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Congratulations – SPAIN!

Yanee Zhang- Jilin, China

Jaime Fernandez Cuervo- Madrid, Spain

Alejandro Chinchilla Vargas- San Jose, Costa Rica

Enrique Parra Arce- Madrid,

Spain

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http://www.youtube.com/watch?v=jS7O9RhNa18

Created By: Sandeep Jain (Summer Research Assistant)

Image Source: http://mwanamishale.files.wordpress.com/2010/06/2010_logo_large1.jpg http://www.tofocus.info/images/flags/china-flag.gifhttp://www.spain-flag.eu/photos/spain-flag.gifhttp://www.33ff.com/flags/XL_flags/Costa-Rica_flag.gif

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Introduction Midterm Grades Syllabus – Draft Reports Chapter 8: Regional Economic Integration Case Study: Boeing vs. Airbus: Two Decades of

Trade Disputes The “Trade Game” Chapter 9: The Foreign Exchange Market

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Wendy Jeffus

Harvard Summer School

Chapter 8: Regional Economic Integration

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Introduction Trend - Regional Economic Integration

Regional Trade Agreements – – Agreements among countries in a geographic region to reduce,

and ultimately remove, tariff and non-tariff barriers to the free flow of goods, services, and factors of production.

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New Zealand – China New Zealand – China Free Trade Agreement

– a bilateral free trade agreement signed between the People's Republic of China and New Zealand in April 2008.

– 07/10/10 – “the free trade agreement has seen exports to China increase 28 per cent in the past year. Kiwi dairy products into China are up 75 per cent, wood is up 73 per cent and wool is up 18 per cent. China is now New Zealand's second-largest trading partner, taking about 10 per cent of everything that leaves our shores.”

– New Zealand remains the only developed country to hold an FTA with China.

http://www.topnews.in/files/china-new-zealand.jpghttp://en.wikipedia.org/wiki/New_Zealand_%E2%80%93_China_Free_Trade_Agreementhttp://www.stuff.co.nz/national/politics/3905096/Kiwis-aim-for-a-bigger-slice-of-the-Chinese-pie

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US - Taiwan 07/08/10 The United States has ruled out a free

trade agreement with Taiwan amid a dispute over beef imports.

http://www.google.com/hostednews/afp/article/ALeqM5j_RuJvFhIiqUQNvp8GOVPhOLGdqg

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India - Malaysia 07/09/10 - Comprehensive Economic

Cooperation Agreement (CECA) Negotiations - movement of persons are a key

concern to New Delhi, while for Kuala Lumpur palm oil is an issue

India is Malaysia's 12th largest trading partner and 11th largest major export destination. Malaysia is currently the 13th largest export destination of India.

http://www.crossed-flag-pins.com/Friendship-Pins/Malaysia/Flag-Pins-Malaysia-India.jpghttp://www.thehindu.com/business/article507786.ece

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Levels of Economic Integration Free trade area

– Barriers to trade are removed, but each country determines its own external trade policy Example: European Free Trade Association (Norway, Iceland, Liechtenstein, & Switzerland)

– Basically for industrial goods (i.e. heavy equipment) Customs union

– Internal barriers to trade are removed and a common external trade policy is adopted Example: Andean Community of Nations (Bolivia, Colombia, Ecuador, & Peru)

– Common external tariffs 5 – 20% Common market

– Has no barriers to trade between member countries, includes a common external trade policy, and also allows factors of production to move freely between members.

Example: MERCOSUR (Argentina, Brazil, Paraguay, & Uruguay) Economic union

– Involves the free flow of products and factors of production between member countries and the adoption of a common external trade policy, but it also requires a common currency, harmonization of members’ tax rates, and a common monetary and fiscal policy.

