1

Introduction Midterm Grades Executive Summary Due Today Chapter 8: Regional Economic Integration Case Study: Hyundai and Kia The “Trade Game” Chapter 9: The Foreign Exchange Market

Midterm Results High Score 120 (3 Students) Low Score 73

Best Study Sheet(s)– Keith Lee (Web Retail)– Julia Van Rosendael (Beryna)

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Best Diamond(s) Davey Gant (Global Green) Shadia Damra ( PCTE) Joseph Cornwell (PCTE) Douglas Bell (Web Retail) Keith Lee (Web Retail) Juan Manzanera (Web Retail) Sarthak Gandhi (Web Retail) Andres Echeverri (PCTE) Harpreet Kang ( PCTE) Vikram Bajaj (PCTE) Aayush Singhania (Global Green) Jorge Hernandez (Global Green) Akash Mathran (Paper 2 Paper) Philipp Krispin (Beryna) Livia Machado (Beryna) Julia Van Rosendael (Beryna) Preben Johannessen (Unirate) Mohammed Ahmed (Unirate) Gurmat Sahni (Unirate)

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Example: Children’s Book: U.S. Market

http://www.teagasc.ie/research/reports/foodprocessing/4984/eopr-4984.htmhttp://www.rif.org/us/about/press/1927.htmImage source: Google images search “diamond”

Example: Children’s Book: U.S. Market

Government Chance

DemandConditions

FactorConditions

Related & Supporting Industries

Firm Strategy, Structure, & Rivalry

Literacy ratesSize of the population

Michelle Obama advocates Children’s literacyGovernment cut Reading Program(provided 4.4M children w/ Free books)

Universities, publishers, artists,Technological innovation (printing & electronic)

Many Authors, Fierce CompetitionEntrepreneurship

Strong IP ProtectionCulture: Importance of reading to childrenPreference for picture booksPopularity of Gifts (holidays, birthdays, etc.)

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Wendy Jeffus

Harvard Summer School

Chapter 8: Regional Economic Integration

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Introduction Regional Trade Agreements –

– Agreements among countries in a geographic region to reduce, and ultimately remove, tariff and non-tariff barriers to the free flow of goods, services, and factors of production.

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India - Malaysia 06/30/11 - New Delhi: The India-Malaysia

Comprehensive Economic Cooperation Agreement (Ceca), which was inked earlier this year, will come into effect on July 1, 2011.

The Ceca envisions liberalization of trade in goods, trade in services, investments and other areas of economic cooperation. Trade between the two countries reached $10 billion in 2010-11, an increase of 26% from the previous year.

http://www.crossed-flag-pins.com/Friendship-Pins/Malaysia/Flag-Pins-Malaysia-India.jpghttp://www.financialexpress.com/news/India-Malaysia-trade-pact-comes-into-force-today/811228/

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Levels of Economic Integration Free trade area

– Barriers to trade are removed, but each country determines its own external trade policy Example: European Free Trade Association (Norway, Iceland, Liechtenstein, & Switzerland)

– Basically for industrial goods (i.e. heavy equipment) Customs union

– Internal barriers to trade are removed and a common external trade policy is adopted Example: Andean Community of Nations (Bolivia, Colombia, Ecuador, & Peru)

– Common external tariffs 5 – 20% Common market

– Has no barriers to trade between member countries, includes a common external trade policy, and also allows factors of production to move freely between members.

Example: MERCOSUR (Argentina, Brazil, Paraguay, & Uruguay) Economic union

– Involves the free flow of products and factors of production between member countries and the adoption of a common external trade policy, but it also requires a common currency, harmonization of members’ tax rates, and a common monetary and fiscal policy.

Example: EU (although not all members have adopted the common currency) Political union

– Occurs when a central political apparatus coordinates the economic, social, and foreign policy of the member states

Example: United States

http://www.efta.int/, http://www.comunidadandina.org/, http://www.mercosul.gov.br/

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Levels of Economic Integration

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Example: EU Trade Agreements

http://en.wikipedia.org/wiki/Member_State_of_the_European_Union

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Case for IntegrationPros Economic Arguments

– Stimulates economic growth in member countries

– Increases FDI and world production

– Countries specialize in goods and services that can be efficiently produced

– Creates additional gains from free trade beyond the international agreements such as the WTO

Political Arguments– Economic interdependence

creates incentives for political cooperation

This reduces the potential for violent confrontation

– Together, the countries have more economic clout to enhance trade with other countries or trading blocs

Cons Integration is hard to achieve and

sustain Nations may benefit but groups

within countries may be hurt.– Example: (Canadian & U.S. textile

workers) Potential loss of sovereignty and

control over domestic issues (especially for the “economically weaker” members)

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Trade Creation & Trade Diversion Economists point out that the benefits of regional

integration are determined by the extent of trade creation, as opposed to trade diversion

– Trade creation occurs when high cost domestic producers are replaced by low cost producers within the free trade area.

