9602 in fin solve

Chapter 1 Financial Goals and Corporate Governance

�� Questions

Trident’s globalization

1. After reading the chapter’s description of Trident’s globalization process, how would you explain the distinctions between international, multinational, and global companies.

The difference in definitions for these three terms is subjective, with different writers using different terms at different times. No single definition can be considered definitive, although as a general matter the following probably reflect general usage.

International simply means that the company has some form of business interest in more than one country. That international business interest may be no more than exporting and importing, or it may include having branches or incorporated subsidiaries in other countries. International trade is usually the first step in becoming “international,” but the term also encompasses foreign subsidiaries created for the single purpose of marketing, distribution, or financing. The term international is also used to encompass what are defined as multinational and global below.

Multinational is usually taken to mean a company that has operating subsidiaries and performs a full set of its major operations in a number of countries; i.e., in “many nations.” “Operations” in this context includes both manufacturing and selling, as well as other corporate functions, and a multinational company is often presumed to operate in a greater number of countries than simply an international company. A multinational company is presumed to operate with each foreign unit “standing on its own”—although that term does not preclude specialization by country and/or supplying parts from one country operation to another.

Global is a newer term which essentially means about the same as “multinational;” i.e., operating around the globe. Global has tended to replace other terms because of its use in demonstrators at the international meetings (“global forums?”) of the International Monetary Fund and World Bank that took place in Seattle in 1999 and Rome in 2001. Terrorist attacks on the World Trade Center and the Pentagon in 2001 led politicians to refer to the need to eliminate “global terrorism.”

Trident, the MNE

2. At what point in the globalization process did Trident become a multinational enterprise (MNE)?

Trident became a multinational enterprise (MNE) when it began to establish foreign sales and service subsidiaries, followed by creation of manufacturing operations abroad or by licensing foreign firms to produce and service Trident’s products. This multinational phase usually follows the international phase, which involved the import and/or export of goods and/or services.

2 Moffett • Fundamentals of Multinational Finance, Second Edition

Trident’s advantages

3. What are the main advantages that Trident gains by developing a multinational presence?

(a) Entry into new markets, not currently served by the firm, which in turn allow the firm to grow and possibly to acquire economies of scale.

(b) Acquisition of raw materials, not available elsewhere.

(c) Achievement of greater efficiency, by producing in countries where one or more of the factors of production are underpriced relative to other locations.

(d) Acquisition of knowledge and expertise centered primarily in the foreign location.

(e) Location of the firms’ foreign operations in countries deemed politically safe.

Trident’s phases

4. What are the main phases that Trident passed through as it evolved into a truly global firm? What are the advantages and disadvantages of each?

(a) International trade. Two advantages are finding out if the firms’ products are desired in the foreign country and learning about the foreign market. Two disadvantages are lack of control over the final sale and service to final customer (many exports are to distributors or other types of firms that in turn resell to the final customer) and the possibility that costs and thus final customer sales prices will be greater than those of competitors that manufacture locally.

(b) Foreign sales and service offices. The greatest advantage is that the firm has a physical presence in the country, allowing it great control over sales and service as well as allowing it to learn more about the local market. The disadvantage is the final local sales prices, based on home country plus transportation costs, may be greater than competitors that manufacture locally.

(c) Licensing a foreign firm to manufacture and sell. The advantages are that product costs are based on local costs and that the local licensed firm has the knowledge and expertise to operate efficiently in the foreign country. The major disadvantages are that the firm might lose control of valuable proprietary technology and that the goals of the foreign partner might differ from those of the home country firm. Two common problems in the latter category are whether or not the foreign firm (that is manufacturing the product under license) is a shareholder wealth or corporate wealth maximizer, which in turn often leads to disagreements about reinvesting earning to achieve greater future growth versus making larger current dividends to owners and payments to other stakeholders.

(d) Part ownership of a foreign, incorporated, subsidiary; i.e., a joint venture. The advantages and disadvantages are similar to those for licensing: Product costs are based on local costs and that the local joint owner presumably has the knowledge and expertise to operate efficiently in the foreign country. The major disadvantages are that the firm might lose control of valuable proprietary technology to its joint venture partner, and that the goals of the foreign owners might differ from those of the home country firm.

(e) Direct ownership of a foreign, incorporated, subsidiary. If fully owned, the advantage is that the foreign operations may be fully integrated into the global activities of the parent firm, with products resold to other units in the global corporate family without questions as to fair transfer prices or too great specialization. (Example: the Ford transmission factory in Spain is of little use as a self-standing operation; it depends on its integration into Ford’s European operations.) The disadvantage is that the firm may come to be identified as a “foreign exploiter” because politicians find it advantageous to attack foreign owned businesses.

Chapter 1 Financial Goals and Corporate Governance 3

Corporate goals: shareholder wealth maximization

5. Explain the assumptions and objectives of the shareholder wealth maximization model.

The Anglo-American markets are characterized by a philosophy that a firm’s objective should be to maximize shareholder wealth. Anglo-American is defined to mean the United States, United Kingdom, Canada, Australia, and New Zealand. This theory assumes that the firm should strive to maximize the return to shareholders—those individuals owning equity shares in the firm, as measured by the sum of capital gains and dividends, for a given level of risk. This in turn implies that management should always attempt to minimize the risk to shareholders for a given rate of return.

Corporate goals: corporate wealth maximization

6. Explain the assumptions and objectives of the corporate wealth maximization model.

Continental European and Japanese markets are characterized by a philosophy that all of a corporation’s stakeholders should be considered, and the objective should be to maximize corporate wealth. Thus a firm should treat shareholders on a par with other corporate stakeholders, such as management, labor, the local community, suppliers, creditors, and even the government. The goal is to earn as much as possible in the long run, but to retain enough to increase the corporate wealth for the benefit of all. This model has also been labeled the stakeholder capitalism model.

Corporate governance

7. Define the following terms:

(a) Corporate governance Corporate governance is the control of the firm. It is a broad operation concerned with choosing the board of directors and with setting the long run objectives of the firm. This means managing the relationship between various stakeholders in the context of determining and controlling the strategic direction and performance of the organization. Corporate governance is the process of ensuring that managers make decision in line with the stated objectives of the firm.

Management of the firm concerns implementation of the stated objectives of the firm by professional managers employed by the firm. In theory managers are the employees of the shareholders, and can be hired or fired as the shareholders, acting through their elected board, may decide. Ownership of the firm is that group of individuals and institutions which own shares of stock and which elected the board of directors.

(b) The market for corporate control The relationship among stakeholders used to determine and control the strategic direction and performance of an organization is termed corporate governance. The corporate governance of the organization is therefore the way in which order and process is established to ensure that decisions are made and interests are represented—for all stakeholders—properly.

(c) Agency theory In countries and cultures in which the ownership of the firm has continued to be an integral part of management, agency issues and failures have been less a problem. In countries like the United States, in which ownership has become largely separated from management (and widely dispersed), aligning the goals of management and ownership is much more difficult.


(d) Stakeholder capitalism The philosophy that all of a corporation’s stakeholders should be considered, and the objective should be to maximize corporate wealth. Thus a firm should treat shareholders on a par with other corporate stakeholders, such as management, labor, the local community, suppliers, creditors, and even the government. The goal is to earn as much as possible in the long run, but to retain enough to increase the corporate wealth for the benefit of all. This model has also been labeled the stakeholder capitalism model.

Operational goals

8. What should be the primary operational goal of an MNE?

Financial goals differ from strategic goals in that the former focus on money and wealth (such as the present value of expected future cash flows.). Strategic goals are more qualitative—operating objectives such as growth rates and/or share-of-market goals.

Trident’s strategic goals are the setting of such objectives as degree of global scope and depth of operations. In what countries should the firm operate? What products should be made in each country? Should the firm integrate its international operations or have each foreign subsidiary operate more or less on its own? Should it manufacture abroad through wholly owned subsidiaries, through joint ventures, or through licensing other companies to make its products? Of course, successful implementation of these several strategic goals is undertaken as a means to benefit shareholders and/or other stakeholders.

Trident’s financial goals are to maximize shareholder wealth relative to a risk constraint and in consideration of the long-term life of the firm and the long-term wealth of shareholders. I.e., wealth maximization does not mean short term pushing up share prices so executives can execute their options before the company crashes—a consideration that must be made in the light of the Enron scandals.

Knowledge assets

9. “Knowledge assets” are a firm’s intangible assets, the sources and uses of its intellectual talent—its competitive advantage. What are some of the most important “knowledge assets” that create shareholder value?

The definition of corporate wealth is much broader than just financial wealth. It includes the firm’s technical, market, and human resources. This means that a MNE that believes it must close a manufacturing facility in Stuttgart, Germany, and shift its operations to Penang, Malaysia, may not do so without considering the employment and other social impacts on the Stuttgart community. As one study put it, “[Corporate wealth] goes beyond the wealth measured by conventional financial reports to include the firm’s market position as well as the knowledge and skill of its employees in technology, manufacturing processes, marketing and administration of the enterprise.”

Labor unions

10. In Germany and Scandinavia, among others, labor unions have representation on boards of directors or supervisory boards. How might such union representation be viewed under the shareholder wealth maximization model compared to the corporate wealth maximization model?

Labor union representation required by statute is an example of governmental direction toward the corporate wealth maximization (CWM) model, in that such a requirement is intended to make the board responsive to stakeholders other than owners. Under the CWM model, such a statute would be viewed favorably, while under the SWM model such a statute would be viewed as undue interference in the right of owners to manage the assets into which they alone have invested money.


Interlocking directorates

11. In an interlocking directorate members of the board of directors of one firm also sit on the board of directors of other firms. How would interlocking directorates be viewed by the shareholder wealth maximization model compared to the corporate wealth maximization model?

Interlocking directorates allow firms, via intertwined management and governance, to cooperate and/or collude. A simple answer along corporate wealth maximization (CWM) or stockholder wealth maximization (SWM) lines is not so easy here. Many countries characterized by the CWM model, such as Germany and Japan, allow interlocking directorates so that “all stakeholders” will be represented. SWM countries, such as the United States, often prohibit interlocking directorates on the premise they may stifle unfettered competition because decision may be based on friendships, influence, or promises of reciprocity. “Crony capitalism” is a term often used to describe economic systems where decisions are frequently based on friendships, influence, or promises of reciprocity.

Leveraged buyouts

12. A leveraged buyout is a financial strategy in which a group of investors gain voting control of a firm and then liquidate its assets in order to repay the loans used to purchase the firm’s shares. How would leveraged buyouts be viewed by the shareholder wealth maximization model compared to the corporate wealth maximization model?

A leveraged buyout is perceived in a country that believes in corporate wealth maximization (CWM) as generally irresponsible. The liquidation of assets, often at market prices that do not reflect the value of the activity to workers and their communities, is not consistent with the CWM philosophy. Those believing in shareholder wealth maximization (SWM) argue that if the selling shareholders—the initial owners of the firm—are paid a price for their shares that is higher than the market as a result of the leveraged buyout, the market forces which are so important for competition and growth are allowed to work. Additionally the selling shareholders now have more capital to freely invest in other ventures, in turn creating more jobs and attendant benefits.

High leverage

13. How would a high degree of leverage (debt/assets) be viewed by the shareholder wealth maximization model compared to the corporate wealth maximization model?

High leverage increases both the risk of corporate bankruptcy and the possibility of a greater rate of return for shareholders. The corporate wealth maximization (CWM) model looks askance at higher leverage because any benefits will flow only to shareholders, while other stakeholders (such as labor) will bear the brunt of the risk should the company go bankrupt because of the fixed financial costs of disproportionately high debt. Under the shareholder wealth maximization (SWM) model, the decision on the degree of leverage resides with the owners as represented by the board, and the tradeoff between risk and return is presumably based on their risk-return preferences. Under modern financial theory, the risk-return attributes of a single company are meaningful only in the context of the contribution that company makes to a diversified portfolio.


Conglomerates

14. Conglomerates are firms that have diversified into unrelated fields. How would a policy of conglomeration be viewed by the shareholder wealth maximization model compared to the corporate wealth maximization model?

Conglomerates created to achieve diversification are presumably looked upon more favorably in countries tied to the corporate wealth maximization (CWM) model because the greater size of the conglomerate means the business entity in its entirety is larger; i.e., has greater wealth and is possibly less vulnerable to competition or takeover by another firm. Worker jobs are safer. An offsetting argument is that firms in CWM countries with interlocking directorates can act as if they were conglomerates, even though structurally they are not.

Under the shareholder wealth maximization (SWM) model, conglomerates created to achieve diversification are formed only when the owners alone believe that synergies will come about because of the consolidation. Critics of conglomerates in SWM countries point out that shareholders can achieve unique diversification in their own portfolios without conglomerate diversification being “forced” upon them. Additionally an argument is sometimes made that management skilled in one type of economic activity may be quite incapable in another type of activity, and that consequently conglomerates may perform less well overall than would a portfolio composed of the no-longer-existing separate constituent companies.

Risk

15. How is risk defined in the shareholder wealth maximization model compared to the corporate wealth maximization model?

Shareholder Wealth Maximization (SWM) firms usually consider risk as a constraint on seeking to maximize current earnings. In an operational context for managers, risk is usually taken to be the expected variability for earnings over a period of future years. In a more specific portfolio sense for investors (as distinct from managers), risk in SWM countries is the added systematic risk that the firm’s shares bring to a diversified portfolio. Unsystematic risk, the risk of the individual security, can be eliminated through portfolio diversification by the investors. Thus unsystematic risk is not be a prime concern for management unless it increases the prospect of bankruptcy. Systematic risk, the risk of the market in general, cannot be eliminated.

Corporate Wealth Maximization (CWM) firms define risk in a much more qualitative sense. The term “patient capital” is sometimes used to imply that only performance over a very long term is of concern. In addition, the much greater array of stakeholders with divergent interests implies that some sort of consensus must be reached before a decision is made that might negatively impact one of the set of stakeholders—even if other sets of stakeholders gain.

Stock options

16. How would stock options granted to a firm’s management and employees be viewed by the shareholder wealth maximization model compared to the corporate wealth maximization model?

Stock options are used in Shareholder Wealth Maximizing firms to align the interests of managers with those of shareholders, in the belief that those managers will then make decisions which will enhance the wealth of all stockholders, including those executives. Of course, those executives are punished (financially) if the firm they manage fails to increase in market value.

Stock options to managers in Corporate Wealth Maximizing firms are unlikely, because they seek to cause managers to act to benefit the shareholders without, necessarily, benefitting the array of other stakeholders in the firm.


Shareholder dissatisfaction

17. If shareholders are dissatisfied with their company what alternative actions can they take?

Disgruntled shareholders may:

(a) Remain quietly disgruntled. This puts no pressure on management to change its ways under both the Shareholder Wealth Maximization (SWM) model and the Corporate Wealth Maximization (CWM) model.

