Final Essay Stage Two ah W334 A.docx

Final Essay Stage Two
ah W
334: ARTH
Outline and Annotated Bibliography
June 27, 201
2
Outline & Annotated Bibliography
The option I chose for the final project was option (b), to select
and write about a feature length film made between 1970-2000.
The film I chose is a story by Stephen King, ‘The Green Mile’,
directed by Frank Darabont. Below I will outline my final paper
for the course, as well as list and discuss a few sources that I
will be citing.
· Introduction
· Discuss the making of the film
· The film’s success (box office/awards and nominations)
· Critical reaction to the film
· Personal reaction to the film (what I liked/did not like,

critique of main character roles and actors/actresses who played
them)
· Discuss direction of film (montage/sound and music)
· Discuss direction of film cont. (cinematography/ special
effects)
· Conclusion
· Bibliography
Cinematography of The Green Mile. (2014). Cinematography of
The Green Mile. Retrieved 27 June 2017, from
https://bnyce82.wordpress.com/
This reference is specific to the cinematography techniques
used in the film, ‘The Green Mile’. It provides insight into the
various aspects of cinematography, such as the tone of the film,
the camera angles and lighting, as well as the dialogue between
the characters. This reference will help backup the information I
will provide in my final paper.
Darabont, F. (1999). The Green Mile. Retrieved from
https://www.youtube.com/watch?v=VslrToVsu80
This reference is the actual film, ‘The Green Mile’, found
on YouTube. I will be watching the entire film to gather
information for my final paper. The information I will be
looking for while watching this film are the editing techniques
used by the director, as well as my personal reaction to draw a
general conclusion from.
Ebert, R. (1999). The Green Mile Movie Review & Film
Summary (1999) | Roger Ebert. Rogerebert.com. Retrieved 27
June 2017, from http://www.rogerebert.com/reviews/the-green-
mile-1999
The movie review of, ‘The Green Mile’, by the late Roger
Ebert is a perfect reference to gain insight to the critical review
of the film upon its release. I will be referencing opinions and
points made by the infamous film critic, as he discusses the
direction of the film, as well as the actors’ performance.
Kuhn, A., & Westwell, G.(2012). cinematography. In A
Dictionary of Film Studies. : Oxford University Press.

Retrieved 28 Jun. 2017, from
http://www.oxfordreference.com/view/10.1093/acref/978019958
7261.001.0001/acref-9780199587261-e-0124.
This general reference on cinematography is from the Oxford
Dictionary of Film Studies. I found this entry very useful during
week 4 of the course when it was presented and will use it as a
reference for my final paper, as well as future discussions. The
entry defines cinematography in film making as capturing
movement on film, as well as explains the role of a
cinematographer on a movie set.
Week 5 - Assignment: Analyze the Global Sourcing of Debt and
Equity
Research and analyze global financing alternatives and write a
paper to:
1. Describe the methods for sourcing equity funds from the
global financial market. Form a table that would assist a
multinational manager in summarizing the options with
characteristics of each option.
2. Summarize the methods for sourcing debt funds from the
global financial market. Form a table that would assist a
multinational manager in summarizing the options with
characteristics of each option.
3. Define and assess the cost of capital in a global context verse
a domestic environment. Describe some of the reasons why the
optimal capital structure might differ for a multinational firm.
Discuss the role of the demand for foreign securities and the
evidence of the cost of capital for multinationals verse domestic
forms.
Support your paper with at least five (5) resources. In addition
to these specified resources, other appropriate scholarly

resources, including older articles, may be included. Your paper
should demonstrate thoughtful consideration of the ideas and
concepts that are presented in the course and provide new
thoughts and insights relating directly to this topic. Your
response should reflect scholarly writing and current APA
standards.
Length: 5-7 pages (not including title and reference pages).
https://blogs.imf.org/2020/03/20/blunting-the-impact-and-hard-
choices-early-lessons-from-china/
Instructor’s Resource Manual
For
Multinational Business Finance
Fourteenth Edition
David K. Eiteman
University of California, Los Angeles
Arthur I. Stonehill
Oregon State University and University of Hawaii at Manoa
Michael H. Moffett
Thunderbird School of Global Management

at Arizona State University
Copyright 2016 Pearson Education, Inc.
Vice President, Product Management: Donna Battista
Acquisitions Editor: Kate Fernandes
Program Manager: Kathryn Dinovo
Team Lead, Project Management: Jeff Holcomb
Project Manager: Meredith Gertz
Copyright © 2016, 2013, 2010 Pearson Education, Inc., or its
affiliates. All Rights Reserved.
Manufactured in the United States of America. This publication
is protected by copyright, and permission
should be obtained from the publisher prior to any prohibited
reproduction, storage in a retrieval system,
or transmission in any form or by any means, electronic,
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otherwise. For information regarding permissions, request
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Pearson Education Global Rights and Permissions department,
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www.pearsoned.com/permissions/.

www.pearsonhighered.com
ISBN-13: 978-0-13-387987-2
ISBN-10: 0-13-387987-9
©2016 Pearson Education, Inc.
Contents
Chapter 1 Multinational Financial Management: Opportunities
and Challenges .......................... 1
Chapter 2 The International Monetary System
.............................................................................. 7
Chapter 3 The Balance of Payments
............................................................................................
12
Chapter 4 Financial Goals and Corporate Governance
................................................................ 20
Chapter 5 The Foreign Exchange Market
.................................................................................... 25
Chapter 6 International Parity Conditions
................................................................................... 31

Chapter 7 Foreign Currency Derivatives: Futures and Options
................................................... 38
Chapter 8 Interest Rate Risk and Swaps
...................................................................................... 43
Chapter 9 Foreign Exchange Rate Determination
....................................................................... 48
Chapter 10 Transaction Exposure
...............................................................................................
. 55
Chapter 11 Translation Exposure
...............................................................................................
.. 60
Chapter 12 Operating Exposure
...............................................................................................
..... 64
Chapter 13 The Global Cost and Availability of Capital
............................................................. 68
Chapter 14 Raising Equity and Debt Globally
............................................................................. 72
Chapter 15 Multinational Tax Management
................................................................................ 79
Chapter 16 International Trade Finance
....................................................................................... 85
Chapter 17 Foreign Direct Investment and Political Risk
........................................................... 89

Chapter 18 Multinational Capital Budgeting and Cross-Border
Acquisitions ........................... 101
© 2016 Pearson Education, Inc.
CHAPTER 1
MULTINATIONAL FINANCIAL MANAGEMENT:
OPPORTUNITIES AND CHALLENGES
1. Globalization Risks in Business. What are some of the risks
that come with the growing
globalization of business?
Exchange rates. The international monetary system, an eclectic
mix of floating and managed
fixed exchange rates, is constantly changing. For example, the
growth of the Chinese yuan is now
changing the global currency landscape.
Interest rates. Large fiscal deficits, including the current
eurozone crisis, plague most of the major
trading countries of the world, complicating fiscal and monetary
policies, and ultimately, interest

rates and exchange rates.
Many countries experience continuing balance of payments
imbalances, and in some cases,
dangerously large deficits and surpluses, all will inevitably
move exchange rates.
Ownership, control, and governance vary radically across the
world. The publicly traded
company is not the dominant global business organization—the
privately held or family-owned
business is the prevalent structure—and their goals and
measures of performance vary
dramatically.
Global capital markets that normally provide the means to
lower a firm’s cost of capital, and even
more critically, increase the availability of capital, have in
many ways shrunk in size and have
become less open and accessible to many of the world’s
organizations.
Financial globalization has resulted in the ebb and flow of
capital in and out of both industrial and
emerging markets, greatly complicating financial management
(Chapters 5 and 8).
2. Globalization and the MNE. The term globalization has
become widely used in recent years. How

would you define it?
Narayana Murthy’s quote is a good place to start any
discussion of globalization:
“I define globalization as producing where it is most cost-
effective, selling where it is most
profitable, and sourcing capital where it is cheapest, without
worrying about national
boundaries.”
Narayana Murthy, President and CEO, Infosys
3. Assets, Institutions, and Linkages. Which assets play the
most critical role in linking the major
institutions that make up the global financial marketplace?
The debt securities issued by governments. These low risk or
risk-free assets form the foundation for
the creation, trading, and pricing of other financial assets like
bank loans, corporate bonds, and
equities (stock). In recent years, a number of additional
securities have been created from the existing
2 Eiteman/Stonehill/Moffett | Multinational Business Finance,
14th Edition

securities—derivatives, whose value is based on market value
changes in the underlying securities.
The health and security of the global financial system relies on
the quality of these assets.
4. Currencies and Symbols. What technological change is even
changing the symbols we use in the
representation of different country currencies?
As currency trading has shifted from verbal telephone
conversations to electronic and digital trading,
currency symbols (many of which were not common across
alphabetic platforms, like the British
pound, £) have been replaced with the ISO-4217 codes, three-
letter currency codes like USD, EUR,
and GBP.
5. Eurocurrencies and LIBOR. Why have eurocurrencies and
LIBOR remained the centerpiece of the
global financial marketplace for so long?
Eurocurrencies and LIBOR (and there are LIBOR rates for all
eurocurrencies) reflect the “purest” of
market-driven currencies and instrument rates. They are largely
unregulated and, therefore, reflect
freely traded assets whose value is set by the daily global
marketplace.
6. Theory of Comparative Advantage. Define and explain the

