ICF Final exam material PDF

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Warning: TT: undefined function: 32 ICF Final exam materialTopic 1a. Multinational Enterprise - Globalization (including digital): implications for domestic and international companies - Multinational enterprise (MNE): definition, opportunities and challenges - Rationale for multinational corporatio...

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ICF Final exam material Topic 1a. Multinational Enterprise • Globalization (including digital): implications for domestic and international companies • Multinational enterprise (MNE): definition, opportunities and challenges • Rationale for multinational corporations • Risks and opportunities of MNC vs. domestic firm • Different modes of foreign engagement (exporting, licencing, FDIs including greenfield and M&A) - benefits and risks • New Zealand: level of international involvement •

What are the implications of (digital) globalization for international and domestic companies? - (Free trade allocates resources to their highest valued use) - (Globalization fosters creative destruction) - Companies must be able to quickly adapt their policies to respond to new global market opportunities and challenges - More financial options but also increasing complexity (due to international mobility of capital) - Global managers need in-depth knowledge of their operations + industry - Global managers have to understand the economic + political choices facing key nations and how those choices affect the outcomes of their decisions - Implications domestic firms: - Exposure to foreign competition in the domestic market - Import & export of products, components and services - Indirect exposure to international risks through relationships with customers and suppliers

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Name four strategic reasons for a firm to invest in a foreign country. Explain the rationale behind each of the reasons named. 1. Market seekers - MNC’s firm-specific advantages can be profitably applied to foreign markets - Achieve economies of scale + exploit premiums associated with strong brand names - Exploitation of foreign markets possible at lower costs 2. Production efficiency seekers / cost minimizers - Costs can be minimized by combining production shifts with rationalization and integration of the firm’s global manufacturing facilities - Factors of production are undervalued 3. Raw material seekers - Exploit raw materials found in foreign countries 4. Knowledge seekers - Gain information and experience in other markets 5. Political safety seekers - Operate in countries that are considered unlikely to expropriate or interfere with private business

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Uncertainty in country due to actions of government, high political risk in home country; probability of war, potential regulations

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Are multinational firms riskier than purely domestic firms? Explain. Multinational firms may be less risky than domestic firms if the added risks of operating overseas (e.g. foreign exchange risk, foreign country political risk) are more than offset by the ability to operate in countries whose economic cycles are not perfectly in phase.

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Explain why setting up production facilities abroad (=become MNE) might lead to expanded sales in the foreign market and greater profitability of the firm. Becoming an MNE implies new investment opportunities (new consumer markets), could lead to reduced operating costs and higher returns (access to cheaper resources, economy of scales, flexibility) and a potential reduced cost of capital due to access to the global capital market. When production facilities are set up abroad, firms are able to exploit such competitive factors as economy of scale, managerial and technological expertise, product differentiation and financial strength. Also, firms can keep abreast of market conditions and adapt products to changing local tastes and conditions, faster order fulfillment and ability to provide more comprehensive after-sales service, convey commitment to local market and ensure certainty of supply. Trade barriers are overcome (tariffs, quotas and transportation costs). What are the benefits and risks of exporting a company's product to a foreign country versus establishing its own overseas production (=become MNE)? - Benefits: - Exporting has none of the unique risks facing licensing and FDI and with minimal political risks - typically lower amount of front-end investment than other modes of foreign involvement - Risks: - Risks of losing markets to imitators and global competitors - Potentially lower profits

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Topic 1b. Introduction to Foreign exchange • Foreign exchange rates • – Direct vs. indirect quotes • – Appreciation (depreciation) of currencies; strong vs. weak currency • – Determination of exchange rates; demand and supply for currency • – Calculate % changes in the value of foreign currency (for direct and indirect quotes)