Example: EU (although not all members have adopted the common currency) Political union

– Occurs when a central political apparatus coordinates the economic, social, and foreign policy of the member states

Example: United States

http://www.efta.int/, http://www.comunidadandina.org/, http://www.mercosul.gov.br/

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Levels of Economic Integration

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Example: EU Trade Agreements

http://en.wikipedia.org/wiki/Member_State_of_the_European_Union

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Case for IntegrationPros Economic Arguments

– Stimulates economic growth in member countries

– Increases FDI and world production

– Countries specialize in goods and services that can be efficiently produced

– Creates additional gains from free trade beyond the international agreements such as the WTO

Political Arguments– Economic interdependence

creates incentives for political cooperation

This reduces the potential for violent confrontation

– Together, the countries have more economic clout to enhance trade with other countries or trading blocs

Cons Integration is hard to achieve and

sustain Nations may benefit but groups

within countries may be hurt.– Example: (Canadian & U.S. textile

workers) Potential loss of sovereignty and

control over domestic issues (especially for the “economically weaker” members)

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Trade Creation & Trade Diversion Economists point out that the benefits of regional

integration are determined by the extent of trade creation, as opposed to trade diversion

– Trade creation occurs when high cost domestic producers are replaced by low cost producers within the free trade area.

Example: NAFTA/Mexico, EU/Poland – Trade diversion occurs when lower cost external suppliers are

replaced by higher cost suppliers within the free trade area. Example: Britain imported lamb from New Zealand, until the EU

imposed the common external tariff. Now Britain imports lamb from France.

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Evolution of the European Union Product of two political factors:

– A desire for peace (after the devastation from WWI & WWII)

– A desire for strong political & economic position on the world stage

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EU Membership

Image Source: Wikipedia.org (EU)

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Enlargement of the European Union To qualify for EU membership applicants must:

– Privatize state assets– Deregulate markets– Restructure industries– Control inflation– Include EU laws into their own systems– Establish stable democratic governments– Respect human rights

Current Candidate Countries: Croatia, Iceland, Macedonia, and Turkey.

– http://ec.europa.eu/enlargement/candidate-countries/index_en.htm

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Key Dates 1951 - European Coal and Steel

Community. 1957- Treaty of Rome establishes

the European Community 1993 – Treaty of Maastricht

established the European Union January 1, 1999 11 countries January 1, 2001 + Greece - Greek

drachma (GRD) exchange rate of 340.750000

January 1, 2002 old currencies were not accepted

– Actually you could exchange currency for about 2 months until February 28, 2002.

Source: Wikipedia.org

EU Membership

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The Euro

http://en.wikipedia.org/wiki/Euro

B

A

FF

L

I

N

G

P

I

G

S

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Economic Gains of 1 Currency Reduced exchange costs Reduced currency risk Increased price competition Major investment and export opportunities for

firms within region Allows firms to optimize mix of resources to

reduce overall costs

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NAFTA The North American Free Trade Agreement (NAFTA)

became law January 1, 1994 NAFTA includes the following:

– Over 10 year period: tariffs reduced (99% of goods traded)– Removal of most barriers on cross border flow of services– Removal of restrictions on FDI except in certain sectors

Mexican railways and energy US airlines and radio communications Canadian culture

– Protection of intellectual property rights– National environmental standards apply– Establishment of commission to police violations

Image source: http://www.ustr.gov/sites/default/files/nafta.jpg

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The Case For & Against NAFTA Pros

– Enlarged and productive regional base

– Labor-intensive industries move to Mexico

– Mexico gets investment and employment

– Increased Mexican income to buy US/Canada goods

– Demand for goods increases jobs

– Consumers get lower prices

Cons– Loss of jobs to Mexico– Mexican firms have to

compete against efficient US/Canada firms

– Environmental degradation– Loss of national

sovereignty

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Most Active Regional Trade Blocs

http://en.wikipedia.org/wiki/Trade_blocks

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The Andean Community Bolivia, Colombia, Ecuador,

Peru, Venezuela Nearly failed. Rejuvenated in

1990 Changed from FTA to customs

union in 1992 Still has many political and

economic problems

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In the news… July 2, 2009 - United States has decided to remove

Bolivia from the Andean Trade Preference Act, a bill that allows many goods from Colombia, Bolivia, Ecuador, and Peru to enter into the United States duty free.

– The idea behind the act is that providing tariff free access to the U.S. market will help convince farmers to stop growing coca in favor of another commodity.

– Bolivia was removed because it is not doing enough to reduce the cultivation of coca.

– The U.S. Trade Representative to Bolivia said there has been "explicit acceptance and encouragement of coca production at the highest levels of the Bolivian government."