(b) Sell their shares. Under the SWM model, this action (if undertaken by a significant number of shareholders) drives down share prices, making the firm an easier candidate for takeover and the probable loss of jobs among the former managers. Under the CWM model, management can more easily ignore any drop in share prices.

(c) Change management. Under the one-share, one-vote procedures of the SWM model, a concerted group of shareholders can vote out existing board members if they fail to change management practices. This usually takes the form of the board firing the firm’s president or chief operating officer. Cumulative voting, which is a common attribute of SWM firms, facilitates the placing of minority stockholder representation on the board. If, under the CWM model, different groups of shareholders have voting power greater than their proportionate ownership of the company, ousting of directors and managers is more difficult.

(d) Initiate a takeover. Under the SWM model it is possible to accumulate sufficient shares to take control of a company. This is usually done by a firm seeking to acquire the target firm making a tender offer for a sufficient number of shares to acquire a majority position on the board of directors. Under the CWM model acquisition of sufficient shares to bring about a takeover is much more difficult, in part because non-shareholder stakeholder wishes are considered in any board action. (One can argue as to whether the long-run interests of non-shareholding stakeholders are served by near-term avoidance of unsettling actions.) Moreover, many firms have disproportionate voting rights because of multiple classes of stock, thus allowing entrenched management to remain.

Dual classes of common stock

18. In many countries it is common for a firm to have two or more classes of common stock with differential voting rights. In the United States the norm is for a firm to have one class of common stock with one-share-one-vote. What are the advantages and disadvantages of each system?

A variety of arguments exist as to why Europeans allow this differential in voting rights. In some countries it is believed that “ordinary” individual shareholders are not qualified to influence business decisions. The average share-owning individual investor is presumed to be neither business-oriented nor knowledgeable about the business and prospects for the firm in which shares are owned. Hence they are not sufficiently informed to be trusted with influence of the selection of directors or other important corporate issues. Dual classes of stock allow one class (the “informed professional”) to control the company while the second class (the “uninformed amateur”) to provide capital and reap ownership rewards but not have a chance to “mess up the company” by having power over decisions.

A second reason for dual classes of stock is that takeover bids by other companies are made more difficult because the acquiring company would have to purchase the class of stock that has voting power, which class is usually held or controlled by existing management. Hence the job tenure of existing management is made more secure, even if they do not perform well and the value of shares in the market drops.


Emerging markets corporate governance failures

19. It has been claimed that failures in corporate governance have hampered the growth and profitability of some prominent firms located in emerging markets. What are some typical causes of these failures in corporate governance?

Causes include lack of transparency, poor auditing standards, cronyism, insider boards of directors (especially among family-owned and operated firms), and weak judicial systems.

Emerging markets corporate governance improvements

20. In recent years emerging market MNEs have improved their corporate governance policies and become more shareholder-friendly. What do you think is driving this phenomenon?

It is driven by the need to access global capital markets. The depth and breadth of capital markets is critical to the evolution of corporate governance practices. Country markets which have had relatively slow growth, as in the emerging markets, or have industrialized rapidly utilizing neighboring capital markets (as is the case of Western Europe), may not form large public equity market systems. Without significant public trading of ownership shares, high concentrations of ownership are preserved and few disciplined processes of governance developed.

�� Mini-Case: The Failure of Corporate Governance at Enron

1. Which parts of the corporate governance system, internal and external, do you believe failed Enron the most?

The failures at Enron were so wide and deep, it is difficult to say which failed most. If pushed, it might be argued that the massive failures and internal culture of accounting earnings and self-enrichment at all costs led to a contagion of the external. Because many of Enron’s businesses such as power trading fell between the cracks of many regulatory systems, some failures were inevitable. In other cases, however, such as with its auditors and the debt and equity markets, the failures were in many cases related to the self-enrichment and profits at all costs culture from within.

2. Describe how you think each of the individual stakeholders and components of the corporate governance system should have either prevented the problems at Enron or acted to resolve the problems before they reached crisis proportions.

The chief internal officers—and the culture they created—are in many people’s opinions that primary cause of many of the problems at Enron. The CEO and other senior management team members are typically those held most visibly responsible for creating solid and sustainable value for the firm, as well as serving as the premier examples of the company’s global ethics. The second major internal unit, the corporate Board, could also be seen as extremely deficient in their due diligence of many of the practices of the firm. In a number of cases the Board literally knew it was breaking its own rules and corporate code of conduct, but decided very cavalierly to ignore them.

In terms of the many external constituents to Enron’s corporate governance structure—the debt markets, the equity markets and their analysts, the auditors, the law firms, the regulators for both Enron’s industry and its investors of all kinds—all could simply have done their job with less conflict of interest. In nearly each and every case (the possible exceptions are most of the regulatory agencies which are generally hindered by law or budget from pursuing their duties as possibly needed), these external constituents had more to gain from Enron’s business and new business than from the conduct of their own due diligence.


3. If all publicly-traded firms in the United States are operating within the same basic corporate governance system as Enron, why would some people believe this was an isolated incident, and not an example of many failures to come?

In fact, it appears that much of American society did indeed believe the Enron (and Worldcom, and HealthSouth) was an indication of things to come. This is most likely why Sarbanes-Oxley and a number of other rather extraordinary measures were taken in the years following the Enron collapse. Given how visible Enron was, particularly during its glory years, many experts have argued that Enron would be followed by many other similar corporate governance failures as a variety of the weaknesses in the current system continued to be exploited.

Ironically, there is now a growing debate as to whether the cure is worse than the illness. Many senior executives today argue that the costs associated with Sarbanes-Oxley compliance (among other measures) will result in many firms moving toward private ownership, and at the least, some of the truly talented people in business moving towards the private-ownership sector to avoid many of the personal liabilities of being an officer in a publicly traded company.


�� Problems

Problem 1.1 Shareholder returns What are the shareholder’s returns? Assumptions Value Share price, P1 $16.00 Share price, P2 $18.00 Dividend paid, D2 — a. If the company paid no dividend (plugging zero in for the dividend): Return = (P2 – P1 + D2)/(P1) 12.500% Assumptions Value Share price, P1 $16.00 Share price, P2 $18.00 Dividend paid, D2 $1.00 b. Total shareholder return, including dividends, is: 18.750% Return = (P2 – P1 + D2)/(P1)


Problem 1.2 Shareholder choices Assumptions Value Share price, P1 $62.00 Share price, P2 $74.00 Dividend paid, D2 $2.25 b. Total shareholder return for the period is 22.98% Return = (P2 – P1 + D2)/(P1) The share’s expected return of 22.98% far exceeds the required return by Mr. Fong of 12%. He should therefore make the investment.

Problem 1.3 Microsoft’s dividend What would the return have been on Microsoft shares if it had paid a constant dividend in the recent past? Closing If Shareholder Shareholder Share Dividend Return Return Assumptions Price Paid (without Div) (with Div) 1998 (January 2) $131.13 1999 (January 4) $141.00 $0.16 7.53% 7.65% 2000 (January 3) $116.56 $0.16 –17.33% –17.22% 2001 (January 2) $43.38 $0.16 –62.78% –62.65% 2002 (January 2) $67.04 $0.16 54.54% 54.91% 2003 (January 2) $53.72 $0.16 –19.87% –19.63% a. Average shareholder return for the period is –7.58% Return = (P2 – P1)/(P1)

b. Total shareholder return if Microsoft had paid a constant dividend: –7.39% Return = (P2 – P1 + D)/(P1)

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Problem 1.4 Dual Classes of Common Stock (A) What are the implications for the distribution of voting rights and dividend distributions for Powlitz?

Local

Currency Powlitz Manufacturing (millions) Votes per Share Total Votes Long-term debt 200 Retained earnings 300 Paid-in common stock: 1 million A-shares 100 10 1,000 Paid-in common stock: 4 million B-shares 400 1 400 Total long-term capital 1,000 1,400 a. What proportion of the total long-term capital has been raised by A-shares?

A-shares/Total long-term capital 100/1,000 10.00% b. What proportion of voting rights is represented by A-shares?

A-share total votes/Total Votes 1,000/1,400 71.43% c. What proportion of the dividends should the A-shares receive?

A-shares in local currency/Total equity shares in local currency 100/(100 + 400) 20.00%


Problem 1.5 Dual Classes of Common Stock (B)

What are the implications for the distribution of voting rights and dividend distributions for Powlitz?

Local Currency Powlitz Manufacturing (millions) Votes per Share Total Votes Long-term debt 200 Retained earnings 300 Paid-in common stock: 1 million A-shares 100 10 1,000 Paid-in common stock: 4 million B-shares 400 1 400 Total long-term capital 1,000 1,400 a. What proportion of the total long-term capital has been raised by A-shares?

A-shares/Total long-term capital 100/1,000 10.00% b. What proportion of voting rights is represented by A-shares?

A-share total votes/Total Votes 1,000/1,400 71.43% c. What proportion of the dividends should the A-shares receive?

A-shares in local currency/Total equity shares in local currency 100/(100 + 400) 20.00%

Problem 1.6 Price/Earnings ratios and acquisitions Market Total Number Value Market Company P/E Ratio of Shares per Share Earnings EPS Value Pharm-Italy 20 10,000,000 $20.00 $10,000,000 $1.00 $200,000,000 Pharm-USA 40 10,000,000 $40.00 $10,000,000 $1.00 $400,000,000 Rate of exchange: Pharm-USA shares per Pharm-Italy shares: 5,500,000 a. How many shares would Pharm-USA have outstanding after the acquisition of Pharm-Italy? 10,000,000 + 5,500,000 15,500,000 Because Pharm-Italy shares are worth$20 per share, they are only worth one-half the value per share of Pharm-USA’s$40 per share. So, on a straight exchange, 1 Pharm-USA share is worth 2 Pharm-Italy shares. But, Pharm-USA also needs to pay a premium for gaining control of Pharm-Italy, so it pays an additional 10% over market. So, Pharm-USA pays: 10 million divided by 2 × (1 + 10% premium) b. What would be the consolidated earnings of the combined Pharm-USA and Pharm-Italy? Pharm-Italy earnings + Pharm-USA earnings $20,000,000 c. Assuming the market continues to capitalize Pharm-USA’s earnings at a P/E ratio of 40, what would be the new market value of Pharm-USA? P/E × Consolidated earnings = 40 × $20,000,000 $800,000,000 (Continued)

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Problem 1.6 Price/Earnings ratios and acquisitions (Continued) d. What is the new earnings per share of Pharm-USA? $20,000,000/15,500,000 shares $1.29 e. What is the new market value of a share of Pharm-USA? New market value/Total shares outstanding = $800,000,000/15,500,000 $51.61 f. How much did Pharm-USA’s stock price increase? Share price rose from$40.00 to$51.61. $11.61 Percentage increase 29.03% g. Assume that the market takes a negative view of the acquisition and lowers Pharm-USA’s P/E ratio to 30. What would be the new market price per share of stock? What would be its percentage loss? New market value = Total earnings × P/E = $20,000,000 × 30 $600,000,000 New market price per share = total market value/shares outstanding = $38.71 Percentage loss to original Pharm-USA shareholders = ($38.71 – $40.00)/($40.00) –3.23%

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Problem 1.7 Corporate governance: Overstating earnings Market Total Number Value Market Company P/E Ratio of Shares per Share Earnings EPS Value Pharm-Italy 20 10,000,000 $20.00 $10,000,000 $1.00 $200,000,000 Pharm-USA 40 10,000,000 $20.00 $5,000,000 $1.00 $200,000,000 If earnings were lowered to$5 million from the previously reported$10 million, could Pharm-USA still do the deal? To do the deal, Pharm-Italy’s shareholders need to be paid their market value plus a 10% premium, or $220,000,000 At new market rates for Pharm-USA, this would require the offer of ($220 million/$20 per share) 11,000,000 shares. This 11 million shares would exceed Pharm-USA’s existing shares outstanding, effectively giving Pharm-Italy control. Therefore the acquistion would probably not take place.

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Problem 1.8 Trident Corporation’s Consolidated Earnings USA Brazil Germany China Business Performance (000s) (US$) (reais, R$) (euros, E) (renminbi, Rmb) Earnings before taxes, EBT (local currency) 4,500.00 6,250.00 4,500.00 2,500.00 Less corporate income taxes 35% (1,575.00) 25% (1,562.50) 40% (1,800.00) 30% (750.00) Net profits of individual subsidiary 2,925.00 4,687.50 2,700.00 1,750.00 Avg exchange rate for the period (fc/$) — 3.5000 0.92600 8.5000 Net profits of individual subsidiary (US$) $2,925.00 $1,339.29 $2,915.77 $205.88 Consolidated profits (total across units) $7,385.93 Total diluted shares outstanding (000s) 650.00 a. Consolidated earnings per share (EPS) $11.36 b. Proportion of total profits originating by country 39.6% 18.1% 39.5% 2.8% c. Proportion of total profits originating from outside the United States 60.4%

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Problem 1.9 Trident’s EPS Sensitivity to Exchange Rates

USA Brazil Germany China

Business Performance (000s) (US$) (reais, R$) (euros, E) (renminbi, Rmb)

Earnings before taxes, EBT (local currency) 4,500.00 6,250.00 4,500.00 2,500.00

Less corporate income taxes 35% (1,575.00) 25% (1,562.50) 40% (1,800.00) 30% (750.00)

Net profits of individual subsidiary 2,925.00 4,687.50 2,700.00 1,750.00

Avg exchange rate for the period (fc/$) — 4.5000 0.92600 8.5000

Net profits of individual subsidiary (US$) $2,925.00 $1,041.67 $2,915.77 $205.88

Consolidated profits (total across units) $7,088.32

Total diluted shares outstanding (000s) 650.00

Baseline earnings per share (EPS) $11.36

a. If Brazilian real falls to R$4.50/$: EPS $10.91 EPS has fallen 4 percent from baseline. –4.0%

US Parent Brazilian German Chinese

Company Subsidiary Subsidiary Subsidiary

Business Performance (000s) (US$) (reais, R$) (euros, E) (renminbi, Rmb)

Earnings before taxes, EBT (local currency) 4,500.00 5,800.00 4,500.00 2,500.00

Less corporate income taxes 35% (1,575.00) 25% (1,450.00) 40% (1,800.00) 30% (750.00)

Net profits of individual subsidiary 2,925.00 4,350.00 2,700.00 1,750.00

Avg exchange rate for the period (fc/$) — 4.5000 0.92600 8.5000

Net profits of individual subsidiary (US$) $2,925.00 $966.67 $2,915.77 $205.88

Consolidated profits (total across units) $7,013.32 Total diluted shares outstanding (000s) 650.00

Baseline earnings per share (EPS) $11.36

b. If both the real and the earnings in $10.79 EPS has fallen 5 percent from baseline. –5.0%

Brazil fall, Trident’s EPS is now:

Chapter 1

Financial G


overnance

19

Problem 1.10 Trident’s Earnings and Global Taxation USA Brazil Germany China

Business Performance (000s) (US$) (real, R$) (euros, �) (renminbi, Rmb) Earnings before taxes, EBT (local currency) 4,500.00 6,250.00 4,500.00 2,500.00 Less corporate income taxes 35% (1,575.00) 25% (1,562.50) 40% (1,800.00) 30% (750.00) Net profits of individual subsidiary 2,925.00 4,687.50 2,700.00 1,750.00 Avg exchange rate for the period (fc/$) — 3.5000 0.92600 8.5000 Net profits of individual subsidiary (US$) $2,925.00 $1,339.29 $2,915.77 $205.88 Consolidated profits (total across units) $7,385.93 Total diluted shares outstanding (000s) 650.00 Consoldiated earnings per share (EPS) $11.36 Tax payments by country in US dollars $1,575.00 $446.43 $1,943.84 $88.24 a. Total global tax bill, US$ $4,053.51 b. What is Trident’s effective tax rate? EBT by country, US$ $4,500.00 $1,785.71 $4,859.61 $294.12 Consolidated EBT $11,439.44 Total tax bill $4,053.51 Effective tax rate 35.4% c. What would be the impact on Trident’s EPS and global effective tax rate if Germany instituted a tax cut to 28% and German subsidiary earnings rose to 5 million euros? After plugging in the new values, EPS is $12.86 and the effective tax rate would be 30.2%

20

Moffett • F

undamentals of M


econd Edition

Chapter 2 The International Monetary System

�� Questions

The gold standard and the money supply

1. Under the gold standard all national governments promised to follow the “rules of the game.” This meant defending a fixed exchange rate. What did this promise imply about a country’s money supply?

