July 23, 2007
Discussion Section
Foreign Direct Investment; Political Economy of FDI;
Foreign Exchange; International Monetary System
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Chapters 3,4,5,6 in a nutshell
Review Chapters 7,8
◦ Discussion 1: Western automobile firms in Russia
(time permitting)
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Review Chapter 10, 11
◦ Discussion 2: Chinese Currency Change
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Q&A regarding the Midterm
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Chapter 3:
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Chapter 4:
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Chapter 5:
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Chapter 6:
◦ What is culture? What are the determinants of culture? How
does culture affect business?
◦ What are ethical dilemmas? How do ethical dilemma’s arise?
What are some of the standards used to evaluate ethics?
Which ones are “straw men” arguments?
◦ What are the theories that explain the observed pattern of
international trade?
◦ What are some of the instruments that governments use to
restrict trade? What are some political and economic
justifications for trade intervention? Are these justifications
“justified”? How has the world trading system developed?
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What is FDI?
FDI in the world economy
◦ Trends; Direction of FDI; Source of FDI; Shift to Services
◦ Form of FDI
 Greenfield vs. Acquisitions and Mergers
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Types of FDI
◦ Horizontal FDI
 Why undertake horizontal FDI?
 Transportation costs; market imperfections (internalization
theory: impediments to exporting, impediments to sale of
know how); strategic behavior
◦ Vertical FDI
 Why undertake vertical FDI?
 Strategic behavior; market imperfections (impediments to the
sale of know how; investment in specialized assets)
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In 2003, inward FDI accounted for some 78%
of gross fixed capital formation in Ireland,
but only 0.6% in Japan. What do you think
explains this differences in FDI flows into the
two countries?
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Read the Management Focus on recent
investments by Western automobile firms in
Russia. Which theory best explains these
investments? Why?
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Political Ideology and FDI
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What are the benefits of FDI to host countries?
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What are the costs of FDI to host countries?
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What are the costs and benefits to home countries?
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What are some government regarding FDI?
◦ Radical View
◦ Free Market View
◦ Pragmatic Nationalism
◦ Resource-transfer effects (capital, technology, know-how); Employment
effects; Balance-of-payment effects; Effect on competition and economic
growth
◦ Adverse effect on competition; adverse effects on the balance of
payments; national sovereignty and autonomy
◦ Benefits: inward cash flow; employment effects; skills learned from abroad
◦ Costs: balance of payments; employment effects (outsourcing)
◦ Home country: encourage some outward FDI; restrict some outward FDI
◦ Host country: encourage some inward FDI; restrict other inward FDI
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Read the Country Focus on FDI in Ireland.
How important has FDI been to the health of
the Irish economy?
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Inward FDI is bad for (i) a developing
economy and (ii) a developed economy and
should be subjected to strict controls.
Discuss.
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Firms should not be investing abroad when
there is a need for investment to create jobs
at home. Discuss.
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Do you think the successful conclusion of a
multilateral agreement to liberalize
regulations governing FDI will benefit the
world economy? Why?
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What is the FOREX market for?
◦ Currency conversion; insuring against foreign exchange
risk (using spot exchange, forward exchange, or
currency swaps)
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Arbitrage in FOREX markets
Theories about how FOREX rates are determined
◦ Price and exchange rates: law of one price; purchasing
power parity; money supply and price inflation
◦ Interest rates and exchange rates: Fisher Effect;
International Fisher Effect
◦ Investor psychology and bandwagon effects
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For example, consider the US-based company ("Acme Tool & Die") that has raised money by
issuing a Swiss Franc-denominated Eurobond with fixed semi-annual coupon payments of 6%
on 100 million Swiss Francs. Upfront, the company receives 100 million Swiss Francs from the
proceeds of the Eurobond issue (ignoring any transaction fees, etc.). They are using the Swiss
Francs to fund their US operations.
[Why issue bonds in Swiss Francs? The only rationale for doing this is because there are
investors with Swiss Franc funds who are looking to diversify their portfolios with US credits
such as Acme's. They are willing to buy Acme's Eurobonds at a lower yield than Acme can issue
bonds in the US. A Eurobond is any bond issued outside of the country in whose currency the
bond is denominated.]
Because this issue is funding US-based operations, we know two things straightaway. Acme is
going to have to convert the 100 million Swiss Francs into US dollars. And Acme would prefer
to pay its liability for the coupon payments in US dollars every six months.
Acme can convert this Swiss Franc-denominated debt into a US dollar-like debt by entering
into a currency swap with the First London Bank.
Acme agrees to exchange the 100 million Swiss Francs at inception into US dollars, receive the
Swiss Franc coupon payments on the same dates as the coupon payments are due to Acme's
Eurobond investors, pay US dollar coupon payments tied to a pre-set index and re-exchange
the US dollar notional into Swiss Francs at maturity.
Acme's US operations generate US dollar cash flows that pay the US-dollar index payments.
First London Bank make Swiss-Franc denominated payments.
In essence, Acme and First London Bank have “swapped currencies”
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The interest rate on South Korean
government securities with one-year maturity
is 4% and the expected inflation rate is 2%.
