UGBA 178: Introduction to International

BusinessSpring 2009 Midterm Review

Nelda GabbayErik 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 TheoryChapter 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 TheoryChapter 4: Absolute Advantage (Adam Smith)

200 units of resources

In tons

International Trade TheoryChapter 4: Comparative Advantage (David Ricardo)

200 units of resources

In tons

International Trade TheoryChapter 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 TheoryChapter 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 TheoryChapter 4: Porter’s Diamond

Foreign Direct InvestmentChapter 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

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 InvestmentChapter 7: Why the increase in both the flow and stock of FDI in the world economy over the last 30 years?

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

Foreign Direct InvestmentChapter 7: Who’s got the FDI?

Purchasing Power ParityChapter 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 ParityChapter 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 EffectChapter 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 EffectChapter 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 RatesChapter 9Suppose 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 DOWNDollar 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 LingoChapter 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?