Example: NAFTA/Mexico, EU/Poland – Trade diversion occurs when lower cost external suppliers are

replaced by higher cost suppliers within the free trade area. Example: Britain imported lamb from New Zealand, until the EU

imposed the common external tariff. Now Britain imports lamb from France.

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Evolution of the European Union Product of two political factors:

– A desire for peace (after the devastation from WWI & WWII)

– A desire for strong political & economic position on the world stage

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EU Membership

Image Source: http://europa.eu/about-eu/countries/index_en.htm

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Enlargement of the European Union To qualify for EU membership applicants must:

– Privatize state assets– Deregulate markets– Restructure industries– Control inflation– Include EU laws into their own systems– Establish stable democratic governments– Respect human rights

Current Candidate Countries: Croatia, Iceland, Macedonia, Montenegro and Turkey.

– http://ec.europa.eu/enlargement/candidate-countries/index_en.htm

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Key Dates 1951 - European Coal and Steel

Community. 1957- Treaty of Rome establishes

the European Community 1993 – Treaty of Maastricht

established the European Union January 1, 1999 11 countries January 1, 2001 + Greece - Greek

drachma (GRD) exchange rate of 340.750000

January 1, 2002 old currencies were not accepted

– Actually you could exchange currency for about 2 months until February 28, 2002.

Source: Wikipedia.org

EU Membership

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Economic Gains of 1 Currency Reduced exchange costs Reduced currency risk Increased price competition Major investment and export opportunities for

firms within region Allows firms to optimize mix of resources to

reduce overall costs

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Most Active Regional Trade Blocs

http://en.wikipedia.org/wiki/Trade_blocks

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In the news… July 2, 2009 - United States has decided to remove

Bolivia from the Andean Trade Preference Act, a bill that allows many goods from Colombia, Bolivia, Ecuador, and Peru to enter into the United States duty free.

– The idea behind the act is that providing tariff free access to the U.S. market will help convince farmers to stop growing coca in favor of another commodity.

– Bolivia was removed because it is not doing enough to reduce the cultivation of coca.

– The U.S. Trade Representative to Bolivia said there has been "explicit acceptance and encouragement of coca production at the highest levels of the Bolivian government."

– Coca is seen as a cultural crop in Bolivia, where it is used for numerous reasons other than cocaine (such as religious ceremonies and as a mild sedative).

http://www.examiner.com/x-9463-NY-International-Security-Examiner~y2009m7d2-Wake-up-Evo-Morales; Image Bolivia Coca tea (google images)CocoBlast Image: http://www.mysteriousbolivian.com/catalog/COCA%20BLAST_thumb.jpg

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Implications for Managers Opportunities:

– Creation of single markets Protected markets, now open Lower costs doing business in a single market

Threats:– Differences in culture and competitive practices make realizing

economies of scale difficult– More price competition– Outside firms shut out of market– EU intervention in M&A

For your final project: discover what trade agreements are relevant for the country you have selected.

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Take a Break… Read the Handouts Hyundai and Kia team if you haven’t done so,

load your presentations on the desktop, grab a drink, meet your classmates…

see you in 10 min.

Image source: http://www.graduatejunction.net/images/take_a_break.jpg

After the case presentationI will select groups forthe “trade game”

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Case Study Hyundai and Kia Present a 5-10min (timed) assessment of the

case (answer case questions) All group members must participate.

23

Wendy Jeffus

Harvard Summer School

The Trade Game

Assignments Tier I $12,500

– Sojung (& Sojung’s Friend) – Douglas

Tier I $26,500*– Luis– Shadia

Tier II $27,500*– Sophie– Philipp– Preben– Davey

Tier II (somewhere between $0 and $45K)

– Keith– Helena– Andres– Rafael

Tier II $26,500– Livia– Lasse– Aayush– Juan Carlos

Tier III (Somewhere between $0 and $45K)

– Azamat– Joseph– Berre– Julia– Mohammed– Jorge– Sarthak

Tier III $0– Jonathan– Nakul– Vikram– Akash– Dominic– Jolly

Power Brokers– Harpreet & Divya

Bankers– Radhika &Alessandro

Chief Economists – Yu & Pong

24*Winning countries (congrats)

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The Game is Extended to 9pm! The Game is Extended to 9pm! (By the clock on the wall) Less than 15 seconds….Is the END of the

game.

