Unit 2

International trade theory, FDI and Foreign Exchange

Market

Objetives

1. Examine Porter’s and other theories related to trade flows between nations.

2. Analyze the implications that international trade holds in business practices and management.

3. Be familiar with current trends regarding FDI in the world economy.

4. Understand the benefits of FDI for the home and host country.

5. Define the terms foreign exchange market and exchange rate.

6. Understand the functions of foreign exchange market and currency conversion.

7. Analyze the implications of foreign exchange exposure.

International Trade Theory

• Free trade.

• Trade theory shows why it is beneficial for a country.

• International trade allows a country

• Easy to explain.

• Mercantilist philosophy.

• Smith, Ricardo, and Heckscher-Ohlin promote unrestricted free trade

• New trade theory and Porter’s theory of national competitive advantage.

What Is Mercantilism?

• Mercantilism suggests that the best interest to export more than it imports.

• Mercantilism views trade as a zero-sum game - one in which a gain by one

country results in a loss by another

What Is Smith’s Theory Of Absolute Advantage?

• The country has an absolute advantage.

Is Unrestricted Free Trade Always Beneficial?

• Unrestricted free trade is beneficial, but the gains may not be as great as

the simple model of comparative advantage would suggest.

• Opening a country to trade could increase.

Could A Rich Country Be Worse Off With Free Trade?

• Paul Samuelson, the dynamic gains from trade may not always be

beneficial.

• The ability to offshore services jobs.

• Protectionist measures could create a more harmful situation than free

trade.

What Is The Heckscher-Ohlin Theory?

• Eli Heckscher and Bertil Ohlin - comparative advantage arises from

differences in national factor endowments – the extent to which a country

is endowed with resources like land, labor, and capital.

Does The Heckscher-Ohlin Theory Hold?

• Wassily Leontief theorized that since the U.S. was relatively abundant in

capital compared to other nations, the U.S. would be an exporter of capital

intensive goods and an importer of labor-intensive goods.

• However, he found that U.S. exports were less capital intensive than U.S.

imports

• Since this result was at variance with the predictions of trade theory, it

became known as the Leontief Paradox

What Is The Product Life Cycle Theory?

• Production facilities.

• As the market in the U.S. and other advanced nations matured, the product

would become more standardized, and price the main competitive weapon.

• Producers based in advanced countries.

• If cost pressures were intense, developing countries would acquire a

production advantage over advanced countries.

• Production became concentrated in lower-cost foreign locations.

What Is New Trade Theory?

• New trade theory suggests that the ability of firms to gain economies of

scale.

• Through its impact on economies of scale, trade can increase the variety

of goods available to consumers and decrease the average cost of those

goods.

1. In those industries when output required to attain economies of scale

represents a significant proportion of total world demand, the global

market may only be able to support a small number of enterprises.

2. In those industries when output required to attain economies of scale

represents a significant proportion of total world demand, the global

market may only be able to support a small number of enterprises.

What Is Porter’s Diamond Of Competitive Advantage?

• Michael Porter tried to explain why a nation achieves international success in a particular industry and identified four attributes that promote or impede the creation of competitive advantage.

1. Factor endowments - a nation’s position in factors of production necessary to compete in a given industry.

2. Demand conditions - the nature of home demand for the industry’s product or service.

3. Relating and supporting industries - the presence or absence of supplier

industries and related industries that are internationally competitive.

4. Firm strategy, structure, and rivalry - the conditions governing how

companies are created, organized, and managed, and the nature of

domestic rivalry.

What Are The Implications Of Trade Theory For Managers?

What Is The Balance Of Payments?

Is A Current Account Deficit Bad?

1. Location implications.

2. First-mover implications.

3. Policy implications.

• Balance of payments accounts.• The current account records transactions that pertain to goods, services,

and income, receipts and payments. 1. The capital account records one time changes in the stock of assets.2. The financial account records transactions that involve the purchase or

sale of assets.

• Does current account deficit in the United States matter?

• a current account deficit implies a net debtor

• A dollar crisis could occur

What Is The Source Of FDI?

• Since World War II, the U.S. has been the largest source country for FDI.

Why Do Firms Choose Acquisition Versus Greenfield Investments?

• Most cross-border investment is in the form of mergers and acquisitions

rather than greenfield investments.

• Firms prefer to acquire existing assets because.

Why Choose FDI?

1. Exporting - producing goods at home and then shipping them to the receiving country for sale.

2. Licensing - granting a foreign entity the right to produce and sell the firm’s product in return for a royalty fee on every unit that the foreign entity sells.

What Are The TheoreticalApproaches To FDI?

• The radical view - the MNE is an instrument of imperialist domination and a tool for exploiting host countries to the exclusive benefit of their capitalist-imperialist home countries

• The free market view- international production should be distributed among countries according to the theory of comparative advantage

• Pragmatic nationalism - FDI has both benefits (inflows of capital, technology, skills and jobs) and costs (repatriation of profits to the home country and a negative balance of payments effect).

