0.0147, which forecasting technique is the
most accurate? (Use the absolute forecast error
as a percentage of the realized value to answer
the last part of this question.)
7 Do you think the technique you have identified in
Question 6 will always be the most accurate? Why
or why not?
SMALL BUSINESS DILEMMA
Exchange rate forecasting by the Sports Exports Company
The Sports Exports Company converts euros
into British pounds every month. The prevailing
spot rate is about 1.45 euros, but there is much
uncertainty about the future value of the euro. Jim
Logan, owner of the Sports Exports Company,
expects that British inflation will rise substantially in
the future. In previous years when British inflation
was high, the pound depreciated. The prevailing
British interest rate is slightly higher than the
prevailing euro interest rate. The pound has risen
slightly over each of the last several months. Jim
wants to forecast the value of the pound for each of
the next 20 months.
1 Explain how Jim can use technical forecasting
to forecast the future value of the euro. Based
on the information provided, do you think that a
technical forecast will predict future appreciation or
depreciation in the pound?
2 Explain how Jim can use fundamental forecasting
to forecast the future value of the euro. Based
on the information provided, do you think that a
fundamental forecast will predict appreciation or
depreciation in the pound?
3 Explain how Jim can use a market-based forecast
to forecast the future value of the euro. Do you
think the market-based forecast will predict
appreciation, depreciation, or no change in the
value of the pound?
4 Does it appear that all of the forecasting techniques
will lead to the same forecast of the euro’s future
value? Which technique would you prefer to use in
this situation?
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CHAPTER 8
International arbitrage and
covered interest rate parity
LEARNING OBJECTIVES
The specific objectives of this chapter are to:
●●
Explain the conditions that will result in various forms of international arbitrage, along with the realignments that
will occur in response to various forms of international arbitrage.
●●
Explain the concept of interest rate parity and how it prevents arbitrage opportunities.
The foreign exchange market is one of the most sophisticated of all world markets. If inconsistencies occur within the
foreign exchange market, rates will be realigned by market traders. The process is driven by international arbitrage,
which offers the highly attractive prospect of being able to make a profit without taking a risk. Financial managers of
multinational corporations (MNCs) must understand how international arbitrage realigns exchange rates in order to
begin to predict exchange rate behaviour. Arbitrage processes are therefore fundamental to assessing the foreign
exchange risk faced by MNCs and indeed are fundamental to all pricing in finance and an essential extension of the
efficient markets hypothesis. Put simply, if something appears to be obviously profitable, such as a higher interest rate,
too often students and even practitioners think they can make an easy profit when really they should stop and think
‘there must be a catch, I have forgotten something ...’: well, they have!
242
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CHAPTER 8
International arbitrage and covered interest rate parity
243
International arbitrage
Arbitrage can be loosely defined as making a profit from a discrepancy in quoted prices. The strategy does
not involve risk (or at least the risk is trivially small) and, in many cases, does not require an investment of
funds to be tied up for any length of time.
EXAMPLE
Two coin shops buy and sell coins. If Shop A is willing
to sell a particular coin for £120, while Shop B is
willing to buy that same coin for £130, a person can
execute arbitrage by purchasing the coin at Shop A
for £120 and selling it to Shop B for £130. The profit is
certain (£10 less any travel costs) and the risk trivial –
the trader might be mugged going from one shop to the
other! The prices at coin shops can nevertheless vary
because demand conditions may vary among shop
locations. But if two coin shops are not aware of each
other’s prices and are sufficiently close to each other, the
opportunity for arbitrage may occur. The act of arbitrage
will cause prices to realign. In our example, arbitrage
would cause Shop A to raise its price (due to high
demand for the coin). At the same time, Shop B would
reduce its buying price after receiving a surplus of coins
as arbitrage occurs. The two prices will adjust to being
nearly the same in both shops – the difference being
only the inconvenience and trivial cost of executing the
arbitrage. The beauty of the process is that Shop A and
Shop B need not know even of each other’s existence,
they simply have to react to demand and supply.
Arbitrage is therefore a very simple mechanism for determining prices and price behaviour and is a
fundamental process in many financial proofs. The reasoning is that, from the example, if the price in
Shop A can be calculated, then it should be possible to predict the price in Shop B by arbitrage processes.
In finance, the two ‘shops’ may be two financial packages that offer the same benefits. Modigliani and
Miller’s1 propositions use this argument: personal gearing acting as the ‘Shop A’ price offers the same
returns as company gearing, i.e. the ‘Shop B’ price, therefore they must have the same value.
For the financial manager, arbitrage possibilities implies an inefficient market. So if they are offered
a package that provides the same service but at a cheaper rate, then it is important for the manager to
identify the imperfection that enables one price to be cheaper than another. If the advantage is not clear
then there may be hidden differences for the unwary.
The type of arbitrage discussed in this chapter is primarily international in scope. It is applied to foreign
exchange and international money markets and takes three common forms:
1 locational arbitrage
2 triangular arbitrage
3 covered interest arbitrage.
Each form will be discussed in turn.
Locational arbitrage
Commercial banks providing foreign exchange services normally quote about the same rates as each
other on currencies, so shopping around may not necessarily lead to a more favourable rate. If there are
differences that are not of any real value then market forces will force realignment. That is to say, traders
will exploit market differences, ultimately forcing the same price for the same ‘product’.
When the market is not efficient and quoted exchange rates vary for no clear reason among locations,
participants in the foreign exchange market can capitalize on the discrepancy. Specifically, they can use
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locational arbitrage, which is the process of buying a currency at the location where it is priced cheaply and
immediately selling it at another location where the price is higher.
EXAMPLE
Akron Bank and Zyn Bank serve the foreign exchange
market by buying and selling currencies. Assume that
there is no bid/ask spread. The exchange rate quoted
at Akron Bank is £0.62 for $1, while the exchange
rate quoted at Zyn Bank is £0.63. You could conduct
locational arbitrage by purchasing dollars at Akron
Bank for £0.62 per dollar and then selling them to
Zyn Bank for £0.63 per dollar. Under the condition
that there is no bid/ask spread and there are no other
costs to conducting this arbitrage strategy, your gain
would be £0.01 per dollar. The gain is risk-free in that
you knew when you purchased the dollars how much
you could sell them for. Also, you did not have to tie
your funds up for any length of time.
Locational arbitrage is normally conducted by banks or other foreign exchange dealers whose computers
can continuously monitor the quotes provided by other banks. If other banks noticed a discrepancy between
Akron Bank and Zyn Bank, they would quickly engage in locational arbitrage to earn an immediate risk-free
profit. The calculations are a little more complex as banks have a bid/ask spread on currencies, and this next
example demonstrates the spread.
EXAMPLE
The bid/ask spread is important to arbitrage in
that prices can differ and yet there is no arbitrage
opportunity. In Exhibit 8.1 you cannot profit from
locational arbitrage. If you buy pounds from Akron
Bank at £0.62 (the bank’s ask price) and then sell
the pounds to Happy Travel Agent at its bid price
of £0.58, you lose. If you try it the other way around
and buy from Happy at £0.63 and sell to Akron at
EXHIBIT 8.1
£0.61 you will also make a loss. As this example
demonstrates, even when the bid or ask prices of
two traders are different, locational arbitrage will
not always be possible. To achieve profits from
locational arbitrage, the bid price of one bank must
be higher than the ask price of another bank – you
buy at the bank’s ask price and sell at the bank’s
bid price.
Currency quotes for locational arbitrage example
Akron Bank
Dollar quote
Happy Travel Agent
Bid (bank buys
dollars)
Ask (bank sells
dollars)
£0.61
£0.62
Dollar quote
Bid (bank buys dollars)
Ask (bank sells
dollars)
£0.58
£0.63
Gains from locational arbitrage. Gains from locational arbitrage are based on the amount of money used
to capitalize on the exchange rate discrepancy, along with the size of the discrepancy.