– Coca is seen as a cultural crop in Bolivia, where it is used for numerous reasons other than cocaine (such as religious ceremonies and as a mild sedative).

http://www.examiner.com/x-9463-NY-International-Security-Examiner~y2009m7d2-Wake-up-Evo-Morales; Image Bolivia Coca tea (google images)CocoBlast Image: http://www.mysteriousbolivian.com/catalog/COCA%20BLAST_thumb.jpg

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Mercosur 1988: Argentina, Brazil. 1990:

Paraguay, Uruguay 1995: Agreed to move toward a

full customs union Trade quadrupled between 1990-

1998 Has significant trade diversion

issues Revival in 2003 by Brazil’s

president to be modeled after EU with common currency and elected parliament

2006: Venezuela

http://en.wikipedia.org/wiki/Mercosur

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Mercosur Political issues: The delayed incorporation of Venezuela The A/H1N1 virus pandemic, Protectionism and hurdles to intra-trade Bilateral disputes

– Argentina and Uruguay paper mills – Brazil and Paraguay over the sale of power from the

hemisphere’s largest operational hydroelectric complex

http://www.vheadline.com/readnews.asp?id=81021http://en.mercopress.com/2009/06/12/public-opinion-rapidly-loosing-enchantment-with-mercosurhttp://en.mercopress.com/2009/07/03/mercosur-agrees-on-the-agenda-for-the-presidential-summit

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Other Associations Central American Common Market

– 1960s: Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua.– Collapsed in 1969

CARICOM– 1973: English-speaking Caribbean countries– 1991: Failed for third time to establish common external tariff

Free Trade Area of the Americas– Two stumbling blocks include intellectual property rights and reductions

in agriculture subsidies

http://www.globalexchange.org/campaigns/ftaa/

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ASEAN Countries Association of Southeast

Asian Nations– Created in 1967– Objective to achieve free

trade between member countries and achieve cooperation in their industrial

– Brunei, China, Indonesia, Laos, Malaysia, the Philippines, Myanmar, Singapore, Thailand, and Vietnam

– Progress limited by Asian financial crisis of the 90’s

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APEC Countries ‘Promote a sense of

community’ 18 members

– 50% of world’s GNP– 40% of global trade

Despite slow progress, if successful, could become the world’s largest free trade area

Asia Pacific Economic Cooperation

Founded in 1990 to ‘promote open trade and practical economic cooperation

http://www.apec.org/

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African Union

The only African state that is not a member of the African Union is Morocco, which left the AU's predecessor, the Organisation of African Unity (OAU), in 1984.

Source: Wikipedia.org

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Implications for Managers Opportunities:

– Creation of single markets Protected markets, now open Lower costs doing business in a single market

Threats:– Differences in culture and competitive practices make realizing

economies of scale difficult– More price competition– Outside firms shut out of market– EU intervention in M&A

For your final project: discover what trade agreements are relevant for the country you have selected.

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Take a Break… Read the Handouts Boeing/Airbus teams if you haven’t done so,

load your presentations on the desktop, grab a drink, meet your classmates…

see you in 10 min.

Image source: http://www.graduatejunction.net/images/take_a_break.jpg

After the case presentationI will select groups forthe “trade game”

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Case Study Boeing vs. Airbus: Two Decades of Trade

Disputes Present a 5-10min (timed) assessment of the

case (answer case questions) All group members must participate.

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Wendy Jeffus

Harvard Summer School

The Trade Game

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Country Assignments Tier I (A)

– Tier I (B)

– Tier II (D)

Tier II (E)–

Tier II (F)–

Tier III (H)–

Tier III (I)–

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8:10 (By the clock on the wall) Is the END of the game.

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Trade Simulation Starting Output Prices

– Small Triangle $500– Circle $500– Half-Moon with circle cut out $1,000– Large Triangle with Half-moon cut out

$1,500– Parallelogram with Square cut out

$1,500 Power Brokers’ Price List

– Environmental Token $500– Pencil $3,000– White Paper (2 sheets) $3,000– Labor (per person) $4,000– Compass $5,000 (sold out)– Pencil Sharpener $8,000– Red Paper (1 full sheet) $10,000– Ruler $10,000– Scissors $12,000

The Bankers will pay you in cash for the shapes. You will need this cash to provide for the subsistence of your people (at $500 per person per year). You may also use this cash to purchase additional capital, raw materials, labor, and environmental tokens.

