Weeks 1-2 Flashcards
what are agency problems and costs?
- The conflict of goals between managers and shareholders
- ▪ Definition: Cost of ensuring that managers maximize
shareholder wealth
▪ Costs are normally higher for MNCs than for purely
domestic firms for several reasons:
▪ Monitoring managers of distant subsidiaries in foreign
countries is more difficult
▪ Foreign subsidiary managers raised in different cultures
may not follow uniform goals
▪ Sheer size of larger MNCs can create large agency
problems
how to control agency problems?
Corporate control of agency problems
▪ Entire management of the MNC must be focused on maximising
shareholder wealth.
Parent control of agency problems
▪ Parent should clearly communicate the goals for each subsidiary
to ensure managers focus on maximising the value of the MNC
and not of their respective subsidiary.
Sarbanes-Oxley Act (SOX)
▪ Ensures a more transparent process for managers to report on the
productivity and financial condition of their firm.
Why MNCs Pursue International Business
- Theory of competitive advantage:
– Specialisation increases production efficiency. - Imperfect markets theory:
– Factors of production are somewhat immobile, providing
incentive to seek out foreign opportunities. - Product cycle theory:
– As a firm matures, it recognises opportunities outside its
domestic market
How Firms Engage in
International Business
- International Trade
- Licensing
- Franchising
- Joint Ventures
- Acquisitions of Existing Operations
- Establishment of New Foreign Subsidiaries
what is international trade
- Relatively conservative approach that can be
used by firms to:
– penetrate markets (by exporting).
– obtain supplies at a low cost (by importing). - Minimal risk — no capital at risk
– The internet facilitates international trade by
allowing firms to advertise their products and
accept orders on their websites.
what is licensing?
Obligates a firm to provide its technology
(copyrights, patents, trademarks, or trade names) in
exchange for fees or some other specified benefits
▪ Allows firms to use their technology in foreign
markets without a major investment and without
transportation costs that result from exporting
▪ Major disadvantage: difficult to ensure quality
control in foreign production process
what is franchising
Obligates firm to provide a specialised sales or service
strategy, support assistance, and possibly an initial
investment in the franchise in exchange for periodic fees.
▪ Allows penetration into foreign markets without a major
investment in foreign countries.
what are joint ventures?
▪ A venture that is jointly owned and operated by two or
more firms. A firm may enter the foreign market by
engaging in a joint venture with firms that reside in those
markets.
▪ Allows two firms to apply their respective cooperative
advantages in a given project.
what are acquisitions of existing operations
Acquisitions of firms in foreign countries allows
firms to have full control over their foreign
businesses and to quickly obtain a large portion of
foreign market share.
* Subject to the risk of large losses because of
larger investment.
* Liquidation may be difficult if the foreign
subsidiary performs poorly.
what is the establishment of new foreign subsidiaries?
Firms can penetrate markets by establishing new
operations in foreign countries.
▪ Requires a large investment.
▪ Acquiring new as opposed to buying existing
allows operations to be tailored exactly to the
firms needs.
▪ May require smaller investment than buying
existing firm.
what is foreign direct invesment?
Any method of increasing international business
that requires a direct investment in foreign
operations is referred to as foreign direct
investment (FDI).
▪ International trade and licensing usually not
included.
▪ Foreign acquisition and establishment of new
foreign subsidiaries represent the largest portion
of FDI.
what are the objectives of exchange rates
▪ Describe the exchange rate systems used by
various governments.
▪ Describe the development and implications of a
single European currency.
▪ Explain how governments can use direct
intervention to influence exchange rates.
▪ Explain how governments can use indirect
intervention to influence exchange rates.
what are ER systems?
Exchange rate systems can be classified according
to the degree of government control and fall into the
following categories:
▪ Fixed
▪ Freely floating
▪ Managed float
▪ Pegged
what are fixed ER system?
Exchange rates are either held constant or allowed
to fluctuate only within very narrow boundaries.
▪ Central bank can reset a fixed exchange rate by
devaluing or reducing the value of the currency
against other currencies.