A country’s money supply was limited to the amount of gold held by its central bank or treasury. For example, if a country had 1,000,000 ounces of gold and its fixed rate of exchange was 100 local currency units per ounce of gold, that country could have 100,000,000 local currency units outstanding. Any change in its holdings of gold needed to be matched by a change in the number of local currency units outstanding.

Causes of devaluation

2. If a country follows a fixed exchange rate regime, what macroeconomic variables could cause the fixed exchange rate to be devalued?

The following macroeconomic variables could cause the fixed exchange rate to be devalued:

• An interest rate that is too low compared to other competing currencies

• A continuing balance of payments deficit

• An inflation rate consistently higher than in other countries

Fixed versus flexible exchange rates

3. What are the advantages and disadvantages of fixed exchange rates?

• Fixed rates provide stability in international prices for the conduct of trade. Stable prices aid in the growth of international trade and lessen risks for all businesses.

• Fixed exchange rates are inherently anti-inflationary, requiring the country to follow restrictive monetary and fiscal policies. This restrictiveness, however, can often be a burden to a country wishing to pursue policies that alleviate continuing internal economic problems, such as high unemployment or slow economic growth.


• Fixed exchange rate regimes necessitate that central banks maintain large quantities of international reserves (hard currencies and gold) for use in the occasional defense of the fixed rate. As international currency markets have grown rapidly in size and volume, increasing reserve holdings has become a significant burden to many nations.

• Fixed rates, once in place, may be maintained at rates that are inconsistent with economic fundamentals. As the structure of a nation’s economy changes, and as its trade relationships and balances evolve, the exchange rate itself should change. Flexible exchange rates allow this to happen gradually and efficiently, but fixed rates must be changed administratively—usually too late, too highly publicized, and at too large a one-time cost to the nation’s economic health.

The Impossible Trinity

4. Explain what is meant by the term “Impossible Trinity” and what it implies.

• Countries with floating rate regimes can maintain monetary independence and financial integration but must sacrifice exchange rate stability.

• Countries with tight control over capital inflows and outflows can retain their monetary independence and stable exchange rate, but surrender being integrated with the world’s capital markets.

• Countries that maintain exchange rate stability by having fixed rates give up the ability to have an independent monetary policy.

Currency board or dollarization

5. Fixed exchange rate regimes are sometimes implemented through a currency board (Hong Kong) or dollarization (Ecuador). What is the difference between the two approaches?

In a currency board arrangement, the country issues its own currency but that currency is backed 100% by foreign exchange holdings of a hard foreign currency—usually the U.S. dollar. In dollarization, the country abolishes its own currency and uses a foreign currency, such as the U.S. dollar, for all domestic transactions.

Emerging market exchange rate regimes

6. High capital mobility is forcing emerging-market nations to choose between free-floating regimes and currency board or dollarization regimes. What are the main outcomes of each of these regimes from the perspective of emerging market nations?

There is no doubt that for many emerging markets a currency board, dollarization, and freely-floating exchange rate regimes are all extremes. In fact, many experts feel that the global financial marketplace will drive more and more emerging market nations towards one of these extremes. As illustrated by Exhibit 2.5, there is a distinct lack of “middle ground” left between rigidly fixed and freely floating. In anecdotal support of this argument, a poll of the general population in Mexico in 1999 indicated that 9 out of 10 people would prefer dollarization over a floating-rate peso. Clearly, there are many in the emerging markets of the world who have little faith in their leadership and institutions to implement an effective exchange rate policy.

Chapter 2 The International Monetary System 23

Argentine currency board

7. How did the Argentine currency board function from 1991 to January 2002 and why did it collapse?

Argentina’s currency board exchange regime of fixing the value of its peso on a one-to-one basis with the U.S. dollar ended for several reasons:

(a) As the U.S. dollar strengthened against other major world currencies, including the euro, during the 1990s, Argentine export prices rose vis-à-vis the currencies of its major trading partners.

(b) This problem was aggravated by the devaluation of the Brazilian real in the late 1990s. (c) These two problems, in turn, led to continued trade deficits and a loss of foreign exchange

reserves by the Argentine central bank. (4) This problem, in turn, led Argentine residents to flee from the peso and into the dollar, further worsening Argentina’s ability to maintain its one-to-one peg.

The euro

8. On January 4, 1999, 11 member states of the European Union initiated the European Monetary Union (EMU) and established a single currency, the euro, which replaced the individual currencies of participating member states. Describe three of the main ways that the euro affects the members of the EMU.

The euro affects markets in three ways: (1) countries within the euro zone enjoy cheaper transaction costs; (2) currency risks and costs related to exchange rate uncertainty are reduced; and (3) all consumers and businesses both inside and outside the euro zone enjoy price transparency and increased price-based competition.


Mavericks

9. The United Kingdom, Denmark, and Sweden have chosen not to adopt the euro but rather to maintain their individual currencies. What are the motivations of each of these three countries that are also members of the European Union?

The United Kingdom chose not to adopt the euro because of the extensive use of the U.K. pound in international trade and financial transactions. London is still the world’s most important financial center. The British are also very proud of their long tradition in financial matters when “Britannia ruled the waves.” They are afraid that monetary and financial matters may eventually migrate to Frankfurt where the European Central Bank is located. The British are also worried about continued concentration of decision making in Brussels where the main European Union institutions are located.

Denmark is also worried about losing its economic independence as a small country surrounded by big neighbors. Denmark’s currency, the krone, is mostly tied to the euro anyway, so it does not suffer a misalignment with the primary currency unit of the surrounding economies. Sweden has strong economic ties to Denmark, Norway, and the United Kingdom, none of which adopted the euro so far. Sweden, like the others, are afraid of over concentration of power within European Union institutions.

Despite popular fears and a certain amount of nationalism, all three countries have strong fores within that would like these countries to adopt the euro. This would usually require popular referendums, so you may see them adopt the euro in the future.

International Monetary Fund (IMF)

10. The IMF was established by the Bretton Woods Agreement (1944). What were its original objectives?

The IMF was established to render temporary assistance to member countries trying to defend the value of their currencies against cyclical, seasonal, or random occurrences. Additionally it was to assist countries having structural trade problems. More recently it has attempted to help countries, such as Russia, Brazil, Argentina, and Indonesia to resolve financial crises.

Special Drawing Rights

11. What are the Special Drawing Rights?

The Special Drawing Right (SDR) is an international reserve asset created by the IMF to supplement existing foreign exchange reserves. It serves as a unit of account for the IMF and other international and regional organizations, and is also the base against which some countries peg the exchange rate for their currencies.

Defined initially in terms of a fixed quantity of gold, the SDR has been redefined several times. It is currently the weighted value of currencies of the five IMF members having the largest exports of goods and services. Individual countries hold SDRs in the form of deposits in the IMF. These holdings are part of each country’s international monetary reserves, along with official holdings of gold, foreign exchange, and its reserve position at the IMF. Members may settle transactions among themselves by transferring SDRs.


Definitions

12. Define the following currency terms:

(a) devaluation of a currency refers to a drop in foreign exchange value of a currency that is pegged to gold or to another currency

(b) revaluation of a currency refers to an increase in foreign exchange value of a currency that is pegged to gold or to another currency

(c) depreciation of a currency refers to a drop in the foreign exchange value of a floating currency

(d) appreciation of a currency refers to an increase in the foreign exchange value of a floating currency

(e) soft or weak describes a currency that we expect to devalue or depreciate relative to other major currencies

(f) hard or strong describes a currency that we expect to revalue or appreciate relative to other major trading currencies

(g) eurodollar is a U.S. dollar-denominated interest-bearing deposit in a bank outside of the United States

(h) euroyen is a Japanese yen-denominated interest-bearing deposit in a bank outside of Japan

Exchange rate regime classifications

13. The IMF classifies all exchange rate regimes into eight specific categories that are summarized in this chapter. Under which exchange rate regime would you classify the following countries?

(a) France: Exchange arrangements with no separate legal tender

(b) The United States: independent floating

(c) Japan: independent floating

(d) Thailand: managed floating with no pre-announced path for the exchange rate. Prior to the Asian Crisis of 1997 it was tied to the U.S. dollar.

The ideal currency

14. What are the attributes of the ideal currency?

If the ideal currency existed in today’s world, it would possess three attributes, often referred to as The Impossible Trinity:

(1) Exchange rate stability. The value of the currency would be fixed in relationship to other major currencies so traders and investors could be relatively certain of the foreign exchange value of each currency in the present and into the near future.

(2) Full financial integration. Complete freedom of monetary flows would be allowed, so traders and investors could willingly and easily move funds from one country and currency to another in response to perceived economic opportunities or risks.

(3) Monetary independence. Domestic monetary and interest rate policies would be set by each individual country to pursue desired national economic policies, especially as they might relate to limiting inflation, combating recessions, and fostering prosperity and full employment.


Bretton Woods failure

15. Why did the fixed exchange rate regime of 1945–1973 eventually fail?

The fixed exchange rate regime of 1945–1973 failed because of widely diverging national monetary and fiscal policies, differential rates of inflation, and various unexpected external shocks. The U.S. dollar was the main reserve currency held by central banks was the key to the web of exchange rate values. The United States ran persistent and growing deficits in its balance of payments requiring a heavy outflow of dollars to finance the deficits. Eventually the heavy overhang of dollars held by foreigners forced the United States to devalue the dollar because the U.S. was no longer able to guarantee conversion of dollars into its diminishing store of gold.


�� Problems

Problem 2.1 Frankfurt and New York What is the exchange rate between the dollar and the euro? Assumptions Values Buy a US dollar in Frankfurt for (in euros/$) 0.9200 Which is equivalent, the reciprocal, in $/euro $1.0870 Buy a euro in NY for (in $/euros) $1.0870 Which is equivalent, the reciprocal, in euros/$ 0.9200


Problem 2.2 Peso exchange rate changes Peso was “devalued” from 3.2 per dollar to 5.5 per dollar. Any time a government sets, or resets, the value of a currency, it is a managed or fixed exchange rate. A governmental decision to decrease a currency’s value when it is a fixed exchange rate is termed a “devaluation.” Calculation of Percentage Change in Value Values Initial exchange rate (peso/$) 3.20 Devalued exchange rate (peso/$) 5.50 Percentage change in peso value –41.82% (beginning rate – ending rate)/(ending rate)


Problem 2.3 Good as gold What if gold had cost $38.00 per ounce? Gold Standard Assumptions Values What If Price of an ounce of gold in US dollars ($/oz) $20.67 $38.00 Price of an ounce of gold in British pounds (£/oz) £4.2474 £4.2474 What is the implied US$/£ exchange rate? $4.8665 $8.9466 (dollar price of an ounce/pound price of an ounce)


Problem 2.4 Gold standard What was the exchange rate between the FF and US$? Assumptions Values Price of an ounce of gold in US dollars ($/oz) $20.67 Price of an ounce of gold in French francs (FF/oz) 310.00 What is the implied French franc/US$ exchange rate? 15.00 (French franc price of an ounce/US$ price of an ounce) …. Or if expressed as US$/FF $0.0667


Problem 2.5 Spot Rate—customer What must your company pay? Assumptions Values Spot rate on Mexican peso (pesos/US$) 9.5200 Your company buys this amount of pesos 100,000.00 What is the cost in US$? $10,504.20 (the peso amount divided by the spot exchange rate) Spot transactions are settled in two business days, so in this case, Wednesday.


Problem 2.6 Forward rate Settlement for a forward contract? Assumptions Values

180-day forward rate, euros/$ �0.9210 Maturity of forward, days 180

Euros bought forward �100,000.00 What must the company pay to settle the forward? $108,577.63 Payment = Amount in euros/forward rate

The contract would be settled 180 days later plus 2 days for actual settlement on March 6, 2004. Please note that 2004 is actually a leap year.


