Transcript UGBA 178: Introduction to International Business

UGBA 178: Introduction
to International
Business
Spring 2009 Midterm Review
Nelda Gabbay
Erik Kiewiet de Jonge
Where we’re headed today…
 Overview of major trade theories
 Foreign Direct Investment (FDI)
 Purchasing Power Parity (PPP)
 The Fisher Effect and The International Fisher Effect
 Balance of Payments and Exchange Rates
 FX Lingo
 Questions
International Trade Theory
Chapter 4
Focus on understanding the central concepts of the most
widely recognized trade theories:
 Mercantilism
 Absolute Advantage
 Comparative Advantage
 Heckscher-Ohlin Theory
 New Trade Theory
 Porter’s Diamond
International Trade Theory
Chapter 4: Absolute Advantage (Adam Smith)
200 units of
resources
In tons
International Trade Theory
Chapter 4: Comparative Advantage (David Ricardo)
200 units of
resources
In tons
International Trade Theory
Chapter 4: Hecksher-Ohlin Theory
 Comparative advantage rises from factor endowments
 Nations have varying factor endowments
 Beware the Leontief Paradox: theories sound great on
paper, but do they actually work in practice?
 Case in point: The US exports many skill and innovation
intensive products and imports many capital intensive
products, despite having a large capital stock (and great
technology to boot!)
International Trade Theory
Chapter 4: New Trade Theory
 Suggests that the ability of firms to gain economies of
scale can have important implications for international
trade
 First movers to capture significant economies of scale
may gain scale-based competitive advantage
 Ability to attain economies of scale may trump other
advantages for countries
 All this suggests that for some industries, the world
market may only be able support a limited number of
firms
International Trade Theory
Chapter 4: Porter’s Diamond
Foreign Direct Investment
Chapter 7: What is it?
 Occurs when a firm invests directly in new facilities to
produce and/or market in a foreign country
 Must have controlling stake in foreign operations
 E.g., Haier in Cali, Toyota in Kentucky, GM in Shenyang
 Once a firm undertakes FDI it becomes a multinational
enterprise
Foreign Direct Investment
Chapter 7: Why the increase in both the flow and stock of FDI
in the world economy over the last 30 years?
 Firms still fear the threat of protectionism
 The general shift toward democratic political institutions and
free market economies has encouraged FDI
 The globalization of the world economy is having a positive
impact on the volume of FDI as firms undertake FDI to
ensure they have a significant presence in many regions of
the world
Foreign Direct Investment
Chapter 7: Who’s got the FDI?
 Most FDI has historically been directed at the developed
nations of the world, with the United States being a favorite
target
 FDI inflows have remained high during the early 2000s for
the United States, and also for the European Union
 South, East, and Southeast Asia, and particularly China, are
now seeing an increase of FDI inflows
 Latin America is also emerging as an important region for
FDI
Purchasing Power Parity
Chapter 9
 PPP theory argues that given relatively efficient markets, the
price of a “basket of goods” should be roughly equivalent in
each country.
 For example, in the US, this basket costs $100. How much,
according to PPP, would this basket cost in Japan if $1 = ¥ 98?
 Basket = $100  $1 x 100 x 98 ¥/$  ¥ 9,800
 If the basket costs ¥ 10,780 a year later (still $100 in the US),
what must happen to exchange rates?
 ¥ depreciates relative to the $, since Japanese prices rose by
10%. The new exchange rate will be $1 = ¥ 107.8
Purchasing Power Parity
Chapter 9
 Or, mathematically:
E$/¥ = P$/P¥
 In essence, PPP predicts that changes in relative prices will
result in changes in exchange rates:
 e.g., If prices rise in the US by 10% while prices remain
constant in the Eurozone, PPP predicts that the Euro will
appreciate by 10% relative to the dollar.
 Inflation causes currencies to depreciate. High inflation in
Mexico will cause the peso to depreciate vis-à-vis the dollar.
 For fun, The Economist’s Big Mac Index provides a simplified
and informative take on PPP
The Fisher Effect
Chapter 9: Interest Rates and Exchange Rates
 The Fisher Effect states that a country’s nominal
interest rate (i) is the sum of the required real rate of
interest (r) and the expected rate of inflation (I) over the
lending period:
i=r+I
 Thus, you can see the relation between interest
rates and inflation.
 Let’s take this international…
The International Fisher Effect
Chapter 9: Interest Rates and Exchange Rates
The International Fisher Effect states that for any two
countries the spot exchange rate should change in an
equal amount but in the opposite direction to the
difference in nominal interest rates between two
countries. In other words:
(S1 - S2) / S2 x 100 = i $ - i ¥
If the US has i = 10% and Japan has i = 6%, we would
expect?
…The dollar to depreciate by 4% against the yen (don’t
worry about the equation for the midterm).
Balance of Payments and Exchange Rates
Chapter 9
 Suppose a country runs a trade deficit for several years
(imports more than exports) (e.g., US)
 Foreigners accumulate currency ($)
 Foreigners want to buy stuff in their own country and need




their own currency to do so.
How to they get it? Covert! Use dollars to buy foreign
currency.
Supply of dollars UP, foreign currency supply DOWN
Dollar depreciates, foreign currency appreciates.
NOTE: Not a perfect explanation – don’t forget about
interest rates! If the US has relatively high interest rates,
foreigners may hold those dollars (probably in assets like
US Treasuries, stocks, bonds, real estate, etc.) This won’t
depreciate the dollar and may have the opposite effect.
Foreign Exchange Lingo
Chapter 9
 Spot Contract/Rate: the “here and now” FX rate
 Forward Contract: “I’ll sell you € at Day 30 for € = $1.30”
 Currency Swap: simultaneous purchase and sale of a given
amount of exchange for two different value dates:
 Today’s spot is $1 = ¥120 and the 90-day forward is $1 = ¥110.
 Step 1: Sell $1M to bank for ¥120M today.
 Step 2: Enter forward contract to convert ¥120M to $.
 Step 3: Time passes, receive $1.09M (¥120M/110)
 What happened? Yen was trading at a premium on the 90-day
forward market, so firm gains by buying low, selling high.
Questions?