chapter eleven Financial Forces McGraw-Hill/Irwin International Business, 11/e Copyright © 2008 The McGraw-Hill Companies, Inc All rights reserved Learning Objectives 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 11-3 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 11-4 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 Vehicle currency A currency used as a vehicle for international trade or investment Intervention currency A currency used by a country to intervene in the foreign currency exchange markets, often to buy (strengthen) its own currency 11-5 Foreign Exchange Quotations Exchange Rates Foreign currency X’s per US$ rate can be computed from the reciprocal of the US$ equivalent rate of currency X (and vice versa) (1) / (US$ equivalent rate of currency X) = = (Currency X per US$ rate) (1) / (Currency X per US$ rate) = = (US$ equivalent rate of currency X) 11-6 Exchange Rate for June 19 and June 16, 2006 11-7 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 11-8 Exchange Rates Trading at a premium A currency’s forward rate quote is stronger than the spot rate Trading at a discount A currency’s forward rate quotes is weaker than the spot rate Premium or a discount depends on the expectations of the world financial community, businesses, individuals, and governments about what the future will bring 11-9 Exchange Rates Cross Rates Currency exchange rates for trading directly between non-U.S dollar currencies Bid price Price offered to buy Ask price Sales price 11-10 Influences of Exchange Rate Fluctuation Supply and demand of the currency Interest rates Inflation Expectations 11-11 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 11-12 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 11-13 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 11-14 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 11-15 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 11-16 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 11-17 Tariffs • Tariffs – Taxes, usually on imported goods – May be ad valorem, specific, compound, or variable 11-18 Taxation 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 11-19 Corporate Tax Rates 11-20 Inflation • 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 11-21 GDP Deflator Average annual growth in percentage, 1991-2004 11-22 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 11-23 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 11-24 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 11-25 ... planning more difficult 11- 24 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... 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... 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