Problem 2.7 Forward discount on the dollar What is the forward discount on the dollar? Assumptions Values Spot rate, $/euros $1.0200 Forward rate, 180-days, $/euros $1.0858 Days forward 180 What is the forward discount on the dollar? 12.90% Since these are direct quotes on the dollar, the calculation is: forward discount = (F – S)/(S) × (360/180)


Problem 2.8 Forward premium on the euro What is the forward premuim on the euro? Assumptions Values

Spot rate, euros/$ �0.9804

Forward rate, 180-days, euros/$ �0.9210 Days forward 180 What is the forward premium on the euro? 12.90% Since these are direct quotes on the euro, the calculation is: forward premium = (S – F)/(F) × (360/180)


Problem 2.9 Saudi import What is the dollar price after all exchanges and fees? Assumptions Values

Purchase price, in euros �375,000 Spot rate of exchange, Jordanian dinar (JD)/euro 0.8700 Spot rate of exchange, Jordanian dinar (JD)/US$ 0.7080 Spot rate of exchange, Saudi Arabian (SRI)/Jordanian dinar (JD) 5.2966 Jordanian import duty on EU products 12.00% Jordanian resale fees 22.00% Spot rate of exchange, Saudi Arabian riyal (SRI)/US$ 3.750 What is the dollar price after all exchanges and fees? Purchase price, converted to Jordanian dinar (JD) 326,250.00 Additional fees due on importation 39,150.00 Total cost, Jordanian dinar (JD) 365,400.00 Resale fee in Jordan 80,388.00 Resale price to Saudi Arabian, in JD 445,788.00 Price paid in Iraqi dinar, converting JD to SRI 2,361,165.25 US dollar equivalent of final price paid $629,644.07


Problem 2.10 Chinese yuan (renminbi) revaluation What if the Chinese yuan were revalued? Any time a government sets, or resets, the value of a currency, it is a managed or fixed exchange rate. A governmental decision to decrease a currency’s value when it is a fixed exchange rate is termed a “devaluation.” Calculation of Percentage Change in Value Values Initial exchange rate (Rmb/$) 8.27 Percentage devaluation against the US dollar 20.00% Revalued exchange rate (Rmb/$) 6.89

Chapter 3 The Balance of Payments

�� Questions

Balance of payments defined

1. The measurement of all international economic transactions between the residents of a country and foreign residents is called the balance of payments (BOP). What institution provides the primary source of similar statistics for balance of payments and economic performance worldwide?

The primary source of similar statistics for balance of payments and economic performance worldwide is the International Monetary Fund, Balance of Payments Statistics.

Importance of BOP

2. Business managers and investors need BOP data to anticipate changes in host country economic policies that might be driven by BOP events. From the perspective of business managers and investors list three specific signals that a country’s BOP data can provide.

• The BOP is an important indicator of pressure on a country’s foreign exchange rate, and thus on the potential for a firm trading with or investing in that country to experience foreign exchange gains or losses. Changes in the BOP may predict the imposition or removal of foreign exchange controls.

• Changes in a country’s BOP may signal the imposition or removal of controls over payment of dividends and interest, license fees, royalty fees, or other cash disbursements to foreign firms or investors.

• The BOP helps to forecast a country’s market potential, especially in the short run. A country experiencing a serious trade deficit is not likely to expand imports as it would if running a surplus. It may, however, welcome investments that increase its exports.

Economic activity

3. What are the two main types of economic activity measured by a country’s BOP?

(a) Current transactions having cash flows completed within one year, such as for the import or export of goods and services.

(b) Capital and financial transactions, in which investors acquire ownership of a foreign asset, such as a company, or a portfolio investment, such as bonds or shares of common stock.


Balance

4. Why does the BOP always “balance”?

The algebraic sum of all flows accounted for in the current account and the capital and financial accounts should, in theory, equal changes in a country’s monetary reserves. Because data for the balance of payments is collected on a single entry basis and some data is missed, the equalization usually does not occur. The imbalance is plugged by an entry called “errors and omissions” which makes the accounts balance.

BOP accounting

5. If the BOP were viewed as an accounting statement, would it be a balance sheet of the country’s wealth, an income statement of the country’s earnings, or a funds flow statement of money into and out of the country?

A country’s balance of payments is similar to a corporation’s funds statement in that the balance of payments records events that cause the receipt (earnings) and disbursement (expenditures) of foreign exchange.

Current account

6. What are the main component accounts of the current account? Give one debit and one credit example for each component account for the United States.

The main components and possible examples are:

Trade in goods: Debit: U.S. firm purchases German machine tools. Credit: Singapore Air Lines buys a Boeing jet.

Trade in services: Debit: An American takes a cruise on a Dutch cruise line. Credit: The Brazilian tourist agency places an ad in The New York Times.

Income payments and receipts: Debit: The U.S. subsidiary of a Taiwan computer manufacturer pays dividends to its parent. Credit: A British company pays the salary of its executive stationed in New York.

Unilateral current transactions. Debit: The U.S.-based International Rescue Committee pays for an American working on the

Afghan border. Credit: A Spanish company pays tuition for an employee to study for an MBA in the United

States.

Real versus financial assets

7. What is the difference between a “real” asset and a “financial” asset?

Real assets are goods (merchandise) and useful services. Financial assets are financial claims, such as shares of stock or bonds.

Chapter 3 The Balance of Payments 39

Direct versus portfolio investments

8. What is the difference between a direct foreign investment and a portfolio foreign investment? Give an example of each. Which type of investment is a multinational industrial company more likely to make?

A direct investment is made with the intent that the investor will have a degree of control over the asset acquired. Typical examples are the building of a factory in a foreign country by the subsidiary of a multinational enterprise or the acquisition of more than 10% of the voting shares of a foreign corporation. A portfolio investment is the purchase of less than 10% of the voting shares of a foreign corporation or the purchase of debt instruments. Multinational enterprises are more likely to engage in direct foreign investment than in portfolio investment.

Capital and financial accounts

9. What are the main components of the financial accounts? Give one debit and one credit example for each component account for the United States.

The main components and possible examples are:

Direct investment. Debit: Ford Motor Company builds a factory in Australia. Credit: Ford Motor Company sells its factory in Britain to British investors.

Portfolio investment. Debit: An American buys shares of stock of a European food chain on the Frankfurt Stock

Exchange. Credit: The government of Korea buys United States treasury bills to hold as part of its foreign

exchange reserves.

Other investment. Debit: A U.S. firm deposits $1 million in a bank balance in London. Credit: A U.S. firm generates an account receivable for exports to Canada.

Classifying transactions

10. Classify the following as a transaction reported in a sub-component of the current account or the capital and financial accounts of the two countries involved:

(a) A U.S. food chain imports wine from Chile. Debit to U.S. goods part of current account, credit to Chilean goods part of current account.

(b) A U.S. resident purchases a euro-denominated bond from a German company. Debit to U.S. portfolio part of financial account; credit to German portfolio of financial account.

(c) Singaporean parents pay for their daughter to study at a U.S. university. Credit to U.S. current transfers in current account; debit to Singapore current transfers in current account.

(d) A U.S. university gives a tuition grant to a foreign student from Singapore. If the student is already in the United States, no entry will appear in the balance of payments because payment is between U.S. residents. (A student already in the U.S. becomes a resident for balance of payments purposes.)


(e) A British Company imports Spanish oranges, paying with eurodollars on deposit in London. A debit to the goods part of Britain’s current account; a credit to the goods part of Spain’s current account.

(f) The Spanish orchard deposits half the proceeds of its sale in a New York bank. A debit to the income receipts/payments part of Spain’s current account; a credit to the income receipts/payments part of the U.S. current account.

(g) The Spanish orchard deposits half the proceeds in a eurodollar account in London. No recording in the U.S. balance of payments, as the transaction was between foreigners using dollars already deposited abroad. A debit to the income receipts/payments of the British current account; a credit to the income receipts/payments of the Spanish current account.

(h) A London-based insurance company buys U.S. corporate bonds for its investment portfolio. A debit to the portfolio investment section of the British financial accounts; a credit to the portfolio investment section of the U.S. balance of payments.

(i) An American multinational enterprise buys insurance from a London insurance broker. A debit to the services part of the U.S. current account; a credit to the services part of the British current account.

(j) A London insurance firm pays for losses incurred in the United States because of an international terrorist attack. A debit to the services part of the British current account; a credit to the services part of the U.S. current account.

(k) Cathay Pacific Airlines buys jet fuel at Los Angeles International Airport so it can fly the return segment of a flight segment back to Hong Kong. Hong Kong keeps its balance of payments separate from those of the People’s Republic of China. Hence a debit to the goods part of Hong Kong’s current account; a credit to the goods part of the U.S. current account.

(l) A California-based mutual fund buys shares of stock on the Tokyo and London stock exchanges. A debit to the portfolio investment section of the U.S. financial account; a credit to the portfolio investment section of the Japanese and British financial accounts.

(m) The U.S. army buys food for its troops in South Asia from venders in Thailand. A debit to the goods part of the U.S. current account; a credit to the goods part of the Thai current account.

(n) A Yale graduate gets a job with the International Committee of the Red Cross working in Bosnia and is paid in Swiss francs. A debit to the income part of the Swiss current account; a credit to the income part of the Bosnia current account. This assumes the Yale graduate spends her earnings within Bosnia; should she deposit the sum in the United States then the credit would be to the income part of the U.S. current account.

(o) The Russian government hires a Dutch salvage firm to raise a sunken submarine. A debit to the service part of Russia’s current account; a credit to the service part of the Netherlands’s current account.

(p) A Colombian drug cartel smuggles cocaine into the United States, receives a suitcase of cash, and flies back to Colombia with that cash. This would not get captured in the goods part of the U.S. or the Columbian current accounts. Assuming the cash was “laundered” appropriately, from the point of view of the smugglers, bank accounts in the U.S. or somewhere else (probably not Colombia, possibly Switzerland) would be credited. This imbalance would end up in the errors and omissions part of the U.S. balance of payments.


(q) The U.S. government pays the salary of a foreign service officer working in the U.S. embassy in Beirut. Diplomats serving in a foreign country are regarded as residents of their home country, so this payment would not be recorded in any balance of payments accounts. If or when the diplomat spent the money in Beirut, at that time a debit should be incurred in the goods or services part of the U.S. current account and a contrary entry in the Lebanon balance of payments. It is doubtful that the goods or services transaction would get reported or recorded, although on a net basis changes in bank balances would reflect half of the transaction.

(r) A Norwegian shipping firm pays U.S. dollars to the Egyptian government for passage of a ship through the Suez canal. If the Norwegian firm paid with dollar balances held in the U.S. and the Suez Canal Authority of Egypt redeposited the proceeds in the U.S. no entry would appear in the U.S. balance of payments. Norway would debit a purchase of services, and Egypt would credit a sale of services.

(s) A German automobile firm pays the salary of its business executive working for a subsidiary in Detroit. Germany would record a debit in the income payments/receipts in its current account; the U.S. would record a credit in the income payments/receipts in its current account.

(t) An American tourist pays for a hotel in Paris with his American Express card. A debit would be recorded in the services part of the U.S. current account; a credit would be recorded in the services part of the French current account.

(u) A French tourist from the provinces pays for a hotel in Paris with his American Express card. A French resident most likely has a French-issued credit card, issued by the French subsidiary of American Express. In this instance, no entry would appear in either country’s balance of payments. If, later, the French subsidiary of American express paid a dividend back to the U.S., that would be recorded in the income part of the current accounts.

(v) A U.S. professor goes abroad for a year and lives on a Fulbright grant. The current transfers section of the U.S. current account would be debited for the salary paid to a foreign resident. (Even though an American, the professor is a foreign resident during the time he lives abroad.) The current transfers section of the host country’s current account would be credited.

The Balance

11. What are the main summary statements of the balance of payments accounts and what do they measure?

(a) The balance on goods (also called the balance of trade) measures the balance on imports and exports of merchandise.

(b) The balance on current account expands the balance on goods to include receipts and expenses for services, income flows, and unilateral transfers.

(c) The basic balance measures all of the international transactions (current, capital, and financial) that come about because of market forces. I.e., the balance resulting from all decisions made for private motives. (This includes international operating expenses of the government.)

(d) The overall balance (also called the official settlements balance) is the total change in a country’s foreign exchange reserves caused by the basic balance plus any governmental action to influence foreign exchange reserves.


Drugs and terrorists

12. Where in the balance of payments accounts do the flows of “laundered” money by drug dealers and international terrorist organizations flow?

Quite obviously the merchandise involved in the import or export of marijuana, heroin, cocaine, or other drugs is not reported to customs officials and so does not appear in the goods section of the current account. For similar reasons, the cash payments used to finance terrorists are not reported in the current transfers section of the current account.

The opposite side to any of these transactions is changes in bank balances held by foreigners or foreign bank balances held by home country residents. These are usually reported, but only in the aggregate. That is, the total changes in holdings are reported by banks, but the parties to the millions and millions of individual transactions that lead to the total change are not reported. The imbalance shows up in the errors and omissions part of the balance of payments.

Capital mobility—United States

13. The US dollar has maintained or increased its value over the past 20 years despite running a gradually increasing current account deficit. Why has this phenomenon occurred?

The U.S. dollar has maintained or increased its value over the past 20 years despite running a gradually increasing current account deficit because the current account deficit has been more than offset by an inflow of dollars on capital and financial accounts.

Capital mobility—Brazil

14. Brazil has experienced periodic depreciation of its currency over the past 20 years despite occasionally running a current account surplus. Why has this phenomenon occurred?

Brazil has experienced periodic depreciation of its currency because of speculative flights of capital out of Brazil in response to political and/or economic shocks, including periods of hyper-inflation.

BOP Transactions

15. Identify the correct BOP account for each of the following transactions.

(a) A German based pension fund buys U.S. government 30 year bonds for its investment portfolio.

Financial account: portfolio investment liabilities

(b) Scandinavian Airlines System (SAS) buys jet fuel at Newark Airport for its flight to Copenhagen.

Current account: Goods: Exports FOB

(c) Hong Kong students pay tuition to the University of California, Berkeley.

Current account: Services: credit

(d) The U.S. Air Force buys food in South Korea to supply its air crews.

Current account: Goods: Imports FOB

(e) A Japanese auto company pays the salaries of its executives working for its U.S. subsidiaries.

Current account: Services: credit


(f) A U.S. tourist pays for a restaurant meal in Bangkok.

Current account: Services: debit

(g) A Colombian citizen smuggles cocaine into the United States, receives cash, and smuggles the dollars back into Colombia.

Net errors and omissions

(h) A U.K. corporation purchases a euro-denominated bond from an Italian MNE. Does not enter the U.S. balance of payments

�� Mini-Case: Turkey’s Kriz (A): Deteriorating Balance of Payments

1. Where in the Current Account would the imported telecommunications equipment be listed? Would this correspond to the increase in magnitude and timing of the Financial Account?

The telecom equipment would appear in the Current Account as an import of goods. Net other investment would include financing by the vendors that sold TelSim the equipment. This and other imports of capital equipment probably accounted for most of the increase in net other investment and thus the large negative balance in the Financial Account in the year 2000.

2. Why do you think that net direct investment declined from $571 million in 1998 to $112 million in 2000?

The decline was probably caused by a lack of confidence in Turkey’s political stability and long-term growth prospects. Turkey’s war on its own’ inflation during the period 1999 to early 2000 must have included high interest rates and other macroeconomic policies to slow down the rate of growth. A slower rate of growth, if maintained in the long run, would reduce expected returns and direct investment inflows.

