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This course is about...

Environment in which managers operate


Why does financial capital flow?
How are prices determined in international setting?
Why do countries trade?

Exchange rate determination:


What is exchange rate?
What are exchange rate regimes?
Why is it important for MNCs?

Economic Exposure and International Instruments


How do companies hedge?
Forwards, Futures, and Options.
Portfolio diversification.
International Finance is important
because we are now living in a highly
globalized and integrated world economy
Cross-border transactions

Production Globalization
Multinational Corporations go where cost is lower and profit is higher.
IBM = Korean keyboards + Taiwanese monitors + US chips + Malaysian
assembly + Indian preinstalled software.

Financial Markets Integration


These days investors can relatively easy pour money into overseas
markets.
Cross-listing of IBM, Sony, etc. (New York, Frankfurt, Tokyo)
What do Canadians sell?

OECD- Organization for Economic Co-operation and Development: Australia


Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Iceland, Ireland,
Italy, Japan, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Portugal, Spain,
Sweden, Switzerland, Turkey, UK, USA
WE EXPORT (millions of $)
Agricultural and fishing products (AgriCore United, La Coop Federee) 25,567.7
Wheat 3,406.8
Other agricultural and fishing products 22,160.9

Energy products (Imperial Oil, EnCana, Canadian Natural Resourses) 29,722.4


Crude petroleum 11,015.4
Natural gas 10,951.4
Other energy products 7,755.6

Forestry products (Abitibi-Consolidated, Canfor, Domtar, Tembec) 39,116.5


Lumber and sawmill products (Canfor Corp.) 19,659.5
Wood pulp and other wood products 6,961.9
Newsprint and other paper and paperboard products (ABITIBI-CONSOLIDATED INC.) 12,495.1

Industrial goods and materials (Nova Chemicals, Novelis, Dofasco) 57,429.3


Metals and metal ores 5,081.7
Chemicals, plastics and fertilizers 18,518.1
Metals and alloys 18,292.6
Other industrial goods and materials 15,536.9

85,985.3
Machinery and equipment (Bombardier, Linamar, Pratt & Whitney Canada)
Industrial and agricultural machinery 16,591.0
Aircraft and other transportation equipment 17,852.9
Other machinery and equipment 51,541.4

95,493.8
Automotive products (General Motors of Canada, Magna)
Passenger autos and chassis 51,054.6
Trucks and other motor vehicles 19,375.7
Motor vehicle parts 25,063.5
What do Canadians buy?
Canadian imports
WE IMPORT (millions of $)

Agricultural and fishing products 17,643.4


Fruits and vegetables 4,931.3
Other agricultural and fishing products 12,712.1

Energy products 10,708.7


Crude petroleum 7,160.3
Other energy products 3,548.4

Forestry products 2,740.8


Industrial goods and materials 62,130.9
Metals and metal ores 14,086.7
Chemicals and plastics 22,675.8
Other industrial goods and materials 25,368.4

Machinery and equipment 108,168.2


Industrial and agricultural machinery 27,768.2
Aircraft and other transportation equipment 13,226.0
Office machines and equipment 16,908.1
Other machinery and equipment 50,265.9

Automotive products 75,916.1


Passenger autos and chassis 19,587.3
Trucks and other motor vehicles 10,644.6
Motor vehicle parts 45,684.2

Other consumer goods 36,954.2


Apparel and footwear 6,844.7
Miscellaneous consumer goods 30,109.5
Globalization

Over the past 50 years, international trade increased about


twice as fast as world GDP. There has been a change in
the attitudes of many of the world’s governments who
have abandoned mercantilist views and embraced free
trade as the surest route to prosperity for their citizens.

Trade Liberalization and Economic Integration


 General Agreement on Tariffs and Trade (GATT)

 American Free Trade Agreement (NAFTA)

 European Union (EU)

 WTO, NAFTA, and EU play a vital role reducing trade


barriers within regions
GATT

 General Agreement on Tariffs and Trade (GATT): 1947 reduces


import tariffs, increases the proportion of duty-free products.
Now it is World Trade Organization (WTO) that has the power
to enforce the rules of international trade.
NAFTA

 American Free Trade Agreement (NAFTA): 1994 includes


US, Canada, and Mexico and establishes trade free area.
The North American Free Trade Agreement (NAFTA)
calls for phasing out impediments to trade between
Canada, Mexico and the United States over a 15-year
period. For Mexico, the ratio of export to GDP has
increased dramatically from 2.2% in 1973 to 28.7% in
2001. The increased trade will result in increased
numbers of jobs and a higher standard of living for all
member nations.
EU