theory of comparative advantage.
The theory of comparative advantage provides a basis for
explaining and justifying international trade
in a model world assumed to enjoy free trade, perfect
competition, no uncertainty, costless
information, and no government interference. The theory
contains the following features:
Exporters in Country A sell goods or services to unrelated
importers in Country B.
Firms in Country A specialize in making products that can be
produced relatively efficiently,
given Country A’s endowment of factors of production: that is,
land, labor, capital, and
technology. Firms in Country B do likewise, given the factors
of production found in Country B.
In this way, the total combined output of A and B is maximized.
Because the factors of production cannot be moved freely from
Country A to Country B, the
benefits of specialization are realized through international
trade.
The way the benefits of the extra production are shared
depends on the terms of trade, the ratio at
which quantities of the physical goods are traded. Each
country’s share is determined by supply

and demand in perfectly competitive markets in the two
countries. Neither Country A nor
Country B is worse off than before trade, and typically both are
better off, albeit perhaps
unequally.
7. Limitations of Comparative Advantage. Key to understanding
most theories is what they say and
what they don’t. Name four or five key limitations to the theory
of comparative advantage.
Although international trade might have approached the
comparative advantage model during the
nineteenth century, it certainly does not today, for the following
reasons:
Countries do not appear to specialize only in those products
that could be most efficiently
produced by that country’s particular factors of production.
Instead, governments interfere with
comparative advantage for a variety of economic and political
reasons, such as to achieve full
employment, economic development, national self-sufficiency
in defense-related industries, and
and Challenges 3

protection of an agricultural sector’s way of life. Government
interference takes the form of
tariffs, quotas, and other non-tariff restrictions.
At least two of the factors of production, capital and
technology, now flow directly and easily
between countries, rather than only indirectly through traded
goods and services. This direct flow
occurs between related subsidiaries and affiliates of
multinational firms, as well as between
unrelated firms via loans and license and management contracts.
Even labor flows between
countries, such as immigrants into the United States (legal and
illegal), immigrants within the
European Union and other unions.
Modern factors of production are more numerous than in this
simple model. Factors considered in
the location of production facilities worldwide include local and
managerial skills, a dependable
legal structure for settling contract disputes, research and
development competence, educational
levels of available workers, energy resources, consumer demand
for brand name goods, mineral
and raw material availability, access to capital, tax differentials,
supporting infrastructure (roads,
ports, communication facilities), and possibly others.
Although the terms of trade are ultimately determined by

supply and demand, the process by
which the terms are set is different from that visualized in
traditional trade theory. They are
determined partly by administered pricing in oligopolistic
markets.
Comparative advantage shifts over time as less developed
countries become more developed and
realize their latent opportunities. For example, during the past
150 years, comparative advantage
in producing cotton textiles has shifted from the United
Kingdom to the United States to Japan to
Hong Kong to Taiwan and to China.
The classical model of comparative advantage did not really
address certain other issues, such as
the effect of uncertainty and information costs, the role of
differentiated products in imperfectly
competitive markets, and economies of scale.
Nevertheless, although the world is a long way from the
classical trade model, the general principle of
comparative advantage is still valid. The closer the world gets
to true international specialization, the
more world production and consumption can be increased,
provided the problem of equitable
distribution of the benefits can be solved to the satisfaction of
consumers, producers, and political
leaders. Complete specialization, however, remains an
unrealistic limiting case, just as perfect

competition is a limiting case in microeconomic theory.
8. International Financial Management. What is different about
international financial management?
Multinational financial management requires an understanding
of cultural, historical, and institutional
differences, such as those affecting corporate governance.
Although both domestic firms and MNEs
are exposed to foreign exchange risks, MNEs alone face certain
unique risks, such as political risks,
that are not normally a threat to domestic operations.
MNEs also face other risks that can be classified as extensions
of domestic finance theory. For
example, the normal domestic approach to the cost of capital,
sourcing debt and equity, capital
budgeting, working capital management, taxation, and credit
analysis needs to be modified to
accommodate foreign complexities. Moreover, a number of
financial instruments that are used in
domestic financial management have been modified for use in
international financial management.
Examples are foreign currency options and futures, interest rate
and currency swaps, and letters of
credit.
14th Edition

9. Ganado’s Globalization. After reading the chapter’s
description of Ganado’s globalization process,
how would you explain the distinctions between international,
multinational, and global companies?
The difference in definitions for these three terms is subjective,
with different writers using different
terms at different times. No single definition can be considered
definitive, although as a general
matter the following probably reflect general usage.
International simply means that the company has some form of
business interest in more than one
country. That international business interest may be no more
than exporting and importing, or it may
include having branches or incorporated subsidiaries in other
countries. International trade is usually
the first step in becoming “international,” but the term also
encompasses foreign subsidiaries created
for the single purpose of marketing, distribution, or financing.
The term international is also used to
encompass what are defined as multinational and global in the
following two paragraphs.
Multinational is usually taken to mean a company that has
operating subsidiaries and performs a full
set of its major operations in a number of countries, i.e., in
“many nations.” “Operations” in this
context includes both manufacturing and selling, as well as

other corporate functions, and a
multinational company is often presumed to operate in a greater
number of countries than simply an
international company. A multinational company is presumed to
operate with each foreign unit
“standing on its own,” although that term does not preclude
specialization by country or supplying
parts from one country operation to another.
Global is a newer term that essentially means about the same as
“multinational,” i.e., operating
around the globe. Global has tended to replace other terms
because of its use by demonstrators at the
international meetings (“global forums?”) of the International
Monetary Fund and World Bank that
took place in Seattle in 1999 and Rome in 2001. Terrorist
attacks on the World Trade Center and the
Pentagon in 2001 led politicians to refer to the need to
eliminate “global terrorism.”
10. Ganado, the MNE. At what point in the globalization
process did Ganado become a multinational
enterprise (MNE)?
Ganado became a multinational enterprise (MNE) when it began
to establish foreign sales and service
subsidiaries, followed by creation of manufacturing operations
abroad or by licensing foreign firms to
produce and service Trident’s products. This multinational
phase usually follows the international
phase, which involved the import and/or export of goods and/or
services.

11. Role of Market Imperfections. What is the role of market
imperfections in the creation of
opportunities for the multinational firm?
MNEs strive to take advantage of imperfections in national
markets for products, factors of
production, and financial assets.
Imperfections in the market for products translate into market
opportunities for MNEs. Large
international firms are better able to exploit such competitive
factors as economies of scale,
managerial and technological expertise, product differentiation,
and financial strength than their
local competitors are.
MNEs thrive best in markets characterized by international
oligopolistic competition, where these
factors are particularly critical.
and Challenges 5

Once MNEs have established a physical presence abroad, they
are in a better position than purely
domestic firms are to identify and implement market
opportunities through their own internal
information network.
12. Why Go. What do firms become multinational?
1. Entry into new markets, not currently served by the firm,
which in turn allow the firm to grow
and possibly to acquire economies of scale
2. Acquisition of raw materials, not available elsewhere
3. Achievement of greater efficiency, by producing in countries
where one or more of the factors of
production are underpriced relative to other locations
4. Acquisition of knowledge and expertise centered primarily in
the foreign location
5. Location of the firms’ foreign operations in countries deemed
politically safe
13. Multinational Versus International. What is the difference
between an international firm and a
multinational firm?
A multinational firm goes beyond simply selling to or trading
with firms in foreign countries
(international), by expanding its intellectual capital and

acquiring a physical presence in foreign
countries. This allows the firm to expand and deepen its core
competitiveness and global reach to
more markets, customers, suppliers, and partners.
14. Ganado’s Phases. What are the main phases that Ganado
passed through as it evolved into a truly
global firm? What are the advantages and disadvantages of
each?
a. International trade. Two advantages are finding out if the
firms’ products are desired in the
foreign country and learning about the foreign market. Two
disadvantages are lack of control
over the final sale and service to final customer (many exports
are to distributors or other types of
firms that in turn resell to the final customer) and the
possibility that costs and thus final customer
sales prices will be greater than those of competitors that
manufacture locally.
b. Foreign sales and service offices. The greatest advantage is
that the firm has a physical presence
in the country, allowing it great control over sales and service
as well as allowing it to learn more
about the local market. The disadvantage is the final local sales
prices, based on home country
plus transportation costs, may be greater than competitors that
manufacture locally.

c. Licensing a foreign firm to manufacture and sell. The
advantages are that product costs are based
on local costs and that the local licensed firm has the knowledge
and expertise to operate
efficiently in the foreign country. The major disadvantages are
that the firm might lose control of
valuable proprietary technology and that the goals of the foreign
partner might differ from those
of the home country firm. Two common problems in the latter
category are whether the foreign
firm (that is manufacturing the product under license) is a
shareholder wealth or corporate wealth
maximizer, which in turn often leads to disagreements about
reinvesting earning to achieve
greater future growth versus making larger current dividends to
owners and payments to other
stakeholders.
d. Part ownership of a foreign, incorporated, subsidiary, i.e., a
joint venture. The advantages and
disadvantages are similar to those for licensing: Product costs
are based on local costs and that the
local joint owner presumably has the knowledge and expertise
to operate efficiently in the foreign
14th Edition

country. The major disadvantages are that the firm might lose
control of valuable proprietary
technology to its joint venture partner, and that the goals of the
foreign owners might differ from
those of the home country firm.
e. Direct ownership of a foreign, incorporated, subsidiary. If
fully owned, the advantage is that the
foreign operations may be fully integrated into the global
activities of the parent firm, with
products resold to other units in the global corporate family
without questions as to fair transfer
prices or too great specialization. (Example: the Ford
transmission factory in Spain is of little use
as a self-standing operation; it depends on its integration into
Ford’s European operations.) The
disadvantage is that the firm may come to be identified as a
“foreign exploiter” because
politicians find it advantageous to attack foreign-owned
businesses.
15. Financial Globalization. How do the motivations of
individuals, both inside and outside the
organization or business, define the limits of financial
globalization?
If influential insiders in corporations and sovereign states
continue to pursue the increase in firm
value, there will be a definite and continuing growth in
financial globalization. But if these same
influential insiders pursue their own personal agendas, which