You will be given 10 tokens at the start of each year. You can trade with other countries to get additional tokens and/or you can buy more tokens from the Power Brokers. At the end of each year, you must turn in any leftover tokens for which you will receive $500 each.

1. Meet your production quota - by paying the Chief Economist $500 for each citizen of your country. If you do not have enough money, then some of your people will starve, and DIE!

2. Protect and/or clean up your environment - by giving the Chief Economist one environmental token (penny) for each $1000 worth of shapes which you produced and sold to the bank. If you do not have enough tokens, the pollution will be so toxic that some of your people will DIE!

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Designing Negotiation Strategies Organizing to influence – creating, staffing, funding, and directing

institutions in ways that influence the trade negotiation process. Selecting the forum – identifying the most promising forum in which to

pursue one’s objectives and then ensuring that negotiations take place there.

Shaping the agenda – adding or removing issues from the agenda, dividing the larger agenda into modules for parallel negotiations, and establishing some high-level principles to govern the process.

Building coalitions – identifying potential winning and blocking coalitions and then devising plans for building supportive coalitions and breaking or forestalling opposing ones.

Leveraging linkages – linking and de-linking issues or sets of negotiations in order to create and claim value.

Playing the frame game – crafting a favorable framing of “the problem” and “the options”

Creating momentum – channeling the flow of the negotiations process in promising directions by establishing appropriate stages to take advantage of action forcing events.

http://www.petersoninstitute.org/publications/chapters_preview/392/02iie3624.pdf

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Wendy Jeffus

Harvard Summer School

9: The Foreign Exchange Market

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Definitions Foreign exchange market

– A market for converting the currency of one country into the currency of another.

Exchange rate– The rate at which one currency is converted into another

Foreign exchange risk– The risk that arises from changes in exchange rates

Spot exchange rate– Rate at which a dealer converts one currency into another

currency on a particular day Forward exchange rate

– An exchange rate governing future transactions (can be used to reduce foreign exchange risk)

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The FX Market The following participants operate within the FX market:

– Individuals (investors and tourists)

– Speculators and arbitragers

– Governments (central banks and treasuries)

– Brokers and dealers

– Businesses Payments for exports & purchases from foreign suppliers Foreign income (licensing, royalty payments, etc.) Investment/Speculation/Hedging activities

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FX Rates and Quotations Most foreign exchange transactions involve the US

dollar.

Professional dealers and brokers may state foreign exchange quotations in one of two ways:

– European Terms - the exchange rate between the US dollar and Japanese yen is stated in European terms by the WSJ below ¥106/$

– American Terms - the exchange rate between US dollars and the Japanese yen can also be stated in American terms $0094/¥.

http://markets.ft.com/markets/overview.asp, http://online.wsj.com/public/page/2_1569.html?mod=2_1569

FT vs. WSJ

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FX Quotations Be careful reading FX quotes, know which

currency is first.

Source: http://online.wsj.com/mdc/page/marketsdata.htmlhttp://finance.yahoo.com/currency-investing

¥/$

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FX Market Foreign Exchange Market (FX Market) World’s largest financial market ($2.5 trillion

average daily turnover) Open 24 hours a day, 6 days a week

– Sunday at 5pm (EST) to Friday 4:30pm (EST)

Sydney & Tokyo west to Hong Kong & Singapore to Bahrain to Frankfurt, Zurich, & London to New York to Chicago to San Francisco & LA

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Currency Hedging Volkswagen, Europe’s largest carmaker, reported a

95% drop in Q4’03 profits. Two causes stood out:

– The unprecedented rise in the value of the Euro against the dollar

– Volkswagen’s decision to only hedge 30% of its foreign currency exposure as opposed to the 70% it had traditionally hedged.

Example:– Suppose the Jetta costs €14,000 to manufacture & ship from

Germany to the U.S. where it sells for $15,000.– If the exchange rate is $1 = €1, VW earns €1,000 on the sale.– If the dollar depreciates to $1.25 = €1 (or $1 = 0.80€) the

$15,000 price will only convert to €12,000.– In other words, VW would lose €2,000 on every Jetta sold!

