Chapters 1, 2, 3: MNCs, International Monetary Systems, and Exchange Rate Determination
Week 1 Readings (Shapiro, 10E)
Chapter 1 – Introduction: Multinational Enterprise and Multinational Financial Management
1.1 The Rise of the Multinational Corporation: p. 2-7
1.2 The Internationalization of Business and Finance
Appendix 1A: The Origins and Consequences of International Trade Chapter 2 – The Determination of Exchange Rates
2.1 Setting the Equilibrium Spot Exchange Rate
2.2 Expectations and the Asset Market Model of Exchange Rates – only content covered in lecture
2.3 The Fundamentals of Central Bank Intervention – only content covered in lecture Chapter 3 – The International Monetary System
3.1 Alternative Exchange Rate Systems
3.2 A Brief History of the International Monetary System – only content covered in lecture
3.3 The European Monetary System and Monetary Union – only content covered in lecture
3.4 Emerging Market Currency Crises – only content covered in lecture Note: “only content covered in lecture” does not imply you can skip these parts of the book – it means you only have to know the concepts and theories explained in the lectures.
Week 2 Tutorial Questions
MNCs: Conceptual Question 8a, 9, 10
Appendix 1A: Question 3
Exchange Rate Changes: Conceptual Questions 1, 2, 3
Currency Appreciation/Depreciation: Problems 1, 2, 3, 4, 5
Exchange Rate Systems: Conceptual Question 1
Cross-Exchange Rates & Target-Zone Systems: Problems 1, 2Chapter 1
8.a. Are multinational firms riskier than purely domestic firms?
ANSWER. Although multinational corporations are confronted with many added risks when venturing overseas, they can also take advantage of international diversification to reduce their overall riskiness.
We will also see in Chapter 16 that foreign operations enable MNCs to retaliate against foreign competitive intrusions in the domestic market and to more closely track their foreign competitors,reducing the risk of being blind sided by new developments overseas.
- Is there any reason to believe that MNCs may be less risky than purely domestic firms? Explain.
ANSWER. Yes. International diversification may actually allow firms to reduce the total risk they face.
Much of the general market risk facing a company is related to the cyclical nature of the domestic economy of the home country. Operating in a number of nations whose economic cycles are not perfectly in phase may, therefore, reduce the overall variability of the firm’s earnings. Thus, even though the riskiness of operating in any one country may exceed the risk of operating in the United States (or other home country), much of that risk is eliminated through diversification. In fact, as shown in Chapter 15, the variability of earnings appears to decline as firms become more internationally oriented.
- In what ways do financial markets grade government economic policies?
ANSWER. Traders and their customers receive a continuing flow of news from around the world. The announcement of a new policy leads traders to buy or sell currency, stocks or bonds based on their evaluation of the effect of that policy on the market. A desirable policy leads them to buy more of the assets favorably affected by the policy, while a policy that is judged to be harmful leads to sell orders of those assets that will be hurt by the policy. The result is a continuing global referendum on a nation’s economic policies, even before they are implemented.
Politicians who pursue particular economic policies that they perceive to be beneficial to them (e.g., by improving their re-election odds), even if these policies harm the national economy, usually don’t appreciate the grades they receive. But the market’s judgments are clear-eyed and hard-nosed and will respond negatively to unsound fiscal and monetary policies. Politicians will not admit that it was their own policies that led to higher interest rates or lower currency values or stock prices; that would be political suicide. It is much easier to blame greedy speculators rather than their policies for the market’s response.
Appendix 1A: Question 3
Given the resources available to them, countries A and B can produce the following combinations of steel and corn.
a.Do you expect trade to take place between countries A and B? Why?