may increase their personal power,
influence, or wealth, then capital will not flow into these
sovereign states and corporations. The result
is the growth of financial inefficiency and the segmentation of
globalization outcomes creating
winners and losers.
The three fundamental elements—financial theory, global
business, management beliefs and
actions—combine to present either the problem or the solution
to the growing debate over the benefits
of globalization to countries and cultures worldwide.
CHAPTER 2
THE INTERNATIONAL MONETARY SYSTEM
1. The Rules of the Game. Under the gold standard, all national
governments promised to follow the
“rules of the game.” What did this mean?
A country’s money supply was limited to the amount of gold
held by its central bank or treasury. For
example, if a country had 1,000,000 ounces of gold and its fixed
rate of exchange was 100 local

currency units per ounce of gold, that country could have
100,000,000 local currency units
outstanding. Any change in its holdings of gold needed to be
matched by a change in the number of
local currency units outstanding.
2. Defending a Fixed Exchange Rate. What did it mean under
the gold standard to “defend a fixed
exchange rate,” and what did this imply about a country’s
money supply?
Under the gold standard, a country’s central bank was
responsible for preserving the exchange value
of the country’s currency by being willing and able to exchange
its currency for gold reserves upon
the demand by a foreign central bank. This required the country
to restrict the rate of growth in its
money supply to a rate that would prevent inflationary forces
from undermining the country’s own
currency value.
3. Bretton Woods. What was the foundation of the Bretton
Woods international monetary system, and
why did it eventually fail?
Bretton Woods, the fixed exchange rate regime of 1945–73,
failed because of widely diverging
national monetary and fiscal policies, differential rates of
inflation, and various unexpected external
shocks. The U.S. dollar was the main reserve currency held by

central banks and was the key to the
web of exchange rate values. The United States ran persistent
and growing deficits in its balance of
payments requiring a heavy outflow of dollars to finance the
deficits. Eventually the heavy overhang
of dollars held by foreigners forced the United States to devalue
the dollar because it was no longer
able to guarantee conversion of dollars into its diminishing
store of gold.
4. Technical Float. What specifically does a floating rate of
exchange mean? What is the role of
government?
A truly floating currency value means that the government does
not set the currency’s value or
intervene in the marketplace, allowing the supply and demand
of the market for its currency to
determine the exchange value.
5. Fixed versus Flexible. What are the advantages and
disadvantages of fixed exchange rates?
Fixed rates provide stability in international prices for the
conduct of trade. Stable prices aid in
the growth of international trade and lessen risks for all
businesses.
Fixed exchange rates are inherently anti-inflationary, requiring
the country to follow restrictive

monetary and fiscal policies. This restrictiveness, however, can
often be a burden to a country
14th Edition
wishing to pursue policies that alleviate continuing internal
economic problems, such as high
unemployment or slow economic growth.
Fixed exchange rate regimes necessitate that central banks
maintain large quantities of
international reserves (hard currencies and gold) for use in the
occasional defense of the fixed
rate. As international currency markets have grown rapidly in
size and volume, increasing reserve
holdings has become a significant burden to many nations.
Fixed rates, once in place, may be maintained at rates that are
inconsistent with economic
fundamentals. As the structure of a nation’s economy changes,
and as its trade relationships and
balances evolve, the exchange rate itself should change.
Flexible exchange rates allow this to
happen gradually and efficiently, but fixed rates must be
changed administratively—usually too
late, too highly publicized, and at too large a one-time cost to

the nation’s economic health.
6. De facto and de jure. What do the terms de facto and de jure
mean in reference to the International
Monetary Fund’s use of the terms?
A country’s actual exchange rate practices is the de facto
system. This may or may not be what the
“official” or publicly and officially system commitment, the de
jure system.
7. Crawling Peg. How does a crawling peg fundamentally differ
from a pegged exchange rate?
In a crawling peg system, the government will make occasional
small adjustments in its fixed rate of
exchange in response to changes in a variety of quantitative
indicators, such as inflation rates or
economic growth. In a truly pegged exchange rate regime, no
such changes or adjustments are made
to the official fixed rate of exchange.
8. Global Eclectic. What does it mean to say the international
monetary system today is a global
eclectic?
The current global market in currency is dominated by two
major currencies, the U.S. dollar and the

European euro, and after that, a multitude of systems,
arrangements, currency areas, and zones.
9. The Impossible Trinity. Explain what is meant by the term
impossible trinity and why it is in fact
“impossible.”
Countries with floating rate regimes can maintain monetary
independence and financial
integration but must sacrifice exchange rate stability.
Countries with tight control over capital inflows and outflows
can retain their monetary
independence and stable exchange rate but surrender being
integrated with the world’s capital
markets.
Countries that maintain exchange rate stability by having fixed
rates give up the ability to have an
independent monetary policy.
10. The Euro. Why is the formation and use of the euro
considered to be of such a great
accomplishment? Was it really needed? Has it been successful?
The creation of the euro required a near-Herculean effort to
merge the monetary institutions of
separate sovereign states. This required highly disparate
cultures and countries to agree to combine,

Chapter 2 The International Monetary System 9
giving up a large part of what defines an independent state.
Member states were so highly integrated
in terms of trade and commerce that maintaining separate
currencies and monetary policies was an
increasing burden on both business and consumers, adding cost
and complexity, which added sizable
burdens to global competitiveness. The euro is widely
considered to have been extremely successful
since its launch.
11. Currency Board or Dollarization. Fixed exchange rate
regimes are sometimes implemented through
a currency board (Hong Kong) or dollarization (Ecuador). What
is the difference between the two
approaches?
In a currency board arrangement, the country issues its own
currency but that currency is backed
100% by foreign exchange holdings of a hard foreign
currency—usually the U.S. dollar. In
dollarization, the country abolishes its own currency and uses a
foreign currency, such as the U.S.
dollar, for all domestic transactions.
12. Argentine Currency Board. How did the Argentine currency

board function from 1991 to January
2002, and why did it collapse?
Argentina’s currency board exchange regime of fixing the value
of its peso on a one-to-one basis with
the U.S. dollar ended for several reasons:
As the U.S. dollar strengthened against other major world
currencies, including the euro, during
the 1990s, Argentine export prices rose vis-à-vis the currencies
of its major trading partners.
This problem was aggravated by the devaluation of the
Brazilian real in the late 1990s.
These two problems, in turn, led to continued trade deficits and
a loss of foreign exchange
reserves by the Argentine central bank.
This problem, in turn, led Argentine residents to flee from the
peso and into the dollar, further
worsening Argentina’s ability to maintain its one-to-one peg.
13. Special Drawing Rights. What are Special Drawing Rights?
The Special Drawing Right (SDR) is an international reserve
asset created by the IMF to supplement

existing foreign exchange reserves. It serves as a unit of
account for the IMF and other international
and regional organizations and is also the base against which
some countries peg the exchange rate
for their currencies.
Defined initially in terms of a fixed quantity of gold, the SDR
has been redefined several times. It is
currently the weighted value of currencies of the five IMF
members that have the largest exports of
goods and services. Individual countries hold SDRs in the form
of deposits in the IMF. These
holdings are part of each country’s international monetary
reserves, along with official holdings of
gold, foreign exchange, and its reserve position at the IMF.
Members may settle transactions among
themselves by transferring SDRs.
14. The Ideal Currency. What are the attributes of the ideal
currency?
If the ideal currency existed in today’s world, it would possess
three attributes, often referred to as the
Impossible Trinity:
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1. Exchange rate stability. The value of the currency would be
fixed in relationship to other major
currencies so that traders and investors could be relatively
certain of the foreign exchange value
of each currency in the present and into the near future.
2. Full financial integration. Complete freedom of monetary
flows would be allowed; thus, traders
and investors could willingly and easily move funds from one
country and currency to another in
response to perceived economic opportunities or risks.
3. Monetary independence. Domestic monetary and interest rate
policies would be set by each
individual country to pursue desired national economic policies,
especially as they might relate to
limiting inflation, combating recessions, and fostering
prosperity and full employment.
The reason that it is termed the Impossible Trinity is that a
country must give up one of the three goals
described by the sides of the triangle, monetary independence,
exchange rate stability, or full financial
integration. The forces of economics do not allow the
simultaneous achievement of all three.
15. Emerging Market Regimes. High capital mobility is forcing
emerging market nations to choose

between free-floating regimes and currency board or
dollarization regimes. What are the main
outcomes of each of these regimes from the perspective of
emerging market nations?
Highly restrictive regimes like currency boards and
dollarization require a country to give up the
majority of its discretionary ability over its own currency’s
value. Currency boards, like that used by
Argentina in the 1990s, restricted the rate of growth in the
country’s monetary policy in order to
preserve a fixed exchange rate regime. This proved to be a very
high price for Argentine society to
pay and, in the end, could not be maintained. Dollarization, an
even more radical extreme in the
adoption of another country’s currency for all exchange,
removes one of a government’s major
attributes of sovereignty.
A free-floating rate of exchange is, however, in many ways not
that different from the highly
restrictive choices just mentioned. In a free-floating regime, the
government allows the foreign
currency markets to determine the currency’s value, although
the government does maintain
sovereignty over its own monetary policy, which in turn has
significant direct impacts on the
currency’s value.
16. Globalizing the Yuan. What are the major changes and
developments that must occur for the
Chinese yuan to be considered “globalized”?