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Economic Theories of Exchange Rate Determination:

Exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another– Law of One Price– Purchasing Power Parity (PPP)– Money supply and price inflation– Investor psychology and “Bandwagon” effects

Exchange Rate Determination

Note: For additional information on exchange rates see: www.wendyjeffus.com,Exchange Rate Determination (A) and (B) under “International Finance”

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Law of One Price In competitive markets, identical products sold in

different countries should sell for the same price when their price is expressed in terms of the same currency.

– Assumptions: No transportation or other transaction costs No barriers to trade Tradable goods

Example: If the euro/dollar exchange rate is 0.78EUR/USD.

– A jacket selling for $50 in New York should retail for €39.24 in Paris ($50 x 0.78EUR/USD = €39.24)

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Example 1 You can rent a compact car in Washington, D.C. for

$31.99 You can rent a compact car in Bangkok, Thailand for

4000.00 BHT Therefore the exchange rate should be =

4000.00BHT/31.99USD = 125.04BHT/USD

Source: Avis.com

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PPP & The Law of One Price The implied exchange rate based on the

absolute theory of PPP is 4000.00BHT/31.99USD = 125.04BHT/USD

But the actual exchange rate today is 32.81BHT/USD.

Is the baht over or under valued vs. the dollar?

Calculate (implied – actual) / actual. 125.04 – 32.81 / 32.81 = 281% The baht is overvalued by 281% vs. the dollar.

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Example 2

http://www.burj-al-arab.com/ http://boston.langhamhotels.com/

You can enjoy a chocolate lunch for $30 per person at the Langham hotel in Boston.

You can enjoy a chocolate lunch for 250 AED per person at the Burj Al Arab hotel in Dubai.

Therefore the exchange rate should be 8.33AED/USD.

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PPP & The Law of One Price Given this information, the exchange rate should

be 8.33AED/USD. The actual exchange rate today is

3.6720AED/USD. Is the UAE Dirham over or under valued?

Calculate (implied – actual) / actual. 8.33 - 3.6720 / 3.6720 = 126% The UAE Dirham is overvalued by 126%.

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The Big Mac Hamburger Standard The Economist developed the Big Mac Standard

to track PPP:– Assuming that the Big Mac is identical in all countries,

it serves as a comparison point as to whether or not currencies are trading at market prices.

– A Big Mac in Switzerland costs Sfr6.30 while the same Big Mac in the US costs $2.54.

– The implied PPP of this exchange rate is:

$Sfr2.4803/ $2.54

Sfr6.30

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The Big Mac Hamburger Standard However, on the date of the survey, the actual

exchange rate was Sfr1.73/$, therefore the Swiss franc is overvalued by:

43.37% or 1.4337 Sfr1.73

Sfr2.4803

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Big Mac Index The Economist's Big Mac

index is based on the theory of purchasing-power parity.

– The cheapest burger is in China, where it costs $1.30, compared with an average American price of $3.15. This implies that the yuan is 69% undervalued.

– 3.15/1.30 = 2.46– Actual rate on 01/09

= 8.0680– 2.46/8.06 – 1 = -69%

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Memories of your class…

Submitted by BC Student (Costa Rica) 2009

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Latte Index The Economist asked: what

can the price of Starbucks coffee—now served in as many as 32 countries—tell us about exchange rates?

– The theory of purchasing-power parity (PPP) says that, in the long run, exchange rates should move towards levels that equalize the prices of a basket of goods and services in different countries—ie, a dollar should buy the same amount of stuff everywhere.

Source: “Burgers or beans?” Jan 15th 2004 The Economist A new theory is percolating through the foreign-exchange markets

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Interest Rates & Exchange Rates Theory says that interest rates reflect

expectations about future exchange rates.– Fisher Effect– International Fisher Effect

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Fisher Effect Fisher Effect A country’s “nominal” interest rate (i) is the sum

of the required “real” rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I).

i = r + I

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International Fisher Effect International Fisher Effect (IFE) For any two countries the spot exchange rate (S) should

change in an equal amount but in the opposite direction to the difference in nominal interest rates (i) between the two countries.