 European Union (EU): member states eliminated


barriers to the free flow of capital, goods, and people.
Globalization promotes formation of Multinational
Corporations

 MNC (sometimes MNE) is a firm that has


incorporated on one country and has production
and sales operations in other countries.
 A There are more than 60,000 MNCs in the world.
 Many MNCs obtain raw materials from one nation,
financial capital from another, produce goods with
labor and capital equipment in a third country and
sell their output in various other national markets.
Top 10 MNCs

1 General Electric United States


2 ExxonMobile Corporation United States
3 Royal Dutch/Shell Group Netherlands/ UK
4 General Motors United States
5 Ford Motor Company United States
6 Toyota Motor Corporation Japan
7 DaimlerChrysler AG Germany
8 TotalFina SA France
9 IBM United States
10 BP United Kingdom
There are four major dimensions that distinguish
international finance from domestic finance

International Finance is different because...

1. Foreign exchange risk

2. Political risks

3. Market Imperfections

4. Expanded opportunity set


Foreign Exchange Risk: exchange rates are very
volatile
 The risk that foreign currency profits may evaporate in
dollar terms due to unanticipated unfavorable exchange
rate movements.
 Suppose $1 = ¥100 and you buy 10 shares of Toyota for
¥100,000 (i.e. $100 per share = ¥10,000 per share).
 One year later the investment is worth ten percent more in
yen: ¥110,000
 But, if the yen has depreciated to $1 = ¥120, your
investment has actually lost money in dollar terms.
Political Risk

 Sovereign governments have the right to regulate the


movement of goods, capital, and people across their
borders. These laws sometimes change in unexpected
ways. (Enron, 1990 signed a contract to build India’s
largest power plant, spent $30m when the project was
canceled in 1995 by Maharashtra state politicians)
Market Imperfections

 Legal restrictions on movement of goods, people, and


money
 Transactions costs
 Shipping costs
 Tax arbitrage (Honda established production facilities in
Ohio to circumvent trade barriers)
Expanded Opportunity Set or “It doesn’t make
sense to play in only one corner of the sandbox”:

Lower cost of labor


Economies of scale: Canada and the US do
not need different versions of Microsoft
Word
Portfolio diversification: can diversify
country-specific risks
International Trade

Questions:

1) Why do countries trade?


2) What determines world-wide patterns of trade?
3) Who produces what, and why?

Theories of International Trade:

1) The Theory of Comparative Advantage


(David Ricardo, 19th century, benefits of international trade are connected to the differences
among countries in the relative OC of producing the same commodities)
2) Modern trade theory
The Theory of Comparative Advantage

Idea:
Countries with a lot of capital (K) have
comparative advantage in making
capital-intensive goods (e.g., cars), while
countries poor in capital but with a lot of
labor (L) should make labor-intensive
goods (e.g., textiles)

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Definition:
A comparative advantage exists when one
party can produce a good or service at a
lower opportunity cost than another party.
Example:
There are two countries, A and B, that can
each produce only food and textiles. Initially
they do not trade with each other.

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Textiles A production possibilities curve shows the various
amounts of food or textiles that each country can produce.
The production possibilities of country A are such that if
all its resources will be concentrated to produce textiles,
the country will produce 180 million yards of textiles.
If A puts all resources into the production of food, as
180 much as 300 million pounds of food can be produced.

Food
300 Country A can produce any combination of
food and textiles between these two points.
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Opportunity cost (OC) of good X is defined as “ how many units
of the other good Y you need to give up producing to
increase your production of X by 1 unit.
In this example, one unit of textiles has an opportunity cost of
300/180 = 1.6667 units of food. Similarly, to produce one
extra unit of food you need to give up 180/300 = 0.6 units
of textiles, or, in other words, an OC of food = 0.6 units of
textiles.
Geometrically, an OC of textiles is given by α and an OC of
food is given by β .

Textiles

180

β
300 Food
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Textiles

As a practical matter, citizens of country A must


choose a point along the production possibilities curve.
For example they can choose 200 million pounds of
food, and 60 million yards of textiles.

180

60
Food
200 300
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Textiles
Production possibilities of country B are such that if all
resources will be concentrated to produce textiles, 240
million yards of textiles will be produced.