• Recently, there has been a strong shift toward the free market stance creating.

Benefits Host Country

CostHost Country

Benefits Home Country

CostHome Country

Government’s Influence

International Institutions’ Influence

Managers

Resource transfer effects

Adverse effects of FDI on competition within the host nation

Effect on the capital account

The home country’s balance of payments can suffer

Governments can encourage outward FDI

1990s, there was no consistent involvement by multinational institutions

Consider what trade theory implies about FDI

Employment effects

Adverse effects on the balance of payments

Employment effects

Employment may also be negatively affected if the FDI

Governments can restrict outward/inward FDI

Today, the World Trade Organization is changing this by trying to establish a universal set of rules designed to promote the liberalization of FDI

The direction of FDI can be explained through the location-specific advantages argument associated with John Dunning

Balance of payments effects

Perceived loss of national sovereignty and autonomy

Gains from learning valuable skills from foreign markets

Governments can encourage inward FDI

An important variable in decisions about where to locate foreign production facilities

What Is The Nature Of The Foreign Exchange Market?

• The foreign exchange market is a global network of banks, brokers, and foreign

exchange dealers connected by electronic communications systems.

• The foreign exchange market.

• The exchange rate is the rate at which one currency is converted into another

• Events in the foreign exchange market affect firm sales, profits, and strategy

Importance

When Do Firms Use The Foreign Exchange Market?

• The payments they receive for exports, the income they receive from foreign investments.

• They must pay a foreign company for its products or services in its country’s currency.

• They have spare cash that they wish to invest for short terms in money markets.

How Can Firms Hedge Against Foreign Exchange Risk?

• The foreign exchange market provides insurance to protect against foreign

exchange risk - the possibility that unpredicted changes in future exchange

rates will have adverse consequences for the firm

• A firm that insures itself against foreign exchange risk is hedging

• To insure or hedge against a possible adverse foreign exchange rate

movement, firms engage in forward exchanges - two parties agree to

exchange currency and execute the deal at some specific date in the future

What Is The Difference Between Spot Rates And Forward Rates?

• The spot exchange rate is the rate at which a foreign exchange dealer

converts one currency into another currency on a particular day.

• A forward exchange rate is the rate used for hedging in the forward

market.

What Is A Currency Swap?

• A currency swap is the simultaneous purchase and sale of a given amount

of foreign exchange for two different value dates.

• Swaps are transacted.

How Are Exchange Rates Determined?• Exchange rates are determined by the demand and supply for different

currencies.

1. A country’s price inflation.

2. A country’s interest rate.

3. Market psychology.

How Do Prices Influence Exchange Rates?• Law of one price.

• Purchasing power parity theory.

• A positive relationship exists between the inflation rate and the level of money supply

• When the growth in the money supply is greater than the growth in output, inflation will occur

• PPP theory suggests that changes in relative prices between countries will lead to exchange rate changes, at least in the short run

How Do Interest Rates Influence Exchange Rates?

• International Fisher Effect.

• In other words:

(S1 - S2) / S2 x 100 = i $ - i ¥

• Where i $ and i ¥ are the respective nominal interest rates in two countries

(in this case the US and Japan), S1 is the spot exchange rate at the beginning

of the period and S2 is the spot exchange rate at the end of the period.

How Does Investor Psychology Influence Exchange Rates?• Bandwagon effect.

Should Companies Use Exchange Rate Forecasting Services?• There are two schools of thought

1. Efficient market school.

2. Inefficient market school.How Are Exchange Rates Predicted?• There are two schools of thought on forecasting

1. Fundamental analysis.

2. Technical analysis.

Are All Currencies Freely Convertible?• Freely convertible.

• Externally convertible.

• Nonconvertible.

• Capital flight.

• Countertrade.What Do Exchange Rates Mean For Managers?1. Transaction exposure.

2. Translation exposure.

3. Economic exposure.How Can Managers Minimize Exchange Rate Risk?• Lead strategy.

• Lag strategy.

Activities To be evaluated %

Forum: International trade theoryIs free trade fair? Why or why not?What are the potential costs of adopting a free trade regime? Do you think governments should do anything to reduce these costs? What?

Interventions: content, consistent with the discussion topic and argument.

10%

Study Case: Management Focus on Cemex. Answer the following questions:What value does Cemex bring to the host economy? Can you see any drawbacks of Cemex’s inward investment in an economy?Define a Greenfield Venture.Cemex has a strong preference for acquisitions over Greenfield ventures as an entry mode. Why?

Structure, content, grammar, coherence, argument and analysis.

10%

Group work: Watch and discuss one of the following videos:FDI in Sudanese Oil Changes – Sudanese Economy.U.S. Farmers respond to CAFTA.China: Changing the Yuan/Dolar. Write on one page document the outcomes of your discussion, and present them in a videoconference.

Structure, content, grammar, consistent with the topic of the video and argument.

10%