3. Why do you think that TelSim defaulted on its payments for equipment imports from Nokia and Motorola?

TelSim needed to invest heavily in capital equipment in order to create a modern high speed, high capacity network. Unfortunately, a considerable time gap typically exists between the time a network is created and it s capacity is utilized by revenue-paying customers. Thus long-term financing rather than short-term trade financing is needed. The timing gap experienced by TelSim was also experienced by many other telecommunications companies worldwide, including the highly-publicized case of Global Crossing, which also went bankrupt.

Expectations for the telecom industry and its ability to “monetize its customer base,” the ability to generate significant revenues from installed networks, proved overly optimistic. A worldwide overcapacity of telecommunications networks led to cutthroat price competition, adding to the shortfall in revenues experience worldwide. The overcapacity continued for several years, however, as firms attempted to survive by covering variable costs but not fixed capital costs of providing services.

Finally, there has been a continuing debate over the intentions and ethics of the Uzan family itself – the controlling interest group of TelSim. The press has run a number of stories raising the question as to whether the Uzan family had ever truly intended to repay the massive infrastructure financing provided by Motorola and Nokia. At the time of this writing, however, there is no proof that this was the case.

�� Problems

Problems 3.1–3.4 Australia’s current account Assumptions (millions of US dollars) 1998 1999 2000 2001 2002 2003 Goods: exports 55,884 56,096 64,052 63,676 65,099 70,577 Goods: imports 61,215 65,857 68,865 61,890 70,530 85,946

Balance on goods –5,331 –9,761 –4,813 1,786 –5,431 –15,369 Services: credit 16,181 17,399 18,677 16,689 17,906 21,205 Services: debit 17,272 18,330 18,388 16,948 18,107 21,638

Balance on services –1,091 –931 289 –259 –201 –433 Income: credit 6,532 7,394 8,984 8,063 8,194 9,457 Income: debit 17,842 18,968 19,516 18,332 19,884 24,245

Balance on income –11,310 –11,574 –10,532 –10,269 –11,690 –14,788 Current transfers: credit 2,651 3,003 2,622 2,242 2,310 2,767 Current transfers: debit 2,933 3,032 2,669 2,221 2,373 2,851

Balance on current transfers –282 –29 –47 21 –63 –84 Questions 1998 1999 2000 2001 2002 2003 3.1 What is Australia’s balance on goods? –5,331 –9,761 –4,813 1,786 –5,431 –15,369 (goods exports – goods imports) 3.2 What is Australia’s balance on services? –1,091 –931 289 –259 –201 –433 (services credit – services debit)

3.3 What is Australia’s balance on goods and services? –6,422 –10,692 –4,524 1,527 –5,632 –15,802 (balance on goods + balance on services) 3.4 What is Australia’s current account balance? –18,014 –22,295 –15,103 –8,721 –17,385 –30,674 (the sum of the four balances listed above, goods, services, income, and current transfers)

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Problems 3.5–3.9 Uruguay’s current account Assumptions (millions of US dollars) 1998 1999 2000 2001 2002 Goods: exports 2,829.3 2,290.6 2,383.8 2,139.4 1,933.1 Goods: imports 3,601.4 3,187.2 3,311.1 2,914.7 1,872.9 Balance on goods –772.1 –896.6 –927.3 –775.3 60.2 Services: credit 1,319.1 1,261.6 1,275.7 1,122.5 774.7 Services: debit 883.6 802.3 881.8 801.4 652.2 Balance on services 435.5 459.3 393.9 321.1 122.5 Income: credit 608.0 735.5 781.5 832.0 455.9 Income: debit 805.9 879.3 841.8 895.2 446.3 Balance on income –197.9 –143.8 –60.3 –63.2 9.6 Current transfers: credit 75.0 78.4 48.0 48.0 83.7 Current transfers: debit 16.0 4.9 20.5 18.3 14.3 Balance on current transfers 59.0 73.5 27.5 29.7 69.4 Questions 1998 1999 2000 2001 2002 3.5 What is Uruguay’s balance on goods? –772.1 –896.6 –927.3 –775.3 60.2 3.6 What is Uruguay’s balance on services? 435.5 459.3 393.9 321.1 122.5 3.7 What is Uruguay’s balance on goods and services? –336.6 –437.3 –533.4 –454.2 182.7 3.8 What is the balance on goods, services and income? –534.5 –581.1 –593.7 –517.4 192.3 3.9 What is Uruguay’s current account balance? –475.5 –507.6 –566.2 –487.7 261.7

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Problems 3.10–3.13 Myanmar’s balance of payments Assumptions (millions of US dollars) 1998 1999 2000 2001 A. Current account balance –499.1 –284.7 –211.7 –308.5 B. Capital account balance 0.0 0.0 0.0 0.0 C. Financial account balance 540.9 251.2 212.8 399.1 D. Net errors and omissions 18.7 –12.4 –24.5 89.3 E. Reserves and related items –60.4 45.9 23.4 –179.8 Questions 1998 1999 2000 2001 3.10 Is Myanmar experiencing a net capital inflow or outflow? 540.9 251.2 212.8 399.1 “inflow” “inflow” “inflow” “inflow” 3.11 What is Myanmar’s total for groups A and B? –499.1 –284.7 –211.7 –308.5 3.12 What is Myanmar’s total for groups A through C? 41.8 –33.5 1.1 90.6 3.13 What is Myanmar’s total for groups A through D? 60.5 –45.9 –23.4 179.9

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Problems 3.14–3.20 Argentina’s balance of payments

Assumptions (millions of US dollars) 1998 1999 2000 2001 2002

A. Current Account Goods: exports 26,434 23,309 26,341 26,543 25,709 Goods: imports 29,531 24,103 23,889 19,158 8,473 Balance on goods –3,097 –794 2,452 7,385 17,236

Services: credit 4,704 4,554 4,765 4,398 2,966 Services: debit 9,136 8,660 9,039 8,298 4,577 Balance on services –4,432 –4,106 –4,274 –3,900 –1,611

Income: credit 6,125 6,095 7,489 5,370 3,176 Income: debit 13,531 13,558 14,959 13,117 9,645 Balance on income –7,406 –7,463 –7,470 –7,747 –6,469

Current transfers: credit 720 704 724 681 570 Current transfers: debit 314 307 369 399 167 Balance on current transfers 406 397 355 282 403

Current Account Balance (Group A) –14,529 –11,966 –8,937 –3,980 9,559

B. Capital Account (Group B) 73 86 106 101 39 C. Financial Account Direct investment abroad 2,325 1,730 901 161 –627 Direct investment in Argentina 7,291 23,988 10,418 2,166 785 Direct investment in Argentina, net 4,966 22,258 9,517 2,005 1,412

Portfolio investment assets, net –1,906 –2,005 –1,252 1,797 477 Portfolio investment liabilities, net 10,693 –4,780 –1,331 –9,574 –6,596 Balance on other investment assets and liabilities, net 5,183 –1,065 784 –7,596 –18,738

D. Net Errors and Omissions –389 –515 –63 –4,155 –1,422 E. Reserves and Related Items –4,090 –2,013 1,176 21,405 15,269

Questions

3.14 What is Argentina’s balance on services? –4,432 –4,106 –4,274 –3,900 –1,611 3.15 What is Argentina’s current account balance? –11,432 –11,172 –11,389 –11,365 –7,677 3.16 What seems to have been the primary driver in Argentina’s current account balance? income debit income debit income debit income debit income credit 3.17 What is Argentina’s financial account balance? 18,936 14,408 7,718 –13,368 –23,445 3.18 What is Argentina’s total for groups A through C? 7,577 3,322 –3,565 –24,632 –31,083 3.19 What is Argentina’s total for groups A through D? 7,188 2,807 –3,628 –28,787 –32,505 3.20 Unless the financial account could grow a very large surplus, a crisis will ensue.

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Chapter 4 International Parity Conditions

�� Questions

Purchasing power parity

1. What is the Law of One Price? According to this “law,” what should happen to the currency of a country experiencing hyper-inflation?

The law of one prices states that producers’ prices for goods or services of identical quality should be the same in different markets; i.e., different countries (assuming no restrictions on the sale and allowing for transportation costs). If a country has higher inflation than other countries, its currency should devalue or depreciate so that the real price remains the same as in all countries. Application of this law results in the theory of Purchasing Power Parity (PPP).

Undervalued and overvalued

2. What is an undervalued currency? What is an overvalued currency?

In its semantic sense, undervalued means current value (current price) is lower than true intrinsic worth, and overvalued means current value (current price) is above true intrinsic worth. Application of these concepts to currencies implies that one has some basis, such as purchasing power parity, to determine true intrinsic worth.

(a) An undervalued currency is a currency for which the current exchange rate (e.g., current value), stated as the foreign currency price for the base currency is lower than it should be. Assume the current exchange rate for the Slovak koruna is K50.0/$ at a time when the koruna’s intrinsic worth is K40.0/$. Using reciprocals (1 ÷ K50.0/$ = $0.0200/K; 1 ÷ K40/$ = $0.0250/K), the koruna is currently priced in dollars at 2.0¢ per koruna at a time when its intrinsic worth is 2.5¢ per koruna. Hence at its present price it is undervalued, meaning the value placed on the koruna by the market (2.0¢) is below its true worth (2.5¢).

(b) An overvalued currency is a currency for which the current exchange rate (e.g., current value), stated as the foreign currency price for the base currency is higher than it should be. Assume the current exchange rate for the Sri Lankan rupee is R100/$ at a time when the rupee’s intrinsic worth is R125/$. Using reciprocals (1 ÷ R100/$ = $0.0100/R; 1 ÷ R125/$ = $0.0800/R), the rupee is currently priced in dollars at 1.0¢ per rupee at a time that its intrinsic worth is only 0.8¢ per koruna. Hence at its present price it is overvalued, meaning the value placed on the rupee by the market (1.0¢) is greater than its true worth (0.9¢).

Most exchange rates are stated as the number of foreign currency units needed to buy one U.S. dollar. For these currencies, then, an exchange rate where the stated rate is greater than the intrinsic worth of the currency is undervalued; and vice versa. One will note that in Exhibit 4.1 in the text, those currencies given a minus sign in column (5) are undervalued—see heading of column (5). I.e. their “actual exchange rate” (column 2, expressed as currency units per dollar) is greater than their inherent worth, the implied PPP vis à vise the dollar (column 4).

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Hamburger standard

3. Using the data in Exhibit 4.1, separate the countries in which the actual exchange rate on April 17, 2004, was overvalued; i.e., above the hamburger parity rate, from those in which the actual exchange rate was undervalued; i.e., below the implied parity rate. What do you conclude?

In Exhibit 4.1, currencies with a minus sign in the third column entry per country are undervalued. It is in fact easier to simply identify which currencies are overvalued against the dollar, because there are so few!

Overvalued countries/currencies

Britain Iceland Denmark Jordan Euro area Kuwait Sweden Norway Switzerland

Data in the current table suggest that most of the world’s currencies were undervalued against the dollar at that time, making hamburgers cheaper in the rest of the world than they were in Britain, Denmark, Switzerland, the Euro area, Sweden, Iceland, Jordan, Kuwait, and Norway. If the hamburger standard is a correct measure of overall purchasing power parity, goods in general are less expensive in all countries except these specific countries.

Relativity

4. What is the difference between the absolute theory of purchasing power parity and the relative version of that theory?

The absolute version of the theory of purchasing power parity states that exchange rates should reflect the difference in price indices for traded goods and services between two countries. The relative version of the theory uses changes in such price indices between two time periods to predict changes in the exchange rate (rather than the absolute exchange rate) relative to some past base period.

PPP and BOP

5. What is the connection between changes in purchasing power parity and changes in a country’s balance of payments?

If a country’s inflation rate exceeds that of its main trading partners and its exchange rate does not change, its exports of goods and services become evermore expensive while imports become evermore cheaper at home. These conditions lead to a deficit in the current account of the balance of payments.

Validating PPP

6. What two general conclusions can be made about the actual working of purchasing power parity?

As a general matter research has shown (a) that PPP works well over the very long run but poorly over the short run, and (b) the theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets.


Exchange rate indices

7. What is a nominal effective exchange rate index and how does it differ from a real effective exchange rate index?

An exchange rate index is an index that measures the value of a given country’s exchange rate against all other exchange rates in order to determine if that currency is overvalued or undervalued.

(a) The nominal effective exchange rate index is based on a weighted average of actual exchange rates over a period of time. It is unrelated to PPP and simply measures changes in the exchange rate (i.e., currency value) relative to some arbitrary base period. It is used in calculating the real effective exchange rate index.

(b) “The real effective exchange rate index adjusts the nominal effective exchange rate index to reflect differences in inflation. The adjustment is achieved by multiplying the nominal index by the ratio of domestic costs to foreign costs. The real index measures deviation from purchasing power parity, and consequently pressures on a country’s current account and foreign exchange rate.

Interest rates

8. What is the difference between nominal interest rates and real interest rates?

Nominal interest rates are simply the stated contractual rate of interest within a country. Real interest rates are the nominal interest rate less the rate of inflation. (If one earns 8% interest on a debt instrument, but inflation “eats away” 3 percentage points of those earnings, the real interest rate is only 5%. The purchasing power of debt holders rose only 5% during the year.)

International Fisher effect

9. What did Irving Fisher postulate about the relationship between nominal interest rates and foreign exchange rates?

Irving Fisher stated that the spot exchange rate should change in an equal amount but opposite in direction to the difference in nominal interest rates. Stated differently, the real return in different countries should be the same, so that if one country has a higher nominal interest rate, the gain from investing in that currency will be lost by a deterioration of its exchange rate.

The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as the international Fisher effect. “Fisher-open,” as it is often termed, states that the spot exchange rate should change in an equal amount but in the opposite direction to the difference in interest rates between two countries. More formally:

$ ¥1 2

2

S S100 i i ,

S

−× = −

where i$ and i¥ are the respective national interest rates, and S is the spot exchange rate using indirect quotes (an indirect quote on the dollar is, for example, ¥/$) at the beginning of the period (S1) and the end of the period (S2). This is the approximation form commonly used in industry. The precise formulation is:

$ ¥1 2

¥2

S S i i.

S 1 i

− −=+


Fisher effect

10. What did Irving Fisher state to be the relationship between nominal and real interest rates?

Irving Fisher stated that nominal interest rates in each country should equal the required rate of return plus compensation for inflation. Using i for the nominal rate, r for the real rate, and π for the rate of inflation, the Fisher effect may be stated two ways:

i = r + π, or r = i – π

The Fisher effect also states that real interest rates in various countries should be the same.

�� Mini-Case: The Introduction of the Porsche 911 Carrera 4S Cabriolet

1. Clearly, at some point sooner or later, Porsche must raise the US dollar price of this model and all product models (particularly if the euro continues to strengthen and maintains this strength compared to the dollar). But when would that be?