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CHAPTER 8
International arbitrage and covered interest rate parity
245
EXAMPLE
Quotations for the New Zealand dollar (NZ$) at two
banks are shown in Exhibit 8.2. You can obtain New
Zealand dollars from North Bank at the ask price of
£0.38 and then sell New Zealand dollars to South Bank
at the bid price of £0.39. This represents one ‘roundtrip’ transaction in locational arbitrage. If you start with
£10,000 and conduct one round-trip transaction, how
many British pounds will you end up with? The £10,000
is initially exchanged for NZ$26,316 (£10,000/£0.38 per
New Zealand dollar) at North Bank. Then the NZ$26,316
EXHIBIT 8.2
are sold for £0.39 each, for a total of £10,263. Thus,
your gain from locational arbitrage is £263.
A briefer calculation is to observe that for every
£0.38 a profit of £0.39 2 £0.38 5 £0.01 is made. As
a percentage, this profit is £0.01/£0.38 5 2.63 per
cent, which for £10,000 is £10,000 3 0.0263 5 £263.
As a note of caution, it is advisable to avoid short
cuts unless very familiar with the calculation; the
safer, longer route of calculating a ‘round-trip’ is
preferable.
Locational arbitrage – buy at the bank’s ask and sell at the bid
North Bank
Bid
Ask
NZ$ quote £0.37 £0.38
Step 1:
Buy NZ$s for £s
from North Bank
£
South Bank
Bid
Ask
NZ$ quote £0.39 £0.41
NZ$
£
NZ$
Step 2:
Sell NZ$s for £s
to South Bank
Foreign exchange
market participants
Step 3:
Calculate the profit
The gain of £263 in this example may appear to be small relative to the investment of $10,000. However,
consider that funds were not tied up for any length of time and there was no risk. The round-trip transaction
could take place over a telecommunications network within a matter of seconds at hundreds of times a day.
Also, if a larger sum of money were used the gain would be larger each ‘round-trip’. In financial terms, this
transaction amounts to earning limitless amounts of money for no risk – the financial equivalent of a ‘free
lunch’ and there are no ‘free lunches’ in finance. It is important to emphasize, therefore, that such a misalignment of prices is only likely to last for a very short period of time.
If you notice an apparent mis-alignment of prices in the financial press, the likely explanations are that:
1 The prices are not accurate (for example they may have been taken at different times of the day).
2 There are regulations and restrictions concerning the purchase and selling of the currencies that make the
proposed round-trip impossible.
3 The difference does not cover transaction costs which include commissions.
4 You have not identified the element of risk.
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Unfortunately, the press often uses the word ‘arbitrage’ for transactions that are risky and therefore
give the impression that such profits are common. In any event do not attempt to pay for your education
through part-time locational arbitrage.
Realignment due to locational arbitrage. Quoted prices will react to the locational arbitrage strategy used
by foreign exchange market participants.
EXAMPLE
In the previous example, the high demand for
New Zealand dollars at North Bank (resulting from
arbitrage activity) will cause a shortage of New
Zealand dollars there. As a result of this shortage,
North Bank will raise its ask price for New Zealand
dollars. The excess supply of New Zealand dollars
at South Bank (resulting from sales of New Zealand
dollars to South Bank in exchange for US dollars)
will force South Bank to lower its bid price. As the
currency prices are adjusted, gains from locational
arbitrage will be reduced. Once the ask price of
North Bank is not any lower than the bid price
of South Bank, locational arbitrage will no longer
occur. Prices may adjust in a matter of seconds
or minutes from the time when locational arbitrage
occurs.
The concept of locational arbitrage is relevant in that it explains why exchange rate quotations among
banks at different locations normally will not differ by a significant amount. This applies not only to banks
on the same street or within the same city but to all banks across the world. Technology allows banks to be
electronically connected to foreign exchange quotations at any time. Thus, banks can ensure that their quotes
are in line with those of other banks. They can also immediately detect any discrepancies among quotations
as soon as they occur and capitalize on those discrepancies. Technology enables more consistent prices among
banks and reduces the likelihood of significant discrepancies in foreign exchange quotations among locations.
Triangular arbitrage
Cross exchange rates represent the relationship between two currencies that are quoted in terms of another
currency. Taking the UK as the base currency, if Currency A is 2A:£1 and currency B is 4B:£1 the term cross
exchange rate refers to the implied exchange rate between A and B. By inspection this is 2A 5 4B as they are both
worth £1. The cross exchange rate is therefore ½ A:1B or 2B:1A; we divide 2A 5 4B by 4 or by 2 respectively.
EXAMPLE
If the US dollar is worth £0.50 and the euro is worth
£0.80 there is an implied or cross exchange rate
between the euro and the dollar. This is because the
holder of euros wanting to convert to dollars could do
so indirectly by converting into British pounds and then
converting the pounds into dollars. This method uses
the cross exchange rate, the implied rate. To calculate
the rate we can use a simple equation approach.
The above exchange rates can be written as:
£0.50 5 $1 or dividing both sides by
0.50 £1 5 $2.00
£0.80 5 €1 or dividing both sides by
0.80 £1 5 €1.25
Therefore $2.00 = €1.25 as they are both worth £1
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CHAPTER 8
International arbitrage and covered interest rate parity
Putting this exchange rate in more traditional form:
$2.00 = €1.25 S divide both sides by 1.25 S $1.60
equals €1
or
247
Therefore, to calculate the cross exchange rate, find
out the value of the currencies involved in the cross
rate to one unit of the common (other) currency. Then
equate those values and convert the equation to
traditional form.
$2.00 = €1.25 S divide both sides by 2.00 S
$1 equals €0.625
If a quoted direct exchange rate differs from the appropriate cross exchange rate (as determined by the
preceding formula), you can attempt to capitalize on the discrepancy. Specifically, you can use triangular
arbitrage, in which currency transactions are conducted in the spot market to capitalize on a discrepancy
in the cross exchange rate between two currencies.
EXAMPLE
Assume that a UK bank has quoted the US dollar
at $1.60 to the British pound, the Malaysian ringgit
(MYR) at MYR8.10 to the pound, and the third
exchange rate at $0.20 for MYR1. If, as a UK business
person, you wanted to convert £100,000 into ringgit,
would it be preferable to convert at the direct rate of
EXHIBIT 8.3
£1 5 MYR8.10 or use the cross exchange rate by
converting the ringgit into dollars and then the dollars
into pounds (Exhibit 8.3)?
From Exhibit 8.3 it is clear that you would do better
to buy ringgit directly.
Converting ringgit to pounds
Indirect route
Direct route
$1.6:£1
British pound (£)
Direct route
MYR8.10:£1
US dollar ($)
$0.20:1RM
Malaysian ringgit (MYR)
Indirect route £1 converts to $1.6
which converts to 1.6/0.20 = MYR8
so MYR8.0:£1
Note that as these exchange rates are mis-aligned a profit can be made. Convert £100 directly into
ringgit, so 810 ringgit, then into dollars so 810 3 0.20 5 $162, then back into pounds $162/1.6 5
£101.25, making a profit of 1.25 per cent. If this had been done the other way the £100 would have
ended up as £98.7654, so there is not really a loss but merely a signal to go the other way. Start out with
£98.7654 and end up with £100, a profit of 100>98.7654 2 1 5 0.0125 or 1.25 per cent. In practice
with this example, transaction costs would use up any surplus. Like locational arbitrage, triangular
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248
PART II
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arbitrage does not tie up funds as the return is instantaneous. Also, the strategy is risk-free, since there is
no uncertainty about the prices at which you will buy and sell the currencies. As the market does not like
profit to be earned for no risk, any gains are likely to be for a very short period of time.
