Test 3 Flashcards
What is the Foreign Exchange Market?
A market for converting the currency of one country into that of another country, involving a global network of banks, brokers, and foreign exchange dealers.
What is the function of the foreign exchange market?
Enables companies to trade with each other, hedges foreign exchange risk, allows currency speculation and currency arbitrage.
Define Currency Speculation.
Movement of funds from one currency to another in the hope of profiting from shifts in exchange rates.
What is a Carry Trade?
Involves borrowing in one currency when interest rates are low and investing in another currency where interest rates are high.
What does EUR/USD 1.3732 mean?
1 Euro equals 1.3732 USD.
What is Currency Appreciation?
An increase in the value of one currency in terms of another.
What is Foreign Exchange Risk?
Risk introduced into international business transactions by changes in exchange rates.
List the three main categories of Foreign Exchange Risk.
- Transaction or Contractual Exposure
- Translation Exposure
- Economic or Operating Exposure
What is Transaction Exposure?
The extent to which income from individual transactions is affected by fluctuations in foreign exchange values.
What is Translation Exposure?
The impact of currency exchange rate changes on the reported financial statements of a company.
What is Economic Exposure?
The extent to which a firm’s future international earning power is affected by changes in exchange rates.
What are the two types of risk management strategies in Foreign Exchange Risk?
- Hedging
- Exploiting differences in interest rates
What is a Forward Exchange Contract?
An agreement between two parties to exchange currency and execute the deal at a specific date in the future.
What is a Currency Swap?
The simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.
How are exchange rates determined?
By the demand and supply for different currencies.
What is the Law of One Price?
In competitive markets, identical products must sell for the same price when expressed in the same currency.
Define Purchasing Power Parity Theory (PPP).
The price of a ‘basket of goods’ should be roughly equivalent in each country.
What does high inflation imply for currency value?
More supply of money on the foreign exchange market leads to currency depreciation relative to others.
What is the International Fisher Effect (IFE)?
The spot exchange rate should change in the opposite direction to the difference in nominal interest rates between two countries.
What influences short-term exchange rate movements?
Investor psychology, political factors, microeconomic events, and bandwagon effects.
What strategies can managers use to minimize transaction and translation exposure?
- Buy forwards
- Use swaps
- Lead and lag payables and receivables
What is the International Monetary System (IMS)?
The institutional arrangements that govern exchange rates.
What are Fixed Exchange Rates?
The value of a set of currencies are fixed against each other at mutually agreed on exchange rates.
Define the Gold Standard.
A system in which countries peg currencies to gold and guarantee their convertibility.
What were the strengths of the Gold Standard?
Achieved balance-of-trade equilibrium and reduced inflation during trade deficits.
What was established at the Bretton Woods Conference in 1944?
A fixed exchange rate system where foreign currencies were fixed to the USD.
What is the role of the International Monetary Fund (IMF)?
To maintain order in the international monetary system and approve devaluations greater than 10%.
What do fixed exchange rates discourage?
Competitive devaluations of the currency
How do fixed exchange rates impose monetary discipline?
Countries must maintain a fixed exchange rate
What is the role of the International Monetary Fund (IMF) in the Bretton Woods System?
Provides lending facilities and adjustable parities
What can members borrow from the IMF during balance-of-payments deficits?
A limited amount equal to their contribution in the pool of reserves
What are adjustable parities in the Bretton Woods System?
Devaluations (>10%) permitted in cases of fundamental disequilibrium
What was the initial purpose of the World Bank?
To help finance rebuilding of war-torn economies of Europe
What overshadowed the World Bank’s initial efforts?
The U.S. Marshall Plan
What are the two main arms through which countries can borrow from the World Bank?
- International Bank for Reconstruction and Development (IBRD)
- International Development Association (IDA)
What type of loans does the IDA provide?
Interest-free loans to the poorest countries
What significant event led to the collapse of the Bretton Woods system?
Floating exchange rates were formalized in 1976
What are the main advantages of floating exchange rates?
- Monetary policy autonomy
- Automatic trade balance adjustments
- Crisis recovery
What are the advantages of a fixed exchange rate system?