This pricing dilemma—when to pass through to final price cost pressures—is experienced in all industries all of the time. In the case of Porsche, the firm has publicly argued that it can afford to maintain its pricing by way of the ‘subsidization’ coming from its successful option hedging program over the past few years. The second factor which aids in the postponement of price changes is that exchange rates, unlike many other input prices, do not just go one direction (up). Many believe that the dollar/euro exchange rate will return to a more traditional trading range (and Porsche appears to be one of them by way of its public announcements) which would eliminate the need. But, if these subsidies and market movements do not occur in the near term—say by early to mid 2005—the retail price of the Porsche in target markets like the US would have to be raised to simply cover the costs of production, independent of degree of profitability as seen in margins.

2. What would it take to convince Porsche’s management that ‘now is the time’ to pass-through more of the exchange rate change in the price?

Ironically, much of the news in late 2004 and early 2005 in which senior government and treasury officials in the United States publicly stated that exchange rates are best set by markets (meaning there will be no concerted effort by the Bush administration to push the dollar up against the euro), adds to a market opinion that $1.30 or better is where the euro may stay for some time to come. If this rate of exchange is sustained, and several other major European-based automakers like Volkswagen and Mercedes start pushing dollar prices up, Porsche may indeed decide the time is now.


�� Problems

Problem 4.1 Passing through Steps Value Initial spot exchange rate (¥/US$) 125.00 Initial price of a Honda in, in yen 4,000,000 Expected US dollar inflation rate for the coming year 3.000% Expected Japanese yen inflation rate for the coming year 1.000% Desired rate of pass through by Honda 60.000% a. What was the dollar price for a Honda at the beginning of the year? Year-beginning price of a Honda (in yen) 4,000,000 Spot exchange rate (¥/US$) 125.00 Year-beginning price of a Honda (in US$) $32,000.00 b. What is the expected spot rate one year from now assuming PPP? Initial spot rate (¥/US$) 125.00 Expected US$ inflation 3.00% Expected Japanese yen inflation 1.00% Expected spot rate one year from now assuming PPP (¥/US$) 122.57 c. Assuming complete pass through, what will the price be in US$ in one year? Price of Honda at beginning of year (in yen) 4,000,000 Japanese yen inflation over the year 1.000% Price of Honda at end of year (in yen) 4,040,000 Expected spot rate one year from now assuming PPP (¥/US$) 122.57 Price of Honda at end of year (in US$) $32,960.00 d. Assuming partial pass through, what will the price be in US$ in one year? Price of Honda at end of year (in yen) 4,040,000 Amount of expected exchange rate change, in percent 1.980% Proportion of exchange rate change passed through by Honda 60.000% Proportional percentage change 1.188% Effective exchange rate used by Honda to price in US$ for end of year 123.532 Price of Honda at end of year (in US$) $32,704


Problem 4.2 Chilean pesos Assumptions Value Spot exchange rate, one year ago, pesos per US$ 500.00 Change in value of peso over the year –25.00% US inflation over year 0.00% Chilean inflation over year 22.00% a. What is the actual exchange rate today? Beginning spot rate (pesos/US$) 500.00 Percentage change in the peso –25.00% Actual exchange rate today (pesos/US$) 666.67 Check: (Beginning-Ending)/(Ending) –25.00% b. What should be the exchange rate today based on PPP? Beginning spot rate (pesos/US$) 500.00 Chilean inflation 22.00% US inflation 0.00% PPP exchange rate 610.00 c. By what percentage is the peso overvalued or undervalued? Actual exchange rate today (pesos/US$) 666.67 PPP exchange rate (pesos/US$) 610.00 Percentage overvaluation (positive) or undervaluation (negative) –8.500%


Problem 4.3 International Interest Rates Assumptions Value One year interest rate in the United States (dollars, US$) 1.500% One year interest rate in the United Kingdom (pounds, £) 4.800% Current spot rate (US$/£) 1.8500

Expected spot rate according to International Fisher effect (US$/£) 1.7917


Problem 4.4 Trident borrows euros Assumptions Value Trident is borrowing the following principal, in euros (€) �� Trident’s cost of borrowing euros (€) 5.000% Interest savings over borrowing rate in the US 3.000% Current spot exchange rate (US$/€) $1.3200 Expected US inflation rate for the coming year 3.000% Expected euro inflation rate for the coming year 2.000% Euro borrowing: Trident borrows the following euros �� At the following interest rate 5.000% Repaying principal and interest of the following in one year �� Proceeds of euro loan in US dollars $5,280,000 Expected spot rate in one year: Current spot rate (US$/euro) $1.3200 US inflation rate 3.000% euro inflation rate 2.000% Expected spot rate assuming PPP (US$/€) 1.3329 Repaying the euro loan in US dollars will cost: Required repayment in euros �� At the following expected spot rate ($/€) $1.3329 Will require this amount of US dollars $5,598,353

Cost of the loan in dollar terms is = (Repayment/Proceeds) – 1 6.0294% This is the real cost of borrowing in euros as Trident would expect.


Problem 4.5 Covering How does the risk of an uncovered interest arbitrage investment differ from the risk of a covered interest arbitrage investment? By being “uncovered,” the investor still bears foreign exchange rate risk. The investment’s Returns—in the originating currency of the investment—are not protected against exchange rate changes if uncovered. UIA is therefore significantly risky compared to CIA.


Problem 4.6 Mary Smyth—CIA Assumptions Value Spot exchange rate (Swiss francs per US dollar) SFr. 1.1520 3-month forward ratae (Swiss francs per US dollar) SFr. 1.1472 3-month US dollar interest rate (per annum) 4.500% 3-month Swiss franc interest rate (per annum) 3.200% Principal to be invested $1,000,000.00 Invest the Dollars in the US: Principal $1,000,000.00 Interest for the 3-month period 1.125% Gross return $1,011,250.00 Net return in US dollars $11,250.00 Convert Dollars to Swiss francs and Cover: Principal $1,000,000.00 Converted to Swiss francs at the current spot rate (SFr./$) of SFr. 1.1520 Yielding this principal of Swiss francs SFr. 1,152,000 Invested at Swiss franc interest rate for the 3-month period 0.800% Yielding this amount of Swiss francs at the end of one year SFr. 1,161,216 Which are simultaneously sold forward at the forward rate of 1.1472 Gross return in US dollars, fully covered, at the end of one year $1,012,217.57 Net return in US dollars $12,217.57 Mary Smyth is better off investing in the Swiss franc deposits.

Problem 4.7 Mary Smyth—UIA Assumptions Value Spot exchange rate (Swiss francs per US dollar) SFr. 1.1520 3-month forward ratae (Swiss francs per US dollar) SFr. 1.1472 3-month US dollar interest rate (per annum) 4.500% 3-month Swiss franc interest rate (per annum) 3.200% Principal to be invested $1,000,000.00 Invest the Dollars in the US: Principal $1,000,000.00 Interest for the 3-month period 1.125% Gross return $1,011,250.00 Net return in US dollars $11,250.00 Convert Dollars to Swiss francs and Cover: Principal $1,000,000.00 $1,000,000.00 $1,000,000.00 Converted to Swiss francs at the current spot rate (SFr./$) of SFr. 1.1520 SFr. 1.1520 SFr. 1.1520 Yielding this principal of Swiss francs SFr. 1,152,000.00 SFr. 1,152,000.00 SFr. 1,152,000.00 Invested at Swiss franc interest rate for the 3-month period 0.800% 0.800% 0.800% Yielding this amount of Swiss francs at the end of one year SFr. 1,161,216.00 SFr. 1,161,216.00 SFr. 1,161,216.00 The outcome of Uncovered Interest Arbitrage depends on the ending spot rate (SF/$): SFr. 1.1000 SFr. 1.1500 SFr. 1.2000 Gross return in US dollars, fully covered, at the end of one year $1,055,650.91 $1,009,753.04 $967,680.00 Net return in US dollars $55,650.91 $9,753.04 ($32,320.00) Compared to investing in the US dollar markets,

Mary Smyth, by investing uncovered in Swiss francs, earns: $44,400.91 ($1,496.96) ($43,570.00)

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Problem 4.8 Mary Smyth—one month later Assumptions Value Spot exchange rate (Swiss francs per US dollar) SFr. 1.1800 3-month forward ratae (Swiss francs per US dollar) SFr. 1.1680 3-month US dollar interest rate (per annum) 4.800% 3-month Swiss franc interest rate (per annum) 3.000% Principal to be invested $1,000,000.00 Invest the Dollars in the US: Principal $1,000,000.00 Interest for the 3-month period 1.200% Gross return $1,012,000.00 Net return in US dollars $12,000.00 Convert Dollars to Swiss francs and Cover: Principal $1,000,000.00 Converted to Swiss francs at the current spot rate (SF/$) of SFr. 1.1800 Yielding this principal of Swiss francs SFr. 1,180,000.00 Invested at Swiss franc interest rate for the 3-month period 0.750% Yielding this amount of Swiss francs at the end of one year SFr. 1,188,850.00 Which are simultaneously sold forward at the forward rate of SFr. 1.1680 Gross return in US dollars, fully covered, at the end of one year $1,017,851.03 Net return in US dollars $17,851.03 Mary Smyth is better off investing in the Swiss franc deposits.

Problem 4.9 Langkawi Island Resort Assumptions Value Charge for suite plus meals (in ringgit) 760.00 Spot exchange rate (ringgit per US$) 3.8000 US$ cost today for a 30 day stay $6,000.00 Malaysian ringgit inflation rate expected to be 4.000% U.S. dollar inflation rate expected to be 1.000% a. How many dollars might you expecte to need one year hence for your 30-day vacation? Spot exchange rate (ringgit per US$) 3.8000 Malaysian ringgit inflation rate expected to be 4.000% U.S. dollar inflation rate expected to be 1.000% Expected spot rate one year from now based on PPP (ringgit per US$) 3.9129 Hotel charges expected to be paid one year from now for a 30-day stay 23,712.00 US dollars needed on the basis of these two expectations: $6,060.00 b. By what percent has the dollar cost gone up? Why? New dollar cost $6,060.00 Original dollar cost $6,000.00 Percent change in US$ cost 1.000% The dollar cost has risen by the US dollar inflation rate. This is a result of your estimation of the future suite costs and exchange rate changing in relation to inflation.

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Problem 4.10 Covered interest against the krone Assumptions Value Spot exchange rate (NKr/$) 6.2280 3-month forward rate (NKr/$) 6.2640 US 3-month Treasury bill rate 4.400% Norwegian 3-month Treasury bill rate 4.800% Notional investment $500,000.00 Invest the Dollars in the US: Principal $500,000.00 Interest for the 3-month period 1.100% Gross return $505,500.00 Net return in US dollars $5,500.00 Covered Interest Arbitrage in Norwegian Kroner: Principal $500,000.00 Converted to Norwegian kroner at the spot rate (NKr/$) of 6.2280 Yielding this principal in Norwegian kroner 3,114,000.00 Invested at Norwegian Treasury bill rate for the 3-month period 1.200% Yielding this amount of Norwegian kroner at the end of 3 months 3,151,368.00 Which are simultaneously sold forward at the forward rate of 6.2640 Gross return in US dollars, fully covered, at the end of one year $503,091.95 Net return in US dollars $3,091.95

Opportunity cost of investing in Norway over the US: ($2,408.05)

Problem 4.11 Frankfurt and New York Assumptions Frankfurt New York Spot exchange rate (US$/euro) 1.2200 1.2200 One-year Treasury bill rate 2.100% 1.500% Expected inflation rate ? 2.000% a. What do the financial markets suggest for inflation in Europe next year? According to the Fisher Effect, real interest rates should be the same in both Europe and the United States. Since the nominal rate = [(1 + real) × (1 + expected inflation)] – 1: 1 + real rate = (1 + nominal)/(1 + expected inflation) 1 + nominal rate 102.100% 101.500% 1 + expected inflation ? 102.000% So 1 + real = 99.510% � 99.510% and therefore the real rate in the US is: –0.490%

The expected rate of inflation in Frankfurt is then: 2.603% b. Estimate today’s one-year forward exchange rate between the dollar and the euro. Spot exchange rate (US$/euro) 1.2200 US dollar one-year Treasury bill rate 1.500%

European euro one-year Treasury bill rate 2.100%

One year forward rate (US$/euro) 1.2128

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Problem 4.12 The Beer Standard Beer Prices Spot Under or Local Local In Implied Rate Overvalued Country Beer Currency Currency Rand PPP Rate 3/15/99 to Rand (%) South Africa Castle Rand 2.30 — — — — Botswana Castle Pula 2.20 2.94 0.96 0.75 27.9% Ghana Star Cedi 1,200.00 3.17 521.74 379.10 37.6% Kenya Tusker Shilling 41.25 4.02 17.93 10.27 74.6% Malawi Carlsberg Kwacha 18.50 2.66 8.04 6.96 15.6% Mauritius Phoenix Rupee 15.00 3.72 6.52 4.03 61.8% Namibia Windhoek N$ 2.50 2.50 1.09 1.00 8.7% Zambia Castle Kwacha 1,200.00 3.52 521.74 340.68 53.1% Zimbabwe Castle Z$ 9.00 1.46 3.91 6.15 –36.4% Notes: 1. Beer price in South African rand = Price in local currency/spot rate on 3/15/99. 2. Implied PPP exchange rate = Price in local currency/2.30. 3. Under or overvalued to rand = Implied PPP rate/spot rate on 3/15/99.

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Chapter 5 Foreign Exchange Rate Determination

�� Questions

Term forecasting

1. What are the major differences between short-term and long-term forecasts for a fixed versus floating exchange rate?

Long-run forecasts may be motivated by a multinational firm’s desire to initiate a foreign investment in Japan, or perhaps to raise long-term funds denominated in Japanese yen. Or a portfolio manager may be considering diversifying for the long term in Japanese securities. The longer the time horizon of the forecast, the more inaccurate but also the less critical the forecast is likely to be. The forecaster will typically use annual data to display long-run trends in such economic fundamentals as Japanese inflation, growth, and the BOP.

Short-term forecasts are typically motivated by a desire to hedge a receivable, payable, or dividend for perhaps a period of three months. In this case the long-run economic fundamentals may not be as important as technical factors in the marketplace, government intervention, news, and passing whims of traders and investors. Accuracy of the forecast is critical since most of the exchange rate changes are relatively small even though the day-to-day volatility may be high.