First, the yuan must become readily accessible for trade
transaction purposes. This is the fundamental
and historical use of currency. Secondly, it then needs to mature
toward a currency easily and openly
useable for international investment purposes. The third and
final stage of currency globalization is
when the currency itself takes on a role as a reserve currency,
currency held by central banks of other
countries as a store of value and a medium of exchange for their
own currencies.
17. Triffin Dilemma. What is the Triffin Dilemma? How does it
apply to the development of the Chinese
yuan as a true global currency?
The Triffin Dilemma is the potential conflict in objectives that
may arise between domestic monetary
and currency policy objectives and external or international
policy objectives when a country’s
currency is used as a reserve currency. Domestic monetary and
economic policies may on occasion
require both contraction and the creation of a current account
surplus (balance on trade surplus).
Chapter 2 The International Monetary System 11

18. China and the Impossible Trinity. What choices do you
believe that China will make in terms of
the Impossible Trinity as it continues to develop global trading
and use of the Chinese yuan?
This is purely speculative opinion, but many believe China will
continue to move the yuan toward
globalization rapidly. As Chinese financial institutions and
policies become more mature, and policies
more consistent with those of other major country financial
markets, the yuan will grow as a medium
of exchange for both commercial trade and capital investment
transactions. The gradual opening of
the Chinese economy to foreign investment is a critical
component of this process.
CHAPTER 3
THE BALANCE OF PAYMENTS
1. Balance of Payments Defined. What is the balance of
payments?
The measurement of all international economic transactions

between the residents of a country and
foreign residents is called the balance of payments (BOP).
2. BOP Data. What institution provides the primary source of
similar statistics for balance of payments
and economic performance worldwide?
The primary source of similar statistics for balance of payments
and economic performance
worldwide is the International Monetary Fund, Balance of
Payments Statistics.
3. Importance of BOP. Business managers and investors need
BOP data to anticipate changes in host
country economic policies that might be driven by BOP events.
From the perspective of business
managers and investors, list three specific signals that a
country’s BOP data can provide.
The BOP is an important indicator of pressure on a country’s
foreign exchange rate and thus on
the potential for a firm trading with or investing in that country
to experience foreign exchange
gains or losses. Changes in the BOP may predict the imposition
or removal of foreign exchange
controls.
Changes in a country’s BOP may signal the imposition or

removal of controls over payment of
dividends and interest, license fees, royalty fees, or other cash
disbursements to foreign firms or
investors.
The BOP helps to forecast a country’s market potential,
especially in the short run. A country
experiencing a serious trade deficit is not likely to expand
imports as it would if running a
surplus. It may, however, welcome investments that increase its
exports.
4. Flow Statement. What does it mean to describe the balance of
payments as a flow statement?
The BOP is often misunderstood because many people infer
from its name that it is a balance sheet,
whereas in fact it is a cash flow statement. By recording all
international transactions over a period
such as a year, the BOP tracks the continuing flows of
purchases and payments between a country
and all other countries. It does not add up the value of all assets
and liabilities of a country on a
specific date like a balance sheet does for an individual firm.
5. Economic Activity. What are the two main types of economic
activity measured by a country’s
BOP?

Current transactions having cash flows completed within one
year, such as for the import or
export of goods and services.
Capital and financial transactions, in which investors acquire
ownership of a foreign asset, such
as a company, or a portfolio investment, such as bonds or shares
of common stock.
Chapter 3 The Balance of Payments 13
6. Balance. Why does the BOP always “balance”?
The algebraic sum of all flows accounted for in the current
account and the capital and financial
accounts should, in theory, equal changes in a country’s
monetary reserves. Because data for the
balance of payments are collected on a single entry basis and
some data are missed, the equalization
usually does not occur. The imbalance is plugged by an entry
called “errors and omissions” that
makes the accounts balance.
7. BOP Accounting. If the BOP were viewed as an accounting
statement, would it be a balance sheet of

the country’s wealth, an income statement of the country’s
earnings, or a funds flow statement of
money into and out of the country?
A country’s balance of payments is similar to a corporation’s
funds flow statement in that the balance
of payments records events that cause the receipt (earnings) and
disbursement (expenditures) into and
out of the country.
8. Current Account. What are the main component accounts of
the current account? Give one debit and
one credit example for each component account for the United
States.
The main components and possible examples are:
Trade in goods
Debit: U.S. firm purchases German machine tools.
Credit: Singapore Air Lines buys a Boeing jet.
Trade in services
Debit: An American takes a cruise on a Dutch cruise line.
Credit: The Brazilian tourist agency places an ad in The New
York Times.
Income payments and receipts
Debit: The U.S. subsidiary of a Taiwan computer manufacturer
pays dividends to its parent.
Credit: A British company pays the salary of its executive
stationed in New York.

Unilateral current transactions
Debit: The U.S.-based International Rescue Committee pays
for an American working on the
Afghan border.
Credit: A Spanish company pays tuition for an employee to
study for an MBA in the United
States.
9. Real versus Financial Assets. What is the difference between
a “real” asset and a “financial” asset?
Real assets are goods (merchandise) and useful services.
Financial assets are financial claims, such as
shares of stock or bonds.
10. Direct versus Portfolio Investments. What is the difference
between a direct foreign investment and
a portfolio foreign investment? Give an example of each. Which
type of investment is a multinational
industrial company more likely to make?
A direct investment is made with the intent that the investor
will have a degree of control over the
asset acquired. Typical examples are the building of a factory in
a foreign country by the subsidiary
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of a multinational enterprise or the acquisition of more than
10% of the voting shares of a foreign
corporation. A portfolio investment is the purchase of less than
10% of the voting shares of a foreign
corporation or the purchase of debt instruments. Multinational
enterprises are more likely to engage in
direct foreign investment than in portfolio investment.
11. Net International Investment Position. What is a country’s
net international investment position,
and how does it differ from the balance of payments?
The net international investment position (NIIP) of a country is
an annual measure of the assets
owned abroad by its citizens, its companies, and its government,
less the assets owned by foreigners
public and private in their country. Whereas a country’s balance
of payments is often described as a
country’s international cash flow statement, the NIIP may be
interpreted as the country’s
international balance sheet. NIIP is a country’s stock of foreign
assets minus its stock of foreign
liabilities.
12. The Financial Account. What are the primary sub-
components of the financial account?
Analytically, what would cause net deficits or surpluses in these

individual components?
The main components and possible examples follow:
Direct investment
Debit: Ford Motor Company builds a factory in Australia.
Credit: Ford Motor Company sells its factory in Britain to
British investors.
Portfolio investment
Debit: An American buys shares of stock of a European food
chain on the Frankfurt Stock
Exchange.
Credit: The government of Korea buys U.S. treasury bills to
hold as part of its foreign exchange
reserves.
Net financial derivatives
Debit: A U.S. firm purchases a financial derivative, like a
currency swap, in London
Credit: A U.S. firm sells a financial derivative, like a forward
contract on the dollar versus the
pound, to a London buyer
Other investment.
Debit: A U.S. firm deposits $1 million in a bank balance in
London.
Credit: A U.S. firm generates an account receivable for
exports to Canada.
13. Classifying Transactions. Classify the following as a

transaction reported in a sub-component of the
current account or the capital and financial accounts of the two
countries involved:
a. A U.S. food chain imports wine from Chile. Debit to U.S.
goods part of current account, credit to
Chilean goods part of current account.
b. A U.S. resident purchases a euro-denominated bond from a
German company. Debit to U.S.
portfolio part of financial account; credit to German portfolio of
financial account.
c. Singaporean parents pay for their daughter to study at a U.S.
university. Credit to U.S. current
transfers in current account; debit to Singapore current transfers
in current account.
d. A U.S. university gives a tuition grant to a foreign student
from Singapore. If the student is
already in the United States, no entry will appear in the balance
of payments because payment is
between U.S. residents. (A student already in the United States
becomes a resident for balance of

payments purposes.)
e. A British Company imports Spanish oranges, paying with
eurodollars on deposit in London. A
debit to the goods part of Britain’s current account; a credit to
the goods part of Spain’s current
account.
f. The Spanish orchard deposits half the proceeds in a
eurodollar account in London. No recording
in the U.S. balance of payments, as the transaction was between
foreigners using dollars already
deposited abroad. A debit to the income receipts/payments of
the British current account; a credit
to the income receipts/payments of the Spanish current account.
g. A London-based insurance company buys U.S. corporate
bonds for its investment portfolio. A
debit to the portfolio investment section of the British financial
accounts; a credit to the portfolio
investment section of the U.S. balance of payments.
h. An American multinational enterprise buys insurance from a
London insurance broker. A debit to
the services part of the U.S. current account; a credit to the
services part of the British current
account.

i. A London insurance firm pays for losses incurred in the
United States because of an international
terrorist attack. A debit to the services part of the British
current account; a credit to the services
part of the U.S. current account.
j. Cathay Pacific Airlines buys jet fuel at Los Angeles
International Airport so it can fly the return
segment of a flight back to Hong Kong. Hong Kong keeps its
balance of payments separate from
those of the People’s Republic of China. Hence a debit to the
goods part of Hong Kong’s current
account; a credit to the goods part of the U.S. current account.
k. A California-based mutual fund buys shares of stock on the
Tokyo and London stock exchanges.
A debit to the portfolio investment section of the U.S. financial
account; a credit to the portfolio
investment section of the Japanese and British financial
accounts.
l. The U.S. army buys food for its troops in South Asia from
vendors in Thailand. A debit to the
goods part of the U.S. current account; a credit to the goods part
of the Thai current account.
m. A Yale graduate gets a job with the International Committee
of the Red Cross working in Bosnia

and is paid in Swiss francs. A debit to the income part of the
Swiss current account; a credit to the
income part of the Bosnia current account. This assumes the
Yale graduate spends her earnings
within Bosnia; should she deposit the sum in the United States,
then the credit would be to the
income part of the U.S. current account.
n. The Russian government hires a Dutch salvage firm to raise
a sunken submarine. A debit to the
service part of Russia’s current account; a credit to the service
part of the Netherlands’s current
account.
o. A Colombian drug cartel smuggles cocaine into the United
States, receives a suitcase of cash, and
flies back to Colombia with that cash. This would not get
captured in the goods part of the U.S. or
Colombian current accounts. Assuming the cash was
“laundered” appropriately, from the point of
14th Edition
view of the smugglers, bank accounts in the United States or
somewhere else (probably not