Accounting for the bid/ask spread. As noted, the previous example was simplified in that it did not
account for transaction costs. In reality, there is a bid and ask quote for each currency, which means that
the arbitrageur incurs transaction costs that will normally eliminate the gains from triangular arbitrage.
The following example illustrates how bid and ask price spreads eliminate arbitrage profits.
EXAMPLE
Exhibit 8.4 recasts Exhibit 8.3 in the context of bid/ask
spreads.
With bid/ask spreads a loss is made in whatever
direction is taken; an initial £100 results in a final
EXHIBIT 8.4
£98.89, having gone from pounds to ringgit to dollars
and then back into pounds. Going the other way
£100 ends up as £93.87.
Triangular arbitrage both ways
Ringgit
Ringgit
Dollar
Bid
(Bank buys)
Ask
(Bank sells)
£0.1234
$0.2000
£0.6250
£0.1264
$0.2100
£0.6260
UK pound
£100
£98.89
£0.1264: MYR1
$0.6250:£1
$158.23
MYR791.14
$0.2000:MYR1
Malaysian ringgit (MYR)
US dollar
UK pound
£93.87
£100
$0.6260:£1
$159.74
US dollar
£0.1234:MYR1
$0.2100:MYR1
MYR760.67
Malaysian ringgit (MYR)
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CHAPTER 8
249
International arbitrage and covered interest rate parity
The example in Exhibit 8.4 is the normal state of the market, the bid/asks spread absorbing any possible
profit allowing for a band of variation in the rates whereby arbitrage profits cannot be made.
Covered interest arbitrage
Covered interest arbitrage is the process of capitalizing on interest rate differences between two countries
while covering exchange rate risk. The logic of the term covered interest arbitrage becomes clear when it
is broken down into two parts: ‘interest arbitrage’ refers to the process of capitalizing on the difference
between the interest rates of two countries; ‘covered’ refers to hedging your position against exchange
rate risk by converting at today’s quote for a forward exchange transaction, rather than taking a risk and
converting at whatever the spot rate is at the future point in time.
Covered interest arbitrage differs from conventional arbitrage in that investment and a period of time
are required in the process. However, the profit is made at the moment of concluding the arbitrage package
in the present in much the same way as any other arbitrage operation. An arbitrageur can always sell the
package and obtain the discounted value of the profit immediately as with other arbitrage arrangements.
The following is an example of such an arbitrage operation.
EXAMPLE
As a UK currency trader, you desire to capitalize on
relatively high rates of interest in the US compared
with the UK and have funds available for 90 days. The
interest rate is certain; only the future exchange rate
from dollars into pounds is uncertain. You can use a
forward sale of dollars to guarantee the rate at which
you can exchange dollars for pounds at a future point
in time (Exhibit 8.5). The strategy is as follows:
1 On day one, convert your British pounds into
dollars and set up a 90-day deposit account in a
EXHIBIT 8.5
US bank. Work out the value of the account after
90 days.
2 On day one, engage in a 90-day forward contract
to sell the dollars accumulated in step 1 for
pounds. The arbitrage deal is now complete and
the profit guaranteed.
3 In 90 days, when the deposit matures, fulfil the
90-day forward contract and convert the dollars
back into pounds at the agreed forward rate.
Covered interest arbitrage
Day 1
1. Convert UK pounds into
dollars
Day 90
5. Return
is the same as
home investment
2. Invest in 90-day $ deposit
account + take out forward
exchange rate 90 days
4. Convert back into UK pounds
at the Day 1 forward rate
3. 90-day deposit matures
or home investment
1. Invest UK pounds in UK
deposit account
A no risk-return
UK deposit account
matures
Arbitrage:
Both offer a
guaranteed 90-day
return in pounds.
Therefore,
the forward rate
must be set so
the returns are
the same as
home investment
to avoid riskless
profits.
If the proceeds from engaging in covered interest arbitrage exceed the proceeds from investing in a
domestic bank deposit, and assuming neither deposit is subject to default risk or transaction costs, covered
interest arbitrage is feasible. The feasibility of covered interest arbitrage is based on the interest rate
differential and the forward rate premium. To illustrate with numbers, consider the next example.
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250
PART II
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EXAMPLE
Assume the following information:
●●
You can borrow £800,000 at 2 per cent.
●●
The current spot rate of the dollar is £0.625.
●●
The one-year forward rate of the pound is £0.624.
●●
The one-year interest rate in the UK is 2 per cent.
●●
The one-year interest rate in the US is 3 per cent.
Based on this information, you should proceed as
follows:
1 On day one, borrow the £800,000 and convert
the £800,000 to $1,280,000 and deposit the
$1,280,000 in a US bank, which will mature to
$1,280,000 3 1.03 5 $1,318,400 in one year’s
time.
2 On day one, arrange for the conversion of the
$1,318,400 in one year’s time at the one-year
forward rate of £0.624 to the dollar.
3 In one year when the deposit matures, the
$1,318,400 converts at the prearranged forward
rate to £822,682.
4 Repay the £800,000 borrowed plus interest 5
800,000 3 1.02 5 £816,000
5 You have made a profit of 822,682 2 816,000 5
£6,682 without taking a risk due to the
mis-alignment of the rates.
This is not a stable scenario, as if the return is
certain you might as well invest £8 million and more.
Realignment due to covered interest arbitrage. An efficient market does not allow profit to be made
without taking a risk. So if the previous example were real, you would only see the mis-alignment very
briefly and probably not at all. Only if there were transaction costs would the forward rate not be in
alignment with the interest rate differential.
Covered interest arbitrage affects four variables. For example, in the UK and the US they are: pound
spot rate, British interest rate, US interest rate and the pound forward rate. The normal assumption is that
the forward rate adjusts to the other variables. In practice, future expectations drive all four variables at
the same time and a more accurate description would be to say that the variables are co-determined. This
simply means that there is no clear direction of causality. You would therefore expect the variables to
change such that there is no profit to be made through arbitrage.
Consideration of spreads. We have made the point that without spreads if a loss is made in one direction
a profit can be made in the other direction. This is true generally and applies, for example, to triangular
arbitrage when going the wrong way around the triangle when there are no spreads between bid and ask
rates. This is not especially useful knowledge except to the student taking an exam faced with a question
that does not have spreads. In practice a loss is made in both directions when there are spreads between bid
and ask rates if the market is efficient, i.e. arbitrage or riskless profits cannot be made. We illustrated this in
the context of triangular arbitrage, but the same effect is to be had with covered interest arbitrage and all
arbitrage.
Summary of arbitrage effects
●●
The threat of locational arbitrage ensures that quoted exchange rates are similar across banks in
different locations.
●●
The threat of triangular arbitrage ensures that exchanging money via another currency is in line with direct
conversion.
●●
The threat of covered interest arbitrage ensures that the forward exchange rate is aligned with interest
rates and the spot rate.
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CHAPTER 8
●●
International arbitrage and covered interest rate parity
251
Arbitrage or the threat of arbitrage ensures consistency in pricing. The efficient markets hypothesis tells us
that all prices react to market information; that reaction is consistent between prices that are subject to free
trading.
We now turn to estimating the precise relationship that an efficient market determines between
exchange rates, interest rates and forward rates.
Interest rate parity (IRP)
Once market forces cause interest rates and exchange rates to adjust such that covered interest arbitrage
is no longer feasible, there is an equilibrium state referred to as interest rate parity (IRP). In equilibrium,
the forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential
between two currencies.
The particular point that is often not fully appreciated is that a country with a higher interest rate will
not offer a higher return to the foreign investor as the forward rate offsets the gain in interest rates. The
overall gain to the foreign investor has to be measured in the home currency of that investor and therefore
the foreign investment returns have to be converted back to the home currency.
If interest parity holds, what is gained on interest rates is lost on the exchange rates when converting
back to the home currency.