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Trade Simulation Starting Output Prices (at least 3 inches each; higher price for red shapes)

– Small Triangle $500– Circle $500– Half-Moon with circle cut out $1,000– Large Triangle with Half-moon cut out

$1,500– Parallelogram with Square cut out

$1,500 Power Brokers’ Price List

– Pencil $3,000– Colored Paper (2 sheets) $3,000– Labor (per person) $4,000– Red Paper (1 full sheet) $10,000– Ruler $10,000– Scissors $12,000

The Bankers will pay you in cash for the shapes. You will need this cash to provide for the subsistence of your people (at $500 per person per year). You may also use this cash to purchase additional capital, raw materials, labor, and environmental tokens.

Meet your production quota - by paying the Chief Economist $500 for each citizen of your country. If you do not have enough money, then some of your people will starve, and DIE!

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Designing Negotiation Strategies Organizing to influence – creating, staffing, funding, and directing

institutions in ways that influence the trade negotiation process. Selecting the forum – identifying the most promising forum in which to

pursue one’s objectives and then ensuring that negotiations take place there.

Shaping the agenda – adding or removing issues from the agenda, dividing the larger agenda into modules for parallel negotiations, and establishing some high-level principles to govern the process.

Building coalitions – identifying potential winning and blocking coalitions and then devising plans for building supportive coalitions and breaking or forestalling opposing ones.

Leveraging linkages – linking and de-linking issues or sets of negotiations in order to create and claim value.

Playing the frame game – crafting a favorable framing of “the problem” and “the options”

Creating momentum – channeling the flow of the negotiations process in promising directions by establishing appropriate stages to take advantage of action forcing events.

http://www.petersoninstitute.org/publications/chapters_preview/392/02iie3624.pdf

29

Wendy Jeffus

Harvard Summer School

9: The Foreign Exchange Market

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Definitions Foreign exchange market

– A market for converting the currency of one country into the currency of another.

Exchange rate– The rate at which one currency is converted into another

Foreign exchange risk– The risk that arises from changes in exchange rates

Spot exchange rate– Rate at which a dealer converts one currency into another

currency on a particular day Forward exchange rate

– An exchange rate governing future transactions (can be used to reduce foreign exchange risk)

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The FX Market The following participants operate within the FX market:

– Individuals (investors and tourists)

– Speculators and arbitragers

– Governments (central banks and treasuries)

– Brokers and dealers

– Businesses Payments for exports & purchases from foreign suppliers Foreign income (licensing, royalty payments, etc.) Investment/Speculation/Hedging activities

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FX Rates and Quotations Most foreign exchange transactions involve the US

dollar.

Professional dealers and brokers may state foreign exchange quotations in one of two ways:

– European Terms - the exchange rate between the US dollar and Japanese yen is stated in European terms by the WSJ below ¥106/$

– American Terms - the exchange rate between US dollars and the Japanese yen can also be stated in American terms $0094/¥.

http://markets.ft.com/markets/overview.asp, http://online.wsj.com/public/page/2_1569.html?mod=2_1569

FT vs. WSJ

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FX Quotations Be careful reading FX quotes, know which

currency is first.

Source: http://online.wsj.com/mdc/page/marketsdata.htmlhttp://finance.yahoo.com/currency-investing

¥/$

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FX Market Foreign Exchange Market (FX Market) World’s largest financial market ($2.5 trillion

average daily turnover) Open 24 hours a day, 6 days a week

– Sunday at 5pm (EST) to Friday 4:30pm (EST)

Sydney & Tokyo west to Hong Kong & Singapore to Bahrain to Frankfurt, Zurich, & London to New York to Chicago to San Francisco & LA

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Currency Hedging Volkswagen, Europe’s largest carmaker, reported a

95% drop in Q4’03 profits. Two causes stood out:

– The unprecedented rise in the value of the Euro against the dollar

– Volkswagen’s decision to only hedge 30% of its foreign currency exposure as opposed to the 70% it had traditionally hedged.