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Forecasting services normally undertake fundamental economic analysis for long-term forecasts, and some base their short-term forecasts on the same basic model. Others base their short-term forecasts on technical analysis similar to that conducted in security analysis. They attempt to correlate exchange rate changes with various other variables, regardless of whether there is any economic rationale for the correlation. The chances of these forecasts being consistently useful or profitable depends on whether one believes the foreign exchange market is efficient. The more efficient the market is, the more likely it is that exchange rates are “random walks,” with past price behavior providing no clues to the future. The less efficient the foreign exchange market is, the better the chance that forecasters may get lucky and find a key relationship that holds, at least for the short run. If the relationship is really consistent, however, others will soon discover it and the market will become efficient again with respect to that piece of information. Exhibit 5.9 summarizes the various forecasting periods, regimes, and the authors’ opinions on the preferred methodologies.

Exchange rate dynamics

2. What is meant by the term overshooting? What causes it and how is it corrected?

Assume that the current spot rate between the dollar and the euro, as illustrated in Exhibit 5.10 in the text, is S0. The U.S. Federal Reserve announces an expansionary monetary policy which cuts U.S. dollar interest rates. If euro-denominated interest rates remain unchanged, the new spot rate expected by the exchange markets on the basis of interest differentials is S1. This immediate change in the exchange rate is typical of how the markets react to news, distinct economic and political events which are observable. The immediate change in the value of the dollar/euro is therefore based on interest differentials. As time passes, however, the price impacts of the monetary policy change start working their way through the economy. As price changes occur over the medium to long-term, purchasing power parity forces drive the market dynamics, and the spot rate moves from S1 towards S2. Although both S1 and S2 were rates determined by the market, they reflected the dominance of different theoretical principles. As a result, the initial lower value of the dollar of S1 is often explained as an overshooting of the longer-term equilibrium value of S2.


Fundamental equilibrium

3. What is meant by the term fundamental equilibrium path for a currency value? What is noise?

It appears from decades of theoretical and empirical studies that exchange rates do adhere to the fundamental principles and theories outlined in the chapter (namely purchasing power parity and interest rate parity). Fundamentals do apply in the long term. There is, therefore, something of a fundamental equilibrium path for a currency’s value.

It also seems that in the short term, a variety of random events, institutional frictions, and technical factors may cause currency values to deviate significantly from their long-term fundamental path. This is sometimes referred to as noise. Clearly, therefore, we might expect deviations from the long-term path not only to occur, but to occur with some regularity and relative longevity.

Asset market approach to forecasting

4. Explain how the asset market approach can be used to forecast future spot exchange rates. How does the asset market approach differ from the BOP approach to forecasting?

The asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers. These drivers include the following:

(1) Relative real interest rates are a major consideration for investors in foreign bonds and short term money market instruments.

(2) Prospects for economic growth and profitability are an important determinant of cross-border equity investment in both securities and foreign direct investment.

(3) Capital market liquidity is particularly important to foreign institutional investors. Cross-border investors are not only interested in the ease of buying assets, but also in the ease of selling those assets quickly for fair market value if desired.

(4) A country’s economic and social infrastructure is an important indicator of that country’s ability to survive unexpected external shocks and to prosper in a rapidly changing world economic environment.

(5) Political safety is exceptionally important to both foreign portfolio and direct investors. The outlook for political safety is usually reflected in political risk premiums for a country’s securities and for purposes of evaluating foreign direct investment in that country.

(6) The credibility of corporate governance practices is important to cross-border portfolio investors. A firm’s poor corporate governance practices can reduce foreign investors’ influence and cause subsequent loss of the firm’s focus on shareholder wealth objectives.

(7) Contagion is defined as the spread of a crisis in one country to its neighboring countries and other countries that have similar characteristics—at least in the eyes of cross-border investors. Contagion can cause an ‘innocent’ country to experience capital flight with a resulting depreciation of its currency.

(8) Speculation can both cause a foreign exchange crisis or make an existing crisis worse. We will observe this effect through the three illustrative cases that follow shortly.


Technical analysis

5. Explain how technical analysis can be used to forecast future spot exchange rates. How does technical analysis differ from the BOP and asset market approaches to forecasting?

Technical analysts, traditionally referred to as chartists, focus on price and volume data to determine past trends that are expected to continue into the future. The single most important element of technical analysis is that future exchange rates are based on the current exchange rate. Exchange rate movements, similar to equity price movements, can be subdivided into three periods: (1) day-to-day movement, which is seemingly random; (2) short-term movements extending from several days to trends lasting several months; (3) long-term movements, which are characterized by up and down long-term trends. Long-term technical analysis has gained new popularity as a result of recent research into the possibility that long-term “waves” in currency movements exist under floating exchange rates.

Forecasting services

6. Many treasurers subscribe to rather expensive on-line foreign exchange forecasting services even if these services have a dubious record of consistently correct forecasts. What might motivate a treasurer to continue to use a forecasting service?

A treasurer might continue to use a forecasting service because “it exists.” If the treasurer does not use it, and guesses wrong on an exchange rate, the treasurer could be criticized for not using available “expert advice.”

Cross-rate consistency in forecasting

7. Explain the meaning of “cross-rate consistency” as used by MNEs. How do MNEs use a check of cross-rate consistency in practice?

International financial managers must often forecast their home currency exchange rates for the set of countries in which the firm operates, not only to decide whether to hedge or to make an investment, but also as an integral part of preparing multi-country operating budgets in the home country’s currency. These are the operating budgets against which the performance of foreign subsidiary managers will be judged. Checking the reasonableness of the cross rates implicit in individual forecasts acts as a reality check to the original forecasts.

Infrastructure weakness

8. Infrastructure weakness was one of the causes of the emerging market crisis in Thailand in 1997. Define infrastructure weakness and explain how it could affect a country’s exchange rate.

Infrastructure weakness refers to situations where public services (roads, railroads, electric power, impartial judicial system, minimum corruption by politicians, adequate police and fire services, reasonable health care systems, etc.) are dysfunctional. Lack of quality services increases the difficulty and risk of operating a business in that country, which in turn means domestic investment funds will tend to escape from the country and foreign investment funds will not enter. The flight of domestic currencies and the lack of foreign demand for the domestic currency force the exchange rate down (floating regime) or force the government to devalue (fixed exchange rate regime.)


Infrastructure strength

9. Explain why infrastructure strengths have helped to offset the large BOP deficits on current account in the United States.

The strength of the U.S.—infrastructure encourages foreign capital to invest in the safety of the United States. Foreign investors like the U.S. legal system, protection of intellectual property rights, freedom from ethnic strife, and other aspects of the U.S. infrastructure conducive to business development.

Speculation

10. The emerging market crises of 1997–2002 were worsened because of rampant speculation. Do speculators cause such crisis or do they simply respond to market signals of weakness? How can a government manage foreign exchange speculation?

“Hot money” is a term used to describe funds held in one currency (country) that will move very quickly to another currency as soon as it is deemed weak. Such a quick flow will create severe short-term pressures on the exchange rate., forcing depreciation or a devaluation. This run on the currency may cause others to also try to exchange their local currency holdings for foreign money, aggravating the already apparent weakness.

If a currency is fundamentally weak, a speculator such as George Soros may lead a flight from that currency. He will succeed if he is correct in his assessment of the fundamentals, but if he is in error he will lose on the speculation. In the Malaysian situation, Soros correctly assessed the situation, and by moving first was probably instrumental in setting in motion underlying factors that would have influenced exchange rates in any case—possibly at a later date. In other words, Soros did not cause the currency crisis in a fundamental sense, but he may well have caused (and advanced) the timing of what would have occurred eventually in any case.

Foreign direct investment

11. Swings in foreign direct investment flows into and out of emerging markets contribute to exchange rate volatility. Describe one concrete historical example of this phenomenon during the last 10 years.

Cross-border investment flows are of two types: direct and portfolio. Investment flows into a country mean that foreigners are buying the local currency, which factor will drive up the value of that local currency. Such flows also give local entities, either private individuals and corporations or the central bank, foreign exchange balances that can be used to import goods and services or held as foreign exchange reserves. Together the investment inflows and their usage influence the country’s exchange rate.

In the case of Thailand, investment flows went into the country before the 1997 crisis because Thai interest rates and expected returns on direct investments were high, because the outside world believed the Thai government would continue to support its currency, and because the outside world did not pay attention to the infrastructure weaknesses in Thailand. When Thailand devalued its baht, the outside world suddenly became aware of structural weaknesses and new investment inflows stopped at once. This precipitated the devaluation of the baht and the beginning of devaluation in neighboring countries.


Thailand’s crisis of 1997

12. What were the main causes of Thailand’s crisis of 1997? What lessons were learned and what steps were eventually taken to normalize Thailand’s economy?

The basic cause was a period of large imports of goods (deficit on current account) financed by inflows of foreign capital (surplus on financial account), including local borrowing in cheaper overseas markets. Maintenance of exchange rates of the various southeast Asian currencies had been expected. The crisis was exacerbated by what came to be called “crony capitalism” where many dealings were driven by friendships and relationships to governing officials rather than by market factors.

Once the crisis was apparent, financial managers of MNEs should rationally stop expansion of local facilities and try to repatriate cash balances in local currencies, if possible. This would cause the financial component of the balance of payments to worsen for the countries involved. For companies manufacturing for local consumption, a drop in local demand, possibly caused by an increase in costs if imported components were needed, would lead to cut backs in production and resultant unemployment, making the crisis-caused depression even worse.

Russia’s crisis of 1998

13. What were the main causes of Russia’s crisis of 1998? What lessons were learned and what steps were taken to normalize Russia’s economy?

This crisis was caused by a deterioration over the prior half decade or so of the Russian economy. During these years private and governmental Russian entities had borrowed large amounts of money abroad, most of which was denominated in U.S. dollars. To service this foreign currency debt Russia had to earn dollars from exports; however dollars earned, as well as dollars obtained by borrowing, flowed out almost at once in the form of capital flight. Furthermore, most dollar earnings came from the export of commodities, and commodity prices were falling worldwide, in part because of the Asian crisis.

Deteriorating conditions in Russia, combined with corruption and incompetence by governmental officials and continued capital flight meant that MNE financial managers should minimize the amount of cash held in any Russian subsidiary. In effect they should join the capital flight, although the form might be that of avoiding inflows of capital rather than flight of capital already in Russia. Plans for additional investments should be delayed until the Russian economy stabilized. Of course, such rational behavior on the part of managers of individual private entities worsens to some degree what is already happening.

Argentina’ crisis of 2001–2002

14. What were the main causes of Argentina’s crisis of 2001–2002? What lessons were learned and what steps were taken to normalize Argentina’s economy?

By 2001 crisis conditions had revealed three very important underlying problems with Argentina’s economy: (1) the Argentine peso was overvalued; (2) the currency board regime had eliminated monetary policy alternatives for macroeconomic policy; and (3) the Argentine government budget deficit—and deficit spending—was out of control.

The peso had indeed been stabilized. But inflation had not been eliminated, and the other factors which are important in the global market’s evaluation of a currency’s value—economic growth, corporate profitability, etc.—had not necessarily always been positive. The inability of the peso’s value to change with market forces led many to believe increasingly that it was overvalued, and that the overvaluation gap was rising as time passed.


Argentina’s large neighbor to the north, Brazil, had also suffered many of the economic ills of hyperinflation and international indebtedness in the 1980s and early 1990s. Brazil’s response, the Real Plan, was introduced in July 1994. The real plan worked, for a while, but eventually collapsed in January 1999 as a result of the rising gap between the real’s official value and the market’s assessment of its true value.

Brazil was by far Argentina’s largest trading partner. With the fall of the Brazilian real, however, Brazilian consumers could no longer afford Argentine exports. It simply took too many real to purchase a peso. In fact, Argentine exports became some of the most expensive in all of South America as other countries saw their currencies slide marginally against the dollar over the decade. But not the Argentine peso.

�� Mini-Case: Turkey’s Kriz (B) Uncovered Interest Arbitrage

1. Was the Turkish lira’s collapse the result of a balance of payments crisis, an inflation crisis, a political crisis, or an economic crisis?

Although we are tempted to say “all of the above,” the more rigorous response is a political landscape which led to many of the common economic ills of a struggling emerging market. The inflationary pressures, continual volatility in current and financial balance of payment accounts, and struggling process of privatization—all reflect an economy in both political and structural transition. Although the struggles with BOP accounts and inflation had been recurring, the Turkish lira’s fixed rate could probably have survived if it had not been for the dollar-debt obligations acquired by the Turkish banks. The activities of the banks served to not only undermine some of the economic reforms underway, they threatened the stability of the banking system itself—the pillar of any market economy’s ability to grow and develop.

2. Describe precisely how the Turkish banks were performing uncovered interest arbitrage. Do you feel this was an inappropriate investment policy?

Turkish banks simply took advantage—at least for as long as it lasted—of a very easy arbitrage opportunity. As illustrated in the following diagram, the Turkish banks borrowed Eurodollars at relatively attractive rates, 8.000% per annum. They then exchanged the dollars for Turkish lira at the currently fixed or managed exchange rate, TL500,000/$. The Turkish lira proceeds were then invested in Turkish government bonds yielding the higher inflation-based rates of 20.00% per annum. At the end of the period, the Turkish lira were then converted back to U.S. dollars at the fixed exchange rate of TL500,000/$, yielding an uncovered interest rate arbitrage profit of $120,000.


Note that the profits from the arbitrage activity as described here are in U.S. dollars. This was also a characteristic of the Turkish bank positions—ultimately positioning their profitability in the foreign hard currency, the U.S. dollar. The arbitrage activity could continue as long as the exchange rate at the end of the period did not change radically against the banks—a severe devaluation of the lira. This was what, in the end, occurred.

3. How could the Turkish banks be contributing to financial crisis if they were purchasing Turkish government bonds and helping finance and support their own government?

While it sounds helpful that the Turkish banks were promoting an active and growing market for Turkish government debt, and in the process allowing the government to finance its expenditures at a lower cost than without their activity, the source of their funds was the problem. By acquiring large quantities of dollar-denominated debt, for a country already running a current account deficit, this would inevitably lead to a currency crisis as the ability of the Turkish economy to generate sufficient hard-currency earnings (U.S. dollars in this case) in order to service this debt would fall short.

4. Which do you think is more critical to a country such as Turkey, fighting inflation or fighting a large trade and current account deficit?

The consensus among most international economists and various international organizations is that inflation is the first and foremost problem that must be controlled in order to establish a solid foundation for economic growth, industrial development, full employment, and managed trade. Current account deficits are not of themselves necessarily evil or destructive, but actually often a characteristic of a fully employed rapidly expanding economy.


5. The quote from Corporate Finance magazine, although noting the outside possibility of a devaluation, was largely positive regarding Turkey’s future in January 2001. What would you have thought?

It seems that throughout history, after every currency crisis, there is the wailing voice crying out “why didn’t you see this coming?” This quotation is rather useful in pointing out that in many (most?) currency crises there were at least murmurs in the marketplace prior to the crisis. The quotation points out that there have been some positive actions—the IMF capital injections—but that there are continuing problems with inflation. The latter was expected to drive the value of the lira down in the near future.