ANSWER. Yes. Given the data presented, we can see that if country A has 6 units of resources and it devotes X of these units to steel production, where X is an integer, it can produce a total of 6X tons of steel and 3(6 – X) bushels of corn Similarly, with 54 units of resources, country B of which it devotes Y units to steel production, it can produce Y tons of steel plus (54 – Y) bushels of corn. The net effect of these production functions is that one bushel of corn is worth 2 tons of steel in country A. In contrast, one bushel of corn is worth only one ton of steel in country B. These relative prices indicate that country A has a comparative advantage in the production of steel, whereas B has a comparative advantage in the production of corn.
b.Which country will export steel? Which will export corn? Explain.
ANSWER. Given these comparative advantages, A will export steel and B will export corn.
The price of corn will settle somewhere between one and two tons of steel. Suppose it settles at 1.5 tons of steel. Then, instead of producing, say, 30 tons of steel and 3 bushels of corn, it can devote an additional resource unit to the production of an additional 6 tons of steel. It can trade these 6 tons of steel with B for 6/1.5 = 4 bushels of corn, leaving it one bushel of corn better off. Similarly, B can now get 6 tons of steel for the 4 bushels of corn it trades to A instead of the 4 tons of steel it could produce on its own with the resources it took to produce the 4 bushels of corn.
Chapter 2, Question 1
- Describe how these three typical transactions should affect present and future exchange rates.
a.Joseph E. Seagram & Sons imports a year’s supply of French champagne. Payment in euros is due immediately.
ANSWER. The euro should appreciate relative to the dollar since demand for euros is rising.
b.MCI sells a new stock issue to Alcatel, the French telecommunications company. Payment in dollars is due immediately.
ANSWER. The spot value of the dollar should increase as Alcatel demands dollars to pay for the new stock issue. The future value of the dollar should decline as dividend payments are sent to Alcatel and other Alcatel equipment and parts are imported. However, the value of the dollar in the future could increase if expanded MCI output substitutes for telecom imports.
c.Korean Airlines buys five Boeing 747s. As part of the deal, Boeing arranges a loan to KAL for the purchase amount from the U.S. Export Import Bank. The loan is to be paid back over the next seven years with a two year grace period.
ANSWER. The spot price of the dollar should be unaffected. The future price of the dollar should increase as KAL repays the loan.
Chapter 2, Question 2
- The maintenance of money’s value is said to depend on the monetary authorities. What might the monetary authorities do to a currency that would cause its value to drop?
ANSWER. The value of any good or asset is driven by its scarcity. What the monetary authorities could do is to make money less scarce by issuing more of it. This would lower its scarcity value. Even though its nominal value will always be the same, the added supply will reduce the purchasing power per unit of money.
Chapter 2, Question 3
- For each of the following six scenarios, say whether the value of the dollar will appreciate, depreciate, or remain the same relative to the Japanese yen. Explain each answer. Assume that exchange rates are free to vary and that other factors are held constant.
a.The growth rate of national income is higher in the United States than in Japan.
ANSWER. The value of the dollar should rise as more rapidly rising GNP in the United States leads to a relative increase in demand for dollars.
b.Inflation is higher in the U.S. than in Japan.
ANSWER. The value of the dollar should fall in line with purchasing power parity.
c.Prices in Japan and the United States are rising at the same rate.
ANSWER. The exchange rate should remain the same.
d.Real interest rates are higher in the United States than in Japan.
ANSWER. The value of the dollar should rise as the higher real rates attract capital from Japan that must first be converted into dollars.
e.The United States imposes new restrictions on the ability of foreigners to buy American companies and real estate.
ANSWER. The value of the dollar should fall as foreigners find it less attractive to own U.S. assets.
f.U.S. wages rise relative to Japanese wages, and American productivity falls behind Japanese productivity.
ANSWER. Higher U.S. wages and declining relative productivity weaken the American economy and make it less attractive for investment purposes. Assuming that a weak economy leads to a weak currency, the dollar will fall. From a somewhat different perspective, when a nation’s productivity growth lags behind that of its major trading partners, the other countries will become more depreciating currency is the market’s way of restoring balance. The lagging country regains its balance, but only by accepting a lower real price for its goods. In effect, the cheaper currency is the market’s way of cutting wages in the lagging country.
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