Topic 2. The Foreign Exchange Market • Foreign exchange market: size, geographic extent, major currencies • FX market participants (banks and non-bank dealers, firms and individuals, speculators and arbitragers, central banks and treasuries) • Types of transactions: spot, forward, swap • Bid and ask prices, bid-ask spread, determinants of the bid ask spread • Cross-rates (including using bid and ask prices) • Identify arbitrage opportunities in foreign exchange – bilateral arbitrage and triangular arbitrage; calculate profit from triangular arbitrage • Calculate forward premium/ discount • Major vs. minor currencies •

What is a foreign exchange dealer/ market maker? Foreign exchange dealers serve as intermediaries in the foreign exchange market by exchanging currencies desired by MNCs or individuals. A foreign exchange dealer can be a bank or nonbank foreign exchange dealer operating in the interbank and client markets. They make profit through buying currency at lower rate (bid rate) and sell currency at a higher rate (offer/ask rate). Dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies. Foreign exchange dealers trade on behalf of the customer and seek the bid/ask spread.

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What is a role of a Central bank in the foreign exchange market? Central banks use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded. They may act to support the value of their own currency. The motive is not to earn profit as such, but rather to influence the foreign exchange value of their currency in a manner that will benefit the interests of their citizens.

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What are the determinants of bid-ask spread in FX market? - Currency liquidity: higher liquidity -> lower spread - Currency risk: higher risk -> higher spread • Order costs (+) Order costs are the costs of processing orders; these costs include clearing costs and the costs of recording transactions. • Inventory costs (+) Inventory costs are the costs of maintaining an inventory of a particular currency. Holding an inventory involves an opportunity cost because the funds could have been used for some other purpose. If interest rates are relatively high, then the opportunity cost of holding an inventory should be relatively high. The higher the inventory costs, the larger the spread that will be established to cover these costs. • Competition (-) The more intense the competition, the smaller the spread quoted by intermediaries. Competition is more intense for the more widely traded currencies because there is more business in those currencies. The establishment of trading platforms that allow MNCs to trade directly with each other is a form of competition against foreign

exchange dealers, and it has forced dealers to reduce their spread in order to remain competitive. • Volume (-) Currencies that are more liquid are less likely to experience a sudden change in price. Currencies that have a large trading volume are more liquid because there are numerous buyers and sellers at any given time. This means that the market has enough depth that a few large transactions are unlikely to cause the currency’s price to change abruptly. • Currency risk (+) Some currencies exhibit more volatility than others because of economic or political conditions that cause the demand for and supply of the currency to change abruptly. For example, currencies in countries that have frequent political crises are subject to sudden price movements. Intermediaries that are willing to buy or sell these currencies could incur large losses due to such changes in their value. •

What is forward transaction in FX market? Provide an example. A forward transaction requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. It implies a forward rate, which is the price at which currencies are quoted for delivery at a specified future date. The exchange rate is established at the time of agreement, but payment and delivery are not required until maturity. Exchange rate risk is eliminated by locking in a known future exchange rate.

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What is swap transaction in FX market? Provide an example. FX swap transactions involve a package of spot (currencies are traded for immediate delivery) and forward transactions (contracts are made to buy or sell currencies for future delivery). A swap transaction involves a spot transaction along with a corresponding forward contract that will ultimately reverse the spot transaction.

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Explain how a trader can profit in FX markets using triangular arbitrage. Provide a numerical example. Using triangular arbitrage, traders take advantage of exchange rate inconsistencies in different money markets by buying a currency in one market and simultaneously selling it in another. A triangular arbitrage opportunity occurs if the quoted cross-rate between two currencies is higher or lower than the cross-rate implied by the exchange rates of the two currencies against a third currency.