Derivation of interest rate parity
The underlying transactions for investing abroad are: (a) convert home currency to the foreign currency
of the investment, (b) buy bonds or similar investment in that currency, (c) at the end of the investment
period convert back to the home currency.
Returns from covered interest rate arbitrage (R) are therefore made up of the foreign interest rate (if)
and the movement in the value of the foreign currency (p), the forward premium. Remember that the
forward premium is the percentage amount by which the foreign currency increases (positive) or decreases
(negative) in value. It is the movement in the value of a currency that affects the return on the foreign
investment as it is going into the currency and then being converted out of the currency.
The basic premise is that:
Home investment (ih) should yield a return that is the same as the return from foreign investment (R)
when measured in the home currency according to IRP:
R 5 ih
Expanding the return on foreign investment (R) using the above formula we have:
(1 1 if) (1 1 p) 2 1 5 ih
By rearranging terms, we can determine what the forward premium (p) of the foreign currency should be
under conditions of IRP:
(1 1 if) (1 1 p) 21 5 ih
(1 1 if)(1 1 p) 5 1 1 ih
(1 1 p) 5
p5
(1 1 ih)
(1 1 if)
(1 1 ih)
21
(1 1 if)
In words, where interest rate parity exists, the premium (p) is determined by the ratio of the interest rates.
Determining the forward premium
From the above, the premium or discount can be simply determined.
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252
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EXAMPLE
Assume that the South African rand offers an interest
rate of 6 per cent, while the British pound offers
an interest rate of 5 per cent. From a UK investor’s
perspective, the British pound is the home currency.
According to IRP, the forward rate premium of the
rand with respect to the pound should be:
p5
(1 1 ih)
21
(1 1 if)
p5
1 1 0.05
2 1 5 20.0094339
1 1 0.06
Thus, the rand should exhibit a forward discount of
about 0.943 per cent (rounded). This implies that UK
investors would receive 0.943 per cent less when
selling rands one year from now (based on a forward
sale) than the price they pay for rands today at the
spot rate. Such a discount would offset the interest
rate advantage of the rand. If the rand’s spot rate is
£0.10, a forward discount of 0.943 per cent means
that the one year forward rate is as follows:
F 5 S(1 1 p)
F 5 0.10(1 2 0.00943) 5 0.099057
At this forward rate, covered interest arbitrage
would not be any more profitable than domestic
investment. As a brief check: £100 would convert to
£100>£0.10 5 1,000 rand, which would earn 1,000
(1.06) 1,060 rand, and then convert back to pounds
at the forward rate calculated above at £0.099057,
so 1,060 3 £0.099057 5 £105.00042, a rounding
error of £0.00042 means that the absolute returns
of £105.00042 2 0.00042 5 £105 are the same as
investing domestically at 5 per cent.
Arbitrage opportunities also do not exist for
South African investors. Again, a brief check will
confirm this relationship. A South African investor
with 1,000 rand will convert at the spot rate of £0.10
to the rand, so 1,000 3 £0.10 5 £100, which will
earn 5 per cent in the UK, so the investor will end
up with £100 3 1.05 5 £105 and convert back at
the forward rate of £0.099057 producing absolute
returns of £105>£0.099057 5 1,059.99576 rand, a
rounding error of 0.00424 rand means that the return
will be 1,059.99576 + 0.00424 = 1,060 rand, the
same amount as would be achieved domestically by
investing at 6 per cent.
This is a slightly counterintuitive result in that the
forward rate allows UK investors (or rather holders of
British pounds) to earn 5 per cent and South African
investors (or holders of rand) to earn 6 per cent. The
point is that the 5 per cent is earned in pounds and
the 6 per cent is earned in rand. If we assume that the
only reason for a difference is a difference in inflation,
then the purchasing power of the UK investment
would be the same as the purchasing power of the
South African investment. In real terms (i.e. what can
be bought with the money) they have earned the same
rate of return. So the positions of the two investors
are not quite as different as at first might seem.
The approximate relationship between forward premium and interest rate differential
The forward premium (p), as a reminder, is derived from:
F 5 S(1 1 p)
where F is the forward rate and S the spot rate. The premium is simply the amount by which the forward
rate is more or less than the spot rate.
The exact relationship between the forward premium (or discount) and the interest rate differential
according to IRP is as given above:
(1 1 ih)
p5
21
(1 1 if)
Note that the right-hand side is approximately equal to (ih 2 if) when the interest rates are low. So, where
home interest rates are 6 per cent and foreign interest rates are 4 per cent, the premium on the value of
foreign currency should be:
1 1 0.06
p5
2 1 5 0.01923 or 1.923%
1 1 0.04
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CHAPTER 8
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International arbitrage and covered interest rate parity
In approximate form, the premium should be home less foreign interest rates:
p 5 ih 2 if
5 6% 2 4%
5 2%
Note that the two results are about the same:
1.923% ^ 2%
In many calculations this approximate relationship will suffice, particularly in calculations that do not
involve actual trading, but you should always state that the approximate method is being used where
appropriate.
Graphic analysis of interest rate parity
The interest rate differential can be compared to the forward premium (or discount) with the use of a
graph. All the possible points that represent interest rate parity are plotted on Exhibit 8.6 by using the
approximation expressed earlier and plugging in numbers.
EXHIBIT 8.6
Illustration of interest rate parity
ih – if (%)
Foreign interest
rates lower
IRP line
3
D
1
Forward
discount (%)
–5
–1
Z
A
–1
Y
C
3
5
Forward
premium (%)
B
X
–3
Foreign interest
rates higher
Points representing a discount. For all situations in which the foreign interest rate exceeds the home
interest rate, the forward rate should exhibit a discount approximately equal to that differential. Therefore
if the foreign interest rate (if) exceeds the home interest rate (ih) by 1 per cent (ih 2 if 5 21%), then the
forward value of the foreign currency should exhibit a discount of 1 per cent to cancel out its advantage.
This is represented by point A on the graph. If the foreign interest rate exceeds the home rate by 2 per cent,
then the forward value of the foreign currency should exhibit a discount of 2 per cent, as represented by
point B on the graph and so on.
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Points representing a premium. For all situations in which the foreign interest rate is less than the home
interest rate, the forward value of the foreign currency should exhibit a premium approximately equal to
that differential to make up for the shortfall. For example, if the home interest rate exceeds the foreign rate
by 1 per cent (ih 2 if 5 1%), then the forward premium should be 1 per cent, as represented by point C.
If the home interest rate exceeds the foreign rate by 2 per cent (ih 2 if 5 2%), then the forward premium
should be 2 per cent, as represented by point D and so on.
Points representing IRP. Any points lying on the diagonal line cutting the intersection of the axes represent
IRP. For this reason, that diagonal line is referred to as the interest rate parity (IRP) line. Covered interest
arbitrage is not possible for points on the IRP line.
An individual or corporation can at any time examine all currencies to compare forward rate premiums
(or discounts) to interest rate differentials. From a UK perspective, interest rates in Japan are usually
lower than the home interest rates. Consequently, the forward rate of the Japanese yen usually exhibits a
premium and may be represented by points such as C or D or even points above D along the diagonal line
in Exhibit 8.6. Conversely, South American and African currencies often have higher interest rates than the
UK, so the pound’s forward rate often exhibits a discount, represented by point A or B.
Points off the IRP line. What if a three-month deposit represented by a foreign currency offers an annualized
interest rate of 10 per cent versus an annualized interest rate of 7 per cent in the home country? Such a scenario
is represented on the graph by ih 2 if 5 23%. Also assume that the foreign currency exhibits an annualized
forward discount of 1 per cent. The combined interest rate differential and forward discount information can
be represented by point X on the graph. Since point X is not on the IRP line, we should expect that covered
interest arbitrage will be beneficial for some investors. The investor attains an additional 3 percentage points
for the foreign deposit, and this advantage is only partially offset by the 1 per cent forward discount.