�� Problems

Problem 5.1 Brazilian real What was the percentage change in its value? Assumptions Values Spot rate, Monday January 11, 1999, R$/$ 1.21 Spot rate, Friday January 15, 1999, R$/$ 1.43 Calculation percentage appreciation or depreciation Percentage change in the real versus the dollar –15.38% Because the real fell in value: Depreciation


Problem 5.2 Turkish lira What was the exchange rate and percent devaluations? Assumptions Values Spot rate, February 20, 2001 (TL/$) 68,000 Turkish government announces a devaluation of: –20.00% Spot rate, February 24, 2001 (TL/$) 100,000 a. What was the exchange rate after devaluation? Spot rate after devaluation 85,000 Check calculation: percentage change in values –20.0% b. What was percentage change after falling to TL100,000/$? Percentage change from initial value –32.0% Percentage change from “devalued” value –15.0%


Problem 5.3 Mexican peso What was the percentage devaluation? Assumptions Values Spot rate, December 20, 1994 (Ps/$) 3.30 Spot rate, December 21, 1994 (Ps/$) 5.50 Calculation percentage of devaluation: Percentage change in the peso versus the dollar –40.00%


Problem 5.4 Russian ruble What was the percentage devaluation? Assumptions Values Spot rate, August 7, 1998 (Rub/$) 6.25 Spot rate, September 10, 1998 (Rub/$) 20.00 Calculation of percentage change: Percentage change in the ruble versus the dollar –68.75%


Problem 5.5 Thai baht What was the percentage devaluation? Assumptions Values Opening spot rate, July 2, 1997 (Bt/$) 25.00 Closing spot rate, July 2, 1997 (Bt/$) 29.00 Calculation of percentage change: Percentage change in the baht versus the dollar –13.79%


Problem 5.6 Ecuadoran sucre What was the percentage change in its value? Assumptions Values Initial spot rate, 1999 (Sucre/$) 5,000 Ending spot rate, 1999 (Sucre/$) 25,000 Calculation of percentage change: Percentage change in the sucre versus the dollar –80.00%

Problem 5.7 Forecating the Argentine peso What will be the peso’s future value in the coming weeks?

“Eye-balled” Date Values February 1st (Ps/$) 2.00 February 28th (Ps/$) 2.20 Percent change –9.09% If peso continued to fall at same rate for 1 month: March 1, 2002 (Ps/$) 2.20 Percent change –9.09% March 30, 2002 (Ps/$) 2.42 The period immediately following the peso’s devaluation was highly volatile and a period of transition. Most forecasters would view the February period as a period in which the new exchange rate is beginning to “stabilize” in its trading.

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Problems 5.8–5.10 Forecasting the Pan-Pacific Pyramid: Australia, Japan & The United States Gross Domestic Product Industrial Retail Unemployment Forecast Forecast Production Sales Rate Country Recent Qtr 2003 2004e 2005e Recent Qtr Recent Qtr Recent Qtr Australia 0.9% 2.8% 3.8% 3.1% –0.9% 7.7% 5.5% Japan 6.1% 2.3% 4.1% 2.1% 8.7% -0.5% 4.7% United States 4.4% 3.2% 4.7% 3.6% 6.3% 8.5% 5.6% Consumer Prices Producer Prices Wages & Earnings Forecast Country Year Ago 2003 2004e Latest Year Ago Latest Year Ago Australia 3.4% 2.7% 2.3% –1.1% 3.0% 5.1% 4.4% Japan –0.1% –0.3% –0.1% 1.1% –1.1% 0.7% 1.8% United States 2.1% 2.3% 2.3% 4.9% 2.4% 2.2% 3.0% Money Interest Rates (percent per annum) Supply 3-month money market 2-year 10-year Govt Bonds Corporate Country Growth Latest Year Ago Govt Bonds Latest Year Ago Bonds Australia 11.0% 5.48% 4.62% 5.18% 5.90% 4.73% 6.66% Japan 2.0% 0.02% 0.01% 0.20% 1.87% 0.63% 1.93% United States 5.5% 1.40% 0.88% 2.74% 4.70% 3.35% 6.11% Trade Balance Current Account Trade-Weighted Exchange Currency Last 12 mos Last 12 mos Actual 2003 Forecast 04 Rate (1990 ==== 100) per Pound Country (billion $) (billion $) (% of GDP) (% of GDP) June 23 Year Ago June 23 Australia –16.8 –$33.0 –6.2% –5.2% 81.6 83.5 2.65 Japan 121.4 $157.2 3.0% 3.3% 136.1 128.5 198 United States –568.9 –$537.3 –5.0% –5.1% 97.5 101.9 1.82

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8. Current spot rates. What are the current spot exchange rates for the following cross rates? a. Japanese yen/US dollar exchange rate = (yen/pound spot)/(US$/pound spot) 108.79 b. Japanese yen/Australian dollar exchange rate = (yen/pound spot)/(A$/pound spot) 74.72 c. Australian dollar/US dollar exchange rate = (A$/pound spot)/(US$/pound spot) 1.4560 9. Purchasing power parity forecasts. Assuming purchasing power parity, and that the forecast of consumer price increases for the coming year are correct, forecast the: a. Japanese yen/US dollar in 1 year = Spot (Y/US$) × (1 + Y-inflation)/(1 + US$-inflation) 106.24 b. Japanese yen/Australian dollar in 1 = Spot (Y/A$) × (1 + Y-inflation)/(1 + A$-inflation) 72.96 c. Australian dollar/US dollar in 1 year = Spot (A$/US$) × (1 + A$-inflation)/(1 + US$ inflation) 1.4560 10. International Fisher forecasts. Asssuming International Fisher applies to the coming year, forecast the following future spot exchange rates using the 2-year government bond interest rates: a. Japanese yen/US dollar in 1 year = Spot (Y/US$) × (1 + i-2year-Yen)/(1 + i-2year-US$) 106.10 b. Japanese yen/Australian dollar in 1 year = Spot (Y/A$) × (1 + i-2year-Yen)/(1 + i-2year-A$) 71.18 c. Australian dollar/US dollar in 1 year = Spot (A$/US$) × (1 + i-2year-A$)/(1 + i-2year-US$) 1.4906

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Problem 5.11–5.13 Forecasting the Pan-Pacific Pyramid: Australia, Japan & The United States Gross Domestic Product Industrial Retail Unemployment

Forecast Forecast Production Sales Rate

Country Recent Qtr 2003 2004e 2005e Recent Qtr Recent Qtr Recent Qtr

Australia 0.9% 2.8% 3.8% 3.1% –0.9% 7.7% 5.5% Japan 6.1% 2.3% 4.1% 2.1% 8.7% –0.5% 4.7% United States 4.4% 3.2% 4.7% 3.6% 6.3% 8.5% 5.6% Consumer Prices Producer Prices Wages & Earnings

Forecast Country Year Ago 2003 2004e Latest Year Ago Latest Year Ago

Australia 3.4% 2.7% 2.3% –1.1% 3.0% 5.1% 4.4% Japan –0.1% –0.3% –0.1% 1.1% –1.1% 0.7% 1.8% United States 2.1% 2.3% 2.3% 4.9% 2.4% 2.2% 3.0% Money Interest Rates (percent per annum)

Supply 3-month money market 2-year 10-year Govt Bonds Corporate Country Growth Latest Year Ago Govt Bonds Latest Year Ago Bonds

Australia 11.0% 5.48% 4.62% 5.18% 5.90% 4.73% 6.66% Japan 2.0% 0.02% 0.01% 0.20% 1.87% 0.63% 1.93% United States 5.5% 1.40% 0.88% 2.74% 4.70% 3.35% 6.11% Trade Balance Curent Account Trade-Weighted Exchange Currency

Last 12 mos Last 12

mos Actual 2003 Forecast 04 Rate (1990 ==== 100) per Pound

Country (billion $) (billion $) (% of GDP) (% of GDP) June 23 Year Ago June 23

Australia –16.8 –$33.0 –6.2% –5.2% 81.6 83.5 2.65 Japan 121.4 $157.2 3.0% 3.3% 136.1 128.5 198 United States –568.9 –$537.3 –5.0% –5.1% 97.5 101.9 1.82

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11. Implied real interest rates. If the nominal interest rate is the 2-year government bond rate, and the consumer price forecast is expected inflation, calculate the following real interest rates:

a. Australian dollar real rate forecast for 2003: = (1 + nominal)/(1 + 2yr – consumer price change forecast) – 1 2.82%

b. Japanese yen real rate forecast for 2003: = (1 + nominal)/(1 + 2yr – consumer price change forecast) – 1 0.30%

c. US dollar real rate forecast for 2003: = (1 + nominal)/(1 + 2yr – consumer price change forecast) – 1 0.43%

Note that none of the real interest rates calculated is larger than 1.8%. In the case of Japan, the real interest rate calculated

is only as large as it is because of the forecast deflation in the price level (negative change in consumer prices). In the case

of the United States, the real rate calculated is actually negative as a result of unusually low nominal interest rates while

consumer prices are still seen to be rising over 2% per annum.

12. Forecasting with real interest rates. Using the real interest rates calculated in problem 11, forecast the

following future spot exchange rates using real interest rate differentials:

a. Japanese yen/US dollar exchange rate in 1 year = Spot (Y/US$) × (1 + Y-real)/(1 + US$-real) 108.65

b. Japanese yen/Australian dollar exchange rate in 1 year = Spot (Y/A$) × (1 + Y-real)/(1 + A$-real) 72.89

c. Australian dollar/US dollar exchange rate in 1 year = Spot (A$/US$) × (1 + A$-real)/(1 + US$-real) 1.4906

13. Forward rates as forecasts. Calculate the 90-day forward rate on the following currency pairs using the current spot rate and the latest 3-month money market interest rates:

a. Japanese yen/US dollar 90-day forward rate = Spot (Y/US$) × (1 + i-3mo-Yen × 90/360)/(1 + i-3mo-US$ × 90/360) 108.42

b. Japanese yen/Australian dollar 90-day forward rate = Spot (Y/A$) × (1 + i-3mo-Yen × 90/360)/(1 + i-3mo-A$ × 90/360) 73.71

c. Australian dollar/US dollar 90-day forward rate = Spot (A$/US$) × (1 + i-3mo-A$ × 90/360)/(1 + i-3mo-US$ × 90/360) 1.4708

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Problems 5.14–5.15 Forecasting the Pan-Pacific Pyramid: Australia, Japan & The United States Gross Domestic Product Industrial Retail Unemployment Forecast Forecast Production Sales Rate Country Recent Qtr 2003 2004e 2005e Recent Qtr Recent Qtr Recent Qtr Australia 0.9% 2.8% 3.8% 3.1% –0.9% 7.7% 5.5% Japan 6.1% 2.3% 4.1% 2.1% 8.7% –0.5% 4.7% United States 4.4% 3.2% 4.7% 3.6% 6.3% 8.5% 5.6% Consumer Prices Producer Prices Wages & Earnings Forecast Country Year Ago 2003 2004e Latest Year Ago Latest Year Ago Australia 3.4% 2.7% 2.3% –1.1% 3.0% 5.1% 4.4% Japan –0.1% –0.3% –0.1% 1.1% –1.1% 0.7% 1.8% United States 2.1% 2.3% 2.3% 4.9% 2.4% 2.2% 3.0% Money Interest Rates (percent per annum) Supply 3-month money market 2-year 10-year Govt Bonds Corporate Country Growth Latest Year Ago Govt Bonds Latest Year Ago Bonds Australia 11.0% 5.48% 4.62% 5.18% 5.90% 4.73% 6.66% Japan 2.0% 0.02% 0.01% 0.20% 1.87% 0.63% 1.93% United States 5.5% 1.40% 0.88% 2.74% 4.70% 3.35% 6.11% Trade Balance Current Account Trade-Weighted Exchange Currency Last 12 mos Last 12 mos Actual 2003 Forecast 04 Rate (1990 ==== 100) per Pound Country (billion $) (billion $) (% of GDP) (% of GDP) June 23 Year Ago June 23 Australia –16.8 –$33.0 –6.2% –5.2% 81.6 83.5 2.65 Japan 121.4 $157.2 3.0% 3.3% 136.1 128.5 198 United States –568.9 –$537.3 –5.0% –5.1% 97.5 101.9 1.82

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14. Real economic activity and misery. Calculate the country’s Misery Index (unemployment ++++ inflation) and then use it like interest differentials to forecast the future spot exchange rate, one year into the future. Australia’s Misery Index 7.80% Forecast spot = Spot × ( 1 + Misery-1)/( 1 + Misery-2) Japan’s Misery Index 4.60% United States’s Misery Index 7.90% Starting Forecast Spot Rate Spot Rate a. Japanese yen/US dollar exchange rate in 1 year 108.79 105.46 b. Japanese yen/Australian dollar exchange rate in 1 year 74.72 72.50 c. Australian dollar/US dollar exchange rate in 1 year 1.4560 1.45 15. Balance of payments approach. Using the trade and current account information, forecast the direction of the spot exchange rates for the coming year. a. Japanese yen/US dollar exchange rate in 1 year Japan is running a trade & current account surplus US is running a trade & current account deficit Dollar should weaken against the Japanese yen. b. Japanese yen/Australian dollar exchange rate in 1 year Japan is running a trade & current account surplus Australia is running a trade & current account deficit Australian dollar should weaken against the yen. c. Australian dollar/US dollar exchange rate in 1 year Australia is running a trade & current account deficit US is running a trade & current account deficit Indeterminate.

Chapter 5

Foreign E

xchange Rate D

etermination

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Problem 5.16–5.17 Forecasting the Pan-Pacific Pyramid: Australia, Japan & The United States

© 2004 by Prof. Werner Antweiler, University of British Columbia, Vancouver BC, Canada. Time period shown in diagrams: 1/Jan/1999–7/Sep/2004 16. Current accounts and spot rates. Are the current account forecasts from the previous question consistent with the exchange rate trends shown above?

The Japanese yen appreciated in value against the US dollar over most of 2002 and 2003, stabilizing in 2004. This is consistent with the trade and current account balances being run by the two countries.

The Australian dollar consistently strengthened against the US dollar over 2002–2003 period. The US dollar recovered some of its lost value in 2004. Although Australia and the United States have similar inflation rate fundamentals, the Australian economy has grown at a more rapid rate in recent years.

17. Exchange rate trends and bounds. Use the graphs to determine trends, mean values, and upper and lower bounds to spot exchange rate movements. Upper Lower Trend Mean Bound Bound

Yen/US$ US$ down 110–115 135.00 102.50 A$/US$ US$ down 1.50–1.60 2.00 1.3

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undamentals of M


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