- •Chapter 3: The international financial marketplace key chapter concepts
- •Glossary of new terms
- •Financial challenge
- •Introduction
- •The global economy and multinational enterprises
- •Table 3—1
- •Table 3—1
- •Foreign currency markets and exchange rates
- •Direct and Indirect Quotes
- •Table 3 — 2 Spot Foreign Exchange Rates
- •Spot Rates
- •Forward Rates
- •Table 3 — 3. Forward Foreign Exchange Rates
- •Foreign Currency Futures
- •Table 3-4. Futures Contract Quotations
- •Foreign Currency Options
- •The Eurocurrency Market
- •Factors that affect exchange rates
- •Covered Interest Arbitrage and Interest Rate Parity
- •Purchasing Power Parity
- •Expectations Theory and Forward Exchange Rates
- •The International Fisher Effect
- •An Integrative Look at International Parity Relationships
- •Figure 3—1. International Parity Conditions: An Integrative Look
- •Forecasting future exchange rates
- •Using Forward Rates
- •Using Interest Rates
- •Foreign exchange risk
- •Transaction Exposure
- •Table 3-5. Example of Transaction Exchange Rate Risk
- •Economic Exposure
- •Translation Exposure
- •Table 3 – 6. Effect of a Decrease in the Exchange Rate on American Products' Balance Sheet
- •International finance and the practice of financial management
- •Ethical issues: payment of bribes abroad
- •Summary
- •Questions and topics for discussion
- •Self test problems
- •Problems
- •Solutions to self test problems
Economic Exposure
Economic (or operating) exposure refers to changes in a firm's operating cash flows (and hence the firm's value) that come about because of real rather than nominal changes in exchange rates. Real exchange rate changes occur when there are deviations from purchasing power parity (PPP). Under relative PPP, exchange rates should vary to reflect changes in the price level of goods and services in one country relative to another. For example, if the inflation rate in Mexico is 5 percent higher, per year, than in the United States, relative PPP says that the value of the Mexican peso can be expected to decline by about 5 percent relative to the dollar. Thus goods purchased in the United States from Mexico will cost the same as they did before the increase in Mexican inflation, after adjusting for the decline in the value of the peso.
Real exchange rate changes can affect the way competing companies in two countries do business and can impact the business conditions in the countries. Consider the exchange rate data in Table 3-2 between the Japanese yen (¥) and the dollar. In December 1993, $1 equaled about ¥108.8 ($1 ÷ 0.009191). In March 1986, $1 equaled about ¥179.5 ($1 ÷ 0.00571). In relative terms, the dollar was "weak" and the yen was "strong" in December 1993, whereas in March 1986, the dollar was "strong" and the yen was "weak."
The weakening of the dollar and the strengthening of the yen over this period has had a dramatic impact on firms doing business in the United States and Japan. The showcase example of these effects is the relative performance of the Japanese and American automobile industries. In the mid-1980s, Japanese products were generally cheaper (and of better quality) than their American counterparts. The Japanese share of the U.S. auto market was growing, restrained only by voluntary import restrictions agreed to by the Japanese. By 1993, the increased value of the yen relative to the dollar had reversed the fortunes of auto makers in both countries. Japanese autos were selling for several thousand dollars more in 1993 and 1994 than comparable U.S. products. American firms began to report significant increases in U.S. market share at the expense of the Japanese. Japanese auto firms were experiencing significant financial difficulties at a time when U.S. auto firms were reporting substantial increases in profit. U.S. firms also had begun exporting vehicles to Japan.
In an attempt to offset the impact of their significant economic exposure in the United Slates, Japanese firms have aggressively moved to establish manufacturing and assembly operations in the United States and some European countries, so that many of their costs will be denominated in the same currency as their revenues. Also, by locating plants in many different countries, multinational firms have the flexibility to shift production from one location to another, in order to offset unfavorable economic exposure.
Managing Economic Exposure. Economic exposure is much more difficult and expensive to manage than the shorter-term transactions exposure already discussed. Strategies to manage the impact of real changes in exchange rates in countries where a multinational firm operates include:
1. Shift production from high-cost, (exchange-rate adjusted) plants to lower-cost plants—for example, moving labor intensive sewing operations from U.S. textile plants to plants in Mexico.
2. Increase productivity—adopt labor saving technologies, implement flexible manufacturing systems, reduce product cycles, make use of benchmarking, i.e., copy your strongest competitors.
3. "Outsource" the supply of many of the components needed to produce a product to lower-cost locations — for example, some U.S. publishing houses have outsourced typesetting to areas in the Far East with lower labor costs.
4. Increase product differentiation to reduce the price sensitivity in the market — for example, the Japanese have moved more to the luxury car market as the yen has strengthened because of the greater price flexibility the luxury market provides relative to the economy car market.
5. Enter markets with strong currencies and reduce involvement in competitive markets with weak currencies — U.S. firms have become increasingly aggressive in entering the Japanese market as the yen has increased in value relative to the dollar.