Assume that the annualized interest rate in the foreign currency is 5 per cent, as compared to 7 per cent in
the home country. The interest rate differential expressed on the graph is ih 2 if 5 2%. However, assume that
the forward premium of the foreign currency is 4 per cent (point Y in Exhibit 8.6). Thus, the high forward
premium more than makes up what the investor loses on the lower interest rate from the foreign investment.
If the current interest rate and forward rate situation is represented by point X or Y, home country
investors can engage in covered interest arbitrage. By investing in a foreign currency, they will earn a higher
return (after considering the foreign interest rate and forward premium or discount) than the home interest
rate. This type of activity will place upward pressure on the spot rate of the foreign currency, and downward
pressure on the forward rate of the foreign currency, until covered interest arbitrage is no longer feasible.
Now shift to the left side of the IRP line. Take point Z, for example. This represents a foreign interest
rate that exceeds the home interest rate by 1 per cent, while the forward rate exhibits a 3 per cent discount.
This point, like all points to the left of the IRP line, represents a situation in which investors would achieve
a lower return on a foreign investment than on a domestic one.
For points such as these, however, covered interest arbitrage is feasible from the perspective of foreign
investors. Consider South African investors whose interest rate is 1 per cent higher than the UK interest
rate, and the forward rate (with respect to the pound) contains a 3 per cent discount (as represented by
point Z). South African investors will sell their home currency in exchange for pounds, invest in pounddenominated securities and engage in a forward contract to purchase rand forward. Though they earn 1 per
cent less on the UK investment, they are able to purchase their home currency for 3 per cent less than what
they initially sold it for. This type of activity will place downward pressure on the spot rate of the rand (as
it is sold now to invest in the pound) and upward pressure on the pound’s forward rate (as investors seek to
convert back to rand and consolidate their gain), until covered interest arbitrage is no longer feasible.
Interpretation of interest rate parity
As pointed out in the previous example, covered interest rate parity means that holders of, say, British
pounds who invest abroad at a higher interest rate will not get a higher overall return compared to home
investment. This is because the forward rate will be at a discount such that any interest rate gain is exactly
offset by a fall in the value of the foreign currency in the forward market.
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CHAPTER 8
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International arbitrage and covered interest rate parity
Also, as pointed out in the examples (above), interest rate parity does not mean that all currencies
must have the same interest rate. One of the major benefits of having an independent currency is that
a separate interest rate can be set for that currency and hence the economy where the currency is used.
A currency experiencing high inflation and high interest rates, as a result, can neutralize the effect with
other currencies by devaluing. Hot money will not flow into the country to exploit the high interest rates
because the currency will be quoted at a devalued, lower rate on the forward market.
Does interest rate parity hold?
To determine conclusively whether interest rate parity holds, it is necessary to compare the forward rate
(or discount) with interest rate quotations occurring at the same time. If the forward rate and interest
rate quotations do not reflect the same time of day, then results could be somewhat distorted. Due to
limitations in access to data, it is difficult to obtain quotations that reflect the same point in time.
A comparison of annualized forward rate premiums and annualized interest rate differentials for seven
widely traded currencies, as of 10 February 2004, is provided in Exhibit 8.7 from a US perspective. At this
time, the US interest rate was higher than the Japanese interest rate and lower than the interest rates in
other countries. The exhibit shows that the yen exhibited a forward premium, while all other currencies
exhibited a discount. The Brazilian real exhibited the most pronounced forward discount, which is
attributed to its relatively high interest rate. The forward premium or discount of each currency is in line
with the interest rate differential and therefore reflects IRP.
EXHIBIT 8.7
Forward rate premiums and interest rate differentials for seven currencies
iUS – if
10
8
6
4
2
Forward
discount –10
Japan
–8
–6
–4
Canada
Mexico
Australia
New Zealand
–2 UK
2
4
6
8
10
Forward
premium
–2
–4
–6
–8
Brazil
–10
Notes:
• The data are as of 10 February 2004. The forward rate premium is based on the six-month forward rate and is annualized. The interest rate differential
represents the difference between the six-month annualized US interest rate and the six-month foreign interest rate. This period has been chosen as it
reflects quite large interest rate differentials. The period 2009–10, for instance, experienced much lower differentials. The difference between bid and ask
rates and the movements of prices during the day in such periods becomes greater than the premiums and differentials, thus obscuring the relationship.
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PART II
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At different points in time, the position of a country may change. For example, if Mexico’s interest rate
increased while other countries’ interest rates stayed the same, Mexico’s position would move down along
the y-axis. Yet, its forward discount would likely be more pronounced (further to the left along the x-axis)
as well, since covered interest arbitrage would occur otherwise. Therefore, its new point would be further
to the left but would still be along the 45º line.
Numerous academic studies have conducted empirical examination of IRP in several periods. The
actual relationship between the forward rate premium and interest rate differentials generally supports
IRP. Although there are deviations from IRP, they are often not large enough to make covered interest
arbitrage worthwhile, as we will now discuss in more detail.
Considerations when assessing interest rate parity
If interest rate parity does not hold, covered interest arbitrage still may not be worthwhile due to
various characteristics of foreign investments, including transaction costs, political risk and differential
tax laws.
Transaction costs. If an investor wishes to account for transaction costs, the actual point reflecting the
interest rate differential and forward rate premium must be further from the IRP line to make covered
interest arbitrage worthwhile. Exhibit 8.8 identifies the areas that reflect potential for covered interest
arbitrage after accounting for transaction costs. Notice the band surrounding the IRP line. For points
not on the IRP line but within this band, covered interest arbitrage is not worthwhile (because the excess
return is offset by costs). For points to the right of (or below) the band, investors residing in the home
country could gain through covered interest arbitrage. For points to the left of (or above) the band, foreign
investors could gain through covered interest arbitrage.
EXHIBIT 8.8
Potential for covered interest arbitrage when considering transaction costs
ih – if (%)
IRP line
Zone of potential
profit from
covered interest
arbitrage by
foreign investors
Forward
discount (%)
–4
–2
–2
–4
4
2
2
4
Zone of potential
profit from
covered interest
arbitrage by
investors residing
in the home
country
Forward
premium (%)
Zone where covered
interest arbitrage is
not profitable
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CHAPTER 8
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257
Political risk. Even if covered interest arbitrage appears feasible after accounting for transaction costs,
investing funds overseas is subject to political risk. Though the forward contract locks in the rate at which
the foreign funds should be reconverted, there is no guarantee that the foreign government will allow the
funds to be reconverted. A crisis in the foreign country could cause its government to restrict any exchange
of the local currency for other currencies. In this case, the investor would be unable to use these funds until
the foreign government removed the restriction.
Investors may also perceive a slight default risk on foreign investments such as foreign Treasury bills,
since they may not be assured that the foreign government will guarantee full repayment of interest and
principal upon default. Therefore, because of concern that the foreign Treasury bills may default, they
may accept a lower interest rate on their domestic Treasury bills rather than engage in covered interest
arbitrage in an effort to obtain a slightly higher expected return.
Differential tax laws. Because tax laws vary among countries, investors and firms that set up deposits in
other countries must be aware of the existing tax laws. Covered interest arbitrage might be feasible when
considering before-tax returns but not necessarily when considering after-tax returns. Such a scenario
would be due to differential tax rates.
Changes in forward premium. Generally, given low transaction costs and low political and regulatory risk,
changes in the forward premium will match changes in the relative interest rates. In this way, currency acts as
a financial ‘lubricant’ allowing different currency areas to have their own interest rates and hence their own
monetary policy. A corollary of this is to consider countries with a fixed forward rate between each other, as
is the case between countries in the eurozone. A higher interest rate of one of the member countries would be
more attractive to investors of another country within that zone as there would be no offsetting forward rate.