(S1 – S2)/S2 x 100 = i$ - i¥

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Interest Rates & Exchange Rates Why do these theories (generally) hold?

– Arbitrage.– In the following slide, a US dollar-based investor

with $1 million to invest, is shown to be indifferent between dollar-denominated securities for 90 days earning 8.00% per annum, or Swiss franc-denominated securities of similar risk and maturity earning 4.00% per annum, when a “cover” against currency risk is obtained with a forward contract.

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90 days

Dollar money market

Swiss franc money market

$1,000,000 $1,020,000$1,019,993*

S = SF 1.4800/$

SF 1,480,000 SF 1,494,800

F90 = SF 1.4655/$

x 1.01

x 1.02Start End

i $ = 8.00 % per annum(2.00 % per 90 days)

i SF = 4.00 % per annum(1.00 % per 90 days)

•Note that the Swiss franc investment yields $1,019,993, $7 less on a $1 million investment.

Exhibit 4.6 Interest Rate Parity

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Investor Psychology & Bandwagon Effects Evidence suggests that neither PPP nor the International

Fisher Effect are good at explaining short term movements in exchange rates

Explanation may be investor psychology and the bandwagon effect

– Investor Psychology Example: if the market is bullish on the dollar, then the dollar is likely

to strengthen versus other currencies.

– Bandwagon Effect Examples: Investors sell their positions to get out of a falling asset.

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Exchange Rate Forecasting Individuals that believe in the efficient market theory believe that

prices reflect all available public information– Forward rates should be unbiased predictors of future spot rates

Individuals that feel there is an inefficient market believe that prices do not reflect all available information

– Forward exchange rates will not be the best possible predictor of future spot exchange rates

– If this is true, it may be worthwhile for international businesses to invest in forecasting services

Approaches to Forecasting– Fundamental analysis

Draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements

– Technical analysis Uses price and volume data to determine trends

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Technical Analysis Where is the dollar headed versus the yuan?

Exhibit 8.1 Conceptual Comparison of Transaction, Operating and Accounting Foreign Exchange Exposure

Moment in time whenexchange rate changes

Translation(Accounting) exposure

Transaction exposure

(Economic) Operating exposure

Time

Changes in reported owners’ equityin consolidated financial statementscaused by a change in exchange rates

Change in expected future cash flows arising from an unexpected change inexchange rates

Impact of settling outstanding obligations entered into before changein exchange rates but to be settled after change in exchange rates

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Example: Transaction Exposure Suppose that CHC Helicopters of Canada[1] has billed British

Petroleum (BP) for services provided to BP’s sites on the North Sea.– CHC’s invoice is for £1 million, due in three months.

When CHC Helicopters receives £1 million three months from now, it will convert the British pounds into Canadian dollars at the spot rate.

[1] A “world leader in supply logistics to offshore oil rigs” Photo source: http://www.chc.ca/

Imagine the exchange rate at time 0 = 1GBP/1CAD

What are three things that can happen to the British pound over the next three months?

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The Life Span of a Transaction Exposure

t1 t2 t3 t4

Seller quotesa price to buyer

(in verbal or written form)

Buyer placesfirm order withseller at price

offered at time t1

Seller shipsproduct (or

performs service) and bills buyer

(becomes A/R for the seller)

Buyer settles A/Pwith cash in

amount of currencyquoted at time t1

QuotationExposure

BacklogExposure

BillingExposure

Time between quotinga price and reaching a

contractual sale

Time it takes tofill the order aftercontract is signed

Time it takes toget paid in cash after

A/R is issued

Time and Events

Source: Modified from Multinational Financial Management, 11th edition, Ch 8, Exhibit 8.3

CHC offers services to BP for £1M

BP accepts bid for £1M

CHC provides services and bills BP £1M

t = 0Spot Rate(known)

t = 3 monthsSpot Rate(unknown)

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Example: Transaction Exposure Suppose that CHC Helicopters of Canada[1] has billed British

Petroleum (BP) for services provided to BP’s sites on the North Sea.– CHC’s invoice is for £1 million, due in three months.

When CHC Helicopters receives £1 million three months from now, it will convert the British pounds into Canadian dollars at the spot rate.