Explain how the developments in technology in the recent decades have affected foreign exchange trading. Electronic trading systems o first created in 1992 o enable automatic matching and execution of foreign exchange transactions •

reduce cost of trading by eliminating brokers and reducing the number of transactions traders had to engage in to obtain market prices o gather and publish information on prices and quantities of currencies as they are traded o provide opportunities for algorithmic and high frequency trading ¨ HFT (a subset of algorithmic trading (AT)) is a strategy for which trade execution is performed electronically at extraordinary high speed. o ¨ Features of HFT: o Automated orders and order management; no human intervention o Observe markets and process information in real time o Trade execution times are measured in microseconds o Huge number of orders and cancelations o Short holding periods; zero positions at the end of the day o Trade very liquid instruments o

Topic 3. International Monetary System • Floating vs. fixed exchange rate regime – The role of government / central bank • Brief history – Gold standard – Bretton Woods Agreement – Contemporary currency regimes • Trilemma (Impossible trinity) – Monetary independence, exchange rate stability, capital market integration • Euro •

Explain the differences between fixed and floating exchange rate regimes. What are the costs and benefits associated with each of these currency regimes? In a fixed regime, the government (central bank) sets a fixed (or pegged) rate and maintains this rate as the official exchange rate. It is determined against a major world currency. In order to maintain the local exchange rate, the CB buys and sells its own currency on the forex market in return for the currency to which it is pegged. In order to maintain the rate, the CB must keep a high level of foreign reserves. The costs imply the need for CBs to maintain large quantities of hard currencies and gold to defend the fixed rate; fixed rates can be maintained at rates that are inconsistent with economic fundamentals. However, a benefit is the stable atmosphere for foreign investment. In contrast, in a floating exchange rate regime, a flexible (or floating) rate is determined by the private market through supply and demand. A floating exchange rate is constantly changing. The costs associated with this regime include more volatility and higher currency risk. However, the benefit is that a true market value is established for currency, which fluctuates daily to reflect market forces of demand and supply.

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What is the Trilemma (the Impossible Trinity) in international finance and does it affect the choice of the exchange rate regime? It is impossible to have all three of the following at the same time: monetary independence, exchange rate stability, capital market integration. A country that wants to fix the value of its currency and have an interest-rate policy that is free from outside influence cannot allow capital to flow freely across its borders. If the exchange rate is fixed but the country is open to cross-border capital flows, it cannot have an independent monetary policy. And if a country chooses free capital mobility and wants monetary autonomy, it has to allow its currency to float.

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When was a common European currency, the euro, adopted by 11 member nations? How did the introduction of the euro, a common European currency, affect the economies of member nations? On January 1, 1999, the euro became a currency and conversion rates for the euro were locked in for member countries. Positive effects of the euro include greater coordination of monetary policy, lower cross-border currency conversion costs, eliminated risk of currency fluctuations, encouraged flow of trade and investments among member countries, greater integration of Europe’s capital, labor and commodity markets, and an increase in competitiveness of some of the member countries. However, there were also negative effects such as the loss of control over domestic monetary policy and exchange rate determination, the separation of monetary and fiscal policies and reduction in competitiveness of some of the member countries.

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What are the advantages and disadvantages of the Gold Standard as an international monetary system? In this system the value for each currency was determined as a fixed number in one ounce of gold in that currency. All currency in circulation had to be backed up by gold reserves. It is a very stable system but stable to the point that it eliminates the growth. Expansionary monetary policy was limited to a government’s supply of gold.