▪ Central bank can also revalue or increase the
value of its currency against other currencies.
2 examples
what are examples of fixed ER systems?
▪ Bretton Woods Agreement 1944 – 1971 — Each
currency was valued in terms of gold.
▪ Smithsonian Agreement 1971 – 1973 — called for a
devaluation of the U.S. dollar by about 8% against other
currencies.
what are advantages and disadavntages of fixed ER
▪ Advantages of fixed exchange rates
▪ Insulate country from risk of nominal currency appreciation.
▪ Allow firms to engage in foreign direct investment without
currency risk.
▪ Disadvantages of fixed exchange rates
▪ Governments can still abruptly alter the value of currency.
▪ Country and MNC may be more vulnerable to economic
conditions in other countries.
what are advantages n disadavantages of freely floating ER system
Exchange rates are determined by market forces without
government intervention.
▪ Advantages of a freely floating system:
▪ Country is more insulated from inflation of other countries.
▪ Country is more insulated from unemployment of other countries.
▪ Does not require central bank to maintain exchange rates within
specified boundaries.
▪ Disadvantages of a freely floating exchange rate
system:
▪ Can adversely affect a country that has high unemployment
▪ Demand FC Falls, HC Value Rises, Cost of imports fall
▪ Can adversely affect a country with high inflation.
what are managed ER system?
Governments sometimes intervene to prevent their
currencies from moving too far in a certain direction.
* Countries with floating exchange rates: Currencies of
most large developed countries are allowed to float,
although they may be periodically managed by their
respective central banks.
* Criticisms of the managed float system: Critics suggest
that managed float allows a government to manipulate
exchange rates to benefit its own country at the expense
of others.
what is a pegged ER system
Home currency value is pegged to one foreign currency or to an
index of currencies.
* May attract foreign investment because exchange rate is
expected to remain stable.
* Limitations of pegged exchange rate
– Weak economic or political conditions can cause firms and
investors to question whether the peg will be broken.
Currency Boards Used to Peg Currency Values
▪ A system for pegging the value of the local currency to
some other specified currency. The board must maintain
currency reserves for all the currency that it has printed.
Interest Rates of Pegged Currencies
▪ Interest rate will move in tandem with the interest rate of
the currency to which it is tied.
Exchange Rate Risk of a Pegged Currency
▪ Currencies are commonly pegged to the U.S. dollar or to
the euro
what is dollarisiation
Currency Substitution
* Replacement of a foreign currency with U.S. dollars.
▪ This process is a step beyond a currency board because it
forces the local currency to be replaced by the U.S. dollar.
Although dollarisation and a currency board both attempt
to peg the local currency’s value, the currency board does
not replace the local currency with dollars.
what is monetary policy in the eurozone
▪ European Central Bank — Based in Frankfurt and is
responsible for setting monetary policy for all participating
European countries
▪ Objective is to control inflation in the participating
countries and to stabilize (within reasonable boundaries) the
value of the euro with respect to other major currencies.
**Impact on Firms in the Eurozone **— Prices of products are
now more comparable among European countries.
Impact on Financial Flows in the Eurozone — Bond investors
who reside in the eurozone can now invest in bonds issued by
governments and corporations in these countries without
concern about exchange rate risk, as long as the bonds are
denominated in euros.
Exposure of Countries within the Eurozone
▪ A single European monetary policy prevents any individual
European country from solving local economic problems with its
own unique monetary policy.
▪ Any given monetary policy used in the eurozone during a particular
period may enhance conditions in some countries and adversely
affect others.
**Impact of Crises within the Eurozone **— may affect the economic
conditions of the other participating countries because they all rely on the
same currency and the same monetary policy.
ECB Role in Resolving Economic Crises
▪ The bank’s role has expanded to include providing credit for
eurozone countries that are experiencing a financial crisis.
▪ The ECB imposes restrictions intended to help resolve the
country’s budget deficit problems over time.
Impact of Crises within the Eurozone
▪ Financial problems of one bank can easily spread to other
banks.
▪ Banks in Eurozone frequently engage in loan
participations. If companies have trouble repaying, all
banks may be affected.