If all resources will be put into the production of food,


country B can produce as much as 900 million pounds
240 of food.
180

60
Food
200 300 900 1,20
0
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Textiles

As a practical matter, citizens of country B must


choose a point along the production possibilities curve;
for example they can choose to produce 600 million
pounds of food, and 80 million yards of textiles.
240
180

80
60
Food
200 300 600 900 1,20
0
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Textiles Country A enjoys a comparative advantage in textiles
because they have to give up food at a lower rate than
B when making textiles.
Put another way, country B enjoys a comparative
advantage in food because they have to give up textiles
240 at a lower rate than A when making more food.
180 Geometrically, a CA exists because the slopes
80 of the production possibilities differ.
60
Food
200 300 600 900
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Textiles If countries specialize according to their comparative
advantage, then A should make textiles and trade for
food, while B should make food and trade for textiles.

240
180

80
60
Food
200 300 600 900
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Textiles Before trade, if both countries made only textiles, the
combined production would be 420 million yards of
textiles = 240 + 180.
420 Before trade, if both countries made only food,
the combined production would be 1,200 million
pounds of food = 900 + 300.
240
180

80
60
Food
200 300 600 900 1,200
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Textiles County B can produce food at a lower opportunity cost,
so let B produce the first 900 million pounds of food.

420 Country A can produce textiles at a lower


opportunity cost, so let them produce the first 180
million yards of textiles.
240
180

80
60
Food
200 300 600 900 1,200

30
Textiles
The combined production possibility curve with trade
is composed of the original curves joined as shown.
420

240
180

80
60
Food
200 300 600 900 1,200
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Note, that if people in country A consume only textiles while people in
county B consume only food, no trade is necessary. Country A will produce
and consume 180 units of textile (point Α ) and country B will produce and
Textiles consume 900 units of food (point Β ). The total world production will be at
point Ω (900 food and 180 textile).

420

240 Ω
180 Α

80
60
Β Food
200 300 600 900 1,200

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However, if people in both countries like to wear clothes and eat, the trade is
beneficial for at least one of the countries (or both) and does not hurt the
other. For example, if people like to eat exactly 900/180=5 times more units
of food then they wear units of textile, the world production with trade will
Textiles be at point Ω (900 food, 180 textile). In particular, country A will produce
all 180 units of textile and country B will produce all 900 units of food.
Without trade Country A will produce at point Α (225 food, 45 textile),
country B at point Β (514 food, 103 textile) and total production will be
420 739 food, 148 textile (which is less than in point Ω )

240 Ω
180
Β
80 Α
60
Food
200 300 600 900 1,200
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If people like to eat exactly 10 times more units of food than units of textile,
the world production with free trade will be at point Ω (1028 food, 102.8
textile). In particular, country A will produce all 102.8 units of textile and use
the remaining sources to produce 128 units of food, while country B will
Textiles produce 900 units of food. Without trade Country A will produce at point Α
(257 food, 25.7 textile), country B at point Β (654 food, 65.4 textile) and
total production will be 911 food, 91.1 textile (which is less than in point Ω )

420

240
180 Ω
Β
80 Α
60
Food
200 300 600 900 1,200
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If people like to eat exactly by 2 times more units of food then they wear units
of textile, the world production with trade will be at point Ω (548 food, 274
textile). In particular, country B will produce all 548 units of food and use the
remaining sources to produce 94 units of textile, while country A will produce
Textiles 180 units of textile. Without trade Country A will produce at point A (164
food, 82 textile), country B at point B (313 food, 156.5 textile) and total
production will be 477 food, 238.5 textile (which is less than in point Ω )

420


240
180 B
A
80
60
Food
200 300 600 900 1,200
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Without trade, the relative price of textile in terms of food depends on the
country’s opportunity costs. Assuming that 1 unit of food costs $1, the
price of textile in country A will be 300/180=$1.67 and it will be $3.75 in
Textiles country B. With free trade, the relative price should be the same in both
countries. It should be between the “no-trade” prices (i.e., between $1.67
and $3.75, including boundaries) and depend on the total world
production. In particular, it must be a tangent to the world’ production
420 possibility curve at the point of the world’s production

240
180 B

80 A
60
Food
200 300 600 900 1,200
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In situation depicted below the price of textiles must be 300/180=$1.67
(assuming that the price of food is $1). This is so because in equilibrium
country A must produce both food and textiles. As a result, any other price
will make production of one of the goods inefficient.
Textiles
Such price level implies that all benefits of the trade are ripped off by
country B while country A’s welfare is the same with or without trade.