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Describe the Bretton Woods agreement. How long did the agreement last? What forced its collapse? In 1944, an international agreement known as the Bretton Woods Agreement (19451973) called for fixed exchange rates between currencies. Exchange rates were established between currencies, and governments intervened to prevent exchange rates from moving more than 1 per cent above or below their initially established levels. It meant that each country had to have a monetary policy that kept the exchange rate of its currency within a fixed value—plus or minus one percent—in terms of gold. The Bretton Woods Agreement established a US dollar based international monetary system and created two new institutions the International Monetary Fund (IMF) and the World Bank. The purpose of the IMF was to monitor exchange rates and identify nations that needed global monetary support. The World Bank, initially called the International Bank for Reconstruction and Development, was established to manage funds available for providing assistance to countries that had been physically and financially devastated by World War II. New postwar monetary system: Allied nations pledged to maintain a fixed (pegged) exchange rate in terms of the dollar or gold. o 1 ounce of gold = $35 o Exchange rates could fluctuate only within 1% of their stated par values o Fixed rates were maintained by central bank intervention in foreign exchange markets However, it was a fixed rate system in name only. Of 21 major industrial countries only the US and Japan maintained their par values. Inflation in the US (printing money to finance Viet Nam war) forced its collapse. In 1971, concerned that the U.S. gold supply was no longer adequate to cover the number of dollars in circulation, President Richard M. Nixon declared a temporary suspension of the dollar’s convertibility into gold. On August 15, 1971 President Nixon was forced to suspend official purchases or sales of gold by the US Treasury. The dollar was devalued in 1971 and attempts to set new fixed rates were unsuccessful. An international floating exchange rate system was instituted in 1973, marking the end of the Bretton Woods agreement.

Topic 4. International Parity Conditions • Prices and Exchange Rates – Absolute and Relative Purchasing Power Parity • Interest Rates and Exchange Rates – The Fisher Effect – International Fisher Effect – Interest Rate Parity • Covered and Uncovered Interest Arbitrage – Explain the steps and calculate arbitrage profit 1. What does the Interest Rate Parity theory postulate? The theory of Interest Rate Parity (IRP) states: The difference in national interest rates for securities of similar risk and maturity should be equal to the forward rate discount or premium for foreign currency, ignoring transaction costs. In equilibrium, the forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential between two currencies.

2. Provide a numerical example to illustrate the Interest Rate Parity theory.

3. Show the derivation of the Interest Rate Parity condition: F1/e0 = (1+iH)/(1+iF).

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Explain how an investor can profit from covered interest arbitrage across countries. Provide a numerical example.

When the market is not in equilibrium, the potential for “risk-less” or arbitrage profit exists ◦ The arbitrager will exploit the imbalance by investing in whichever currency offers the higher return on a covered basis

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What is carry trade? Explain how an investor can profit from carry trade. Provide a numerical example.

Uncovered Interest Arbitrage (UIA): investors borrow in currencies exhibiting relatively low interest rates and convert the proceed into currencies that offer much higher interest rates (also called Currency Carry Trade). It is “uncovered” because the investor does not sell the higher yielding currency proceeds forward, choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end of the period. Investors attempt to capitalise on the difference in interest rates between two countries. Specifically, the strategy involves borrowing a currency with a low interest rate and investing the funds in a currency with a high interest rate. Example: Ausbil Investment Management Ltd is an Australian company that executes a carry trade in which it borrows Singapore dollars (where interest rates are presently low) and invests in Malaysian ringgit (where interest rates are presently high). Ausbil uses A$100,000 of its own funds and borrows an additional 600,000 Singapore dollars. It will pay 0.22 per cent on its Singapore dollars borrowed for the next month and will earn 0.55 per cent on funds invested in Malaysian ringgit. Assume that the Singapore dollar’s spot rate is A$0.8123 and that the Malaysian ringgit’s spot rate is A$0.3349. Therefore, the ringgit is worth 0.4123 Singapore dollars at this time (A$0.3349 per Malaysian ringgit / A$0.8123 per Singapore dollar). Ausbil uses today’s spot rate as its best guess of the spot rate one month from now. Ausbil’s expected profits from its carry trade can be derived as follows.

Topic 5. Country Risk • Main destinations for FDI; attractiveness of emerging markets for FDI e.g. China: Market size, Market growth potential, Access to export markets ¨ Government incentives, Production / labor costs, Infrastructure • Political risk • Types of political risk: transfer risk, operational risk, control risk. Provide examples. ¨ Transfer Risk = Uncertainty regarding cross-border flows of capital e.g. Blockage of f...