▪ News about concerns in one area of the Eurozone can
trigger actions in other areas.
▪ Eurozone country governments must rely on fiscal policy
when they experience serious financial problems.
▪ Banks lend heavily to governments. Performance is
related to whether that government can repay its debts.
Government Intervention – Reasons
Smoothing exchange rate movements
▪ If a central bank is concerned that its economy will be affected by
abrupt movements in its home currency’s value, it may attempt to
smooth the currency movements over time.
Establishing implicit exchange rate boundaries
▪ Some central banks attempt to maintain their home currency rates
within some unofficial, or implicit, boundaries.
Responding to temporary disturbances
▪ A central bank may intervene to insulate a currency’s value from a
temporary disturbance.
Stimulate foreign demand for products
▪ Weak home currency
Encourage domestic consumers and corporations to buy
goods from other countries
▪ Strong home currency
what is direct intervention
To force the dollar to depreciate, the Fed can intervene
directly by exchanging dollars that it holds as reserves
for other foreign currencies in the foreign exchange
market.
▪ By “flooding the market with dollars” in this
manner, the Fed puts downward pressure on the
dollar.
▪ If the Fed desires to strengthen the dollar, it can
exchange foreign currencies for dollars in the
foreign exchange market, thereby putting upward
pressure on the dollar.
different types of direct intervention
Reliance on reserves
▪ The potential effectiveness of a central bank’s
direct intervention is the amount of reserves it can
use.
Frequency of Intervention
▪ Number of direct interventions has declined from
97 different days in 1989 to no more than 20 days
in a year
Coordinated Intervention
▪ Intervention more likely to be effective when it is
coordinated by several central banks.
Non-sterilised versus sterilised intervention
▪ When the Fed intervenes in the foreign exchange market
without adjusting for the change in the money supply, it is
engaging in a non-sterilised intervention.
▪ In a sterilised intervention, the Fed intervenes in the
foreign exchange market and simultaneously engages in
offsetting transactions in the Treasury securities markets.
Speculating on direct intervention
▪ Some traders in the foreign exchange market attempt to
determine when Federal Reserve intervention is occurring
and the extent of the intervention in order to capitalise on
the anticipated results of the intervention effort.
what is indirect intervention
Government Control of Interest Rates by increasing
or reducing interest rates.
Government Use of Foreign Exchange Controls such
as restrictions on the exchange of the currency.
Intervention Warnings intended to warn speculators.
The announcements could discourage additional
speculation and might even encourage some speculators
to unwind (liquidate) their existing positions in the
currency
what is the foreign exchange market
- Allows for the exchange of one currency for another.
- Exchange rate specifies the rate at which one
currency can be exchanged for another.
what is the history of foreign exchange
- Gold Standard (1876 - 1913)
– Each currency was convertible into gold at a specified rate.
When World War I began in 1914, the gold standard was
suspended. - Agreements on Fixed Exchange Rates
– Bretton Woods Agreement 1944 - 1971
– Smithsonian Agreement 1971 - 1973 - Floating Exchange Rate System
– Widely traded currencies were allowed to fluctuate in
accordance with market forces
what is the history of the australian dollar
1971: Australian dollar was pegged to the U.S. dollar
1974: Australian dollar was pegged to the trade
weighted index (weighted average of a basket of
currencies).
1976: Australia’s currency system was changed to a
crawling peg (regular adjustments to the level of the
exchange rate) to address its growth in money supply
with a policy known as ‘monetary targeting’
1980: Australian high inflation made the lack of
monetary control a key issue.