- Ensures monetary discipline
- Minimizes speculation
- Reduces uncertainty
What percentage of IMF members follow a free float policy?
21%
What types of financial crises does the IMF focus on?
- Currency crisis
- Banking crisis
- Foreign debt crisis
What characterizes a currency crisis?
Speculative attack leading to sharp depreciation or large reserve expenditures
What is a banking crisis?
Loss of confidence leading to a run on the banks
What is a foreign debt crisis?
Inability of a country to service its foreign debt obligations
What are some conditions that come with IMF loans?
- Increase taxes
- Cut public spending
- Privatize state-owned enterprises
- Raise interest rates
- Open the economy to foreign investors
What criticism has been directed at the IMF’s approach?
One-size-fits-all macroeconomic policies do not work
What is the focus of the global capital market?
Bringing together investors and borrowers
What are the two types of loans in capital markets?
- Equity loans
- Debt loans
What has facilitated the growth of international capital markets since the 1980s?
Deregulation by governments
What is a Eurocurrency?
Any currency banked or held outside its country of origin
What is the significance of the Eurocurrency market?
An important source of low-cost funds for international companies
What are foreign bonds?
Bonds issued in a host country’s financial market by a foreign borrower
What are Eurobonds?
Bonds issued in countries other than the one in whose currency the bond is denominated
What makes the Eurobond market attractive?
- Lacks regulatory interference
- Lower cost of issuing bonds
- Less stringent disclosure requirements
What do global capital markets allow firms to do?
- Attract international capital
- Raise funds in foreign markets
What is strategy in the context of a firm?
Actions that managers take to attain the goals of the firm
What is the difference between profitability and profit growth?
- Profitability: rate of return on invested capital
- Profit growth: percentage increase in net profits over time
What is value added?
The difference between costs of production and the value perceived by consumers
What are the two strategies firms can pursue to increase profitability according to Michael Porter?
- Differentiation strategy
- Low cost strategy
What must a firm establish to maximize profitability?
Its strategic position
What should a firm’s organization structure be aligned with?
Its strategy
What are value creation activities categorized as?
Operations within the firm
What is the first step to maximize profitability?
Pick a position on the efficiency frontier that is viable for the firm.
What are the two main categories of value creation activities?
- Primary activities
- Support activities
What does the organizational structure consist of?
- Formal division of the organization into subunits
- Location of decision-making responsibilities
- Establishment of integrating mechanisms
What is required for a firm to attain a competitive advantage?
The strategy, operations, and organizational structure must all be consistent with each other.
List four ways a multinational firm can increase profitability.
- Expand their market
- Realize location economies
- Realize greater cost economies from experience effects
- Leverage the multinational network
What type of competitive pressure forces a firm to lower unit costs?
Pressures for cost reductions.
What are the pressures for local responsiveness driven by?
- Differences in consumer tastes and preferences
- Differences in traditional practices and infrastructure
- Differences in distribution channels
- Host government demands
What is the international strategy of MNCs?
Take products produced for the domestic market and sell them internationally with only minimal local customization.
When is the international strategy most effective?
When there are low-cost pressures and low pressures for local responsiveness.
What does the localization strategy involve?
Customizing goods or services to match tastes and preferences in different national markets.
When is the localization strategy most effective?
When there are substantial differences across nations in consumer tastes and preferences and cost pressures are not too intense.
What is the goal of the global standardization strategy?
To market a standardized product worldwide to reap benefits from economies of scale, learning effects, and location economies.
What is a key characteristic of the transnational strategy?
Simultaneously achieve low costs, differentiated product offering, and flow of knowledge between different subsidiaries.
What challenges does the transnational strategy present?
It is extremely difficult to implement and involves creating a viable organization structure and related control systems.
Fill in the blank: Organizational structure involves the establishment of ________ to coordinate activities of subunits.
[integrating mechanisms]
True or False: The localization strategy typically involves centralized decision-making.
False.
What do pressures for cost reductions arise from?
- Commodity type products
- Major competitors in low cost locations
- Persistent excess capacity
- Powerful consumers with low switching costs
What is the primary focus of operations in a firm?
Value creation activities.
What is the relationship between strategy and structure in a firm?
Strategy and structure must be aligned for effective implementation.