420

240
180 Ω

80
60
Food
200 300 600 900 1,200
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In situation depicted below the price of textiles must be 900/240=$3.75
(assuming that the price of food is $1). This is so because in
equilibrium country B produces must produce both food and textiles.
Textiles In this case all benefits from trade are received by country A while
country B’s welfare does not change from free trade.

420


240
180

80
60
Food
200 300 600 800 900 1,200
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In situation depicted below the price of textiles may be any number
between 300/180=$1.67 and 900/240=$3.75 (assuming that the price
of food is $1). This is so because in equilibrium country B produces
only food and country A produces only textiles. Given each country’s
opportunity costs, It is beneficial for country B to produce food if and
Textiles only if the price of textiles is less than 900/240=$3.75 and it is
beneficial for country A to produce textiles if and only if the price of
textiles is higher than 300/180=$1.67. When prices are not equal to
the country’s opportunity costs the country will usually benefit from
trade, so in this case both countries are better off with free trade.
420

240 Ω
180

80
60
Food
200 300 600 900 1,200
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Key points:
 Comparative advantage matters for trade;

absolute advantage is irrelevant


 All countries benefit overall from free

trade
 Not all sectors within a country benefit from

reducing barriers to trade


 Consumers benefit (goods become cheaper)
 Exporting firms and their workers benefit from
the ability to sell their products abroad
 Uncompetitive firms facing new competition from
imports (firms that domestically produce goods
similar to the ones that are coming from abroad)
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Puzzle: If comparative
advantage determines
international trade, why does the
U.S. trade heavily with Canada,
Europe, and Japan?

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 Comparative advantage theory
clearly explains some international
trade patterns but not all.
 Modern trade theory: what other
factors influence patterns of trade.
 increasing returns to scale (many modern
products (pharmaceuticals, software, aircraft,
movies) require substantial fixed costs of research
and development but have more constant and
often substantially smaller marginal costs to
producing additional units of the product (entry is
difficult, so need to buy (another country will be
happy to sell since MC are low))
 differentiated products (consumer
preferences) (Honda, Toyota, Volvo, BMW)

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Comparative advantage: practice problem
(a) country C can produce 12 pounds of food or 4 yards of textiles per unit of input.
Compute the opportunity cost of producing food instead of textiles. Compute the
opportunity cost of producing textiles instead of food.
(b) country D can produce 12 pounds of food or 8 yards of textiles per unit of input.
Compute the opportunity cost of producing textiles instead of food. Compute the
opportunity cost of producing food instead of textiles.
(c) Which of the country has comparative advantage in food? In textile? What about
absolute advantage?
(d) draw the production possibilities curve for each country and the world’s production
possibility curve with trade
(e) If the world’s production of textiles is 6 yards, what will be the world production of food?
How much food and textiles will each of the country produce? What will be the relative price
of textile in terms of food? Which country will benefit from the free trade?
(f) If the world’s production of textiles is 10 yards, what will be the world production of
textiles and it relative price? How much food and textiles will each country produce? What
will be the relative price of textiles in terms of food? Which country will benefit from the free
trade?
(g) If the world’s production of textiles is 8 yards, what will be the world production of food?
How much food and textiles will each of the country produce? What will be the relative price
of textiles in terms of food? Which country will benefit from the free trade?
(h) If country C produces 2 yards of textiles, how much food country D produces?
(i) If country D produces 2 yards of textile, how much food country C produces?
(j) If people in both countries would like to consume same amounts of food as textiles, how
much food and textiles each county will produce and consume without free trade?
(k) If people in both countries would like to consume same amounts of food as textiles, how
much food and textiles is going to be produced by each country with free trade? What the
price of textiles is going to be if the price of food is $10/Lb? How many units of food and 43
Solution
(a) country C can produce 12 pounds of food or 4 yards of textiles per unit of input.
Compute the opportunity cost of producing food instead of textiles. Compute the
opportunity cost of producing textiles instead of food.

12/4=3 pounds

(b) country D can produce 12 pounds of food or 8 yards of textiles per unit of input.
Compute the opportunity cost of producing textiles instead of food. Compute the
opportunity cost of producing food instead of textiles.