1983: Australian dollar was floated for gaining greater
control of domestic monetary conditions
what are the foreign exchange transactions
- Use of the dollar in spot markets: The U.S. Dollar is the
commonly accepted medium of exchange in the spot market. - Spot market time zones: At any given time on a weekday,
somewhere around the world a bank is open and ready to
accommodate foreign exchange requests. - The over-the-counter market is the telecommunications
network where companies normally exchange one currency
for another. - Foreign exchange dealers serve as intermediaries in the foreign
exchange market - Spot market: A foreign exchange transaction for immediate
exchange is said to trade in the spot market. The exchange
rate in the spot market is the spot rate. - Spot market structure: Trading between banks occurs in the
interbank market.
what are the primary trading centres
Five Primary FX Trading Centres:
UK (38%) US (19%)
Singapore (9%) Hong Kong SAR (7%) Japan (4%)
Dealers: Financial institutions that actively participate
in FX markets. (Trading FX for themselves or their
customers)
Other Financial Institutions: Non-Dealer institutions
– End users of instruments.
Non-Financial Customers: Non-Financial End Users.
what is the reported FX turnover
- Dealer -> Dealer (Interbank Market) 46%
- Dealer -> Other Financial Institution 48%
» Small / Regional Banks 22%
» Institutional Investors 11%
» Hedge Funds 7%
» Other Institutions 7%
» Central Banks 1% - Dealer -> Non-Financial Customers 6%
what is the FX execution types
Voice-Direct
-Voice trades not intermediated (in-person / phone)
Voice-Indirect
-Voice trades intermediated by a third party (voice broker)
Electronic-Direct
-Executed over an electronic medium, not-intermediated.
-Single Bank Electronic Trading system (e.g. DB Autobahn, Velocity)
-Other Direct Electronic Means (e.g. Bloomberg Chat)
Electronic-Indirect
-Executed over an electronic medium, intermediated (Matching system)
-Interdealer Market: Refinitiv Eikon (Reuters) / EBS (CME)
-Multi Bank Dealing Systems
what are the major currencies used in FX transaction\s
MAJOR CURRENCIES (176% / 200%)
USD 88%
EUR 31% (69% trading versus USD)
JPY 17% (Peaked 2013)
GBP 13%
CNY 7% (94% trading versus the USD)
AUD 6% (80% trading versus USD)
CAD 6%
CHF 5%
HKD 3%
OTHER CURRENCIES
2% : SEK, KRW, NOK, NZD, INR, MXN
what are exchange rate quotations
- No organisation decides foreign exchange trading
standards. However particular market conventions are
generally followed: - ISO 4217 (Currency Code)
- A Spot Quotation
Unit* / Currency
AUD / USD
*It is market convention for the currency before the slash to
represent the unit (base currency).
what are bid and ask quotes?
- The bid - price the market maker offers to buy
currency from the customer. - The ask - price the market maker offers to sell
currency to the customer
NOTE: This quotation is in INDIRECT terms.
what is the bid/ask spread
- Bid/Ask spread of banks: The bid/ask spread
covers the bank’s cost of conducting foreign
exchange transactions.
– The bid/ask spread here is 1 point (pip) - A commission is not normally charged (large
trades) - Dealers profit from the bid/ask spread
– The bid/ask spread represents ‘the cost of immediacy’
– quotes are adjusted very quickly in response to news,
expectations and trading strategies
what are the factors that affect the spread
Order costs: Costs of processing orders, including clearing
costs and the costs of recording transactions.
**Inventory costs: **Costs of maintaining an inventory of a
particular currency.
Competition: The more intense the competition, the smaller
the spread quoted by intermediaries.
Volume: Currencies that have a large trading volume are
more liquid because there are numerous buyers and sellers
at any given time.
Currency risk: Economic or political conditions that cause
the demand for and supply of the currency to change
abruptly.
what is direct vs indirect quote?
▪ Direct Quotation represents the value of a foreign currency in
US dollars (number of dollars per currency).
▪ The value of the FC in Australian Dollars.
- Amount of home currency needed to buy a unit of foreign
currency.
▪ Example: The EUR is worth 1.40 USD
indirect quote:
– Amount of foreign currency bought with a unit of home
currency.
▪ Indirect quotation represents the number of units of a foreign
currency per US dollar.
▪ Example: The USD is worth 0.71 EUR
▪ Indirect quotation = 1 / Direct quotation
how does direct/indirect affect appreciation/depreciation
▪ When the euro is appreciating against the dollar (based on an
upward movement of the direct exchange rate of the euro), the
indirect exchange rate of the euro is declining.