Colombia, possibly Switzerland) would be credited. This
imbalance would end up in the errors
and omissions part of the U.S. balance of payments.
p. The U.S. government pays the salary of a Foreign Service
Officer working in the U.S. embassy in
Beirut. Diplomats serving in a foreign country are regarded as
residents of their home country, so
this payment would not be recorded in any balance of payments
accounts. If or when the diplomat
spent the money in Beirut, at that time a debit should be
incurred in the goods or services part of
the U.S. current account and a contrary entry in the Lebanon
balance of payments. It is doubtful
that the goods or services transaction would get reported or
recorded, although on a net basis
changes in bank balances would reflect half of the transaction.
q. A Norwegian shipping firm pays U.S. dollars to the Egyptian
government for passage of a ship
through the Suez Canal. If the Norwegian firm paid with dollar
balances held in the United States
and the Suez Canal Authority of Egypt redeposited the proceeds
in the United States, no entry
would appear in the U.S. balance of payments. Norway would
debit a purchase of services, and
Egypt would credit a sale of services.
r. A German automobile firm pays the salary of its executive
working for a subsidiary in Detroit.

Germany would record a debit in the income payments/receipts
in its current account; the U.S.
would record a credit in the income payments/receipts in its
current account.
s. An American tourist pays for a hotel in Paris with his
American Express card. A debit would be
recorded in the services part of the U.S. current account; a
credit would be recorded in the
services part of the French current account.
t. A French tourist from the provinces pays for a hotel in Paris
with his American Express card. A
French resident most likely has a French-issued credit card,
issued by the French subsidiary of
American Express. In this instance, no entry would appear in
either country’s balance of
payments. If, later, the French subsidiary of American Express
paid a dividend back to the United
States, that would be recorded in the income part of the current
accounts.
u. A U.S. professor goes abroad for a year and lives on a
Fulbright grant. The current transfers
section of the U.S. current account would be debited for the
salary paid to a foreign resident.
(Even though an American, the professor is a foreign resident
during the time he lives abroad.)
The current transfers section of the host country’s current
account would be credited.

14. The Balance. What are the main summary statements of the
balance of payments accounts, and what
do they measure?
The balance on goods (also called the balance of trade)
measures the balance on imports and
exports of merchandise.
The balance on current account expands the balance on goods
to include receipts and expenses
for services, income flows, and unilateral transfers.
The basic balance measures all of the international transactions
(current, capital, and financial)
that come about because of market forces,that is, the balance
resulting from all decisions made
for private motives. (This includes international operating
expenses of the government.)
The overall balance (also called the official settlements

balance) is the total change in a country’s
foreign exchange reserves caused by the basic balance plus any
governmental action to influence
foreign exchange reserves.
15. Twin Surpluses. Why is China’s twin surpluses—a surplus
in both the current and financial
accounts—considered unusual?
China’s surpluses in both the current and financial accounts—
termed the twin surplus in the business
press—is highly unusual. Ordinarily, countries experiencing
large current account deficits fund these
deficits through equally large surpluses in the financial account,
and vice versa.
China has experienced a massive current account surplus and a
sometimes sizable financial account
surplus simultaneously. This is rare and an indicator of just how
exceptional the growth of the
Chinese economy has been. Although current account surpluses
of this magnitude would ordinarily
create a financial account deficit, the positive prospects of the
Chinese economy have drawn such
massive capital inflows into China in recent years that the
financial account too is in surplus.
16. Capital Mobility—United States. The U.S. dollar has
maintained or increased its value over the past
20 years despite running a gradually increasing current account

deficit. Why has this phenomenon
occurred?
The U.S. dollar has maintained or increased its value during the
past 20 years despite running a
gradually increasing current account deficit because the current
account deficit has been more than
offset by an inflow of dollars on capital and financial accounts.
17. Capital Mobility—Brazil. Brazil has experienced periodic
depreciation of its currency over the past
20 years despite occasionally running a current account surplus.
Why has this phenomenon occurred?
Brazil has experienced periodic depreciation of its currency
because of speculative flights of capital
out of Brazil in response to political and/or economic shocks,
including periods of hyperinflation.
18. BOP Transactions. Identify the correct BOP account for
each of the following transactions.
a. A German-based pension fund buys U.S. government 30-
year bonds for its investment portfolio.
Financial account: portfolio investment liabilities
b. Scandinavian Airlines System (SAS) buys jet fuel at Newark
Airport for its flight to Copenhagen.
Current account: Goods: Exports FOB
c. Hong Kong students pay tuition to the University of

California, Berkeley.
Current account: Services: credit
d. The U.S. Air Force buys food in South Korea to supply is air
crews.
Current account: Goods: Imports
e. A Japanese auto company pays the salaries of its executives
working for its U.S. subsidiaries.
Current account: Services: credit
f. A U.S. tourist pays for a restaurant meal in Bangkok.
Current account: Services: debit
g. A Colombian citizen smuggles cocaine into the United
States, receives cash, and smuggles the
dollars back into Colombia.
Unrecorded but should be a current account item.
14th Edition
h. A U.K. corporation purchases a euro-denominated bond from
an Italian MNE.
Does not enter the U.S. balance of payments
19. BOP and Exchange Rates. What is the relationship between
the balance of payments and a fixed or
floating exchange rate regime?

Fixed Exchange Rate System. Under a fixed exchange rate
system, the government bears the
responsibility to ensure that the BOP is near zero. If the sum of
the current and capital accounts do
not approximate zero, the government is expected to intervene
in the foreign exchange market by
buying or selling official foreign exchange reserves. If the sum
of the first two accounts is greater
than zero, a surplus demand for the domestic currency exists in
the world. To preserve the fixed
exchange rate, the government must then intervene in the
foreign exchange market and sell domestic
currency for foreign currencies or gold in order to bring the
BOP back to near zero.
Floating Exchange Rate System. Under a floating exchange rate
system, the government of a
country has no responsibility to peg its foreign exchange rate.
The fact that the current and capital
account balances do not sum to zero will automatically—in
theory—alter the exchange rate in the
direction necessary to obtain a BOP near zero. For example, a
country running a sizable current
account deficit and a capital and financial accounts balance of
zero will have a net BOP deficit. An
excess supply of the domestic currency will appear on world
markets. Like all goods in excess
supply, the market will rid itself of the imbalance by lowering
the price. Thus, the domestic currency
will fall in value, and the BOP will move back toward zero.
20. J-Curve Dynamics. What is the J-Curve adjustment path?

A country’s trade balance may change as a result of an
exchange rate change in the shape of a
flattened “j.” International economic analysis characterizes the
trade balance adjustment process as
occurring in three stages: (1) the currency contract period, (2)
the pass-through period, and (3) the
quantity adjustment period. Assuming that the trade balance is
already in deficit prior to the
devaluation, a devaluation may actually result in the trade
balance first worsening before improving
as a result of the three distinct commercial periods.
21. Evolution of Capital Mobility. Has capital mobility
improved steadily over the past 50 years?
The magnitude of capital movements globally has increased
dramatically during the past 50 years.
Capital inflows and outflows for major industrial countries now
dwarf the transaction values of
current account activities. These massive capital movements, if
allowed to move without restriction,
may cause increasing instability in economies, however, like
that of Iceland in recent years. So to ask
if “capital mobility has improved” is a bit of tricky question;
capital mobility has definitely increased,
if that is what is meant by “improved.”
22. Restrictions on Capital Mobility. What factors seem to play
a role in a government’s choice to
restrict capital mobility?