Example:– Suppose the Jetta costs €14,000 to manufacture & ship from

Germany to the U.S. where it sells for $15,000.– If the exchange rate is $1 = €1, VW earns €1,000 on the sale.– If the dollar depreciates to $1.25 = €1 (or $1 = 0.80€) the

$15,000 price will only convert to €12,000.– In other words, VW would lose €2,000 on every Jetta sold!

7/13/11 Financial Times: Toyota shaken by quake and strong yen7/5/11 USA Today: Volkswagen’s New Plant in Tennessee

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Economic Theories of Exchange Rate Determination:

Exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another– Law of One Price– Purchasing Power Parity (PPP)– Money supply and price inflation– Investor psychology and “Bandwagon” effects

Exchange Rate Determination

Note: For additional information on exchange rates see: www.wendyjeffus.com,Exchange Rate Determination (A) and (B) under “International Finance”

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Law of One Price In competitive markets, identical products sold in

different countries should sell for the same price when their price is expressed in terms of the same currency.

– Assumptions: No transportation or other transaction costs No barriers to trade Tradable goods

Example: If the euro/dollar exchange rate is 0.78EUR/USD.

– A jacket selling for $50 in New York should retail for €39.24 in Paris ($50 x 0.78EUR/USD = €39.24)

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Example 1 You can rent a compact car in Washington, D.C. for

$31.99 You can rent a compact car in Bangkok, Thailand for

4000.00 BHT Therefore the exchange rate should be =

4000.00BHT/31.99USD = 125.04BHT/USD

Source: Avis.com

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PPP & The Law of One Price The implied exchange rate based on the

absolute theory of PPP is 4000.00BHT/31.99USD = 125.04BHT/USD

But the actual exchange rate today is 29.88BHT/USD.

Is the baht over or under valued vs. the dollar?

Calculate (implied – actual) / actual. 125.04 – 29.88 / 29.88 = 318% The baht is overvalued by 318% vs. the dollar.

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Example 2

http://www.burj-al-arab.com/ http://boston.langhamhotels.com/

You can enjoy a chocolate lunch for $30 per person at the Langham hotel in Boston.

You can enjoy a chocolate lunch for 250 AED per person at the Burj Al Arab hotel in Dubai.

Therefore the exchange rate should be 8.33AED/USD.

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PPP & The Law of One Price Given this information, the exchange rate should

be 8.33AED/USD. The actual exchange rate today is

3.6720AED/USD. Is the UAE Dirham over or under valued?

Calculate (implied – actual) / actual. 8.33 - 3.6720 / 3.6720 = 126% The UAE Dirham is overvalued by 126%.

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The Big Mac Hamburger Standard The Economist developed the Big Mac Standard

to track PPP:– Assuming that the Big Mac is identical in all countries,

it serves as a comparison point as to whether or not currencies are trading at market prices.

– A Big Mac in Switzerland costs Sfr6.30 while the same Big Mac in the US costs $2.54.

– The implied PPP of this exchange rate is:

$Sfr2.4803/ $2.54

Sfr6.30

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The Big Mac Hamburger Standard However, on the date of the survey, the actual

exchange rate was Sfr1.73/$, therefore the Swiss franc is overvalued by:

43.37% or 1.4337 Sfr1.73

Sfr2.4803

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Memories of your class…

Submitted by BC Student (Costa Rica) 2009

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Latte Index The Economist asked: what

can the price of Starbucks coffee—now served in as many as 32 countries—tell us about exchange rates?

– The theory of purchasing-power parity (PPP) says that, in the long run, exchange rates should move towards levels that equalize the prices of a basket of goods and services in different countries—ie, a dollar should buy the same amount of stuff everywhere.

Source: “Burgers or beans?” Jan 15th 2004 The Economist A new theory is percolating through the foreign-exchange markets

Example Senegal Rumors have it there are 2 local beers:

1. Gazelle

2. Flag Flag sells for CFA 300.

CFA 300 is the price in local currency [1]

The spot rate was 96.80 CFA Franc = 1 South African Rand, so the price in rand = 3.10 [2]

Implied PPP = 3.10/2.30 = 1.35 [3] 1.35/96.80 = 1.39%, which means

the CFA franc was over valued by 1.35% versus the rand.