▪ When the euro is depreciating (based on a downward movement
of the direct exchange rate) against the dollar, the indirect
exchange rate is rising.
Relationship
what is american vs european terms?
- American terms
– number of U.S. dollars per unit of foreign
currency - European terms
– number of foreign currency units per U.S.
dollar
how to measure exchange rate movements
Depreciation: decline in a currency’s value
Appreciation: increase in a currency’s value
- Comparing foreign currency spot rates over two points in time,
S and St-1 - A positive change indicates that the currency has appreciated. A
negative change indicates that it has depreciated.
what is the exchange rate equilibiurm?
The exchange rate represents the price of a currency, or the rate at
which one currency can be exchanged for another.
Demand for a currency increases when the value of the currency
decreases, leading to a downward sloping demand schedule.
Supply of a currency for sale increases when the value of the
currency increases, leading to an upward sloping supply schedule.
Equilibrium equates the quantity of pounds demanded with the
supply of pounds for sale
how can gov/central banks affect currency values
Governments / Central Banks can affect currency
values indirectly by influencing the factors that
determine them.
– Imposing foreign exchange barriers
– Imposing foreign trade barriers
– Intervening in foreign exchange markets
– Influence expectations
– Affecting macro variables such as inflation, interest
rates, and income levels
what are the impacts of expectations and currency speculation
Impact of favourable expectations
* If investors expect interest rates in one country to rise, they
may invest in that country, leading to a rise in the demand for
foreign currency and an increase in the exchange rate for
foreign currency.
Impact of unfavourable expectations
* Speculators can place downward pressure on a currency when
they expect it to depreciate.
Impact of signals on currency speculation
* Speculators may overreact to signals, causing currency to be
temporarily overvalued or undervalued.
how does inflation affect currency?
Increase in U.S.
inflation leads to
increase in U.S.
demand for
foreign goods, an
increase in U.S.
demand for
foreign currency,
and an increase
in the exchange
rate for the
foreign currency.
how does interest rates affect currency?
Increase in U.S.
rates leads to
increase in demand
for U.S. deposits
and a decrease in
demand for foreign
deposits, leading
to an increase in
demand for dollars
and an increased
exchange rate for
the dollar.
what are the effects of relative income levels on currency
Increase in U.S.
income leads to an
increase in U.S.
demand for foreign
goods, an increased
demand for foreign
currency relative to
the dollar, and an
increase in the
exchange rate for
the foreign currency
what are the factors that influence exchange rates?
Interaction of Factors:
* Some factors place upward pressure while other
factors place downward pressure
Influence of Factors across Multiple Currency
Markets:
* Common for European currencies to move in the
same direction against the dollar.
Influence of Liquidity on Exchange Rate adjustment:
* If a currency’s spot market is liquid, then its exchange
rate will not be highly sensitive to a single large
purchase or sale.
what are cross rates?
Cross exchange rates express the relation between two currencies
that each differ from one’s base currency.
In the United States, the term cross exchange rate refers to the
relationship between two non-dollar currencies.
The USD is traded in 88% of all FX transactions (volume
measure).
how does cross exchange rates move?
- If currencies A and B move in same direction, there
is no change in the cross exchange rate. - When currency A appreciates against the dollar by a
greater (smaller) degree than currency B, then
currency A appreciates (depreciates) against B. - When currency A appreciates (depreciates) against
the dollar, while currency B is unchanged against the
dollar, currency A appreciates (depreciates) against
currency B by the same degree as it appreciates
(depreciates) against the dollar.
how to capitalise on expected ER movements
Institutional speculation based on expected appreciation
* When financial institutions believe that a currency is valued
lower than it should be in the foreign exchange market, they
may invest in that currency before it appreciates.
Institutional speculation based on expected depreciation
* If financial institutions believe that a currency is valued higher
than it should be in the foreign exchange market, they may
borrow funds in that currency and convert it to their local
currency now before the currency’s value declines to its proper
level.
Speculation by individuals
* Individuals can speculate in foreign currencies.