Therefore countries within a currency area are forced through arbitrage to have similar interest rates – the
only difference being risk. A common interest rate means similar monetary policies – borrowing and spending.
It is tempting to think that changes in interest rates cause changes in the forward rate. But governments
sometimes seek to protect their currencies by buying them on the forward market. This will in turn affect
interest rates in order to avoid riskless profits. As we have said, the direction of causality is never clear and
to avoid the problem, forward rates and interest rates are sometimes referred to as being co-determined.
USING THE WEB
Forward rates
Forward rates of the Canadian dollar, British pound, euro and Japanese yen are provided for various
periods at: markets.ft.com/ft/markets/currencies.asp.
MANAGING FOR VALUE
How interest rate parity affects IBM’s hedge
Many MNCs (and you may think of Renault or IBM)
have subsidiaries based in Brazil. Since the Brazilian
real has historically depreciated against the dollar,
MNCs naturally consider hedging any funds that
their Brazilian subsidiaries plan to remit to the parent.
Forward and futures contracts can be used to hedge
the future transactions in which the Brazilian real
will be converted into dollars. Due to interest rate
parity, however, the forward or futures rate of the
Brazilian real is unfavourable relative to its spot rate.
(Continued )
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Since the Brazilian interest rate is higher than the
European interest rate, IRP forces the forward rate of
the Brazilian real to exhibit a discount. The discount
is especially pronounced when the Brazilian interest
rate is very high. Thus, if an MNC hedges its future
conversions of Brazilian real to dollars, it must accept
a heavily discounted exchange rate for conversion
in the future. This exchange rate may not be as
favourable as the prevailing spot rate at that future
time, even if today’s spot rate declines over time. This
is an important cost of doing business in countries
with high interest rates. Since high interest rates are
usually caused by a high level of expected inflation,
this example illustrates the indirect effect that a
foreign country’s expected inflation can have on an
MNC. IBM, Renault and other MNCs can increase
their value by identifying countries that will have a
high degree of expected inflation and limiting their
exchange rate exposure in those countries.
Summary
●●
Arbitrage is arguably the most important market
force in determining prices because it offers a
certain profit. The free movement of market prices
will ensure that such profits are not possible in
anything other than the very short term – business
people will never turn down a certain profit.
●●
Locational arbitrage may occur if foreign exchange
quotations differ between banks. The act of
locational arbitrage should force the foreign
exchange quotations of banks to become realigned,
and locational arbitrage will no longer be possible.
●●
Triangular arbitrage is related to cross exchange
rates. A cross exchange rate between two
currencies is determined by the values of these
two currencies with respect to a third currency.
If the actual cross exchange rate of these two
currencies differs from the rate that should
exist, triangular arbitrage is possible. The act of
triangular arbitrage should force cross exchange
rates to become realigned, at which time
triangular arbitrage will no longer be possible.
●●
Covered interest arbitrage is based on the
relationship between the forward rate premium
and the interest rate differential. The size of the
premium or discount exhibited by the forward
rate of a currency should be about the same as
the differential between the interest rates of the
two countries of concern. In general terms, the
forward rate of the foreign currency will contain
a discount (premium) if its interest rate is higher
(lower) than the home interest rate. The forward
premium should never deviate substantially from
the interest rate differential as that would imply
a profit from covered interest rate arbitrage.
In effect this would be a riskless profit. Efficient
markets do not allow riskless profits to be made.
●●
Interest rate parity (IRP) is a theory that states that
the size of the forward premium (or discount) on
the spot rate should be equal to the interest rate
differential between the two countries of concern.
When IRP exists, the carry trade (borrowing in one
currency and lending in another and converting
back at the prevailing spot rate at the end of the
lending period) would not result in profits as any
interest rate advantage in the foreign country will be
offset by the discount on the prevailing spot rate in
the future. However, profits (and losses) are made
from the carry trade as IRP does not in general hold
except in extreme circumstances.
Critical debate
Should arbitrage be more regulated?
Proposition. Yes. Large financial institutions have the
technology to recognize when one participant in the
foreign exchange market is trying to sell a currency
for a higher price than another participant. They also
recognize when the forward rate does not properly
reflect the interest rate differential. They use arbitrage
to capitalize on these situations, which results in large
foreign exchange transactions. In some cases, their
arbitrage involves taking large positions in a currency and
then reversing their positions a few minutes later. This
jumping in and out of currencies can cause abrupt price
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CHAPTER 8
International arbitrage and covered interest rate parity
adjustments of currencies and may create more volatility
in the foreign exchange market. Regulations should be
created that would force financial institutions to maintain
their currency positions for at least one month. This
would result in a more stable foreign exchange market.
Opposing view. No. When financial institutions engage
in arbitrage, they create pressure on the price of a
currency that will remove any pricing discrepancy. If
arbitrage did not occur, pricing discrepancies would
become more pronounced. Consequently, firms and
individuals who use the foreign exchange market would
have to spend more time searching for the best exchange
rate when trading a currency. The market would become
fragmented, and prices could differ substantially among
banks in a region, or among regions. If the discrepancies
became large enough, firms and individuals might even
attempt to conduct arbitrage themselves. The arbitrage
259
conducted by banks allows for a more integrated foreign
exchange market, which ensures that foreign exchange
prices quoted by any institution are in line with the
market.
With whom do you agree? State your reasons.
Use InfoTrac or search engines recommended by your
institution to access academic journals subscribed to by
your institution. The keyword ‘arbitrage’ is probably the
best means of selecting relevant articles. Such articles
often conduct statistical tests of some sophistication. It
is the conclusions from these tests and the discussion
surrounding their design and the literature review that
are the real contributions to the debate. Do not be put
off by the rather more obscure aspects of the statistical
tests. For this subject, newspapers are not a good
source as they often confuse speculation with arbitrage.
Speculation is considered in the next chapter.
Self test
Answers are provided in Appendix A at the back of
the text.
1 Assume that the following spot exchange rates
exist today:
1 5 $1.50
C$1 5 $0.75
change in the value of the dollar as a percentage
and compare with the difference in interest rates.
Based on this information, is covered interest
arbitrage by UK investors feasible (assume a UK
investor has £100 to possibly invest in the US)?
Explain.
1 5 C$2
Assume no transaction costs. Based on these
exchange rates, can triangular arbitrage be used
to earn a profit? Explain.
2 Assume the following information:
Spot rate of $1 5 0.625
180-day forward rate of $1 5 0.641
180-day UK interest rate 5 4%
180-day US interest rate 5 3%
Explain in words what is happening to the value of
the dollar over the 180-day period. Calculate the
3 Using the information in the previous question,
outline how the market might react to the given rates.
4 Explain in general terms how various forms of
arbitrage can remove any discrepancies in the
pricing of currencies.
5 Assume that the US dollar’s one-year forward
rate exhibits a premium. Assume that interest
rate parity continually exists. Explain how the premium on the US dollar’s one-year forward rate
would change if UK one-year interest rates rose by
3 percentage points while US one-year interest
rates rose by 2 percentage points.
Questions and exercises
1 Locational arbitrage. Explain the concept of locational arbitrage and the scenario necessary for it to be plausible.
2 Locational arbitrage. Assume the following information:
Beal Bank
Yardley Bank
Bid price of New Zealand dollar
£0.020
£0.018
Ask price of New Zealand dollar
£0.022
£0.019
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PART II
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Given this information, is locational arbitrage possible? If so, explain the steps involved in locational arbitrage,
and compute the profit from this arbitrage if you had £1,000,000 to invest. What market forces would occur to
eliminate any further possibilities of locational arbitrage?