Photo Source: Modified from www.mapsofworld.com/africa-political-map.htmhttp://www.thebackpacker.net/worldbeers/senegal/index.htmCFA stands for Communauté financière d'Afrique ("Financial Community of Africa").http://www.oanda.com/convert/fxhistory (CFA price is as of 3/13/99)http://www.corporatefinance101.com/fundamentals.of.corporate.finance/fundamentals.of.corporate.finance-615.html

The Beer Standard

Country Beer Currencyin local

currencyin

RandImplied

PPPSpot

(3/15/99)Under/Over

valued[1] [2] [3] [4] [5]

South Africa Castle Rand 2.3 2.3 NA NA NABotswana Castle Pula 2.2 2.94 0.96 0.75 27.54%Ghana Star Cedi 1,200 3.17 521.74 379.1 37.63%Kenya Tusker Shilling 41.25 4.02 17.93 10.27 74.63%Malawi Carlsberg Kwacha 18.5 2.66 8.04 6.96 15.57%Mauritius Phoenix Rupee 15 3.72 6.52 4.03 61.83%Namibia Windhoek N$ 2.50 2.5 1.09 1 8.70%Zambia Castle Kwacha 1,200 3.52 521.74 340.68 53.15%Zimbabwe Castle Z$ 9 1.46 3.91 6.15 -36.37%Source: International Finance, Chapter 4 (Economist , May 8, 1999)[2] local price / [4][3] Implied PPP = Price in local currency / 2.30[4] local / rand As of 3/15/99[5] % Over (Under) = (Implied PPP / Spot) - 1

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Exchange Rate Forecasting Individuals that believe in the efficient market theory believe that

prices reflect all available public information– Forward rates should be unbiased predictors of future spot rates

Individuals that feel there is an inefficient market believe that prices do not reflect all available information

– Forward exchange rates will not be the best possible predictor of future spot exchange rates

– If this is true, it may be worthwhile for international businesses to invest in forecasting services

Approaches to Forecasting– Fundamental analysis

Draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements

– Technical analysis Uses price and volume data to determine trends

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Technical Analysis Where is the dollar headed versus the yuan?

Exhibit 8.1 Conceptual Comparison of Transaction, Operating and Accounting Foreign Exchange Exposure

Moment in time whenexchange rate changes

Translation(Accounting) exposure

Transaction exposure

(Economic) Operating exposure

Time

Changes in reported owners’ equityin consolidated financial statementscaused by a change in exchange rates

Change in expected future cash flows arising from an unexpected change inexchange rates

Impact of settling outstanding obligations entered into before changein exchange rates but to be settled after change in exchange rates

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Example: Transaction Exposure Suppose that CHC Helicopters of Canada[1] has billed British

Petroleum (BP) for services provided to BP’s sites on the North Sea.– CHC’s invoice is for £1 million, due in three months.

When CHC Helicopters receives £1 million three months from now, it will convert the British pounds into Canadian dollars at the spot rate.

[1] A “world leader in supply logistics to offshore oil rigs” Photo source: http://www.chc.ca/

Imagine the exchange rate at time 0 = 1GBP/1CAD

What are three things that can happen to the British pound over the next three months?

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The Life Span of a Transaction Exposure

t1 t2 t3 t4

Seller quotesa price to buyer

(in verbal or written form)

Buyer placesfirm order withseller at price

offered at time t1

Seller shipsproduct (or

performs service) and bills buyer

(becomes A/R for the seller)

Buyer settles A/Pwith cash in

amount of currencyquoted at time t1

QuotationExposure

BacklogExposure

BillingExposure

Time between quotinga price and reaching a

contractual sale

Time it takes tofill the order aftercontract is signed

Time it takes toget paid in cash after

A/R is issued

Time and Events

Source: Modified from Multinational Financial Management, 11th edition, Ch 8, Exhibit 8.3

CHC offers services to BP for £1M

BP accepts bid for £1M

CHC provides services and bills BP £1M

t = 0Spot Rate(known)

t = 3 monthsSpot Rate(unknown)

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Example: Transaction Exposure Suppose that CHC Helicopters of Canada[1] has billed British

Petroleum (BP) for services provided to BP’s sites on the North Sea.– CHC’s invoice is for £1 million, due in three months.

When CHC Helicopters receives £1 million three months from now, it will convert the British pounds into Canadian dollars at the spot rate.

Core Issue:– The future spot rate cannot be known in advance. Consequently, in

terms of the CAD, the value of the settlement is uncertain. – If CHC Helicopter does nothing to address this uncertainty, it is

effectively speculating on the future course of the exchange rate. Doing nothing is as if CHC is willing to take a bet that the British pound will appreciate against the Canadian dollar.

[1] A “world leader in supply logistics to offshore oil rigs” Photo source: http://www.chc.ca/

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Risk-sharing Risk-sharing is a contractual arrangement in which the

buyer and seller agree to “share” or split currency movement impacts.

