EXAM STUDY GUIDE
BAIM 500 The International Trading Environment
Period 1, January/February 2004 — Prof. Werner Antweiler
This Version: February 4, 2004
This exam study guide is intended to help you prepare for the final exam by highlighting
learning objectives and key questions for the topics we have covered in BAIM 500. In
general, the exam focuses on the ability to express sound reasoning when making management decisions. The exam is not meant to test your ability to memorize institutional
details or mathematical formulae; the few places where calculations are involved are
identified below. The lecture notes should provide the basis for your exam preparations.
They are essential to understanding the key concepts and how they are applied in the
cases we have studied. The lecture notes have been colour-coded. Slides with an orange
background are considered advanced material and will not be covered on the exam.
1. Introdution: Canada in the Global Economy
The introductory section offers a collection of “stylized facts.” You should acquire
an idea of which countries Canada is trading with, how the commodity composition of exports has changed over time, and understand the preeminence of the
trading relationship with the United States. In addition to a general appreciation
of Canada’s role in the world economy, you need to understand the logic of the
Balance of Payment system that keeps track of all international transactions. This
involves understanding both the accounting identities as well as the economic dynamics that link the BoP balances to exchange rate movements (both fixed and
floating). You should be prepared to answer the questions that appear on slide 17.
Furthermore, you should know how the BoP measures on slide 19 identify country
risk. You should also understand the “dimensions of separation” that help explain
why countries trade with each other, as well as why international trade faces many
impediments.
2. Trade Determinants: Comparative Advantage and other Theories
This section identifies a number of economic theories that explain the pattern of
trade and specialization in the world. In addition to understanding the principal
economic forces (productivity differences, factor endowments, economies of scale),
you should be able to assess competitive advantage and identify related strategic
moves. Concretely, the calculation of competitive advantage (slide 10) is an essential tool to link wage rate, productivity, and exchange rate. Understand which
forces shift competitive advantage over time (the Mexico/China case) and how regional development leads to agglomeration effects (the Pearl River Delta case). In
regard to the neoclassical trade theory, a simple computational exercise is to identify a country’s relative factor abundance (slide 17). In our discussion of increasing
returns to scale, focus your attention on slides 23-25: the different types of scale
returns and the concept of first-mover advantage. The strategies for creating and
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defending a first-mover advantage, and the advantages and disadvantages of being
a second mover, should be studied in depth.
3. Trade Determinants: Porter’s Model, Transaction Costs
The applications of trade theory emphasize managerial decision making. Such applications are an obvious source of exam questions. First, you need to be able to
identify a business’s core competence; how to project it into an export market; and
how to defend it against competitors and imitators. The Porter model provides a
very practical analytical tool to identify strategic moves of an exporter. To apply
the model, identify the key issues pertaining to each of the four corners and two
external forces. Then define appropriate strategic moves (e.g., slide 8). In the discussion of the CAGE distance framework (slide 9), you should be able to identify
industries that are subject to particular distance costs. You should be prepared to
offer strategies to respond to them effectively, or to overcome their limits. Slide 15
itemizes the most important physical trade costs. The gravity model puts an empirical perspective on physical trade costs. Distance matters, as does the “border
effect.” You should be able to provide explanations for the border effect.
The Product Life Cycle model (in particular, slides 11, 13 and 14) identifies dynamic
forces that influence the international location choice for production. Prepare answers for the questions on slide 13.
Slides 21 and 22 identify contractual trade costs and transaction costs, while slide
23 introduces a sequential procedural view through the ‘SENSE’ framework. You
should understand what is involved and required in each of the five SENSE steps.
4. Practical Export Pricing
The material from session four was covered in part in our 9th session due to the
cancellation of our first-scheduled meeting. Focus on the practical issues in pricing
exports starting on slide 5. You need to know the basic pricing strategies (slides 7
and 8), and the distinction between full-cost and marginal pricing (and the implications for dumping). The concept of international price discrimination outlined on
slides 9 and 10 is absolutely essential. However, the numerical example on (slides
11-13) will not be covered on the exam. You should also understand the special
role of sunk costs, and be able to name examples of such sunk costs. Lastly, slide
17 provides reasons why (surety) bonds are often required when exporters bid for
foreign contracts, especially government contracts.
5. International Finance: Theory
The two theories covered in greater depth are purchasing power parity (PPP) and interest rate parity (IRP). The bottom-line formulae pertaining to absolute and relative
PPP, and covered and uncovered IRP, should be memorized. Thus you ought to pay
great attention to the issues covered on slides 14-21, and you should be prepared
to carry out calculations based on PPP and IRP. For covered IRP, you should be able
to calculate a forward rate given information on domestic and foreign (per annum)
interest rates, and the prevailing spot rate. Concretely, Etf = Et0 [(1 + i∗ )/(1 + i)]1/f ,
where f is the length of the forward period in years. Note the exponent (1/f) when
you are dealing with periods other than a full year.