3 Triangular arbitrage. Explain the concept of triangular arbitrage and the scenario necessary for it to be plausible.
4 Triangular arbitrage. Assume the following information:
Quoted price
Value of Canadian dollar in British pounds
£0.60
Value of New Zealand dollar in British pounds
£0.20
Value of Canadian dollar in New Zealand dollars
NZ$3.02
Given this information, is triangular arbitrage possible? If so, explain the steps that would reflect triangular
arbitrage, and compute the profit from this strategy if you had £1,000,000 to invest.
What market forces would occur to eliminate any further possibilities of triangular arbitrage?
5 Covered interest arbitrage. Explain the concept of covered interest arbitrage and the scenario necessary for it
to be plausible.
6 Covered interest arbitrage. Assume the following information:
Spot rate of Canadian dollar
5 £0.4400
90-day forward rate of Canadian dollar
5 £0.4345
90-day Canadian interest rate
5 4%
90-day UK interest rate
5 2.5%
Given this information, what would be the yield (percentage return) to a UK investor who used covered interest
arbitrage? (Assume the investor invests £1,000,000.)
What market forces would occur to eliminate any further possibilities of covered interest arbitrage?
7 Covered interest arbitrage. Assume the following information:
Spot rate of Mexican peso
5 €14.00
180-day forward rate of Mexican peso
5 €13.72
180-day Mexican interest rate
5 6%
180-day euro interest rate
5 5%
Given this information, is covered interest arbitrage worthwhile for Mexican investors who have pesos to invest?
Explain your answer.
8 Interest rate parity. Explain the concept of interest rate parity. Provide the rationale for its possible existence.
9 Inflation effects on the forward rate. Why do you think currencies of countries with high inflation rates tend to
have forward discounts?
10 Covered interest arbitrage in both directions. Assume that the existing UK one-year interest rate is 10 per cent
and the EU one-year interest rate is 11 per cent. Also assume that interest rate parity exists. Should the forward
rate of the euro exhibit a discount or a premium?
a If UK investors attempt covered interest arbitrage, what will be their return?
b If eurozone investors attempt covered interest arbitrage, what will be their return?
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CHAPTER 8
International arbitrage and covered interest rate parity
261
11 Interest rate parity. Why would UK investors consider covered interest arbitrage in France when the interest rate
on euros in France is lower than the UK interest rate?
12 Interest rate parity. Consider investors who invest in either US or UK one-year Treasury bills. Assume zero
transaction costs and no taxes.
a ‘If interest rate parity exists, then the return for UK investors who use covered interest arbitrage will be the same
as the return for US investors who invest in UK Treasury bills.’
Is this statement true or false? If false, correct the statement.
b ‘If interest rate parity exists, then the return for UK investors who use covered interest arbitrage will be the same as
the return for UK investors who invest in UK Treasury bills.’
Is this statement true or false? If false, correct the statement.
13 Changes in forward premiums. Assume that the Japanese yen’s forward rate currently exhibits a premium of
6 per cent and that interest rate parity exists. If eurozone interest rates decrease, how must this premium change
to maintain interest rate parity? Why might we expect the premium to change?
14 Changes in forward premiums. Assume that the forward rate premium of the euro was higher last month than
it is today. What does this imply about interest rate differentials between the US and Europe today compared to
those last month?
15 a Go to the www1.oanda.com/currency/live-exchange-rates/ website and calculate the triangular arbitrage
outcome for £100 (GDP) converted to Japanese yen (JPY) via the euro (EUR). Compare your result with the
JPYGBP direct result and comment on any differences.
b Convert South African Rand (ZAR) to UK pounds (GBP) via the US dollar (USD) and compare with the ZARUSD
direct rate.
Discussion in the boardroom
Running your own MNC
This exercise can be found in the digital resources for
this book.
This exercise can be found in the digital resources for
this book.
Endnote
1 Modigliani, F. and Miller, M. H. (1958) ‘The cost of
capital, corporation finance and the theory of investment’,
American Economic Review, 48(3), 261–97. For example
refer to Vernimmen, P. (2005) Corporate Finance: Theory
and Practice, Wiley, 660 et seq.
Essays/discussion and articles can be found at the end of Part II.
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262
PART II
EXCHANGE RATE BEHAVIOUR
BLADES PLC CASE STUDY
Assessment of potential arbitrage opportunities
Recall that Blades, a UK manufacturer of rollerblades,
has chosen Thailand as its primary export target for
‘Speedos’, Blades’ primary product. Moreover, Blades’
primary customer in Thailand, Entertainment Products,
has committed itself to purchasing 180,000 Speedos
annually for the next three years at a fixed price
denominated in baht, Thailand’s currency. Because of
quality and cost considerations, Blades also imports
some of the rubber and plastic components needed to
manufacture Speedos.
Lately, Thailand has experienced weak economic
growth and political uncertainty. As investors lost
confidence in the Thai baht as a result of the political
uncertainty, they withdrew their funds from the
country. This resulted in an excess supply of baht for
sale over the demand for baht in the foreign exchange
market, which put downward pressure on the baht’s
value. As foreign investors continued to withdraw their
funds from Thailand, the baht’s value continued to
deteriorate. Since Blades has net cash flows in baht
resulting from its exports to Thailand, a deterioration
in the baht’s value will affect the company negatively.
Ben Holt, Blades’ Finance Director, would like
to ensure that the spot and forward rates Blades’
bank has quoted are reasonable. If the exchange
rate quotes are reasonable, then arbitrage will not
be possible. If the quotations are not appropriate,
however, arbitrage may be possible. Under these
conditions, Holt would like Blades to use some form
of arbitrage to take advantage of possible mispricing
in the foreign exchange market. Although Blades
is not an arbitrageur, Holt believes that arbitrage
opportunities could offset the negative impact
resulting from the baht’s depreciation, which would
otherwise seriously affect Blades’ profit margins.
Ben Holt has identified three arbitrage opportunities
as profitable and would like to know which one
of them is the most profitable. Thus, he has asked
you, Blades’ financial analyst, to prepare an analysis
of the arbitrage opportunities he has identified. This
would allow Holt to assess the profitability of arbitrage
opportunities very quickly.
The first arbitrage opportunity relates to locational
arbitrage. Holt has obtained spot rate quotations from
two banks in Thailand: Minzu Bank and Sobat Bank,
both located in Bangkok. The bid and ask prices of Thai
baht for each bank are displayed in the table below:
Minzu Bank
Sobat Bank
Bid
£0.0149
£0.0152
Ask
£0.0151
£0.0153
1 Besides the bid and ask quotes for the Thai baht
provided in the previous question, Minzu Bank has
provided the following quotations for the pound
and the Japanese yen:
Quoted
bid price
Quoted
ask price
Value of a Japanese
yen in British
pounds
£0.0057
£0.0058
Value of a Thai baht
in Japanese yen
¥2.69
¥2.70
2 Ben Holt has obtained several forward contract
quotations for the Thai baht to determine whether
covered interest arbitrage may be possible. He
was quoted a forward rate of £0.015 per Thai
baht for a 90-day forward contract. The current
spot rate is £0.0151. Ninety-day interest rates
available to Blades in the UK are 2 per cent, while
90-day interest rates in Thailand are 3.75 per cent
(these rates are not annualized). Holt is aware
that covered interest arbitrage, unlike locational
and triangular arbitrage, requires an investment
of funds. Thus, he would like to be able to estimate
the British pound profit resulting from arbitrage
over and above the amount available on a 90-day
UK deposit.
3 Determine whether the forward rate is priced
appropriately. If it is not priced appropriately,
determine the profit that could be generated for
Blades by withdrawing £100,000 from Blades’
current account and engaging in covered interest
arbitrage. Measure the profit as the excess amount
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CHAPTER 8
International arbitrage and covered interest rate parity
above what you could generate by investing in the
UK money market.