The interest rate on U.S. government
securities with one-year maturity is 7%, and
the expected rate of inflation is 5%. The
current spot exchange rate for Korean won is
$1 = W1,200. Forecast the spot exchange
rate one year from today. Explain the logic of
your answer
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Drawing on what we know about the Fisher effect,
the real interest rate in both the US and South
Korea is 2%. The international Fisher effect
suggests that the exchange rate will change in an
equal amount but in an opposite direction to the
difference in nominal interest rates. Hence since
the nominal interest rate is 3% higher in the US
than in South Korea, the dollar should depreciate
by 3% relative to the South Korean Won. Using the
formula from the book: (S1 - S2)/S2 x 100 = i$ iWon and substituting 7 for i$, 4 for iWon, and
1200 for S1, yields a value for S2 of $1=W1165.
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Two countries, Great Britain and the United
States, produce just one good: beef. Suppose the
price of beef in the United States is $2.80 per
pound and in Britain it is ₤3.70 per pound.
◦ According to PPP theory, what should the dollar/pound
spot exchange rate be?
◦ Suppose the price of beef is expected to rise to $3.10 in
the United States and to ₤4.65 in Britain. What should
the one-year forward dollar/pound exchange rate be?
◦ Given your answers to parts a and b, and given that the
current interest rate in the United States is 10%, what
would you expect the current interest rate to be in
Britain?
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(a) According to PPP, the $/£ rate should be
2.80/3.70, or .76$/£.
(b) According to PPP, the $/£ one year forward
exchange rate should be 3.10/4.65, or .67$/£.
(c) Since the dollar is appreciating relative to the
pound, and given the relationship of
the international Fisher effect, the British must
have higher interest rates than the US. Using the
formula (S1 - S2)/S2 x 100 = i£ - i$ we can solve
the equation for i£, with S1=.76, S2=.67, I$ = 10,
yielding a value of 23.4% for the British interest
rates.
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You manufacture wine goblets. In mid-June
you receive an order for 10,000 goblets from
Japan. Payment of ¥400,000 is due in
December. You expect the yen to rise from
the present rate of $1 = ¥130 to $1 = ¥100
by December. You can borrow yen at 6% a
year. What should you do?
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(1) The simplest solution would be to just wait until December, take the
¥400,000 and convert it at the spot rate at that time, which you assume will
be $1=¥100.
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(2) Forward Contract
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In this case you would have $4,000 in mid-December.
If the current 180-day forward rate is lower than 100¥/$, then a forward contract might be
preferable since it both locks in the rate at a better level and reduces risk.
If the rate is above ¥100/$, then whether you choose to lock in the forward rate or wait and see
what the spot does will depend upon your risk aversion.
(3) Borrow Money
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There is a third possibility also. You could borrow money from a bank that you will pay back with
the ¥400,000 you will receive (400,000/1.03 = ¥388,350 borrowed), convert this today to US$
(388,350/130 = $2,987), and then invest these dollars in a US account. For this to be preferable to
the simplest solution, you would have to be able to make a lot of interest (4,000 - 2,987 = $1,013),
which would turn out to be an annual rate of 51% ((1,013/4000) * 2). If, however, you could lock in
these interest rates, then this method would also reduce any exchange rate risk. What you should
do depends upon the interest rates available, the forward rates available, how large a risk you are
willing to take, and how certain you feel that the spot rate in December will be ¥100 = $1.
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1. China, which has been under strong
political pressure for some time to revalue its
currency, has finally agreed to do just that,
only in a very small way. Is this move by
China a win for the U.S. or a win for China?
What are the political implications of this
action?
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2. Until now, China’s currency valuation has
represented a significant subsidy to Chinese
exporters, a situation that is seen in a
negative light by American exporters.
However, as a beneficiary of cheap goods
made in China, how do you feel about the
U.S.’ efforts to force China to raise its
currency?
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3. After more than a decade, the value of the
yuan has risen relative to the dollar. While
the revaluation amounts to just a two percent
difference at the moment, there is
speculation that the Chinese will continue to
allow the yuan to rise. What effect will this
initial movement have on Chinese workers
and consumers? What are the effects if the
yuan continues is ascent?
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4. China’s revaluation of the yuan was echoed
in other parts of Asia. For example, in India,
the rupee appreciated, as did the Japanese
yen. Consider the implications of further
currency revaluations for the Asian region.
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Different exchange rate regimes:
◦ Fixed
◦ Floating: pegged; dirty float
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Fixed versus Floating Exchange Rates
◦ Why choose floating exchange rates?
 Monetary policy autonomy
 Trade balance adjustments
◦ Why choose fixed exchange rates?
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Monetary discipline
Speculation
Uncertainty
Trade Balance Adjustment
◦ Who is right?
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Debate the relative merits of fixed and
floating exchange rate regimes. From the
perspective of an international business, what
are the most important criteria in a choice
between the systems? Which system is the
more desirable for an international business?
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Imagine that Canada, the United States, and
Mexico decide to adopt a fixed exchange rate
system. What would be the likely
consequences of such a system for (a)
international businesses and (b) the flow of
trade and investment among the three
countries?