The remainder of the section provides a bird’s eye perspective on other models of
exchange rate determination. Keep in mind that the FX models apply at differ2
ent time horizons. PPP is a (very!) long-run model. The asset-market models are
forward-looking, as is explained at the bottom of page 21. Thus, asset-market
models require rational predictions of the state of the economy at future periods
in time. Identify the role of key economic variables (money supply and output)
in the flexible-price model. The market microstructure models provide short-term
forecastability. Here, information is revealed through order flow and order inventory, and decentralized multi-dealer FX markets are characterized by information
asymmetries.
6. International Finance: Practice
While understanding exchange rate economics is useful, managing exchange rate
risk is absolutely indispensable. Start with slide 18 that identifies the types of
risks and risk exposures. The strategies outlined on slide 19 must all be fully understood. You should be able to identify: Which strategy can be applied in which
context? How useful is each strategy? What are the limitations of a particular
strategy? You need to know the general economic trade-off between hedging (costly
financial instruments) and holding speculative positions (no instruments required,
but risky), and why businesses tend to prefer mixtures of both (an optimizing decision). It is also important to recapitulate the mechanics of the main hedging instrument, the currency swap. Work through the example on slide 22. Currency options
will not be covered on the exam. Further, briefly review the key “signal extraction”
tools offered by technical analysis (corridor break-outs, support/resistance levels,
moving-average crossovers; slides 9-12).
This section also highlights that in addition to the level of exchange rates (and the
obvious implications for exporters) we must also be concerned with the volatility
of exchange rates. More volatility means greater unpredictability, and thus higher
cost ensuring against exchange rate risk. While forecasting exchange rate levels is
very difficult, forecasting volatility is a lot easier due to persistence effects. (There
are well-understood statistical tools available for this.) In making export decisions,
appreciate the vastly different levels of currency volatility (slide 16), which identifies
some export markets as more risky than others. Compare the volatility risk of
floating exchange rates with the revaluation or devaluation risk (timing, size) of
fixed exchange rates. Appreciate the lessons learned from the Asian currency crisis
and the Mexican Peso crisis that we discussed in class. What are the economic
trade-offs when countries choose floating and fixed exchange rate regimes?
7. International Trade Law
International trade law is resting on two pillars of non-discrimination: the MostFavoured Nation Principle and the National Treatment Principle; recapitulate the
material covered on slides 4-7. Understand the general GATT exceptions (slide
11) and the limitations placed on their use (slide 12). GATT favours tariffs over
quantitative restrictions. Even though the latter are generally prohibited, quantitative restrictions (in particular: VERs) proliferated due to loopholes in GATT. The
Uruguay agreement has reversed that trend and restricted the use of VERs, but
now protectionism is resurfacing through other GATT instruments.
There are three major interventions: antidumping duties (slides 29, 32-33); countervailing duties (slides 34-35); and safeguards (slide 38). You are expected to understand their definitions and terms of use. For instance, under which conditions
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can an antidumping duty be applied? How large can it be? Why do firms dump
in the first place? How should firms react when they face antidumping duties?
Focus on the strategic aspects relevant to businesses. It will not be necessary to
recapitulate the procedural elements of the dispute settlement mechanisms.
8. Instruments of Trade Policy
Our case discussions at the beginning of this session was intended to give you
an overview of the practical questions that firms encounter in dealing with trade
instruments. Along the way you should have gained an insight into protectionist
abuses of GATT instruments, and you should be able to distinguish frivolous use
from legitimate use of GATT instruments. Familiarize yourself again with Bhagwati’s discussion of the link between a country’s openness to trade and economic
development. What is “fair trade”?
Slide 8 lists ten normative reasons for trade policy. You should understand the
political and economic logic behind them (see also slides 9 and 10). Ignore the
diagrams on the orange-coloured slides. We did not have time to discuss them, and
they will not be relevant for the exam.
Regional economic integration is a key instrument of trade policy. Slide 21 details
the steps toward closer integration, and slide 22 describes the positive and negative
economic effects. You should know the differences between trade creation, trade
diversion, and trade modification. To understand the distinction between free trade
areas and customs unions, refer to slide 8 from the previous module. FTAs rely on
rules of origin; see slides 27-28 in the previous module.
Standards are increasingly becoming the new battlefield of international trade. Understand the economic forces (i.e., network effects and adaptation costs) that push
countries to mutual recognition of standards, standards unions, or non-recognition
of foreign standards.
9. Export & Import Strategies
In this section we have covered the principles of preparing an export quote, writing
an export contract, and securing an export payment through a letter of credit.
(To start with, review the SENSE framework from the end of module 3.) First,
understand the determinants of the allocation of shipping costs between buyer
and seller, and the use of invoicing currency. Carefully review the role of the L/C
and the economic trade-off between using open accounts and L/C’s; see also slide
21 in module 3. Furthermore, assess the pros and cons of entering countertrade
deals. In reviewing distribution strategies, compare the pros and cons of direct and
indirect methods, and using either an import agent or foreign distributor.
The points highlighted in the exam study guide should provide you with a rough filter to
the material we have covered, and help you prioritize your learning effort. Nevertheless,
the final exam is inclusive. All topics covered are potential sources for exam questions,
with the exception of mathematical derivations or material marked “advanced.”
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