8/12=0.67 yards

(c) Which of the country has comparative advantage in food? In textile? What about
absolute advantage?

For country D opportunity cost of producing textiles instead of food is 12/8=1.5<3


Therefore, country C has comparative advantage in food and country D has comparative
advantage in textiles. Since country D can produce more textiles than country C, country
D has absolute advantage in textiles. Neither country has absolute advantage in food

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(d) draw the production possibilities curve for each country
and the world’s production possibility curve with trade

Textiles
12

D 8

C 4

12 24
Food

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(e) If the world’s production of textiles is 6 yards, what will be the world
production of food? How much food and textiles will each of the country
produce? What will be the relative price of textile in terms of food? Which
country will benefit from the free trade?
Production will be in point E: 6 textile, 15 food. Country D will produce 6
Textiles textiles and 3 food, country C will produce 12 food. Relative price of textiles =
12/8=1.5 pounds of food. Country C will benefit, Country D will be indifferent
12

D8 E somewhere here

C 4

12 24
Food

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(f) If the world’s production of textiles is 10 yards, what will be the world
production of textiles and it relative price? How much food and textiles will
each country produce? What will be the relative price of textiles in terms of
food? Which country will benefit from the free trade?

Production will be in point E: 10 textiles, 6 food. Country C will produce 2


Textiles textiles and 6 food, country D will produce 8 textiles. Relative price of textiles =
12/4=3 pounds of food. Country D will benefit, Country C will be indifferent
12
E somewhere here

D8

4
C

12 24
Food

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(g) If the world’s production of textiles is 8 yards, what will be the world
production of food? How much food and textiles will each of the country
produce? What will be the relative price of textiles in terms of food? Which
country will benefit from the free trade?

Production will be in point E: 8 textile, 12 food. Country C will produce 12


Textiles food, country D will produce 8 textile. Relative price of textile will be
between 18/8=1.5 and 12/4=3 pounds of food. Both countries will benefit.
12

E
D8

4
C

12 24
Food

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(h) If country C produces 2 yards of textiles, how much food country D
produces?

Country C has comparative advantage in food. Since it produces textiles,


it must be the case that country D cannot produce enough textiles, i.e.,
Textiles country D produces as much textiles as it can (8 yards) and no food.
World production will be in point E: 10 textiles, 6 food.
12 E

D8

4
C

12 24
Food

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(i) If country D produces 2 yards of textile, how much food country C
produces?

Country D has comparative advantage in textiles. Since it produces only 2


yards, it must be the case that country C cannot produce enough food,
i.e., country C produces as much food as it can (12 pounds) and no food.
Textiles World production will be at point E: 2 textiles, 21 food.

12

D8
E

C 4

12 24
Food

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(j) If people in both countries would like to consume same amounts of
food as textiles, how much food and textiles each county will produce and
consume without free trade?

Draw the line: food=textiles. Intersection with each country’s production


Textiles possibility curve are that country’s production. Country C: produce and
consume food=textiles=3; country D: produce and consume
food=textiles=4.8

D8

C 4

12
Food

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(k) If people in both countries would like to consume same amounts of food as textiles, how much food and textiles is
going to be produced by each country with free trade? What the price of textiles is going to be if the price of food is
$10/Lb? How many units of food and textiles will be consumed by each country? Which country will benefit from free
trade?

Draw the line: food=textiles. Intersection with the world’s production possibilities curve
is the world production (food = textiles=9). Thus, Country C produces 9 food and 1
textiles, country D produces 8 textiles. (note that total production: food=textiles=9 is
higher than 7.8 as in case without the trade on the last slide). Relative price of textiles
Textiles = 12/4=3 pounds of food. Thus, price of textiles = 3*10=$30. It should be the case that
country D benefits while country C is indifferent. To find each country’s consumption,
12 D we can find how much money each country
makes (country C: 9*10+1*30=$120; country D:
8*30=$240) and use the prices of food ($10) and
F A textiles ($30) to find that country C consumes
8+x C food=textiles=3 and country D consumes
8 B food=textiles=6.
E Alternatively, since we
know that country C is
indifferent, it must
consume food=textiles=3
C 4 (as without trade), so,
country D consumes
food=textiles=6
M
O 12-3x 12 24
Food
∆ABC it is similar to ∆DEC → if AB =x then BC = 3x, since OA is a 45 degree
line OM = OF and 8+x = 12-3x , so x =1 and world production is (9, 9)
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