Lecture International business (11/e) - Chapter 11: Financial forces

The main goals of this chapter are to: Explain how money can be made and lost in the foreign exchange (FX) markets; understand foreign exchange quotations, including cross rates; describe currency exchange controls; explain how financial forces such as tariffs, taxes, inflation and the balance of payments can affect international management.

Financial Forces

chapter eleven

 Describe currency exchange controls

 Explain how financial forces such as tariffs, taxes, inflation and the balance of payments can affect international management

Fluctuating Currency Values

• Freely floating currencies fluctuate

against each other

• Fluctuations may be quite large

• Financial managers must understand

how to protect against losses or optimize gains

Foreign Exchange Terminology

 Foreign Exchange Quotation

 The price of one currency expressed in terms of another

 Reported in the world’s currency exchange markets

 Central reserve asset

 Asset, usually currency, held by a government’s central bank

Foreign Exchange Quotations

(1) / (Currency X per US$ rate) =

= (US$ equivalent rate of currency X)(1) / (US$ equivalent rate of currency X) =

= (Currency X per US$ rate)

Exchange Rate for June 19 and June 16,

2006

Exchange Rates

 Spot rates

 The exchange rate between two currencies for delivery within two business days

 Forward currency market

 Trading market for currency contracts

deliverable 30, 60, 90, or 180 days in the future

 Forward rate

 The exchange rate between two currencies for delivery in the future, usually 30, 60, 90,

or 180 days

 Premium or a discount depends on the

expectations of the world financial community, businesses, individuals, and governments

about what the future will bring

Influences of Exchange Rate Fluctuation

 Supply and demand of the currency

 Interest rates

 Inflation

 Expectations

Exchange Rate Fluctuation

• Monetary policies

– Government policies that control the amount of

money in circulation and its growth rate

• Fiscal policies

– Policies that address the collecting and spending of

money by the government

• Law of one price

– Concept that in an efficient market, like products

will have like prices

• Arbitrage

– The process of buying and selling instantaneously

to make profit with no risk

Exchange Rate Fluctuation

• Fisher effect

– The relationship between real and nominal interest

rates: the real interest rate will be the nominal

interest rate minus the expected rate of inflation

• International Fisher effect

– Concept that the interest rate differentials for any

two currencies will reflect the expected change in their exchange rates

• Purchasing Power Parity (PPP)

– Theory that predicts that currency exchange rates

between two countries should equal the ratio of the price levels of their commodity baskets

Exchange Rate Forecasting

 Efficient market approach

 Assumption that current market prices fully reflect all available relevant information

 Random walk hypothesis

 Assumption that the unpredictability of

factors suggests that the best predictor of tomorrow’s prices is today’s prices

Exchange Rate Forecasting

 Fundamental approach

 Exchange rate prediction based on

econometric models that attempt to capture the variables and their correct relationships

 Technical analysis

 An approach that analyzes data for trends and then projects these trends forward

Currency Exchange Controls

 Government controls that limit the legal uses

of a currency in international transactions

 Value of currency is arbitrarily fixed at a rate higher than its market value

 If you see “official rate” next to a currency rate quotation, that country has currency exchange controls in place

Currency Exchange Controls

 A black market typically surfaces as a result of currency exchange controls

 However, this type of currency exchange

transaction is illegal

 The black market is rarely able to

accommodate transactions of the size

involved in international business

• Tariffs

– Taxes, usually on imported goods

– May be ad valorem, specific, compound, or

variable

 Income tax

• Direct tax on personal and corporate income

 Value-added tax (VAT)

• A tax charged on the value added to a good as it

moves through production from raw materials to final purchaser

 Withholding tax

• Indirect tax levied on passive income that the

corporation would pay out to non residents

Corporate Tax Rates

• A trend of rising prices

– May be caused by demand exceeding

supply

– May be caused by an increase in the money

supply

• Measured by consumer price index (CPI)

– Basket of consumer goods

• Gross domestic product deflator OECD

– Takes into account the prices of

intermediate goods and services

GDP Deflator Average annual growth in

percentage, 1991-2004

Inflation and the International Company

 High inflation rates

 Make capital expenditure planning more

difficult

 Cause the cost of goods and services to rise

 Tend to cause BOP deficits

 Could lead to more restrictive fiscal or

monetary policies, currency controls, export incentives, and import obstacles

Inflation and the International Company

 High inflation rates

 Encourage borrowing because the loan will be repaid

with cheaper money

 Bring high interest rates

 Discourage lending

 Make capital expenditure planning more difficult

Balance of Payments (BOP)

 The state of a nation’s BOP reveals the state

of that country’s economy

 If the BOP is slipping into deficit

 the government is probably considering one or

more market or nonmarket measures to correct or suppress that deficit

 Currency devaluation or restrictive monetary or fiscal policies to induce deflation are likely

 Currency or trade controls may be near