July 23, 2007
Foreign Direct Investment; Political Economy of FDI;
Foreign Exchange; International Monetary System
Chapters 3,4,5,6 in a nutshell
Review Chapters 7,8
◦ Discussion 1: Western automobile firms in Russia (time
Review Chapter 10, 11
◦ Discussion 2: Chinese Currency Change
Q&A regarding the Midterm
◦ 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
◦ 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?
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
Types of FDI
◦ Horizontal FDI
Why undertake horizontal FDI?
Transportation costs; market imperfections (internalization theory:
impediments to exporting, impediments to sale of know how);
◦ Vertical FDI
Why undertake vertical FDI?
Strategic behavior; market imperfections (impediments to the sale of
know how; investment in specialized assets)
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?
Read the Management Focus on recent
investments by Western automobile firms in
Russia. Which theory best explains these
Political Ideology and FDI
◦ Radical View
◦ Free Market View
◦ Pragmatic Nationalism
What are the benefits of FDI to host countries?
◦ Resource-transfer effects (capital, technology, know-how); Employment effects;
Balance-of-payment effects; Effect on competition and economic growth
What are the costs of FDI to host countries?
◦ Adverse effect on competition; adverse effects on the balance of payments;
national sovereignty and autonomy
What are the costs and benefits to home countries?
◦ Benefits: inward cash flow; employment effects; skills learned from abroad
◦ Costs: balance of payments; employment effects (outsourcing)
What are some government regarding FDI?
◦ Home country: encourage some outward FDI; restrict some outward FDI
◦ Host country: encourage some inward FDI; restrict other inward FDI
Read the Country Focus on FDI in Ireland. How
important has FDI been to the health of the Irish
Inward FDI is bad for (i) a developing economy
and (ii) a developed economy and should be
subjected to strict controls. Discuss.
Firms should not be investing abroad when there
is a need for investment to create jobs at home.
Do you think the successful conclusion of a
multilateral agreement to liberalize regulations
governing FDI will benefit the world economy?
What is the FOREX market for?
◦ Currency conversion; insuring against foreign exchange risk
(using spot exchange, forward exchange, or currency swaps)
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
◦ Investor psychology and bandwagon effects
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”
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
$1 = W1,200. Forecast the spot exchange rate
one year from today. Explain the logic of your
Drawing on what we know about the Fisher effect, the
real interest rate in both the US and South Korea is 2%.
The international Fisher effect suggests that the
exchange rate will change in an equal amount but in an
opposite direction to the difference in nominal interest
rates. Hence since the nominal interest rate is 3%
higher in the US than in South Korea, the dollar should
depreciate by 3% relative to the South Korean Won.
Using the formula from the book: (S1 - S2)/S2 x 100 =
i$ - iWon and substituting 7 for i$, 4 for iWon, and 1200
for S1, yields a value for S2 of $1=W1165.
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?
(a) According to PPP, the $/£ rate should be 2.80/3.70,
(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.
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?
(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.
◦ In this case you would have $4,000 in mid-December.
(2) Forward Contract
◦ If the current 180-day forward rate is lower than 100¥/$, 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/$, then whether you choose to lock in the forward rate or wait and see what the spot
does will depend upon your risk aversion.
(3) Borrow Money
◦ There is a third possibility also. You could borrow money from a bank that you will pay back with the
¥400,000 you will receive (400,000/1.03 = ¥388,350 borrowed), convert this today to US$ (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.
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?
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?
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?
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.
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?
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?