Core Issue:– The future spot rate cannot be known in advance. Consequently, in

terms of the CAD, the value of the settlement is uncertain. – If CHC Helicopter does nothing to address this uncertainty, it is

effectively speculating on the future course of the exchange rate. Doing nothing is as if CHC is willing to take a bet that the British pound will appreciate against the Canadian dollar.

[1] A “world leader in supply logistics to offshore oil rigs” Photo source: http://www.chc.ca/

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Risk-sharing Risk-sharing is a contractual arrangement in which the

buyer and seller agree to “share” or split currency movement impacts.

– Example: Ford purchases from Mazda in Japanese yen at the current spot rate as long as the spot rate is between ¥115/$ and ¥125/$.

If the spot rate falls outside of this range, Ford and Mazda will share the difference equally.

Photo source: http://www.mitsubishicars.com “Eclipse Spider”

Mazda(Japan)

Ford(U.S.)

¥115 ¥125parts

cash

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Risk-sharing: Example Ford purchases from Mazda in Japanese yen at the current spot rate as long

as the spot rate is between ¥115/$ and ¥125/$ -- and if the spot rate falls outside of this range, Ford and Mazda will share the difference equally.

…So if on the date of invoice for a ¥25M payment, the spot rate is ¥110/$, then Mazda would agree to accept the following amount from Ford:

Note that this movement is in Mazda’s favor but it didn’t cost Ford as much as it could have (Ford saved $5,050)…

¥25,000,000 ¥25,000,000$222,222

¥5.00/$ ¥112.50/$¥115.00/$ - 2

¥115 ¥125Mazda(Japan)

Ford(U.S.)

¥110/$

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Reducing FX Exposure Reducing Translation and Transaction Exposure

– These tactics are primarily designed to protect short-term cash flows from adverse changes in exchange rates

Firms can use a lead strategy – Attempt to collect foreign currency receivables when a foreign currency

is expected to depreciate Expect foreign depreciation: Collect Early

– Paying foreign currency payables before they are due when a currency is expected to appreciate

Expect foreign appreciation: Pay Early Firms can use a lag strategy

– Attempt to delay the collection of foreign currency receivables if that currency is expected to appreciate

Expect foreign appreciation: Collect Late– Delay paying foreign currency payables if the currency is expected to

depreciate Expect foreign depreciation: Pay Late

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Why Hedge?1. Risk aversion.

– Maybe you would prefer a sure $10 million over a 50/50 chance at $20 million.

2. Focus on the business of the company rather than “currency speculation” which makes available cash more volatile and takes resources away from the core business.

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Hedging Pros & ConsArguments Against Hedging Shareholders are much more

capable of diversifying currency risk than the management of the firm

Currency risk management does not increase the expected cash flows of the firm

Management often conducts hedging activities that benefit management at the expense of the shareholders (agency conflict)

Managers cannot outguess the market

Arguments Supporting Hedging Reducing the risk of future cash

flows improves the planning capability of the firm

…and the likelihood that the firm’s cash flows will fall below a necessary minimum (the point of financial distress)

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Management is in better position to take advantage of disequilibrium conditions in the market

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Other Steps Central control of exposure

– to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies

Forecasts of future exchange rate movements Establish good reporting systems & monthly FX

exposure reports.– so the central finance function can regularly monitor the firm’s

exposure positions.

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Currency Convertibility In some countries the ability to convert currency is restricted by the

government. Government restrictions can include

– A restriction on residents’ ability to convert the domestic currency into a foreign currency

– Restricting domestic businesses’ ability to take foreign currency out of the country

Governments will limit or restrict convertibility for a number of reasons that include:

– Preserving foreign exchange reserves– A fear that free convertibility will lead to a run on their foreign exchange

reserves – known as capital flight

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Implications for Managers It is critical that international businesses

understand the influence of exchange rates on the profitability of trade and investment deals – Adverse changes in exchange rates can make

apparently profitable deals unprofitable And remember to: “think outside of the box”

For your final projects: know the currency, determine if it is fixed or floating, report whether it is expected to strengthen or depreciate, and discuss the impact on your investment.

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Congratulations – SPAIN!

http://www.youtube.com/watch?v=jS7O9RhNa18