– Example: Ford purchases from Mazda in Japanese yen at the current spot rate as long as the spot rate is between ¥115/$ and ¥125/$.

If the spot rate falls outside of this range, Ford and Mazda will share the difference equally.

Photo source: http://www.mitsubishicars.com “Eclipse Spider”

Mazda(Japan)

Ford(U.S.)

¥115 ¥125parts

cash

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Risk-sharing: Example Ford purchases from Mazda in Japanese yen at the current spot rate as long

as the spot rate is between ¥115/$ and ¥125/$ -- and if the spot rate falls outside of this range, Ford and Mazda will share the difference equally.

…So if on the date of invoice for a ¥25M payment, the spot rate is ¥110/$, then Mazda would agree to accept the following amount from Ford:

Note that this movement is in Mazda’s favor but it didn’t cost Ford as much as it could have (Ford saved $5,050)…

¥25,000,000 ¥25,000,000$222,222

¥5.00/$ ¥112.50/$¥115.00/$ - 2

¥115 ¥125Mazda(Japan)

Ford(U.S.)

¥110/$

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Reducing FX Exposure Reducing Translation and Transaction Exposure

– These tactics are primarily designed to protect short-term cash flows from adverse changes in exchange rates

Firms can use a lead strategy – Attempt to collect foreign currency receivables when a foreign currency

is expected to depreciate Expect foreign depreciation: Collect Early

– Paying foreign currency payables before they are due when a currency is expected to appreciate

Expect foreign appreciation: Pay Early Firms can use a lag strategy

– Attempt to delay the collection of foreign currency receivables if that currency is expected to appreciate

Expect foreign appreciation: Collect Late– Delay paying foreign currency payables if the currency is expected to

depreciate Expect foreign depreciation: Pay Late

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Why Hedge?1. Risk aversion.

– Maybe you would prefer a sure $10 million over a 50/50 chance at $20 million.

2. Focus on the business of the company rather than “currency speculation” which makes available cash more volatile and takes resources away from the core business.

Davey… Imagine you were asked to pay $1,000,000 on

Friday July 15th… …but you forgot and turned off your computer Did you turn it back on and do the trade… …or go home and wait to do the trade on

Monday?

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Were you fired or promoted? On Friday July 15th the exchange rate between

the S. African rand was 6.88… On Monday July 18th the exchange rate was

6.97… I hope you turned your computer back on!

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Livia… Imagine you were asked to pay $1,000,000 on

Friday July 15th… …but you forgot and turned off your computer Did you turn it back on and do the trade… …or go home and wait to do the trade on

Monday?

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Were you fired or promoted? On Friday July 15th the exchange rate between

the Brazilian real was 1.57… On Monday July 18th the exchange rate was

1.58… I hope you turned your computer back on!

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Mohammed… Imagine you were asked to pay $1,000,000 on

Friday July 15th… …but you forgot and turned off your computer Did you turn it back on and do the trade… …or go home and wait to do the trade on

Monday?

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Were you fired or promoted? On Friday July 15th the exchange rate between

the Egyptian pound was 5.9529… On Monday July 18th the exchange rate was

5.9295… I hope you waited until Monday!

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Hedging Pros & ConsArguments Against Hedging Shareholders are much more

capable of diversifying currency risk than the management of the firm

Currency risk management does not increase the expected cash flows of the firm

Management often conducts hedging activities that benefit management at the expense of the shareholders (agency conflict)

Managers cannot outguess the market

Arguments Supporting Hedging Reducing the risk of future cash

flows improves the planning capability of the firm

…and the likelihood that the firm’s cash flows will fall below a necessary minimum (the point of financial distress)

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Management is in better position to take advantage of disequilibrium conditions in the market

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Currency Convertibility In some countries the ability to convert currency is restricted by the

government. Government restrictions can include

– A restriction on residents’ ability to convert the domestic currency into a foreign currency

– Restricting domestic businesses’ ability to take foreign currency out of the country

Governments will limit or restrict convertibility for a number of reasons that include:

– Preserving foreign exchange reserves– A fear that free convertibility will lead to a run on their foreign exchange

reserves – known as capital flight

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Implications for Managers It is critical that international businesses

understand the influence of exchange rates on the profitability of trade and investment deals – Adverse changes in exchange rates can make

apparently profitable deals unprofitable

For your final projects: know the currency, determine if it is fixed or floating, report whether it is expected to strengthen or depreciate, and discuss the impact on your investment.