There is a spectrum of motivations for capital controls, with
most associated with either insulating the
domestic monetary and financial economy from outside markets
or political motivations over
ownership and access interests. Capital controls are just as
likely to occur over capital inflows as they
are over capital outflows. Although there is a tendency for a
negative connotation to accompany
capital controls (possibly the bias of the word “control” itself),
the impossible trinity requires that
capital flows be controlled if a country wishes to maintain a
fixed exchange rate and an independent
monetary policy.
23. Capital Controls. Which do most countries control, capital
inflows or capital outflows? Why?
Although the fear of major government policy makers is often
the flight of capital, capital outflows,
massive capital inflows are often considered potentially more
disruptive if not managed correctly. As
a result, most countries are slow and careful to deregulate
capital inflows, allowing them more control
over what kinds of capital over what periods of time enter the
country. If regulated on entry, they are

typically easier to regulate on exit.
24. Globalization and Capital Mobility. How does capital
mobility typically differ between
industrialized countries and emerging market countries?
Emerging market countries, by definition, have relatively small
and undeveloped financial systems
and sectors. Outside of some potential foreign direct investment
opportunities, they offer few choices
for capital to flow in of substance. Industrialized countries,
however, typically have large and
sophisticated financial sectors that offer a multitude of financial
investment options and assets, which
on occasion may attract large capital inflows (and in other
periods, may suffer large capital outflows).
CHAPTER 4
FINANCIAL GOALS AND CORPORATE GOVERNANCE
1. Business Ownership. What are the predominant ownership
forms in global business?
Business ownership can first be divided between state
ownership and private ownership. State

ownership, public ownership, is probably the largest globally.
Private ownership, where a business is
owned by an individual, partners, a family, or a collection of
private investors, is business that is
owned generally for more singular purposes like profit.
2. Business Control. How does ownership alter the control of a
business organization? Is the control of
a private firm that different from a publicly traded company?
Privately controlled companies—a single individual or family—
is often characterized by top-down
control, where the owner is active in more of the daily strategic
and operational decisions made in the
firm. The publicly traded firm, where management acts as an
agent of the owner, often has more
decentralized decision making and may use more consensus
based direction.
3. Separation of Ownership and Management. Why is this
separation so critical to the understanding
of how businesses are structured and led?
The field of agency theory is the study of how shareholders can
motivate management to accept the
prescriptions of the Shareholder Wealth Maximization (SWM)
model. For example, liberal use of
stock options should encourage management to think like
shareholders. Whether these inducements
succeed is open to debate. However, if management deviates too

much from SWM objectives of
working to maximize the returns to the shareholders, the board
of directors should replace them. In
cases where the board is too weak or ingrown to take this
action, the discipline of the equity markets
could do it through a takeover. This discipline is made possible
by the one-share, one-vote rule that
exists in most Anglo-American markets.
4. Corporate Goals: Shareholder Wealth Maximization. Explain
the assumptions and objectives of
the shareholder wealth maximization model.
The Anglo-American markets are characterized by a philosophy
that a firm’s objective should be to
maximize shareholder wealth. Anglo-American is defined to
mean the United States, United
Kingdom, Canada, Australia, and New Zealand. This theory
assumes that the firm should strive to
maximize the return to shareholders—those individuals owning
equity shares in the firm, as measured
by the sum of capital gains and dividends, for a given level of
risk. This in turn implies that
management should always attempt to minimize the risk to
shareholders for a given rate of return.
5. Corporate Goals: Stakeholder Capitalism Maximization
(SCM). Explain the assumptions and
objectives of the stakeholder capitalization model.

Continental European and Japanese markets are characterized
by a philosophy that all of a
corporation’s stakeholders should be considered and the
objective should be to maximize corporate
wealth. Thus, a firm should treat shareholders on a par with
other corporate stakeholders, such as
management, labor, the local community, suppliers, creditors,
and even the government. The goal is
Chapter 4 Financial Goals and Corporate Governance 21
to earn as much as possible in the long run, but to retain enough
to increase the corporate wealth for
the benefit of all. This model has also been labeled the
stakeholder capitalism model.
6. Management’s Time Horizon. Do shareholder wealth
maximization and stakeholder capitalism have
the same time-horizon for the strategic, managerial, and
financial objectives of the firm? How do they
differ?
Companies pursuing shareholder returns, particularly publicly
traded firms, have a very short time
horizon for financial results. The 90-day time interval, the
quarterly result, is a very short period for
companies to continually demonstrate the success or failure of
corporate strategy and operational

execution. Stakeholder capitalist firms, firms pursuing a
complex combination of goals and services
for a variety of stakeholders, may have a consistently longer
time horizon.
7. Operational Goals. What should be the primary operational
goal of an MNE?
Financial goals differ from strategic goals in that the former
focus on money and wealth (such as the
present value of expected future cash flows). Strategic goals are
more qualitative-operating
objectives, such as growth rates and/or share-of-market goals.
Trident’s strategic goals are the setting of such objectives as
degree of global scope and depth of
operations. In what countries should the firm operate? What
products should be made in each
country? Should the firm integrate its international operations
or have each foreign subsidiary operate
more or less on its own? Should it manufacture abroad through
wholly owned subsidiaries, through
joint ventures, or through licensing other companies to make its
products? Of course, successful
implementation of these several strategic goals is undertaken as
a means to benefit shareholders
and/or other stakeholders.
Trident’s financial goals are to maximize shareholder wealth
relative to a risk constraint and in
consideration of the long-term life of the firm and the long-term
wealth of shareholders. In other

words, wealth maximization does not mean short-term pushing
up share prices so executives can
execute their options before the company crashes—a
consideration that must be made in the light of
the Enron scandals.
8. Financial Returns. How do shareholders in a publicly traded
firm actually reap cash flow returns
from their ownership? Who has control over which of these
returns?
The return to a shareholder in a publicly traded firm combines
current income in the form of
dividends and capital gains from the appreciation of share price:
2 2 1
1 1
ShareholderReturn
−
= +
D P P
P P
where the initial price, P1, is equivalent to the initial
investment by the shareholder, and P2 is the price
of the share at the end of period. The shareholder theoretically
receives income from both
components. For example, duirng the past 60 years in the U.S.

marketplace, a diversified investor
may have received a total average annual return of 14%, split
roughly between dividends, 2%, and
capital gains, 12%.
Management generally believes it has the most direct influence
over the first component, the dividend
yield. Management makes strategic and operational decisions,
which grow sales and generate profits,
14th Edition
and then distributes those profits to ownership in the form of
dividends. Capital gains, the change in
the share price as traded in the equity markets, is much more
complex and reflects many forces that
are not in the direct control of management. Despite growing
market share, profits, or any other
traditional measure of business success, the market may not
reward these actions directly with share
price appreciation.
A privately held firm has a much simpler shareholder return
objective function: maximize current and
sustainable income. The privately held firm does not have a
share price (it does have a value, but this
is not a definitive market-determined value in the way in which
we believe markets work). It

therefore simply focuses on generating current income, dividend
income, to generate the returns to its
ownership. If the privately held ownership is a family, the
family may also place a great emphasis on
the ability to sustain those earnings over time while maintaining
a slower rate of growth that can be
managed by the family itself.
9. Dividend Returns. Are dividends really all that important to
investors in publicly traded companies?
Aren’t capital gains really the point or objective of the
investor?
Although on average over the past century in the U.S. capital
markets capital gains are larger than
dividend income, dividend income is considered much more
stable and more reliable than capital
gains. As a result, different investors view dividends versus
capital gains differently. Investors
looking for regular current period income may be attracted to
high dividend yielding equities.
10. Ownership Hybrids. What is a hybrid? How may it be
managed differently?
Many firms around the world are both publicly traded but
privately controlled. This is typical of
family-owned businesses that have gone public but the family
retains controlling interest in the firm.
Because private/family ownership generally has a longer time
horizon than publicly traded firms,

these firms may behave more like private firms, being more
“patient” in terms of seeing the financial
and operational results of corporate investment and strategy.
11. Corporate Governance. Define corporate governance and the
various stakeholders involved in
corporate governance. What is the difference between internal
and external governance?
Corporate governance is the control of the firm. It is a broad
operation concerned with choosing the
board of directors and with setting the long run objectives of
the firm. This means managing the
relationship between various stakeholders in the context of
determining and controlling the strategic
direction and performance of the organization. Corporate
governance is the process of ensuring that
managers make decisions in line with the stated objectives of
the firm.
Management of the firm concerns implementation of the stated
objectives of the firm by professional
managers employed by the firm. In theory, managers are the
employees of the shareholders and can
be hired or fired as the shareholders, acting through their
elected board, may decide. Ownership of the
firm is that group of individuals and institutions that own shares
of stock and that elected the board of
directors.
The governance of all firms is a combination of internal and

external. Internal governance comes
from the corporate board and the senior executive management
team. External governance is
exercised by all external stakeholders of the firm—the equity
markets, debt markets, exchanges,
regulatory bodies of all kinds, auditors, and legal service
providers.
12. Governance Regimes. What are the four major types of
governance regimes and how do they differ?
Chapter 4 Financial Goals and Corporate Governance 23
The four major corporate governance regimes are (1) market-
based, characterized by dispersed
ownership and a separation of ownership from management; (2)
family-based, where ownership and
management are often combined; (3) bank-based, where
government frequently controls bank lending
practices, restricting the growth rate of industry, and sometimes
combined control between family and
government; and (4) government affiliated, where government
exclusively directs business activity
with little minority interest or influence. Exhibit 4.6 details the
four regimes as well as providing a
sampling of representative countries characterized by these
regimes.