4 Why are arbitrage opportunities likely to disappear
soon after they have been discovered? To illustrate
your answer, assume that covered interest
263
arbitrage involving the immediate purchase and
forward sale of baht is possible. Discuss how the
baht’s spot and forward rates would adjust until
covered interest arbitrage is no longer possible.
What is the resulting equilibrium state called?
SMALL BUSINESS DILEMMA
Assessment of prevailing spot and forward rates by the Sports Exports Company
As the Sports Exports Company from Ireland exports
basketballs to the UK, it receives British pounds. The
cheque (denominated in pounds) for last month’s
exports has just arrived. Jim Logan (owner of the
Sports Exports Company) normally deposits the
cheque with his local bank and requests that the bank
convert the cheque to euros at the prevailing spot
rate (assuming that he did not use a forward contract
to hedge this payment). Jim’s local bank provides
foreign exchange services for many of its business
customers who need to buy or sell widely traded
currencies. Today, however, Jim decided to check
the quotations of the spot rate at other banks before
converting the payment into euros.
1 Do you think Jim will be able to find a bank that
provides him with a more favourable spot rate than
his local bank? Explain.
2 Do you think that Jim’s bank is likely to provide
more reasonable quotations for the spot rate of
the British pound if it is the only bank in town that
provides foreign exchange services? Explain.
3 Jim is considering using a forward contract to
hedge the anticipated receivables in pounds next
month. His local bank quoted him a spot rate
of 1.45 euros and a one-month forward rate of
1.4435 euros. Before Jim decides to sell pounds
one month forward, he wants to be sure that the
forward rate is reasonable, given the prevailing
spot rate. A one-month Treasury security in Ireland
currently offers a yield (not annualized) of 1 per
cent, while a one-month Treasury security in the
UK offers a yield of 1.4 per cent. Do you believe
that the one-month forward rate is reasonable
given the spot rate of 1.45 euros?
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CHAPTER 9
Relationships between
inflation, interest rates
and exchange rates
LEARNING OBJECTIVES
The specific objectives of this chapter are to:
●
Explain the purchasing power parity (PPP) theory and its implications for exchange rate changes.
●●
Explain the international Fisher effect (IFE) theory or uncovered interest rate parity (UIP) and its implications for
exchange rate changes.
●●
Compare the PPP theory, the IFE theory and the theory of interest rate parity (IRP), which was introduced in the
previous chapter.
In the previous chapter we considered arbitrage operations where there was no risk. Here we admit the possibility of
risk by not taking out forward exchange rates and instead converting back at the future spot, whatever that spot rate
may be. Profits and losses are now possible and the investor can only now work with expectations as to the future
rather than guarantees.
MNC treasurers who do not take out forward rate protection (refer to the previous chapter) will need to understand
the relationship between exchange rates, interest rates and inflation in order to understand how the extensive debates
in the financial press over inflation and interest rates are likely to affect exchange rates. Also, where a government
seeks to control exchange rates, it is important to understand the effect on inflation and interest rates in that country.
We assume in this chapter, unless stated otherwise, that exchange rates are free floating and wholly determined by
non-government market forces.
264
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CHAPTER 9
Relationships between inflation, interest rates and exchange rates
265
Purchasing power parity (PPP)
In Chapter 5 the expected impact of relative inflation rates on exchange rates was discussed. Recall from
this discussion that when the inflation rate in Country A (for example) rises, the immediate impact is that
demand for its currency declines as its exports decline (due to its higher prices). In addition, consumers
and firms in Country A tend to increase their importing (increasing the supply of home currency for
foreign currency). The reduced demand for Country A’s currency and the increased supply of Country A’s
home currency for foreign currency, both place downward pressure on the value of Country A’s currency.
Inflation rates vary among countries, causing international trade patterns and exchange rates to adjust
accordingly. One of the most popular and controversial theories in international finance is purchasing
power parity (PPP). The theory bases its predictions of exchange rate movements on changing patterns of
trade due to different inflation rates between countries.
Interpretations of purchasing power parity
There are two forms of PPP theory: the absolute form and the broader relative form.
Absolute form of PPP. The absolute form of PPP is based on the notion that without international trade
barriers and transport costs, consumers shift their demand to wherever prices are lower. It suggests that
prices of the same basket of products in two different countries should be equal when measured in a
common currency. If there is a discrepancy in prices as measured by a common currency, demand should
shift so that these prices converge.
EXAMPLE
If the same basket of products is produced by the US
and the UK, and the price in the UK is lower when
measured in a common currency, US consumers
should seek to import the cheaper UK products.
Consequently, the actual price charged in each
country may be affected, and/or the exchange
rate may adjust. Remember that for a US resident
seeking to import the cheaper goods from the UK, an
increase in the value of the British pound represents
a price rise just as much as an increase in the price
of the goods themselves. There are two purchases by
the US importer: the currency has to be purchased
in order to buy the goods, then there is the price of
the goods in that currency. Even if the US importer
is paying in dollars, one of the parties in the supply
chain is converting to British pounds and thus taking
on exchange rate risk. Overall, market demand would
cause the prices of the baskets to be similar when
measured in a common currency. Exchange rates are
a part of the price adjustment process.
Realistically, the existence of transportation costs, tariffs and quotas may prevent the absolute form of
PPP. If transportation costs were high in the preceding example, the demand for the baskets of products
might not shift as suggested. Thus, the discrepancy in prices would continue.
Relative form of PPP. The relative form of PPP accounts for the possibility of market imperfections such as
transportation costs, tariffs and quotas. Also, quite simply there may be a difference in prices due to tastes –
an unpopular product may not sell except at a very low price. There is also the Harrod Balassa Samuelson
effect (Chapter 6) to explain the difference in hamburger prices. Whatever the explanation, the relative
form accepts that not all prices across countries will be the same. Instead PPP states that the difference
in prices in percentage terms should be constant. If importing a product from the US is 10 per cent more
expensive in terms of British pounds compared to the UK equivalent in January, whatever happens to
inflation in the two countries, in December the exchange rate should have adjusted so that the pound cost
of the US import is still 10 per cent more expensive.
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266
PART II
EXCHANGE RATE BEHAVIOUR
In allowing for differences but keeping them constant in percentage terms, PPP is more realistic with no
loss of implications for the exchange rate.
EXAMPLE
For clarity we will propose some unrealistically high
figures for the US and the UK and assume that the
US experiences a 9 per cent inflation rate, while the
UK experiences a 5 per cent inflation rate. All goods
in the US are going to appear to be approximately
9% 2 5% 5 4% more expensive to the UK resident
and 4 per cent cheaper to the US resident over any
given period. Under these conditions, PPP theory
suggests that the US dollar should depreciate by
approximately 4 per cent – the difference in inflation
rates. The price differences, it is argued, would
reduce the demand for dollars by British pounds and
increase the supply of dollars for pounds which will,
in a free floating exchange rate regime, lower the
value of the dollar against the pound to cancel the
effect of the higher inflation. Thus, the exchange rate
should adjust to offset the differential in the inflation
rates of the two countries. If this occurs, then the
difference in prices that existed before the inflation
changes will remain after the inflation changes. If a
particular washing machine costs 6 per cent more
in the US before the inflation change, it will still cost
6 per cent more after the inflation and exchange rate
change.
So PPP maintains that the relative increase in US
prices of 4 per cent is offset by the fall of 4 per cent
in the value of the dollar. Remember that there are
two prices in international trade, and in this case the
price movement of the goods is offset by the price
movement of the currency.
Therefore, the exchange rate adjusts so that relative
prices are undisturbed by inflation differences. Relative
PPP does not require that prices translated into
one currency be the same – differences may persist
because of transportation costs – the requirement is
merely that the differences remain constant.
Power parity theory – an informal approach
To get an intuitive feel for the problem, let us take