13. Governance Development Drivers. What are the primary
drivers of corporate governance across the
globe? Is the relative weight or importance of some drivers
increasing over others?
Changes in corporate governance principles and practices
globally have had four major drivers: (1)
the financial market development; (2) the degree of separation
between management and ownership;
(3) the concept of disclosure and transparency; and (4) the
historical development of the legal system.
14. Good Governance Value. Does good governance have a
“value” in the marketplace? Do investors
really reward good governance, or does good governance just
attract a specific segment of investors?
This is basically a rhetorical question for student discussion.
There have been a number of studies, for
example by McKinsey, as to what premium—if any—that
institutional investors would be willing to
pay for companies with good governance within specific
country-markets. The results indicate in
certain circumstances the market may be willing to pay a small
premium, but in general, the results to
date have been unconvincing.
15. Shareholder Dissatisfaction. What alternative actions can
shareholders take if they are dissatisfied

with their company?
Disgruntled shareholders may do the following:
a. Remain quietly disgruntled. This puts no pressure on
management to change its ways under both
the Shareholder Wealth Maximization (SWM) model and the
Corporate Wealth Maximization
(CWM) model.
b. Sell their shares. Under the SWM model, this action (if
undertaken by a significant number of
shareholders) drives down share prices, making the firm an
easier candidate for takeover and the
probable loss of jobs among the former managers. Under the
CWM model, management can
more easily ignore any drop in share prices.
c. Change management. Under the one-share, one-vote
procedures of the SWM model, a concerted
group of shareholders can vote out existing board members if
they fail to change management
practices. This usually takes the form of the board firing the
firm’s president or chief operating
officer. Cumulative voting, which is a common attribute of
SWM firms, facilitates the placing of
minority stockholder representation on the board. If, under the
CWM model, different groups of
shareholders have voting power greater than their proportionate
ownership of the company,
ousting of directors and managers is more difficult.

d. Initiate a takeover. Under the SWM model, it is possible to
accumulate sufficient shares to take
control of a company. This is usually done by a firm seeking to
acquire the target firm making a
tender offer for a sufficient number of shares to acquire a
majority position on the board of
directors. Under the CWM model, acquisition of sufficient
shares to bring about a takeover is
14th Edition
much more difficult, in part because nonshareholder stakeholder
wishes are considered in any
board action. (One can argue as to whether the long-run
interests of nonshareholding stakeholders
are served by near-term avoidance of unsettling actions.)
Moreover, many firms have
disproportionate voting rights because of multiple classes of
stock, thus allowing entrenched
management to remain.
16. Emerging Markets Corporate Governance Failures. It has
been claimed that failures in corporate
governance have hampered the growth and profitability of some
prominent firms located in emerging

markets. What are some typical causes of these failures in
corporate governance?
Causes include lack of transparency, poor auditing standards,
cronyism, insider boards of directors
(especially among family-owned and operated firms), and weak
judicial systems.
17. Emerging Markets Corporate Governance Improvements. In
recent years, emerging-market
MNEs have improved their corporate governance policies and
become more shareholder-friendly.
What do you think is driving this phenomenon?
It is driven by the need to access global capital markets. The
depth and breadth of capital markets is
critical to growth. Country markets that have had relatively
slow growth or have industrialized rapidly
utilizing neighboring capital markets, may not form large public
equity market systems. Without
significant public trading of ownership shares, high
concentrations of ownership are preserved and
few disciplined processes of governance developed.
CHAPTER 5

THE FOREIGN EXCHANGE MARKET
1. Definitions. Define the following terms:
a. Foreign exchange market. The foreign exchange market
provides the physical and institutional
structure through which the money of one country is exchanged
for that of another country, the
rate of exchange between currencies is determined, and foreign
exchange transactions are
physically completed .
b. Foreign exchange transaction. A foreign exchange transaction
is an agreement between a buyer
and seller that a fixed amount of one currency will be delivered
for some other currency at a
specified rate.
c. Foreign exchange. Foreign exchange means the money of a
foreign country; that is, foreign
currency bank balances, bank notes, checks, and drafts.
2. Functions of the Foreign Exchange Market. What are the
three major functions of the foreign
exchange market?
To transfer purchasing power from one country and its currency

to another. Typical parties would
be importers and exporters, investors in foreign securities, and
tourists.
To finance goods in transit. Typical parties would be importers
and exporters.
To provide hedging facilities. Typical parties would be
importers, exporters, and creditors and
debtors with short-term monetary obligations.
3. Structure of the FX Market. How is the global foreign
exchange market structured? Is digital
telecommunications replacing people?
One of the biggest changes in the foreign exchange market in
the past decade has been its shift from a
two-tier market (the interbank or wholesale market and the
client or retail market) to a single-tier
market. Electronic platforms and the development of
sophisticated trading algorithms have facilitated
market access by traders of all kinds and sizes.
Participants in the foreign exchange market can be
simplistically divided into two major groups: those
trading currency for commercial purposes, liquidity seekers, and
those trading for profit, profit
seekers. Although the foreign exchange market began as a
market for liquidity purposes, facilitating
the exchange of currency for the conduct of commercial trade

and investment purposes, the
exceptional growth in the market has been largely based on the
expansion of profit-seeking agents. As
might be expected, the profit seekers are typically much better
informed about the market, looking to
profit from its future movements, while liquidity seekers simply
wish to secure currency for
transactions. As a result, the profit seekers generally profit from
the liquidity seekers.
14th Edition
4. Market Participants. For each of the foreign exchange market
participants, identify their motive for
buying or selling foreign exchange.
Foreign exchange dealers are banks and a few nonbank
institutions that “make a market” in
foreign exchange. They buy and sell foreign exchange in the
wholesale market and resell or rebuy
it from customers at a slight change from the wholesale price.
Foreign exchange brokers (not to be confused with dealers) act
as intermediaries in bringing

dealers together, either because the dealers do not want their
identity revealed until after the
transaction or because the dealers find that brokers and “shop
the market,” i.e., scan the bid and
offer prices of many dealers very quickly.
Individuals and firms conducting international business consist
primarily of three categories:
importers and exporters, companies making direct foreign
investments, and securities investors
buying or selling debt or equity investments for their portfolios.
Speculators and arbitragers buy and sell foreign exchange for
profit. Speculators and arbitragers
buy or sell foreign exchange on the basis of which direction
they believe a currency’s value will
change in the immediate or speculative horizon.
Central banks and treasuries buy and sell foreign exchange for
several purposes, but most
importantly, for intervention in the marketplace. Direct
intervention, in which the central bank
will buy (sell) its own currency in the market with its foreign
exchange reserves to push its value
up (down), is a very common activity by government treasuries
and central banking authorities.
5. Foreign Exchange Transaction. Define each of the following
types of foreign exchange

transactions:
a. Spot. A spot transaction is an agreement between two parties
to exchange one currency for
another, with the transaction being carried out at once for
commercial customers and on the
second following business day for most interbank (i.e.,
wholesale) trades.
b. Outright forward. A forward transaction is an agreement
made today to exchange one currency
for another, with the date of the exchange being a specified time
in the future—often one month,
two months, or some other definitive calendar interval. The rate
at which the two currencies will
be exchanged is set today.
c. Forward-forward swaps. A more sophisticated swap
transaction is called a “forward-forward”
swap. A dealer sells £20,000,000 forward for dollars for
delivery in, say, two months at
$1.6870/£ and simultaneously buys £20,000,000 forward for
delivery in three months at
$1.6820/£. The difference between the buying price and the
selling price is equivalent to the
interest rate differential, i.e., interest rate parity, between the
two currencies. Thus, a swap can be
viewed as a technique for borrowing another currency on a fully
collateralized basis.

6. Swap Transactions. Define and differentiate the different
type of swap transactions in the foreign
exchange markets.
A swap transaction in the interbank market is the simultaneous
purchase and sale of a given amount
of foreign exchange for two different value dates. Both
purchase and sale are conducted with the
same counterparty. There are several types of swap transactions.
Chapter 5 The Foreign Exchange Market 27
Spot Against Forward. The most common type of swap is a
“spot against forward.” The dealer buys
a currency in the spot market (at the spot rate) and
simultaneously sells the same amount back to the
same bank in the forward market (at the forward exchange rate).
Because this is executed as a single
transaction, with just one counterparty, the dealer incurs no
unexpected foreign exchange risk. Swap
transactions and outright forwards combined made up more than
half of all foreign exchange market
activity in recent years.
Forward-Forward Swaps. A more sophisticated swap transaction

is called a forward-forward swap.
For example, a dealer sells £20,000,000 forward for dollars for
delivery in, say, two months at
$1.8420/£ and simultaneously buys £20,000,000 forward for
delivery in three months at $1.8400/£.
The difference between the buying price and the selling price is
equivalent to the interest rate
differential, which is the interest rate parity described in
Chapter 6, between the two currencies. Thus,
a swap can be viewed as a technique for borrowing another
currency on a fully collateralized basis.
Nondeliverable Forwards (NDFs). Created in the early 1990s,
the nondeliverable forward (NDF) is
now a relatively common derivative offered by the largest
providers of foreign exchange derivatives.
NDFs possess the same characteristics and documentation
requirements as traditional forward
contracts, except that they are settled only in U.S. dollars; the
foreign currency being sold forward or
bought forward is not delivered.
7. Nondeliverable Forward. What is a nondeliverable forward,
and why does it exist?
The nondeliverable forward (NDF) is now a relatively common
derivative offered by the largest
providers of foreign exchange derivatives. NDFs possess the
same characteristics and documentation
requirements as traditional forward contracts, except that they
are settled only in U.S. dollars; the
foreign currency being sold forward or bought forward is not
delivered.

The dollar-settlement feature reflects the fact that NDFs are
contracted offshore, for example in New
York for a Mexican investor, and so are beyond the reach and
regulatory frameworks of the home
country governments (Mexico in this case). NDFs are traded
internationally using standards set by the
International Swaps and Derivatives Association (ISDA).
Although originally envisioned to be a
method of currency hedging, it is now estimated that more than
70% of all NDF trading is for
speculation purposes.
8. Foreign Exchange Market Characteristics. With reference to
foreign exchange turnover in 2010:
a. Rank the relative size of spot, forwards, and swaps as of
2007. Ranking: 1. Swaps; 2. Spot;
3. Forwards
b. Rank the five most important geographic locations for
foreign exchange turnover. Ranking:
1. United Kingdom; 2. United States; 3. Singapore (just barely
passing Japan); 4. Japan (used to
be third); 5. Hong Kong (rising rapidly)
c. Rank the three most important currencies of denomination.
Ranking: 1. U.S. dollar; 2. European
euro; 3. Japanese yen

9. Foreign Exchange Rate Quotations. Define and give an
example of each of the following quotes:
a. Bid rate quote.
b. Ask rate quote.
14th Edition
Interbank quotations are given as a bid and ask (also referred to
as offer). A bid is the price (i.e.,
exchange rate) in one currency at which a dealer will buy
another currency. An ask is the price (i.e.,
exchange rate) at which a dealer will sell the other currency.
Dealers bid (buy) at one price and ask
(sell) at a slightly higher price, making their profit from the
spread between the buying and selling
prices.
Bid and ask quotations in the foreign exchange markets are
superficially complicated by the fact that
the bid for one currency is also the offer for the opposite
currency. A trader seeking to buy dollars
with Swiss francs is simultaneously offering to sell Swiss francs
for dollars. Assume a bank makes
the quotations shown in the top half of Exhibit 6.5 for the
Japanese yen. The spot quotations on the
first line indicate that the bank’s foreign exchange trader will

buy dollars (i.e., sell Japanese yen) at
the bid price of ¥118.27 per dollar. The trader will sell dollars
(i.e., buy Japanese yen) at the ask price
of ¥118.37 per dollar.
10. Reciprocals. Convert the following indirect quotes to direct
quotes and direct quotes to indirect
quotes:
a. Euro: €1.22/$ (indirect quote); 1/1.22 = $0.8197/€ (direct)
b. Russia: Rub 30/$ (indirect quote); 1/30 = $0.0333/Rub
(direct)
c. Canada: $0.72/C$ (direct quote); 1/0.72 = C$1.3889/$
(indirect)
d. Denmark: $0.1644/DKr (direct quote); 1/0.1644 = Dkr
6.0827/$ (indirect)
11. Geographical Extent of the Foreign Exchange Market.
a. What is the geographical location? All countries.
b. What are the two main types of trading systems? (1) Trading
on an exchange or exchange floor
and (2) telecommunications linkages.
c. How are foreign exchange markets connected for trading
activities? Telecommunications
linkages.

12. American and European Terms. With reference to interbank
quotations, what is the difference
between American terms and European terms?
Most foreign currencies in the world are stated in terms of the
number of units of foreign currency
needed to buy one dollar. For example, the exchange rate
between U.S. dollars and Swiss franc is
normally stated
SF1.6000/$, read as “1.6000 Swiss francs per dollar”
This method, called European terms, expresses the rate as the
foreign currency price of one U.S.
dollar. An alternative method is called American terms. The
same exchange rate above expressed in
American terms is
$0.6250/SF, read as “0.6250 dollars per Swiss franc”
Chapter 5 The Foreign Exchange Market 29
Under American terms, foreign exchange rates are stated as the
U.S. dollar price of one unit of

foreign currency. Note that European terms and American terms
are reciprocals:
1
USD 0.6250 / SF
SF1.60000 / USD
=
With several exceptions, including two important ones, most
interbank quotations around the world
are stated in European terms. Thus, throughout the world the
normal way of quoting the relationship
between the Swiss franc and U.S. dollar is SF1.6000/$; this
method may also be called “Swiss terms.”
A Japanese yen quote of ¥118.32/$ is called “Japanese terms,”
although the expression “European
terms” is often used as the generic name for Asian as well as
European currency prices of the dollar.
European terms were adopted as the universal way of expressing
foreign exchange rates for most (but
not all) currencies in 1978 to facilitate worldwide trading
through telecommunications
13. Direct and Indirect Quotes. Define and give an example of
the following:
a. An example of a direct quote between the U.S. dollar and the
Mexican peso, where the United
States is designated as the home country.

A direct quote is a home currency price of a unit of foreign
currency. An example, using Mexico
and the United States (home country) is $0.1050/Peso.
b. An example of an indirect quote between the Japanese yen
and the Chinese renminbi (yuan),
where China is designated as the home country.
An indirect quote is a foreign currency price of a unit of home
currency. An example, using Japan
and China (home country) is ¥14.75/Rmb.
14. Base and Price Currency. Define base currency, unit
currency, price currency, and quote currency.
Foreign exchange quotations follow a number of principles,
which at first may seem a bit confusing
or nonintuitive. Every currency exchange involves two
currencies, currency 1 (CUR1) and currency 2
(CUR2):
CUR1/CUR2
The currency to the left of the slash is called the base currency
or the unit currency. The currency to
the right of the slash is called the price currency or quote
currency. The quotation always indicates
the number of units of the price currency, CUR2, required in

exchange for receiving one unit of the
base currency, CUR1.
For example, the most commonly quoted currency exchange is
that between the U.S. dollar and the
European euro. For example, a quotation of
EUR/USD 1.2174
designates the euro (EUR) as the base currency, the dollar
(USD) as the price currency, and the
exchange rate is If you can remember that the currency quoted
on the left of the slash is always the
base currency, and always a single unit, you can avoid
confusion. Exhibit 5.6 provides a brief
14th Edition
overview of the multitude of terms often used around the world
to quote currencies through an
example using the European euro and U.S. dollar.
15. Cross Rates and Intermarket Arbitrage. Why are cross
currency rates of special interest when
discussing intermarket arbitrage?

Because many currencies are traded in volume against a single
other currency, cross rates can be used
to check on opportunities for intermarket arbitrage. These
arbitrage opportunities arise when a
currency like the Mexican peso, which is traded heavily against
the U.S. dollar, may have profit
opportunities arise when the dollar rises or falls against a third
currency like the Brazilian real or the
Chilean peso, which are also traded against the Mexican peso.
16. Percentage Change in Exchange Rates. Why do percentage
change calculations end up being rather
confusing on occasion?
Unlike the price of a share of stock or an orange, an exchange
rate is the price of one money in terms
of a second money. Confusion occasionally arises when looking
at a commonly quoted exchange rate
like the number of Mexican pesos to exchange for one dollar. If
that rate has changed from 10 to 11,
the percentage change can be calculated either of two ways.
Foreign Currency Terms. When the foreign currency price (the
price, Ps) of the home currency (the
unit, $) is used, Mexican pesos per U.S. dollar in this case, the
formula for the percent change (%Δ)
in the foreign currency becomes
Beginning Rate Ending Rate 10.00 / $ 11.00 / $

% 100 100 9.09%
Ending Rate 11.00 / $
− =
Δ = × = × = −
Ps Ps
Ps
The Mexican peso fell in value 9.09% against the dollar. Note
that it takes more pesos per dollar,
and the calculation resulted in a negative value, both
characteristics of a fall in value.
Home Currency Terms. When the home currency price (the
price) for a foreign currency (the unit)
is used – the reciprocals of the numbers above – the formula for
the percent change in the foreign
currency is:
Beginning Rate Ending Rate $0.09091 / $0.1000 /
% 100 100 9.09%
Ending Rate $0.1000 /
− =
Δ = × = × = −
Ps Ps
Ps

The calculation yields the identical percentage change, a fall in
the value of the peso by 9.09%.
Although many people find the second calculation, the home
currency term calculation, to be the
more “intuitive” because it reminds them of many percentage
change calculations, one must be
careful to remember that these are exchanges of currency for
currency, and the currency that is
designated as home currency is significant.
CHAPTER 6
INTERNATIONAL PARITY CONDITIONS
1. Law of One Price. Define the law of one price carefully,
noting its fundamental assumptions. Why
are these assumptions so difficult to find in the real world in
order to apply the theory?
If identical products or services can be sold in two different
markets, and no restrictions exist on the
sale or transportation of product between markets, the product’s

price should be the same in both
markets. This is called the law of one price.
A primary principle of competitive markets is that prices will
equalize across markets if frictions or
costs of moving the products or services between markets do not
exist. If the two markets are in two
different countries, the product’s price may be stated in
different currency terms, but the price of the
product should still be the same. Comparing prices would
require only a conversion from one
currency to the other. For example,
$ ¥ ,× =P S P
where the price of the product in U.S. dollars, P$, multiplied
by the spot exchange rate (S, yen per
U.S. dollar), equals the price of the product in Japanese yen, P¥.
Conversely, if the prices of the two
products were stated in local currencies, and markets were
efficient at competing away a higher price
in one market relative to the other, the exchange rate could be
deduced from the relative local product
prices:
¥
$=
P
S
P

The challenge in applying the theory in the real world is that
few products exist that are truly identical
across markets, and if they are identical, are truly
“transportable” across markets with nearly zero
transportation costs and fees.
2. Purchasing Power Parity. Define the following terms:
a. The law of one price. The law of one prices states that
producers’ prices for goods or services of
identical quality should be the same in different markets; i.e.,
different countries (assuming no
restrictions on the sale and allowing for transportation costs). If
a country has higher inflation
than other countries, its currency should devalue or depreciate
so that the real price remains the
same as in all countries. Application of this law results in the
theory of purchasing power parity
(PPP).
b. Absolute purchasing power parity. If the law of one price
were true for all goods and services,
the purchasing power parity (PPP) exchange rate could be found
from any individual set of
prices. By comparing the prices of identical products
denominated in different currencies, one
could determine the “real” or PPP exchange rate which should
exist if markets were efficient.

This is the absolute version of the theory of purchasing power
parity. Absolute PPP states that the
spot exchange rate is determined by the relative prices of
similar baskets of goods.
14th Edition
c. Relative purchasing power parity. If the assumptions of the
absolute version of PPP theory are
relaxed a bit more, we observe what is termed relative
purchasing power parity. This more
general idea is that PPP is not particularly helpful in
determining what the spot rate is today, but
that the relative change in prices between two countries over a
period of time determines the
change in the exchange rate over that period. More specifically,
if the spot exchange rate between
two countries starts in equilibrium, any change in the
differential rate of inflation between them
tends to be offset over the long run by an equal but opposite
change in the spot exchange rate.
3. Big Mac Index. How close does the Big Mac Index conform
to the theoretical requirements for a one
price measurement of purchasing power parity?

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